fy ba micro economics[1]

First Year Bachelor of Arts

Micro Economics [With effect from 2007-08]

Micro Economics With effect from June 2007

F.Y.B.A

Lecture Notes

Dr. Ranga Sai Vaze College, Mumbai

Dr.Ranga Sai

Micro Economics, F.Y.B.A. (w.e.f. June 2007)

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First Year Bachelor of Arts

Micro Economics With effect from June 2007

Section I

Module 1: Introduction Meaning and scope of micro economics, Ceteris paribus

assumption, concepts and types of equilibrium: partial and general

Module 2 Consumer Behavior: Cardinal and ordinal approaches – Indifference

curve – consumers’ equilibrium, income, price and substitution effects;

Giffen’s paradox – Revealed preference Hypotheses – elasticity of

demand: price, income, cross and promotional – consumer surplus, Engel

curve

Module 3: Production and costs

Production; short run and long run – law of variable proportions –

isoquants, iso-cost line and producers’ equilibrium – returns to scale –

economies of scale – Cobb-Douglas production function

Module 4: Costs and revenue Costs: short run and long run cost, derivation of short run cost curves and

their relationship – derivation of long run average cost curve and its

features.

Revenue: Total revenue, average revenue and marginal revenue:

relationship between AR and MR under different market structures:

relationship between AR, MR and elasticity of demand.

Section II

Module 5: Theory of firm

Objectives of a firm: Profit, sales and growth maximization – breakeven

analysis – analysis of equilibrium of a firm – pricing methods in practice:

marginal cost and full cost approaches

Module 6: Perfect competition

Perfect competition: features; short run equilibrium of the firm and

industry: derivation of supply curve of the firm and industry; long run

equilibrium of firm and industry

Module 7: Monopoly

Monopoly : features, short run equilibrium and monopolist under different

cost conditions and long run equilibrium of the monopolist; discriminating

monopoly, equilibrium under discriminating monopoly, dumping –

comparison between perfect competition and monopoly with respect to out

put and price

Module 8: Monopolistic competition and oligopoly

Monopolistic competition; features, equilibrium in the short and in the

long run , wastages under Monopolistic competition, features of oligopoly.

Available for free and private circulation

At www. rangasai.com and www. vazecollege.net

Dr.Ranga Sai


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CONTENT

Introduction Meaning and scope of micro economics,

Ceteris paribus assumption,

Types of equilibrium

Consumer Behavior:

Cardinal and ordinal approaches

Indifference curve – consumers’ equilibrium,

Income, price and substitution effects; Giffen’s paradox

Revealed preference Hypotheses

Elasticity of demand: price, income, cross and promotional

Consumer surplus,

Engel curve

Production and costs Production function

Law of variable proportions

Isoquants, producers’ equilibrium –

Returns to scale – economies of scale –

Cobb-Douglas production function

Costs and revenue

Cost concepts:

Short run

Long run cost,

Revenue concepts

Relationship between AR and MR.

Theory of firm

Objectives of a firm

Pricing methods in practice: marginal cost and full cost approaches

Perfect competition

Perfect competition: features;

Short run equilibrium of the firm and industry:

Derivation of supply curve of the firm and industry;

Long run equilibrium of firm and industry

Monopoly

Monopoly: features, short run equilibrium and different cost conditions

long run equilibrium

Discriminating monopoly

Dumping

Comparison between perfect competition and monopoly

Monopolistic competition and oligopoly

Monopolistic competition; features,

Equilibrium in the short and in the long run ,

Wastages under Monopolistic competition,

Features of oligopoly.

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Dear Student friends…

During these days of commercialization it becomes very difficult to find

information on web which is relevant, authentic as well as free.

We believe that knowledge should be free and accessible to all those who

need.

With this intention the notes, which are originally intended for the

students of Vaze College, Mumbai, are made available to all, without any

restrictions.

These notes will be useful to all the F.Y.B.A students of University of

Mumbai, who will be writing their Micro Economics examinations on or

during and after 20007-08. Distance Education students are advised to

refer the recommended syllabus.

This is neither a text book nor an original work of research. It is simple

reading material, complied to help the students readily understand the

subject and write the examinations. We no way intend to replace text

books or any reference material.

This is purely for academic purposes and do not have any commercial

value.

Feel free to use and share.

We solicit your opinions and suggestions on this endeavor.

Dr. Prof. Ranga Sai [email protected]

June 2010

Dr.Ranga Sai


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Module 1: Introduction

Nature and scope of Micro Economics

Micro economics is that branch of economics which analyzes the market

behavior of individual consumers and firms to understand the decision-

making process of firms and households.

Microeconomics deals with economics decisions made at individual

level. The individual can be a consumer, the producer/firm, or a

household.

"Microeconomics deals with the decision making and

market results of consumers and firms".

In detail the microeconomics deals with decisions at

1. Consumption: The consumer aims at maximizing consumer

satisfaction, he has to optimize his performance within the

limitations of income and prices

2. Production: The producer has to coordinate inputs to produce

goods so that the out put is maximized and the cost is minimized.

The producer has to optimize, costs and factors.

3. Exchange: The buyers and sellers meet at the market. They have

conflicting interests. Depending on the market the prices are

determined which fulfill the consumer objectives as well as the

firm objectives.

4. Distribution: Distribution deals with determinations of factor

prices. It is important in the determinations of factor incomes/

household incomes.

5. Welfare: Welfare economics uses micro economic tools in defining

and optimizing welfare of a society.

Micro economic theories help in the designing the models of demand

forecasting, consumer behavior models, pricing and determination of

factor prices.

Most micro economic theories are partial equilibriums which provide in

depth details of a specific economic activity.

Ceteris paribus Ceteris paribus is a Latin phrase, which means “all other things being

equal or held constant”

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A ceteris paribus assumption is used to formulate scientific laws, for

separating factors which interfere while studying a cause and effect

relationship.

By holding all the other relevant factors constant, a cause and effect

relationship can be studies in greater detail.

In economics the laws are made based on the cause and effect

relationship. These functional relationships relate one dependent variable

and several independent variables.

Ceteris paribus represent relationships (such as demand and supply)

between two variables (such as price and quantity), holding all other

things constant, (or ceteris paribus), in order to isolate the influence of

one independent variable (such as price) on the dependent variable (such

as quantity).

The demand function relates the quantity demanded-Q, as an effect of

several factors like price-P, income-Y, advertising-A, and tax-T.

Quantity demanded, Q = f (P, Y,A,T/F)

Yet while studying the relationship as a law, it assumes all factors to be

constant and isolates one major determinant. The clause of keeping other

factors constant by retaining one major determinant for the purpose of

forming a law is called as ceteris paribus.

Economic equilibrium Equilibrium is a state of rest where there is no urge to change. The

equilibrium is attained by a set of two or more economic forces.

At equilibrium, the objectives of economic activity are achieved.

• Consumer equilibrium – consumer satisfaction is maximized;

• Producers’ equilibrium – the cost are minimized

• Market equilibrium – the price and quantity are so determined that

are acceptable to both buyers and sellers.

Economic equilibrium is not permanent. The equilibrium is valid as long

as the factors determining it remain unchanged. Any change in any one of

the factor, the equilibrium will undergo a change.

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Static equilibrium: In economics static equilibrium refers to rigid models

which do not accept more or changing variables. Subject to the given

set of variables, the equilibrium is attained. Such equilibrium may

not have large policy applications;

e.g. circular flow of incomes- it explains the relationship between various

economic activities

Dynamic equilibrium: It is an advanced economic model which gives

relationships between several economic variables and can also

accommodate change. Such economic models have large application

in policy making

e.g. input-output matrix of national income accounting provide

relationships as well as determinants at each level of economic

activity. The output of one sector becomes the input for the other

sector. This is an advanced model of explaining circular flow of

incomes. .

Partial and General Equilibrium

Partial equilibrium deals with a state of rest between few variable but has

a large ceteris paribus clause. The equilibrium explains only a part of

the economic activity.

Micro economic theories deal with partial equilibrium. Since the

theories deal with a specific activity, al other related variables are kept

constant.

These are specialized theories providing in-depth details.

Micro economic theories are mostly partial equilibriums. They are

applied in pricing, consumer decisions, demand forecasting etc.

General equilibrium in turn deals with macro economic state. General

equilibrium was first used by Lean Walrus to explain unity of

equilibrium at consumption and production. It is the state of rest at

macro level. Circular flow of incomes, effective demand, input output

tables are example of general equilibrium.

Equilibrium at macro level has to provide description at aggregate

level. So the general equilibrium may not provide depth of details as

in case of partial equilibrium.

General equilibrium is useful in policy and planning.

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Module 2 Consumer Behavior

Utility analysis of consumer behavior given by Marshall is based on the

cardinal measure of utility. The theory is based on the basic assumption

that the utility can be measured.

Accordingly, the theory describes utility as the want satisfying capacity

of a good. Such utility is classified as time utility- a good changes form

time to time depending on the seasons; place utility- a good changes

utility form place to place; form utility- where the good changes utility

with changing form.

Use value is the value of a good in use. It depends on thr want satisfying

capacity of the good.

Exchange value, on the other hand deals with what a good can get in

return in the market.

The value paradox states that use value and exchange value are inversely

proportional. With increasing use value of good its exchange value

decreases. e.g. water, air.

Similarly with increasing exchange value its use value decrease .e.g.

diamonds, gold

But a transaction can take place only when use value is equal to exchange

value. This conflict is called as value paradox.

Under the utility theory the consumer behavior is explained by the Law of

diminishing marginal utility. According to the law ‘with the increasing

use of a good its marginal utility decreases’.

The consumer maximizes his satisfaction by equating marginal utilities of

all the goods he consumes. This is called the law of equi-marginal

utilities.

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Indifference Curve Analysis

Consumption theory in economics contains two parts. Firstly, the theory

studies the consumer behavior and secondly, the theory will suggest the

consumer the way in which satisfaction van be maximized.

In utility analysis, the Law of Diminishing marginal utility studies

consumer behavior and the law of Equi-marginal utilities suggested a

method of maximizing consumer satisfaction.

Indifference curve analysis is a consumption theory given by Hicks and

RGD Allen. The theory is an improvement over Utility analysis. Utility

analysis had a major draw back that it measured utility in cardinal terms.

Indifference curve analysis measures utility in ordinal terms. Further, IC

analysis provides wider descriptions and details as compared to utility

analysis.

IC deals with various combinations of two goods which give the

consumer the same amount of satisfaction.

All these combinations give the consumer same amount of satisfaction. In

this case the consumer will not be able to choose any combination as

better than other. The consumer will be indifferent between these

combinations. The curve drawn indifference schedule is called the IC.

Hicks use an IC to explain the consumer behavior.

ICs can be understood better with the help of its properties.

Indifference Schedule

X Y

1 12

2 10

3 7

4 3

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Properties of Indifference curves

1. Indifference curves towards the axis represent lower satisfaction and

IC away from the axis represents higher satisfaction.

In the diagram IC 1 represents lower satisfaction and IC2 represents

higher satisfaction.

This is because on higher IC the consumption increases and on lower IC

consumption decreases.

It can be seen that for the same amount of Y the consumer gets +2 on IC2

and gets -2 on IC1. Higher the consumption higher the satisfaction and

lower the consumption lower the satisfaction

2. Indifference curves never touch the axis. By touching the axis the

indifference curve will represent only one good. In fact an IC should

necessarily represent two goods always.

3. Indifference curve is a down ward sloping curve. It slopes down

from left to right. A consumer has to sacrifice one goods to gain the

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other. This is essential to keep the level of satisfaction constant on an

IC.

4. On an indifference curve the marginal rate of substitution decreases.

The marginal rate of substitution, is the rate at which a substitutes one

commodity with the other.

By gaining one commodity the consumer shall sacrifice the other. This is

needed to keep the level of satisfaction constant on an IC.

the slope of an indifference curve, MRS = ∆y/∆x.

The marginal rate of substitution decreases on an IC. On the diagram it

can be seen that

On the upper half, the consumer sacrifices 4 Y for 1 X, that is the rate of

substitution is 4/1

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On the Lower half it can be seen that the rate of substitution is 1/ 4 i.e. the

consumer equates 1Y with 4 X.

This is because on the upper half the consumer has more of Y so he likes

more of X and lower half he has more of X so he likes more of Y.

In this process the rate of substitution decreases from 4/1 to 1/ 4.

On an IC the consumer expresses his utility behavior through decreasing

Marginal rate of substitution.

Comparing the IC analysis and the Utility analysis it can be seen that

the marginal rate of substitution is equal to the ratio of the marginal

utilities,

MRS = ∆Y/∆X = - MUx/MUy

5. An indifference curve is convex to the origin. Only on a convex curve

the marginal rate of substitution decreases. Slope of an IC is found by

drawing a tangent. The slope of the tangent is the slope of IC at that

point.

On a concave curve the slope of IC increases that is MRS increases. So it

is not an IC. Similarly, a straight line has constant slope or constant MRS

hence not an IC.

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A curve convex to the origin has decreasing slope or decreasing MRS,

hence, an IC.

6. Indifference curves need not be parallel. Converging indifference

curves are accepted to be correct.

7. Indifference curves do not intersect. Indifference curves need not be

parallel. Converging indifference curves are accepted to be correct but

they shall not intersect. Intersection of Indifference curves is considered

to be illogical, inconsistent and irrational.

In the diagram it can be seen that

Combination A gives larger satisfaction, because it is on a higher

indifference curve IC1

And

Combination B gives smaller satisfaction, because it is on a lower

indifference curve IC2

But

Combination C gives same satisfaction, yet it is on two indifference

curves IC1 and IC2.

Two indifference curves can not give same satisfaction. This is illogical,

inconsistent and irrational.

Foundations of Assumptions of Indifference curves:

Indifference curve analysis is based on the following assumptions:

1. Transitivity: It is assumed that the combinations are continuous to form

a curve. The combinations between two tested sets are given.

2. Ordinality: The indifference curve analysis considers ordinal measure

of utility. That is utility is compared but not qualified.

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2. Rationality: The consumer is rational. He always prefers higher

satisfaction to the lower and he knows all the combinations giving him

same satisfaction or different satisfactions.

3. Convexity: A convex indifference curve represents the consumer

behavior. The convex IC shows the utility behavior with out actually

measuring utility in cardinal terms.

4. Scale of preference: On a series of indifference curves the consumer

has a preference increases from low to high. The consumer always prefers

higher satisfaction to lower. This is called the scale of preference.

Price Line The price line represents the budget of the consumer. It is made up of the

money income of the consumer and the prices of two goods. The price

line deals with various combinations of two good that a consumer can

buy with in his limited income. This is only the possibility of buying and

does not represent the choice of the consumer. Given the price line, the

consumer can buy any combination on the line or combinations below the

line.

When the price of a good decreases the real income of the consumer

increases. Real income is what the consumer can buy with his money

income. With this, the price line will shift upwards on a single axis (shift

on X axis if the price of X decreases)

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Similarly, if the money income increases the price line will shift upwards

parallel on both axes.

Consumer equilibrium

The consumer equilibrium suggests the method in which he consumer can

maximize satisfaction with in the given limitations of money income and

prices.

The indifference curve analysis is an improvement over the utility

analysis. It is given by Hicks and RGD Allen. As an improvement IC

analysis uses ordinal measure of utility in place of cardinal measure.

Assumptions

Consumer equilibrium is based on the following assumptions:

1. The prices of two goods are given and constant.

2. The money income of the consumer remains constant

3. The tastes and preferences of the consumer remain same

4. The consumer is rational, i.e. the consumer prefers larger satisfaction

to smaller satisfactions.

5. The theory follows all the foundations of indifference curves, like

convexity, transitivity, ordinality and scale of preference.

The consumer equilibrium considers the indifference map and the price

line.

The indifference map represents the consumer behavior, tastes and

preferences of the consumer. On the other hand the price line represents

income and the prices of two goods.

The indifference curve is made up of combinations the consumer wants to

consume on the other hand the hand the price line denote the

combinations the consumer can buy. Consumer equilibrium determines

such combinations which the consumer can buy, those which he likes and

finally gets maximum satisfaction.

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The consumer equilibrium is derived by combing the indifference curves

and the price line.

In the diagram

IC3 is possible because the consumer can not reach this with

his limited income.

IC1 is possible because there are several combinations with

in the budget; price line

IC2 and the price line have one combination common. At the

point of tangency between the IC and price line i.e. E.

This is the consumer equilibrium. A combination which offers maximum

satisfaction and is also falls with in the price line.

Conditions of Consumer Equilibrium

The consumer equilibrium is found at a place where Indifference Curve

(IC) and Price Line (PL) are tangential.

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Slope of the price line = Slope of the Indifference curve

Or Slope of the price line = Marginal Rate of substitution

[Equilibrium condition]

In the diagram

E1 is not equilibrium because slope of IC > Slope of PL

E2 is not equilibrium because slope of IC < Slope of PL

At E Slope of IC= Slope of PL, hence equilibrium

There are two conditions of consumer equilibrium

a. Necessary Condition: Tangency is a necessary condition.

It is case of optimizing satisfaction. In the diagram E2 is a

necessary condition. Yet it is not the equilibrium.

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b. Sufficient condition: Tangency + convexity is sufficient

condition. Tangency represents mathematical

optimization and convexity denotes consumer behavior. In

the diagram E2 is necessary condition. It fulfills tangency as

well as convexity.

Such consumer equilibrium remains valid as long as the price and money

income remain unchanged.

Income Effect Income effect shows the effect of changes in the money income of a

consumer on his consumption.

All other things remaining constant if the money income of the consumer

increases, the price line will shift upwards parallel. An upward shift of

price line indicates an increase in the income. With an increase in the

income the consumer will consume more. The IC will shift upwards on

the new price line. The increase in the consumption of a commodity is

called income effect.

When the money income increases the consumer shifts on to IC2. The

increase in consumption of X is called income effect. If we join the points

of equilibrium an income consumption curve can be drawn.

Income consumption curve shows changes in the consumption of a

commodity for changes in money income. The nature shape of the ICC

indicates the nature of commodity, whether normal good, inferior or

Giffen’s good.

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With increase in the money income if the consumption increases it is

called positive income effect and if consumption decreases with

increasing income it is called negative income effect.

The nature of income effect determines the shape of the Income

Consumption Curve.

ICC1: If the ICC slopes upwards to the right both X and Y are normal

goods with positive income effect.

ICC2: If the ICC slopes backwards, Y is inferior with negative income

effect and X is normal with positive income effect.

ICC3: If the ICC slopes forwards to the right, X is inferior with negative

income effect and Y is normal with positive income effect.

Assumptions

Income effect is based on the following assumptions:

1. The prices of two goods are given and constant.

2. The money income of the consumer is given and subject to changes.






Substitution Effect When the price of commodity decreases the consumer substitutes a

costlier commodity with a cheaper commodity with out affecting the level

of satisfaction. This is called Substitution effect.

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In the diagram, the movement from Eq1 to E2 is called substitution

effect. The consumer consumes more of X by sacrificing Y. The

movement is on the same IC showing that the level of satisfaction

remains same.

The substitution effect is always positive for normal as well as inferior

goods. For Giffen’s goods substitution effect is positive but very weak.

Substitution effect together with income effect constitutes the price effect.

Price Effect Price effect shows the effect of changes in the price of a good on

consumption.

All other things remaining constant if the price of a commodity increases,

the price line will shift upwards on that axis. An upward shift of price line

indicates an increase in the real income. With an increase in the real

income the consumer will consume more. The IC will shift upwards on

the new price line. The increase in the consumption of a commodity is

called price effect.

When the price decreases the consumer shifts on to IC2. The increase in

consumption of X is called price effect. If we join the points of

equilibrium a price consumption curve can be drawn.

Price consumption curve shows changes in the consumption of a

commodity for changes in price. The nature shape of the PCC indicates

the nature of commodity, whether normal good, inferior or Giffen’s good.

Assumptions

Price effect is based on the following assumptions:

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1. The prices of two goods are given and the price of one good only

changes.

2. The money income of the consumer is given and constant.






Composition of Price Effect

Price effect is made up of income effect and substitution effects. When

the price of a commodity decreases:

a. The real income increases and the consumer consume

more of a commodity. This is called income effect.

b. When a commodity becomes cheaper the consumer has a

natural tendency to substitute the costlier commodity with a

cheaper commodity. This is called as substitution effect.

Thus, Price Effect= Income Effect+ Substitution Effect

.

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In the diagram

E1 is the consumer equilibrium

With a decrease in the price of X the price line shifts upwards and

the consumer will shift on to IC2 at equilibrium E2. The

movement from E1 to E2 is called Price effect

To separate income effect from price effect-

Shift the price line parallel from E2 downwards, so as to reach IC1

at E3.

A parallel downward shift indicates decrease in the income.

The price line shall be shifted to such level on IC1 that the

consumer comes back on to his original level if satisfaction.

With a decrease in income effect the consumption is reduced to E3,

The consumption from E1 to E3 is substitution effect, found on the

same IC.

According to Hicks the price line should be shifted on to lower IC

such that the ‘consumer is neither better off nor worse off’

Nature of Price Effect

Positive price effect means with a decrease in the price the consumption

increases. This is same as the law of demand. The exception to the law of

demand is negative price effect.

The price effect is positive for normal goods and inferior goods. There

are some inferior goods where the price effect is negative. These goods

with negative price effect are called Giffen’s goods.

The price effect depends on the components - income and substitution

effects.

Income Effect Substitution Effect Price effect

Normal Goods +ve +ve +ve

Inferior goods -ve (weak) +ve (strong) +ve

Giffen’s Goods -ve (strong) +ve (weak) -ve

For normal goods the price effect is positive because the components

income and substitution effects are positive.

Inferior Goods In case of inferior goods in general, the price effect is positive.

The income effect is negative but very weak. The substitution effect is

positive and very strong. So finally, the price effect remains positive.

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In the diagram:

The movement from E3 to E2 is negative income effect. This is negative

The movement from E1 to E2 is positive substitution effect which positive

and strong.

So, finally, the movement from E1 to E2 is positive price effect.

Inferior goods in general follow the law of demand with positive price

effect.

Giffen’s Goods

Giffen’s goods are those inferior goods where the income effect is

strongly negative and substitution effect is weak.

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Giffen’s goods re inferior goods but all inferior goods are not Giffen’s

goods. Giffen’s goods are those inferior good which have a negative price

effect.

In the diagram:

The movement from E3 to E2 is negative income effect. This is negative

and strong

The movement from E1 to E2 is positive substitution effect which positive

but week.

So, finally, the movement from E1 to E2 is negative price effect.

Derivation of demand curve from Price Consumption Curve

For drawing the demand curve there is a need for a set of prices and

corresponding quantities. The Price Consumption curve shows different

price lines. Each price line represents one price of commodity X. The

corresponding quantities can be read fro the X axis at different

equilibriums.

The quantities from different equilibriums are drawn on the lower graph

with X axis marked quantity. The price at different quantities can be

plotted on the Y axis. By joining all the points the demand curve can be

drawn on

the lower panel.

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Elasticity of Demand

Elasticity of demand measures intensity of changes in the quantity of a

commodity for changes in the price, income or the price of a related

commodity. Accordingly, it is called price elastic, income elasticity or

cross price elasticity of demand.

Price Elasticity of demand

Price elasticity of demand measures proportionate changes in the quality

of a commodity for proportionate changes in the price.

Price elasticity relates quantity demanded and the price.

Price elasticity is measured as

The price elasticity has a negative value, because the price decreases for

an increase in the quantity demanded.

ep = 1, Unitary elastic, reference elasticity

ep > 1, Relatively elastic, luxury goods

ep < 1, Relatively inelastic, necessary goods

ep = ∞∞∞∞, Perfectly elastic, hypothetical

ep = 0, Perfectly inelastic, hypothetical

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The value of elasticity changes with changing responsiveness of quantity

changes for changes in the price. Larger the responsiveness greater will

be the elasticity. No change in the quantity the elasticity will be zero. For

highly sensitive quantity, the elasticity will be infinity.

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Income Elasticity of demand


of a commodity for proportionate changes in the income.

Income elasticity relates quantity demanded and the income.

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With an increase in the income the consumer increases the consumption.

This happens in case of normal goods. Incase of inferior goods with

increase in the income the consumer degreases the consumption. This is

called negative income effect.

For normal goods the value of income elasticity is positive for inferior

goods it is negative,

ey = 1, Unitary elastic, reference elasticity positive income effect

ey > 1, Relatively elastic, luxury goods positive income effect

ey < 1, Relatively inelastic, necessary goods positive income effect

ey < 0, Inferior goods negative income

effect

ey = 0, Perfectly inelastic, hypothetical

ey = ∞∞∞∞, Perfectly elastic, hypothetical

Cross Price Elasticity of Demand

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of one commodity for proportionate changes in the price of a related

commodity.

Cross Price elasticity relates quantity demanded of one commodity and

the price of a related commodity.

The value of cross price elasticity depends on the type of relationship

between the goods.

exy < 0, Complementary goods

When the price of X increases, the demand for x decreases, the consumer

decreases the demand for Y. Since, X and Y are complementary goods.

Complementary goods are those which give utility only in combinations.

These are called joint goods having joint demand. e.g. shoe and shoe lace,

pen and ink

exy > 0, Substitute goods

When the price of X increases, the demand for x decreases, the consumer

increases the demand for Y. Since, X and Y are substitutes.

Substitute gods are those goods which give similar utility. Since the

goods give similar utility the consumer can consume one in the place of

the other.

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exy = 0, Unrelated goods

If the price of X increase the demand for Y remains unchanged this is

because the goods are unrelated and independent in consumption and

utility.

Point Elasticity of Demand

According to Lucas all goods tend to be elastic at higher prices and

inelastic at lower prices. This principle can be shown geometrically on a

demand curve using point elasticity of demand method.

It is ratio of lower segment to the upper segment.

The elasticity increase as it moves upon the demand curve to the left.

The demand curve is extended on both sides so as to make a right angle

triangle.

Then the elasticity at point is measured as

E= Lower segment

Upper segment

Or BC

AB

So

e = 1, Unitary elastic, reference elasticity

e = 0, Perfectly inelastic, hypothetical

e > 1, Relatively elastic, luxury goods

e < 1, Relatively inelastic, necessary goods

e = ∞∞∞∞, Perfectly elastic, hypothetical

Promotional Elasticity of Demand

Promotional elasticity of demand measures proportionate changes in the

sales of a commodity for proportionate changes in the promotional

budget.

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Price elasticity relates sales and the promotional budget.

Promotional elasticity is a managerial tool of corporate decision making.

It enables the enterprise to decide whether a sales promotion budget is

desirable or not in terms of generating corporate incomes and sales.

An elastic promotional elasticity means that the sales are in larger

proportions than the promotional budget and desirable. If the promotional

elasticity is less than one that inelastic it means that the promotional

budget has failed in promoting proportionate sales, hence undesirable.

The promotional budget may have components like media, advertising,

sales promotions, free samples, gifts, promotional offers etc.

Revealed preference Theory Revealed preference theory s based on the observed behavior of the

consumer. A consumer during his consumption selects a combination of

goods. By selecting a combination of goods he rejects all other

combinations revealing his preference for consumption.

The revealed preference theory is given by Paul Samuelson.

The consumer selects combination P o the price line MN. By doing so the

consumer optimizes his satisfaction within the limitations of income and

prices. This is the case of revealed preference.

The consumer continues to be with this combination as long as the price

and income remains same. This is a case of strong order preference.

It is assumed that the consumer has not arrived at saturation. So the

consumer can always go for higher satisfaction. This is called as the non-

satiety condition.

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The consumer will leave this combination only when he can no longer

afford. If the price of A increases, the price line will shift down wards.

The consumer can no longer afford P . So he leaves combination P.

However, if there is an increase in money income the consumer will

rearrange his preference in a manner to attain P again

Consumer Surplus

Consumer surplus is the excess of Utility drawn over the price paid.

According to the law of demand the price decreases with increasing

quantity. This is because the utility decrease with in creasing

consumption as per the law of diminishing marginal utility.

A consumer pays the price according to the utility drawn on the last

commodity. This price is uniform for all the earlier units. In this process

the consumer derives surplus utility over the price paid on earlier units.

This surplus utility is called the Consumer Surplus.

Consumer surplus = Utility derived – price paid

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Consumer surplus is the excess of utility derived by consumer. The

producer surplus is the surplus of price charged by the producer over the

supply price. The supply curve shows that the price increases with

increasing quantity. The price is charged as per the last unit produced,

whereas the producer receives a surplus over the supply price. This is

called producers’ surplus. The producers’ surplus can be increased by

reducing consumer surplus. This is called consumer exploitation.

Assumptions

1. The concept believes in the law of diminishing marginal utility

2. The law of demand is considered for determining the price.

3. The price remains uniform.

4. The supply of goods is uniform.

5. The tastes of the consumer remain constant

6. There is perfect competition.

Limitations

The concept of consumer surplus has several limitations due to its rigid

assumptions.

1. The utility can not be measured

2. Consumer surplus can not be easily quantified.

3. Market imperfections deny consumer surplus to the consumer.

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4. Marketing techniques increase consumer surplus by showing greater

utility and then in crease price.

5. Consumer surplus encourages the government to levy tax.

Applications:

Consumer surplus is a very useful concept applied in marketing, product

design and pricing.

1. It helps in determining the price. Larger the consumer surplus, greater

the possibility of increasing the price.

2. The Government can determine tax based on consumer surplus.

3. Under monopoly, the producer charges different prices for the same

commodity depending on the consumer surplus. It helps on price

discrimination.

4. Necessities have larger consumer surplus than luxury goods.

5. Consumer surplus helps in demand forecasting.

Engel Curve

Engel curve relates changes in consumption for changes in the income.

The Income consumption curve tells us about changes in consumption

from changes in income. ICC can be used for deriving the Engel curve

Each shift in the price line represents increase in the money income. With

such shift the ICs shift upwards and the consumption increases.

Such increase in consumption is marked on the lower graph against

corresponding changes in the money income. Thus Engel’s curve is

derived on the lower graph.

The shape and slope of Engel curve depends on the shape and slope of

ICC.

ICC depends on the nature of goods whether, normal or inferior,

necessary good or luxury.

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Module 3: Production and costs

Production function

A production function provides the relationship between out put and

various factors of production. A production function is a functional

relation between the inputs and out put.

The production function can be classified as per time period. There can

be short run production function and the long run production function.

Between time periods the nature of factors can change.

In the long run all factors change; when all factors change there can be

large changes in the out put can be brought, the technology can change,

the cost structure may be totally renewed. So, the expression of long run

production function will be

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Quantity of out put,

Q = f ( Labour, raw material, power, land, buildings, machinery / T)

Where T, is technology; an embedded (associated) factor of production. It

is the qualitative description of capital,

In the short run certain factors are fixed certain other variable. Fixed

factors remain fixed even with changing out put. On the other hand

variable factors change with changes in the out put. So the expression of

production function will have fixed and variable factors.


Q, = f ( labour, raw material, power/ F , T)

Where F represents the fixed factors which remain unchanged in the short

run and T is the level of technology given and constant.

The short run production function will always carry the expression fixed

and variable, separately.

Law of variable proportions

The law of variable proportions studies the relationship between one

variable factor and the out put. It studies the behavior of out put for

changing variable factor. It deals with a short run production function

with one variable factors with all other factors are given and kept

constant.

Q, = f ( labour / F , T)

Where F represents the fixed factors which remain unchanged in the short

run and T is the level of technology given and constant.

According to the law of variable proportions, ‘all other factors remaining

constant, if the usage of one variable factor increases, the out put will

increase rapidly, then slowly and finally decreases’.

I Stage: Stage of increasing returns During the first stage the out put increase rapidly because

a. The variable factors become more and more productive, initially.

b. The fixed factors become more productive.

c. The elasticity of production is more than 1 ( Ep>1)

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During the first stage AP, MP and TP are increasing. MP reaches a

maximum called as the point of inflexion. From this point onwards there

will be a change in the level of factor productivity.

At the end of the stage, AP=MP and TP continues to increase.

Labour

Units

Total

Product

TP

Average

Product

AP

Marginal

Product

MP

Production

Elasticity

Stages of production

1 5 5 0 Increasing

2 8 4 3 Ep>1 returns

3 15 5 7 I Stage

4 24 6 9

5 30 6 6

6 30 5 0 Ep<1 Diminishing returns

II Stage

7 28 4 -2 Ep<0 Negative returns

III Stage

II Stage: Stage of diminishing returns During the second stage the out put increase slowly because

a. The factor substitution becomes limited

b. Other factors become less and less productive

c. The elasticity of production is more less 1 ( Ep<1)

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During the second stage AP decreases but it is slower than MP. Further,

MP<AP, MP decreases and TP is increasing, but slowly. At the end of the

stage MP=0

II Stage: Stage of negative returns

During the third stage the out put decreases because

a. There will overcrowding of one variable factor

b. Fixed factors also become less productive.

c. The elasticity of production is less than o ( Ep<0)

During the third stage, AP, MP and TP are all decreasing.

Assumptions:

1. All factors re given and remain constant and only labour changes

2. The level of technology remains same.

3. There is perfect competition in product and factor markets.

4. Variable factors are of similar productivity.

Isoquants

An isoquant is made up of various combinations of two factors which

give rise to a fixed amount of out put.

Isoquant deals with a production function with two variable factors.

Output = f (K,L / F ,T)

where K - Capital, L – labour, F – fixed factors, kept constant in the short

run and T – the technology given.

Each Isoquant deal with a specific level of out put. Isoquants away from

the origin represent higher out put and isoquants towards the axis

represent lower out put.

The Isoquant depends on the level of factor substitutability. Factors of

production are not perfect substitutes. The ridge lines give the limits of

factor substitutability. The area between the ridge lines is called the

economic zone. This is the area where there is factor substitutability. The

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analysis is confined to this area alone. The area out side the ridgelines can

not be used for any study, because the factor substitutability ends.

The slope of the Isoquant represents the Marginal rate of technical

substitution (MRTS). It is the ratio of change in K for changes in L.

The Marginal rate of technical substitution is the manner one factor is

substituted by the other factor so as to give a fixed output through out the

isoquant. Such slope of isoquant depends on the nature of factors and

intensity of production.

Producers' equilibrium (Least cost combination)

Producers’ equilibrium deals with a least cost combination of producing a

specific level of out put the producer would like to produce.

A producer will be a t a state of equilibrium when he produces a desired

level of out put at a cost which is least. This can be done by using

isoquants. By choosing isoquant we consider a production function with

two variable factors all other factors and technology remaining constant.


Where K - Capital, L – labour, F – fixed factors, kept constant in the short


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Firstly the producer will determine the level of out put to be produced;

the isoquant is selected. The producers' equilibrium is found at a place

where the slope of the isoquant is same as the factor price ratio line.

Mathematically, the slope of the isoquant is equal to the slope of the price

ratio line. Or the slope of the price ratio line is same as the Marginal rate

of Technical Substitution.

The producers' equilibrium finds the least cost combination. Least cost

combination is the combination of two factors which will produce a given

level of out put at least cost.

There are different least cost combinations for different levels of out put.

Assumptions

1. Producers’ equilibrium considers a production function with two

variable factors.

2. The level of technology remains same

3. All other factors are given and constant

4. There is perfect competition in factor and product markets.

The prices of two factors are given and remain unchanged.

Least cost combinations are found at different levels of out put by

following the condition of producers’ equilibrium. When all the points of

equilibriums or the least cost combinations at different levels of out put

are joined, the production path or the scale line can be derived.

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The shape and position of the scale line will indicate the type of

technology or the intensity of factor usage. If the production path is

towards the capital axis it is capital intensive, if it is toward the labour

axis the technology is labour intensive.

Laws of Returns to Scale

The laws of returns to scale deals with the long run production function.

In the long run all factors change; when all factors change there can be

large changes in the out put can be brought, the technology can change,

the cost structure may be totally renewed. So, the expression of long run

production function will be


Q = f ( Labour, raw material, power, land, buildings, machinery /

T)

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Where T, is technology; an embedded (associated) factor of production. It

is the qualitative description of capital,

According to the laws of returns to scale -

In the long run when the scale of production increase,

a. The out put may increase in larger proportions than the inputs

used called Increasing returns to scale

OR

b. The out put may increase in the same proportions as the inputs

used called Constant returns to scale

OR

c. The out put may increase in lesser proportions than the in puts

used called Diminishing returns to scale.

The laws of returns to scale can be explained with the help of isoquants.

By choosing isoquant we consider a production function with two

variable factors all other factors and technology remaining constant.


Where K - Capital, L – labour, F – fixed factors, kept constant in the short


1. Increasing returns to Scale According to Increasing returns to scale

In the long run when the scale of production increase, the out put may

increase in larger proportions than the inputs used called increasing

returns to scale

Increasing returns to Scale

- The gap between E1, E2, E3,

and E4 decreases

- Economies of scale

- Decreasing costs

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The out put responds positively because; it operates on economies of

scale. In the long run the firm derives certain advantages called

economies of scale. These economies of scale can come from within

called internal economies or come from out side the firm called external

economies.

Due to economies of scale the costs keep on decreasing. This is called

decreasing costs.

In the diagram it can be seen that the gap between the isoquants keep on

decreasing thus showing that lesser and lesser factors are needed for

producing additional output.

2. Constant returns to scale

In the long run when the scale of production increase, the out put

may increase in the same proportions as the inputs used called

Constant returns to scale

In case of constant returns to scale the out put increases in the same

proportions as the inputs. The firm is a said to be operating on neutral

economies. The firms neither get nor loose any advantages due to large

scale production.

In the diagram it can be seen that the gap between the isoquants remain

constant thus showing that same ratio of factors are needed for producing

Constant returns to Scale

- The gap between E1, E2, E3,

and E4 remains constant - Neutral Economies of scale

- Constant costs

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additional output. The per unit costs remain constant. This is case of

constant costs

3. Diminishing returns to scale.

In the long run when the scale of production increase, the out put

may increase in lesser proportions than the in puts used called

Diminishing returns to scale.

The out put responds discouragingly, because; it operates on

diseconomies of scale. In the long run the firm may face certain

disadvantages called diseconomies of scale. These diseconomies of scale

can come from within called internal diseconomies or come from out side

the firm called external diseconomies.

Due to diseconomies of scale the costs keep on increasing. This is called

increasing costs.

In the diagram it can be seen that the gap between the isoquants keep on

increasing thus showing that more and more factors are needed for

producing additional output.

Assumptions:

1. It is case of long run production function

2. The scale of production increases

Diminishing returns to

Scale

- The gap between E1, E2,

E3, and E4 increases

- Diseconomies of scale

- Increasing costs

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3. Technology remains same

4. There is a perfect completion in factor and product markets.

5. Each isoquant represents a fixed increment of output.

Economics of Scale

In the long run all factors becomes viable and the firm can increases its

scale of production. When the firm increases the scale of production it

gets certain advantages. These advantages are called economies of scale.

A. Internal economies of scale

These are the advantages the firm gets from the factors within the firm.

These factors are endogenous to the production function.

1. Managerial economies: In the long run the firm will have better

managerial talent in organizing factors for better productivity.

2. Technical economies: The firms will have improved

technology in the long run and the firm will progressively

reduce costs.

3. Economies of by product: The firm will be able to develop

waste into marketable by product in the long run. This will

add to the revenues of the firm.

4. Economies of supervision: Better supervision will improve the

factor productivity in the long run.

5. Economies of cost: With improved supply chain and labour

productivity the costs will reduce in the long run.

6. Economies of integration: In case of forward integration the

firm will undertake an additional process of production and

add value o the out put. The revenue will increase

Similarly, backward integration will enable a firm produce

such factors which were earlier bought form the factor

markets. This again reduces the cost and adds to the profit

margins.

7. Risk bearing economies: Firms will greatly increase capacity to

take risk with new products and technologies in the long run.

This is due to established market and strong finances.

8. Economics of specialization: The firm may develop certain

specialization in the long run depending on the production

function and acceptance in the market. This may create niche

and better price.

B. External economies of scale

These are the advantages the firm gets from the factors out side the firm.

These factors are exogenous to the production function.

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1. Economies of marketing: The firms will be able to market with

ease due to establishment of brand and dealership network

2. Economies of finance: The firms will have better financial

position in the long run due to accumulated profits. The firm will

also have better institutional axis for raising more finance easily.

3. Economies of environment: In the long run the firm becomes

more environmentally friendly with larger investment on

pollution control and resource conservation

Cobb-Douglas production function

The Cobb-Douglas production function represents the relationship

between output to inputs

The Cobb-Douglas production function deals with short run production

with two variable factors.

The function they used to model production was of the form:

Where:

• P = total production (the monetary value of all goods

produced in a year)

• L = labor input (the total number of person-hours worked

in a year)

• K = capital input (the monetary worth of all machinery,

equipment, and buildings)

• b = total factor productivity

• α and β are the output elasticities of labor and capital,

respectively.

These values are constants determined by available technology.

Output elasticity measures the responsiveness of output to a change in

levels of either labor or capital used in production, ceteris paribus. For

example if α = 0.15, a 1% increase in labor would lead to approximately

a 0.15% increase in output.

Further, if:

α + β = 1,

The production function has constant returns to scale. That is, if L and K

are each increased by 20%, then P increases by 20%.

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Returns to scale refers to a technical property of production that examines

changes in output subsequent to a proportional change in all inputs

(where all inputs increase by a constant factor). If, output increases by

that same proportional change then there are constant returns to scale.

If output increases by less than that proportional change, there are

decreasing returns to scale. If output increases by more than that

proportion, there are increasing returns to scale.

However, if

α + β < 1,

Returns to scale are decreasing, and

If

α + β > 1,

Returns to scale are increasing.

Module 4: Costs and revenue

Costs There are several concepts of cost developed, each suitable for a different

purpose. There are financial cost and social costs, accounting cost and

economic costs, short run and long run costs and the opportunity cost.

1. Accounting cost and economic costs: Accounting costs consider

documentation of expenditure for purpose of future analysis. It is

the analysis in retrospection. The analysis deals with spent money.

As against this, the economic cost study the nature of costs, their

behavior and methods of optimizing cists for minimizing cost of

production and maximizing profits.

2. Financial cost and social costs: Financial costs are private costs, the

costs paid by a firm to procure factors for creating out put. The

major consideration is optimizing usage of factors for cost

reduction and maximizing profits.

On the other hand the social cost deal with the burden of

production on the society, environment, and resource conservation.

Most of the social costs can not be quantified. But these cots are

very important in terms of social objectives and justice.

3. Financial costs and physical costs: Financial costs are economic costs

mentioned in uniform value terms. Since all the factors are

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mentioned in uniform terms, it is easy to apply any quantitative or

statistical method for regulating their usage and optimizing for

profits.

Physical costs on the other hand are factors mentioned in dissimilar

units. Since they are dissimilar in expression and quantitative, it is

not easy to apply techniques of quantitative analysis. Yet physical

costs are important for production planning and procurement of

factors.

4. Opportunity Cost: Opportunity cost is the cost of a factor in its

alternative use. This is the minimum which needs to be paid to

bring a factor in use. Any payment less than this will make the

factor leave the production function and join an alternative use.

The concept of opportunity cost is useful in determining the factor

price. The factor price needs to be equal to or greater than the

opportunity cost. Larger the opportunity cost higher will be the

factor price.

Short run Cost curves In the short run certain factors are fixed certain other variable.

Accordingly, certain costs are fixed and certain costs variable.

In the shot run there are three costs - total fixed cost, total variable cost

and total cost. In addition there are four per unit costs- average fixed cost,

average variable cost, average cost and the marginal cost.

Illustration: for a given TFC of 100 and TVC over 8 units, the costs will

be

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Out

put

TFC TVC TC AFC AVC AC MC

1 1000 100 1100 1000 100 1100 -

2 “ 180 1180 500 90 590 80

3 “ 240 1240 333 80 413 60

4 : 340 1340 250 85 335 100

5 “ 480 1480 200 96 296 140

6 “ 680 1680 166 113 179 200

7 “ 980 1980 142 140 282 300

8 “ 1480 2480 125 185 310 500

1. Total Fixed cost

The fixed cost remains constant in the short run at level of out put. The

fixed cost curve is a horizontal curve parallel to x axis. At zero level of

out put the total cost is equal to total fixed cost.

2. Total variable cost

The total variable cost increases with increasing cost. The shape of the

variable cost curve is drawn form the law of variable proportions. This

it has three segments. At zero level of out put the variable cost is zero.

3. Total cost

Total cost = Total fixed cost + Total variable cost

The total cost is the sum of total fixed cost and total variable cost. At

zero level of out put the total cost is equal to total fixed cost. The

shape and size of total cost is similar to total variable; cost but it starts

form total fixed cost.

4. Average Fixed cost

Average Fixed Cost = Total fixed cost

Out put

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Average fixed cost curve is a downward sloping curve. It keeps on

decreasing, but never touches the axis. It is asymptotic to x axis.

Geometrically, on this curve the product of coordinates always a

constant.

5. Average Variable Cost

Average Variable Cost = Total Variable Cost

output

Average variable cost is a broad U shaped curve; the shape of the

curve is drawn from the behavior of variable facto and the law of

variable proportions.

6. Average Cost

Average Cost = Total cost

Out put

Or Average Cost = Average Fixed cost + Average Variable

Cost

Average cost curve is a U shaped curve; the shape is derived by the

combination AC and AVC. AC curve lies above AVC. Average cost is

minimum when AC = MC

7. Marginal cost

Marginal cost = TC (n-1) - TC n

Marginal cost curve is a J shaped curve. It passes through the minimum

point of AC. When AC=MC, Marginal cost is minimum. The shape is

derived from the behavior of marginal product in the law of variable

proportions.

The short run Average Cost Curve is a U shaped Curve

The U shape of the average cost curve is made up of three segments;

down ward part, change in the trend and upward trend:

a. Initially, AVC and AFC are both decreasing so the resultant

AC also decreases

b. There after, AFC continues to decrease but AVC increases.

There is a change it the trend. The decreasing curve now

changes trend towards increase.

c. Finally, the increasing AVC is stronger than decreasing AFC

and AC now continues to increase.

The Ac curve takes a U shape.

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Further, Average Cost = Average Fixed cost + Average Variable Cost

So, the gap between AVC and AC is equal to AFC.

Long run costs The long run cost curves are derived from the short run cost curves. The

long run AC is derived from the short run AC. In the long run when the

scale of production increases, the AC curves shift down wards showing

decreasing costs. This is due to economies of scale. This is case of

decreasing costs

In the long run, when the scale of production increases, the AC curves

may shift horizontally to the right. This is due to neutral economies of

scale. This is case of constant costs.

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In the long run when the scale of production increases, the AC curves

shift upwards showing increasing costs. This is due to diseconomies of

scale. This is case of decreasing costs

The long run AC is made up of these three segments. Thus the LAC is

flatter than the SACs. The LAC is also called the envelope curve. For this

reason “The long run average cost curve is flatter than the

short run average cost curve.”

Long run Marginal cost curve passes through the minimum point of LAC.

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Following are the long run factors responsible for flatter long run average

cost curve:

1. Population

Though population changes even in the short run. The effect of

population can be seen only in the ling run, by way of changes in

the pattern of demand and labor force.

2. Technology

Technology helps in the ling run in reducing costs and making

production function efficient.

3. Alternative sources of raw material and energy

Alternative and cheaper sources of raw material and energy

change the production function and help in expanding out put and

making it economical.

4. Expanding markets

Expanding markets provide purpose for the industry to produce

and distribute. In the long run, mass consumption in the economy

increases.

Revenue concepts

Total revenue (TR): This is the revenue got by the firm by selling certain

amount of out put.

Average Revenue (AR): This is the average proceeds per unit. This is

same as the price. For this reason, the demand curve is same as the

average revenue curve.

Marginal Revenue (MR): This is the additional revenue got by affirm by

selling an additional unit.

Revenue relationships under perfect competition

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The price under perfect competition is determined by the industry. A

single firm is too insignificant to determine the price. Larger number of

firms together determines the price. Under perfect competition the

number of firms is so large that no single firm can, alone, influence the

price.

A firm can produce only an insignificant part of the total out put. This is

the reason why a firm continues to get the same price at any level of out

put. It means that the fir has a demand curve with infinite elasticity.

Quality Price TR AR MR

1 10 10 10 10

2 10 20 10 10

3 10 30 10 10

4 10 40 10 10

5 10 50 10 10

6 10 60 10 10

Under perfect completion the firm is a price taker and it has to determine

that level of out put which will give maximum profits. The firm has also

AR=MR in revenue relationships.

Revenue relationships under imperfect competition

A monopolist faces a downward sloping demand curve: Under monopoly,

there is no distinction between firm and industry. The demand is direct on

to the firm. Incase of perfect competition, the industry faces down ward

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sloping demand curve and the firm gets the perfectly elastic demand

curve. In case of monopoly the firm directly faced the downward facing

demand curve.

It means that the firm can sell more only by reducing price. With this

difference, the relation ship between AR and MR also changes


1 10 10 10 10

2 9 18 9 8

3 8 24 8 6

4 7 28 7 4

5 6 30 6 2

Relationship between AR and MR

AR and MR are downward sloping curves. MR curve lies below AR

curve. MR curve cuts the plane below AR curve into two halves.

Geometrically, it has a property:

A perpendicular drawn on Y axis will show

ab = bc.

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Relationship between Elasticity of demand and Revenues

Where e – is the point elasticity of Demand, AR is average revenue and

MR is Marginal Revenue.

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Section II

Theory of firm Objectives of Firm

The firm may have several objectives ranging from, economic, short run,

long run material and non material in nature. All objectives are important.

However the firm may decide its own priorities in objectives. Certain

firms may have material objectives significant certain other firms may

have normative objectives significant. Some objectives are uniformly

significant for all firms.

Following are some of the important objectives of a firm.

a. Economic objectives

Economic objectives are material objectives which may be short as well

as long run. Economic objectives are normally considered by all firms.

These economic objectives can be classified as follows:

1. Profit maximization:

Each firm tries to maximize profits. This is a universal objective

for firms. The firms aim at maximizing the difference between

total revenue and total cost.

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The firm will produce such out put which will give maximum

profit. The gap between TR and TC can be maximized by

drawing two tangents, one on each with same slope.

The slope of TC is MC and slope of TR is MR. By equating

slopes; MC is equated with MR.

So, MC=MR emerges as equilibrium condition for optimizing out

put for a firm.

Firms may aim at maximizing rate of profit or profit. The rate of

profit is maximized by pricing so that there is larger gross profit

margin. On the other hand maximizing profit may be attained by

maximizing out put.

2. Workers welfare

Workers welfare helps in maintaining harmonious relationships

and also maintaining high levels of productivity and loyalty.

3. Consumer satisfaction

Consumer satisfaction helps in maintaining brand image, market

share, prevents defection of consumers to another brand.

4. Investors benefit

In case of joint stock companies, the firm will aim at increasing the

net asset value of the company. Accordingly, it will have a investor

friendly policy in dividends and bonus.

5. Specialization

Specializing in certain product or service will be useful in

establishing brand image, market share and growth.

6. Creating brand equity

Every firm aims at creating a brand and as large consumer

following as possible. This is in the long run interest of the firm.

b. Long run objectives

1. Survival

The basic objective of firm is to survive in the long run. In the long

run the competition may increase, in such a market the basic

principle is to survive.

2. Market leadership

The firm wills always aim at being the market leader. This is a

material objective as well as normative objective. In most cases

profit depends on this objective.

3. Increasing market share

The firms will initially aim at increasing market share. This is the

objective before aspiring for market leadership.

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4. Growth: forward and backward integration

The firm may go for forward integration thus adopting an

additional process of production or take up backward integration

whereby, produce locally such component which was earlier

brought form the factor market.

c. Non material objective

1. Social responsibility

The forms may assume social responsibility as an important

factor. It is give back from the society from where the firm makes

a living.

2. Environmental protection

The firm may work in the direction of protecting the

environment. This is dome by being eco-friendly and having less

pollution.

3. Resource conservation

The resource conservation may help in reducing costs but it also

helps in reducing social costs. The society benefits form resource

conservation

4. Creating social infrastructure

The firm may create social infrastructure by constructing

educational institutions, hospitals, townships, and aforestation.

Break even Analysis

Break even out refers to the level of output where TR = TC. This is the

minimum out put the firm need to produce its costs. Any output there

after will grant profit to the firm. Usage of break even point for corporate

decision making is called Break even analysis.

At break even point total cost is equal to total revenue. After break even

point the profitability begins. The out put less than break even out put

shows losses.

Every firm aims at break even level of output in the beginning. The break

even level is a no profit no loss condition. In other words it is case of

normal profits. The costs cover only the manager’s remuneration and

there is no surplus over that. It is similar to the condition AR = AC.

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At break even point there are no profits, so TR = TC

Where,

TR is total revenue

TC is total cost

P is price

AVC is average variable cost

TFC is total fixed cost

Q is out put

Break even analysis is based on the following assumptions

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1. The cost and revenue functions are linear functions. This is for the

sake of simplicity.

2. The firm can estimate the cost and revenues in advance.

3. Price remains uniform at all levels of out put.

4. The costs are made up of fixed and variable costs.

Angle of Incidence

The angle of incidence is the angle made by the TR and TC functions at

the break even point. In break even analysis the angle of incidence is very

important in selecting a project among various competing projects.

The angle of incidence decides the nature of break even point.

If the angle of incidence is larger the break even out put will be smaller.

In other words, if the angel of incidence is smaller the break even out put

will be larger.

While comparing competing projects on the basis of break even points, a

project with larger angle of incidence will be selected. Because a firm

will always wishes to keep the Break even out put small so that, it can

operate on profits hat sooner.

Application of Break even analysis

A firm will firstly, attain the break even out put so that it can be out of

losses and start making profits.

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However, the firm needs to allot revenues for different purposes

depending on the earnings of profit or revenue.

Firstly, the firm will slot revenue for depreciation on assets. Depreciation

is a nominal expenditure. It is that part of fixed assets that is consumed

during the year and that part of fixed cost that can be charged to the out

put. Depreciation is the first priority after attaining break even out put.

When a firm makes profits it has to pay taxes. The firm now provides for

taxes after deducting depreciation.

Thereafter, marketing overheads can be deducted. These marketing

overheads are for more than one year. So if the revenue permits the firm

may provide for durable marketing overheads.

Finally, the revenue in excess of all these provisions yield profits that can

be distributed among owners or retained as reserves and surplus.

Limitations

1. Break-even analysis is only a supply side analysis, as it

tells you nothing about what sales are actually likely to be

for the product at these various prices.

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2. It assumes that the price remains uniform at levels of out

put

3. It assumes that fixed costs are constant

4. It assumes average variable costs are constant per unit of

output,

5. It assumes that the quantity of goods produced is equal to

the quantity of goods sold

6. In multi-product companies, it assumes that the relative

proportions of each product sold and produced are constant

Pricing Methods in practice

Marginal Cost Pricing

The Conventional pricing is followed when MC = MR, the price is

determined by AR curve. The conventional pricing is described by the

theory of firm and pricing. Independent of markets and competition the

pot put is determined by equating MC and MR. This as an optimizing

output will help in determining the price as per the AR (demand) curve.

Marginal Cost pricing: when AR=MC, the price is equated with Marginal

Cost. The Marginal cost pricing is more advantageous than conventional

pricing because, the out put tends to be larger than the conventional

method. Further, the price tends to be smaller.

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This is the method followed by the Government in most administered

pricing methods.

Administered pricing refers to the pricing adopted by the government in

determining the price of a product independent of market and profitability

considerations.

The resources are put to efficient use when the price equated with MC.

The price is lower and the out put is higher.

Thus way the government can encourage the consumption of a product

and also utilize the production capacity fully, thus achieving efficient

allocation of resources. The Government follows this method for pricing

petroleum prices.

Under administered pricing the Government can also follow Average cost

pricing: when AR=AC, the price is equated with Average Cost. This is a

pricing where the firm will be operating at normal profits. In this case the

out put is highest and the price is lowest. The government follows this

method for pricing products like fertilizers. The consumption of fertilizers

is desirable in the national interests in increasing the output of agriculture.

Full Cost Pricing

The corporate pricing practices are mostly based on the cost sheet

approach, where the price includes all the costs chargeable to the product.

The considerations of average and marginal costs are no more valid. The

cost sheet approach to pricing includes relevant inputs of production and

overheads.

Out line of cost sheet:

Direct labour + direct material+ direct expenses = Prime cost

Prime cost + Production over heads = Works cost

Works cost + administration overheads = Cost of

production

Cost of production + selling and distribution over heads = Cost of sales

Full cost pricing considers all relevant costs and over heads. The costs

include all the variable costs and part of fixed cots. The fixed cost is

represented in different ways

As per the standard accounting procedures, the fixed cost is represented

as depreciation. It is that part of the fixed capital that is consumed during

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that year on out put. The amount charged on the out put pit depends on

the life span of the asset and cost of replacement.

Alternatively, the fixed cost can be represented as the interest on fixed

capital for that year.

In both the cases the fixed capital is represented in the cost of production.

To this cost the firm will add a profit mark up. The price so determined is

called as the price of the product as per full cost pricing or profit mark-up

method.

Price = Mc + Lc+ FC+ π q Where,

Mc is the cost of material

Lc is the labour cost

FC is the fixed cost apportioned to the out put

q

π is the profit mark-up

Full cost pricing a popular method of pricing method. This is because of

its several advantages

1. Represents all costs

As against the conventional pricing methods, full cost pricing is

realistic

2. Fixed costs

Fixed costs are correctly represented. The costs which can be

assigned to the out put are correctly drawn.

3. Realistic representation of creation of utility

The cost represents the actual inputs going into production

representing their scarcities and productivities.

4. Easy for firms to adopt

Since it is simple and provides great scope for analysis of cost of

production it is commonly adopted by firms.

5. Flexible

The system is very flexible. Simple cost sheet method enables the

firm to apply the system across time and products.

6. Extendable to multi commodity or multi location pricing

A firm producing multiple goods or producing from various

locations can use the method easily. The system can be

integrated in multi- product pricing and branch accounting.

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Profit mark-up Profit mark-up is the rate of return expected by the firm on its sales. It is

the gross profit margin. Determination of Profit mark-up is matter of

great care and risk. Firms determine the Profit mark-up depending on

several factors.

The profit mark-up depends on several factors

1. Corporate policy

The policy of the firm will determine the level of profit mark-up

2. Nature of product

The product can be consumer good, further, consumer durable,

luxury good, perishable or similar. Profit mark-up changes in

each case.

3. Nature of market and competition

Market and competition have great bearing on the Profit mark-up.

Highly competitive markets will have lower Profit mark-ups.

4. Pricing strategy

Having a certain degree of Profit mark-up can be matter of

corporate strategy. It is an internal matter for a firm.

5. Industry standard

Every industry has its own standard of Profit mark-up. May it be

hospitality, automobile, housing or consumer goods; each has its

own degrees of Profit mark-up.

6. Product life cycle

The product life cycle decides the degree of Profit mark-up.

Whether the product is at introduction, growth, competition,

stagnant or decay will all have a Profit mark-up of their own.

7. Cost of capital

The cost of capital has a direct bearing on the levels of Profit

mark-up expected. There is a direct relation between these.

7. Expected rate of return or profitability

Each firm will have its own expected rate pf return on

investment. The Profit mark-up will depend on that.

Module 6: Perfect competition Perfect competition: features; short run equilibrium of the firm and

industry: derivation of supply curve of the firm and industry; long run

equilibrium of firm and industry

Perfect competition refers to a competition between large umber of

buyers and sellers dealing in homogenous product at uniform price.

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Features of perfect competition

1. Large number of buyers and sellers

The number of buyers and sellers should be so larger that no firm can

determine the supply or no single buyer can determine demand and no

singe person can determine the price.

2. Homogenous product

The product is homogenous, so that no form has a reason to charge a

different price.

3. Free entry and exit of firms:

When there is free entry and exit of firms, the firms keep joining the

production as long as there are profits. With new firms joining the super

normal profits, get distributed among more and more firms.

At the same time when the profits decrease the less efficient firms leave

the industry. So in the long run, efficient firms which can operate at

normal profits only exist. In the long run the perfect competition has only

firm which operate on normal profits.

4. Perfect knowledge

The buyers and sellers have perfect knowledge of \demand, supply and

price.

5. Free mobility of factors of production

Free mobility of factors ensures that the cost of factors is same across all

the regions. Equal factor prices give all the firms same opportunity to

make profits and survive. So, efficiency of firms will determine the

profitability of firms.

6. No transport cost

The transport cost should be insignificant as compared wt the cost of

production. This is possible only when the firms cater to local markets.

7. No advertising

The firms need not advertise, because each firm will have infinite market

at the given price. Advertising will add to cost and reduce profits

8. Uniform price

Uniform price ensures that the consumers have choice between firms and

the firms have no reason to charge different price due to homogenous

product.

9. No Government restrictions

There are no government interventions by way of taxes or mobility of

goods.

Price determination under perfect competition (Industry)

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The price under perfect competition is determined by the industry. Perfect

competition is a market condition where the buyers and sellers are

equally important in the determination of price. It is an ideal situation

whether both the buyers and the sellers are equally represented.

Under perfect competition the price is determined by the firms and

buyers, no single firm or buyer can influence the price. The buyers are

represented by demand curve and the firms are represented by supply

curve.

The demand curve indicates

� The choice and tastes of the consumers

� The utility of the good

� The utility behavior of the consumer

� The capacity and willing of the consumer to pay the

price

Similarly, the supply curve indicates

� The willing ness of the firm, to sell goods at different

price

� The cost conditions

� Nature of factor markets

Supply and demand curve together determine the equilibrium price. The

equilibrium price is the one which is acceptable to both buyers and

sellers. This is determined by the large number of buyers and spellers.

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Price Quantity

demanded

Quantity Supplied Market

10 600 1000 D<S Surplus

9 700 900 D<S Surplus

8 800 800 D=S Equilibrium

7 900 700 D>S Scarcity

6 1000 600 D<S Scarcity

At P1 D<S, Goods are not being sold, price is high

At P2 D<S, there is scarcity, the firms do not accept low price

At P3 D=S, the price is acceptable to both sellers and buyers

This is the equilibrium price. The price remains unchanged as long as the

demand and supply remain constant.

Nature of perfect competition:

Demand and supply are both responsible in the determination of

equilibrium.

According to classical economics, the equilibrium is a natural process;

the demand and supply get equated automatically.

Perfect competition encourages efficiency of firms. It leads to efficient

allocation of resources.

Perfect competition is an assumption for all the theories of economics.

The equilibrium quantity and price remain unchanged as long as the

demand and supply remain constant.

Out put determination under perfect competition by a firm

Perfect competition is a market condition where the buyers and sellers are

equally important in the determination of price. It is an ideal situation

whether both the buyers and the sellers are equally represented.

The price under perfect competition is determined by the industry. A

single firm is too insignificant to determine the price. Larger number of

firms together determines the price. Under perfect competition the

number of firms is so large that no single firm can, alone, influence the

price.

A firm can produce only an insignificant part of the total out put. This is

the reason why a firm continues to get the same price at any level of out

put. It means that the fir has a demand curve with infinite elasticity.

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1 10 10 10 10

2 10 20 10 10

3 10 30 10 10

4 10 40 10 10

5 10 50 10 10

6 10 60 10 10

Under perfect completion the firm is a price taker and it has to determine

that level of out put which will give maximum profits. The firm has also

AR=MR in revenue relationships.

Given, these condition the firm will optimize its out put at a point where

MC=MR,

Conditions of out put determination:

While maximizing out put the firm shall follow two conditions

I Order condition: MC=MR

II Order Condition: MC cuts MR from below.

At a point where MC=MR the difference between TC and TR will be

maximum.

The gap between TR and TC can be maximized by drawing two tangents,

one on each with same slope.

The slope of TC is MC and slope of TR is MR. By equating slopes; MC

is equated with MR.

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So, MC=MR emerges as equilibrium condition for optimizing out put for

a firm.

Nature of firm A firm can make profits or incur losses depending on the price and costs.

A firm can earn profits; normal profits and super normal profits or incur

losses; maximum bearable loss and shut down condition. Each on of this

will determine the nature of firm. This is true in case of any firm, whether

perfect competition or imperfect competition.

Normal profit: A firm is said to be making normal profit when AR = AC. The price (AR)

covers the costs. The cost includes the managers’ remuneration. However

there is no surplus above managers’ remuneration. If the entrepreneur

him self is the manager, he will receive normal profit as his share of

remuneration

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Normal profit is also called ‘no profit no loss’ condition or break even

point in managerial economics.

Super Normal profit: A firm is said to be making supernormal profits if AR > AC. The price

charged by the firm covers all the costs and also generates a surplus over

the expenditure. In this case the firm receives the managers’ remuneration

(normal profits) and also a surplus over it. Hence it is called super normal

profits.

Losses

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A firm is said to be making losses if, AR < AC. In case of loss there is a

need for further analysis. The firm needs to decide whether to stay in

production or shut down. In such a case Average variable cost (AVC) is

considered.

Maximum bearable loss: If AR = AVC the firm is said to be at maximum bearable loss.

The price received covers the AVC and the fixed cost is not covered. So

even if the firm closes down, in the short run the fixed cost remains as

loss. This is a case where, the loss remains same (fixed cost) whether the

firm stays in production or shuts down. This is called the maximum

bearable loss.

Shut down Condition If AR < AVC, the firm needs to close down.

The price received fails to cover fixed cost as well as a part of variable

cost. So if the firm closes down the loss is equal to fixed cost. If the firm

continues to produce the loss will be fixed cost and a part of variable cost.

So, the firm can reduce losses by closing down. This is called Shut down

condition

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Derivation of Supply curve from MC

Supply curve of a firm can be derived from the MC curve. A firm

determines its out put at a point where MC=MR. Under perfect

competition, it is known that AR = MR = P. So, MR can be considered as

price.

If MR keeps changing, the out put of the firm also changes. These

changes can draw the supply curve.

The form produces certain out put at MR1. As the MR keeps changing

from MR1 to 2 to 3 to 4; the out put also changes from Q1 to 2 to 3 to 4.

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This data of out put and prices can be drawn a different graph to get the

supply curve.

The out put and price remains directly proportional. The nature and shape

of MC curve determines the nature and shape of the supply curve.

Long run equilibrium under perfect competition

In the long run the following factors operate:

The supply becomes more elastic: With time, supply becomes more and

more elastic. So the price tends to decrease. The AR=MR received by the

firm also decrease. However, at the same time the average cost curve also

becomes flatter, showing decline in costs. Flatter AVC means more out

put being produced at lesser cost.

There is free entry and exit of firms: When there is free entry and exit of

firms, the firms keep joining the production as long as there are profits.

With new firms joining the super normal profits, get distributed among

more and more firms.





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The long run average cost curve becomes flatter than short run cost curve

Following are the long run factors responsible for changes in average cost

curve in the long run:

1. Population

Though population changes even in the short run. The effect of

population can be seen only in the ling run, by way of changes in

the pattern of demand and labor force.

2. Technology

Technology helps in the ling run in reducing costs and making

production function efficient.

3. Alternative sources of raw material and energy

Alternative and cheaper sources of raw material and energy

change the production function and help in expanding out put and

making it economical.

4. Expanding markets

Expanding markets provide purpose for the industry to produce

and distribute. In the long run, mass consumption in the economy

increases.

Hence in the long run the equilibrium of the firm is arrived at a point

where:

LAC = MR (long run) = LMC = AR(long run)

Where

MR (long run) =MC represents determination of optimum out put,

LAC = LMC indicate the firm operating at optimum level, and

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LAC = AR (long run) means the firm is operating on normal

profits

Module 7: Monopoly Monopoly refers to an imperfect market situation where a single seller

sells the product in different markets at uniform or discriminating prices.

Monopoly is identified with single firm large number of buyers and the

monopolist as the price maker.

Following are the features of monopoly market.

Features of Monopoly

1. Single seller: The monopoly market has a single firm. There is no

distinction between firm and industry. Since a single firm supplies to the

large number of buyers, the firm tends to be large and specializing in its

production

2. Large number of buyers: There is a large market even under monopoly.

However there may be differences in the elasticity of demand in each

segmented market.

3. Product: The product may be homogenous or even differentiated

depending on the nature of market and division of submarkets.

4. Monopoly power: The entry into monopoly market for other firms is

restricted. This is due to the monopoly power the firm has. The monopoly

power is got by the firm due to following factors.

a. Legal restriction: The law may prevent other firms from

entering. E.g. Government monopolies on entry

b. Exclusive ownership of technology of production: If the

technology of production is known only to a single

firm the monopoly power remains un effected.

c. Exclusive ownership of raw material: Access to raw

material is held by a single firm, the monopoly

power remains intact

d. Registered trade marks and brands: I case of registered

trade marks; firms can not duplicate and compete in a

market. It remains as monopoly.

e. Personal monopolies: Personal monopolies have

individual branding. They can not be duplicated. The

personal monopolies continue

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5. Price discrimination: With price discrimination a monopolist sells the

same product at different prices in different markets at the same time. The

objective of price discrimination is profit maximization.

6. A monopolist faces a downward sloping demand curve: Under

monopoly, there is no distinction between firm and industry. The demand

is direct on to the firm. Incase of perfect competition, the industry faces

down ward sloping demand curve and the firm gets the perfectly elastic

demand curve. In case of monopoly the firm directly faced the downward

facing demand curve.

It means that the firm can sell more only by reducing price. With this

difference, the relation ship between AR and MR also changes

Relationship between Average revenue and Marginal revenue

under monopoly

A monopolist faces a downward sloping demand curve, so he can sell

more only by reducing the price. This will change the AR and MR

relationship. Since it is an imperfect market, AR is not equal to MR. It

can be seen that AR is greater than MR. Further, AR and MR are related

through elasticity of demand.

Q Price TR AR MR

1 10 10 10 -

2 9 18 9 8

3 8 24 8 6

4 7 28 7 4

5 6 30 6 2

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Geometrically, AR curve cuts the plain below AR into two halves. So any

perpendicular drawn on Y axis will show the property, ab = bc

Equilibrium under simple monopoly

Under monopoly, the demand curve is downward sloping, so the AR and

MR curves also slope down wards and look different. However the

optimizing condition for out put remains same as in case of perfect

competition.

At a point where MC = MR the firm finds its equilibrium out put. When

MC = MR the difference between TC and TR will be maximum.

The output is found on the x axis. The price determination is done by AR

curve. This is the demand curve which will tell the maximum price that

can be charged for this level of out put.

In case of simple monopoly, there will be only one product and single

price. In case of differentiated monopoly

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Nature of firm A firm can make profits or incur losses depending on the price and costs.

A firm can earn profits; normal profits and super normal profits or incur

losses; maximum bearable loss and shut down condition. Each on of this

will determine the nature of firm. This is true in case of any firm, whether

perfect competition or imperfect competition.

Normal profit: A firm is said to be making normal profit when AR = AC. The price (AR)

covers the costs. The cost includes the managers’ remuneration. However

there is no surplus above managers’ remuneration. If the entrepreneur

him self is the manager, he will receive normal profit as his share of

remuneration

Normal profit is also called ‘no profit no loss’ condition or break even

point in managerial economics.

Super Normal profit: A firm is said to be making supernormal profits if AR > AC. The price

charged by the firm covers all the costs and also generates a surplus over

the expenditure. In this case the firm receives the managers’ remuneration

(normal profits) and also a surplus over it. Hence it is called super normal

profits.

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Losses A firm is said to be making losses if, AR < AC. In case of loss there is a

need for further analysis. The firm needs to decide whether to stay in

production or shut down. In such a case Average variable cost (AVC) is

considered.

Maximum bearable loss:

Shut down Condition If AR < AVC, the firm needs to close down.





condition.

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Monopolist under different Cost Conditions

Changing cost conditions are determined by changing returns to scale.

Increasing returns to scale leads to decreasing costs and decreasing

returns to scale leads to increasing costs. Constant costs are due to

constant returns to scale.

In case of increasing costs, the physical out put shows decreasing returns.

AC and MC curves will be upward sloping.

The monopolist will find his equilibrium at a point where

MC = MR and accordingly, the out put is determined.

The price is determined as per AR.

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In case of constant costs, the physical out put shows proportional returns.

AC and MC curves will same and horizontal.




In case of decreasing costs, the physical out put shows increasing returns.

AC and MC curves will be downward sloping.




Long run equilibrium under monopoly

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In the long run the monopolist will find his equilibrium at a point where

MR (Long run) = MC (Long run)

In the long run the AC curve becomes flatter an the firm will be able to

produce more out put at lesser cost.

At the equilibrium the monopolist can

Determine price P1 by restricting the out put at Q1. In this case the

monopolist will have super normal profits.

OR

Determine price P2 price with larger output Q2 and optimize the cost by

producing at minimum AC in the long run. In this case the monopolist

will have normal profits.

Discriminative Pricing

Price discrimination means the firm selling the same product in different

markets at the same time at different prices. The objective of price

discrimination is profit maximization.

Price discrimination is generally followed by a monopolist.

Price discrimination is not always possible. There are certain conditions

to be fulfilled for practice of price discrimination.

Price discrimination is possible only under the following conditions

1. Legal sanction

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The practice of price discrimination shall be accepted by the law.

In absence of legal sanction price discrimination will be called

cheating.

2. Geographically distant markets

The markets with different pieces shall be geographically far. The

markets should be far enough to prevent resale of goods.

3. No possibility of resale

Resale should be prohibited. In case of resale the monopoly

profits will be drained out by those reselling the goods.

4. No storage possible

Resale is not possible only I those goods whether storage is not

possible.

5. Apparent product differentiation

The firm shall follow apparent product differentiation. In such

cases the buyers will find justification for paying a different

price.

6. Let go attitude of the consumer

The consumers should have a let go attitude. In case of consumer

resistance, price discrimination is not possible.

7. Difference in elasticities of demand

Difference in elasticities is an essential condition for price discrimination.

There will be as many sub markets as the differences in elasticities.

In an elastic market, the firm can not charge higher price. Any increase in

price will greatly decrease quantity demanded. So the price tends to be

low. In an inelastic market, the quantity is not sensitive to price, so the

firm will charge a higher price.

The inelastic market: Market A has higher price and lower out put.

The elastic market; Market B has lower price and higher out put

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Equilibrium with price discrimination

Firstly, the market is divided into sub markets depending on the elasticity

of demand. Each market will have a different elasticity of demand.

Suppose the firm can divide the markets into two sub markets: market A -

an inelastic market and Market B - an elastic market.

1. Out put determination

MC = Σ MR

2. Out put distribution

Σ MR = MRa = MRb

3. Price determination

The prices are determined as per ARs.

Though the markets are different, the place of production is centralized.

The firm will produce at a single place. Depending on the component

markets, the aggregate market is constructed.

The firm will determine the equilibrium out put; this is the out put which

will be distributed among different markets. The firm will consider the

aggregate MR i.e. Σ MR for determining the equilibrium.


MC = Σ MR

This is the optimum out put determined at the aggregate market.


Σ MR = MRa = MRb

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The out put is distributed in different markets by equating Marginal

revenues. The equilibrium level of MR is passed over to different

markets, this way the equilibrium is created in sub markets. The

equilibrium level of MR will indicate the out put in different markets.


The prices are determined in different markets as per the Average

revenues (demand) in different markets.

It can be seen that the

The inelastic market: Market A has higher price and lower out put.

The elastic market: Market B has lower price and higher out put

Dumping Dumping is a special case of price discrimination where the firm is a

monopolist in the home market and faces competition in the foreign

market.

In the home market the firm faces a downward sloping (demand) AR

curve whereas in the foreign market the AR curve is perfectly elastic with

AR=MR=Price relation.

The firm firstly, determines the out put to be produced for the local as

well as the foreign markets. There after, the out put needs to be

distributed among home and foreign markets. Finally, the price is

determined.


MC = MR ( maximum possible MR)


MRh = MRf


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The prices are determined as per AR in the home market

and at the existing price at the foreign market.

The out put is determined by equating MC=MR. This is the profit

maximizing out put. The out put is distributed by equating MRs in

different markets. i.e. MRf = MRh

At this point the out put is allotted for home market and he price is

determined as per the downward sloping demand curve. The remaining

out put is sold in the foreign market at the price prevailing as per

AR=MR=Price.

It can be seen that the firm sells a small out put in the home market at

high price and a large out put in the foreign market at low price. This is

called dumping.

Comparison between Imperfect and perfect competitions

A comparison between perfectly competitive firm and that of

imperfect competition shows that there are differences in the

methods of out put and price determination.

Out put determination

The out put under imperfect competition is lesser than the

competitive output. By restricting the out put the firm can charge

higher price.

Both firms determine the out put at a point where MC = MR.

With perfectly elastic AR curve the competitive firm produces

more than the monopolist.

Price determination

A firm determines price as per the AR curve. Under perfect

competition the firm being a price taker has a perfectly elastic AR

demand curve.. The monopolist determined price on a down ward

sloping demand curve.

While pricing on the down ward sloping AR, the out put is

restricted so as to charge a higher price.

The monopolist charges price as per the down ward sloping

demand AR curve. So by restricting out put the monopolist can

charge a higher price.

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The price monopolistic competition is higher than the competitive

price. The AR being high at the equilibrium out put the firm

charges higher price.

In both these case, Monopolist firm is exploitative as compared

with a competitive firm.

Module 8: Monopolistic competition and oligopoly

Monopolistic Competition

Monopolistic competition is a case of imperfect competition where

limited number of firms, compete with differentiated product at dissimilar

prices.

Following are the features of monopolistic competition:

1. Large number of buyers: The number of buyers is large. It is a large

market where firms compete.

2. Limited number of firms: The number of firms remains limited due to

intense competition. The entry is not restricted by law, but competition

discourages new firms.

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3. The prices need not be uniform. Each firm produces goods as per their

own market, so the product quality, utility differ. In such a case the prices

also differ.

4. Product differentiation Product differentiation means the same product being projected different,

by modifying with additional utility, quality or term of sale.

The product differentiation is done in flowing ways:

a. By an additional quality: the firm may show a different quality

of the product which may not exist in the market. The quality

should be such that the utility of the product gets enhanced.

b. Additional quality: The product can be designed with an

additional utility. Products with different utilities have elastic

and larger demand. This is one method of improving the appeal

of the product. It is seen that dual utilities have improved the

quality of the product like the two-in-one products.

c. By different term of sale: the fir may offer a different terms of

sale. It may be by way of guarantees, after sale service, quizzes,

contests, prices, Etc.

The objective of price differentiation is to claim monopoly power in an

imperfect market. This is done by creating unique selling proposition.

Product differentiation means differences in cost. With differences in cost

the price also changes. Firms sell at different prices. The competition

between firms with different prices is called non-price competition. The

firms justify the price by either different image/ brand equity or by

different qualities/utility of the product.

Non-price competition benefits the firms. The consumer is made to pay

higher pries which are falsely justified through advertising.

5. Selling cost

Selling cost is the cost of generating demand. Under monopolistic

competition, the firms engage in non price competition. The firms

charging different prices justify their prices by advertising, publicity,

field campaign and similar promotional activities.

Selling cot helps in generating demand, brand image and justifying the

price. Selling cost does not give utility. Selling cost is a burden on the

consumer.

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Production cost on the other hand generates utility. The production cost

decreases with increasing out put in, proportion. This is due to economies

of scale. Whereas, the selling cost increases in larger proportions to

increasing out put. This is because, advertising becomes more and more

expensive, with increasing out put.

Selling cost makes demand elastic and shifts demand curve u wards.

In the diagram it can be seen that, selling cot has increased the average

cost. Yet, the demand curve has shifted upwards and also became elastic.

This is the advantage the firm receives by spending selling cost.

Short run Equilibrium under Monopolistic Competition

A firm under monopoly competition arrives at equilibrium like a

monopoly firm. For a firm, the demand curve is downward sloping, so the

AR and MR curves also slope down wards and look different. However

the optimizing condition for out put remains same as in case of perfect

competition.

At a point where MC = MR the firm finds its equilibrium out put. When

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MC = MR the difference between TC and TR will be maximum.

The output is found on the x axis. The price determination is done by AR

curve. This is the demand curve which will tell the maximum price that

can be charged for this level of out put.

Profits: A firm is said to be making supernormal profits if AR > AC. The

price charged by the firm covers all the costs and also generates a surplus

over the expenditure. In this case the firm receives the managers’

remuneration (normal profits) and also a surplus over it. Hence it is called

super normal profits.

Losses: A firm is said to be making losses if, AR < AC. In case of loss

there is a need for further analysis. The firm needs to decide whether to

stay in production or shut down. In such a case Average variable cost

(AVC) is considered.

Maximum bearable loss:

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Shut down Condition

If AR < AVC, the firm needs to close down.





condition.

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Long run equilibrium under monopolistic competition

There is free entry and exit of firms under monopolistic competition.

When there is free entry and exit of firms, the firms keep joining the

production as long as there are profits. With new firms joining the super

normal profits, get distributed among more and more firms.





In the long run the equilibrium is drawn at a point where LMC = MR. In

he ling run all firm will operate at normal profits. It means the firm

covers only the manager’s remuneration and there is no surplus over and

above this. At this point AR = MR = AC, where AC = AR is a condition

of normal profits.

Wastages in Monopolistic competition

A comparison between perfectly competitive firm and that of imperfect

competition shows that there are wastages and exploitation under,

imperfect competition.

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1. The price monopolistic competition is higher than the

competitive price. The AR being high at the equilibrium out put

the firm charges higher price.

2. The out put under imperfect competition is lesser than the

competitive output. By restricting the out put the firm can charge

higher price.

3. Imperfect competition leads to less than optimum size of out put:

The monopoly firm restricts the out put so that it can realize

higher price. In the process it produces less than optimum size of

out put. The firm will be producing at higher cost, but the price

charged, will be much higher granting larger profits to the

monopoly firm.

4. Imperfect competition will lead to unfair competition.

Monopolistic competition has wasteful advertising. Advertising

leads to increases in cost and dos not yield any utility to the

consumer.

5. Non price competition leads to price exploitation of consumers.

Under non price competition the firms sell goods at different

price and justify higher price by advertising. In case of perfect

competition the prices are low and uniform.

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Oligopoly Oligopoly is an imperfect market condition identified with limited

number of firms with high interdependence competing with differentiated

or uniform product at uniform prices.

Following are the features of oligopoly market

1. Limited number of firms:

The number of firms is limited due to intense competition. The industry

remains as a small group of firms.

2. Large number of buyers

The number of buyers will be very large. There will be huge market for

which the firms compete.

3. High degree of interdependence between firms

The firms will have high degree of interdependence in terms of price and

product design. The firms almost share the same demand curve.

However, the demand is made elastic or remains inelastic depending on

the nature of advertising.

No firm can deviate and change the product description. Any change

made by the firm will lead to the consumer shifting to other competing

firms. The demand remains very flimsy for a firm. The demand is

maintained carefully by maintaining the same price, similar product

details and advertising.

4. Rigid and uniform prices

The price will remain uniform and rigid. When the price is accepted by

the firms and the buyers, it continues for a long time. A consumer will not

pay a higher price because he can continue to get the same price from

other firms. A firm will not reduce the price because the consumer is

willing to pay the given price. On the other hand reduction in the price

may be treated as a loss of quality. This is called as price illusion.

5. Advertising

Advertising is an essential part of oligopoly market. Advertising is

essential for registering the product with the consumer. Advertising

allows the product to have the required exposure to the consumer so that

the consumer can include the product in his options.

Further, advertising make the demand elastic. By making the demand

elastic, the firm will be able to sell more goods at the given price.

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6. Types of oligopoly

There are different types of oligopoly each based in a different marketing

practices followed to manage competition.

a. Pure and differentiated oligopoly

Pure oligopoly deals with goods are homogenous whereas differentiated

oligopoly may have apparent product differentiation. The market offers

flexibility the firms to change the nature of the product keeping the base

utility same. In ace of pure oligopoly it is easy to maintain price

uniformity. With product differentiation, the price tends to change

because of cost variations. Even in theses conditions the firms need to

maintain the uniform prices. For this reasons the firma can only adopt

apparent product differentiation without changing the cost structure.

b. Complete and partial oligopoly

Complete oligopoly refers to market where all the firms are equally

placed in terms of competition, price and market share. Whereas in case

of partial oligopoly, there can be one large firm emerging as the leader.

The leader will have the advantage of giving a lead price to the product

which other firma will follow. The leadership firm will have the privilege

of designing the product, price and the nature of competition.

Pure oligopoly may at times change to partial oligopoly by frequent

mergers. Firms merge among themselves to form a large firm so that a

leadership role can be achieved.

c. Collusive and Non collusive oligopoly

Non collusive oligopoly refers to a market where the forms operate

independently, however with interdependence. In case of collusive

oligopoly, the firms may collide, enter into agreements to lessen

competition and share the market to exploit the consumers.

7. Cartels

Cartels are a case of collusive oligopoly. Firms in market with intense

competition form arrangements to avoid competition by making

agreements so that all firms tend to benefit at the cot of the consumer.

Cartels are harmful business organization formed to enhance exploitation

and increase profits.

There can be different types of cartels depending on agreements.

a. In a cartel, the firms with high price may insist that its price

prevail, so that all firms can maximize profits.

b. At the same time the firm with lesser price may insist on its price

to be followed so that larger out put can be sold.

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These are price cartels. In both these cases competition is avoided

and market becomes lucid.

c. The firms may divide the market geographically and restrict mutual

entry in respective territory. In this case the market has one

monopoly firm selling the product.

d. The firms may have system of marketing royalties as consideration

for sharing territory for attaining monopoly power. A firm

operating in market as an exclusive monopolist may have to pay

market royalty to other firms restricting entry.

The cartels can be operating at international levels, where the regions

are shared on the basis of trading currencies or countries. The counter

may form commodity agreements, bilateral agreements, and

multilateral agreements for a specific time. All these agreements

where the firms or the counties get captive markets belong to cartels.

Duopoly Duopoly is a model of oligopoly market with two firms designed to study

the interdependence of firms for pricing.

Following are the feature of a model duopoly market:

1. Two firms:

The number of firms is limited to two. This is for the purpose of studying

the details of interdependence. Hence it is a model of oligopoly.

2. Large number of buyers

The number of buyers will be very large. There will be huge market for

which the firms compete.

3. High degree of interdependence between firms

The two firms will have high degree of interdependence in terms of price

and product design. Two firms almost share the same demand curve.

However, the demand is made elastic or remains inelastic depending on

the nature of advertising.

Single firm can deviate and change the product description. Any change

made by the firm will lead to the consumer shifting to other competing

firm. The demand remains very flimsy for a firm. The demand is

maintained carefully by maintaining the same price, similar product

details and advertising.

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4. Rigid and uniform prices

The price will remain uniform and rigid. When the price is accepted by

both the firms and the buyers, it continues for a long time. A consumer

will not pay a higher price because he can continue to get the same price

from other firm. A firm will not reduce the price because the consumer is

willing to pay the given price. On the other hand reduction in the price

may be treated as a loss of quality. This is called as price illusion.

5. Advertising

Advertising is an essential part of oligopoly market. Advertising is

essential for registering the product with the consumer. Advertising

allows the product to have the required exposure to the consumer so that

the consumer can include the product in his options.

Further, advertising make the demand elastic. By making the demand

elastic, the firm will be able to sell more goods at the given price.

6. Kinky demand curve

The demand curve for the duopoly market is med up of the individual

demand curves of two forms. These are the demand curves made by the

firms by the independent advertising campaigns and publicity.

Yet the firms will have demand curves with different elasticities. The

demand curve for the market is made up of these tow demand curves.

The inelastic segment of the demand curve at lower price s and the elastic

segment of demand curve ay higher prices form the segmented demand

curve in duopoly.

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It is learn in point elasticity of demand that all goods tend to be elastic at

higher prices and inelastic at lower prices.

The firms will be operating on the segmented demand curve which forms

a kink at P. P is the point which is common on both the demand curves.

This is the price which can be followed on both the firms.

P is the uniform and rigid price followed by firms under duopoly.

(19006)5-05-2010

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Other books in this series

Business Economics Paper I B.Com First Year

Business Economics Paper II B.Com Second Year

Business Economics Paper III B.Com Third Year

Introduction to Economics B.M.M. First Year

Micro Economics First Year B.Com Accounting and Finance I Semester

First Year B.Com Banking and Insurance I Semester

Macro Economics First Year B.Com Banking and Insurance II Semester

Second Year BCom Accounting and Finance IIISemester

Based on University of Mumbai curriculum

Available for free and private circulation

At www. rangasai.com and www. vazecollege.net

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