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MANAGERIAL ECONOMICS

MBA

First Semester

VINOBA BHAVE UNIVERSITYHAZARIBAG, JHARKHAND

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Author: D.N. Dwivedi, Prof. of Economics, Maharaja Agrasen Institute of Management Studies, Delhi

Copyright © Author, 2016

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BOARD OF STUDIES

Prof. (Dr.) Gurdeep Singh Vice ChancellorVice Chancellor,Vinoba Bhave UniversityHazaribag

Prof. (Dr.) K.K. Srivastava Director - DDEProfessorDepartment of ChemistryVinoba Bhave UniversityHazaribag

Dr. Saroj Ranjan Subject ExpertAssociate ProfessorUniversity Department of Management StudiesVinoba Bhave UniversityHazaribag

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Unit - INature, scope and application of Managerial Economics.

Theory of the firm and business objectives. Economic, Behaviouraland Managerial theories.

Unit - IIDemandAnalysis. Law of Demand. Determinants of Demand.Elasticity of Demand. Demand forecasting.

Unit - IIIConsumer Behaviour, Cardinal and ordinal approaches:Consumer’s equilibrium; the revealed preference.

Unit - IVInput-Output decisions. Law of supply; Elasticity of supply.Production function; short-run analysis; Long-run function. Short-run and long-run cost functions.

Unit - VPrice-Output Decisions. Market structures. Price determinationunder perfect, imperfect, monopoly and duopoly. Pricing practicesand strategies.

Unit - VIMeasurement of profit and profit policy.

Unit - VIIMicro-economic concepts: National Income: Marginal propensityof consume; Multiplier effect; Effective demand.

Unit 1: Introduction to ManagerialEconomics

(Pages: 3-40)

Unit 2: Analysis of Demand(Pages: 41-89)

Unit 3: Theory of ConsumerDemand

(Pages: 91-121)

Unit 4: Input-Output Decisions(Pages: 123-162)

Unit 5: Price and OutputDetermination

(Pages: 163-222)

Unit 6: Measurement of Profitand Profit Policy

(Pages: 223-234)

Unit 7: Macroeconomic Concept(Pages: 235-263)

SYLLABI-BOOK MAPPING TABLEManagerial Economics

Syllabi Mapping in Book

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CONTENTSINTRODUCTION 1

UNIT 1 INTRODUCTION TO MANAGERIAL ECONOMICS 3-401.0 Introduction1.1 Unit Objectives1.2 Nature, Scope and Application of Managerial Economics

1.2.1 What is Economics?1.2.2 What is Managerial Economics?1.2.3 Why do Managers Need to Know Economics?1.2.4 Application of Economics to Business Decisions: An Example1.2.5 The Scope of Managerial Economics1.2.6 Gap between Theory and Practice and the Role of Managerial Economics1.2.7 How Managerial Economics Fills the Gap

1.3 Theory of the Firm and Business Objectives1.3.1 Profit as Business Objective1.3.2 Problems in Profit Measurement1.3.3 Profit Maximization as Business Objective1.3.4 Controversy Over Profit Maximization Objective: Theory vs. Practice1.3.5 Alternative Objectives of Business Firms1.3.6 Making a Reasonable Profit — a Practical Approach1.3.7 Profit as Control Measure

1.4 Summary1.5 Key Terms1.6 Answers to ‘Check Your Progress’1.7 Questions and Exercises1.8 Further Reading

UNIT 2 ANALYSIS OF DEMAND 41-892.0 Introduction2.1 Unit Objectives2.2 Law of Demand2.3 Determinants of Demand2.4 Elasticity of Demand

2.4.1 Price Elasticity of Demand2.4.2 Measuring Price Elasticity from a Demand Function2.4.3 Price Elasticity and Total Revenue2.4.4 Price Elasticity and Marginal Revenue2.4.5 Determinants of Price Elasticity of Demand2.4.6 Cross-Elasticity of Demand2.4.7 Income-Elasticity of Demand2.4.8 Advertisement or Promotional Elasticity of Sales2.4.9 Elasticity of Price Expectations

2.5 Demand Forecasting2.5.1 Why Demand Forecasting2.5.2 Steps in Demand Forecasting

2.6 Techniques of Demand Forecasting2.6.1 Survey Methods2.6.2 Statistical Methods

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2.7 Summary2.8 Key Terms2.9 Answers to ‘Check Your Progress’

2.10 Questions and Exercises2.11 Further Reading

UNIT 3 THEORY OF CONSUMER DEMAND 91-1213.0 Introduction3.1 Unit Objectives3.2 Consumer Behaviour3.3 Cardinal Utility Approach

3.3.1 Meaning and Measurability of Utility3.3.2 Total and Marginal Utility3.3.3 Law of Diminishing Marginal Utility3.3.4 Consumer’s Equilibrium

3.4 Ordinal Utility Approach3.4.1 Meaning and Nature of Indifference Curve and Indifference Map3.4.2 Diminishing Marginal Rate of Substitution (MRS)3.4.3 Properties of Indifference Curves3.4.4 Consumer’s Equilibrium3.4.5 Income and Substitution Effects

3.5 Revealed Preference Approach3.6 Summary3.7 Key Terms3.8 Answers to ‘Check Your Progress’3.9 Questions and Exercises

3.10 Further Reading

UNIT 4 INPUT-OUTPUT DECISIONS 123-1624.0 Introduction4.1 Unit Objectives4.2 Law of Supply4.3 Elasticity of Supply4.4 Production Function4.5 Short-run and Long-run Production Function4.6 Short-run and Long-run Cost Functions

4.6.1 Short-run Cost-Output Relations4.6.2 Short-run Cost Functions and Cost Curves4.6.3 Cost Curves and the Law of Diminishing Returns4.6.4 Some Important Cost Relationships4.6.5 Output Optimization in the Short-run4.6.6 Long-run Cost-Output Relations



UNIT 5 PRICE AND OUTPUT DETERMINATION 163-2225.0 Introduction5.1 Unit Objectives5.2 Competition and Market Structures

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5.2.1 Features of Perfect Competition5.2.2 Price and Output Determination under Perfect Competition

5.3 Monopoly5.3.1 Demand and Revenue Curves under Monopoly5.3.2 Cost and Supply Curves under Monopoly5.3.3 Profit Maximization under Monopoly5.3.4 Absence of Supply Curve in a Monopoly5.3.5 Price Discrimination in a Monopoly5.3.6 Measures of Monopoly Power

5.4 Oligopoly, Non-Price Competition5.4.1 Oligopoly: Meaning and Characteristics5.4.2 Duopoly Models5.4.3 Oligopoly Models5.4.4 Game Theory Approach to Oligopoly


UNIT 6 MEASUREMENT OF PROFIT AND PROFIT POLICY 223-2346.0 Introduction6.1 Unit Objectives6.2 The Meaning of Pure Profit6.3 Theories of Profit

6.3.1 Walker’s Theory of Profit: Profit as Rent of Ability6.3.2 Clark’s Theory of Profit: Profit as Reward for Dynamic Entrepreneurship6.3.3 Hawley’s Risk Theory of Profit: Profit as Reward for Risk-Bearing6.3.4 Knight’s Theory of Profit: Profit as a Return to Uncertainty Bearing6.3.5 Schumpeter’s Innovation Theory of Profit: Profit as Reward for Innovations


UNIT 7 MACROECONOMIC CONCEPT 235-2637.0 Introduction7.1 Unit Objectives7.2 National Income

7.2.1 Measures of National Income7.2.2 Choice of Methods7.2.3 Theory of National Income Determination7.2.4 Aggregate Supply and Aggregate Demand

7.3 Consumption Function7.4 Shift in Aggregate Demand Function and the Multiplier7.5 Summary7.6 Key Terms7.7 Answers to ‘Check Your Progress’7.8 Questions and Exercises7.9 Further Reading

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Self-InstructionalMaterial 1

Introduction

NOTES

INTRODUCTION

The natural curiosity of a student who begins to study a subject is to know its nature andscope. Such as it is, a student of economics would like to know ‘What is economics’ and‘What is its subject matter’. Surprisingly, there is no precise answer to these questions.

Attempts made by economists over the past 300 years to define economics havenot yielded a precise and universally acceptable definition of economics. Economistsright from Adam Smith—the ‘father of economics’—down to modern economists havedefined economics differently, depending on their own perception of the subject matterof economics of their era. Thus, economics is fundamentally the study of choice-makingbehaviour of the people. The choice-making behaviour of the people is studied in asystematic or scientific manner. This gives economics the status of a social science.However, the scope of economics, as it is known today, has expanded vastly in the post-World War II period. Modern economics is now divided into two major branches:Microeconomics and Macroeconomics.

Microeconomics is concerned with the microscopic study of the various elementsof the economic system and not with the system as a whole. As Lerner has put it,‘Microeconomics consists of looking at the economy through a microscope, as it were,to see how the millions of cells in body economic—the individuals or households asconsumers and the individuals or firms as producers—play their part in the working ofthe whole economic organism.’ Macroeconomics is a relatively new branch of economics.Macroeconomics is the study of the nature, relationship and behaviour of aggregatesand averages of economic variables. Therefore, the technique and process of businessdecision-making has of late changed tremendously.

The basic functions of business managers is to take appropriate decisions onbusiness matters, to manage and organize resources, and to make optimum use of availableresources with the objective of achieving the business goals. In today’s world, businessdecision-making has become an extremely complex task due to the ever-growingcomplexity of the business world and the business environment. It is in this context thatmodern economics—howsoever defined—contributes a great deal towards businessdecision-making and performance of managerial duties and responsibilities. Just as biologycontributes to the medical profession and physics to engineering, economics contributesto the managerial profession.

This book, Managerial Economics, aims at equipping management students witheconomic concepts, economic theories, tools and techniques of economic analysis asapplied to business decision-making.

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Introduction toManagerial Economics

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UNIT 1 INTRODUCTION TOMANAGERIAL ECONOMICS

Structure1.0 Introduction1.1 Unit Objectives1.2 Nature, Scope and Application of Managerial Economics

1.2.1 What is Economics?1.2.2 What is Managerial Economics?1.2.3 Why do Managers Need to Know Economics?1.2.4 Application of Economics to Business Decisions: An Example1.2.5 The Scope of Managerial Economics1.2.6 Gap between Theory and Practice and the Role of Managerial Economics1.2.7 How Managerial Economics Fills the Gap

1.3 Theory of the Firm and Business Objectives1.3.1 Profit as Business Objective1.3.2 Problems in Profit Measurement1.3.3 Profit Maximization as Business Objective1.3.4 Controversy Over Profit Maximization Objective: Theory vs. Practice1.3.5 Alternative Objectives of Business Firms1.3.6 Making a Reasonable Profit — a Practical Approach1.3.7 Profit as Control Measure


1.0 INTRODUCTION

In this unit, you will learn about the nature, scope and application of managerial economicsand the theory of the firm.

Emergence of managerial economics as a separate course of management studiescan be attributed to at least three factors: (a) growing complexity of business decision-making process due to changing market conditions and business environment,(b) consequent upon, the increasing use of economic logic, concepts, theories and toolsof economic analysis in the process of business decision-making, and (c) rapid increasein demand for professionally trained managerial manpower. Let us have a glance at howthese factors have contributed to the creation of ‘managerial economics’ as a separatebranch of study.

1.1 UNIT OBJECTIVES

After going through this unit, you will be able to:

Describe the nature, scope and application of managerial economics

Discuss the theory of firm and business objectives

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Self-Instructional4 Material


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1.2 NATURE, SCOPE AND APPLICATION OFMANAGERIAL ECONOMICS

It is a widely accepted fact that business decision-making process has become increasinglycomplicated due to ever growing complexities in the business world. There was a timewhen business units (shops, firms, factories, mills, etc.) were set up, owned and managedby individuals or business families. In India, there were 22 top business families likeTatas, Birlas, Singhanias, Ambanis and Premjis, etc. Big industries were few and scaleof business operation was relatively small. The managerial skills acquired throughtraditional family training and experience were sufficient to manage small and mediumscale businesses. Although a large part of private business is still run on a small scaleand managed in the traditional style of business management, the industrial businessworld has changed drastically in size, nature and content. The growing complexity of thebusiness world can be attributed to the growth of large scale industries, growth of alarge variety of industries, diversification of industrial products, expansion and diversificationof business activities of corporate firms, growth of multinational corporations, and mergersand takeovers, especially after the Second World War. These factors have contributed agreat deal to the recent increase in inter-firm, inter-industry and international rivalry,competition, risk and uncertainty. Business decision-making in this kind of businessenvironment is a very complex affair. The family training and experience is no longersufficient to meet the managerial challenges.

The growing complexity of business decision-making has inevitably increased theapplication of economic concepts, theories and tools of economic analysis in this area.The reason is that making an appropriate business decision requires a clear understandingof market conditions, the nature and degree of competition, market fundamentals andthe business environment. This requires an intensive and extensive analysis of the marketconditions in the product market, input market and financial market. On the other hand,economic theories, logic and tools of analysis have been developed to analyse and predictmarket behaviour. The application of economic concepts, theories, logic and analyticaltools in the assessment and prediction of market conditions and business environmenthas proved to be of great help in business decision-making. The contribution of economicsto business decision-making has come to be widely recognized. Consequently, economictheories and analytical tools, which are widely used in business decision-making havecrystallized into a separate branch of management studies, calledmanagerial economicsor business economics.

Let us begin our study of managerial economics by learning:

(i) What economics is

(ii) About managerial decision-making problems, and

(iii) How economics contributes to business decision-making?

1.2.1 What Is Economics?

Managerial economics essentially constitutes of economic theories and analyticaltools that are widely applied to business decision-making. It is therefore useful toknow, ‘what is economics’1. Economics is a social science. Its basic function is to

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study how people—individuals, households, firms and nations—maximize their gainsfrom their limited resources and opportunities. In economic terminology, this is calledmaximizing behaviour or, more appropriately, optimizing behaviour. Optimizingbehaviour is, selecting the best out of available options with the objective ofmaximizing gains from the given resources. Economics is thus a social science,which studies human behaviour in relation to optimizing allocation of availableresources to achieve the given ends. For example, economics studies how householdsallocate their limited resources (income) between the various goods and services theyconsume so that they are able to maximize their total satisfaction. It analyzes howhouseholds with limited income decide ‘what to consume’ and ‘how much to consume’with the aim of maximizing total utility.

Consider the case of firms, the producers of goods and services. Economicsstudies how producers—the firms—make the choice of the commodity to produce, theproduction technology, location of the firm, market or market segment to cater to, priceof the product, the amount to spend on advertising (if necessary) and the strategy forfacing competition, etc.

At macro level, economics studies how nations allocate their resources, men andmaterial, between competing needs of the society so that economic welfare of the societycan be maximized. Also, economics studies how government formulates its economicpolicies—taxation policy, expenditure policy, price policy, fiscal policy, monetary policy,employment policy, foreign trade (export-import policy), tariff policy, etc. – and, theeffects of these policies.

Economics is obviously a study of the choice-making behaviour of the people. Inreality, however, choice-making is not as simple as it looks because the economic world isvery complex and most economic decisions have to be taken under the condition of imperfectknowledge, risk and uncertainty. Therefore, taking an appropriate decision or making anappropriate choice in an extremely complex situation is a very difficult task. In theirendeavour to study the complex decision-making process, economists have developed alarge kit of analytical tools and techniques with the aid of mathematics and statistics andhave developed a large corpus of economic theories with a fairly high predictive power.Analytical tools and techniques, economic laws and theories constitute the body ofeconomics.

1.2.2 What is Managerial Economics?

The subject matter of economic science consists of the logic, tools and techniquesof analyzing economic phenomena as well as, evaluating economic options,optimization techniques and economic theories. The application of economic sciencein business decision-making is all pervasive. More specifically, economic laws and toolsof economic analysis are now applied a great deal in the process of business decision-making. This has led, as mentioned earlier, to the emergence of a separate branch ofstudy called managerial economics. The application of economic concepts and theoriesin combination with quantitative methods is illustrated in Fig. 1.1.

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Managerial Decision Areas

• Assessment ofSelecting

• Choice of• Determining• Determining• Determining• Sales Promotion

Investible Funds• Business Area

ProductOptimum OutputPrice of the ProductInput-Combination and Technology

Application ofEconomic Conceptsand Theories inDecision-Making

• Mathematical Tools• Statistical Tools• Econometrics

Managerial EconomicsApplication of Economic Concepts, Theories and AnalyticalTools to find Optimum Solution to Business Problems.

Fig. 1.1 Application of Economics to Managerial Decision-Making

Managerial economics can be broadly defined as the study of economictheories, logic and tools of economic analysis that are used in the process ofbusiness decision-making. Economic theories and techniques of economic analysisare applied to analyse business problems, evaluate business options andopportunities with a view to arriving at an appropriate business decision. Managerialeconomics is thus constituted of that part of economic knowledge, logic, theories andanalytical tools that are used for rational business decision-making.

Some Definitions of Managerial Economics

Let us look at some definitions of managerial economics offered by a few eminenteconomists.

“Managerial economics is concerned with the application of economic conceptsand economics to the problems of formulating rational decision making”2.—Mansfield

“Managerial economics ... is the integration of economic theory with businesspractice for the purpose of facilitating decision making and forward planning bymanagement”3.

—Spencer and Seigelman

“Managerial economics is concerned with the application of economicprinciples and methodologies to the decision-making process within the firm ororganization. It seeks to establish rules and principles to facilitate the attainmentof the desired economic goals of management”4.

—Douglas“Managerial economics applies the principles and methods of economics toanalyze problems faced by management of a business, or other types oforganizations and to help find solutions that advance the best interests of suchorganizations”5. —Davis and Chang

These definitions of managerial economics together reveal the nature of thediscipline even though they do not provide its perfect definition.

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1.2.3 Why do Managers Need to Know Economics?

Economics contributes a great deal towards the performance of managerial duties andresponsibilities. Just as biology contributes to the medical profession and physics toengineering, economics contributes to the managerial profession. All other professionalqualifications being the same, managers with a working knowledge of economics canperform their functions more efficiently than those without it. The basic function of themanagers of a business firm is to achieve the objective of the firm to the maximum possibleextent with the limited resources placed at their disposal. The emphasis here is on themaximization of the objective and limitedness of the resources. Had the resources beenunlimited, the problem of economizing on resources or resource management would havenever arisen. But resources at the disposal of a firm, be it finance, men or material, are byall means limited. Therefore, the basic task of the management is to optimize their use.

How Economics Contributes to Managerial Functions

We have noted above why managers need to know economics. Let us now see howeconomics contributes to the managerial task of decision-making. As mentioned above,economics, though variously defined, is essentially the study of logic, tools andtechniques of making optimum use of the available resources to achieve the givenends. Economics thus provides analytical tools and techniques that managers need toachieve the goals of the organization they manage. Therefore, a working knowledge ofeconomics, not necessarily a formal degree, is essential for managers. In other words,managers are essentially practicing economists.

In performing their functions, managers have to take a number of decisions inconformity with the goals of the firm. Many business decisions are taken under conditionsof uncertainty and risk. These arise mainly due to uncertain behaviour of the marketforces, changing business environment, emergence of competitors with highly competitiveproducts, government policy, international factors impacting the domestic market duemainly to increasing globalization as well as social and political changes in the country.The complexity of the modern business world adds complexity to business decision-making. However, the degree of uncertainty and risk can be greatly reduced if marketconditions are predicted with a high degree of reliability. Economics offers models, toolsand techniques to predict the future course of market conditions and business prospects.

The prediction of the future course of business environment alone is not sufficient.What is equally important is to take appropriate business decisions and to formulate abusiness strategy in conformity with the goals of the firm. Taking a rational businessdecision requires a clear understanding of the technical and environmental conditionsrelated to the business issues for which decisions are taken. Application of economictheories to explain and analyse the technical conditions and the business environmentcontributes a good deal to rational decision-making. Economic theories have, therefore,gained a wide range of application in the analysis of practical problems of business. Withthe growing complexity of business environment, the usefulness of economic theory asa tool of analysis and its contribution to the process of decision-making has been widelyrecognized.

Baumol6 has pointed out three main contributions of economic theory tobusiness ecomomics.

First, ‘one of the most important things which the economic [theories] cancontribute to the management science’ is building analytical models, which help to

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recognize the structure of managerial problems, eliminate the minor details that mightobstruct decision-making, and help to concentrate on the main issue.

Secondly, economic theory contributes to the business analysis ‘a set of analyticalmethods’, which may not be applied directly to specific business problems, but they doenhance the analytical capabilities of the business analyst.

Thirdly, economic theories offer clarity to the various concepts used in businessanalysis, which enables the managers to avoid conceptual pitfalls.

1.2.4 Application of Economics to Business Decisions:An Example

We have discussed above – in general terms, of course – how economics can contributeto business decision-making. In this section, we show this application in some hypotheticalbusiness issues.

Business decision-making is essentially a process of selecting the best out ofalternative opportunities open to the firm. The process of decision-making7 comprisesfour main phases:

(i) determining and defining the objective to be achieved;

(ii) collections and analysis of business related data and other information regardingeconomic, social, political and technological environment and foreseeing thenecessity and occasion for decision;

(iii) inventing, developing and analysing possible courses of action; and

(iv) selecting a particular course of action, from the available alternatives.

This process of decision-making is, however, not as simple as it appears to be.Steps (ii) and (iii) are crucial in business decision-making. These steps put managers’analytical ability to test and determine the appropriateness and validity of decisions in themodern business world. Modern business conditions are changing so fast and becomingso competitive and complex that personal business sense, intuition and experience alonemay not prove sufficient to make appropriate business decisions. Personal intelligence,experience, intuition and business acumen of the decision-makers need to be supplementedwith quantitative analysis of business data on market conditions and business environment.It is in this area of decision-making that economic theories and tools of economic analysiscontribute a great deal.

For instance, suppose a firm plans to launch a new product for which closesubstitutes are available in the market. One method of deciding whether or not to launchthe product is to obtain the services of business consultants or to seek expert opinion. Ifthe matter has to be decided by the managers of the firm themselves, the two areaswhich they will need to investigate and analyse thoroughly are:

(i) production related issues, and

(ii) sales prospects and problems.

In regard to production related issues, managers will be required to collect and analysedata on:

(a) available techniques of production,

(b) cost of production associated with each production technique,

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(c) supply position of inputs required to produce the planned commodity,

(d) price structure of inputs,

(e) cost structure of competitive products, and

( f ) availability of foreign exchange if inputs are to be imported.

In order to assess the sales prospects, managers are required to collect and analyse dataon:

(a) market size, general market trends and demand prospects for the product,

(b) trends in the industry to which the planned product belongs,

(c) major existing and potential competitors and their respective market shares,

(d) prices of the competing products,

(e) pricing strategy of the prospective competitors,

( f ) market structure and degree of competition, and

(g) supply position of complementary goods.

It is in this kind of analysis of input and output markets that the application ofeconomic theories and tools of economic analysis helps significantly in the process ofdecision-making.

Economic theories state the functional relationship between two or more economicvariables, under certain given conditions. Application of relevant economic theories to theproblems of business facilitates decision-making inat least three ways.

First, it gives a clear understanding of various economic concepts (e.g., cost,price, demand, etc.) used in business analysis. For example, the concept of ‘cost’ includes‘total’, ‘average’, ‘marginal’, ‘fixed’, ‘variable’, ‘actual’, and ‘opportunity’. Economicsclarifies which cost concepts are relevant and in what context.

Second, it helps in ascertaining the relevant variables and specifying the relevantdata. For example, it helps in deciding what variables need to be considered in estimatingthe demand for two different sources of energy—petrol and electricity.

Third, economic theories state the general relationship between two or moreeconomic variables and also events. Application of the relevant economic theory providesconsistency to business analysis and helps in arriving at right conclusions. Thus, applicationof economic theories to the problems of business not only guides, assists and streamlinesthe process of decision-making but also contributes a good deal to the validity of thedecisions.

1.2.5 The Scope of Managerial Economics

Economics has two major branches: (i) Microeconomics, and (ii) Macroeconomics.Both micro and macro-economics are applied to business analysis and decision-making—directly or indirectly. Managerial economics comprises, therefore, both micro and macroeconomic theories. The parts of microeconomics and macroeconomics that constitutemanagerial economics depend on the purpose of analysis.

In general, the scope of managerial economics comprises all those economicconcepts, theories and tools of analysis which can be used to analyze issues related todemand prospects, production and cost, market structure, level of competition and generalbusiness environment and to find solutions to practical business problems. In other words,managerial economics is economics applied to the analysis of business problems anddecision-making. Broadly speaking, it is applied economics.

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The areas of business issues to which economic theories can be directly appliedmay be broadly divided into two categories: (a) microeconomics applied to operational orinternal issues, and (b) macroeconomics applied to environmental or external issues.

Microeconomics Applied to Operational Issues

Operational issues are of internal nature. Internal issues include all those problems whicharise within the business organization and fall within the purview and control of themanagement. Some of the basic internal issues are: (i) choice of business and the natureof product, i.e., what to produce; (ii) choice of size of the firm, i.e., how much toproduce; (iii) choice of technology, i.e., choosing the factor-combination; (iv) choice ofprice, i.e., how to price the commodity; (v) how to promote sales;(vi) how to face price competition; (vii) how to decide on new investments;(viii) how to manage profit and capital; (ix) how to manage an inventory, i.e., stock ofboth finished goods and raw materials. These problems may also figure in forwardplanning. Microeconomics deals with such questions confronted by managers of businessenterprises. The following microeconomic theories deal with most of these questions.

Theory of Demand

Demand theory deals with consumers’ behaviour. It answers such questions as: How dothe consumers decide whether or not to buy a commodity? How do they decide on thequantity of a commodity to be purchased? When do they stop consuming a commodity?How do the consumers behave when price of the commodity, their income and tastesand fashions, etc., change? At what level of demand, does changing price becomeinconsequential in terms of total revenue? The knowledge of demand theory can, therefore,be helpful in making the choice of commodities, finding the optimum level of productionand in determining the price of the product.

Theory of Production and Production Decisions

Production theory explains the relationship between inputs and output. It also explainsunder what conditions costs increase or decrease; how total output behaves when unitsof one factor (input) are increased keeping other factors constant, or when all factorsare simultaneously increased; how can output be maximized from a given quantity ofresources; and how can the optimum size of output be determined? Production theory,thus, helps in determining the size of the firm, size of the total output and the amount ofcapital and labour to be employed, given the objective of the firm.

Analysis of Market-Structure and Pricing Theory

Price theory explains how price is determined under different kinds of market conditions;when price discrimination is desirable, feasible and profitable; and to what extent advertisingcan be helpful in expanding sales in a competitive market. Thus, price theory can behelpful in determining the price policy of the firm. Price and production theories together,in fact, help in determining the optimum size of the firm.

Profit Analysis and Profit Management

Profit making is the most common objective of all business undertakings. But, making asatisfactory profit is not always guaranteed because a firm has to carry out its activitiesunder conditions of uncertainty with regard to (i) demand for the product, (ii) input pricesin the factor market, (iii) nature and degree of competition in the product market, and (iv)

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price behaviour under changing conditions in the product market, etc. Therefore, an elementof risk is always there even if the most efficient techniques are used for predicting thefuture and even if business activities are meticulously planned. The firms are, therefore,supposed to safeguard their interest and avert or minimize the possibilities of risk. Profittheory guides firms in the measurement and management of profit, in making allowancesfor the risk premium, in calculating the pure return on capital and pure profit and also forfuture profit planning.

Theory of Capital and Investment Decisions

Capital like all other inputs, is a scarce and expensive factor. Capital is the foundation ofbusiness. Its efficient allocation and management is one of the most important tasks ofthe managers and a determinant of the success level of the firm. The major issuesrelated to capital are (i) choice of investment project, (ii) assessing the efficiency ofcapital, and (iii) most efficient allocation of capital. Knowledge of capital theory cancontribute a great deal in investment-decision making, choice of projects, maintainingthe capital, capital budgeting, etc.

Macro-economics Applied to Business Environment

Environmental issues pertain to the general business environment in which a businessoperates. They are related to the overall economic, social and political atmosphere ofthe country. The factors which constitute economic environment of a country includethe following:

(i) The type of economic system in the country,

(ii) General trends in national income, employment, prices, saving and investment,etc.,

(iii) Structure of and trends in the working of financial institutions, e.g., banks, financialcorporations, insurance companies, etc.,

(iv) Magnitude of and trends in foreign trade,

(v) Trend in labour supply and strength of the capital market,

(vi) Government’s economic policies, e.g., industrial policy, monetary, fiscal, price andforeign trade,

(vii) Social factors like value system of the society, property rights, customs and habits,

(viii) Socio-economic organizations like trade unions, consumers’ associations, consumercooperatives and producers’ unions,

(ix) Political environment, which is constituted of such factors as political system—democratic, authoritarian, socialist, or otherwise, State’s attitude towards privatebusiness, size and working of the public sector and political stability,

(x) The degree of globalization of the economy and the influence of MNCs on thedomestic markets.

It is far beyond the powers of a single business firm, howsoever large it may be,to determine and guide the course of economic, social and political factors of the nation.However, all the firms together or giant business houses can jointly influence the economicand political environment of the country.8 For the business community in general, however,the economic, social and political factors are to be treated as business parameters.

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The environmental factors have a far-reaching bearing upon the functioningand performance of the firms. Therefore, business decision-makers have to take intoaccount the present and future economic, political and social conditions in the countryand give due consideration to the environmental factors in the process of decision-making. This is essential because business decisions taken in isolation of environmentalfactors may not only prove infructuous, but may also lead to heavy losses as has happenedin case of establishing SEZ in Nandigram and Tata’s small care project in Singur districtof West Bengal. Consider also, for example, the following kinds of business decisions—

l A decision to set up a new alcohol manufacturing unit or to expand the existingones ignoring the impending prohibition—a political factor—would be suicidal forthe firm;

l A decision to expand the business beyond the paid-up capital permissible underMonopolies and Restrictive Trade Practices Act (MRTP Act) amounts to invitinglegal shackles;

l A decision to employ a highly sophisticated, labour-saving technology ignoring theprevalence of mass open unemployment—an economic factor—may prove to beself-defeating;

l A decision to expand the business on a large scale, in a society having a low percapita income and hence a low purchasing power stagnant over a long periodmay lead to wastage of resources.

The managers of business firms are, therefore, supposed to be fully aware of theeconomic, social and political conditions prevailing in the country while taking decisionson business issues of wider implications.

Managerial economics is, however, concerned with only the economicenvironment, and in particular with those economic factors which form the businessclimate. The study of political and social factors falls out of the purview of managerialeconomics. It should, however, be borne in mind that economic, social and politicalbehaviour of the people are interdependent and interactive. For example, growth ofmonopolistic tendencies in the industrial sector of India led to the enactment of theMonopolies and Restrictive Trade Practices Act (1961), which restricts the proliferationof large business houses. Similarly, various industrial policy resolutions formulated until1990 in the light of the socio-political ideology of the government restricted the scopeand area of private business and had restrained the expansion of private business inIndia. Some of the major areas in which politics influences economic affairs of thecountry are concentration of economic power, growth of monopoly, state of technology,existence of mass poverty and unemployment, foreign trade, taxation policy, labourrelations, distribution system of essential goods, etc.

In this book, we will concentrate on only some basic aspects of macroeconomics,including meaning and measurement of national income and its determination; theoriesof business cycles, economic growth, and economic factors; content and logic of somerelevant state policies which form the business environment.

Macroeconomic Issues

The major macroeconomic or environmental issues that figure in business decision-making, particularly with regard to forward planning and formulation of the future strategy,may be described under the following three categories.

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1. Issues Related to Macroeconomic Trends in the Economy. Macroeconomic trendsare indicated by the trends in macro variables, e.g., the general trend in the economicactivities of the country, the level of GDP, investment climate, trends in national output(measured by GNP or GDP) and employment, as well as price trends. These factors notonly determine the prospects of private business, but also greatly influence the functioningof individual firms. Therefore, a firm planning to set up a new unit or expand its existingsize would like to ask itself ‘What is the general trend in the economy? What would bethe consumption level and pattern of the society? Will it be profitable to expand thebusiness?’ Answers to these questions and the like are sought through macroeconomicstudies.

2. Issues Related to Foreign Trade. Most countries have trade and financial relationswith other countries. The sectors and firms dealing in exports and imports are affecteddirectly and more than the rest of the economy. Fluctuations in the international market,exchange rate and inflows and outflows of capital in an open economy have a seriousbearing on its economic environment and, thereby, on the functioning of its businessundertakings. The managers of a firm would, therefore, be interested in knowing thetrends in international trade, prices, exchange rates and prospects in the internationalmarket. Answers to such problems are obtained through the study of international tradeand monetary mechanism. These aspects constitute a part of macroeconomic studies.

3. Issues Related to Government Policies. Government policies designed to controland regulate economic activities of the private business affect the functioning of theprivate business undertakings. Besides, firms’ activities as producers and their attemptto maximize their private gains or profits leads to considerable social costs, in terms ofenvironment pollution, traffic congestion in the cities, creation of slums, etc. Such socialcosts not only bring a firm’s interests in conflict with those of the society, but also imposea social responsibility on the firms. The government’s policies and its regulatory measuresare designed, by and large, to minimize such social costs and conflicts. The managersshould, therefore, be fully aware of the aspirations of the people and give such factors adue consideration in their decisions. The forced closure of polluting industrial units set upin the residential areas of Delhi and the consequent loss of business worth billion ofrupees in 2000 is an example of the result of ignoring the public laws and the socialresponsibility by the businessmen. The economic concepts and tools of analysis help indetermining such costs and benefits.

Concluding Remarks

Economic theories, both micro and macro, have a wide range of applications in theprocess of business decision-making. Some of the major theories which are widelyapplied to business analysis have been mentioned above. It must, however, be borne inmind that economic theories, models and tools of analysis do not offer readymade answersto the practical problems of individual firms. They provide only the logic and methods tofind answers, not the answers as such. It depends on the managers’ own understanding,experience, intelligence, training and their competence to use the tools of economicanalysis to find reasonably appropriate answers to the practical problems of business.

Briefly speaking,microeconomic theories including those of demand, production,price determination, profit and capital budgeting, andmacroeconomic theories includingof national income, those economic growth and fluctuations, international trade andmonetary mechanism, and the study of state policies and their repercussions on theprivate business activities, by and large, constitute the scope of managerial economics.

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This should, however, not mean that only these economic theories form the subject-matter of managerial economics. Nor does the knowledge of these theories fulfill whollythe requirement of economic logic in decision-making. An overall study of economicsand a wider understanding of economic behaviour of the society, individuals, firms andstate would always be desirable and more helpful.

Some Other Topics in Managerial Economics

As mentioned earlier, managerial economics is essentially the study of economic analysisapplied to find solutions to the problems of business undertakings. There are, however,certain other disciplines which provide enormous aid to the economic analysis. Thestudy of managerial economics, therefore, includes also the study of certain topics fromother disciplines from which economic analysis borrows. The most important disciplineson which economic analysis draws heavily are mathematics, statistics and operationsanalysis. Other important disciplines associated with managerial economics aremanagement theory and accounting.

Mathematical Tools

Businessmen deal primarily with concepts that are essentially quantitative in nature,e.g., demand, price, cost, product, capital, wages, interest rate, inventories, etc. Thesevariables are interrelated, directly or indirectly. What is needed in economic analysis isto have clarity of these concepts in order to have, as far as possible, accurate estimatesof these economic variables. The use of mathematical tools in the analysis of economicvariables provides not only clarity of concepts, but also a logical and systematic frameworkwithin which quantitative relationships can be measured. More importantly, mathematicaltools are widely used in ‘model’ building, for exploring the relationship between relatedeconomic variables. Mathematical logic and tools are, therefore, a great aid to economicanalysis.

Furthermore, a major problem that managers face is how to minimize cost,maximize profit or optimize sales under certain constraints. Mathematical concepts andtechniques are extensively used in economic analysis with a view to finding answers tothese questions. Besides, certain mathematical tools and optimization techniques, relativelymore sophisticated and advanced, designed during and after World War II have foundwide ranging application to business management, viz., linear programming, inventorymodels and game theory. A working knowledge of these techniques and other mathematicaltools is essential for managers. These topics, therefore, fall very much within the scopeof managerial economics.

Statistics

Similarly, statistical tools provide a great aid in business decision-making. Statisticaltechniques are used in collecting, processing and analyzing business data, testing thevalidity of economic laws with the real life economic data before they are applied tobusiness analysis. A good deal of business decisions are based on probable economicevents. The statistical tools, e.g., theory of probability, forecasting techniques andregression analysis help the decision-makers in predicting the future course of economicevents and probable outcome of their business decisions. Thus, the scope of businesseconomics includes also the study of statistical tools and techniques that are applied toanalyse the business data and to forecast economic variables. The mathematical andstatistical techniques are the tools in the armoury of decision-makers that solve thecomplex problems of business.

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Operations Research (OR)

Operations Research (OR) is an inter-disciplinary technique of finding solutions tomanagerial problems. It combines economics, mathematics and statistics to build modelsfor solving specific business problems and to find a quantitative solution thereto. Linearprogramming and goal programming are two widely used OR techniques in businessdecision-making.

Management Theory and Accountancy

Management theory and accounting are the other disciplines that are closely associatedwith managerial economics. Management theories bring out the behaviour of the firm intheir efforts to achieve certain predetermined objectives. With a change in conditions,both the objectives of firms and managerial behaviour change. An adequate knowledgeof management theory is, therefore, essential for a managerial economist. Accounting,on the other hand, is the main source of data reflecting the functioning and performanceof the firm. Besides, certain concepts used in business accounting are different fromthose used in pure economic logic. It is the task of the managerial economist to seek andprovide clarity and synthesis between the two kinds of concepts to be used in businessdecisions, thus preventing ambiguity and incoherence.

The scope of managerial economics is, thus, very wide. It is difficult to do justiceto the entire subject matter of managerial economics in one volume. In this book, wehave covered only that part of microeconomic theory which has direct application tobusiness decisions, as mentioned above. In addition, some broad aspects ofmacroeconomic theory, international trade and government policies, which often figurein business decision-making have also been covered.

1.2.6 Gap between Theory and Practice and The Role ofManagerial Economics

We have noted above that application of theories to the process of business decision-making contributes a great deal in arriving at appropriate business decisions. In thissection, we highlight the gap between the theoretical world and the real world and seehow managerial economics bridges this gap.

Theory vs. Practice

It is widely known that there exists a gap between theory and practice in all walks of life,more so in the world of economic thinking and behaviour. A theory which appears logicallysound may not be directly applicable in practice. For example, when there are economiesof scale, it seems theoretically sound that if inputs are doubled, output will be, more orless, doubled and if inputs are trebled, output will be, more or less, trebled. This theoreticalconclusion may not hold good in practice. This gap between theory and practice hasbeen very well illustrated in the form of a story by a classical economist, J.M. Clark.9 Hewrites:

‘There is a story of a man who thought of getting the economy of large scaleproduction in plowing, and built a plow three times as long, three times as wide, and threetimes as deep as an ordinary plow and harnessed six horses [three times the usualnumber] to pull it, instead of two. To his surprise, the plow refused to budge, and to hisgreater surprise it finally took fifty horses to move the refractory machine… [and] thefifty could not pull together as well as two’.

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The gist of the story is that managers—assuming they have abundant resources—may increase the size of their capital and labour, but may not obtain the expected results.Most probably the man in Clark’s story did not get the expected result because he waseither not aware of or he ignored or could not measure the resistance of the soil to a hugeplow. This incident clearly shows the gap between theory and practice.

In fact, the real economic world is extremely complex. The reason is that in aneconomy, everything is inter-linked. Economic decisions and economic activities ofeconomic entities—individuals, households, firms, and the government are, therefore,interconnected and interdependent. Change in one important economic variable generatesa wave of changes, beginning with a change in the directly related areas, which createcounter-changes. In economic terminology, a change in one economic variable causeschange in a large number of related variables. As a result, the entire economicenvironment changes. An alterning economic environment changes people’s economicgoals, motivations and aspirations which, in turn, change managers’ decisions. In fact,decision-making becomes a continuous process. The entire system looks ‘hopelesslychaotic’. Under the condition of changing environment and economic decisions, it isextremely difficult to predict human behaviour.

On the contrary, economic theories are rather simplistic because they arepropounded on the basis of economic models built on simplifying assumptions—mosteconomic models assume away the interdependence of economic variables. In fact,through these models, economists create a simplified world with its restrictive boundaries.It is from such models that they derive their own conclusions and formulate their theories.It is another thing that some economic, rather econometric, models are more complexthan the real world itself. Although economic models are said to be an extraction fromthe real world, how close it is to reality depends on how realistic are the assumptions ofthe model.

The assumptions of economic models are often claimed to be unrealistic. Themost common assumption of the economic models is the ceteris paribus assumption,i.e., other things remain constant. For example, consider the law of demand. It statesthat demand for a commodity changes in reverse direction of the change in its price,other things remaining constant. The ‘other things’ include consumers’ income, pricesof substitute and complementary goods, consumer’s tastes and preferences, advertisement,consumer’s expectations about the commodity’s future price, ‘demonstration effect’,and ‘snob effect’, etc. In reality, however, these factors do not remain constant. Since‘other things’ do not remain constant, the ceteris paribus assumption is alleged to be themost unrealistic assumption. Nevertheless, the law of demand does state the nature ofrelationship between the demand for a product and its price, in isolation of the factorsdetermining the demand for that product.

Economic theories are, no doubt, hypothetical in nature but not away fromreality. Economic theories are, in fact, a caricature of reality. In their abstract form,however, they do look divorced from reality. Besides, abstract economic theories cannotbe straightaway applied to real life problems. This should, however, not mean thateconomic models and theories do not serve any useful purpose. ‘Microeconomic theoryfacilitates the understanding of what would be a hopelessly complicated confusion ofbillions of facts by constructing simplified models of behaviour, which are sufficientlysimilar to the actual phenomenon and thereby help in understanding them’.10 Nevertheless,it cannot be denied that there is apparently a gap between economic theory andpractice. This gap arises mainly due to the inevitable gap between the abstract world ofeconomic models and the real world.

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1.2.7 How Managerial Economics Fills the Gap

There is undeniably a gap between economic theory and the real economic world. But,at the same time, it is also a mistaken view that economic theories can be directlyapplied to business decision-making. As already mentioned, economic theories do notoffer a custom-made or readymade solution to business problems but what they actuallydo is to provide a framework for logical economic thinking and analysis. The need forsuch a framework arises because the real economic world is too complex to permitconsidering every bit of relevant facts that influence economic decisions. In the wordsof Keynes, ‘The objective of [economic] analysis is not to provide a machine, or methodof blind manipulation, which will furnish an infallible answer, but to provide ourselveswith an organized and orderly method of thinking out particular problem…’.11 In theopinion of Boulding, the objective of economic analysis is to present the ‘map’ of realityrather than a perfect picture of it.12 In fact, economic analysis presents us with a roadmap; it guides us to the destination, but does not carry us there.

Here, as mentioned earlier, managerial economics can also be compared withmedical science. Just as the knowledge of medical science helps in diagnosing the diseaseand prescribing an appropriate medicine, managerial economics helps in analyzing thebusiness problems and in arriving at an appropriate decision.

Let us now see how managerial economics bridges this gap. On one side, there is thecomplex business world and, on the other, are abstract economic theories. ‘The big gapbetween the problems of logic that intrigue economic theorists and the problems ofpolicy that plague practical management needs to be bridged in order to give executiveaccess to the practical contributions that economic thinking can make to top managementpolicies’.13 Managerial decision-makers deal with the complex, rather chaotic, businessconditions of the real world and have to find the way to their destination, i.e., achievingthe goal that they set for themselves. Managerial economics applies economic logic andanalytical tools to sift wheat from the chaff. The economic logic and tools of analysisguide them in

(i) Identifying their problems in achieving their goal

(ii) Collecting the relevant data and related facts

(iii) Processing and analysing the facts

(iv) Drawing relevant conclusions

(v) Determining and evaluating the alternative means to achieve the goal

(vi) Taking a decision

Without application of economic logic and tools of analysis, business decisionsare most likely to be irrational and arbitrary, which are often counter-productive.

1.3 THEORY OF THE FIRM AND BUSINESSOBJECTIVES

The first and most important responsibility of a business manager is to achieve theobjective of the firm he manages. However, as we will see below, the objectives ofbusiness firms can be varied and also conflicting. Therefore, we begin our study ofmanagerial economics with a discussion on the various objectives of business firms. Theprimary objective of a business firm is to make profit. That is why the conventional

Check Your Progress

1. Define optimizingbehaviour in thecontext ofeconomics.

2. How doeseconomicscontribute tomanagerialeconomics?

3. How do economictheories facilitatebusiness decision-making?

4. What are themarket-relatedfactors whichdetermine if acompany wouldmake a profit?

5. Point out how thereis a differencebetween the theoryand practice ofmanagerialeconomics.

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theory of firm assumes profit maximization—not just making any profit—as the soleobjective of business firms. Baumol, a Nobel laureate in Economics and an authority onbusiness economics, has, however, argued, “There is no reason to believe that allbusinessmen pursue the same objective”.14 Recent researches on this issue reveal thatthe objectives that business firms pursue are more than one. Some important objectives,other than profit maximization, are: (a) maximization of sales revenue, (b) maximizationof firm’s growth rate, (c) maximization of manager’s utility function, (d) making asatisfactory rate of profit, (e) long-run survival of the firm, and (f) entry-prevention andrisk-avoidance.

The question that arises from business analysis point of view is ‘What is the mostcommon objective of business firms?’ There is no definite answer to this question. Perhapsthe best way to find out the common objective of business firms is to ask the businessowners and managers themselves. However, Baumol, has remarked that firms and theirexecutives are often not clear about the objectives they pursue. “In fact, it is commonexperience when interviewing executives to find that they will agree to every plausiblegoal about which they are asked.”15 However, profit maximization is regarded as themost common and theoretically most plausible objective of business firms.

In this section, we discuss briefly the various objectives of business firms suggestedby economists. The various objectives that are found to be pursued by the business firmsare discussed under two heads: (i) profit maximization, and (ii) alternative objectives.We will first discuss the meaning of profit, theory of profit and problems in measuringprofit. This will be followed by a detailed discussion onprofit maximization asthe objectiveof business firms. Finally, we will discuss briefly the alternative objectives of businessfirms.

1.3.1 Profit as Business Objective

Meaning of Profit

Profit means different things to different people. “The word ‘profit’ has different meaningto businessmen, accountants, tax collectors, workers and economists and it is often usedin a loose polemical sense that buries its real significance…”16 In a general sense,‘profit’ is regarded as income accruing to the equity holders, in the same sense as wagesaccrue to the labour; rent accrues to the owners of rentable assets; and interest accruesto the moneylenders. To a layman, profit means all income that flows to the investors. Toan accountant, ‘profit’ means the excess of revenue over all paid-out costs includingboth manufacturing and overhead expenses. It is more or less the same as ‘net profit’.For all practical purposes, profit (or business income) means profit in accountancy senseplus non-allowable expenses.17 Profit figures published by the business firms are profitsconforming to accounting concept of profit. Economist’s concept of profit is of ‘pureprofit’, also called ‘economic profit’ or ‘just profit’. Pure profit is a return over andabove the opportunity cost, i.e., the income which a businessman might expect from thesecond best alternative use of his resources. You will learn more about this in Unit 6.

1.3.2 Problems in Profit Measurement

As mentioned above, accounting profit equals revenue minus all explicit costs, andeconomic profit equals revenue minus both explicit and implicit costs. Once profit isdefined, it should not be difficult to measure the profit of a firm for a given period. Buttwo questions complicate the task of measuring profit: (i) which of the two concepts of

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profit should be used for measuring profit? and (ii) what costs should be or should not beincluded in the implicit and explicit costs?

The answer to the first question is that the use of a profit concept depends on thepurpose of measuring profit. Accounting concept of profit is used when the purpose is toproduce a profit figure for (i) the shareholders to inform them of progress of the firm,(ii) financiers and creditors who would be interested in the firm’s creditworthiness, (iii)the managers to assess their own performance, and (iv) for computation of tax-liability.For measuring accounting profit for these purposes, necessary revenue and cost dataare, in general, obtained from the firm’s books of account. It must, however, be notedthat accounting profit may present an exaggeration of actual profit (or loss) if it is basedon arbitrary allocation of revenues and costs to a given accounting period.

On the other hand, if the objective is to measure ‘true profit’, the concept ofeconomic profit should be used. However, ‘true profitability of any investment or businesscannot be determined until the ownership of that investment or business has been fullyterminated.’18 But then life of a corporation is eternal. Therefore, true profit can bemeasured only in terms of “maximum amount that can be distributed in dividends(theoretically from now to the identifinite future) without impairing the companies’ earningpower. Hence, the concept aims at preservation of stockholders’ real capital. To estimateincome then a forecast of all future changes in demand, changes in production process,cash outlays to operate the business, cash revenues and price changes. [is needed].”19

This concept of business income is, however, an ‘unattainable ideal’ and hence is of littlepractical use. Nevertheless, it serves as a guide to income measurement even frombusinessmen’s point of view.

If follows from the above discussion that, for all practical purposes, profits have tobe measured on the basis of accounting concept. But, measuring even the accountingprofit is not an easy task. The main problem is to decide as to what should be and whatshould not be included in the cost. One might feel that profit and loss accounts and balancesheet of the firms provide all the necessary data for measuring accounting profit. In fact,profit figures published by the joint stock companies are taken to be their actual accountingprofit and are used for analysing firms’ performance. There are, however, three specificitems of cost and revenue which pose conceptual problems. These items are: (i) depreciation,(ii) capital gains and losses, and (iii) current vs. historical costs. Measurement problemsarise for two reasons: (a) economists’ view on these items differs from that of accountants,and (b) there is more than one accepted method of treating these items. We discuss belowthe problems related to these items in detail.

Problem in Measuring Depreciation

Economists view depreciation as capital consumption. From their point of view, thereare two distinct ways of charging for depreciation: (i) the depreciation of an equipmentmust equal its opportunity cost, or alternatively, (ii) the replacement cost that willproduce comparable earning.

Opportunity cost of an equipment is ‘the most profitable alternative use of it that isforegone by putting it to its present use’. The problem is then of measuring the opportunitycost. One method of estimating opportunity cost, suggested by Joel Dean, is to measurethe fall in value during a year. Going by this method, one assumes selling of the equipmentas an alternative use. This method, however, cannot be applied when a capital equipmenthas no alternative use, likea harvester, a printing machine and a hydro-power project, etc.In such cases, replacement cost is the appropriate measure of depreciation.

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To accountants, depreciation is an allocation of capital expenditure over time.Such allocation of historical cost of capital over time, i.e., charging depreciation, is madeunder unrealistic assumptions of (a) stable prices, and (b) a given rate of obsolescence.What is more important in this regard is that there are different methods of chargingdepreciation over the lifetime of an equipment. The use of different methods of chargingdepreciation results in different levels of profit reported by the accountants.

For example, suppose a firm purchases a machine for` 10,000 having an estimated lifeof 10 years. The firm can apply any of the following four methods of chargingdepreciation:

(1) straightline method

(2) reducing balance method

(3) annuity method

(4) sum-of-the-year’s digit approachUnder the straightline method, the following formula is used for measuring

depreciation.

Annual Depreciation =Cost of Capital

Years of Capital life

Using this method for our example, we get

Annual Depreciation =10,000

1,00010 years

`

` . Thus, ` 1,000 would be charged as

depreciation each year.

Under reducing balance method, depreciation is charged at a constant (percent) rate of annually written down values of the machine. Assuming a depreciation rateof 20 per cent, ` 2000 in the first year,` 1600 in the second year,` 1280 in the third year,and so on, shall be charged as depreciation.

Under annuity method, the annual depreciation (d) is measured by using thefollowing formula.

d = (C + Cr)/n

where C = total cost, n is the number of active years of capital, and r is the interest rate.By applying annuity method to our example, we get d as follows.

d =10,000 10,000 0.20 12,000

120010 10

`

Finally, under the sum-of-the-year’s digits approach (i.e., a variant of the reducingbalance method) the years of equipment’s life are aggregated to give an unvaryingdenominator. Depreciation is then charged at the rate of the ratio of the last year’s digitsto the total of the years. In our example, the aggregated years of capital’s life equals1 + 2 + 3 + … + 10 = 55.

Depreciation in the first year will be 10,000 10/55 = ` 1818.18,

in the second year it will be 1,000 9/55 = ` 1636.36 and

in third year it will be 10,000 8/55 = ` 1454.54, and so on.

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Note that the four methods yield four different measures of annual depreciationand, hence, the different levels of profit.

Treatment of Capital Gains and Losses

Capital gains and losses are regarded as ‘windfalls’. Fluctuation in the stock marketprices is one of the most common sources of ‘windfalls’. In a progressive society,according to Dean, capital losses are, on balance, greater than capital gains. Many ofthe capital losses are of insurable nature, and when a businessman over-insures, theexcess insurance premium becomes eventually a capital gain.

Profit is also affected by the way capital gains and losses are treated in accounting.As Dean suggests, “A sound accounting policy to follow concerning windfalls is never torecord them until they are turned into cash by a purchase or sale of assets, since it isnever clear until then exactly how large they are …”20 But, in practice, some companiesdo not record capital gains until it is realized in money terms, but they do write off capitallosses from the current profit. If ‘sound accounting policy’ is followed, there will be oneprofit, and if the other method is followed, there will be another figure of profit. That isthe problem.

An economist is not concerned with what accounting practice or principle isfollowed in recording the past events. He is concerned mainly with what happens infuture. Therefore, the economist would suggest that the management should be awareof the approximate magnitude of such ‘windfalls’ long before they become precise enoughto be acceptable to accountants. This would be helpful in taking the right decision inrespect of affected assets.

Current vs. Historical Costs

Accountants prepare income statements typically in terms of historical costs, i.e., in termsof purchase price, rather than in terms of current price. The reasons given for this practiceare: (i) historical costs produce more accurate measurement of income, (ii) historical costsare less debatable and more objective than the calculated present replacement value, and(iii) accountants’ job is to record historical costs whether or not they have relevance forfuture decision-making. The accountant’s approach ignores certain important changes inearnings and losses of the firms, e.g., (i) the value of assets presented in the books ofaccounts is understated in times of inflation and overstated at the time of deflation and(ii) depreciation is understated during deflation. Historical cost recording does not reflectsuch changes in values of assets and profits. This problem assumes a critical importance incase of inventories and material stocks. The problem is how to evaluate the inventory andthe goods in the pipeline.

There are three popular methods of inventory valuation: (i) first-in-first-out (FIFO),(ii) last-in-first-out (LIFO) and (iii) weighted average cost (WAC).

Under FIFO method, material is taken out of stock for further processing in theorder in which they are acquired. The material stocks, therefore, appear in the firm’sbalance sheet at their actual cost price. This method is suitable when price has a seculartrend. However, this system exaggerates profits at the time of rising prices.

The LIFO method assumes that stocks purchased most recently become thecosts of the raw material in the current production. If inventory levels are stable, thecost of raw materials used at any point in the calculation of profits is always close tomarket or replacement value. But, when inventory levels fluctuate, this method loses itsadvantages.

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The WAC method takes the weighted average of the costs of materials purchasedat different prices and different points of time to evaluate the inventory.

All these methods have their own weaknesses and, therefore, they do not reflectthe ‘true profit’ of business. So the problem of evaluating inventories so as to yield a trueprofit figure remains.

1.3.3 Profit Maximization as Business Objective

As mentioned earlier, profit maximization has been the most important assumption onwhich economists have built price and production theories. This assumption has, however,been strongly questioned and alternative hypotheses suggested. This issue will be discussedin the forthcoming sections. Let us first look into the importance of the profit maximizationassumption and theoretical conditions of profit maximization.

The conventional economic theory assumes profit maximization as the onlyobjective of business firms. Profit maximization as the objective of business firms has along history in economic literature. It forms the basis of conventional price theory. Profitmaximization is regarded as the most reasonable and analytically the most ‘productive’business objective. The strength of this assumption lies in the fact that this assumption‘has never been unambiguously disproved’.

Besides, profit maximization assumption has a greater predictive power. It helpsin predicting the behaviour of business firms in the real world and also the behaviour ofprice and output under different market conditions. No alternative hypothesis explainsand predicts the behaviour of firms better than the profit maximization assumption. Letus now discuss the theoretical conditions for profit maximization.

Profit Maximizing Conditions

Total profit () is defined as

= TR – TC …(1.1)where TR = total revenue, and TC = total cost.

There are two conditions that must be fulfilled for TR – TC to be maximum.These conditions are called (i) necessary or the first order condition, and(ii) secondary or supplementary condition.

The necessary or the first-order condition requires that marginal revenue (MR)must be equal to marginal cost (MC). By definition, marginal revenue is the revenueobtained from the production and sale of one additional unit of output and marginal costis the cost arising due to the production of one additional unit of output.

The secondary or the second-order condition requires that the necessary or first-order condition must be satisfied under the stipulation of decreasingMR and rising MC.The fulfilment of the two conditions makes it the sufficient condition.

The profit maximizing conditions can also be presented algebraically as follows.

We know that a profit maximizing firm seeks to maximize

= TR – TC

Let us suppose that the total revenue (TR) and total cost (TC) functions are,respectively, given as

TR = f(Q) andTC = f(Q)

where Q = quantity produced and sold.

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By substituting total revenue and total cost functions in Eq. (2.1), the profit functionmay be written as

= f(Q)TR

– f(Q)TC

...(1.2)

Equation (1.2) can now be manipulated to illustrate the first and second orderconditions of profit maximization as follows.

First-order condition The first-order condition of maximizing a function is that itsfirst derivative must be equal to zero. Thus, the first-order condition of profit maximizationis that the first derivative of the profit function Eq. (1.2) must be equal to zero.Differentiating the total profit function and setting it equal to zero, we get

0TR TC

Q Q Q

...(1.3)

This condition holds only when

TR TC

Q Q

In Eq. (1.3), the term TR/Q gives the slope of the TR curve which in turn givesthe marginal revenue (MR). Similarly, the term TC/Q gives the slope of the total costcurve which is the same as marginal cost (MC). Thus, the first-order condition for profitmaximization can be stated as

MR = MC

The first-order condition is generally known as necessary condition. Anecessarycondition is one that must be satisfied for an event to take place. In other words, thecondition that MR = MC must be satisfied for profit to be maximum.

Second-order Condition As already mentioned, in non-technical terms, the second-order condition of profit maximization requires that the first order condition is satisfiedunder rising MC and decreasing MR. This condition is illustrated in Fig. 1.2. The MCand MR curves are the usual marginal cost and marginal revenue curves respectively.Incidentally, MC and MR curves are derived from TC and TR functions respectively.MC and MR curves intersect at two points, P

1 and P

2. Thus, the firstorder condition is

satisfied at both the points, but the second order condition of profit maximization issatisfied only at point P

2. Technically, the second-order condition requires that the second

derivative of the profit function is negative. The second derivative of the total profitfunction is given as

Fig. 1.2 Marginal Conditions of Profit Maximization

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2

2

2

2

2

2

Q

TC

Q

TR

Q

...(1.4)

The second-order condition requires that

02

2

2

2

Q

TC

Q

TR

or 2

2

2

2

Q

TC

Q

TR

...(1.5)

Since 2TR/ Q2 gives the slope of MR and 2TC/ Q2 gives the slope of MC, thesecond-order condition may also be written as

Slope of MR < Slope of MC

It implies that MC must have a steeper slope than MR or MC must intersect theMR from below.

To conclude, profit is maximized where both the first and second order conditionsare satisfied.

Algebra of Profit Maximization

We may now apply the profit maximization conditions to a hypothetical example andcompute profit maximizing output.

We know that TR = P.Q

Suppose demand function for a product is given as Q = 50 – 0.5P. Given thedemand function, price (P) function can be derived as

P = 100 – 2Q …(1.6)

By substituting price function for P in TR equation, we get

TR = (100 – 2Q)Q

or TR = 100Q – 2Q2 …(1.7)

Let us also suppose that the total cost function is given as

TC = 10 + 0.5 Q2 …(1.8)

Given the TR function (1.7) and TC function (1.8), we can now apply the firstorder condition of profit maximization and find profit maximizing output. We have notedthat profit is maximum where

MR = MC

orTR TC

Q Q

Given the total TR function in Eq. (1.7) and TC function in Eq. (1.8),

MR =TR

Q

= 100 – 4Q ...(1.9)

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and MC =TC

Q

= Q ...(1.10)

Thus, profit is maximum where

MR = MC

or 100 – 4Q = Q

5Q = 100

Q = 20

The output 20 satisfies the second-order condition also. The second-ordercondition requires that

2 2

2 20

TR TC

Q Q

In other words, the second-order condition requires that

0MR MC

Q Q

or(100 4 ) ( )

0Q Q

Q Q

That is, – 4 – 1 < 0

Thus, the second-order condition is also satisfied at output 20.

1.3.4 Controversy Over Profit Maximization Objective:Theory vs. Practice

Arguments Against Profit Maximization Objective

As noted above, traditional theory assumes profit maximization as the sole objective of abusiness firm. In practice, however, firms have been found to be pursuing many objectivesother than profit maximization. It is argued, in the first place, that the reason for thefirms, especially the large corporations, pursuing goals other than profit maximization isthe dichotomy between the ownership and the management. The separation ofmanagement from ownership gives managers an opportunity and also discretion to setgoals other than profit maximization. It is argued that large firms pursue such goals assales maximization, maximization of managerial utility function, maximization of firm’sgrowth rate, making a target profit, retaining market share, building up the net worth ofthe firm, and so on.

Secondly, traditional theory assumes full and perfect knowledge about currentmarket conditions and the future developments in the business environment of the firm.The firm is thus supposed to be fully aware of its demand and cost conditions in bothshort and long runs. Briefly speaking, a complete certainty about the market conditionsis assumed. Some modern economists question the validity of this assumption. Theyargue that the firms do not possess the perfect knowledge of their costs, revenue andfuture business environment. They operate in the world of uncertainty. Most price andoutput decisions are based on probabilities.

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Finally, the equi-marginal principle of profit maximization, i.e., equalizingMC andMR, has been claimed to be absent in the decision-making process of the firms. Empiricalstudies of the pricing behaviour of the firms have shown that the marginal rule of pricingdoes not stand the test of empirical verification. Hall and Hitch21 have found, in theirstudy of pricing practices of 38 UK firms, that the firms do not pursue the objective ofprofit maximization and that they do not use the marginal principle of equalizingMR andMC in their price and output decisions. Most firms aim at long-run profit maximization.In the short-run, they set the price of their product on the basis ofaverage cost principle,so as to cover AC = AVC + AFC (AC = Average cost, AVC = Average variable cost,AFC = Average fixed cost) and a normal margin of profit (usually 10 per cent). In asimilar study, Gordon22 has found (i) that there is a marked deviation in the real businessconditions from the assumptions of the traditional theory and (ii) that pricing practiceswere notably different from the marginal theory of pricing. Gordon has concluded that thereal business world is much more complex than the one postulated by the theorists. Becauseof the extreme complexity of the real business world and ever-changing conditions, thepast experience of the business firms is of little use in forecasting demand, price and costs.The firms are not aware of their MR and MC. The average-cost-principle of pricing iswidely used by the firms. Findings of many other studies of the pricing practices lendsupport to the view that there is little link between pricing theory and pricing practices.

The Defence of Profit Maximization

The arguments against profit-maximization assumption, however, should not mean thatpricing theory has no relevance to the actual pricing policy of the business firms. Asection of economists has strongly defended the profit maximization objective and‘marginal principle’ of pricing and output decisions. The empirical and theoretical supportput forward by them in defence of the profit maximization objective and marginal rule ofpricing may be summed as follows.

In two empirical studies of 110 ‘excellently managed companies’, J.S. Earley23

has concluded that the firms do apply the marginal rules in their pricing and outputdecisions. Fritz Maclup24 has argued in abstract theoretical terms that empirical studiesby Hall and Hitch and by Lester do not provide conclusive evidence against the marginalrule and these studies have their own weaknesses. He argues further that there hasbeen a misunderstanding regarding the purpose of traditional theory of value. Thetraditional theory seeks to explain market mechanism, resource allocation through pricemechanism and has a predictive value, rather than deal with specific pricing practices ofcertain firms. The relevance of marginal rules in actual pricing system of firms could notbe established for lack of communication between the businessmen and the researchersas they use different terminology like MR, MC and elasticities. Besides, businessmen,even if they do understand economic concepts, would not admit that they are makingabnormal profits on the basis of marginal rules of pricing. They would instead talk of a‘fair profit’. Also, Maclup is of the opinion that the practices of setting price equal toaverage variable cost plus a profit margin is not incompatible with the marginal rule ofpricing and that the assumptions of traditional theory are plausible.

While the controversy on profit maximization objective remains unresolved, theconventional theorists, the marginalists, continue to defend the profit maximization objectiveand its marginal rules.

Other Arguments in Defence of Profit Maximization Hypothesis The conventionaleconomic theorists defend the profit maximization hypothesis on the following grounds also.

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1. Profit is indispensable for firm’s survival. The survival of all the profit-orientedfirms in the long run depends on their ability to make a reasonable profit depending onthe business conditions and the level of competition. What profit is reasonable may be amatter of opinion. But, making profit is a necessary condition for the survival of the firm.Once the firms are able to make profit, they try to make it as large as possible, i.e., theytend to maximize it.2. Achieving other objectives depends on firm’s ability to make profit. Many otherobjectives of business firms have been cited in economic literature, e.g., maximization ofmanagerial utility function, maximization of long-run growth, maximization of sales revenue,satisfying all the concerned parties, increasing and retaining market share, etc. Theachievement of such alternative objectives depends wholly or partly on the primaryobjective of making profit.3. Evidence against profit maximization objective is not conclusive. Profitmaximization is a time-honoured objective of business firms. Although this objective hasbeen questioned by many researchers, some economists have argued that the evidenceagainst it is not conclusive or unambiguous.4. Profit maximization objective has a greater predicting power. Compared toother business objectives, profit maximization assumption has been found to provide amuch more powerful basis for predicting certain aspects of firms’ behaviour. As Friedmanhas argued, the validity of the profit maximization objective cannot be judged by a priorilogic or by asking business executives, as some economists have done. The ultimate testof its validity lies in its ability to predict the business behaviour and the business trends.5. Profit is a more reliable measure of a firm’s efficiency. Though not perfect, profitis the most efficient and reliable measure of the efficiency of a firm. It is also the sourceof internal finance. Profit as a source of internal finance assumes a much greatersignificance when financial market is highly volatile. The recent trend shows a growingdependence on the internal finance in the industrially advanced countries. In fact, indeveloped countries, internal sources of finance contribute more than three-fourthsof the total finance.6. Finally, according to Milton Friedman, whatever one may say about firms’ motivations,if one judges their motivations by their acts, profit maximization appears to be a morevalid business objective.25

1.3.5 Alternative Objectives of Business Firms

While postulating the objectives of business firms, the conventional theory of firm doesnot distinguish between owners’ and managers’ interests. The recent theories of firm,called ‘managerial’ and ‘behavioural’ theories of firm, however, assume owners andmanagers to be separate entities in large corporations with different goals and motivations.Berle and Means26 were the first to point out the dichotomy between the ownership andthe management and its role in managerial behaviour and in setting the goal(s) for thefirm that they manage. Later on Galbraith27 wrote extensively on this issue which isknown as Berle-Means-Galbraith (B-M-G) hypothesis. The B-M-G hypothesis states(i) that owner controlled firms have higher profit rates than manager controlled firms;and (ii) that managers have no incentive for profit maximization. The managers of largecorporations, instead of maximizing profits, set goals for themselves that can keep theowners quiet so that managers can take care of their own interest in the corporation. Inthis section, we will discuss very briefly some important alternative objectives of businessfirms, especially of large business corporations.

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Baumol’s Hypothesis of Sales Revenue Maximization

Baumol28 has postulated maximization of sales revenue as an alternative to profit-maximization objective. He attributes this objective to the dichotomy between ownershipand management in large business corporations. This dichotomy gives managers anopportunity to set their goals other than profit maximization goal which most owners andbusinessmen pursue. Given the opportunity, managers choose to maximize their ownutility function. According to Baumol, the most plausible factor in managers’ utilityfunctions is maximization of the sales revenue.

According to Baumol, the factors which explain the pursuance of salesmaximization by the managers are following.

First, salary and other earnings of managers are more closely related to sales revenuethan to profits.

Secondly, banks and financial corporations look at and lay a great emphasis on salesrevenue while financing a corporation.

Thirdly, trend in sales revenue is a readily available indicator of the performance of thefirm. It helps also in handling the employee’s problem of awarding efficiency and penalizinginefficiency.

Fourthly, increasing sales revenue enchances the prestige, reputation and perks ofmanagers while profits go to the owners.

Fifthly, managers find profit maximization a difficult objective to fulfill consistently overtime and at the same level. Profits may fluctuate with changing conditions.

Finally, growing sales strengthen competitive spirit of the firm in the market whereasdecreasing sales put the survivial of the firm at risk.

However, Baumol’s sales maximization hypothesis has also been questioned onthe following grounds.

First, so far as empirical validity of sales revenue maximization objective is concerned,factual evidences are inconclusive.29 Most empirical works are, in fact, based oninadequate data simply because requisite data is mostly not available. Secondly, eventheoretically, if total cost function (TC) intersects the total revenue function (TR) beforeit reaches its climax, Baumol’s theory collapses.Finally, it is also argued that, in the long run, sales maximization and profit maximizationobjective converge into one. For, in the long run, sales maximization tends to yield onlynormal levels of profit which turns out to be the maximum under competitive conditions.Thus, profit maximization is not incompatible with sales maximization.

Marris’s Hypothesis of Maximization of Firm’s Growth Rate

According to Robin Marris,30 managers maximize firm’s balanced growth rate subjectto managerial and financial constraints. He defines firm’s balanced growth rate (G) as

G = GD = G

C

where GD = growth rate of demand for firm’s product and G

C = growth rate of capital

supply to the firm.

In simple words, a firm’s growth rate is balanced when demand for its productand supply of capital to the firm increase at the same rate. Marris translates the two

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growth rates into two utility functions: (i) manager’s utility function and (ii) owner’sutility function.

The manager’s utility function (Um) and owner’s utility function (U

o) may be

specified as follows.

Um = f (salary, power, job security, prestige, status),

and Uo = f (output, capital, market-share, profit, public esteem).

Owners’ utility function (Uo) implies growth of demand for firm’s product and

supply of capital to the firm. Therefore, maximization of Uo means maximization of

‘demand for firm’s product’ or ‘growth of capital supply’. According to Marris, bymaximizing these variables, managers maximise both their own utility function and thatof the owners. The managers can do so because most of the variables (e.g., salaries,status, job security, power, etc.) appearing in their own utility function and those appearingin the utility function of the owners (e.g., profit, capital market, share, etc.) are positivelyand strongly correlated with a single variable, i.e., size of the firm. Therefore, managersseek to maximize the size of the firm. Maximization of size of the firm depends on themaximization of its growth rate. The managers, therefore, seek to maximize a steadygrowth rate.

Marris’s theory, though more rigorous and sophisticated than Baumol’s salesrevenue maximization, has its own weaknesses. It fails to deal satisfactorily witholigopolistic interdependence. Another serious shortcoming of his model is that it ignoresprice determination which is the main concern of profit maximization hypothesis. In theopinion of many economists, Marris’s model too, does not seriously challenge the profitmaximization hypothesis.

Williamson’s Hypothesis of Maximization of Managerial Utility Function

As mentioned above, in modern corporations, owners (or stockholders) and managers(paid salary for their managerial services) are two separate entities with differentobjectives. The relationship between owners and managers is of principal and agentnature. The problem of determining firm’s objective is generally known also asPrincipal-Agent Problem. Like Baumol and Marris, Williamson31 argues that managers havediscretion to pursue objectives other than profit maximization. Instead of maximizingprofit, the managers of modern corporations seek to maximize their ownutility functionsubject to a minimum level of profit. Managers’ utility function(U) is expressed as

U = f(S, M, ID)

where S = additional expenditure on staff,

M = managerial emoluments,

ID

= discretionary investments.

According to Williamson’s hypothesis, managers maximize their utility functionsubject to a satisfactory profit. A minimum profit is necessary to satisfy the shareholdersor else manager’s job security is endangered.

The utility functions which managers seek to maximize include both quantifiablevariables like salary and slack earnings, and non-quantitative variables such as prestige,power, status, job security, professional excellence, etc. The non-quantifiable variablesare expressed, in order to make them operational, in terms of expense preference

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defined as ‘satisfaction derived out of certain types of expenditures’ (such as slackpayments), and ready availability of funds for discretionary investment.

Like other alternative hypotheses, Williamson’s theory too suffers from certainweaknesses. His model fails to deal with the problem of oligopolistic interdependence.Williamson’s theory is said to hold only where rivalry between firms is not strong. Incase of strong rivalry, profit maximization is claimed to be a more appropriate hypothesis.Thus, Williamson’s managerial utility function too does not offer a more satisfactoryhypothesis than profit maximization.

Cyert-March Hypothesis of Satisficing Behaviour

Cyert-March32 hypothesis is an extension of Simon’s hypothesis of firms’ ‘satisficingbehaviour’ or satisfying behaviour. Simon had argued that the real business world is fullof uncertainty; accurate and adequate data are not readily available; where data areavailable, managers have little time and ability to process them; and managers workunder a number of constraints. Under such conditions it is not possible for the firms toact in terms of rationality postulated under profit maximization hypothesis. Nor do thefirms seeks to maximize sales, growth or anything else. Instead they seek to achieve a‘satisfactory profit’ a ‘satisfactory growth’, and so on. This behaviour of firms is termedas ‘Satisfaction Behaviour’.

Cyert and March added that, apart from dealing with an uncertain business world,managers have to satisfy a variety of groups of people—managerial staff, labour,shareholders, customers, financiers, input suppliers, accountants, lawyers, authorities,etc. All these groups have their interest in the firms. Their interests are often conflicting.The manager’s responsibility is to ‘satisfy’ them all. Thus, according to the Cyert-Marchhypothesis, firm’s behaviour is ‘satisficing behaviour’. The ‘satisficing behaviour’ impliessatisfying various interest groups by sacrificing firm’s interest or objective. The underlyingassumption of ‘Satisficing Behaviour’ is that a firm is a coalition of different groupsconnected with various activities of the firm, e.g., shareholders, managers, workers,input suppliers, customers, bankers, tax authorities, and so on. All these groups havesome kind of expectations–high and low–from the firm, and the firm seeks to satisfy allof them in one way or another by sacrificing some of its interest.

In order to reconcile between the conflicting interests and goals, managers forman aspiration level of the firm combining the following goals: (a) Production goal,(b) Sales and market share goals, (c) Inventory goal, and (d ) Profit goal.

These goals and ‘aspiration level’ are set on the basis of the managers’ pastexperience and their assessment of the future market conditions. The ‘aspiration levels’are modified and revised on the basis of achievements and changing business environment.

The behavioural theory has, however, been criticised on the following grounds.First, though the behavioural theory deals realistically with the firm’s activity, it does notexplain the firm’s behaviour under dynamic conditions in the long run.Secondly, it cannotbe used to predict exactly the future course of firm’s activities, Thirdly, this theory doesnot deal with the equilibrium of the firm or the industry. Fourthly, like other alternativehypotheses, this theory too fails to deal with interdependence of the firms and its impacton firms’ behaviour.

Rothschild’s Hypothesis of Long-Run Survival and Market Share Goals

Another alternative objective of a firm–as an alternative to profit maximization—wassuggested by Rothschild.33 According to him, the primary goal of the firm is long-run

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survival. Some other economists have suggested that attainment and retention of aconstant market share is an additional objective of the firms. The managers, therefore,seek to secure their market share and long-run survival. The firms may seek to maximizetheir profit in the long-run though it is not certain.

Entry-prevention and Risk-avoidance

Yet another alternative objective of the firms suggested by some economists is to prevententry of new firms into the industry. The motive behind entry-prevention may be (a)profit maximization in the long run, (b) securing a constant market share, and (c) avoidanceof risk caused by unpredictable behaviour of new firms. The evidence of whether firmsmaximize profits in the long-run is not conclusive. Some economists argue, however,that where management is divorced from ownership, the possibility of profit maximizationis reduced.

The advocates of profit maximization argue, however, that only profit-maximizingfirms can survive in the long-run. They can achieve all other subsidiary goals easily ifthey can maximize their profits.

It is further argued that, no doubt, prevention of entry may be the major objectivein the pricing policy of the firm, particularly in case of limit pricing. But then, the motivebehind entry-prevention is to secure a constant share in the market. Securing constantmarket share is compatible with profit maximization.

1.3.6 Making A Reasonable Profit—A Practical Approach

As noted above, objectives of business firms can be various. There is no unanimityamong the economists and researchers on the objectives of business firms. One thing is,however, certain that the survival of a firm depends on the profit it can make. So whateverthe goal of the firm—sales revenue maximization, maximization of firm’s growth,maximization of managers’ utility function, long-run survival, market share, or entry-prevention—it has to be a profitable organization. The firms, therefore, adopt a morepractical approach. Maximization of profit in technical sense of the term may not bepracticable, but making profit has to be there in the objective function of the firms. Thefirms may differ on ‘how much profit’ but they do set a profit target for themselves.Some firms set their objective of a ‘standard profit’, some of a ‘target profit’ and someof a ‘reasonable profit’. A ‘reasonable profit’ is the most common objective.

Let us now look into the policy questions related to setting standard or criteria fora reasonable profit. The important policy questions are:

(i) Why do modern corporations aim at a “reasonable profit” rather than attemptingto maximize profit?

(ii) What are the criteria for a reasonable profit?

(iii) How is the “reasonable profit” determined?Let us now briefly examine the policy implications of these questions.

Reasons for Aiming at “Reasonable Profits”

For a variety of reasons, modern large corporations aim at making a reasonable profitrather than maximizing the profit. Joel Dean34 has listed the following reasons.

1. Preventing entry of competitors. Profit maximization under imperfect marketconditions generally leads to a high ‘pure profit’ which is bound to attract competitors,

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particularly in case of a weak monopoly.35 The firms, therefore, adopt a pricing and aprofit policy that assure them a reasonable profit and, at the same time, keep potentialcompetitors away.

2. Projecting a favourable public image. It becomes often necessary for largecorporations to project and maintain a good public image, because if public opinion turnsagainst the firm, its sales begin to fall and if profits are high, government officials startraising their eyebrows on profit figures. Corporations may find it difficult under suchconditions to sail smoothly. So most firms set prices lower than those conforming to themaximum profit but high enough to ensure a “reasonable profit”.3. Restraining trade union demands. High profits make trade unions feel that theyhave a share in the high profit and therefore they raise demands for wage-hike. Wage-hike may lead to wage-price spiral and frustrate the firm’s objective of maximizingprofit. Therefore, profit restrain is sometimes used as a weapon against trade unionactivities.

4. Maintaining customer goodwill. Customer’s goodwill plays a significant role inmaintaining and promoting demand for the product of a firm. Customer’s goodwill dependslargely on the quality of the product and its ‘fair price’. What consumers view as fairprice may not be commensurate with profit maximization. Firms aiming at better profitprospects in the long-run, sacrifice their short-run profit maximization objective in favourof a “reasonable profit”.5. Other factors. Some other factors that put restraint on profit maximization include(a) managerial utility function being preferable to profits maximization for executives,(b) congenial relation between executive levels within the firm, (c) maintaining internalcontrol over management by restricting firm’s size and profit, and (d) forestalling theanti-trust suits.

Standards of Reasonable Profits

When firms voluntarily exercise restraint on profit maximization and choose to makeonly a ‘reasonable profit’, the questions that arise are:

(i) What form of profit standards should be used?

(ii) How should reasonable profits be determined?

(i) Forms of Profit Standard Profit standards may be determined in terms of(a) aggregate money terms, (b) percentage of sales, or (c) percentage return oninvestment. These standards may be determined with respect to the whole product lineor for each product separately. Of all the forms of profit standards, the total net profit ofthe enterprise is more common than other standards. But when purpose is to discouragethe potential competitors, then a target rate of return on investment is the appropriateprofit standard, provided competitors’ cost curves are similar. The profit standard interms of ‘ratio to sales is an eccentric standard’ because this ratio varies widely fromfirm to firm, even if they all have the ‘same return on capital invested’. This is particularlyso when there are differences in (a) vertical integration of production process, (b) intensityof mechanization, (c) capital structure, and (d) turnover.

(ii) Setting the Profit Standard The following are the important criteria that are takeninto account while setting the standards for a ‘reasonable profit’.

(a) Capital-attracting standard. An important criterion used in setting standardprofit is that it must be high enough to attract external (debt and equity) capital. For

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example, if a firm’s stocks are being sold in the market at five times their current earnings,it is necessary that the firm earns a profit of one-fifth or 20 per cent of the bookinvestment.

There are however certain problems associated with this criterion: (i) capitalstructure of the firm (i.e., the proportions of bonds, equity and perference shares) affectsthe cost of capital and thereby the rate of profit, and (ii) whether profit standard has tobe based on current or long-run average cost of capital as it varies widely from companyto company and may at times prove treacherous.

(b) ‘Plough-back’ standard. In case a company intends to rely on its own sourcesfor financing its growth, then the most relevant standard is the aggregate profit thatprovides for an adequate ‘plough-back’ for financing a desired growth of the companywithout resorting to the capital market. This standard of profit is used especially by thosefirms for whom maintaining liquidity and avoiding debt are main considerations in profitpolicy.

Plough-back standard is, however, socially less acceptable compared to capital-attracting standard. From society’s point of view, it is more desirable that all earnings aredistributed to stockholders and they should decide the further investment pattern. This isbased on a belief that market forces allocate funds more efficiently and an individual isthe best judge of his resource use. On the other hand, retained earnings which are underthe exclusive control of the management are likely to be wasted on low-earning projectswithin the company. But one cannot be sure as to which of the two allocating agencies—market or management—is generally superior. It depends on ‘the relative abilities ofmanagement and outside investors to estimate earnings prospects.’

(c) Normal earnings standard. Another important criterion for setting standardof reasonable profit is the ‘normal’ earnings of firms of an industry over a normal period.Company’s own normal earnings over a period of time often serve as a valid criterion ofreasonable profit, provided it succeeds in (i) attracting external capital,(ii) discouraging growth of competition, and (iii) keeping stockholders satisfied. Whenaverage of ‘normal’ earnings of a group of firms is used, then only comparable firms andnormal periods are chosen.

However, none of these standards of profits is perfect. A standard is, therefore,chosen after giving due consideration to the prevailing market conditions and publicattitudes. In fact, different standards are used for different purposes because no singlecriterion satisfies all conditions and all the people concerned.

1.3.7 Profit as Control Measure

An important managerial aspect of profit is its use in measuring and controllingperformance of the executives of the large business undertakings. Researches haverevealed that business executives of middle and high ranks often deviate from profitobjective and try to maximize their own utility functions.36 They think in terms of jobsecurity, personal ambitions for promotions, larger perks, etc., which often conflict withfirms’ profit-making objective. Keith Powlson37 has pointed out three common deviationisttendencies:

(i) more energy is spent in expanding sales volume and product lines than in raisingprofitability;

(ii) subordinates spend too much time and money doing jobs to perfection regardlessof its cost and usefulness and

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(iii) executives cater more to the needs of job security in the absence of any rewardfor imaginative ventures.

In order to control these deviationist tendencies and orienting managerial functionstowards the profit objective, the top management uses ‘managerial decentralization andcontrol-by-profit techniques’. These techniques have distinct advantage for a big businesscorporation. Managerial decentralization is achieved by changing over from functionaldivision of business activities (e.g., production branch, sales division, purchase department,etc.) to a system of product-wise division. Managerial responsibilities are then fixed interms of profit. Managers enjoy autonomy in their operations under the general policyframework. They are allotted a certain amount of money to spend and a profit target tobe achieved by the particular division. Profit is then the measure of executive performance,not the sales or quality. This kind of reorganization of management helps in assessingprofit-performance of various product lines in a multi-product organization. It serves asa useful guide in reorganization of the product lines.

The use of this technique, however, raises many interesting technical issues thatcomplicate its application. These issues centre around the method of measuring divisionalprofits and profit standards to be set. The two important problems that arise are:(i) should profit goals be set in terms of total net profit for the divisions or should they beconfined to their share in the total net profit? and (ii) how should divisional profits bedetermined when there is a long ladder of vertical integration?

In respect to question (i), the most appropriate profit standard of divisionalperformance is revenue minus current expenses. In respect to allocating different costs,however, some arbitrariness is bound to be there. However, where a long verticalintegration is involved, relative profitability of a division can be fixed in terms of a lower‘transfer price’ compared to the market price. But, control measures are not all thatsimple to apply. It is difficult to set a general formula. It has to be settled differentlyunder varying conditions.

Conclusion

Although profit maximization continues to remain the most popular hypothesis in economicanalysis, there is no reason to believe that profit maximization is the only objective thatfirms pursue. Modern corporations, in fact, pursue multiple objectives. Through theirstudy of business firms, the economists have postulated a number of alternative objectivespursued by them. The main factor behind the multiplicity of the objectives, particularly incase of large corporations, is the dichotomy between the management and the ownership.

Moreover, profit maximization hypothesis is a time-tested one. It is more easy tohandle. The empirical evidence against this hypothesis is not conclusive and unambiguous.Nor are the alternative hypotheses strong enough to replace this hypothesis. Moreimportantly, profit maximization hypothesis has a greater explanatory and predictivepower than any of the alternative hypotheses. Therefore, it still forms the basis of firms’behaviour.

1.4 SUMMARY

The growing complexity of business decision-making has inevitably increased theapplication of economic concepts, theories and tools of economic analysis in thisarea. The reason is that making an appropriate business decision requires a clear

Check Your Progress

6. What was Walker’stheory of profit?

7. Give a fewexamples ofinnovation.

8. Which are the threespecific items ofcost and revenuethat poseconceptualproblems in profitmeasurement?

9. Name the threepopular methods ofinventory valuation.

10. What is satisficingbehaviour?

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understanding of market conditions, the nature and degree of competition, marketfundamentals and the business environment.

Economics is obviously a study of the choice-making behaviour of the people. Inreality, however, choice-making is not as simple as it looks because the economicworld is very complex and most economic decisions have to be taken under thecondition of imperfect knowledge, risk and uncertainty.

Many business decisions are taken under conditions of uncertainty and risk. Thesearise mainly due to uncertain behaviour of the market forces, changing businessenvironment, emergence of competitors with highly competitive products,government policy, and international factors impacting the domestic market duemainly to increasing globalization as well as social and political changes in thecountry.

Economics has two major branches: (i) Microeconomics, and (ii) Macroeconomics.Both micro and macro-economics are applied to business analysis and decision-making—directly or indirectly.

It is far beyond the powers of a single business firm, howsoever large it may be,to determine and guide the course of economic, social and political factors of thenation. However, all the firms together or giant business houses can jointly influencethe economic and political environment of the country.

Microeconomic theories including those of demand, production, price determination,profit and capital budgeting, and macroeconomic theories including of nationalincome, those economic growth and fluctuations, international trade and monetarymechanism, and the study of state policies and their repercussions on the privatebusiness activities, by and large, constitute the scope of managerial economics.

The primary objective of a business firm is to make profit. That is why theconventional theory of firm assumes profit maximization—not just making anyprofit—as the sole objective of business firms.

To a layman, profit means all income that flows to the investors. To an accountant,‘profit’ means the excess of revenue over all paid-out costs including bothmanufacturing and overhead expenses. It is more or less the same as ‘net profit’.

Opportunity cost of an equipment is ‘the most profitable alternative use of it thatis foregone by putting it to its present use’. The problem is then of measuring theopportunity cost. One method of estimating opportunity cost, suggested by JoelDean, is to measure the fall in value during a year.

The conventional economic theory assumes profit maximization as the onlyobjective of business firms. Profit maximization as the objective of business firmshas a long history in economic literature. It forms the basis of conventional pricetheory. Profit maximization is regarded as the most reasonable and analyticallythe most ‘productive’ business objective. The strength of this assumption lies inthe fact that this assumption ‘has never been unambiguously disproved’.

While postulating the objectives of business firms, the conventional theory of firmdoes not distinguish between owners’ and managers’ interests. The recent theoriesof firm, called ‘managerial’ and ‘behavioural’ theories of firm, however, assumeowners and managers to be separate entities in large corporations with differentgoals and motivations.

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1.5 KEY TERMS

Managerial economics: can be broadly defined as the study of economic theories,logic and tools of economic analysis that are used in the process of businessdecision-making.

Economics: It is a social science and its basic function is to study how people—individuals, households, firms and nations—maximize their gains from their limitedresources and opportunities.

Accounting profit: To an accountant, profit means the excess of revenue overall paid-out costs including both manufacturing and overhead expenses.

Opportunity cost: It is defined as the payment that would be necessary to drawforth the factors of production from their most remunerative alternativeemployment.

Innovation theory of profit: As per the theory, factors like emergence of interestand profits, recurrence of trade cycles and such other changes are only incidentalto a distinct process of economic development and the principles which couldexplain the process of economic development would also explain these economicvariables.

1.6 ANSWERS TO ‘CHECK YOUR PROGRESS’

1. Optimizing behaviour is, selecting the best out of available options with the objectiveof maximizing gains from the given resources. Economics is thus a social science,which studies human behaviour in relation to optimizing allocation of availableresources to achieve the given ends.

2. Economics, though variously defined, is essentially the study of logic, tools andtechniques of making optimum use of the available resources to achieve the givenends. Economics thus provides analytical tools and techniques that managersneed to achieve the goals of the organization they manage. Therefore, a workingknowledge of economics, not necessarily a formal degree, is essential for managers.In other words, managers are essentially practicing economists.

3. Application of relevant economic theories to the problems of business facilitatesdecision-making in at least three ways:

(i) It gives a clear understanding of various economic concepts (e.g., cost,price, demand, etc.) used in business analysis.

(ii) It helps in ascertaining the relevant variables and specifying the relevantdata.

(iii) Economic theories state the general relationship between two or moreeconomic variables and also events.

4. Making a satisfactory profit is not always guaranteed because a firm has to carryout its activities under conditions of uncertainty with regard to (i) demand for theproduct, (ii) input prices in the factor market, (iii) nature and degree of competitionin the product market, and (iv) price behaviour under changing conditions in theproduct market, and so on.

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5. A theory which appears logically sound may not be directly applicable in practice.For example, when there are economies of scale, it seems theoretically soundthat if inputs are doubled, output will be, more or less, doubled and if inputs aretrebled, output will be, more or less, trebled. This theoretical conclusion may nothold good in practice.

6. According to Walker, profit is the rent of “exceptional abilities that an entrepreneurmay possess” over others. Just as land rent is the difference between the yieldsof the least and the most fertile lands, profit is the difference between the earningsof the least and the most efficient entrepreneurs. In formulating his profit theory,Walker assumed a state of perfect competition in which all firms are presumed topossess equal managerial ability.

7. Innovations may include:

Introduction of a new commodity or a new quality of goods;

The introduction of a new method of production;

The emergence or opening of a new market;

Finding new sources of raw material;

Organizing the industry in an innovative manner with new techniques.

8. These items are: (i) depreciation, (ii) capital gains and losses, and (iii) currentvs. historical costs.

9. There are three popular methods of inventory valuation: (i) first-in-first-out (FIFO),(ii) last-in-first-out (LIFO) and (iii) weighted average cost (WAC).

10. The ‘satisficing behaviour’ implies satisfying various interest groups by sacrificingfirm’s interest or objective. The underlying assumption of ‘Satisficing Behaviour’is that a firm is a coalition of different groups connected with various activities ofthe firm, e.g., shareholders, managers, workers, input suppliers, customers, bankers,tax authorities, and so on. All these groups have some kind of expectations–highand low–from the firm, and the firm seeks to satisfy all of them in one way oranother by sacrificing some of its interest.

1.7 QUESTIONS AND EXERCISES

Short-Answer Questions

1. Managerial economics is the discipline which deals with the application of‘economic theory to business management’. Comment.

2. What are the major areas of business decision-making? How does economictheory contribute to managerial decisions?

3. “Managerial economics bridges the gap between economic theory and businesspractice”. How?

4. What are the related topics other than microeconomic theories in managerialeconomics? How do they contribute to managerial economics?

5. What are the basic functions of a manager? How does managerial economicscontribute to business decision making?

6. Write a note on the nature and scope of managerial economics.

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7. What are the operational issues in business management? How doesmicroeconomics contribute to decision making in the operational issues?

8. What is macroeconomics? In what way is macroeconomics applicable to businessdecision-making?

9. What macroeconomic issues figure in business decision-making? How doesmacroeconomics help in understanding the implications of macroeconomic issues?

10. What is meant by business environment? What branch of economics is related tothe environmental issues of private business?

11. What are the basic functions of business managers? How does economics helpbusiness managers in performing their functions?

Long-Answer Questions

1. Discuss the nature and scope of managerial economics. What are the other relateddisciplines?

2. Managerial economics is essentially the application of microeconomic theory ofbusiness decision-making. Discuss the statement.

3. “Managerial economics is applied microeconomics”. Elucidate.4. “Managerial economics is the integration of economic theory with business practice

for the purpose of facilitating decision-making and forward planning by themanagement.” Explain.

5. How does the study of managerial economics help a business manager in decision-making? Illustrate your answer with examples from production and pricing issues.

6. What are the major macroeconomic issues related directly to business decision-making? What is their significance in business decisions?

7. Distinguish between the following concepts of profit:(a) Accounting profit and economic profit; (b) Normal profit and monopoly

profit;(c) Pure profit and opportunity cost.

8. Explain the following statements:(i) Profit is the rent for exceptional ability of an entrepreneur (Walker).

(ii) Profits arise only in a dynamic world (J.B. Clark).(iii) Profit is a reward for risk bearing (F.B. Hawley).(iv) Profit is a return to uncertainty bearing (F.H. Knight).(v) Profit is reward for innovations (J.A. Schumpeter).

9. What is the most plausible objective of business firms? What is the controversyon profit maximization hypothesis? How will you react to the debate?

10. What problems do the depreciation and capital gains cause in measuring profit?What are the methods of resolving the problems?

11. Examine critically profit maximization as the objective of business firms. Whatare the alternative objectives of business firms?

12. Explain the first and second-order conditions of profit maximization.

13. Explain how profit is used as a control measure. What problems are associatedwith the use of profit figure as a control measure?

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1.8 FURTHER READING

Dwivedi, D. N. 2008. Managerial Economics, Seventh Edition. New Delhi: VikasPublishing.

Keat, Paul G. and Philip, K. Y. Young. 2003. Managerial Economics: EconomicsTools for Today’s Decision Makers, Fourth Edition. Singapore: PearsonEducation.

Keating, B. and J. H. Wilson. 2003. Managerial Economics: An Economic Foundationfor Business Decisions, Second Edition. New Delhi: Biztantra.

Mansfield, E., W. B. Allen, N. A. Doherty, and K. Weigelt. 2002. ManagerialEconomics: Theory, Applications and Cases, Fifth Edition. NY: W. Orton& Co.

Peterson, H. C. and W. C. Lewis. 1999. Managerial Economics, Fourth Edition.Singapore: Pearson Education.

Salvatore, Dominick. 2001. Managerial Economics in a Global Economy, FourthEdition. Australia: Thomson-South Western.

Thomas, Christopher R. and Maurice S. Charles. 2005. Managerial Economics:Concepts and Applications, Eighth Edition. New Delhi: Tata McGraw-Hill.

Endnotes

1. It may be surprising that there is no final answer to this question. It is surprising becauseeconomics is the oldest social science and it has grown over the past two and a quartercenturies much faster than any other social science in terms of literature and applicationand yet could not be defined precisely. Economics has been defined differently at differentstages of its growth. As yet, there is no universal definition of economics, perhaps,because ‘economics is [still] an unfinished science’ (Zeuthen) and also because“Economics is still a young science” (Schultz).

2. Mansfield, E. (ed.), Managerial Economics and Operations Research, (W.W. Norton andCo., Inc., New York, 1966)., p. 11.

3. Spencer, M.H., and Seigelman, L., Managerial Economics, (Irwin Illinois, 1969), p. 1.

4. Douglas, Evan J. Managerial Economics: Analysis and Strategy, (Prentice-Hall, N.J.,1987), p. 1.

5. Davis Ronnie and Semoon Chang, Principles of Managerial Economics, (Prentice-Hall,N.J., 1986), p. 3.

6. Baumol, W.J. ‘What Can Economic Theory Contribute to Managerial Economics’ in AER,Vol. 51, No. 2, May 1961.

7. See also Simon, Herbert A. “The Decision-Making Process” in Mansfield (ed.), op. cit.

8. For example, Federation of Indian Chambers of Commerce and Industries (FICCI) hasbeen influencing the government’s economic policies, especially in regard to foreigninvestment, customs, oil prices, monetary (interest rate) policy and taxation policy.

9. Studies in the Economics of Overhead Costs, University of Chicago, 1923, p. 116, quotedin K.K. Seo, Managerial Economics, Text, Problems, and Short Cases, (Richard, D. Irwin,Inc., Homewood, Ill, 1984), p. 325.

10. Lerner, A.P. “Microeconomic Theory” in Perspective in Economics—Economists Looksat Their Field of Study by A.A. Brown, E. Neuberger, and M. Pakmastier (eds.), (McGraw-Hill, NY), p. 36.

11. Keynes, J.M. The General Theory of Employment Interest and Money, (Harcourt Brace,New York, 1936), p. 297.

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12. Boulding, K.E. Economic Analysis, (Harper and Bros., New York, 1948), p. 14.

13. Dean, Joel Managerial Economics, (Prentice Hall of India, New Delhi, 1977), p. vii..

14. Baumol, J. William, Economic Theory and Operations Analysis, (Prentice-Hall of IndiaPvt. Ltd., New Delhi), 1980, Fourth Edn., pp. 377–79.

15. Ibid., p. 378.

16. Dean, Joel, Managerial Economics, (Asia Publishing House, Bombay), 1960, p. 3.

17. For example, Indian Income Tax Act makes only partial allowance for expenses on‘entertainment and advertisement’.

18. Reekie, W.D. and J.N. Crook, Managerial Economics, (Phillip Allan, 1982), p. 381.

19. Dean, Joel, op. cit., p. 14.

20. Dean, Joel, op. cit., p. 19.

21. Hall, R.L., and C.J. Hitch, “Price Theory and Business Behaviour”, Oxford EconomicsPapers (1939), reprinted in ‘Studies in the Price Mechanism’ (ed.) by Wilson, T. andAndrews, P.W.S. (Oxford University Press, 1952).

22. Gordon, R.A., “Short Period Price Determination in Theory and Practice”, Am. Eco. Rev.,1948.

23. In his ‘Recent Developments in Cost Accounting and the Marginal Analysis’, Journal ofPolitical Economy, 1955, and ‘Marginal Policies of Excellently Managed Companies’, Am.Eco. Rev., 1956.

24. Maclup, Fritz ‘Marginal Analysis and Empirical Research’, Am. Eco. Rev., 1946, and‘Theories of the Firm: Marginalist, Managerialist, Behavioural’, Am. Eco. Rev. (1967).

25. Friedman, Milton, Essays in Positive Economics (Chicago University Press, Chicago,1953), pp. 3–43.

26. Berle, A.A., and G.C. Means, The Modern Corporation and Private Property (CommerceClearing House, New York, 1932).

27. Galbraith, J.K., Amercian Capitalism: The Concept of Countervailing Power, 1952; TheAffluent Society, 1958; The New Industrial State, 1967, all by Houghton Mifflin, Boston.

28. Baumol, W.J., Business Behaviour, Value and Growth (Macmillan, New York, 1959).Revised edition published by Harcourt, (Brace & World Inc., 1967).

29. Koutsoyiannis, A., Modern Microeconomics (Macmillan, 1979), pp. 346–51.30. Marris, Robin, “A Model of the Managerial Enterprise”, Q.J.E., 1963 and Theory of

Managerial Capitalism (N.Y., Macmillan, 1963).

31. Williamson, O.E., “Managerial Discretion and Business Behaviour”, Am. Eco. Rev., 1963and The Economics of Discretionary Behaviour: Managerial Objectives the Theory ofFirm (Markhamm, Chicago, 1967).

32. Cyert, Richard M., and March James, G. A Behavioural Theory of the Firm (Prentice-Hall,1963), Earlier this theme was developed by H.A. Simon, in his “A Behavioural Model ofRational Choice”, Q.J.E., 1955, pp. 99–118.

33. Rothschild, K.W., “Price Theory and Oligopoly”, E.J., 1947, pp., 297–320.34. Dean, Joel, op. cit., pp. 29–33.35. A weak monopoly is one that has no strong barriers to protect its strategic material

markets, patent rights, etc., and where production of a close substitute is technically anear possibility.

36. Managerial utility functions have already been discussed above under ‘AlternativeObjectives of Business Firms’.

37. Quoted in Joel Dean, Managerial Economics, pp. 39–40.

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UNIT 2 ANALYSIS OF DEMAND

Structure2.0 Introduction2.1 Unit Objectives2.2 Law of Demand2.3 Determinants of Demand2.4 Elasticity of Demand

2.4.1 Price Elasticity of Demand2.4.2 Measuring Price Elasticity from a Demand Function2.4.3 Price Elasticity and Total Revenue2.4.4 Price Elasticity and Marginal Revenue2.4.5 Determinants of Price Elasticity of Demand2.4.6 Cross-Elasticity of Demand2.4.7 Income-Elasticity of Demand2.4.8 Advertisement or Promotional Elasticity of Sales2.4.9 Elasticity of Price Expectations

2.5 Demand Forecasting2.5.1 Why Demand Forecasting2.5.2 Steps in Demand Forecasting

2.6 Techniques of Demand Forecasting2.6.1 Survey Methods2.6.2 Statistical Methods



2.0 INTRODUCTION

The demand side of the market for a product refers to all its consumers and the pricethey are willing to pay for buying a certain quantity of the product during a period oftime. The quantity that consumers buy at a given price determines the market size. It isthe size of the market that determines the business prospects of a firm and an industry.The demand side of the market is governed by the law of demand, which governs themarket such that when the prices go up, demand goes down and size of the market isreduced, all other things remaining the same. Similarly, when prices decrease, demandincreases, causing a rise in sales and market size tends to increase.

In this unit, you will learn about the law and determinants of demand, the elasticityof demand and demand forecasting.

2.1 UNIT OBJECTIVES


Define the law of demand

Examine determinants of demand

Analyse the concept of elasticity of demand

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Discuss demand forecasting

Identify techniques of demand forecasting

2.2 LAW OF DEMAND

The law of demand states the nature of relationship between the quantity demanded ofa product and the price of the product. Although quantity demanded of a commoditydepends also on many other factors, e.g., consumer’s income, price of the substitutesand complementary goods, consumer’s taste and preferences, advertisement, etc., thecurrent price is the most important and the only determinant of demand in the short run.

The law of demand can be stated as all other things remaining constant, thequantity demanded of a commodity increases when its price decreases anddecreases when its price increases. This law implies that demand and price are inverselyrelated. Marshall, the originator of the law, has stated the law of demand as “the amountdemanded increases with a fall in price and diminishes with a rise in price”. This lawholds under ceteris paribus assumption, that is, all other things remain unchanged.

2.3 DETERMINANTS OF DEMAND

The market demand for a product is determined by a number of factors, viz. price of theproduct, price and availability of the substitutes, consumer’s income, his own preferencefor a commodity, utility derived from the commodity, ‘demonstration effect’,advertisement, credit facility by the sellers and banks, off-season discounts, number ofthe uses of the commodity, population of the country, consumer’s expectations regardingthe future trend in the price of the product, consumers’ wealth, past levels of demand,past levels of income, government policy, etc. But all these factors are not equallyimportant. Besides, some of these factors are not quantifiable, e.g., consumer’spreferences, utility, demonstration effect, and expectations, and hence are not usable inthe demand estimation. Nevertheless, we will discuss here how some importantquantifiable and non-quantifiable determinants determine the market demand for a product.

1. Price of the Commodity

As stated above, price is the most important determinant of the quantity demanded of acommodity. The price–quantity relationship is the central theme of demand theory. Thenature of relationship between price of a commodity and its quantity demanded hasalready been discussed under the ‘Law of Demand’.

2. Price of Substitutes and Complementary Goods

The demand for a commodity depends also on the prices of its substitutes andcomplementary goods. Two commodities are deemed to be substitutes for each otherif change in the price of one affects the demand for the other in the same direction. Forinstance, commodities X and Y are, in an economic sense, substitutes for each other if arise in the price of X increases the demand for Y, and vice versa. Tea and coffee,hamburger and hot-dog, alcohol and drugs are some common examples of substitutes.

By definition, the relationship between demand of a product (say, tea) and theprice of its substitute (say, coffee) is positive in nature. When price of the substitute(coffee) of a product (tea) falls (or increases), demand for the product falls (or increases).The relationship of this nature is given in Figure 2.1(a).

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A commodity is deemed to be a complement of another when it complements theuse of the other. In other words, when the use of any two goods goes together so thattheir demand changes (increases or decreases) simultaneously, they are treated ascomplements. For example, petrol is a complement of motor vehicles; butter and jam arecomplements of bread; milk and sugar are complements of tea and coffee. Technically,two goods are complements of one another if an increase in the price of one causes adecrease in the demand for another. By definition, there is an inverse relationship betweenthe demand for a good and the price of its complement. For instance, an increase (ordecrease) in the price of petrol causes a decrease (or an increase) in the demand forcar, other things remaining the same. The nature of relationship between the demand fora product and the price of its complement is given in Figure 2.1(b).

(a) (b)

Fig. 2.1 Demand for Substitutes and Complements

3. Consumer’s Income

Income is the basic determinant of the quantity demanded of a product as it determinesthe purchasing power of the consumer. That is why the people with higher currentdisposable income spend a larger amount on normal goods and services than those withlower incomes. Income–demand relationship is of a more varied nature than that betweendemand and its other determinants.

For the purpose of income–demand analysis, goods and services may be groupedunder four broad categories, viz. (a) essential consumer goods; (b) inferior goods; (c)normal goods; and (d) prestige or luxury goods. The relationship between income and thedifferent kinds of consumer goods is presented through the Engel Curves in Figure 2.2.

(a) Essential Consumer Goods (ECG): The goods and services which fall inthis category are consumed, as a matter of necessity, by almost all persons of asociety, e.g., foodgrains, salt, vegetable oils, matches, cooking fuel, a minimumclothing and housing. Quantity demanded of such goods increases with increasein consumer’s income only upto a certain limit, other factors remaining the same.The relation between demand of this category and consumer’s income is shownby curve ECG in Figure 2.2. As the curve shows, consumer’s demand for essentialgoods increases until his income rises to OY

2 and beyond this level of income, it

does not.

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(b) Inferior goods: Inferior and superior goods are generally known to the consumersby and large. For instance, every consumer knows that bajra is inferior to wheatand rice; bidi (an indigenous cigarette) is inferior to cigarette, cars without ACare inferior to AC cars, kerosene-stove is inferior to gas-stove; travelling by busis inferior to travelling by taxi, and so on. In economic terminology, however, acommodity is deemed to be inferior if its demand decreases with the increase inconsumers’ income. The relation between income and demand for an inferiorgood is shown by curve IG in Figure 2.2 under the assumption that otherdeterminants of demand remain the same. Demand for such goods may initiallyincrease with increase in income (say, upto Y

1) but it decreases when income

increases beyond a certain level.

(c) Normal goods: Technically, normal goods are those which are demanded inincreasing quantities as consumers’ income rises. Clothing is the most importantexample of this category of goods. The nature of relation between income anddemand for the normal goods is shown by curve NG in Figure 2.2. As the curveshows, demand for such goods increases with the increase in income of theconsumer, but at different rates at different levels of income. Demand for normalgoods initially increases rapidly, and later, at a lower rate. With the increase in theconsumers’ income, its income-elasticity decreases.

Fig. 2.2 Income–Demand Curves

It may be noted from Figure 2.2 that upto a certain level of income (Y1) the

relation between income and demand for all types of goods is positive. Whiledemand for some NG

s increases at a faster rate, for others, it increase at a low

rate. The difference is of degree only. The income–demand relationship becomesdistinctly different beyond the level of income Y

1.

(d) Prestige or luxury goods: Prestige goods are those which are consumed mostlyby the rich section of the society, e.g., luxury cars, stone-studded jewellery, costlycosmetics, decoration items (like antiques) etc. Demand for such goods arisesonly beyond a certain level of consumer’s income. The income–demand relationshipof this category of goods is shown by the curve LG in Figure 2.2.

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4. Consumers’ Tastes and Preferences

Consumers’ tastes and preferences play an important role in determining the demandfor a product. Tastes and preferences depend, generally, on the social customs, religiousvalues attached to a commodity, habits of the people, the general lifestyle of the society,and also the age and sex of the consumers. Changes in these factors change consumers’taste and preferences. As a result, consumers reduce or give up the consumption ofsome goods and include some others in their consumption basket. Generally, if consumers’liking, taste and preference for certain goods and services change following the changein fashion, people switch their consumption pattern from cheaper, old-fashioned goodsover to costlier ‘mod’ goods, so long as the price differentials commensurate with theirpreference. Consumers are prepared to pay higher prices for ‘mod’ goods even if theirvirtual utility is the same as that of old-fashioned goods. This fact reveals that tastes andpreferences also influence the demand for goods and services.

5. Consumers’ Expectations

Consumers’ expectations regarding the future course of economic events, particularlyregarding changes in prices, income, and supply position of goods, play an important rolein determining the demand for goods and service in the short-run. As mentioned above,if consumers expect a rise in the price of a commodity, they tend to buymore of it at itscurrent price with a view to avoiding the pinch of price–rise in future. For example,when the automobile owners expect or Government of India announces a rise in petroland diesel prices from a future date, automobile owners buy more of petrol and diesel attheir current prices. On the contrary, if consumers expect a fall in the price of certaingoods, they postpone their purchase of such goods with a view to taking advantage oflower prices in future, mainly in the case of non-essential goods. This behaviour ofconsumers reduces the current demand for the goods whose prices are expected todecrease in future.

Similarly, an expected increase in income on account of announcement of revisionof pay scales, dearness allowance, bonus, etc., induces increase in current purchase,and vice versa. Besides, if consumers or users expect scarcity of certain goods in futureon account of a reported fall in future production, labour strikes on a large scale, diversionof civil supplies towards the military use, etc., the current demand for such goods wouldincrease, more so if their prices show an upward trend. Consumers demand more forfuture consumption; profiteers demand more to make money out of expected scarcity.In simple words, expectation regarding the shortage of a commodity in future increasesits current demand at the prevailing price.

6. Demonstration Effect

When new commodities or new models of existing ones appear in the market, richpeople buy them first. Some people buy new goods or new models of goods becausethey have a genuine need for them while others buy because they want to exhibit theiraffluence. Fashion goods make the most common case for this category of goods. Butonce new commodities come in vogue, many households buy them not because theyhave a genuine need for them but because others or neighbours have bought thesegoods. The purchases by the latter category of the buyers are made out of such feelingsas jealousy, competition, equality in the peer group, social inferiority and the desire toraise their social status. Purchases made on account of these factors are the result of‘Demonstration Effect’ or the ‘Bandwagon Effect’. These effects have a positive effect

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on the demand. On the contrary, when a commodity becomes a thing of common use,some people, mostly the rich, decrease or give up the consumption of such goods. Thisis known as ‘Snob Effect’. It has a negative effect on the demand for the related goods.

7. Consumer-Credit Facility

Availability of credit to the consumers from the sellers, banks, relations and friends orfrom any other source encourages the consumers to buy more than what they wouldbuy in the absence of credit facility. That is why the consumers who can borrow morecan consume more than those who can borrow less. Credit facility affects mostly thedemand for consumer durables, particularly those which require bulk payment at thetime of purchase.

8. Population of the Country

The total domestic demand for a product depends also on the size of the population.Given the price, per capita income, taste, preferences, etc., the larger the population, thelarger the demand for a product. With an increase (or decrease) in the size of population,employment percentage remaining the same, demand for the product will increase (ordecrease). The relation between market demand for essential and normal goods and thesize of population is similar to the income–demand relation.

9. Distribution of National Income

Apart from the level of individual incomes, the distribution pattern of national incomealso affects the demand for a commodity. If national income is evenly distributed, marketdemand for normal goods will be the largest. If national income is unevenly distributed,i.e., if majority of population belongs to the lower income groups, market demand foressential goods (including inferior ones) will be the largest whereas the same for otherkinds of goods will be relatively low. Furthermore, given a distribution of national incomeand a market demand for various types of goods, if national income gets distributed infavour of the rich so that this section becomes smaller, the demand for essential goodswill increase and the same for other kinds of goods will decrease and vice versa.

2.4 ELASTICITY OF DEMAND

We have earlier discussed the nature of relationship between demand and itsdeterminants. From managerial point of view, however, the knowledge of nature ofrelationship alone is not sufficient. What is more important is the extent of relationship orthe degree of responsiveness of demand to the changes in its determinants. The degreeof responsiveness of demand to the change in its determinants is called elasticity ofdemand.

The concept of elasticity of demand plays a crucial role in business-decisionsregarding manoeuvring of prices with a view to making larger profits. For instance,when cost of production is increasing, the firm would want to pass the rising cost on tothe consumer by raising the price. Firms may decide to change the price even withoutany change in the cost of production. But whether raising price following the rise in costor otherwise proves beneficial depends on:

(a) the price-elasticity of demand for the product, i.e., how high or low is theproportionate change in its demand in response to a certain percentage change inits price; and

Check Your Progress

1. What is a ceterisparibusassumption?

2. What are prestige/luxury goods?

3. What is theconsumer-creditfacility and howdoes it affectdemand?

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(b) price-elasticity of demand for its substitute, because when the price of a productincreases, the demand for its substitutes increases automatically even if theirprices remain unchanged.

Raising the price will be beneficial only if (i) demand for a product is less elastic;and (ii) demand for its substitute is much less elastic. Although most businessmen areintuitively aware of the elasticity of demand of the goods they make,1 the use of preciseestimates of elasticity of demand will add precision to their business decisions.

In this section, we will discuss various methods of measuring elasticities ofdemand. The concepts of demand elasticities used in business decisions are:(i) Price elasticity, (ii) Cross-elasticity; (iii) Income elasticity; and (iv) Advertisementelasticity, and (v) Elasticity of price expectation.

2.4.1 Price Elasticity of Demand

Price elasticity of demand is generally defined as the responsiveness or sensitivenessof demand for a commodity to the changes in its price. More precisely, elasticity ofdemand is the percentage change in demand as a result of one per cent change in theprice of the commodity. A formal definition of price elasticity of demand (e

p) is given as

ep =

Percentage change in quantity demanded

Percentage change in price

A general formula2 for calculating coefficient of price elasticity, derived from thisdefinition of elasticity, is given as follows:

ep

=Q P Q P

Q P Q P

=Q P

P Q

…(2.1)

where Q = original quantity demanded, P = original price, Q = change in quantitydemanded and P = change in price.

It is important to note here that a minus sign (–) is generally inserted in the formulabefore the fraction in order to make the elasticity coefficient a non-negative value.3

The elasticity can be measured between any two points on a demand curve (calledarc elasticity) or at a point (called point elasticity).

Arc Elasticity

The measure of elasticity of demand between any two finite points on a demand curveis known as arc elasticity. For example, measure of elasticity between points J and K(Fig. 2.3) is the measure of arc elasticity. The movement from point J to K on thedemand curve (D

x) shows a fall in the price from Rs. 20 to Rs. 10 so that

P = 20 – 10 = 10. The fall in price causes an increase in demand from 43 units to 75units so that Q = 43 – 75 = – 32. The elasticity between points J and K (moving fromJ to K) can be calculated by substituting these values into the elasticity formula asfollows:

ep

= – Q P

P Q

(with minus sign)

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=32 20

1.4910 43

...(2.2)

This means that a one per cent decrease in price of commodityX results in a 1.49per cent increase in demand for it.

Problem in Using Arc Elasticity: The arc elasticity should be measured and usedcarefully, otherwise it may lead to wrong decisions. Arc elasticity co-efficients differbetween the same two finite points on a demand curve if direction of change in price isreversed. For instance, as estimated in Eq. (2.2), the elasticity between pointsJ and K—moving from J to K equals 1.49. It may be wrongly interpreted that the elasticity ofdemand for commodityX between points J and K equals 1.49 irrespective of the directionof price change. But it is not true. A reverse movement in the price, i.e., the movementfrom point K to J implies a different elasticity co-efficient (0.43). Movement from pointK to J gives P = 10, P = 10 – 20 = –10, Q = 75 and Q = 75 – 43 = 32. By substitutingthese values into the elasticity formula, we get

Fig. 2.3 Linear Demand Curve

ep = – 32 10

.10 75

= 0.43 ...(2.3)

The measure of elasticity co-efficient in Eq. (2.3) for the reverse movement inprice is obviously different from one given by Eq. (2.2). It means that the elasticitydepends also on the direction of change in price. Therefore, while measuring priceelasticity, the direction of price change should be carefully noted.

Some Modifications: Some modifications have been suggested in economic literatureto resolve the problems associated with arc elasticity.

First, the problem arising due to the change in the direction of price change may beavoided by using the lower values ofP and Q in the elasticity formula, so that

ep = – . l

l

PQ

P Q

where Pl = 10 (the lower of the two prices) and Q

l = 43 (the lower of the two quantities).

Thus,

ep = – 32 10

.10 43

= 0.74 ...(2.4)

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This method is however devoid of the logic of calculating percentage changebecause the choice of lower values of P and Q is arbitrary—it is not in accordance withthe rule of calculating percentage change.

Second, another method suggested to resolve this problem is to use the averageof upper and lower values of P and Q in fraction P/Q. In that case the formula is

ep = – 1 2

1 2

( ) / 2

( ) / 2

P PQ

P Q Q

or ep = – 1 2 1 2

1 2 1 2

( ) 2.( ) 2

Q Q P P

P P Q Q

…(2.5)

where subscripts 1 and 2 denote lower and upper values of prices and quantitites.

Substituting the values from our example, we get,

ep = – 43 75 (20 10) 2

.20 10 (43 75) 2

= 0.81

This method too has its own drawbacks as the elasticity co-efficient calculatedthrough this formula refers to the elasticity mid-way between P

1P

2 and Q

1Q

2. The

elasticity co-efficient (0.81) is not applicable for the whole range of price-quantitycombinations at different points between J and K on the demand curve (Fig. 2.4)—itonly gives a mean of the elasticities between the two points.

Point Elasticity

Point elasticity on a linear demand curve. Point elasticity is also a way to resolve theproblem in measuring the elasticity. The concept of point elasticity is used for measuringprice elasticity where change in price is infinitesimally small.

Point elasticity is the elasticity of demand at a finite point on a demand curve,e.g., at point P or B on the linear demand curve MN in Fig. 2.4. This is in contrast to thearc elasticity between points P and B. A movement from point B towards P implieschange in price (P) becoming smaller and smaller, such that point P is almost reached.Here the change in price is infinitesimally small. Measuring elasticity for an infinitesimallysmall change in price is the same as measuring elasticity at a point. The formula formeasuring point elasticity is given below.

Fig. 2.4 Point Elasticity

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Point elasticity (ep) = P

QQP

...(2.6)

Note thatQ

P

has been substituted forQ

P

in the formula for arc elasticity. The

derivative Q

P

is reciprocal of the slope of the demand curve MN. Point elasticity is

thus the product of price-quantity ratio at a particular point on the demand curve and thereciprocal of the slope of the demand line. The reciprocal of the slope of the straight lineMN at point P is geometrically given by QN/PQ. Therefore,

Q

P

=QN

PQ

Note that at point P, price P = PQ and Q = OQ. By substituting these values in Eq.(2.6), we get

ep =

PQ QN QN

OQ PQ OQ

Given the numerical values for QN and OQ, elasticity at point P can be easilyobtained. We may compare here the arc elasticity between points J and K and pointelasticity at point J in Fig. 2.3. At point J,

ep =

QN

OQ =

108 43

43

= 1.51

Note that ep = 1.51 is different from various measures of arc elasticities

(i.e., ep= 1.49, e

p= 0.43, e

p= 0.7, and e

p= 0.81).

As we will see below, geometrically, QN/OQ = PN/PM. Therefore, elasticity ofdemand at point P (Fig. 2.4) may be expressed as

ep=

PN

PM

Proof. The fact that ep = PN/PM can be proved as follows. Note that in Fig.

8.8, there are three triangles— MON, MRP and PQN—andMON,MRP andPQN are right angles. Therefore, the other corresponding angles of the three triangleswill always be equal and hence, MON, MRP and PQN are similar.

According to geometrical properties of similar triangles, the ratio of any two sidesof a triangles are always equal to the ratio of the corresponding sides of the othertriangles. By this rule, between PQN and MRP,

QN

PN =

RP

PM

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Since RP = OQ, by substituting OQ for RP in the above equation, we get

QN

PN =

OQ

PM

It follows thatQN

OQ =

PN

PM

It means that price elasticity of demand at point P (Fig. 2.4) is given by

ep =

PN

PM

It may thus be concluded that the price elasticity of demand at any point on alinear demand curve is equal to the ratio of lower segment to the upper segments of theline, i.e.,

Fig. 2.5 Non-linear Demand Curve

ep =

Lower segment

Upper segment

Point elasticity on a non-linear demand curve. The ratio Q/ P in respect ofa non-linear demand curve is different at each point. Therefore, the method used tomeasure point elasticity on a linear demand curve cannot be applied straightaway. Asimple modification in technique is required. In order to measure point elasticity on anon-linear demand curve, the chosen point is first brought on a linear demand curve.This is done by drawing a tangent through the chosen point. For example, suppose wewant to measure elasticity on a non-linear demand curve, DD (Fig. 2.5) at point P. Forthis purpose, a tangent MN is drawn through point P. Since demand curve DD and theline MN pass through the same point (P), the slope of the demand curve and that of theline at this point is the same. Therefore, the elasticity of demand curve at pointP will beequal to that of the line at this point. Elasticity of the line at point P can be measured as

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Fig. 2.6 Point Elasticities of Demand

ep =

PP

QP

=PQ QN QN

OQ PQ OQ

As proved above, geometrically,QN

OQ =

PN

PM

To conclude, at midpoint of a linear demand curve, ep = 1. Note that in Fig. 2.6,

point P falls on the mid point of demand curve MN. At point, P, therefore, e = 1. Itfollows that at any point above the point P, e

p > 1, and at any point below the point P, e

p

< 1. According to this formula, at the extreme point N, ep = 0, and at extreme point M, e

p

is undefined because division by zero is undefined. It must be noted here that theseresults are relevant between points M and N.

2.4.2 Measuring Price Elasticity from a Demand Function

The price elasticity of demand for a product can be measured directly from the demandfunction. In this section, we will describe the method of measuring price elasticity ofdemand for a product from the demand function—both linear and non-linear. It may benoted here that if a demand function is given, arc elasticity can be measured simply byassuming two prices and working out P and Q. We will, therefore, confine ourselveshere to point elasticity of demand with respect to price.

Price Elasticity from a Linear Demand Function

Suppose that a linear demand function is given as

Q = 100 – 5P

Given the demand function, point elasticity can be measured for any price. Forexample, suppose we want to measure elasticity at P = 10. We know that

ep = Q

PPQ

The term Q/P in the elasticity formula is the slope of the demand curve. Theslope of the demand curve can be found by differentiating the demand function. That is,

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PQ

= 5)5100(

PP

Having obtained the slope of the demand curve as Q /P = – 5, ep at P = 10 can

be calculated as follows. Since, P = 10, Q = 100 – 5(10) = 50. By substituting thesevalues into the elasticity formula, we get,

ep = (– 5) 10

50 = –1

Similarly, at P = 8, Q = 100 – 5(8) = 60 and

ep = – 5 (8/60) = – 40/60 = – 0.67

And at P = 15, Q = 100 – 5(15) = 25, and

ep = – 5(15/25) = – 75/25 = – 3

Price Elasticity from a Non-linear Demand Function

Suppose a non-linear demand function of multiplicative form is given as follows.

Q = aP–b

and we want to compute the price elasticity of demand. The formula for computing theprice elasticity is the same, i.e.,

ep =

QP

PQ

…(2.7)

What we need to compute the price-elasticity coefficient is to find first the valueof the first term, Q/ P, i.e., the slope of the demand curve. The slope can be obtainedby differentiating the demand function, Thus,

PQ

= – baP–b-1 …(2.8)

By substituting Eq. (2.8) in Eq. (2.7), ep can be expressed as

ep

= – baP–b–1 P

Q

=bbaP

Q

…(2.9)

Since Q = aP – b, by substitution, we get

ep =

b

b

baP

aP

= –b …(2.10)

Equation (2.10) shows that when a demand function is of a multiplicative or powerform, price elasticity coefficient equals the power of the variable P. This means thatprice elasticity in the case of a multiplicative demand function remains constant all alongthe demand curve regardless of a change in price.

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2.4.3 Price Elasticity and Total Revenue

A firm aiming at enhancing its total revenue would like to know whether increasing ordecreasing the price would achieve its goal. The price-elasticity coefficient of demandfor its product at different levels of its price provides the answer to this question. Thesimple answer is that if e

p > 1, then decreasing the price will increase the total revenue

and if eq < 1, then increasing the price will increase the total revenue. To prove this point,

we need to know the total revenue (TR) and the marginal revenue (MR) functions andmeasures of price-elasticity are required. Since TR = Q.P, we need to know P and Q.This information can be obtained through the demand function. Let us recall our demandfunction given as

Q = 100 – 5P

Price function (P) can be derived from the demand function as

P = 20 – 0.2Q …(2.11)

Given the price function, TR can be obtained as

TR = P . Q = (20 – 0.2Q)Q = 20Q – 0.2Q2

From this TR-function, the MR-function can be derived as

MR = QTR

= 20 – 0.4Q

The TR-function is graphed in panel (a) and the demand and MR functions arepresented in panel (b) of Fig. 2.7. As the figure shows, at point P on the demand curve,e = 1 where output, Q = 50. Below point P, e < 1 and above point P, e > 1. It can be seenin panel (a) of Fig. 2.7 that TR increases so long as e > 1; TR reaches its maximum levelwhere e = 1; and it decreases when e < 1.

Fig. 2.7 Price Elasticity and Total Revenue

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The relationship between price-elasticity andTR is summed up in Table 2.1. As thetable shows, when demand is perfectly inelastic (i.e., e

p = 0 as is the case of a vertical

demand line) there is no decrease in quantity demanded when price is raised and viceversa. Therefore, a rise in price increases the total revenue and vice versa.

In case of an inelastic demand (i.e., ep < 1), quantity demanded increases by

less than the proportionate decrease in price and hence the total revenue falls whenprice falls. The total revenue increases when price increases because quantity demandeddecreases by less than the proportionate increase in price.

If demand for a product is unit elastic (ep = 1) quantity demanded increases (or

decreases) in the proportion of decrease (or increase) in the price. Therefore, totalrevenue remains unaffected.

If demand for a commodity has ep > 1, change in quantity demanded is greater

than the proportionate change in price. Therefore, the total revenue increases whenprice falls and vice versa.

The case of infinitely elastic demand represented by a horizontal straight line israre. Such a demand line implies that a consumer has the opportunity to buy any quantityof a commodity and the seller can sell any quantity of a commodity, at a given price. It isthe case of a commodity being bought and sold in a perfectly competitive market. Aseller, therefore, cannot charge a higher or a lower price.

Table 2.1 Elasticity, Price-change and Change in TR

Elasticity Change in Change in

Co-efficient Price TR

e = 0 Increase Increase

Decrease Decrease

e < 1 Increase Increase

Decrease Decrease

e = 1 Increase No change

Decrease No change

e > 1 Increase Decrease

Decrease Increase

e = Increase Decrease to zero

Decrease Infinite increase**Subject to the size of the market.

2.4.4 Price Elasticity and Marginal Revenue

The relationship between price-elasticity and the total revenue (TR) can be known moreprecisely by finding the relationship between price-elasticity and marginal revenue (MR).MR is the first derivative of TR-function and TR = P.Q (where P = price, and Q =quantity sold). The relationship between price-elasticity, MR and TR is shown below.

Since TR = P.Q,

MR =QP

QPQ

QP

)(

= 1Q P

PP Q

…(2.12)

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Note thatQP

PQ

in Eq. (2.12) is the reciprocal of elasticity. That is,

QP

PQ

= – 1ep

By substituting – 1

e for Q

PPQ

in Eq. (2.12), we get

MR =1

1p

Pe

…(2.13)

Given this relationship between MR and price-elasticity of demand, the decision-makers can easily know whether it is beneficial to change the price. If e = 1,MR = 0. Therefore, change in price will not cause any change in TR. If e < 1, MR < 0,TR decreases when price decreases and TR increases when price increases. And, if e >1, MR > 0, TR increases if price decreases and vice versa.

Price Elasticity, AR and MR Given the Eq. (2.13), the formula for price elasticity(e

p) can be expressed in terms of AR and MR. We know that P = AR. So Eq. (2.13) can

be written as

MR =1

1p

ARe

MR = AR –p

AR

e

By rearranging the terms, we get

MR – AR = –p

AR

e

or1

p

MR AR

AR e

The reciprocal of this equation gives the measure of the price elasticity (ep) of

demand which can be expressed as

AR

MR AR = – e

por e

p =

AR

AR MR

2.4.5 Determinants of Price Elasticity of Demand

We have noted above that price-elasticity of a product may vary between zero andinfinity. However, price-elasticity of demand, at a given price, varies from product toproduct depending on the following factors.

1. Availability of Substitutes. One of the most important determinants of elasticity ofdemand for a commodity is the availability of its close substitutes. The higher the degree

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of closeness of the substitutes, the greater the elasticity of demand for the commodity.For instance, coffee and tea may be considered as close substitutes for one another. Ifprice of one of these goods increases, the other commodity becomes relatively cheaper.Therefore, consumers buy more of the relatively cheaper good and less of the costlierone, all other things remaining the same. The elasticity of demand for both these goodswill be higher. Besides, the wider the range of the substitutes, the greater the elasticity.For instance, soaps, toothpastes, cigarettes, etc., are available in different brands, eachbrand being a close substitute for the other. Therefore, the price-elasticity of demand foreach brand is much greater than that for the generic commodity. On the other hand,sugar and salt do not have close substitutes and hence their price-elasticity is lower.

2. Nature of Commodity. The nature of a commodity also affects the price-elasticityof its demand. Commodities can be grouped as luxuries, comforts and necessities. Demandfor luxury goods (e.g., high-price refrigerators, TV sets, cars, decoration items, etc.) ismore elastic than the demand for necessities and comforts because consumption ofluxury goods can be dispensed with or postponed when their prices rise. On the otherhand, consumption of necessary goods, (e.g., sugar, clothes, vegetables) cannot bepostponed and hence their demand is inelastic. Comforts have more elastic demand thannecessities and less elastic than luxuries. Commodities are also categorized as durablegoods and perishable or non-durable goods. Demand for durable goods is more elasticthan that for non-durable goods, because when the price of the former increases, peopleeither get the old one repaired instead of replacing it or buy a ‘second hand’.

3. Weightage in the Total Consumption. Another factor that influences the elasticityof demand is the proportion of income which consumers spend on a particular commodity.If proportion of income spent on a commodity is large, its demand will be more elastic.On the contrary, if the proportion of income spent on a commodity is small, its demand isless price-elastic. Classic examples of such commodities are salt, matches, books, pens,toothpastes, etc. These goods claim a very small proportion of income. Demand forthese goods is generally inelastic because increase in the price of such goods does notsubstantially affect the consumer’s budget. Therefore, people continue to purchase almostthe same quantity even when their prices increase.

4. Time Factor in Adjustment of Consumption Pattern. Price-elasticity of demanddepends also on the time consumers need to adjust their consumption pattern to anew price: the longer the time available, the greater the price-elasticity. The reason isthat over a period of time, consumers are able to adjust their expenditure pattern to pricechanges. For instance, if the price of TV sets is decreased, demand will not increaseimmediately unless people possess excess purchasing power. But over time, people maybe able to adjust their expenditure pattern so that they can buy a TV set at a lower (new)price. Consider another example. If price of petrol is reduced, the demand for petroldoes not increase immediately and significantly. Over time, however, people get incentivefrom low petrol prices to buy automobiles resulting in a significant rise in demand forpetrol.

5. Range of Commodity Use. The range of uses of a commodity also influencesthe price-elasticity of its demand. The wider the range of the uses of a product, thehigher the elasticity of demand for the decrease in price. As the price of a multi-usecommodity decreases, people extend their consumption to its other uses. Therefore, thedemand for such a commodity generally increases more than the proportionate increasein its price. For instance, milk can be taken as it is and in the form of curd, cheese, ghee

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and butter-milk. The demand for milk will therefore be highly elastic for decrease inprice. Similarly, electricity can be used for lighting, cooking, heating and for industrialpurposes. Therefore, demand for electricity has a greater elasticity. However, for theincrease in price, such commodities have a lower price-elasticity because the consumptionof a normal good cannot be cut down substantially beyond a point when the price of thecommodity increases.

6. Proportion of Market Supplied. The elasticity of market demand also depends onthe proportion of the market supplied at the ruling price. If less than half of themarket is supplied at the ruling price, price-elasticity of demand will be higher than 1 andif more than half of the market is supplied, e < 1.

2.4.6 Cross-Elasticity of Demand

The cross-elasticity is the measure of responsiveness of demand for a commodity to thechanges in the price of its substitutes and complementary goods. For instance, cross-elasticity of demand for tea is the percentage change in its quantity demanded withrespect to the change in the price of its substitute, coffee. The formula for measuringcross-elasticity of demand for tea (e

t, c) and the same for coffee (e

c, t) is given below.

et, c

=Percentage change in demand for tea ( )

Percentage change in price of coffee ( )t

c

Q

P

= .c t

t c

P Q

Q P

…(2.14)

and ec, t

= .t c

c t

P Q

Q P

…(2.15)

The same formula is used to measure the cross-elasticity of demand for a goodwith respect to a change in the price of its complementary goods. Electricity to electricalgadgets, petrol to automobiles, butter to bread, sugar and milk to tea and coffee, are theexamples of complementary goods.

It is important to note that when two goods are substitutes for one another, theirdemand has positive cross-elasticity because increase in the price of one increases thedemand for the other. And, the demand for complementary goods has negative cross-elasticity, because increase in the price of a good decreases the demand for itscomplementary goods.

Uses of Cross-Elasticity

An important use of cross-elasticity is to define substitute goods. If cross-elasticitybetween any two goods is positive, the two goods may be considered as substitutes ofone another. Also, the greater the cross-elasticity, the closer the substitute. Similarly, ifcross-elasticity of demand for two related goods is negative, the two may be consideredas complementary of one another: the higher the negative cross-elasticity, the higher thedegree of complementarity.

The concept of cross-elasticity is of vital importance in changing prices of productshaving substitutes and complementary goods. If cross-elasticity in response to the priceof substitutes is greater than one, it would be inadvisable to increase the price; rather,reducing the price may prove beneficial. In case of complementary goods also, reducing

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the price may be helpful in maintaining the demand in case the price of the complementarygood is rising. Besides, if accurate measures of cross-elasticities are available, the firmcan forecast the demand for its product and can adopt necessary safeguards againstfluctuating prices of substitutes and complements.

2.4.7 Income-Elasticity of Demand

Apart from the price of a product and its substitutes, consumer’s income is anotherbasic determinant of demand for a product. As noted earlier, the relationship betweenquantity demanded and income is of positive nature, unlike the negative price-demandrelationship. The demand for most goods and services increases with increase inconsumer’s income and vice versa. The responsiveness of demand to the changes inincome is known as income-elasticity of demand.

Income-elasticity of demand for a product, say X, (i.e., ey) may be defined as:

ey =

q

q q

q

X

X XYY X Y

Y

…(2.16)

(where Xq = quantity of X demanded; Y = disposable income; X

q = change in quantity

of X demanded; and Y = change in income)

Obviously, the formula for measuring income-elasticity of demand is the same asthat for measuring the price-elasticity. The only change in the formula is that the variable‘income’ (Y) is substituted for the variable ‘price’ (P). Here, income refers to the disposableincome, i.e., income net of taxes. All other formulae for measuring price-elasticities mayby adopted to measure the income-elasticities, keeping in mind the difference betweenthem and the purpose of measuring income-elasticity.

To estimate income-elasticity, suppose, for example, government announces a 10per cent dearness allowance to its employees. As a result average monthly salary ofgovernment employees increases from `20,000 to `22,000. Following the pay-hike,monthly petrol consumption of government employees increases from 150 litre per monthto 165 litre. The income-elasticity of petrol consumption can now be worked out asfollows. In this case, Y = `22,000 –`20,000 = `2,000, and Q (oil demand) = 165 litre– 150 litre = 15 litre. By substituting those values in Eq. (2.16), we get

ey =

20,000 151

150 2,000

It means that income elasticity of petrol consumption by government employeesequals 1. It means that a one per cent increase in income results in a one per centincrease in petrol consumption.

Unlike price-elasticity of demand, which is always negative,4 income-elasticity ofdemand is always positive5 because of a positive relationship between income and quantitydemanded of a product. But there is an exception to this rule. Income-elasticity ofdemand for an inferior good is negative, because of the inverse substitution effect. Thedemand for inferior goods decreases with increase in consumer’s income. The reason isthat when income increases, consumers switch over to the consumption of superiorsubstitutes, i.e., they substitute superior goods for inferior ones. For instance, when

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income rises, people prefer to buy more of rice and wheat and less of inferior foodgrains;non-vegetarians buy more of meat and less of potato, and travellers travel more by planeand less by train.

Nature of Commodity and Income-Elasticity

For all normal goods, income-elasticity is positive though the degree of elasticity variesin accordance with the nature of commodities. Consumer goods of the three categories,viz., necessities, comforts and luxuries have different elasticities. The general pattern ofincome-elasticities of different goods for increase in income and their effect on salesare given in Table 2.2.

Table 2.2. Income-Elasticities

Consumer goods Co-efficient of Effect on salesincome-elasticity with change

in income

1. Essential goods Less than one (ey < 1) Less than proportionate

change in sale

2. Comforts Almost equal to unity Almost proportionate

(ey 1) change in sale

3. Luxuries Greater than unity More than proportionate

(ey > 1) increase in sale

Income-elasticity of demand for different categories of goods may, however, varyfrom household to household and from time to time, depending on the choice andpreference of the consumers, levels of consumption and income, and their susceptibilityto ‘demonstration effect’. The other factor which may cause deviation from the generalpattern of income-elasticities is the frequency of increase in income. If frequency of risein income is high, income-elasticities will conform to the general pattern.

Uses of Income-Elasticity in Business Decisions

While price and cross elasticities of demand are of greater significance in the pricing ofa product aimed at maximizing the total revenue in the short run, income-elasticity of aproduct is of a greater significance in production planning and management in the longrun, particularly during the period of a business cycle. The concept of income-elasticitycan be used in estimating future demand provided that the rate of increase in income andincome-elasticity of demand for the products are known. The knowledge of incomeelasticity can thus be useful in forecasting demand, when a change in personal incomesis expected, other things remaining the same. It also helps in avoiding over-production orunder-production.

In forecasting demand, however, only the relevant concept of income and datashould be used. It is generally believed that the demand for goods and services increaseswith increase in GNP, depending on the marginal propensity to consume. This may betrue in the context of aggregate national demand, but not necessarily for a particularproduct. It is quite likely that increase in GNP flows to a section of consumers who donot consume the product in which a businessman is interested. For instance, if the majorproportion of incremental GNP goes to those who can afford a car, the growth rate in

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GNP should not be used to calculate income-elasticity of demand for bicycles. Therefore,the income of only a relevant class or income-group should be used. Similarly, where theproduct is of a regional nature, or if there is a regional division of market between theproducers, the income of only the relevant region should be used in forecasting thedemand.

The concept of income-elasticity may also be used to define the ‘normal’ and‘inferior’ goods. The goods whose income-elasticity is positive for all levels of incomeare termed ‘normal goods’. On the other hand, goods whose income-elasticities arenegative beyond a certain level of income are termed ‘inferior goods’.

2.4.8 Advertisement or Promotional Elasticity of Sales

The expenditure on advertisement and on other sales-promotion activities does help inpromoting sales, but not in the same degree at all levels of the total sales and total ad-expenditure. The concept of advertisement elasticity is useful in determining the optimumlevel of advertisement expenditure. The concept of advertisement elasticity assumes agreater significance in deciding on advertisement expenditure, particularly when thegovernment imposes restriction on advertisement cost or there is competitive advertisingby the rival firms. Advertisement elasticity (e

A) of sales may be defined as

eA =

S/S S A

A/A A S

…(2.17)

where S = sales; S = increase in sales; A = initial advertisement cost, andA = additional expenditure on advertisement.

Suppose, for example, a company increases its advertising expenditure fromRs. 10 million to Rs. 20 million, and as a result, its sales increase from 50,000 units to60,000 units. In this case A = 20 million – 10 million = Rs. 10 million, and S = 60,000– 50,000 = 1000 units. By substituting these values in ad-elasticity formula (2.17), we get

eA

=10,000 10

0.210 50,000

It means that a one per cent increase in ad-expenditure results in only0.2 per cent increase in sales.

Interpretation of Advertisement Elasticity The advertisement elasticity of salesvaries between e

A = 0 and e

A = . Interpretation of some measures of advertising

elasticity is given below.

Elasticities Interpretation

eA = 0 Sales do not respond to the advertisement expenditure.

eA > 0 but < 1 Increase in total sales is less than proportionate to the increase

in advertisement expenditure.

eA = 1 Sales increase in proportion to the increase in expenditure on

advertisement.

eA > Sales increase at a higher rate than the rate of increase of

advertisement expenditure.

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Determinants of Advertisement Elasticity

Some important factors that determine ad-elasticity are the following.

(i) The level of total sales. In the initial stages of sale of a product, particularly of onewhich is newly introduced in the market, advertisement elasticity is greater than unity.As sales increase, ad-elasticity decreases. For instance, after the potential market issupplied, the function of advertisement is to create additional demand by attracting moreconsumers to the product, particularly those who are slow in adjusting their consumptionexpenditure to provide for new commodities. Therefore, demand increases at a ratelower than the rate of increase in advertisement expenditure.

(ii) Advertisement by rival firms. In a highly competitive market, the effectivenessof advertisement by a firm is also determined by the relative effectiveness of advertisementby the rival firms. Simultaneous advertisement by the rival firms reduces sales of salesby a firm.

(iii) Cumulative effect of past advertisement. In case expenditure incurred onadvertisement in the initial stages is not adequate enough to be effective, elasticity maybe very low. But over time, additional doses of advertisement expenditure may have acumulative effect on the promotion of sales and advertising elasticity may increaseconsiderably.

(iv) Other factors. Advertisement elasticity is affected also by other factors affectingthe demand for a product, e.g., change in products’ price, consumers’ income and growthof substitutes and their prices.

2.4.9 Elasticity of Price Expectations

Sometimes, mainly during the period of price fluctuations, consumer’s price expectationsplay a much more important role than any other factor in determining the demand for acommodity. The concept of price-expectation-elasticity was devised and popularized byJ.R. Hicks in 1939. The price-expectation-elasticity refers to the expected change infuture price as a result of change in current prices of a product. The elasticity of price-expectation is defined and measured by the formula given below.

ex =

/

/f f f c

c c c f

P P P P

P P P P

…(2.18)

where Pc and P

f are current and future prices respectively.

The coefficient ex gives the measure of expected percentage change in future

price as a result of 1 per cent change in present price. If ex > 1, it indicates that future

change in price will be greater than the present change in price, and vice versa.If e

x = 1, it indicates that the future change in price will be proportionately equal to the

change in the current price.

The concept of elasticity of price-expectation is very useful in formulating futurepricing policy. For example, if e

x > 1, it indicates that sellers will be able to sell more in

the future at higher prices. Thus, businessmen may accordingly determine their futurepricing policy.

Check Your Progress

4. Why is the conceptof elasticity ofdemand important?

5. What is pointelasticity ofdemand?

6. What are the usesof income-elasticityin businessdecisions?

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2.5 DEMAND FORECASTING

In two preceding chapters, we have dealt with consumer’s decision-making behaviour—how consumers decide what quantity of a commodity to consume; how they allocate thetotal consumption expenditure on various goods and services; how collective decisionsof consumers reflect in market demand; and how total demand responds to change in itsdeterminants. The theory of demand discussed so far deals with current demand whereasa major concern of businessmen, especially the big one, is ‘what would be the futuredemand for their product?’ This question arises because the knowledge about futuredemand for the firm’s product helps it a great deal in forward planning of production,acquiring inputs (man, material and capital), managing finances and chalking out futurepricing strategy, etc. For this purpose, businessmen make their own estimates or even a‘guesstimate’ of the future demand for their product or take the help of specializedconsultants or market research agencies to get the demand for their product forecast.There are a variety of methods used for demand forecasting, that are used depending onthe purpose and perspective of forecasting. In this section, we discuss the methods ofestimating future demand, i.e., methods of demand forecasting. Let us first look at theneed for demand forecasting in some detail.

2.5.1 Why Demand Forecasting

The business world is characterized by risk and uncertainty and, therefore, most businessdecisions are made under the condition of risk and uncertainty. One way to reduce theadverse effects of risk and uncertainty is to acquire knowledge about the future demandprospects for the product. The information regarding the future demand for the product isobtained by demand forecasting. Demand forecasting is predicting the future demandfor firm’s product. The knowledge about the future demand for the product helps a greatdeal in the following areas of business decision-making.

Planning and scheduling production

Acquiring inputs (labour, raw material and capital)

Making provision for finances

Formulating pricing strategy

Planning advertisement

Demand forecasting assumes greater significance where large-scale productionis involved. Large-scale production requires a good deal of forward planning as it involvesa long gestation period. The information regarding future demand is also essential for theexisting firms to be able to avoid under or over-production. Most firms are, in fact, veryoften confronted with the question as to what would be the future demand for theirproducts because they will have to acquire inputs and plan their production accordingly.The firms are hence required to estimate the future demand for their products. Otherwise,their functioning will be shrouded with uncertainty and their objective may be defeated.

This problem may not be of a serious nature for small firms which supply a verysmall fraction of the total demand, and whose product caters to the short-term or seasonaldemand or the demand of a routine nature. Their past experience and business skillsmay be sufficient for the purpose of planning and production. But, firms working on alarge scale find it extremely difficult to obtain a fairly accurate estimate of future marketdemand.6 In some situations, it is very difficult to obtain information needed to make

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even short-term demand forecasts and thus it is extremely difficult to make long-termforecasts. Under such conditions, it is not possible for the firm to determine how changesin specific demand variables like price, advertisement expenditure, credit terms, pricesof competing products, etc., will affect demand. It is nevertheless indispensable for thelarge firms to have at least an approximate estimate of the demand prospects. For,demand forecast plays an important role in planning the acquiring of inputs, both menand material (raw material and capital goods), organizing production, advertising theproduct, and organizing sales channels. These functions can hardly be performedsatisfactorily in an atmosphere of uncertainty regarding demand prospects for the product.The prior knowledge of market-size, therefore, becomes an essential element of decision-making by the large-scale firms.

2.5.2 Steps in Demand Forecasting

The objective of demand forecasting is achieved only when forecast is made systematicallyand scientifically and when it is fairly reliable. The following steps are generally taken tomake systematic demand forecasting.

(i) Specifying the objective. The objective or the purpose of demand forecastingmust be clearly specified. The objective may be specified in terms of (a) short-term orlong-term demand, (b) the overall demand for a product or for firm’s own product, (c)the whole or only a segment7of the market for its product, or (d) firm’s market share.The objective of demand forecasting must be determined before the process of forecastis started. This has to be the first step.

(ii) Determining the time perspective. Depending on the firm’s objective, demandmay be forecast for a short period, i.e., for the next 2-3 years, or for a long period. Indemand forecasting for a short period – 2-3 years – many of the demand determinantscan be taken to remain constant or not to change significantly. In the long run, however,demand determinants may change significantly. Therefore, the time perspective of demandforecasting must be specified.

(iii) Making choice of method for demand forecasting. As we will see below, anumber of different demand forecasting methods are available. However, all methodsare not suitable for all kinds of demand forecasting because the purpose of forecasting,data requirement of a method, availability of data and time frame of forecasting varyfrom method to method. The demand forecaster has therefore to choose a suitablemethod keeping in view his purpose and requirements. The choice of a forecastingmethod is generally based on the purpose, experience and expertise of the forecaster. Itdepends also to a great extent on the availability of required data. The choice of asuitable method saves not only time and cost but also ensures the reliability of forecast toa great extent.

(iv) Collection of data and data adjustment. Once method of demand forecasting isdecided on, the next step is to collect the required data—primary or secondary or both.The required data is often not available in the required mode. In that case, data needs tobe adjusted—even massaged, if necessary—with the purpose of building data seriesconsistent with data requirement. Sometimes the required data has to be generated fromthe secondary sources.

(v) Estimation and interpretation of results. As mentioned above, the availability ofdata often determines the method, and also the trend equation to be used for demandforecasting. Once required data is collected and forecasting method is finalized, the final

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step in demand forecasting is to make the estimate of demand for the predeterminedyears or the period. Where estimates appear in the form of an equation, the result mustbe interpreted and presented in a usable form.

2.6 TECHNIQUES OF DEMAND FORECASTING

The various techniques of demand forecasting are listed in the chart on the next page. Inthis section, we have explained the various demand forecasting methods and theirlimitations.

2.6.1 Survey Methods

Survey methods are generally used where the purpose is to make short-run forecast ofdemand. Under this method, consumer surveys are conducted to collect informationabout their intentions and future purchase plans. This method includes:

(i) Survey of potential consumers’ plan(ii) Opinion poll of experts

Let us now discuss the two methods of survey and look at their limitations.(i) Consumer Survey Method—Direct Interviews. The consumer survey method ofdemand forecasting involves direct interview of the potential consumers. Consumerscan be interviewed by any of the following methods, depending on the purpose, time andcost of survey.

(a) Complete enumeration, (b) Sample survey, or (c) End-use method.These consumer survey methods are used under different conditions and for

different purposes. Their advantages and disadvantages are described below.The most direct and simple way of assessing future demand for a product is to

interview the potential consumers or users and to ask them what quantity of the productunder reference they would be willing to buy at different prices over a given period, say,one year. This method is known as direct interview method. This method may coveralmost all the potential consumers or only selected groups of consumers from differentcities or parts of the area of consumer concentration. When all the consumers areinterviewed, the method is known as complete enumeration survey or comprehensiveinterview method and when only a few selected representative consumers areinterviewed, it is known as sample survey method. In the case of industrial inputs,interviews or postal inquiry of only end-users of a product may be required. Let us nowdescribe these methods in detail.(a) Complete Enumeration Method. In this method, almost all potential users ofthe product are contacted and are asked about their future plan of purchasing the productin question. The quantities indicated by the consumers are added together to obtain theprobable demand for the product. For example, if majority of households in a city reportthe quantity (q) they are willing to purchase of a commodity, then total probable demand(Dp) may be calculated as

Dp = q1 + q2 + q3 + …+ qn =

n

iiq

1

where q1, q2, q3 etc. denote demand by the individual households 1, 2, 3, etc.

Check Your Progress

7. How does demandforecasting help inbusiness decision-making?

8. Mention the stepsin demandforecasting.

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Cha

rt:

Tech

niqu

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f D

eman

d F

orec

asti

ng

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This method has certain limitations. It can be used successfully only in case ofthose products whose consumers are concentrated in a certain region or locality. In caseof a widely dispersed market, this method may not be physically possible or may provevery costly in terms of both money and time. Besides, the demand forecast through thismethod may not be reliable for the following reasons.

(i) consumers themselves may not know their actual demand in future and hencemay be unable or unwilling to answer the query;

(ii) even if they answer, their answers to hypothetical questions may be hypothetical—not real;

(iii) consumers’ response may be biased according to their own expectations aboutthe market conditions; and

(iv) their plans may change with a change in the factors not included in thequestionnaire.

(b) Sample Survey Method. Sample survey method is used when population of thetarget market is very large. Under sample survey method, only a sample of potentialconsumers or users is selected for interview. Consumers to be surveyed are selectedfrom the relevant market through a sampling method. Method of survey may be directinterview or mailed questionnaire to the sample-consumers. On the basis of the informationobtained, the probable demand may be estimated through the following formula.

Dp = R

S

H

H (H . A

D)

where Dp = probable demand forecast; H = census number of households from the

relevant market; Hs = number of households surveyed or sample households; H

R =

number of households reporting demand for the product; AD = average expected

consumption by the reporting households (= total quantity reported to be consumed bythe reporting households numbers of households).

This method is simpler, less costly and less time-consuming compared to thecomprehensive survey method. This method is generally used to estimate short-termdemand of business firms, government departments and agencies and also of thehouseholds who plan their future purchases. Business firms, government departmentsand other such organizations budget their expenditure at least one year in advance. It is,therefore, possible for them to supply a fairly reliable estimate of their future purchases.Even the households making annual or periodic budgets of their expenditure can providereliable information about their purchases.

The sample survey method is the most widely used survey method to forecastdemand. This method, however, has some limitations similar to those of completeenumerations or exhaustive survey method. The forecaster, therefore, should not attributemore reliability to the forecast than is warranted. Besides, the sample survey methodcan be used to verify the demand forecast made by using quantitative or statisticalmethods. Although some authors8 suggest that this method should be used to supplementthe quantitative method for forecasting rather than to replace it, this method can begainfully used where the market is localized. Sample survey method can be of greateruse in forecasting where quantification of variables (e.g., feelings, opinion, expectations,etc.) is not possible and where consumer’s behaviour is subject to frequent changes.

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(c) The End-Use Method. The end-use method of demand forecasting has aconsiderable theoretical and practical value, especially in forecasting demand for inputs.Making forecasts by this method requires building up a schedule of probable aggregatefuture demand for inputs by consuming industries and various other sectors. In thismethod, technological, structural and other changes that might influence the demand,are taken into account in the very process of estimation. This aspect of the end-useapproach is of particular importance.

Stages in the end-use method. The end-use method of demand forecasting consistsof four distinct stages of estimation.

In the first stage, it is necessary to identify and list all the possible users of theproduct in question. This is, of course, a difficult process, but it is fundamental to thismethod of forecasting. Difficulty arises because published data on the end-users israrely available. Despatch records of the manufacturers, even if available, need notnecessarily provide the number of all the final users. Records of the sales pattern byindividual firms or establishments are difficult to be assembled. In several cases, saleschannel of the products covers such a wide network and there are so many wholesaleand retail agencies in the chain, that it would be virtually impossible to organize andcollect data from all these sources so as to know all the end-uses of the product.

Where relevant and adequate data is not available, the managers need to have athorough knowledge of the product and its uses. Such knowledge and experience needto be supplemented by consultations and discussions with manufacturers or theirassociations, traders, users, etc. Preparation of an exhaustive list of all possible end-users is, in any case, a necessary step. Despite every effort made to trace all the end-users, it is quite likely that some of the current users of the product are overlooked. Inorder to account for such lapses, it may be necessary at the final stage of estimation toprovide some margin for error. A margin or allowance is also necessary to provide forpossible new applications of the product in the future.

The second stage of this method involves fixing suitable technical ‘norms’ ofconsumption of the product under study. Norms have to be established for each and everyend-use. Norms are usually expressed in physical terms either per unit of production of thecomplete product or in, some cases, per unit of investment or per capita use. Sometimes,the norms may involve social, moral and ethical values, e.g., in case of consumption ofdrugs, alcohol or running a dance bar. But value-based norms should be avoided as far aspossible because it might be rather difficult to specify later the types and sizes of theproduct in question if value norms are used.

The establishment of norms is also a difficult process mainly due to lack of data.For collecting necessary data, the questionnaire method is generally employed. Thepreparation of a suitable questionnaire is of vital importance in the end-use method, asthe entire subsequent analysis has to be based on and conclusions to flow mainly fromthe information collected through the questionnaires. Where estimating future demand iscalled for in great detail, such as the types and sizes of the concerned product, framingof the questionnaire requires a good knowledge of all the variations of the product. Fora reliable forecast, it is necessary that response is total; if not, then as high as possible.

Having established the technical norms of consumption for the different industriesand other end-uses of the product, the third stage is the application of the norms. Forthis purpose, it is necessary to know the desired or targeted levels of output of the

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individual industries for the reference year and also the likely development in othereconomic activities that use the product and the likely output targets.

The fourth and final stage in the end-use method is to aggregate the product-wise or use-wise content of the item for which the demand is to be forecast. Thisaggregate result gives the estimate of demand for the product as a whole for the terminalyear in question. By the very nature of the process of estimation described here, it isobvious that the end-use approach results in what may be termed as a “derived” demand.

Advantages. The end-use method has two exclusive advantages.

First, it is possible to work out the future demand for an industrial product inconsiderable details by types and size. In other methods, the future demand can beestimated only at the aggregate level. This is because past data are seldom available insuch details as to provide the types and sizes of the product demanded by the economy.Hence, projections made by using the past data, either by the trend method, regressiontechniques or by historical analogies produce only aggregate figures for the product inquestion. On the other hand, by probing into the present use-pattern of consumption ofthe product, the end-use approach provides every opportunity to determine the types,categories and sizes likely to be demanded in future.

Second, in forecasting demand by the end-use approach, it is possible to traceand pinpoint at any time in future as to where and why the actual consumption hasdeviated from the estimated demand. Besides, suitable revisions can also be made fromtime to time based on such examination. If projections are based on other methods andif actual consumption falls below or rises above the estimated demand, all that one cansay is that the economy has or has not picked up as anticipated. One cannot say exactlywhich use of the product has not picked up and why. In the case of end-use method,however, one can.

(ii) Opinion Poll Methods. The opinion poll methods aim at collecting opinions ofthose who are supposed to possess knowledge of the market, e.g., sales representatives,sales executives, professional marketing experts and consultants. The opinion poll methodsinclude:

(a) Expert-opinion method

(b) Delphi method

(c) Market studies and experiments

(a) Expert-Opinion Method. Firms having a good network of sales representativescan put them on to the work of assessing the demand for the target product in the areas,regions or cities that they represent. Sales representatives, being in close touch with theconsumers or users of goods, are supposed to know the future purchase plans of theircustomers, their reactions to the market changes, their response to the introduction of anew product, and the demand for competing products. They are, therefore, in a positionto provide at least an approximate, if not accurate, estimate of likely demand for theirfirm’s product in their region or area. The estimates of demand thus obtained fromdifferent regions are added up to get the overall probable demand for a product. Firmsnot having this facility, gather similar information about the demand for their productsthrough the professional market experts or consultants, who can predict the future demandby using their experience and expertise. This method is also known as opinion pollmethod.

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Limitations Although this method too is simple and inexpensive, it has its own limitations.

First, estimates provided by the sales representatives or professional experts arereliable only to an extent depending on their skill and expertise to analyze the market andtheir experience.

Secondly, demand estimates may involve the subjective judgement of the assessorwhich may lead to over or under-estimation.

Finally, the assessment of market demand is usually based on inadequateinformation available to the sales representatives as they have only a narrow view of themarket. The factors of wider implication, such as change in GNP, availability of credit,future prospects of the industry, etc., fall outside their purview.

(b) Delphi Method.9 Delphi method of demand forecasting is an extension of thesimple expert opinion poll method. This method is used to consolidate the divergentexpert opinions and to arrive at a compromise estimate of future demand. The processis simple.

Under the Delphi method, the experts are provided information on estimates offorecasts of other experts along with the underlying assumptions. The experts mayrevise their own estimates in the light of forecasts made by other experts. The consensusof experts about the forecasts constitutes the final forecast. It may be noted that theempirical studies conducted in the USA have shown that unstructured opinions of theexperts is the most widely used forecast technique. This may appear a bit unusual in asmuch as this gives the impression that sophisticated techniques, e.g., simultaneousequations model and statistical methods, are not the techniques which are used mostoften. However, the unstructured opinions of the experts may conceal the fact thatinformation used by experts in expressing their forecasts may be based on sophisticatedtechniques. The Delphi technique can be used for cross-checking information on forecasts.

(c) Market Studies and Experiments. An alternative method of collecting necessaryinformation regarding current and also future demand for a product is to carry out marketstudies and experiments on consumer’s behaviour under actual, though controlled, marketconditions. This method is known in common parlance as market experiment method.Under this method, firms first select some areas of the representative markets—threeor four cities having similar features, viz., population, income levels, cultural and socialbackground, occupational distribution, choices and preferences of consumers. Then,they carry out market experiments by changing prices, advertisement expenditure andother controllable variables in the demand function under the assumption that otherthings remain the same. The controlled variables may be changed over time eithersimultaneously in all the markets or in the selected markets.10 After such changes areintroduced in the market, the consequent changes in the demand over a period of time (aweek, a fortnight, or a month) are recorded. On the basis of data collected, elasticitycoefficients are computed. These coefficients are then used along with the variables ofthe demand function to assess the future demand for the product.

Alternatively, market experiments can be replaced by consumer clinics orcontrolled laboratory experiments. Under this method, consumers are given somemoney to buy in a stipulated store goods with varying prices, packages, displays, etc.The experiment reveals the consumers’ responsiveness to the changes made in prices,packages and displays, etc. Thus, the laboratory experiments also yield the sameinformation as the market experiments. But the former has an advantage over the latterbecause of greater control over extraneous factors and its somewhat lower cost.

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Limitations The market experiment methods have certain serious limitations anddisadvantages that reduce the usability and reliability of this method.

First, a very important limitation of the experimental methods is that they are veryexpensive. Therefore, experimental methods cannot be afforded by small firms.

Secondly, being a costly affair, experiment are usually carried out on a scale too small topermit generalization with a high degree of reliability.

Thirdly, experimental methods are based on short-term and controlled conditions whichmay not exist in an uncontrolled market. Hence the results may not be applicable to theuncontrolled long-term conditions of the market.

Fourthly, changes in socio-economic conditions during the field experiments, such aslocal strikes or lay-offs, aggressive advertising by competitors, political changes, naturalcalamities may invalidate the results.

Finally, a big disadvantage of experimental methods is that ‘tinkering with price increasesmay cause a permanent loss of customers to competitive brands that might have beentried.’11

Despite these limitations, however, the market experiment method is often usedto provide an alternative estimate of demand and also ‘as a check on results obtainedfrom statistical studies.’ Besides, this method generates elasticity co-efficients that arenecessary for statistical analysis of demand relationships. For example, an experimentof this kind was conducted by Simmons Mattress Company (US). It put on sale twotypes of identical mattresses—one with Simmons label and the other with an unknownname at the same price and then at different prices for determining the cross-elasticity.It was found that at the same price, Simmons mattress sold 15 to 1; and at a price higherby 5 dollars it sold 8 to 1, and at a price higher by 25 per cent, it sold almost 1 to 1.12

2.6.2 Statistical Methods

In the foregoing sections, we have described survey and experimental methods ofestimating demand for a product on the basis of information supplied by the consumersthemselves and on-the-spot observation of consumer behaviour. In this section, we willexplain statistical methods which utilize historical (time-series) and cross-sectional datafor estimating long-term demand. Statistical methods are considered to be superiortechniques of demand estimation for the following reasons.

(i) In the statistical methods, the element of subjectivity is minimum,

(ii) Method of estimation is scientific as it is based on the theoretical relationshipbetween the dependent and independent variables,

(iii) Estimates are relatively more reliable, and

(iv) Estimation involves smaller cost.

Three kinds of statistical methods are used for demand projection.

(1) Trend Projection Methods,

(2) Barometric Methods

(3) Econometric Method

These statistical methods are described here briefly.

1. Trend Projection Methods Trend projection method is a ‘classical method’ ofbusiness forecasting. This method is essentially concerned with the study of movement

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of variables through time. The use of this method requires a long and reliable time-seriesdata. The trend projection method is used under the assumption that the factors responsiblefor the past trends in the variable to be projected (e.g., sales and demand) will continueto play their part in future in the same manner and to the same extent as they did in thepast in determining the magnitude and direction of the variable. This assumption may bequite justified in many cases.

However, since cause - and- effect relationship is not revealed by this method, theprojections made on the trend basis are considered by many as a mechanical or a ‘naïve’approach. Nevertheless, “There is nothing uncomplimentary in the adoption of such anapproach. It merely represents one of the several means to obtain an insight of what thefuture may possibly be and whether or not the projections made using these means areto be considered as most appropriate will depend very much on the reliability of pastdata and on the judgement that is to be exercised in the ultimate analysis.”13

In projecting demand for a product, the trend method is applied to time-seriesdata on sales. Long standing firms may obtain time-series data on sales from their ownsales department and books of account. New firms can obtain the necessary data fromthe older firms belonging to the same industry.

There are three techniques of trend projection based on time-series data.

(a) Graphical method,(b) Fitting trend equation or least square method(c) Box-Jenkins method

In order to explain these methods, let us suppose that a local bread manufacturingcompany wants to assess the demand for its product for the years 2007, 2008 and 2009.For this purpose, it uses time-series data on its total sales over the past 10 years. Supposeits time-series sales data is given as in Table 2.3.

Table 2.3 Time-Series Data on Sale of Bread

Year 1997 1998 1999 2000 2001 2002 2003 2004 20052006

Sales of Bread (000 tonnes) 10 12 11 15 18 14 20 18 2125

Let us first use the graphical method and project demand for the year, 2009.

(a) Graphical Method. In this method, annual sales data is plotted on a graph paper and aline is drawn through the plotted points. Then a free hand line is so drawn that the totaldistance between the line and the points is minimum.The dotted lineM is drawn through themid-values of variations and lineS is a straight trend line. The solid, fluctuating line shows theactual trend, while the dotted lines show the secular trend. By extending the trend lines(marked M and S), we can forecast an approximate sale of 26,200 tonnes in 2009.

Although this method is very simple and least expensive, the projections madethrough this method are not very reliable. The reason is that the extension of the trendline involves subjectivity and personal bias of the analyst. For example, an optimist maytake a short-run view, say since 2004, and extend the trend line beyond pointP towardsO, and predict a sale of 30,000 tonnes of bread in 2009. On the other hand, a conservativeanalyst may consider the fluctuating nature of sales data and expect the total sale in2009 to remain the same as in 2006 as indicated by the line PC. One may even predict

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a fall in the sale to 25,000 tonnes, if one over-emphasizes the fluctuating nature of salesin one’s judgement. This is indicated by the line PN.

(b) Fitting Trend Equation: Least Square Method. Fitting trend equation is aformal technique of projecting the trend in demand. Under this method, a trend line (orcurve) is fitted to the time-series sales data with the aid of statistical techniques.14 Theform of the trend equation that can be fitted to the time-series data is determined eitherby plotting the sales data (as shown in Fig. 9.1) or by trying different forms of trendequations for the best fit.

When plotted, a time-series data may show various trends. We will, however,discuss here only the most common types of trend equations, viz., (i) linear, and(ii) exponential trends.

(i) Linear Trend. When a time-series data reveals a rising trend in sales, then astraightline trend equation of the following form is fitted:

S = a + bT …(2.19)where S = annual sales, T = time (years), a and b are constants. The parameter b givesthe measure of annual increase in sales.

The co-efficients a and b are estimated by solving the following two equationsbased on the principle of least square.

S = na + bT ...(i)

ST = aT + bT2 ...(ii)

The terms included in Eqs. (i) and (ii) are calculated using sales data given inTable 2.3 and presented in Table 2.4.

By substituting numerical values given in Table 2.4 in Eqs. (i) and (ii), we get

164 = 10 a + 55b …(iii)1024 = 55 a + 385b …(iv)

By solving Eqs. (iii) and (iv), we get the trend equation as

S = 8.26 + 1.48T

Table 2.4 Estimation of Trend Equation

Year Sales T T2 ST

1997 10 1 1 10

1998 12 2 4 24

1999 11 3 9 33

2000 15 4 16 60

2001 18 5 25 90

2002 14 6 36 84

2003 20 7 49 140

2004 18 8 64 144

2005 21 9 81 189

2006 25 10 100 250

n = 10 S = 164 T = 55 T2 = 385 ST = 1024

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Having estimated the trend equation, it is quite easy to project the sales for 2007,2008 and 2009 i.e., for the 11th, 12th and 13th years, respectively. The calculation procedureis given below.

2007 S2

= 8.26 + 1.48 (11) = 24,540 tonnes

2008 S3

= 8.26 + 1.48 (12) = 26,020 tonnes

2009 S4

= 8.26 + 1.48 (13) = 27,500 tonnes

Treatment of the Abnormal Years Time series data on sales may reveal, moreoften than not, abnormal years. An abnormal year is one in which sales are abnormallylow or high. Such years create a problem in fitting the trend equation and lead to underor over-statement of the projected sales. Abnormal years should, therefore, be carefullyanalyzed and data be suitably adjusted. The abnormal years may be dealt with (i) byexcluding the year from time-series data, (ii) by adjusting the sales figures of the year tothe sales figures of the preceding and succeeding years, or (iii) by using a ‘dummy’variable.

(ii) Exponential Trend. When the total sale (or any dependent variable) has increasedover the past years at an increasing rate or at a constant percentage rate per time unit,then the appropriate trend equation to be used is an exponential trend equation of any ofthe following forms.

(1) If trend equation is given as

Y = aebT …(2.20)

then its semi-logarithmic form is used

log Y = log a + bT …(2.21)

This form of trend equation is used when growth rate is constant.

(2) If trend equation takes the following form

Y = aTb …(2.22)

then its double logarithmic form is used.

log Y = log a + b log T …(2.23)

This form of trend equation is used when growth rate is increasing.

(3) Polynomial trend of the form

Y = a + bT + cT2 …(2.24)

In these equations a, b and c are constants, Y is sales, T is time and e = 2.718.Once the parameters of the equations are estimated, it becomes quite easy to forecastdemand for the years to come.

The trend method is quite popular in business forecasting because of its simplicity.It is simple to apply because only time-series data on sales are required. The analyst issupposed to possess only a working knowledge of statistics. Since data requirement ofthis method is limited, it is also inexpensive. Besides, the trend method yields fairlyreliable estimates of the future course of demand.

Limitations The first limitation of this method arises out of its assumption that thepast rate of change in the dependent variable will persist in the future too. Therefore, theforecast based on this method may be considered to be reliable only for the period duringwhich this assumption holds.

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Second, this method cannot be used for short-term estimates. Also it cannot beused where trend is cyclical with sharp turning points of troughs and peaks.

Third, this method, unlike regression analysis, does not bring out the measure ofrelationship between dependent and independent variables. Hence, it does not yield thenecessary information (e.g., price and income elasticities) that can be used for futurepolicy formulations. These limitations need to be borne in mind while making the use ofthis method.

(c) Box-Jenkins Method. Box-Jenkins method15 of forecasting is used only forshort-term projections and predictions. Besides, this method is suitable for forecastingdemand with only stationary time-series sales data. Stationary time-series data is onethat does not reveal a long-term trend. In other words, Box-Jenkins technique can beused only in those cases in which time-series analysis depicts monthly or seasonalvariations recurring with some degree of regularity.

When sales data of various commodities are plotted, many commodities willshow a seasonal or temporal variation in sales. For examples, sale of woollen clotheswill show a hump during months of winter in all the years under reference. The sale ofnew year greeting cards will be particularly high in the last week of December everyyear. Similarly the sale of desert coolers is very high during the summers each year.This is called seasonal variation. Box-Jenkins technique is used for predicting demandwhere time-series sales data reveals this kind of seasonal variation.

According to the Box-Jenkins approach, any stationary time-series data can beanalyzed by the following three models:

(i) Autoregression model,

(ii) Moving average model

(iii) Autoregressive-moving average model

The autoregressive-moving average model is the final form of the Box-Jenkinsmodel. The three models are, in fact, the three stages of Box-Jenkins method. Thepurpose of the three models of Box-Jenkins method is to explain movements in thestationary series with minimized error term, i.e., the unexplained components of stationaryseries.

The steps and models of the Box-Jenkins approach are described briefly herewith the purpose of introducing Box-Jenkins method to the reader rather than providingthe entire methodology.16

Steps in Box-Jenkins Approach. As mentioned above, Box-Jenkins methodcan be applied only to stationary time-series data. Therefore, the first step in Box-Jenkins approach is to eliminate trend from the time series data. Trend is eliminated bytaking first differences of time-series data, i.e., subtracting observed value of one periodfrom the observed value of the preceding year. After trend is elimated, a stationary time-series is created.

The second step in the Box-Jenkins approach is to make sure that there isseasonality in the stationary time-series. If a certain pattern is found to repeat over time,there is seasonality in the stationary time-series.

The final step is to use the models to predict sales in the intended period.

We give here a brief description of the Box-Jenkins models that are used in thesame sequence.

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(i) Autoregressive Model. In a general autoregressive model, the behaviour of a variablein a period is linked to the behaviour of the variable in future periods. The general formof the autoregressive model is given below.

Yt = a

1Y

t–1 + a2

Yt–2 + …+ a

nY

t–n + e

t...(2.25)

This model states that the value of Y in period t depends on the values of Y inperiods t – 1, t – 2 …t – n. The term e

t is the random portion of Y

t that is not explained

by the model. If estimated value of one or some of the coefficients a1, a

2, …a

n are

different from zero, it reveals seasonality in data. This completes the second step.

The model (2.25), however, does not specify the relationship between the valueof Y

t and residuals (e

t) of previous periods. Box-Jenkins method uses moving average

method to specify the relationship between Yt and e

t, the values of residuals in previous

years. This is the third step. Let us now look at the moving average model of Box-Jenkins method.

(ii) Moving Average Model. The moving average model estimates Yt in relation to

residuals (et) of the previous years. The general form of moving average model is given

below.

Yt = m + b

1e

t – 1 + b

2e

t – 2 …+ b

pe

t – p + e

t...(2.26)

where m is the mean of the stationary time-series and et–1, e

t–2, …et–p

are the residuals,the random components of Y in t – 1, t – 2, …t – p periods.

(iii) Autoregressive-Moving Average Model. After moving average model isestimated, it is combined with autoregressive model to form the final form of the Box-Jenkins model, called autoregressive-moving average model, given below.

Yt = a

1Y

t–1 + a2

Yt–2 + …+ a

nYt–n + b

1e

t–1 + b2

et–2

+ …+ bp

et–p + et

…(2.27)

Box-Jenkins method of forecasting demand is a sophisticated and complicatedmethod. This method is, however, impracticable without the aid of computer.

Moving Average Method: An Alternative Technique

As noted above, the moving average model of Box-Jenkins method is a part of acomplicated technique of forecasting demand in period t on the basis of its past values.There is a simple, rather a naïve, yet useful method of using moving average to forecastdemand. This method assumes that demand in a future year equals the average ofdemand in the past years. The formula of simple moving average method is expressedas

Dt =

1

N (X

t–1 + Xt–2 + …+ X

t–n)

where Dt = demand in period t; X

t–1, t–2 …t–n = demand or sales in previous years; N =

number of preceding years.

According to this method, the likely demand for a product in period t equals theaverage of demand (sales) in several preceding years. For example, suppose that thenumber of refrigerators sold in the past 7 years in a city is given as Table 2.5 and wewant to forecast demand for refrigerators for the year 2007.

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Table 2.5 Sale of Refrigerators: 2000-2006

Year 2000 2001 2002 2003 2004 2005 2006

Sales (’000) 11 12 12 13 13 15 15

Given this sales data, demand for 2007 will be computed as follows.

D2007

=1

7 (15 + 15 + 13 + 13 + 12 + 12 + 11) = 13

Thus, the demand for refrigerators for 2007 is forecast at 13,000 units. Nowsuppose that the actual sales of refrigerators in the city in 2007 turns out to be 15,000refrigerators against the forecast figure of 13,000. Given the actual sales figure for2007, the demand for 2008 can be forecast as

D2008

=1

7 (15 + 15 + 15 + 13 + 13 + 12 + 12) = 13.57

Note that, in the moving average method, the sale of 2007 is added and the sale of2000 (the last of the preceding years) is excluded from the formula. The reason is, thatthe demand has to be forecast on the basis of sales in the past 7 years.

The moving average method is simple and can be used to make short-term forecasts.This method has a serious limitation, which has to be borne in mind while using it. In thecase of rising trend in sales, this method yields an underestimate of future demand, ascan be seen in the above example. And, in case of declining trend in sales, it may yield anoverestimate of future demand. One way of reducing the margin of over and under-estimation is to take the average of fluctuations and add it to the moving average forecasts.This method is, in fact, more suitable where sales fluctuate frequently within a limitedrange.

2. Barometric Method of Forecasting. The barometric method of forecasting followsthe method meteorologists use in weather forecasting. Meteorologists use the barometerto forecast weather conditions on the basis of movements of mercury in the barometer.Following the logic of this method, many economists use economic indicators as abarometer to forecast trends in business activities. This method was first developed andused in the 1920s by the Harvard Economic Service. It was, however, abandoned as ithad failed to predict the Great Depression of the 1930s.17 The barometric technique washowever revived, refined and developed further in the late 1930s by the National Bureauof Economic Research (NBER) of the US. It has since then been used often to forecastbusiness cycles in the US.18

It may be noted at the outset that the barometric technique was developed toforecast the general trend in overall economic activities. This method can neverthelessbe used to forecast demand prospects for a product, not the actual quantity expected tobe demanded. For example, allotment of land by the Delhi Development Authority (DDA)to the Group Housing Societies (a lead indicator) indicates higher demand prospects forbuilding materials—cement, steel, bricks, etc.

The basic approach of barometric technique is to construct an index of relevanteconomic indicators and to forecast future trends on the basis of movements in theindex of economic indicators. The indicators used in this method are classified as:

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(a) leading indicators

(b) coincidental indicators

(c) lagging indicators

A time-series of various indicators is prepared to read the future economic trend.The leading series consists of indicators which move up or down ahead of some otherseries. Some examples of leading indicators are: (i) index of net business investment; (ii)new orders for durable goods; (iii) change in the value of inventories; (iv) index of theprices of the materials; and (v) corporate profits after tax.

The coincidental series, on the other hand, are the ones that move up or downsimultaneously with the level of general economic activities. Some examples of thecoincidental series are: (i) number of employees in the non-agricultural sector; (ii) rateof unemployment; (iii) gross national product at constant prices; and (iv) sales recordedby the manufacturing, trading and the retail sectors.

The lagging series, consist of those indicators that follow a change after sometime-lag. Some of the indices that have been identified as lagging series by the NBERare: (i) labour cost per unit of manufactured output, (ii) outstanding loans, and(iii) lending rate for short-term loans.

The various indicators are chosen on the basis of the following criteria:(i) Economic significance of the indicator: the greater the significance, the

greater the score of the indicator,(ii) Statistical adequacy of time-series indicators: a higher score is given to an

indicator provided with adequate statistics,(iii) Conformity with overall movement in economic activities,(iv) Consistency of series to the turning points in overall economic activity,(v) Immediate availability of the series, and

(vi) Smoothness of the series.

The problem of choice may arise because some of the indicators appear in morethan one class of indicators. Furthermore, it is not advisable to rely on just one of theindicators. This leads to the usage of what is referred to as the diffusion index. A diffusionindex is the percentage of rising indicators. A diffusion index copes up with the problemof differing signals given by the indicators. In calculating a diffusion index, for a group ofindicators, scores allotted are 1 to rising series, ½ to constant series and zero to fallingseries. The diffusion index is obtained by the ratio of the number of indicators, in aparticular class, moving up or down to the total number of indicators in that group. Thus,if three out of six indicators in the lagging series are moving up, the index shall be 50 percent. It may be noted that the most important one is the diffusion index of the leadingseries. However, there are problems of identifying the leading indicator for the variablesunder study.

Leading indicators can be used as inputs for forecasting aggregate economicvariables, GNP, aggregate consumers’ expenditure, aggregate capital expenditure, etc.The only advantage of this method is that it overcomes the problem of forecasting thevalue of independent variable under the regression method. The major limitationsof thismethod are: (i) it can be used only for short-term forecasting, and (ii) a leading indicatorof the variable to be forecast is not always easily available.

3. Econometric Methods. The econometric methods combine statistical tools witheconomic theories to estimate economic variables and to forecast the intended economic

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variables. The forecasts made through econometric methods are much more reliablethan those made through any other method. The econometric methods are, therefore,most widely used to forecast demand for a product, for a group of products and for theeconomy as a whole. We explain here briefly the use of econometric methods forforecasting demand for a product.

An econometric model may be a single-equation regression modelor it may consistof a system of simultaneous equations. Single-equation regression serves the purpose ofdemand forecasting in the case of most commodities. But, where explanatory economicvariables are so interrelated and interdependent that unless one is determined, the othercannot be determined, a single-equation regression model does not serve the purpose. Inthat case, a system of simultaneous equations is used to estimate and forecast the targetvariable.

The econometric methods are briefly described here under two basic methods.

(1) Regression method

(2) Simultaneous equations model

These methods are explained here briefly.

(1) Regression Method. Regression analysis is the most popular method of demandestimation. This method combines economic theory and statistical techniques of estimation.Economic theory is employed to specify the determinants of demand and to determinethe nature of the relationship between the demand for a product and its determinants.Economic theory thus helps in determining the general form of demand function. Statisticaltechniques are employed to estimate the values of parameters in the estimated equation.

In regression technique of demand forecasting, one needs to estimate the demandfunction for a product. Recall that in estimating a demand function, demand is a ‘dependentvariable’ and the variables that determine the demand are called ‘independent’ or‘explanatory’ variables. For example, demand for cold drinks in a city may be said todepend largely on ‘per capita income’ of the city and its population. Here demand forcold drinks is a ‘dependent variable’ and ‘per capita income’ and ‘population’ are the‘explanatory’ ‘variables.’

While specifying the demand functions for various commodities, the analyst maycome across many commodities whose demand depends, by and large, on a singleindependent variable. For example, suppose in a city, demand for such items as salt andsugar is found to depend largely on the population of the city. If this is so, then demandfunctions for salt and sugar are single-variable demand functions. On the other hand,the analyst may find that demand for sweets, fruits and vegetables, etc. depends on anumber of variables like commodity’s own price, price of its substitutes, household incomes,population, etc. Such demand functions are calledmulti-variable demand functions. Fora single-variable demand function, simple regression equation is used and for multiplevariable functions, multi-variable equation is used for estimating demand function. Thesingle-variable and multi-variable regressions are explained below.

(a) Simple or Bivariate Regression Technique. In simple regression technique, asingle independent variable is used to estimate a statistical value of the ‘dependentvariable’, that is, the variable to be forecast. The technique is similar to trend fitting. Animportant difference between the two is that in trend fitting, the independent variable is‘time’ (t) whereas in a regression equation, the chosen independent variable is the single

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most important determinant of demand. Besides, the regression method is less mechanicalthan the trend fitting method of projection.

Suppose we have to forecast demand for sugar for a country for 2006-07 on thebasis of 7-year data given in Table 2.6. When this data is graphed, it produces acontinuously rising trend in demand for sugar with rising population. This shows a lineartrend. Now, country’s demand for sugar in 2006-07 can be obtained by estimating aregression equation of the form

Y = a + bX …(2.28)

where Y is sugar consumed, X is population, and a and b are the two parameters.

For an illustration, consider the hypothetical data on a country’s annual consumptionof sugar given in Table 2.6.

Table 2.6 Annual Consumption of Sugar

Year Population (millions) Sugar Consumed (million tonnes)

1999–2000 10 40

2000–01 12 50

2001–02 15 60

2002–03 20 70

2003–04 25 80

2004–05 30 90

2005–06 40 100

Equation (2.28) can be estimated by using the ‘least square’ method. The procedureis the same as shown in Table 2.4. That is, the parameters a and b can be estimated bysolving the following two linear equations:

Yi = na + bX

i…(i)

XiY

i = X

ia + bX2

i…(ii)

The procedure of calculating the terms in Eqs. (i) and (ii) above is presented inTable 2.7.

Table 2.7 Calculation of Terms of the Linear Equations(Figures in million)

Year Population Sugar X2 XY

(X) consumed (Y)

1999–2000 10 40 100 400

2000–01 12 50 144 600

2001–02 15 60 225 900

2002–03 20 70 400 1400

2003–04 25 80 625 2000

2004–05 30 90 900 2700

2005–06 40 100 1600 4000

n = 7 Xi = 152 Y

i = 490 X

i2 = 3994 X

iY

i = 12000

By substituting the values from Table 2.7 into Eqs. (i) and (ii), we get

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490 = 7a + 152b …(iii)

12,000 = 152a + 3994b …(iv)

By solving Eqs. (iii) and (iv), we get

a = 27.44 and b = 1.96

By substituting values for a and b in Eq. (9.10), we get the estimated regressionequation as

Y = 27.44 + 1.96 X ...(2.29)

Given the regression Eq. (2.29), the demand for sugar for 2006-07 can be easilyprojected if population for 2006-07 can be known. Supposing population for 2006-07 isprojected to be 50 million, the demand for sugar in 2006-07 can be estimated as follows.

Y = 27.44 + 1.96(50) = 126 million tonnes

The simple regression technique is based on the assumptions (i) that independentvariable will continue to grow at its past growth rate, and (ii) that the relationship betweenthe dependent and independent variables will continue to remain the same in the futureas in the past. (For further details and for the test of the reliability of estimates, consulta standard book on statistics).

(b) Multi-variate Regression. The multi-variate regression equation is used wheredemand for a commodity is considered to be a function of explanatory variables greaterthan one.

The procedure of multiple regression analysis is briefly described here. The firststep in multiple regression analysis is to specify the variables that are supposed to explainthe variations in demand for the product under reference. The explanatory variables aregenerally chosen from the determinants of demand, viz., price of the product, price of itssubstitutes, consumers’ income and their tastes and preferences. For estimating thedemand for durable consumer goods, (e.g., TV sets, refrigerators, houses, etc.), theother explanatory variables that are considered are availability of credit and rate ofinterest. For estimating demand for capital goods (e.g., machinery and equipment), therelevant variables are additional corporate investment, rate of depreciation, cost of capitalgoods, cost of other inputs (e.g., labour and raw materials), market rate of interest, etc.

Once the explanatory or independent variables are specified, the second step isto collect time-series data on the independent variables. After necessary data is collected,the third and a very important step is to specify the form of equation which canappropriately describe the nature and extent of relationship between the dependent andindependent variables. The final step is to estimate the parameters in the chosen equationwith the help of statistical techniques. The multi-variate equation cannot be easily estimatedmanually. Therefore, the equation has to be estimated with the help of a computer.

Specifying the Form of Equation The reliability of the demand forecast dependsto a large extent on the form of equation and the degree of consistency of the explanatoryvariables in the estimated demand function. The greater the degree of consistency, thehigher the reliability of the estimated demand andvice versa. Adequate precaution should,therefore, be taken in specifying the equation to be estimated. Some common forms ofmulti-variate demand functions are given below.

Linear Function Where the relationship between demand and its determinantsis given by a linear equation, the most common form of equation used for estimatingdemand is given below.

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Qx = a – bP

x + cY + dP

y + jA …(2.30)

where Qx = quantity demanded of commodity X; P

x = price of commodity X;

Y = consumers’ income, Py = price of the substitute; A = advertisement expenditure; a is

a constant (the intercept), and b, c, d and j are the parameters expressing the relationshipbetween demand and P

x, Y, P

yand A, respectively.

In a linear demand function, quantity demanded is assumed to change at a constantrate with a change in independent variables P

x, Y, P

y and A. The parameters (regression

co-efficients) are estimated by using the least square method. After parameters areestimated, the demand can be easily forecast if data on independent variables for thereference period is available. Suppose, the estimated equation for sugar takes the followingform:

Qs = 50 – 0.75P

s + 0.1Y + 1.25 P

y + 0.05A …(2.31)

The numerical values in this equation express the quantitative relationship19 betweendemand for sugar and the variables with which it is associated. More precisely, regressionco-efficients give the change in demand for sugar as a result of unit change in theexplanatory variables. For instance, it reveals that a change of one rupee in the sugarprice results in a 0.75 tonne change in sugar demand and a change of one rupee inincome leads to a 0.1 tonne change in sugar demand, and so on.

Power Function It may be noted that in linear Eq. (2.30), the marginal effect ofindependent variables on demand is assumed to be constant and independent of changein other variables. For example, it assumes that the marginal effect of change in price isindependent of change in income or other independent variables, and so on. However,one can find cases in which it is theoretically and also empirically found that the marginaleffect of the independent variables on demand is neither constant nor independent of thevalue of all other variables included in the demand function. For example, the effect ofrise in sugar price may be neutralized by a rise in consumers income. In such cases, amultiplicative form of equation which is considered to be ‘the most logical form of demandfunction’ is used for estimating demand for a product. The multiplicative form of demandfunction or power function is given as

Qx = a P

x–b Yc P

yd Aj …(2.32)

The algebraic form of multiplicative demand function can be transformed into alog-linear form for convenience in estimation, as given below.

log Qx = log a – b log P

x + c log Y + d log P

y + j log A …(2.33)

The log-linear demand function can be estimated by the least square regressiontechnique. The estimated function yields the intercept a and the values of the regressionco-efficients. After regression co-efficients are estimated and data on the independentvariables for the years to come are obtained, forecasting demand becomes an easy task.

Reliability of Estimates As mentioned earlier, statistical methods are scientific, devoidof subjectivity, and they yield fairly reliable estimates. But the reliability of forecastdepends also on a number of other factors.

A very important factor in this regard is the choice of the right kind of variablesand data. Only those independent variables which have a causal relationship betweenthe dependent and independent variables should be included in the demand function. Therelationship between the dependent and independent variables should be clearly defined.

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Besides, the reliability of estimates also depends on the form of demand functionused. The forecaster should, therefore, bear in mind that there is no hard and fast ruleand an a priori basis of determining the most appropriate form of demand function. Thedemand function to be estimated is generally determined by testing different forms offunctions. Whether a particular form of function is a good fit is judged by the coefficientof determination, i.e., the value of R2. The value of R2 gives the proportion of the totalvariation in the dependent variable explained by the variation in the independent variables.The higher the value ofR2, the greater the explanatory power of the independent variables.

Another test is the expected sign of co-efficients of independent variables. Whatis more important, therefore, is to carefully ascertain the theoretical relationship betweenthe dependent and the independent variables.

(2) Simultaneous Equations Model. We may recall that regression technique ofdemand forecasting consists of a single equation. In contrast, the simultaneous equationsmodel of forecasting involves estimating several simultaneous equations. These equationsare, generally, behavioural equations, mathematical identities and market-clearingequations.

Furthermore, regression technique assumes one-way causation, i.e., only theindependent variables cause variations in the dependent variable, not vice versa. Insimple words, regression technique assumes that a dependent variable affects in noway the independent variables. For example, in demand function D = a – bP used inthe regression method, it is assumed that price affects demand, but demand does notaffect price. This is an unrealistic assumption. On the contrary, forecasting througheconometric models of simultaneous equations enables the forecaster to take intoaccount the simultaneous interaction between dependent and independent variables.

The simultaneous equations method is a complete and systematic approach toforecasting. This technique uses sophisticated mathematical and statistical tools that arebeyond the scope of this book20. We will, therefore, restrict ourselves here only to thebasic features of this method of forecasting.

The first step in this technique is to develop a complete model and specify thebehavioural assumptions regarding the variables included in the model. The variablesthat are included in the model are called (i) endogenous variables, and(ii) exogenous variables.

Endogenous variables. The variables that are determined within the model arecalled endogenous variables. These are included in the model as dependent variables,i.e., the variables that are to be explained by the model. These are also called ‘controlled’variables. It is important to note that the number of equations included in the modelmust equal the number of endogenous variables.

Exogenous variables. Exogenous variables are those that are determined outsidethe model. These are inputs of the model. Whether a variable is treated as endogenousor exogenous depends on the purpose of the model. The examples of exogenous variablesare ‘money supply, ‘tax rates’, ‘government spending’, ‘time’, and ‘weather’, etc. Theexogenous variables are also known as ‘uncontrolled’ variables.

The second step in this method is to collect the necessary data on both endogenousand exogenous variables. More often than not, data is not available in the required form.Sometimes data is not available at all. In such cases, data has to be adjusted or correctedto suit the model and, in some cases, data has to be even generated from the availableprimary or secondary sources.

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After the model is developed and necessary data are collected, the third step isto estimate the model through some appropriate method. Generally, a two-stage leastsquare method is used to predict the values of exogenous variables.

Finally, the model is solved for each endogenous variable in terms of exogenousvariables. Then by plugging the values of exogenous variables into the equations, theobjective value is calculated and prediction is made.

Example

For an example, consider a simple macroeconomic model, given below:

Yt = C

t + I

t + G

t + NX

t…(2.34)

where

Yt

= Gross national product,

Ct

= Total consumption expenditure,

It

= Gross private investment,

Gt

= Government expenditure,

NXt

= Net exports (X – M) where M = imports

and subscript t represents a given time unit.

Equation (2.34) is an identity, that may be explained with a system of simultaneousequations. Suppose in Eq. (2.34)

Ct = a + bY

t...(2.35)

It = 20 ...(2.36)

Gt = 10 ...(2.37)

NX = 5 ...(2.38)

In the above system of equations, Yt and C

t are endogenous variables and I

t, G

t

and NXt are exogenous variables. Eq. (2.35) is a regression equation that has to be

estimated. Equations (2.36), (2.37) and (2.38) show the values of exogenous variablesdetermined outside the model.

Suppose we want to predict the value of Yt and C

t simultaneously. Suppose also

that when we estimate Eq. (2.35), we get

Ct = 100 + 0.75 Y

t...(2.39)

Now, using this equation system, we may determine the value of Yt as

Yt = C

t + 20 + 10 + 5 = C

t + 35

Since Ct = 100 + 0.75 Y

t, by substitution, we get

Yt = 100 + 0.75 Y

t + 35

then Yt – 0.75 Y

t = 100 + 35

0.25 Yt = 135

and Yt = 135/0.25 = 540

We may now easily calculate the value of Ct (using Y

t = 540). Since

Ct = 100 + 0.75 Y

t = 100 + 0.75 (540) = 505

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Thus, the predicted values are

Yt = 540 and C

t = 505

Thus, Yt = 505 + 20 + 10 + 5 = 540

It is important to note here that the example of the econometric model givenabove is an extremely simplified model. The econometric models used in actual practiceare generally very complex. They include scores of simultaneous equations.

However, this method is theoretically superior to the regression method. Themain advantage of this method is that it is capable of capturing the effect ofinterdependence of the variables. But, its limitations are similar to those of the regressionmethod. The use of this method is sometimes hampered by non-availability of adequatedata.

2.7 SUMMARY

The law of demand states the nature of relationship between the quantity demandedof a product and the price of the product. Although quantity demanded of acommodity depends also on many other factors, e.g., consumer’s income, priceof the substitutes and complementary goods, consumer’s taste and preferences,advertisement, etc., the current price is the most important and the only determinantof demand in the short run.

The market demand for a product is determined by a number of factors, viz. priceof the product, price and availability of the substitutes, consumer’s income, hisown preference for a commodity, utility derived from the commodity,‘demonstration effect’, advertisement, credit facility by the sellers and banks,off-season discounts, number of the uses of the commodity, population of thecountry, consumer’s expectations regarding the future trend in the price of theproduct, consumers’ wealth, past levels of demand, past levels of income,government policy, etc.

From managerial point of view, the knowledge of nature of relationship alone isnot sufficient. What is more important is the extent of relationship or the degreeof responsiveness of demand to the changes in its determinants. The degree ofresponsiveness of demand to the change in its determinants is called elasticity ofdemand.

The business world is characterized by risk and uncertainty and, therefore, mostbusiness decisions are made under the condition of risk and uncertainty. One wayto reduce the adverse effects of risk and uncertainty is to acquire knowledgeabout the future demand prospects for the product. The information regarding thefuture demand for the product is obtained by demand forecasting.

Survey methods are generally used where the purpose is to make short-run forecastof demand. Under this method, consumer surveys are conducted to collectinformation about their intentions and future purchase plans.

A time-series of various indicators is prepared to read the future economic trend.The leading series consists of indicators which move up or down ahead of someother series. Some examples of leading indicators are: (i) index of net businessinvestment; (ii) new orders for durable goods; (iii) change in the value ofinventories; (iv) index of the prices of the materials; and (v) corporate profitsafter tax.

Check Your Progress

9. How is thecompleteenumerationmethod carried out?

10. Name the threetypes of opinionpoll methods.

11. Why are statisticalmethods consideredsuperior for demandestimation?

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An econometric model may be a single-equation regression modelor it may consistof a system of simultaneous equations. Single-equation regression serves thepurpose of demand forecasting in the case of most commodities.

2.8 KEY TERMS

Law of demand: It can be stated as all other things remaining constant, thequantity demanded of a commodity increases when its price decreases anddecreases when its price increases.

Substitute goods: Two commodities are deemed to be substitutes for eachother if change in the price of one affects the demand for the other in the samedirection.

Complementary goods: A commodity is deemed to be a complement of anotherwhen it complements the use of the other. In other words, when the use of anytwo goods goes together so that their demand changes (increases or decreases)simultaneously, they are treated as complements.

Elasticity of demand: It is the degree of responsiveness of demand to the changein its determinants.

Arc Elasticity: It is the measure of elasticity of demand between any two finitepoints on a demand curve.

Cross-elasticity: It is the measure of responsiveness of demand for a commodityto the changes in the price of its substitutes and complementary goods.

Econometric methods: They combine statistical tools with economic theoriesto estimate economic variables and to forecast the intended economic variables.


1. The ceteris paribus assumption is ‘in case all other things remain unchanged’.2. Prestige goods are those which are consumed mostly by the rich section of the

society, such as luxury cars, stone-studded jewellery, costly cosmetics, antiquesand so on. Demand for such goods arises only beyond a certain level of theconsumer’s income.

3. Availability of credit to the consumers from the sellers, banks, relations and friendsor from any other source encourages the consumers to buy more than what theywould buy in the absence of credit facility. That is why the consumers who canborrow more can consume more than those who can borrow less.

4. The concept of elasticity of demand plays a crucial role in business decisionsregarding manoeuvring of prices with a view to making larger profits. For instance,when cost of production is increasing, the firm would want to pass the rising coston to the consumer by raising the price. Firms may decide to change the priceeven without any change in the cost of production.

5. It is the elasticity of demand at a finite point on the demand curve. The concept ofpoint elasticity is used for measuring price elasticity where change in price isinfinitesimally small.

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6. The concept of income-elasticity can be used in estimating future demand, providedthat the rate of increase in income and income-elasticity of demand for the productsare known. The knowledge of income elasticity can thus be useful in forecastingdemand, when a change in personal incomes is expected, other things remainingthe same.

7. Demand forecasting helps in the following areas of business decision making:

Planning and production schedule

Acquiring inputs (labour, raw material and capital)

Making provision for finances

Formulating pricing strategy

Planning advertisement

8. The steps in the demand forecasting include:(i) Specifying the objective(ii) Determining the time perspective(iii) Selecting the method of demand forecasting(iv) Collection of data and data adjustment(v) Estimation and interpretation of results

9. In this method, almost all potential users of the product are contacted and areasked about their future plan of purchasing the product in question. The quantitiesindicated by the consumers are added together to obtain the probable demand forthe product.

10. The three types of opinion poll methods include expert-opinion method, Delphimethod and market studies and experiments.

11. Statistical methods are considered to be superior techniques of demand estimationfor the following reasons:

In the statistical methods, the element of subjectivity is minimum

Method of estimation is scientific as it is based on the theoretical relationshipbetween the dependent and independent variables

Estimates are relatively more reliable

Estimation involves smaller cost



1. Define the law of demand.

2. Name and briefly describe the various types of consumer goods.

3. Write a short note on the demonstration effect.

4. How does distribution of national income affect the demand for a commodity?

5. What are the uses of cross-elasticity of demand?

6. List the determinants of advertisement elasticity.

7. What are the advantages of the end-use method of demand forecasting?

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8. Briefly discuss the Box-Jenkins method of demand forecasting.

9. What are endogenous and exogenous variables in a forecasting model?


1. Define price elasticity of demand and show how the formula for it is derived.

2. Explain how price elasticity is measured using a demand function.

3. Examine the determinants of price elasticity of demand.

4. Explain why demand forecasting is necessary.

5. Describe in detail the survey method of demand forecasting.

6. Identify the limitations of market experiment methods.

2.11 FURTHER READING




Mansfield, E., W. B. Allen, N. A. Doherty, and K. Weigelt. 2002. ManagerialEconomics: Theory, Applications and Cases, Fifth Edition. NY: W. Orton &Co.




Endnotes

1. Mansfield, Edwin, op. cit., p. 52.

2. The elasticity formula is derived as follows:

1

1

1

1

1

21

1

21

100

100

QP

PQ

PP

QQ

PPP

QQQ

e p

where P1 is old price, P

2 is new price Q

1 is quantity demanded at P

1 and Q

2 is quantity

demanded at P2.

3. Price-elasticity of demand calculated without a minus sign will always be a negative valuebecause either P or Q will carry a negative sign due to inverse relationship betweenprice and quantity demanded. This gives a negative value of elasticity whereas in theconcept of elasticity, a negative value has no meaningful interpretation expect that itindicates inverse relationship between P and Q. The negative elasticity coefficient israther misleading. The ‘minus’ sign is, therefore, inserted as a matter of ‘linguistic’convenience, to make the coefficient of elasticity non-negative. Sometimes, ‘it is also

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suggested to ignore the negative sign in the numerator and denominator of the elasticityformula. The elasticity in Eq. (8.9) ignores the negative sign.

4. Except in case of Giffen’s goods.5. With the exception of inferior goods.

6. Eugene, F. Brigham, and James L. Pappas, Managerial Economics, The Dryden Press,Hinsdale. Illinois, 1976. p. 129.

7. The market segment may be defined in terms of geographical region, income-groups ofthe consumers or a particular section of the society (e.g., libraries and students segmentof market for textbooks).

8. For example, Brigham, Eugene F. and James L. Pappas, op. cit., pp. 548–49.9. The origin of “Delphi method” is traced to Greek mythology. In ancient Greece, Delphi

was an oracle of Apollo and served as a medium for consulting deities. In modern times,Delphi method was developed by Olaf Helmer at the Rand Corporation of the US, as amethod of obtaining a consensus of panelists without direct interaction between them.(J.R. Davis and S. Chang, Managerial Economics (Prentice-Hall, N.J., 1986, p. 191).

10. Brigham, Eugene F. and James, L. Pappas, op. cit., p. 135.

11. Webb, Samuel C., Managerial Economics, (Houghton Miffln Company, Boston, 1976), p.156.

12. Dean, J., Managerial Economics, (Englewood Cliffs, N.J., Indian Edn., 1960), p. 181.

13. Balakrishna, S., Techniques of Demand Forecasting for Industrial Products, p. 4.

14. The statistical technique used to find the trend line, i.e., the ‘least square method’, hasalready been discussed in Chapter 5.

15. This method was suggested by G.E.P. Box and G.M. Jenkins in their book, Time SeriesAnalysis: Forecasting and Control (Holdan-Day, San Francisco, 1970).

16. Computer programs on Box-Jenkins method are available for use.

17. Lange, O., Introduction to Econometrics, 2nd Edn. (Oxford Pergamon Press, 1962), pp.85–95.

18. A summary of use and findings of this method can be had from R. Davis and SemoonChang, Principles of Managerial Economics (Prentice-Hall, NJ, 1986).

19. Estimated values of parameters, – 0.75, 0.1, 1.25 and 0.05 are the regression co-efficients ofdemand with respect to P

x, Y, P

y and A, respectively.

20. For detailed discussion on the use of econometric methods in business decision, see J.W.Elliott, Econometric Analysis for Management Decisions (Homewood, Irwin, 1973).

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Theory of ConsumerDemand

NOTES

UNIT 3 THEORY OF CONSUMERDEMAND

Structure3.0 Introduction3.1 Unit Objectives3.2 Consumer Behaviour3.3 Cardinal Utility Approach

3.3.1 Meaning and Measurability of Utility3.3.2 Total and Marginal Utility3.3.3 Law of Diminishing Marginal Utility3.3.4 Consumer’s Equilibrium

3.4 Ordinal Utility Approach3.4.1 Meaning and Nature of Indifference Curve and Indifference Map3.4.2 Diminishing Marginal Rate of Substitution (MRS)3.4.3 Properties of Indifference Curves3.4.4 Consumer’s Equilibrium3.4.5 Income and Substitution Effects

3.5 Revealed Preference Approach3.6 Summary3.7 Key Terms3.8 Answers to ‘Check Your Progress’3.9 Questions and Exercises

3.10 Further Reading

3.0 INTRODUCTION

In this unit, you will learn in detail about the cardinal and ordinal utility approaches toconsumer demand. You will also be introduced to Paul Samuelson’s revealed preferencetheory.

3.1 UNIT OBJECTIVES

After going through this unit, you will be able to:• Discuss the significance of consumer behaviour• Explain the cardinal utility approach to consumer demand• Explain the ordinal utility approach to consumer demand• Describe the revealed preference theory

3.2 CONSUMER BEHAVIOUR

The central theme of the traditional theory of consumer behaviour is a consumer’sutility maximizing behaviour. The fundamental postulate of the consumption theory isthat a consumer—an individual or a household—is a utility maximizing entity and allconsumption decisions are directed towards maximization of total utility.

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However, ‘can utility be measured?’ has been a matter of dispute. Neo-classicaleconomists, Marshall and his followers, assumed that utility is cardinally measurable.They formulated their theory of consumer behaviour on this very assumption. The moderneconomists have however rejected the assumption of cardinal measurability of utilityand have instead assumed ordinal measurability of utility. Milton Friedman, instead ofresolving the issue of measurability of utility, preferred to rely on the preferences andchoices revealed by the consumers and developed his own Revealed Preference theoryof consumer behaviour. Accordingly, there are three major approaches to the analysis ofconsumer behaviour:

(i) Cardinal Utility Approach, adopted by the neo-classical economists, widelyknown as Marshallian approach;

(ii) Ordinal Utility Approach, known also as Indifference Curve Analysis; and(iii) Revealed Preference Approach of Paul Samuelson.

In this unit, we discuss Cardinal Utility Theory of consumer demand and see how cardinalistshave derived the demand curve. In subsequent sections, we shall take up the OrdinalUtility Theory and some recent developments in the theory of consumer behaviour, viz.,‘Revealed Preference Theory’ and ‘Cardinal Utility Approach involving Risk in Choices’.

The indifference technique was invented and used by Francis Y. Edgeworth1

(1881) to show the possibility of exchange of commodities between two individuals.About a decade later, Irving Fisher2 (1892) used indifference curve to explain consumer’sequilibrium. Both Edgeworth and Fisher, however, believed in cardinal measurability ofutility. It was Vilfred Pareto3 who introduced, in 1906, the ordinal utility hypothesis to theindifference curve analysis. In the subsequent decades, many significant contributionswere made by Eugen E. Slutsky,4 W.E. Johnson,5 and A.L. Bowley.6 Yet, indifferencecurve technique could not gain much ground in the analysis of consumer behaviour tillearly 1930s. In 1934, John R. Hicks and R.G.D. Allen7 developed systematically theordinal utility theory as a powerful analytical tool of consumer analysis. Later, Hicksprovided a complete exposition of indifference curve technique in his Value and Capital.Though in his later work, A Revision of Demand Theory, he has dropped some of hisearlier assumptions, indifference analysis is regarded as the most powerful tool ofconsumer analysis.

The fundamental departure that indifference curve analysis makes from theMarshallian marginal utility analysis is the hypothesis that utility can be measured onlyordinally, not cardinally. Recall that ‘cardinalists’ assumed that utility is cardinallymeasurable, and that utility of one commodity is independent of other commodities. Incontract, the ‘Ordinalists’ believe that cardinal measurement of utility is neither feasiblenor necessary to analyse consumer’s behaviour. According to ordinalists, all that isrequired to analyse consumer’s behaviour is that the consumer should be able to orderhis preferences. In fact, the consumer is able to express his preference for the quantityof a commodity to that of others. For example, a consumer can always say that heprefers to buy 10 kg of wheat to 5 kg of rice.

Assumptions of Ordinal Utility Theory

The indifference curve analysis of consumer’s behaviour makes, at least implicitly, thefollowing assumptions:

1. Rationality. The consumer is a rational being. He aims at maximizing his totalsatisfaction, given his income and prices of goods and services he consumes.Furthermore, he has full knowledge of his circumstances.

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2. Ordinal Utility. Indifference curve analysis assumes that utility can be expressedonly ordinally. That is, the consumer is able to tell only the order of his preferences.

3. Transitivity and Consistency of Choice. Consumer’s choices are transitive.Transitivity of choice means that if a consumer prefers A to B and B to C, he mustprefer A to C. Or, if he treats A = B and B = C, he must treat A = C, Consistencyof choice means that, if he prefers A to B in one period, he will not prefer B to Ain another period or treat them as equal. The transitivity and consistency inconsumer’s choices may be symbolically expressed as follows.Transitivity. If A > B, and B > C, then A > C, andConsistency. If A > B, in one period, then B /> A or B ≠ A in another..

4. Nonsatiety. It is also assumed that the consumer is not oversupplied with goodsin question and that he has not reached the point of saturation in case of anycommodity. Therefore, a consumer always prefers a larger quantity of all thegoods.

5. Diminishing Marginal Rate of Substitution. The marginal rate of substitutionmeans the rate at which a consumer is willing to substitute one commodity (X) foranother (Y), i.e., the units of Y he is willing to give up for one unit of X so that histotal satisfaction remains the same. This rate is given by ∆Y/∆X. The assumption isthat ∆Y/∆X goes on decreasing, when a consumer continues to substitute X for Y.(We shall know more about marginal rate of substitution in the subsequent sections).

3.3 CARDINAL UTILITY APPROACH

The Cardinal Utility Theory of consumer demand was developed by the classicaleconomists, viz. Gossen (1854) of Germany, William Stanley Jevons (1871) of England,Leon Walras (1874) of France, Karl Menger (1840–1921) of Austria. Neo-classicaleconomists, particularly Alfred Marshall (1890) made significant refinements in theCardinal Utility Theory. This led the Cardinal Utility Theory to be known as ‘Neo-classical Utility Theory’ and also as ‘Marshallian Utility Theory’ of demand.

Before we proceed to describe the Cardinal Utility Theory, let us first explain thebasic concepts and axioms used in this theory.

3.3.1 The Meaning and Measurability of Utility

(a) The Meaning of Utility

The notion of ‘Utility’ was introduced to social thought by the British philosopher, JeremyBentham, in the 18th century and to economics by William Stanley Jevons in the 19thcentury. In its economic meaning, the term ‘utility’ is synonymous with ‘pleasure’,‘satisfaction’ and a sense of fulfilment by desire. A person consumes a commoditybecause he or she derives pleasure out it. In other words, he derives utility from theconsumption of the goods and services.

In abstract sense, the term ‘utility’ refers to the power or property of acommodity to satisfy human needs. For example, bread has the power to satisfy hunger;water quenches our thirst; books fulfill our desire for knowledge; and postal stamps takeour letters to their destination, and so on. All the goods that people hold or consumepossess utility. Utility can also be defined as the ‘want-satisfying power’ of a commodity.But it is not absolute—it is relative. It is relative to a person’s need. In other words,

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whether a commodity possesses utility depends on whether a person needs thatcommodity. All the persons need not derive utility from all the commodities. For example,non-smokers do not derive any utility from cigarettes; strict vegetarians do not deriveany utility from meat and chicken; a book on economics has no utility for those who arenot students of economics, and so on. The utility derived by a person from a commoditydepends on his or her intensity of desire for that commodity: the greater the need, thegreater the utility.

Besides, utility of some commodities depends on the availability of complementarygoods. For example, electricity operated gadgets (e.g. TV, VCR, computers, refrigerators)yield utility only where electricity is available and petrol has utility only for those whopossess an automobile.

Furthermore, the concept of utility is ‘ethically neutral’. It is neutral betweengood and bad and between useful and harmful. For example, some drugs are bad andharmful, for everybody but they yield utility to the drug-addicts. Utility is free from moralvalues. It is not subject to social desirability of consuming a commodity. Eating beef maybe immoral or socially undesirable for Hindus, but if a Hindu takes it, it satisfies hishunger.

(b) Measurability of Utility

Measurability of utility has been and remains a debatable issue. Essentially, utility is apsychological phenomenon—it is a feeling of pleasure or a feeling of satisfaction andachievement. Can utility be measured in Quantitative or numeral terms? As mentionedabove, the early and the modern economists have different answers to this question.

The classical and neo-classical economists held the view that utility isquantitatively or cardinally measurable. It can be measured like height, weight, lengthand temperature. Their method of measuring utility can be described as follows:

(i) Walras, a classical economist, used the term ‘util’ meaning ‘units of utility’. Theterm was used as an accounting unit like kilogram, meter, etc.

(ii) The classical economists used ‘util’ as the measure of utility under the assumptionthat one unit of money equals one ‘util’. It implies that price that a consumer paysfor a commodity equals the utility derived from the commodity.

(iii) They assumed that marginal utility of money remains constant, i.e. the utility onederives from each successive unit of money income remains constant whateverthe stock of money one holds.This method of measuring utility has been rejected by the modern economists.

For, it was realized over time that absolute or cardinal measurement of utility is notpossible. The difficulties in measuring utility proved insurmountable. Money was notfound to be a reliable measure of utility because the utility of money itself changes withchange in its stock. Neither economists nor psychologists nor other scientists coulddevise a reliable technique for measuring the feeling of satisfaction or utility. The moderneconomists have therefore discarded the concept of cardinal utility.

Notwithstanding the problems in quantitative measurement of utility, theconsumption theory based on cardinal utility concept provides deep insight into theconsumer psychology and consumer behaviour and remains an indispensable element ofconsumption theory. In fact, it serves as a starting point in the study of further advances

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in the theory of consumer behaviour. In this unit, we discuss the theory of consumerbehaviour based on cardinal utility concept. The consumer theory based on ordinal utilityis discussed in the next Section.

3.3.2 Total and Marginal Utility

The concept of cardinal utility makes it possible to define the Total and MarginalUtility in quantitative terms. Total utility (TU), with reference to a single commodity,may be defined as the sum of the utility derived from all the units consumed of thecommodity. For example, if a consumer consumes 4 units of a commodity and derivesU1, U2, U3 and U4 utils from the successive units consumed, then

TU = U1 + U2 + U3 + U4

If he consumes n units, the total utility (TU) from n units can be expressed asTUn = U1 + U2 + U3 + ... + Un

In case the number of commodities consumed and their units are greater thanone, then

TU = TUx + TUy + TUz + ... + TUn

where subscripts x, y, z and n denote commodities.Marginal Utility may be defined in three ways.One, marginal utility is the utility derived from the marginal or the last unit consumed.Two, marginal utility is the addition to the total utility—the utility derived from theconsumption or acquisition of one additional unit. Or, Marginal Utility (MU) is the changein the total utility resulting from the change in the consumption.

Thus, MU =TUQ

where ΔTU = change in total utility, and ΔQ = change in quantity consumed of acommodity.Three, marginal utility (MU) may also be expressed as

MU = TUn – TUn–1

3.3.3 The Law of Diminishing Marginal Utility

The law of diminishing marginal utility is central to the cardinal utility analysis of theconsumer behaviour. This law states that as the quantity consumed of a commodityincreases per unit of time, the utility derived by the consumer from the successive unitsgoes on decreasing, provided the consumption of all other goods remains constant. Thislaw stems from the facts (i) that the utility derived from a commodity depends on theintensity or urgency of the need for that commodity, and (ii) that as more and morequantity of a commodity is consumed, the intensity of desire decreases and therefore theutility derived from the marginal unit decreases. For example, suppose you are veryhungry and are offered sandwiches to eat. The satisfaction which you derive from thefirst bite of sandwich would be the maximum because intensity of your hunger was thehighest. When you take the second bite, you derive lower satisfaction because the intensityof your hunger is reduced due to consumption of the first bite of sandwich. As you go on

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eating more and more sandwiches, the intensity of your hunger goes on decreasing andtherefore the satisfaction which you derive from the successive units goes on decreasing.This phenomenon is generalized in the form of a theory called the Law of DiminishingMarginal Utility.Numerical Example. Table 3.1 present a numerical illustration of the law of diminishingmarginal utility. As the table shows, total utility (TU) increases with increase in consumptionof sandwiches, but at a decreasing rate. It means that MU decreases with increase inconsumption. This is shown in the last column of the table.

Table 3.1 Total and Marginal Utility

Sandwiches Total Utility (TU) Marginal Utility

0 0 0 – 0 = 01 30 30 – 0 = 302 50 50 – 30 = 203 60 60 – 50 = 104 65 65 – 60 = 55 65 65 – 65 = 0

60 60 – 65 = – 5

It may be seen in the table that the total utility reaches its maximum at 66 utilswhen 5 sandwiches are consumed. Here, MU = 1. Consumption of the 6th sandwichyields negative utility of 6 and therefore total utility starts declining.Graphic Illustration. The law of diminishing marginal utility is graphically illustratedin Fig. 3.1 (a) and (b). The total utility (TU) and marginal utility (MU) curves have beenobtained by plotting the data given in Table 3.1. The total utility curve goes on rising tillthe 5th sandwich is consumed [Fig. 3.1 (a)]. Note that the TU curve is rising but at adiminishing rate. It shows decrease in the MU, i.e., the utility added to the total. Thediminishing MU is shown by the MU curve in Fig. 3.1 (b). Beyond 5 sandwiches consumed,the marginal utility turns negative. It means that additional consumption of sandwichesyields disutility in the form of discomfort or displeasure.

Assumptions

The law of diminishing marginal utility holds only under certain given conditions. Theseconditions are often referred to as the assumptions of the law.First, the unit of the consumer goods must be standard, e.g. a cup of tea, a bottle of colddrink, a pair of shoes or trousers. If the units are excessively small or large, the law maynot hold.Second, consumer’s taste or preference must remain unchanged during the period ofconsumption.Third, there must be continuity in consumption and where break in continuity is necessary,it must be appropriately short.

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Mar

gina

l Util

ity

Fig. 3.1 Total and Diminishing Marginal Utility: Cardinal Approach

Fourth, the mental condition of the consumer must remain normal during the period ofconsumption of a commodity. If a person is eating and also drinking (alcohol) the utilitypattern will not be certain.

Given these conditions, the law of diminishing marginal utility holds universally. Insome cases, e.g. accumulation of money, collection of hobby items like stamps, oldcoins, rare paintings and books, and melodious songs, marginal utility may initially increaserather than decrease, but it does decrease eventually. It may thus be stated that the Lawof Diminishing Marginal Utility generally operates universally.

3.3.4 Consumer’s Equilibrium

As mentioned earlier, a consumer is assumed to be a utility maximizer. A consumerreaches equilibrium position, when he maximizes his total utility given his income andprices of commodities he consumes. Analysing consumer’s equilibrium requires answeringthe question as to how a consumer allocates his money income between the variousgoods and services he consumers to maximize his total utility.

Before we proceed, let us describe the assumptions of the Marshallian approachto the determination of consumer’s equilibrium.

Assumptions

1. Rationality. It is assumed that the consumer is a rational being in the sensethat he satisfies his wants in the order of their merit. It means that he consumesfirst a commodity which yields the highest utility and the last which gives theleast.

2. Limited Money Income. The consumer has a limited money income to spendon the goods and services he consumes.

3. Maximization of Satisfaction. Every rational consumer intends to maximizehis satisfaction from his given money income.

4. Utility is Cardinally Measurable. The cardinalists assume that utility iscardinally measurable, i.e. it can be measured in absolute terms. For them, utilityof one unit of a commodity equals the amount of money paid for it.

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5. Diminishing Marginal Utility. The utility gained from successive units of acommodity consumed decreases as a consumer consumes a larger quantity ofthe commodity.

6. Constant Utility of Money. The marginal utility of money (MUm) remainsconstant and each unit of money has utility equal to 1, i.e., MUm=1.

7. Utility is Additive. Cardinalists maintain that utility is not only cardinallymeasurable but also utility derived from various goods and services consumed bya consumer can be added together to obtain the total utility. The additivity of theutility can be expressed through a utility function. Suppose that the basket ofgoods and services consumed by a consumer contains n items, and their quantitiesexpressed as q1, q2, q3,..., qn. The total utility function (TU) of the consumer isexpressed asU = f(q1, q2, q3, ..., qn)Given the utility function, the total utility gained from n items is expressed asTUn = U1(q1) + U2(q2) + U3(q3) ··· + Un(qn)

Consumer Equilibrium: One Commodity Case

A consumer consumes a large number of goods and services. Let us however begin ouranalysis of consumer’s equilibrium with a simple case of a consumer consuming onlyone commodity. Although unrealistic, this case provides an insight for analysing a generalcase of consumer behaviour.

To illustrate consumer’s equilibrium, let us suppose that a consumer with certainmoney income consumes only one commodity, X. Since both his money income andcommodity X have utility for him, he can either spend his money income on commodityX or retain it with himself. If the consumer holds his total income, the marginal utility ofcommodity X (i.e., MUx) is bound to be greater than marginal utility of money income(MUm). In that case, total utility can be increased by exchanging money for thecommodity. Therefore, a utility maximizing consumer exchanges his money income forthe commodity so long as MUx > MUm. As assumed above, marginal utility of commodityof X is subject to diminishing returns whereas marginal utility of money income (MUm)remains constant. Therefore, the consumer will exchange his money income forcommodity X so long as MUx > Px (MUm). The utility maximizing consumer reaches hisequilibrium—the level of his maximum satisfaction—where

MUx = Px(MUm) ... (3.1)Equation (3.1) states the necessary condition for utility maximization. Alternatively,

the consumer reaches equilibrium where

= 1 ... (3.2)

Consumer’s equilibrium in a single-commodity case is illustrated graphically inFig. 3.2. The horizontal line Px(MUm) shows the constant utility of money weighed byPx, the price of commodity X and MUx curve represents the diminishing marginal utilityof commodity X.

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Fig. 3.2 Consumer’s Equilibrium: Cardinal Approach

As Fig. 3.2 shows, the Px(MUm) line and MUx curve intersect at point E, whereMUx = Px(MUm). Therefore, consumer is in equilibrium at point E. At any point above E,MUx > Px(MUm). Therefore, if consumer exchanges his money income for commodityX, he increases his satisfaction. At any point below E, MUx < Px (MUm), the consumercan therefore increase his satisfaction by reducing his consumption. That is, at any pointother than E, consumer gets satisfaction less than maximum. Therefore, point E is thepoint of consumer’s equilibrium.

Consumer Equilibrium: The General Case— The Law of Equi-MarginalUtility

We have explained above consumer’s equilibrium in a single commodity case. In reality,however, a consumer consumes a large number of goods. The MU schedules of differentcommodities is not the same. Some commodities yield a higher MU schedule and somelower. MU of some goods decreases more rapidly than that of others. A rational andutility maximizing consumer consumes commodities in the order of their utilities. Hepicks up first the commodity which yields the highest utility and then the commodityyielding the second highest utility and so on. He switches his expenditure from onecommodity to another in order of their marginal utility. He continues to switch hisexpenditure from one commodity to the other till he reaches a stage where MU of eachcommodity is the same per unit of expenditure.

Let us now analyse a simple two-commodity case. We assume that a consumerconsumes only two commodities X and Y, their prices being Px and Py, respectively.Following the equilibrium rule of single commodity case, the consumer distributes hisincome between commodities X and Y, so that

MUx = Px(MUm)and MUy = Py(MUm)

or alternatively, in terms of Eq. (3.2) consumer is in equilibrium where

= ... (3.3)

and = ... (3.4)

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Equations (3.3) and (3.4) may be written together and equilibrium condition for two-commodity case can be expressed as

= 1 =

or = ... (3.5)

Since, according to assumption 6, MUm = 1, Eq. (3.5) may be rewritten as

= ... (3.6)

or = ... (3.7)

Equation (3.7) leads to the conclusion that the consumer reaches his equilibriumwhen the marginal utility derived from each unit of money, say each rupee, spent on thetwo commodities X and Y is the same.

3.4 ORDINAL UTILITY APPROACH

In the preceding section, we have explained the cardinal utility theory of consumerbehaviour. In this section, we will discuss the ordinal utility theory of consumer behaviour.The technique economists use under ordinal utility approach is called indifference curve.The basis of indifference curve is the assumption that a consumer is able to makedifferent combinations of any two substitute goods such that each combination of goodsyields the same level of satisfaction, that is, the consumer is indifferent when it comes tomaking a choice. A graphical presentation of such combinations of two substitute goodsproduces a curve, called ‘indifference curve’.

The indifference technique was invented and used by Francis Y. Edgeworth (1881)to show the possibility of exchange of commodities between two individuals. About adecade later, Irving Fisher (1892) used indifference curve to explain consumer’sequilibrium. Both Edgeworth and Fisher, however, believed in cardinal measurability ofutility. It was Vilfred Pareto who introduced, in 1906, the ordinal utility hypothesis to theindifference curve analysis. In the subsequent decades, many significant contributionswere made by Eugen E. Slutsky, W.E. Johnson, and A.L. Bowley. Yet, the indifferencecurve technique could not gain much ground in the analysis of consumer behaviour tillearly 1930s. In 1934, John R. Hicks and R.G.D. Allen developed systematically theordinal utility theory as a powerful analytical tool of consumer analysis. Later, Hicksprovided a complete exposition of indifference curve technique in his Value and Capital.To have a comparative view, recall that ‘cardinalists’ assumed that utility is cardinallymeasurable, and that utility of one commodity is independent of other commodities. Incontrast, the ‘Ordinalists’ believe that cardinal measurement of utility is neither feasiblenor necessary to analyse consumer’s behaviour. According to ordinalists, all that isrequired to analyse consumer’s behaviour is that the consumer should be able to orderhis preferences. In fact, the consumer is able to express his preference for the quantityof a commodity to that of others. The section provides a detailed discussion on theordinal utility approach to the analysis of consumer behaviour.

Check Your Progress

1. Name theeconomistsassociated with theCardinal UtilityTheory ofconsumer demand.

2. What do youunderstand by thelaw of diminishingmarginal utility?

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3.4.1 Meaning and Nature of Indifference Curve and Indifference Map

An indifference curve may be defined as the locus of points, each representing a differentcombination of two goods but yielding the same level of utility or satisfaction. Since eachcombination of two goods yields the same level of utility, the consumer is indifferent betweenany two combinations of goods when it comes to making a choice between them. Aconsumer is very often confronted with such a situation in real life. Such a situation arisesbecause he consumes a large number of goods and services, and often he finds that onecommodity serves as a substitute for another. It gives him an opportunity to substitute onecommodity for another, and to make various combinations of two substitutable goods. Itmay not be possible for him to tell how much utility a particular combination gives, but it isalways possible for him to tell which one between any two combinations is preferable tohim. It is also possible for him to tell which combinations give him equal satisfaction. If aconsumer is faced with equally good combinations, he would be indifferent between thecombinations. When such combinations are plotted graphically, the resulting curve is knownas indifference curve. Indifference curve is also called Iso-utility Curve and EqualUtility Curve.

For example, suppose that a consumer consumes only two commodities X and Yand he makes five combinations which he calls a, b, c, d and e. All these combinationsyield him equal utility. Therefore, he is indifferent between the different combinations ofthe two commodities, X and Y. His combinations are presented in Table 3.2, which maybe called indifference schedule—a schedule of various combinations of two goods—between which a consumer is indifferent. The last column of the table shows an undefinedutility (u) derived from each combination of X and Y. If combinations a, b, c, d, and egiven in Table 3.2 are plotted and joined to form a smooth curve (as shown in Fig. 3.2),the resulting curve is known as indifference curve. On this curve, one can locate manyother points showing many other combinations of X and Y which yield the samesatisfaction. Therefore, the consumer is indifferent between the different combinationsrevealed by the indifference curve.

Table 3.2 Indifference Schedule of Commodities X and Y

Combination Commodity Y Commodity X Utility

a 25 5 ub 15 7 uc 10 12 ud 6 20 ue 4 30 u

The Indifference Map

We have drawn a single indifference curve in Fig. 3.3 on the basis of an indifferenceschedule given in Table 3.2. The combinations of the two commodities, X and Y, given inthe indifference schedule or those indicated by the indifference curve are by no meansthe only combinations of the two commodities. The consumer may be faced with manyother combinations with less of one or both the goods—each combination yielding thesame level of satisfaction but less than the level of satisfaction indicated by the indifferencecurve IC in Fig. 3.3. Therefore, another indifference curve can be drawn, say, throughpoints f, g and h. Note that this indifference curve falls below the curve IC given inFig. 3.3. Similarly, he may be faced with many other combinations with more of one orboth the goods—each combination yielding the same satisfaction—but greater than thesatisfaction indicated by the lower indifference curves. Thus, another indifference curve

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can be drawn above the IC given in Fig. 3.3, say, through points j, k, and l. This exercisemay be repeated as many times as one wants, each time generating a new indifferencecurve.

Fig. 3.3 Indifference Curve

In fact, the area between X and Y axes is known as indifference plane orcommodity space. This plane is full of finite points and each point on the place indicatesa different combination of goods X and Y. Intuitively, it is always possible to locate anytwo or more points indicating different combinations of goods X and Y yielding the samesatisfaction. It is thus possible to draw a number of indifference curves without intersectingor touching the other, as shown in Fig. 3.4. The set of indifference curves, IC1, IC2, IC3and IC4 drawn in this manner make the indifference map. In fact, an indifference mapmay contain any number of indifference curves, ranked in the order of consumer’spreferences.

Fig. 3.4 The Indifference Map

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Assumptions of ordinal utility theory

The indifference curve analysis of consumer’s behaviour is based on the followingassumptions:

1. Rationality. The consumer is a rational being. He aims at maximizing his totalsatisfaction, given his income and prices of goods and services he consumes.Furthermore, he has full knowledge of his choices and preferences.

2. Ordinal Utility. Indifference curve analysis assumes that utility can beexpressed only ordinally or comparatively. That is, the consumer is able to tellonly the order of his preferences.

3. Transitivity and Consistency of Choice. Consumer’s choices are transitive.Transitivity of choice means that if a consumer prefers A to B and B to C, hemust prefer A to C. Or, if he treats A = B and B = C, he must treat A = C,Consistency of choice means that, if he prefers A to B in one period, he will notprefer B to A in another period or treat them as equal. The transitivity andconsistency in consumer’s choices may be symbolically expressed as follows.Transitivity. If A > B, and B > C, then A > C, andConsistency. If A > B, in one period, then B A or B ≠ A in another.

4. Nonsatiety. It is also assumed that the consumer is not oversupplied with goodsin question and that he has not reached the point of saturation in case of anycommodity. Therefore, a consumer always prefers a larger quantity of all thegoods.

5. Diminishing Marginal Rate of Substitution. The marginal rate of substitutionmeans the rate at which a consumer is willing to substitute one commodity (X) foranother (Y), i.e. the units of Y he is willing to give up for one unit of X so that histotal satisfaction remains the same. This rate is given by ΔY/ΔX. The assumptionis that ΔY/ΔX goes on decreasing, when a consumer continues to substitute X forY. The marginal rate of substitution has been discussed in detail in the followingsection.

3.4.2 Diminishing Marginal Rate of Substitution (MRS)

When a consumer makes different combination of two goods, yielding the same level ofsatisfaction, he substitutes one good for another. The rate at which he substitutes onegood for the other is called the ‘Marginal Rate of Substitution (MRS)’. One of the basicpostulates of indifference curve analysis is that (MRS) diminishes. The axiomaticassumption of ordinal utility theory is analogous to the assumption of ‘Diminishing MarginalUtility’ in cardinal utility theory. The postulate of diminishing marginal rate ofsubstitution states an observed behavioural rule that when a consumer substitutes onecommodity (say X) for another (say Y), the ‘Marginal Rate of Substitution’ (MRS)decreases as the stock of X increases and that of Y decreases.

Measuring MRS

Conceptually, the MRS is the rate at which one commodity can be substituted for another,the level of satisfaction remaining the same. The MRS between two commodities, X andY, can also be defined as the number of units of X which are required to replace one unitof Y (or number of units of Y that are required to replace one unit of X), in the combinationof the two goods so that the total utility remains the same. It implies that the utility of

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units of X (or Y) given up is equal to the utility of additional units of Y (or X) added to thebasket.

To explain symbolically the concept of MRS, let us suppose that the utility functionof a consumer is given as

U = f (X, Y) ... (3.8)Let us now suppose that the consumer substitutes X for Y. When the consumer

foregoes some units of Y, his stock of Y decreases by – ΔY. His loss of utility may beexpressed as

– ΔY . MUy

On the other hand, as a result of substitution, his stock of X increases by ΔX. Hisutility from ΔX equals

+ ΔX . MUx

For the total utility U to remain the same, – ΔY. MUy must be equal to ΔX.MUx.That is,

– ΔY.MUy + ΔX.MUx = 0 ...(3.9)Rearranging the terms in Eq. (3.9), we get MRS of X for Y as

–

YX

MUMU

x

y ... (3.10)

Here, ΔY/ΔX is simply the slope of the indifference curve, which gives the MRSx,ywhen X is substituted for Y. Similarly, ΔX/ΔY gives MRSy,x when Y is substituted for X.

and

,

,

xx y

y

yy x

x

MUYMRS

X MU

MUXMRS

Y MU

= Slope of indifference curve

Diminishing MRS

As mentioned, the basic postulate of ordinal utility theory is that the MRSx,y (or MRSy,x)decreases. That is, the number of units of a commodity that a consumer is willing tosacrifice for an additional unit of another goes on decreasing when he goes on substitutingone commodity for another. The diminishing MRSx,y which can be obtained from Table3.2, are presented in Table 3.3.

Table 3.3 The Diminishing MRS between Commodities X and Y

Movements Change in Y Change in X MRSy,xon IC (–ΔΔΔΔΔY) (ΔΔΔΔΔX) (ΔΔΔΔΔY/ΔΔΔΔΔX)

From point a to b – 10 2 – 5.0From point b to c – 5 5 – 1.0From point c to d – 4 8 – 0.5From point d to e – 2 10 – 0.2

As Table 3.3 shows, when the consumer moves from point a to b on the indifferencecurve (Fig. 3.3) he gives up 10 units of commodity Y and gets only 2 units of commodityX, so that

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=−

=−

= −∆∆

As he moves down from points b to c, he loses 5 units of Y and gains 5 units of X,giving

,5 15y x

YMRSX

−∆= = = −∆

The MRSy,x goes on decreasing as the consumer moves further down along theindifference curve. The diminishing marginal rate of substitution causes the indifferencecurves to be convex to the origin.

The diminishing marginal rate of substitution can also be illustrated graphically, asshown in Fig. 3.5.

a

b

c

d

IC

a

b

cIC

Fig. 3.5 Diminishing Marginal Rate of Substitution

As the consumer moves from point a to b, to c, and to d, he gives up a constantquantity of Y, (i.e., ∆Y1 = ∆Y2 = ∆X3). To substitute a constant quantity of ∆Y, herequires an increasing quantity of X (i.e., ∆X1 < ∆X2 < ∆X3). Since MRS is given by theslope of the indifference curve, (i.e., ∆Y/∆X), arranging the slopes between points a andb, b and c, and c and d, in descending order, we get

∆∆

∆∆

∆∆

> >

These inequalities show that MRS (= ∆Y/∆X) goes on decreasing as the consumermoves from point a towards point d.

The diminishing MRS is geometrically illustrated in Fig. 3.5 (b). The lines tangent tothe indifference curve at points a, b and c measure the slope of the curve at thesepoints. It can be seen from the figure, that as the consumer moves from point a towardsd, the tangential lines become flatter indicating decrease in the slope of the indifferencecurve. This also proves the decrease in MRS all along the indifference curve.

Why does MRS diminish?

The negative slope of the indifference curve implies that two commodities are not perfectsubstitutes for each other. In case they are perfect substitutes, the indifference curvewill be a straight line with a negative slope. Since goods are not perfect substitutes foreach other, the subjective value attached to the additional quantity (i.e., MU) of acommodity decreases fast in relation to the other commodity whose total quantityis decreasing. Therefore, when the quantity of one commodity (say, X) increases and

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that of other (say, Y) decreases, it becomes increasingly difficult for the consumer tosacrifice more and more units of commodity Y for one unit of X. But, if he is required tosacrifice additional units of Y, he will demand increasing units of X to maintain the levelof his satisfaction. As a result, the MRS decreases.

Furthermore, when the combination of two goods at a point of indifference curve issuch that it includes a large quantity of one commodity, (say, Y) and a small quantity ofthe other (commodity X), then consumer’s capacity to sacrifice Y is greater than tosacrifice X. Therefore, he can sacrifice a large quantity of Y in favour of a smallerquantity of X. This is an observed behavioural rule that the consumer’s willingness andcapacity to sacrifice a commodity is greater when its stock is greater and it is lowerwhen the stock of a commodity is smaller. These are the reasons why MRS decreasesall along on the indifference curve.

3.4.3 Properties of Indifference Curves

Indifference curves have the following four basic properties or characteristics:1. Indifference curves have a negative slope;2. Indifference curves are convex to the origin;3. Indifference curves do not intersect;4. Upper indifference curves indicate a higher level of satisfaction than the lower

ones.These properties of indifference curves, in fact, reveal consumer’s behaviour, as well ashis choices and preferences, and are therefore very important in the modern theory ofconsumer behaviour.

Shifts in Budget Line

The budget line changes its position following the change in consumer’s income andprices of the commodities. If a consumer’s income increases, prices of X and Y remainingthe same, budget line shifts upwards remaining parallel to the original budget line. Asshown in Fig. 3.6, given the consumer’s income (M), Px and Py, the budget line is givenby line AB. If M increases, (prices remaining the same) the budget line will shift to CD.If in the next period M decreases by the same amount, the budget line will shift backwardto its original position AB.

Fig. 3.6 Shift in the Budget Line

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Likewise, income remaining the same, if prices change, the budget line changesits position. For example, M and Py remaining constant at their original level, if Pxdecreases, point B will shift to F and the budget line will shift to AF. Similarly, M and Pxremaining constant, if Py increases, the budget line shifts to EB.

Slope of the Budget LineThe slope of the budget line is of great importance in determining consumer’s equilibrium.The slope of the budget line (AB) in Fig. 3.7 is given by the following ratios.

∆

∆=

Since OA = M/Py and OB = M/Px (Fig. 3.7) the slope of the budget line may berewritten as

= = ... (3.11)

As Eq. (3.11) shows, the slope of the budget line equals the price ratio (Py/Px).

Fig. 3.7 Slope of the Budget Line

3.4.4 Consumer’s Equilibrium

The consumer attains his equilibrium when he maximizes his total utility, given his incomeand market prices of goods and services he consumes. Under indifference curve analysisof consumer behaviour, a necessary condition for utility maximization is given as MRSmust be equal to the ratio of commodity prices. Considering our earlier two-commoditymodel, the necessary (or the first order) condition may be expressed as

MRSx,y= =

This is a necessary but not sufficient condition of consumer’s equilibrium. Anothercondition, a second order or supplementary condition is that the necessary conditionmust be fulfilled at the highest possible indifference curve.

Consumer’s equilibrium is illustrated in Fig. 3.8. A hypothetical indifference map ofthe consumer is shown by indifference curves IC1, IC2 and IC3. The line AB is thehypothetical budget line. Both necessary and supplementary conditions of consumer’sequilibrium are fulfilled at point E, where indifference curve IC2 is tangent to the budget

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line, AB. Since both, the curve IC2 and the budget line, AB, pass through point E, therefore,at this point, the slopes of the indifference curve IC2 and the budget line (AB) are equal.The consumer is therefore in equilibrium at point E.

That the consumer is in equilibrium at point E can also be proved algebraically. Weknow from Eq. (3.10) that the slope of an indifference curve is given by

− = =∆∆

We know also that the slope of the budget line is given by Eq. (3.11) as

=

At point E, MRSy,x = Py/Px. Therefore, the consumer is in equilibrium at point E. Thetangency of IC2 with the budget line indicates that IC2 is the highest possible indifferencecurve which the consumer can reach, given his budgetary constraint and the prices. Atequilibrium point E, the consumer consumes OQx of X and OQy of Y, which yield himmaximum satisfaction.

Fig. 3.8 Equilibrium of the Consumer

Although the necessary condition is satisfied also on two other points, J and K, thesepoints do not satisfy the supplementary or the second order condition of consumer’sequilibrium. Indifference curve IC1 is not the highest possible curve on which thenecessary condition is fulfilled. Since indifference curve IC1 lies below the curve IC2, atany point on IC1, the level of satisfaction is lower than the level of satisfaction indicatedby IC2. So long as the utility maximizing consumer has the opportunity to reach thecurve IC2, he would not like to settle on a lower curve.

From the information contained in Fig. 3.8, it can be proved that the level of satisfactionat point E is greater than that on any point on IC1. Suppose that the consumer is at pointJ. If he moves to point M, he will be equally well-off because points J and M are on thesame indifference curve. If he moves from point J to M, he will have to sacrifice JP ofY and take PM of X. But in the market, he can exchange JP of Y for PE of X. That is, hegets extra ME (= PE – PM) of X. Since ME gives him extra utility, point E yields a utilityhigher than the point M. Therefore, point E is preferable to point M. The consumer willtherefore, have a tendency to move to point E from any point at the curve IC1, in order

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to reach the highest possible indifference curve, all other things (taste, preference, andprices of goods) remaining the same.

Another fact which is obvious from Fig. 3.8 is that, due to budget constraint, theconsumer cannot move to an indifference curve placed above and to the right of IC2.For example, his income would be insufficient to buy any combination of two goods atthe curve IC3. Note that IC3 falls beyond the budget line.

To conclude, a utility maximizing consumer, given his income, taste and preferencesand prices of goods, will attain his equilibrium when MRS = price ratio at the highestpossible indifference curve.

3.4.5 Income and Substitution Effects

As mentioned earlier, price effect consists of two effects: (i) income effect, and(ii) substitution effect. Income effect occurs due to increase in real income resultingfrom the decrease in the price of a commodity. Substitution effect occurs due toconsumer’s inherent tendency to substitute cheaper goods for the relatively expensiveones.

In this section, we explain how total price effect is split into its two components—income and substitution effects. There are two approaches of decomposing the totalprice effect into income and substitution effects, viz.

(i) Hicksian approach, and(ii) Slutsky approach.

The two methods of measuring the income and substitution effects are explained andillustrated below. We consider first the case of ‘normal goods’ and then take up the caseof ‘inferior goods’.

Fig. 3.9 Income and Substitution Effects: Hicksian Approach

(i) Hicksian Approach

The Hicksian method of decomposing income and substitution effects is demonstratedin Fig. 3.9 Let the consumer be in equilibrium initially at point P on indifference curveIC1 and budget line MN, where he consumes PX1 of Y and OX1 of X. Now, let the priceof X fall, all other things remaining the same, so that new budget line is MN″. The new

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budget line (MN″) is tangent to IC2 at point Q. Thus, when price of X falls, the consumerreaches a new equilibrium at point Q. At this point, he buys additional quantity (X1X3) ofX. That is, total price effect = X1X3.

Now the problem is how to split the price effect (X1X3) into income and substitutioneffects. We know that

Price Effect = Income Effect + Substitution EffectIf one of these effects is measured, we can find the other. The general practice is to

eliminate first the income effect from the price effect and measure the substitutioneffect. Income effect is then obtained by subtracting the substitution effect from thetotal price effect. The Hicksian method of eliminating income effect is to reduceconsumer’s income (by way of taxation) so that he returns to his original indifferencecurve, IC1, keeping in view the new price ratio. This has been done by drawing a budgetline (MN′) parallel to MN″ and tangent to indifference curve IC1. The budget line, MN′is tangent to indifference curve IC1 at point R. The point R represents the equilibrium ofthe consumer at new price ratio of X and Y, after the elimination of the real incomeeffect caused by fall in the price of X. The movement of the consumer from P to Rshows his response to the changes in relative price ratio, his real income being heldconstant at its original level. The consumer’s movement from point P to R means anincrease in quantity demanded of X by X1X2. This change in quantity demanded (X1X2)is called substitution effect. The substitution effect may thus be defined as the changein quantity demanded resulting from a change in relative price after the real-income-effect of price change is eliminated.

Fig. 3.10 Price Consumption Curve

If we subtract substitution effect, X1X2, from the total price effect, X1X3, we get theincome effect. That is,

Income effect = X1X3 – X1X2 = X3X3

Graphically, the income effect (X2X3) occurs when the consumer moves from pointR to Q. In other words, consumer’s movement from R to Q and the correspondingchange in quantity demanded (X2X3) is the income effect caused by the increase in real

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income of the consumer due to fall in price of X. The income-effect of a change in theprice of a commodity may thus be defined as the change in quantity demanded ofthat commodity resulting exclusively from a change in the real income, all otherthings remaining the same.

(ii) Slutsky Approach

Slutsky’s method of measuring income and substitution effects of price effect is similarto the Hicksian method. Both the methods approach the problem by holding consumer’sreal income constant. But there is a difference in the two methods of measuring thereal-income-effect of a fall in the price of a commodity. The difference lies in the levelat which real income is held constant.

Hicksian method considers the real-income-effect of a fall in the price of a commodityequal to an amount which, if taken away from the consumer, brings him back to hisoriginal indifference curve, at the new price ratio, irrespective of the change in theoriginal combination of the two goods. This is accomplished by drawing an imaginarybudget line tangent to the original indifference curve, as shown by MN′ in Fig. 3.10.

On the other hand, according to the Slutskian method, the real-income-effect of afall in the price of a commodity equals only that amount which, if taken away from theconsumer leaves with him an adequate income to buy the original combination of twogoods after the change in price ratio. This approach to measuring the real-income-effect makes the imaginary budget line pass through the original equilibrium point P.

The Slutskian method of splitting the total price-effect into income and substitutioneffects is demonstrated in Fig. 3.11. Suppose that the consumer is initially in equilibriumat point P on indifference curve IC1. When the price of X falls, other things remainingthe same, the consumer moves to another equilibrium point (Q) at indifference curveIC3. The movement from point P to Q increases consumer’s purchase of X by X1X3.This is the price effect caused by the fall in price of X. The problem now is to measurethe substitution and income effects. To measure the substitution effect, the incomeeffect has to be eliminated first. This can be done by taking away the increase inconsumer’s real income resulting from the fall in price of X. It is here that Slutskianapproach differs from the Hicksian approach. According to the Slutskian approach,consumer’s real income is so reduced that he is able to purchase his original combinationof the two goods (i.e. OX1 of X and PX1 of Y) at the new price ratio. This has beenaccomplished by drawing an imaginary budget line, M′N′, through point P, which isparallel to MN,′. Since the whole commodity space is full of indifference curves, one ofthe indifference curves will be tangent to the imaginary budget M′N′ as shown by thepoint R on indifference curve IC2. The equilibrium point R shows the additional quantity(X1X2) of X, i.e., purely as a result of substitution effect. The quantity X1X2 is thereforethe substitution effect. Now income effect (IE) can be found by subtracting thesubstitution effect (SE) from the price effect (PE) as given below.

Income Effect = PE – SE = IE= X1X3 – X1X2 = X1X3

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Fig. 3.11 Income and Substitution Effects: Slutsky Approach

In Fig. 3.11, the movement from P to R and the consequent increase in the quantitypurchased of X (i.e., X1X2) is substitution effect. Similarly the consumer’s movementfrom R to Q and the consequent increase in the quantity (X2X3) purchased of X isincome effect.

(iii) Hicksian Approach vs Slutskian Approach

Let us now compare the Hicksian and Slutskian approaches of splitting price effect intosubstitution and income effects and also their results. As mentioned above, the Slutskianapproach attempts to hold only apparent real income constant, which is obtained byadjusting consumer’s real income by the amount of ‘cost-difference’ so that the consumeris left with an income just sufficient to buy the original combination of the goods. TheHicksian approach holds constant the real income expressed in terms of original levelof satisfaction so that the consumer is able to stay on the original indifference curvethough the combination of X and Y is different from the original one. To express thedifference graphically, The Hicksian method puts the consumer on the originalindifference curve whereas the Slutskian method makes the consumer move on to anupper indifference curve.

The two approaches are compared in Fig. 3.12. Let the consumer initially be inequilibrium at point P on indifference curve IC1. When price of X falls, the consumermoves to point Q. The movement from P to Q is the total price effect which equals X1X4of commodity X. Till this point, there is no difference between the Slutskian and theHicksian approaches. But beyond this point, they differ. According to the Slutskianapproach, the movement from point P to T is the substitution effect and movement fromT to Q is the income effect. According to the Hicksian approach, the movement from Pto R is the substitution effect and movement from R to Q is the income effect. Thesubstitution and income effects of Slutskian and Hicksian approaches are summarizedin quantitative terms in the following table.

Method Price Substitution IncomeEffect Effect Effect

Hicksian X1X4 X1X2 X2X4Slutskian X1X4 X1X3 X3X4

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As depicted in Fig. 3.12, there is a good deal of difference between the Hicksianand the Slutskian measures of income and substitution effects. But it can be shown thatif change in price is small the difference between the Slutskian and Hicksian measureswould be small and if DP tends to be zero, the difference would also be zero.

Fig. 3.12 Hicksian Approach vs. Slutskian Approach

Apart from the above difference between the two approaches, there are someother differences between them. While the Hicksian approach is considered as a ‘highlypersuasive solution’ to the problems of splitting price effect into substitution and incomeeffects, the Slutskian approach is intuitively ‘perhaps less satisfying’. But the merit ofthe Slutskian approach is that substitution and income effects can be directly computedfrom the observed facts, whereas Hicksian measure of these effects cannot be obtainedwithout the knowledge of consumer’s indifference map.

Both the methods however have their own merits. The merit of the Slutskian method,what Hicks calls ‘cost-difference’ method, lies in its property that it makes income-effect easy to handle. Hicks has himself recognized this merit of the Slutskian method.The merit of the Hicksian method or ‘compensating variation method’ is that it is a moreconvenient method of measuring the substitution effect. In Hick’s own words, ‘Themerit of the cost-difference method is confined to [its] property... that its income effectis peculiarly easy to handle. The compensating variation method [i.e., his own method]does not share in this particular advantage; but it makes up for its clumsiness in relationto income effect by its convenience with relation to the substitution effect.’

Need for splitting income and substitution effects

We have discussed above the Hicksian and Slutskian method of decomposing incomeand substitution effects of the price effect. Let us now look into the need for separatingincome effect and the substitution effect. As Hicks has pointed out, ‘substitution effectis absolutely certain; it must always work in favour of an increase in demand for acommodity when the price of that commodity falls. Thus, the behaviour of substitutioneffect is predictable: it follows directly from the principle of diminishing marginal rate ofsubstitution. On the contrary, ‘income effect is not so reliable’ and its behaviour isunpredictable in general. In fact, whether income-effect is positive or negative dependson whether a commodity is treated by the consumer as a ‘superior’ or ‘inferior’ good.Since the subjective valuation of a commodity may vary from person to person, theresponse of the consumer in general to the change in real income becomes uncertain

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and unpredictable. It is quite likely that while in some cases, substitution effect works inpositive direction, income effect works in negative direction. In such cases, a systematicanalysis of price-demand relationships becomes an extremely difficult task. It thereforebecomes necessary to eliminate the unpredictable income effect so that ‘the systematicand predictable behaviour of the substitution effect can be revealed’. That is why theattempts to measure and split away the income effect from the price effect.

Income and substitution effects of price change on inferior goods

We have examined in the foregoing section, the income and substitution effects of achange in price on the consumption of ‘normal’ or ‘superior’ goods. We will see, in thissection, how income and substitution effects of a price change work on the consumptionof an inferior commodity.

As mentioned above, an ‘inferior good’ is one whose consumption decreases withincrease in consumer’s income. In other words, an ‘inferior good’ is one for whichincome-effect is negative. The reason for income effect on the consumption of an‘inferior good’ being negative is the human desire to improve his standard of living. Ingeneral, when income of a consumer increases, he has a tendency to reduce hisconsumption of ‘inferior goods’ and increase the consumption of ‘superior’ or ‘normal’goods.

Income and substitution effects of income change

The income-effect on the consumption of an ‘inferior good’ (say, X), is illustrated inFig. 3.13.

In the figure, the vertical axis measures money income and the horizontal axismeasures an inferior good, X. Let us suppose that the consumer is initially in equilibriumat point E1 where he purchases OX3 units of X. As his income increases from OM1 toOM2, price of X remaining constant, his budget line M1 N1 shifts to M2 N2 and he reachesan upper indifference curve IC2. His new equilibrium point is E2 where he consumesonly OX2 units of X. Note that OX2 < OX3. That is, his consumption of X decreases. Itdecreases further to OX1 when his income increases to OM3. The curve joiningequilibrium points E1, E2 and E3 is ICC for the inferior commodity (X). For most part ofit, ICC has a negative slope showing negative income effect on the consumption of X.

Fig. 3.13 Income Effect: Inferior Goods Case

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It should be borne in mind that inferiority or superiority is not an absolute or instrinsicproperty of a commodity. These properties often arise out of consumer’s taste andpreference. However, a number of commodities is generally treated by the consumersas inferior to their substitutes. For example, bajra and millet are inferior to wheat andrice; cotton fabrics are inferior to silk and synthetic cloth; coal and charcoal (evenkerosene) are inferior fuel to cooking gas; bidi is inferior to cigarettes; bus and railwayservices are inferior to air services.

Income and substitution effects of price change

Let us now examine the income and substitution effects caused by a fall in the price ofX, assumed to be an inferior good. The income and substitution effects of a fall in priceof X are presented in Fig. 3.14. Let the consumer be in equilibrium at point P, wherebudget line M1N1 is tangent to indifference curve IC1. At point P, the equilibriumcombination of X and Y consists of OX1 of X and PX1 of Y. Now let the price of X fall,other things remaining the same, so that the budget line shifts to M1N3 and the consumermoves to equilibrium R. The movement from P to R is the price effect, which equalsX1X2. To eliminate the income effect from the price effect, M2N2, following the Hicksianmethod, let us draw an imaginary budget line, M2N2 tangent to the original indifferencecurve IC1. The budget line M2N2 is tangent to IC1 at point Q, which is equilibrium pointafter the elimination of income effect. Consumer’s movement from P to Q means anincrease in the quantity consumed of X by X1X3. This is substitution effect which resultsfrom a fall in the price of X. Note that substitution effect (X1X3) is greater than the priceeffect (X1X2) in case of inferior goods.

Let us now look at the income effect of change in price of an inferior good. Themovement from Q to R shows negative income effect, (i.e., decrease in the quantitydemanded of X. The negative income effect may be computed from Fig. 3.14 as follows.

PE – SE = IEX1X2 – X1X3 = – X2X3

Note that in case of an ‘inferior good’, income and substitution effects, both beingnegative, work in opposite directions. That is, while income effect of a fall in the price ofan inferior good causes a decrease in the consumption of the good, substitution effectcauses an increase in its quantity demanded.

Fig. 3.14 Income and Substitution Effects: Inferior Good Case

It is important to note here that, in case of an inferior good, substitution effect (X1X3)is greater than the income effect (X1X3). That is, negative substitution effect outweighsthe negative income effect. It means that a stronger substitution effect causes a net

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increase in the demand for an inferior good, even though there exists a negative incomeeffect. This shows that the law of demand applies to most inferior goods.

Giffen goods and giffen paradox

In case of an inferior good, income and substitution effects of a price change work inopposite directions and that substitution effect outweighs the income effect so thatthere is net increase in the quantity demanded of an inferior good when its price falls. Itmeans that the law of demand applies to an ‘inferior good’ as well as to a ‘normalgood’.

However, there are certain cases of inferior goods to which the law of demand doesnot apply. Such goods are known as Giffen goods. In case of Giffen goods, income andsubstitution effects work in the same direction, and income effect is more powerful thanthe substitution effect. In other words, in case of Giffen goods, income effect outweighsthe substitution effect. This phenomenon causes a paradoxical situation, i.e. when priceof an inferior good increases, its quantity demanded increases. This paradox is knownas Giffen paradox. The Giffen paradox is an exception to the law of demand.

Marshall attributed this paradox to Robert Giffen though there is no mention of thisparadox in Giffen’s own writings. Besides, economists doubt whether Giffen’s paradoxwas actually observed. But, since this paradox is useful in explaining an exception to thelaw of demand, it is retained in the economic literature.

The Giffen’s paradox is illustrated in Fig. 3.15. Let us suppose that the consumer isinitially in equilibrium at P. Now, let the price of commodity X decrease, price of Yremaining constant, so that the consumer moves to equilibrium R on IC2. As a result ofthis movement, quantity demanded of X decreases by X1X2.

Let us now separate the income and substitution effects of the price effect X1X2 andsee their behaviour in the case of a Giffen good. Following the Hicksian method, let useliminate the income effect by drawing an imaginary budget line M1N2 parallel to thebudget line M2N3 and tangent to the original indifference curve IC1. The imaginarybudget line is tangent to IC1 at point Q. The consumer’s movement from P to Q and theconsequent increase in the quantity demanded of X by X2X3 is the substitution effect.

Fig. 3.15 Giffen’s Paradox

Income effect = – X1X2 – X2X3 = – X1X3

It may be observed from the Fig. 3.15 that income effect (–X1X3) is greaterthan substitution effect (X2X3). Obviously, income effect outweighs the subs-

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titution effect. The net result, therefore, is decreased in the quantity demanded ofX as its price decreases. That is, contrary to the law of demand, the demand fora Giffen good decreases when its price decreases and it increases when its price increases.

The case of a Giffen good exists when the consumer spends a major portion of hisincome on an inferior good. This kind of situation may be imagined to have existed incase of most poor families of the underdeveloped countries, who spend a major portionof their wage income on some inferior foodgrains (bajra or millet). Given the prices ofinferior foodgrains, poor families may possibly afford some quantity of superiorconsumption items. But when the prices of inferior foodgrains go up, they are forced tocurtail their expenditure on superior items and spend more on inferior items becausethese are still the cheaper food items available to the poor families.

It may finally be noted that all Giffen goods are inferior goods, but not all inferiorgoods are Giffen goods. The important distinction between Giffen goods and non-Giffen inferior goods is that the demand curve for the former has a positive slope, thedemand curve for the latter has a negative slope.

3.5 REVEALED PREFERENCE APPROACH

In succession to Hicks-Allen ordinal utility approach, Samuelson formulated, in 1947, hisown ‘Revealed Preference Theory’ of consumer behaviour. The main merit of therevealed preference theory is that the ‘law of demand’ can be directly derived from therevealed preference axioms without using indifference curve and most of its restrictiveassumptions. What is needed is simply to record the observed behaviour of the consumerin market, i.e., what basket of goods a consumer buys at different prices. Besides, therevealed preference theory is also capable of establishing the existence of indifferencecurves and their convexity. For its merits, revealed preference theory is treated as ‘thethird root of the logical theory of demand’.

Assumptions

Revealed preference hypothesis is based on the following straightforward assumptions.1. Rationality. The consumer is assumed to be a rational being. In his order of

preferences, he prefers a larger basket of goods to the smaller ones.2. Transitivity. Consumer’s preferences are assumed to be transitive. That is,

given the alternative baskets of goods, A, B, and C, if the consumer considersA > B and B > C, then he considers A > C.

3. Consistency. It is also assumed that consumer’s taste remains constant andconsistent. Consistency implies that if a consumer, given his circumstances,prefers A to B, he will not prefer B to A under the same conditions.

4. Price incentive. Given the collection of goods, the consumer can be induced tobuy a particular collection by providing his sufficient price incentive. That is, foreach collection, there exists a price line which makes it attractive for the consumer.

Revealed Preference Axiom

The rule of revealed preference can be stated as follows. Given the budgetary constraintand alternative baskets of goods having the same price, if a consumer chooses a particularbaskets, he reveals his preference. Suppose, for example, there are two alternative

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baskets A and B of two goods X and Y. Both the baskets being equally expensive, if aconsumer chooses basket A rather than basket B, he reveals his preference for basket A.

If a consumer chooses a particular basket, he does so either because be likes itmore or it is less expensive than the other. In the this example, if the consumer choosesA rather than B because it is cheaper, then the preference for A is not revealed becausethe consumer might regret not having been able to buy basket B. But, if both baskets areequally expensive, then there is only one plausible explanation that the consumer likes Amore than B. In this case, the consumer reveals his preference for A.

Quantity of X

Fig. 3.16 Revealed Preference

The revealed preference axiom is illustrated in Fig. 3.16. The consumer’s budgetaryconstraint has been shown by his budget line MN. If he chooses a particular bundle of Xand Y, e.g., a bundle represented by point A on the budget line, it implies that he preferspoint A to any other point on the budget line, say point B. Since point B is on the budgetline it is as expensive as A. If consumer chooses point A, it is revealed preferred to B,and B is revealed inferior to A. Any point below the budget line, like point C, representsa smaller and cheaper basket of X and Y and hence, is not revealed as inferior to A.Therefore, any point above the budget line, like point D, represents a larger and moreexpensive basket of goods than indicated by point A. Hence, it cannot be inferior to A.

3.6 SUMMARY

• The central theme of the traditional theory of consumer behaviour is a consumer’sutility maximizing behaviour. The fundamental postulate of the consumption theoryis that a consumer—an individual or a household—is a utility maximizing entityand all consumption decisions are directed towards maximization of total utility.

• Milton Friedman, instead of resolving the issue of measurability of utility, preferredto rely on the preferences and choices revealed by the consumers and developedhis own Revealed Preference theory.

• The Cardinal Utility Theory of consumer demand was developed by the classicaleconomists, viz. Gossen (1854) of Germany, William Stanley Jevons (1871) ofEngland, Leon Walras (1874) of France, Karl Menger (1840–1921) of Austria.Neo-classical economists, particularly Alfred Marshall (1890) made significantrefinements in the Cardinal Utility Theory.

Check Your Progress

3. What is anindifference curve?

4. What is theMarginal Rate ofSubstitution(MRS)?

5. What are theapproaches ofdecomposing thetotal price effectinto income andsubstitutioneffects?

6. Who postulated thetheory of revealedpreference and whatwas its main merit?

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• The notion of ‘Utility’ was introduced to social thought by the British philosopher,Jeremy Bentham, in the 18th century and to economics by William Stanley Jevonsin the 19th century. In its economic meaning, the term ‘utility’ is synonymous with‘pleasure’, ‘satisfaction’ and a sense of fulfilment by desire.

• The law of diminishing marginal utility is central to the cardinal utility analysis ofthe consumer behaviour. This law states that as the quantity consumed of acommodity increases per unit of time, the utility derived by the consumer from thesuccessive units goes on decreasing, provided the consumption of all other goodsremains constant.

• A consumer reaches equilibrium position, when he maximizes his total utility givenhis income and prices of commodities he consumes.

• The technique which economists use under ordinal utility approach is calledindifference curve. The basis of indifference curve is the assumption that aconsumer is able to make different combinations of any two substitute goodssuch that each combination of goods yields the same level of satisfaction that is,the consumer is indifferent when it comes to making a choice.

• Slutsky’s method of measuring income and substitution effects of price effect issimilar to the Hicksian method. Both the methods approach the problem by holdingconsumer’s real income constant. But there is a difference in the two methods ofmeasuring the real-income-effect of a fall in the price of a commodity. Thedifference lies in the level at which real income is held constant.

• There are certain cases of inferior goods to which the law of demand does notapply. Such goods are known as Giffen goods. In case of Giffen goods, incomeand substitution effects work in the same direction, and income effect is morepowerful than the substitution effect.

3.7 KEY TERMS

• Utility: It refers to the power or property of a commodity to satisfy human needs.• Law of diminishing marginal utility: The law states that as the quantity consumed

of a commodity increases per unit of time, the utility derived by the consumerfrom the successive units goes on decreasing, provided the consumption of allother goods remains constant.

• Indifference curve: It is the technique used by economists under ordinal utilityapproach. The basis of the technique is the assumption that a consumer is able tomake different combinations of any two substitute goods such that eachcombination of goods yields the same level of satisfaction that is, the consumer isindifferent when it comes to making a choice.

• Income effect: This occurs due to increase in real income resulting from thedecrease in the price of a commodity

• Substitution effect: This occurs due to consumer’s inherent tendency to substitutecheaper goods for the relatively expensive ones.

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1. The Cardinal Utility Theory of consumer demand was developed by the classicaleconomists, viz. Gossen (1854) of Germany, William Stanley Jevons (1871) ofEngland, Leon Walras (1874) of France, Karl Menger (1840–1921) of Austria.

2. The law of diminishing marginal utility is central to the cardinal utility analysis ofthe consumer behaviour. This law states that as the quantity consumed of acommodity increases per unit of time, the utility derived by the consumer from thesuccessive units goes on decreasing, provided the consumption of all other goodsremains constant.

3. An indifference curve may be defined as the locus of points, each representing adifferent combination of two goods but yielding the same level of utility orsatisfaction. Since each combination of two goods yields the same level of utility,the consumer is indifferent between any two combinations of goods when it comesto making a choice between them.

4. When a consumer makes different combination of two goods, yielding the samelevel of satisfaction, he substitutes one good for another. The rate at which hesubstitutes one good for the other is called the Marginal Rate of Substitution(MRS).

5. There are two approaches for decomposing the total price effect into incomeand substitution effects:

(i) Hicksian approach, and(ii) Slutsky approach.

6. Paul Samuelson formulated, in 1947, his ‘Revealed Preference Theory’ ofconsumer behaviour. The main merit of the revealed preference theory is that the‘law of demand’ can be directly derived from the revealed preference axiomswithout using indifference curve and most of its restrictive assumptions.



1. Define utility.2. List the assumptions of the law of diminishing marginal utility.3. Define and give the formula for computing the law of equi-marginal utility.4. Write a brief note on Slutsky’s method of measuring income and substitution

effects of price effect.5. Briefly discuss the Giffen paradox.


1. Identify the assumptions of the ordinal utility theory.2. Explain how utility is measured?3. Describe the assumptions of the Marshallian approach to the determination of

consumer’s equilibrium.

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4. Explain the meaning and nature of indifference curve and indifference map.5. Explain in detail the reveal preference approach given by Paul Samuelson.









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Input-Output Decisions

NOTES

UNIT 4 INPUT-OUTPUT DECISIONS

Structure4.0 Introduction4.1 Unit Objectives4.2 Law of Supply4.3 Elasticity of Supply4.4 Production Function4.5 Short-run and Long-run Production Function4.6 Short-run and Long-run Cost Functions

4.6.1 Short-run Cost-Output Relations4.6.2 Short-run Cost Functions and Cost Curves4.6.3 Cost Curves and the Law of Diminishing Returns4.6.4 Some Important Cost Relationships4.6.5 Output Optimization in the Short-run4.6.6 Long-run Cost-Output Relations



4.0 INTRODUCTION

Whatever the objective of business firms, achieving optimum efficiency in production orminimizing cost for a given production is one of the prime concerns of the businessmanagers. In fact, the very survival of a firm in a competitive market depends on theirability to produce at a competitive cost. Therefore, managers of business firms endeavourto minimize the production cost of a given output or, in other words, maximize the outputfrom a given quantity of inputs. In their efforts to minimize the cost of production, thefundamental questions that managers are faced with are:

(i) How can production be optimized or cost minimized?

(ii) How does output respond to change in quantity of inputs?

(iii) How does technology matter in reducing the cost of production?

(iv) How can the least-cost combination of inputs be achieved?

(v) Given the technology, what happens to the rate of return when more plants areadded to the firm?

In this unit, you will learn about the supply elasticity and production and cost functions.

4.1 UNIT OBJECTIVES


Define the law of supply

Explain the concept of elasticity of supply

Discuss the application and derivation of production function

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Describe the short-run and long-run production functions and their significance

Describe the short-run and long-run cost functions and their significance

4.2 LAW OF SUPPLY

The supply of a commodity depends on its price and cost of its production. In otherwords, supply is the function of price and production cost.1 The law of supply is, however,expressed generally in terms of price-quantity relationship. The law of supply can bestated as follows: The supply of a product increases with the increase in its priceand decreases with decrease in its price, other things remaining constant. It impliesthat the supply of a commodity and its price are positively related. This relationship holdsunder the assumption that “other things remain the same”. “Other things” includetechnology, price of related goods (substitute and complements), and weather and climaticconditions in case of agricultural products.

4.3 ELASTICITY OF SUPPLY

Like the law of demand, the law of supply states only the nature of relationship betweenthe change in the price of a commodity and the quantity supplied thereof. The law doesnot quantify the relationship. The quantitative relationship is measured by the priceelasticity of supply.

The price elasticity of supply is the measure of responsiveness of the quantitysupplied of a good to the changes in its market price. The coefficient of price elasticityof supply (e

p) is the measure of percentage change in the quantity supplied of a product

due to a given percentage change in its price. The formula of supply elasticity is given as

ep =

%%

change in quantity supplied ( ) change in price ( )

QP

ep =

Q QP P

QP

PQ

Note that the formula for measuring the price elasticity of supply is the same asfor the price elasticity of demand, without a minus sign. Given the formula, price elasticityof supply can be easily measured.

Example. Suppose that the supply curve for a commodity is given an SS in Fig. 4.1 andwe want to measure the price elasticity of the supply for a price rise in price betweenpoints J and P. In that case

Q = 60 – 100 = – 40P = 5 – 7.5 = – 2.5 P = 5 and Q = 60

By substituting these values into the elasticity formula, we get

ep =

40 51.33

2.5 60

Q P

P Q

Consider another example. Suppose we want to measure the price elasticity ofsupply between points P and K, i.e., for price rise from ` 7.5 to ` 10. Here,

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ep =

100 120 7.5

7.5 10 100

=20 7.5

2.5 100

= 0.6

The price elasticity of a supply curve like one given in Fig. 4.1 may vary betweenzero and infinity depending on the levels of the supply. For example, as we have seenabove, e > 1 between point J to P and e < 1 between point P to K. It can be noted that theprice elasticity below point P is greater than unity and it is less than unity beyond pointK.Thus, a supply curve is said to be (i) elastic when e > 1, (ii) inelastic when e < 1, and(iii) unitary elastic when e = 1. A perfectly inelastic supply has e = 0 throughout its lengthand is a straight vertical line. A perfectly elastic supply curve has e = ¥ all along itslength is a straight horizontal line.

Fig. 4.1 Price Elasticity of Supply Curve

Determinants of the Price Elasticity of Supply

The price elasticity of the supply depends on the following factors:

Time Period. Time period is the most important factor in determining the elasticity ofthe supply curve. In a very short period, the supply of most goods is fixed and inelastic.In the short run, the supply tends to remain inelastic. In the long run, the supply of all theproducts gains its maximum elasticity because of increase in and expansion of firms,new investments, improvement in technology, and a greater availability of inputs.

It is important to note here that short and long periods are not fixed in terms ofdays, months or years. It varies depending on the nature of the product. For example, forthe supply of perishable commodities like milk and fish in a city, a week’s time may be ashort period. For agricultural products, 6 months may be a short period. But in regard to

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the local supply of petroleum products in India, a period of five years or even more maybe regarded as a short period.

Law of Diminishing Returns. The other factor that determines the elasticity ofsupply is the Law of Diminishing Returns. We will discuss this law later in detail whenwe take up the laws of production. Here, it suffices to say that if the law of diminishingreturns come in force at an early level of production, cost increases rapidly. As a result,supply tends to becomes less and less elastic.

4.4 PRODUCTION FUNCTION

Production function is a mathematical presentation of input-output relationship. Morespecifically, a production function states the technological relationship between inputsand output in the form of an equation, a table or a graph. In its general form, it specifiesthe inputs on which depends the production of a commodity or service. In its specificform, it states the quantitative relationships between inputs and output. Besides, theproduction function represents the technology of a firm, of an industry or of the economyas a whole. A production function may take the form of a schedule or a table, a graphedline or curve, an algebraic equation or a mathematical model. But each of these forms ofa production function can be converted into its other forms.

A real-life production function is generally very complex. It includes a wide rangeof inputs, viz., (i) land and building; (ii) labour including manual labour, engineering staffand production manager, (iii) capital, (iv) raw material, (v) time, and (vi) technology. Allthese variables enter the actual production function of a firm. The long-run productionfunction is generally expressed as

Q = f(LB, L, K, M, T, t)

where LB = land and building L = labour, K = capital, M = raw materials,T = technology and t = time.

The economists have however reduced the number of input variables used in aproduction function to only two, viz., capital (K) and labour (L), for the sake ofconvenience and simplicity in the analysis of input-output relations. A production functionwith two variable inputs, K and L, is expressed as

Q = f(L, K)

The reasons for excluding other inputs are following.

Land and building (LB), as inputs, are constant for the economy as a whole,and hence they do not enter into the aggregate production function. However, land andbuilding are not a constant variable for an individual firm or industry. In the case ofindividual firms, land and building are lumped with ‘capital’.2

In case of ‘raw materials’ it has been observed that this input ‘bears a constantrelation to output at all levels of production’. For example, cloth bears a constant relationto the number of garments. Similarly, for a given size of a house, the quantity of bricks,cement, steel, etc. remains constant, irrespective of number of houses constructed. Toconsider another example, in car manufacturing of a particular brand or size, the quantityof steel, number of the engine, and number of tyres and tubes are fixed per car. Therefore,raw materials are left out of production function. So is the case, generally, with time andspace. Also, technology (T) of production remains constant over a period of time. Thatis why, in most production functions, only labour and capital are included.

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We will illustrate the tabular and graphic forms of a production function when wemove on to explain the laws of production. Here, let us illustrate the algebraic ormathematical form of a production function. It is this form of production function that ismost commonly used in production analysis.

To illustrate the algebraic form of production function, let us suppose that a coalmining firm employs only two inputs—capital (K) and labour (L)—in its coal productionactivity. As such, the general form of its production function may be expressed as

QC = f (K, L) …(4.1)

where QC

= the quantity of coal produced per time unit,

K = capital, and L = labour.

The production function (4.1) implies that quantity of coal produced depends onthe quantity of capital (K) and labour (L) employed to produce coal. Increasing coalproduction will require increasing K and L. Whether the firm can increase both K and Lor only L depends on the time period it takes into account for increasing production, i.e.,whether the firm considers a short-run or a long-run.

By definition, as noted above, short-run is a period in which supply of capital is inelastic.In the short-run, therefore, the firm can increase coal production by increasing onlylabour since the supply of capital in the short run is fixed.3 Long-run is a period in whichsupply of both labour and capital is elastic. In the long-run, therefore, the firm canemploy more of both capital and labour. Accordingly, there are two kinds of productionfunctions:

(i) Short-run production function; and

(ii) Long-run production function.

The short-run production function or what may also be termed as ‘single variableinput production function’, can be expressed as

Q = f ( , ),K L where K is a constant …(4.2a)

For example, suppose a production function is expressed as

Q = bL

where b = DQ/DL gives constant return to labour.

In the long-term production function, both K and L are included and the functiontakes the following form.

Q = f (K, L) …(4.2b)As mentioned above, a production function can be expressed in the form of an

equation, a graph or a table, though each of these forms can be converted into its otherforms. We illustrate here how a production function in the form of an equation can beconverted into its tabular form. Consider, for example, the Cobb-Douglas productionfunction—the most famous and widely used production function4—given in the form ofan equation as

Q = AKaLb …(4.3)(where K = Capital, L = Labour, and A, a and b are parameters and b = 1 – a)

Production function (4.3) gives the general form of Cobb-Douglas productionfunction. The numerical values of parameters A, a and b, can be estimated by usingactual factory data on production, capital and labour. Suppose numerical values of

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parameters are estimated as A = 50, a = 0.5 and b = 0.5. Once numerical values areknown, the Cobb-Douglas production function can be expressed in its specific form asfollows.

Q = 50 K0.5 L0.5

This production function can be used to obtain the maximum quantity(Q) that canbe produced with different combinations of capital (K) and labour (L). The maximumquantity of output that can be produced from different combinations ofK and L can beworked out by using the following formula.

Q 50 or 50KL Q K L

For example, suppose K = 2 and L = 5. Then

50 2 5 158Q

and if K = 5 and L = 5, then

50 5 5 250Q

Similarly, by assigning different numerical values to K and L, the resulting outputcan be worked out for different combinations ofK and L and a tabular form of productionfunction can be prepared. Table 4.1 shows the maximum quantity of a commodity thatcan be produced by using different combinations of K and L, both varying between 1and 10 units.

Table 4.1 Production Function in Tabular Form

Table 4.1 shows the units of output that can be produced with different combinationsof capital and labour. The figures given in Table 4.1 can be graphed in a three-dimensionaldiagram.

We now move on to explain the laws of production, first with one variable inputand then with two variable inputs. We will then illustrate the laws of production with thehelp of production function.

Before we proceed, it is important to note here that four combinations of K andL—10K + 1L, 5K + 2L, 2K + 5L and 1K + 10L—produce the same output, i.e., 158 units.When these combinations of K and L producing the same output are joined by a line, it

Check Your Progress

1. What is therelationshipbetween supplyand price, as per thelaw of supply?

2. How are the shortand long periods ofprice elasticity ofsupply determined?

3. What inputs doesthe real-lifeproduction functioninclude?

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produces a curve as shown in the table. This curve is called ‘Isoquant’. An isoquant is avery important tool used to analyze input-output relationship.

4.5 SHORT-RUN AND LONG-RUN PRODUCTIONFUNCTION

The laws of production state the relationship between output and input. In the short-run,input-output relations are studied with one variable input (labour), other inputs (especially,capital) held constant. The laws of production under these conditions are called the‘Laws of Variable Proportions’ or the ‘Laws of Returns to a Variable Input’. In thissection, we explain the ‘laws of returns to a variable input’.

The Law of Diminishing Returns to a Variable Input

The Law of Diminishing Returns. The law of diminishing returns states that whenmore and more units of a variable input are used with a given quantity of fixedinputs, the total output may initially increase at increasing rate and then at aconstant rate, but it will eventually increase at diminishing rates. That is, the marginalincrease in total output decreases eventually when additional units of a variable factorare used, given quantity of fixed factors.

Assumptions. The law of diminishing returns is based on the following assumptions:

(i) labour is the only variable input, capital remaining constant;

(ii) labour is homogeneous;

(iii) the state of technology is given; and

(iv) input prices are given.

To illustrate the law of diminishing returns, let us assume (i) that a firm (say, thecoal mining firm in our earlier example) has a set of mining machinery as its capital (K)fixed in the short-run, and (ii) that it can employ only more mine-workers to increase itscoal production. Thus, the short-run production function for the firm will take the followingform.

Qc = f(L), K constant

Let us assume also that the labour-output relationship in coal production is givenby a hypothetical production function of the following form.

Qc = – L3 + 15L2 + 10L …(4.4)

Given the production function (4.4), we may substitute different numerical valuesfor L in the function and work out a series of Q

c, i.e., the quantity of coal that can be

produced with different number of workers. For example, ifL = 5, then by substitution,we get

Qc = – 53 + 15 × 52 + 10 × 5 = – 125 + 375 + 50 = 300

A tabular array of output levels associated with different number of workersfrom 1 to 12, in our hypothetical coal-production example, is given in Table 4.2 (Cols. 1and 2).

What we need now is to work out marginal productivity of labour (MPL) to

find the trend in the contribution of the marginal labour and average productivity oflabour (AP

L) to find the average contribution of labour.

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Marginal Productivity of Labour (MPL) can be obtained by differentiating the

production function (4.4). Thus,

MPL =

LQ

= – 3L2 + 30L + 10 …(4.5)

By substituting numerical value for labour (L) in Eq. (4.5), MPL can be obtained at

different levels of labour employment. However, this method can be used only wherelabour is perfectly divisible and L 0. Since, in our example, each unit of L = 1,calculus method cannot be used.

Alternatively, where labour can be increased at least by one unit, MPL can be

obtained as

MPL = TP

L – TP

L–1

The MPL worked out by this method is presented in Col. 3 of Table 4.2.

Average Productivity of Labour (APL) can be obtained by dividing the productionfunction by L. Thus,

APL =

3 215 10L L L

L

= –L2 + 15L + 10 ...(4.6)

Now APL can be obtained by substituting the numerical value for L in Eq. (4.6).

APL obtained by this method is given in Col. 4 of Table 4.2.

Tables 4.2 Three Stages of Production

No. of Workers Total Product Marginal Average Stages of(N) (TPL) Product* Product Production

(tonnes) (MPL) (APL) (based on MPL)

(1) (2) (3) (4) (5)

1 24 24 24 I2 72 48 36 Increasing3 138 66 46 returns4 216 78 545 300 84 606 384 84 64

7 462 78 66 II8 528 66 66 Diminishing9 576 48 64 returns

10 600 24 60

11 594 – 6 54 III12 552 – 42 46 Negative returns

*MPL = TPn – TPn–1. MPL calculated by differential method will be different from that given inCol. 3.

The information contained in Table 4.2 is presented graphically in panels (a) and(b) of Fig. 4.1. Panel (a) of Fig. 4.1 presents the total product curve (TP

L) and panel

(b) presents marginal product (MPL) and average product (AP

L) curves. The TP

L schedule

demonstrates the law of diminishing returns. As the curve TPL shows, the total output

increases at an increasing rate till the employment of the 5th worker, as indicated by theincreasing slope of the TP

L curve. (See also Col. 3 of the table). Employment of the 6th

worker contributes as much as the 5th worker. Note that beyond the employment of the6th worker, although TP

L continues to increase (until the 10th worker), the rate of increase

in TPL (i.e., MP

L) begins to fall. This shows the operation of the law of diminishing

returns.

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The three stages in production. Table 4.2 and Fig. 4.1 present the three usual stages inthe application of the laws of diminishing returns.

Fig. 4.2 Total, Average and Marginal Products

In Stage I, TPL increases at increasing rate. This is indicated by the risingMP

L till

the employment of the 5th and 6th workers. Given the production function (4.4), the 6thworker produces as much as the 5th worker. The output from the 5th and the 6thworkers represents an intermediate stage of constant returns to the variable factor,labour.

In Stage II, TPL continues to increase but at diminishing rates, i.e., MP

L begins to

decline. This stage in production shows the law of diminishing returns to the variablefactor. Total output reaches its maximum level at the employment of the 10th worker.Beyond this level of labour employment,TP

L begins to decline. This marks the beginning

of Stage III in production.

To conclude, the law of diminishing returns can be stated as follows. Giventhe employment of the fixed factor (capital), when more and more workers are employed,the return from the additional worker may initially increase but will eventually decrease.

Factors Behind the Laws of Returns. As shown in Fig. 4.2, the marginal productivityof labour (MP

L) increases is Stage I, whereas it decreases in Stage II. In other words, in

Stage I, Law of Increasing Returns is in operation and in Stage II, the law of DiminishingReturns is in application. The reasons which underly the application of the laws ofreturns in Stages I and II may be described as follows.

One of the important factors causing increasing returns to a variable factor is theindivisibility of fixed factor (capital). The minimum size of capital is given as it cannotbe divided to suit the number of workers. Therefore, if labour is less than its optimum

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number, capital remains underutilized. Let us suppose that optimum capital-labourcombination is 1:6. If capital is indivisible and less than 6 workers are employed, thencapital would remain underutilized. When more and more workers are added, utilizationof capital increases and also the productivity of additional worker. The second and themost important reason for increase in labour productivity is the division of labour thatbecomes possible with the employment of additional labour, until optimum capital-labourcombination is reached.

Once the optimum capital-labour ratio is reached, employment of additional workersamounts to substitution of capital with labour. But, technically, there is a limit to whichone input can be substituted for another. That is, labour cannot substitute for capitalbeyond a limit. Hence, to replace the same amount of capital, more and more workerswill have to be employed because per worker marginal productivity decreases. Also,with increasing number of workers, capital remaining the same, capital-labour ratio goeson decreasing. As a result, productivity of labour begins to decline. This marks thebeginning of the second stage.

Application of the Law of Diminishing Returns

The law of diminishing returns is an empirical law, frequently observed in variousproduction activities. This law, however, may not apply universally to all kinds of productiveactivities since it is not as true as the law of gravitation. In some productive activities, itmay operate quickly, in some its operation may take a little longer time and in someothers, it may not appear at all. This law has been found to operate in agriculturalproduction more regularly than in industrial production. The reason is, in agriculture,natural factors play a predominant role whereas man-made factors play the major rolein industrial production. Despite the limitations of the law, if increasing units of an inputare applied to the fixed factors, the marginal returns to the variable input decreaseeventually.

The Law of Diminishing Returns and Business Decisions. The law of diminishingreturns as presented graphically has a relevance to the business decisions. The graphcan help in identifying the rational and irrational stages of operations. It can also tell thebusiness managers the number of workers (or other variable inputs) to apply to a givenfixed input so that, given all other factors, output is maximum. As Fig. 4.1 exhibits,capital is presumably underutilized in Stage I. So a firm operating in Stage I is required toincrease labour, and a firm operating in Stage III is required to reduce labour, with aview to maximizing its total production. From the firm’s point of view, setting an outputtarget in Stages I and III is irrational. The only meaningful and rational stage from thefirm’s point of view is Stage II in which the firm can find answer to the question ‘howmany workers to employ’. Figure 4.1 shows that the firm should employ a minimum of7 workers and a maximum of 10 workers even if labour is available free of cost. Thismeans that the firm has a limited choice—ranging from 7 to 10 workers. How manyworkers to employ against the fixed capital and how much to produce can be answered,only when the price of labour, i.e., wage rate, and that of the product are known. Thisquestion is answered below.

Determining Optimum Employment of Labour

It may be recalled from Fig. 4.1 that an output maximizing coal-mining firm would like toemploy 10 workers since at this level of employment, the output is maximum. The firmcan, however, employ 10 workers only if workers are available free of cost. But labouris not available free of cost—the firm is required to pay wages to the workers. Therefore,

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the question arises as to how many workers will the firm employ—10 or less or morethan 10—to maximize its profit. A simple answer to this question is that the number ofworkers to be employed depends on the output that maximizes the firm’s profit, giventhe product price and the wage rate. This point can be proved as follows.

You know that profit is maximum whereMC = MR

In our example here, since labour is the only variable input, marginal cost (MC)equals marginal wages (MW), i.e., MC = MW.

As regards MR, in case of factor employment, the concept of Marginal RevenueProductivity (MRP) is used. The marginal revenue productivity is the value of productresulting from the marginal unit of variable input (labour). In specific terms, marginalrevenue productivity (MRP) equals marginal physical productivity (MPL) of labourmultiplied by the price (P) of the product, i.e.,

MRP = MPL × PFor example, suppose that the price (P) of coal is given at ̀ 10 per quintal. Now,

MRP of a worker can be known by multiplying its MPL (as given in Table 4.2) by ̀ 10.For example, MRP of the 3rd worker (see Table 4.2) equals 66 × 10 = ̀ 660 and of the4th worker, 78 × 10 = ̀ 780. Likewise, if the entire column (MPL) is multiplied by ̀ 10,it gives us a table showing marginal revenue productivity of workers. Let us supposethat wage rate (per time unit) is given at ̀ 660. Given the wage rate, the profit maximizingfirm will employ only 8 workers because at this employment, MRP = wagerate = MRP of 8th worker; 66 × 10 = ` 660. If the firm employs the 9th worker, hisMRP = 48 × 10 = ̀ 480 < ̀ 660. Clearly, the firm loses ̀ 180 on the 9th worker. And, ifthe firm employees less than 8 workers, it will not maximize profit.

Graphic Illustration

The process of optimum employment of variable input (labour) is illustrated graphicallyin Fig. 4.2. When relevant series of MRP is graphed, it produces a MRP curve like oneshown in Fig. 4.2. Similarly, the MRP curve for any input may be drawn and comparedwith MC (or MW) curve. Labour being the only variable input, in our example, let ussuppose that wage rate in the labour market is given at OW (Fig. 4.2). When wage rateis constant, average wage (AW) equals the marginal wage (MW) i.e., AW = MW, for theentire range of employment in the short-run. When AW = MW, the supply of labour isshown by a straight horizontal line, as shown by the line AW = MW.

With the introduction of MRP curve and AW = MW line (Fig. 4.3), a profitmaximizing firm can easily find the maximum number of workers that can be optimallyemployed against a fixed quantity of capital. Once the maximum number of workers isdetermined, the optimum quantity of the product is automatically determined.

Fig. 4.3 Determination of Labour Employment in the Short-Run

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The marginality principle of profit maximization says that profit is maximum whenMR = MC. This is a necessary condition of profit maximization. Fig. 4.2 shows thatMRP = MW (= MC) are equal at point P, the point of intersection between MRP and AW= MW. The number of workers corresponding to this point is ON. A profit maximizingfirm should therefore employ onlyON workers. Given the number of workers, the totaloutput can be known by multiplying ON with average labour productivity (AP).

Long-Term Laws of Production: Production with Two Variable Inputs

We have discussed in the preceding section the technological relationship between inputsand output assuming labour to be the only variable input, capital held constant. In thissection, we will discuss the relationship between inputs and output under the conditionthat both the inputs, capital and labour, are variable factors. In the long-run, supply ofboth the inputs is supposed to be elastic and firms can hire larger quantities of bothlabour and capital. With larger employment of capital and labour, the scale of productionincreases. The technological relationship between changing scale of inputs and output isexplained under the laws of returns to scale. The laws of returns to scale can beexplained through the production function and isoquant curve technique. The mostcommon and simple tool of analysis is isoquant curve technique. We will, therefore, firstintroduce and elaborate on this tool of analysis. The laws of return to scale will then beexplained through isoquant curve technique. The laws of returns to scale throughproduction function will be explained in the next section.

Isoquant Curves and their Properties

The term ‘isoquant’ has been derived from the Greek word iso meaning ‘equal’ andLatin word quantus meaning ‘quantity’. The ‘isoquant curve’ is, therefore, also knownas ‘Equal Product Curve’ or ‘Production Indifference Curve’. An isoquant curve canbe defined as the locus of points representing various combinations of two inputs—capital and labour—yielding the same output. An ‘isoquant curve’ is analogous to an‘indifference curve’, with two points of distinction: (a) an indifference curve is made oftwo consumer goods while an isoquant curve is constructed of two producer goods(labour and capital), and (b) an indifference curve assumes a level of satisfaction whereasan isoquant measures output of a commodity.

An idea of isoquant can be had from the curve connecting 158 units from 4different combinations of capital and labour given in Table 4.1.

Isoquant curves are drawn on the basis of the following assumptions:

(i) there are only two inputs, viz., labour (L) and capital (K), to produce a commodityX;

(ii) both L and K and product X are perfectly divisible;

(iii) the two inputs—L and K—can substitute each other but at a diminishing rate asthey are imperfect substitutes; and

(iv) the technology of production is given.

Given these assumptions, it is technically possible to produce a given quantity ofcommodity X with various combinations of capital and labour. The factor combinationsare so formed that the substitution of one factor for the other leaves the output unaffected.This technological fact is presented through an isoquant curve (IQ

1= 100) in Fig. 4.3.

The curve IQ1 all along its length represents a fixed quantity, 100 units of productX. This

quantity of output can be produced with a number of labour-capital combinations. For

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example, points A, B, C, and D on the isoquant IQ1 show four different combinations of

inputs, K and L, as given in Table 4.3, all yielding the same output—100 units. Note thatmovement from A to D indicates decreasing quantity of K and increasing number of L.This implies substitution of labour for capital such that all the input combinations yield thesame quantity of commodity X, i.e., IQ

1 = 100.

Fig. 4.4 Isoquant Curves

Table 4.3 Capital Labour Combinations and Output

Points Input Combinations OutputK + L

A OK4 + OL1 = 100B OK3 + OL2 = 100C OK2 + OL3 = 100D OK1 + OL4 = 100

Properties of Isoquant Curves

Isoquants, i.e., production indifference curves, have the same properties as consumer’sindifference curves. Properties of isoquants are explained below in terms of inputs andoutput.

(a) Isoquants have a negative slope. An isoquant has a negative slope in theeconomic region5 and in the economic range of isoquant. The economic regionis the region on the production plane and economic range of isoquant is the rangein which substitution between inputs is technically feasible. Economic region isalso known as the product maximizing region. The negative slope of the isoquantimplies substitutability between the inputs. It means that if one of the inputs isreduced, the other input has to be so increased that the total output remainsunaffected. For example, movement from A to B on IQ

1 (Fig. 4.4) means that if

K4

K3 units of capital are removed from the production process, L

1L

2 units of

labour have to be brought in to maintain the same level of output.

(b) Isoquants are convex to the origin. Convexity of isoquants implies two things:(i) substitution between the two inputs, and (ii) diminishing marginal rate oftechnical substitution (MRTS) between the inputs in the economic region. TheMRTS is defined as

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MRTS = KL

= slope of the isoquant

In plain words, MRTS is the rate at which a marginal unit of labour can substitutea marginal unit of capital (moving downward on the isoquant) without affectingthe total output. This rate is indicated by the slope of the isoquant. The MRTSdecreases for two reasons: (i) no factor is a perfect substitute for another, and(ii) inputs are subject to diminishing marginal returns. Therefore, more and moreunits of an input are needed to replace each successive unit of the other input. Forexample, suppose various units of K (minus sign ignored) in Fig. 4.4 are equal,i.e.,

K1 = K2 = K3

the corresponding units of L substituting K go (in Fig. 4.4) on increasing, i.e.,L1 < L2 < L3

As a result, MRTS = K/L goes on decreasing, i.e.,

3

3

2

2

1

1LK

LK

LK

(c) Isoquants are non-intersecting and non-tangential. The intersection ortangency between any two isoquants implies that a given quantity of a commoditycan be produced with a smaller as well as a larger input-combination. This isuntenable so long as marginal productivity of inputs is greater than zero. Thispoint can be proved graphically. Note that in Fig. 4.5, two isoquants intersecteach other at point M. Consider two other points—point J on isoquant markedQ1 = 100 and point K on isoquant marked Q2 = 200 such that points K and J fallon a vertical line KL2, denoting the same amount of labour (OL2) but differentunits of capital—KL2 units of capital at point K and JL2 units of capital at point J.Note that point M is common to both the isoquants. Given the definition of isoquant,one can easily infer that a quantity that can be produced with the combination ofK and L at point M can be produced also with factor combination at points J andK. On the isoquant Q1 = 100, factor combinations at points M and J yield 100units of output. And, on the isoquant Q2 = 200, factor combinations at M and Kyield 200 units of output. Since point M is common to both the isoquants, it followsthat input combinations at J and K are equal in terms of output. This implies thatin terms of output,

Fig. 4.5 Intersecting Isoquants

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OL2(L) + JL

2(K) = OL

2(L) + KL

2(K)

Since OL2 is common to both the sides, it means,

JL2(K) = KL

2(K)

But it can be seen in Fig. 4.5 that

JL2(K) < KL

2(K)

But the intersection of the two isoquants means that JL2 and KL

2 are equal in

terms of their output. This is wrong. That is why isoquants will not intersect or betangent to each other. If they do, it violates the laws of production.

(d) Upper isoquants represent higher level of output. Between any two isoquants,the upper one represents a higher level of output than the lower one. The reasonis, an upper isoquant has a larger input combination, which, in general, produces alarger output. Therefore, upper isoquant has a higher level of output.

For instance, IQ2 in Fig. 4.6 will always indicate a higher level of output than IQ

1.

For, any point at IQ2 consists of more of either capital or labour or both. For example,

consider point a on IQ1 and compare it with any point at IQ

2. The point b on IQ

2

indicates more of capital (ab), point d more of labour (ad) and point c more of both,capital and labour. Therefore, IQ

2 represents a higher level of output (200 units) than

IQ1 indicating 100 units.

Fig. 4.6 Comparison of Output at Two Isoquants

Isoquant Map and Economic Region of Production

Isoquant map. An isoquant map is a set of isoquants presented on a two-dimensionalplane as shown by isoquants Q

1, Q

2, Q

3 and Q

4 in Fig. 4.7. Each isoquant shows various

combinations of two inputs that can be used to produce a given quantity of output. Anupper isoquant is formed by a greater quantity of one or both the inputs than the inputcombination indicated by the lower isoquants. For example, isoquant Q

2 indicates a

greater input-combination than that shown by isoquant Q1 and so on.

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Fig. 4.7 Isoquant Map

In the isoquant map, each upper isoquant indicates a larger input-combinationthan the lower ones, and each successive upper isoquant indicates a higher level ofoutput than the lower ones. This is one of the properties of the isoquants. For example,if isoquant Q

1 represents an output equal to 100 units, isoquant Q

2 represents an output

greater than 100 units. As one of the properties of isoquants, no two isoquants canintersect or be tangent to one another.

Economic region. Economic region is that area of production plane in which substitutionbetween two inputs is technically feasible without affecting the output. This area ismarked by locating the points on the isoquants at which MRTS = 0. A zero MRTSimplies that further substitution between inputs is technically not feasible. It alsodetermines the minimum quantity of an input that must be used to produce a givenoutput. Beyond this point, an additional employment of one input will necessitate employingadditional units of the other input. Such a point on an isoquant may be obtained bydrawing a tangent to the isoquant and parallel to the vertical and horizontal axes, asshown by dashed lines in Fig. 4.7. By joining the resulting points a, b, c and d, we get aline called the upper ridge line, Od. Similarly, by joining the points e, f, g and h, we getthe lower ridge line, Oh. The ridge lines are locus of points on the isoquants where themarginal products (MP) of the inputs are equal to zero. The upper ridge line implies thatMP of capital is zero along the line, Od. The lower ridge line implies that MP of labouris zero along the line, Oh.

The area between the two ridge lines, Od and Oh, is called ‘Economic Region’or ‘technically efficient region’ of production. Any production technique, i.e., capital-labour combination, within the economic region is technically efficient to produce agiven output. And, any production technique outside this region is technically inefficientsince it requires more of both inputs to produce the same quantity of output.

Other Forms of Isoquants

We have introduced above a convex isoquant that is most widely used in traditionaleconomic theory. The shape of an isoquant, however, depends on the degree ofsubstitutability between the factors in the production function. The convex isoquantpresented in Fig. 4.4 assumes a continuous substitutability between capital and labourbut at a diminishing rate. The economists have, however, observed other degrees ofsubstitutability between K and L and have demonstrated the existence of three otherkinds of isoquants.

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1. Linear Isoquants. A linear isoquant is presented by the line AB in Fig. 4.8. Alinear isoquant implies perfect substitutability between the two inputs, K and L.The isoquant AB indicates that a given quantity of a product can be produced byusing only capital or only labour or by using both. This is possible only when thetwo factors, K and L, are perfect substitutes for one another. A linear isoquantalso implies that the MRTS between K and L remains constant throughout.

Fig. 4.8 Linear Isoquant

The mathematical form of the production function exhibiting perfect substitutabilityof factors is given as follows.

If Q = f(K, L) then, = aK + bL ...(4.7)

The production function means that the total output, Q, is simply the weightedsum of K and L. The slope of the resulting isoquant from this production functionis given by – b/a. This can be proved as shown below.

Given the production function,

MPK =

Qa

K

and MP

L =

Qb

L

Since MRTS = L

K

MP

MP and L

K

MP b

MP a

Therefore, MRTS =b

a

= slope of the isoquant

The production function exhibiting perfect substitutability of factors is, however,unlikely to exist in the real world production process.

2. Isoquants with Fixed Factor-Proportion or L-Shaped Isoquants. Whena production function assumes a fixed proportion between K and L, the isoquanttakes ‘L’ shape, as shown by isoquants Q

1 and Q

2 in Fig. 4.9. Such an isoquant

implies zero substitutability between K and L. Instead, it assumes perfectcomplementarity between K and L. The perfect complementarity assumptionimplies that a given quantity of a commodity can be produced by one and only onecombination of K and L and that the proportion of the inputs is fixed. It alsoimplies that if the quantity of an input is increased and the quantity of the otherinput is held constant, there will be no change in output. The output can be increasedonly by increasing both the inputs proportionately.

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As shown in Fig. 4.9, to produce Q1 quantity of a product, OK

1 units of K and OL

1

units of L are required. It means that if OK1 units of K are being used, OL

1 units

of labour must be used to produce Q1 units of a commodity. Similarly, ifOL

1 units

of labour are employed, OK1 units of capital must be used to produce Q

1. If units

of only K or only L are increased, output will not increase. If output is to beincreased to Q

2, K has to be increased by K

1K

2 and labour by L

1L

2. This kind of

technological relationship between K and L gives a fixed proportion productionfunction.

Fig. 4.9 The L-Shaped Isoquant

A fixed-proportion production function, called Leontief function, is given as

Q = f(K, L) = min (aK, bL) …(4.8)where ‘min’ means that Q equals the lower of the two terms, aK and bL. That is,if aK > bL, Q = bL and if bL > aK, then Q = aK. If aK = bL, it would mean thatboth K and L are fully employed. Then the fixed capital labour ratio will be K/L =b/a.

In contrast to a linear production function, the fixed-factor-proportion productionfunction has a wide range of application in the real world. One can find manytechniques of production in which a fixed proportion of labour and capital is fixed.For example, to run a taxi or to operate a photocopier, one needs only one labour.In these cases, the machine-labour proportion is fixed. Any extra labour would beredundant. Similarly, one can find cases in manufacturing industries where capital-labour proportions are fixed.

3. Kinked Isoquants or Linear Programming Isoquants. The fixed proportionproduction function (Fig. 4.9) assumes that there is only one technique of production,and capital and labour can be combined only in a fixed proportion. It implies thatto double the production, one would require doubling both the inputs,K and L. Theline OB (Fig. 4.9) shows that there is only one factor combination for a given levelof output. In real life, however, the businessmen and the production engineersfind in existence many, but not infinite, techniques of producing a given quantity ofa commodity, each technique having a different fixed proportion of inputs. In fact,there is a wide range of machinery available to produce a commodity. Eachmachine requires a fixed number of workers to work it. This number varies frommachine to machine. For example, 40 persons can be transported from one placeto another by two methods: (i) by hiring 10 taxis and 10 drivers, or (ii) by hiring a

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bus and 1 driver. Each of these methods is a different process of production andhas a different fixed proportion of capital and labour. Handlooms and powerlooms are other examples of two different factor proportions. One can similarlyfind many such processes of production in manufacturing industries, each processhaving a different fixed-factor proportion.

Let us suppose that for producing 10 units of a commodity, X, there are fourdifferent techniques of production available. Each techniques has a different fixedfactor-proportion, as given in Table 4.4.

Table 4.4 Alternative Techniques of Producing 100 Units of X

S. No. Technique Capital + Labour Capital/labour ratio

1 OA 10 + 2 10:22 OB 6 + 3 6:33 OC 4 + 6 4:64 OD 3 + 10 3:10

The four hypothetical production techniques, as presented in Table 4.4, have beengraphically presented in Fig. 4.10. The ray OA represents a production processhaving a fixed factor-proportion of 10K:2L. Similarly, the other three productionprocesses having fixed capital-labour ratios 6:3, 4:6 and 3:10 have been shown bythe rays OB, OC and OD respectively. Points A, B, C and D represent fourdifferent production techniques. By joining the points, A, B, C and D, we get akinked isoquant, ABCD.

Each of the points on the Kinked Isoquant represents a combination of capitaland labour that can produce 100 units of commodityX. If there are other processesof production, many other rays would be passing through different points betweenA and B, B and C, and C and D, increasing the number of kinks on the isoquantABCD. The resulting isoquant would then resemble the typical isoquant. Butthere is a difference—each point on a typical isoquant is technically feasible, buton a kinked isoquant, only kinks are the technically feasible points.

Fig. 4.10 Fixed Proportion Techniques of Production

The kinked isoquant is used basically in linear programming. It is, therefore, alsocalled linear programming isoquant or activity analysis isoquant.

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Elasticity of Factor Substitution

We have introduced earlier the concept of the marginal rate of technical substitution(MRTS) and have noted that MRTS decreases along the isoquant. MRTS refers only tothe slope of an isoquant, i.e., the ratio of marginal changes in inputs. It does not revealthe substitutability of one input for another—labour for capital—with changing combinationof inputs.

The economists have devised a method of measuring the degree of substitutabilityof factors, called the Elasticity of Factor Substitution. The elasticity of substitution (s)is formally defined as the percentage change in the capital-labour ratio (K/L) dividedby the percentage change in marginal rate of technical substitution (MRTS), i.e.,

= Percentage change in

Percentage change in

K L

MRTSor =

( / ) ( / )

( ) ( )

K L K L

MRTS MRTS

Since all along an isoquant, K/L and MRTS move in the same direction, the valueof s is always positive. Besides, the elasticity of substitution (s) is ‘a pure number,independent of the units of the measurement of K and L, since both the numerator andthe denominator are measured in the same units’.

The concept of elasticity of factor substitution is graphically presented in Fig.4.11. The movement from point A to B on the isoquant IQ, gives the ratio of change inMRTS. The rays OA and OB represent two techniques of production with differentfactor intensities. While line OA indicates capital intensive technique, line OB indicateslabour intensive technique. The shift from OA to OB gives the change in factor intensity.The ratio between the two factor intensities measures the substitution elasticity.

Fig. 4.11 Graphic Derivation of Elasticity of Substitution

The value of substitution elasticity depends on the curvature of the isoquants. Itvaries between 0 and µ, depending on the nature of production function. It is, in fact, theproduction function that determines the curvature of the various kinds of isoquants. Forexample, in case of fixed-proportion production function [see Eq. (4.8)] yielding anL-shaped isoquant, s = 0. If production function is such that the resulting isoquant is linear(see Fig. 4.8), s = ¥. And, in case of a homogeneous production function of degree 1 ofthe Cobb-Douglas type, s = 1.

Laws of Returns to Scale

Having introduced the isoquants—the basic tool of analysis—we now return to the lawsof returns to scale. The laws of returns to scale explain the behaviour of output in

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response to a proportional and simultaneous change in inputs. Increasing inputsproportionately and simultaneously is, in fact, an expansion of the scale of production.

When a firm expands its scale, i.e., it increases both the inputs proportionately, thenthere are three technical possibilities:

(i) total output may increase more than proportionately;

(ii) total output may increase proportionately; and

(iii) total output may increase less than proportionately.

Accordingly, there are three kinds of returns to scale:

(i) Increasing returns to scale;

(ii) Constant returns to scale, and

(iii) Diminishing returns to scale.

So far as the sequence of the laws of ‘returns to scale’ is concerned, the law ofincreasing returns to scale is followed by the law of constant and then by the law ofdiminishing returns to scale. This is the most common sequence of the laws.

Let us now explain the laws of returns to scale with the help of isoquants for atwo-input and single output production system.

Increasing Returns to Scale

When inputs, K and L, are increased at a certain proportion and output increases morethan proportionately, it exhibits increasing returns to scale. For example, if quantitiesof both the inputs, K and L, are successively doubled and the resultant output is morethan doubled, the returns to scale is said to be increasing. The increasing returns to scaleis illustrated in Fig. 4.12. The movement from pointa to b on the line OB means doublingthe inputs. It can be seen in Fig. 4.12 that input-combination increases from 1K + 1L to2K + 2L. As a result of doubling the inputs, output is more than doubled: it increases from10 to 25 units, i.e., an increase of 150%. Similarly, the movement from pointb to point cindicates 50% increase in inputs as a result of which the output increases from 25 unitsto 50 units, i.e., by 100%. Clearly, output increases more than the proportionate increasein inputs. This kind of relationship between the inputs and output shows increasingreturns to scale.

Fig. 4.12 Increasing Returns to Scale

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The Factors Behind Increasing Returns to Scale

There are at least three plausible reasons for increasing returns to scale.

(i) Technical and managerial indivisibilities. Certain inputs, particularlymechanical equipments and managers, used in the process of production areavailable in a given size. Such inputs cannot be divided into parts to suit smallscale of production. For example, half a turbine cannot be used and one-third or apart of a composite harvester and earth-movers cannot be used. Similarly, half ofa production manager cannot be employed, if part-time employment is notacceptable to the manager. Because of indivisibility of machinery and managers,given the state of technology, they have to be employed in a minimum quantityeven if scale of production is much less than the capacity output. Therefore,when scale of production is expanded by increasing all the inputs, the productivityof indivisible factors increases exponentially because of technological advantage.This results in increasing returns to scale.

(ii) Higher degree of specialization. Another factor causing increasing returnsto scale is higher degree of specialization of both labour and machinery, whichbecomes possible with increase in scale of production. The use of specializedlabour suitable to a particular job and of a composite machinery increasesproductivity of both labour and capital per unit of inputs. Their cumulative effectscontribute to the increasing returns to scale. Besides, employment of specializedmanagerial personnel, e.g., administrative manager, production managers salesmanager and personnel manager, contributes a great deal in increasing production.

(iii) Dimensional relations. Increasing returns to scale is also a matter of dimensionalrelations. For example, when the length and breadth of a room (15 × 10 = 150sq. ft.) are doubled, then the size of the room is more than doubled: it increases to30 × 20 = 600 sq. ft. When diameter of a pipe is doubled, the flow of water ismore than doubled. In accordance with this dimensional relationship, when thelabour and capital are doubled, the output is more than doubled and so on.

Constant Returns to Scale

When the increase in output is proportionate to the increase in inputs, it exhibitsconstantreturns to scale. For example, if quantities of both the inputs, K and L, are doubled andoutput is also doubled, then the returns to scale are said to be constant. Constant returnsto scale are illustrated in Fig. 4.13. The lines OA and OB are ‘product lines’ indicatingtwo hypothetical techniques of production with optimum capital-labour ratio. The isoquantsmarked Q = 10, Q = 20 and Q = 30 indicate the three different levels of output. In thefigure, the movement from points a to b indicates doubling both the inputs. When inputsare doubled, output is also doubled, i.e., output increases from 10 to 20. Similarly, themovement from a to c indicates trebling inputs—K increase to 3K and L to 3L. Thisleads to trebling the output—from 10 to 30.

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Fig. 4.13 Constant Returns to Scale

Alternatively, movement from point b to c indicates a 50 per cent increase in bothlabour and capital. This increase in inputs results in an increase of output from 20 to 30units, i.e., a 50 per cent increase in output. In simple words, a 50 per cent increase ininputs leads to a 50 per cent increase in output. This relationship between a proportionatechange in inputs and the same proportional change in outputs may be summed up asfollows.

1K + 1L 10

2K + 2L 20

3K + 3L 30

This kind of relationship between inputs and output exhibits constant returns toscale.

The constant returns to scale are attributed to the limits of the economies of scale.6

With expansion in the scale of production, economies arise from such factors asindivisibility of fixed factors, greater possibility of specialization of capital and labour, useof more efficient techniques of production, etc. But there is a limit to the economies ofscale. When economies of scale reach their limits and diseconomies are yet to begin,returns to scale become constant. The constant returns to scale take place also wherefactors of production are perfectly divisible and where technology is such that capital-labour ratio is fixed. When the factors of production are perfectly divisible, the productionfunction is homogeneous of degree 1 showing constant returns to scale.

Decreasing Returns to Scale

The firms are faced with decreasing returns to scale when a certain proportionateincrease in inputs, K and L, leads to a less than proportionate increase in output. Forexample, when inputs are doubled and output is less than doubled, then decreasing returnsto scale is in operation. The decreasing returns to scale is illustrated in Fig. 4.14. As thefigure shows, when the inputsK and L are doubled, i.e., when capital-labour combinationis increased from 1K + 1L to 2K + 2L, the output increases from 10 to 18 units. Thismeans that when capital and labour are increased by 100 per cent, output increases byonly 80 per cent. That is, increasing output is less that the proportionate increase ininputs. Similarly, movement from point b to c indicates a 50 per cent increase in theinputs. But, the output increases by only 33.3 per cent. This exhibitsdecreasing returnsto scale.

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Fig. 4.14 Decreasing Return to Scale

Causes of Diminishing Return to Scale

The decreasing returns to scale are attributed to the diseconomies of scale. Theeconomists find that the most important factor causing diminishing returns to scale is‘the diminishing return to management’, i.e., managerial diseconomies. As the size ofthe firms expands, managerial efficiency decreases. Another factor responsible fordiminishing returns to scale is the limitedness or exhaustibility of the natural resources.For example, doubling of coal mining plant may not double the coal output because oflimitedness of coal deposits or difficult accessibility to coal deposits. Similarly, doublingthe fishing fleet may not double the fish output because availability of fish may decreasein the ocean when fishing is carried out on an increased scale.

4.6 SHORT-RUN AND LONG-RUN COSTFUNCTIONS

The theory of cost deals with the behaviour of cost in relation to a change in output. Inother words, the cost theory deals with cost-output relations. The basic principle of thecost behaviour is that the total cost increases with increase in output. This simplestatement of an observed fact is of little theoretical and practical importance. What is ofimportance from a theoretical and managerial point of view is not the absolute increasein the total cost but the direction of change in the average cost (AC) and the marginalcost (MC). The direction of change in AC and MC—whether AC and MC decrease orincrease or remain constant—depends on the nature of the cost function. A cost functionis a symbolic statement of the technological relationship between the cost and output.The general form of the cost function is written as

TC = f (Q)

TC/Q > 0 …(4.9)

The specific form of the cost function depends on whether the time frameworkchosen for cost analysis is short-run or long-run. It is important to recall here that somecosts remain constant in the short-run while all costs are variable in the long-run. Thus,depending on whether cost analysis pertains to short-run or to long-run, there are two

Check Your Progress

4. What is the law ofdiminishing returnsto a variable input?

5. What is the conceptof MRP in thecontext of factoremployment?

6. What is an isoquantcurve?

7. What is elasticity offactor substitution?

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kinds of cost functions: (i) short-run cost functions, and (ii) long-run cost functions.Accordingly, the cost output relations are analysed in short-run and long-run framework.

4.6.1 Short-Run Cost-Output Relations

In this section, we will analyse the cost-output relations in the short-run. The long-runcost output relations are discussed in the following section.

Before we discuss the cost-output relations, let us first look at the cost concepts andthe components used to analyse the short-run cost-output relations.

The basic analytical cost concepts used in the analysis of cost behaviour areTotal, Average and Marginal costs. The total cost (TC) is defined as the actual cost thatmust be incurred to produce a given quantity of output. Theshort-run TC is composed oftwo major elements: (i) total fixed cost (TFC), and (ii) total variable cost (TVC). Thatis, in the short-run,

TC = TFC + TVC ...(4.10)

As mentioned earlier, TFC (i.e., the cost of plant, building, etc.) remains fixed inthe short run, whereas TVC varies with the variation in the output.

For a given quantity of output (Q), the average cost, (AC), average fixed cost(AFC) and average variable cost (AVC) can be defined as follows.

AC =T C T FC TV C

Q Q

=TFC TVC

Q Q = AFC + AVC

Thus, AFC =T FC

Qand AVC =

TV C

Q

and AC = AFC + AVC ...(4.11)

Marginal cost (MC) is defined as the change in the total cost divided by thechange in the total output, i.e.,

MC =TC

Q

...(4.12)

In fact, MC is the first derivative of cost function, i.e.,TC

Q

It may be added here that since TC = TFC + TVC and, in the short-run,TFC = 0, therefore, TC = TVC. Furthermore, under the marginality concept, whereQ = 1, MC = TVC. Now we turn to cost function and derivation of various costcurves.

4.6.2 Short-Run Cost Functions and Cost Curves

The cost-output relations are determined by the cost function and are exhibited throughcost curves. The shape of the cost curves depends on the nature of the cost function.Cost functions are derived from actual cost data of the firms. Given the cost data, costfunctions may take a variety of forms, e.g., linear, quadratic or cubic, yielding different

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kinds of cost curves. The cost curves produced by linear, quadratic and cubic costfunctions are illustrated below.

1. Linear Cost Function. A linear cost function takes the following form.

TC = a + bQ …(4.13)

(where TC = total cost, Q = quantity produced, a = TFC, and b = Change in TVC due tochange in Q.

Given the cost function [Eq. (4.13)], AC and MC can be obtained as follows.

AC =TC

Q =

a bQ a

Q Q

+ b

and MC =TC

bQ

Note that since ‘b’ is a constant, MC remains constant throughout in case of alinear cost function.

To illustrate a linear cost function, let us suppose that an actual cost function isgiven as

TC = 60 + 10Q …(4.14)Give the cost function (4.14), one can easily work out TC, TFC, TVC, MC and

AC for different levels of output (Q) and can present them in the form of a table asshown in Table 4.5.

Fig. 4.15 Linear Cost Functions

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Table 4.5 Tabular Cost Function

Output Q TFC = 60 TVC = 10Q TC = 60 + 10Q MC = b = 10 AC = 60/Q + 10

1 60 10 70 – 70.0

2 60 20 80 10 40.0

3 60 30 90 10 30.0

4 60 40 100 10 25.0

5 60 50 110 10 22.0

6 60 60 120 10 20.0

7 60 70 130 10 18.6

8 60 80 140 10 17.5

9 60 90 150 10 16.6

10 60 100 160 10 16.0

Table 4.5 presents a series of Q and corresponding TFC, TVC, TC, MC and ACfor output Q from 1 to 10. The figures in Table 4.5, graphed in Fig. 4.15, shows therelationship between total costs and output.

Furthermore, given the cost function (4.14), AC can be worked out as follows

6010

QAC and MC = 10

Fig. 4.15 shows the behaviour of TC, TVC and TFC. The horizontal line showsTFC and the line TVC = 10Q shows the movement in TVC with change in Q. The totalcost function is shown by TC = 60 + 10Q.

More important is the behaviour of AC and MC curves in Fig. 4.16. Note that, incase of a linear cost function, while MC remains constant, AC continues to decline withthe increase in output. This is so simply because of the logic of the linear cost function.

Fig. 4.16 AC and MC Curves Derived from Linear Cost Function

2. Quadratic Cost Function. A quadratic cost function is of the form

TC = a + bQ + Q2 ....(4.15)

where a and b are constants and TC and Q are total cost and total output respectively.

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Given the cost function (4.15), AC and MC can be obtained as follows.

AC =TC

Q =

2a bQ Q

Q

=

a

Q + b + Q ...(4.16)

MC =TC

Q

= b + 2Q ...(4.17)

Let the actual (or estimated) cost function be given as

TC = 50 + 5Q + Q2 …(4.18)

Given the cost function (4.18),

AC =50

Q + Q + 5 and MC =

C

Q

= 5 + 2Q

The cost curves that emerge from the cost function (4.18) are graphed inFig. 4.17 (a) and (b). As shown in panel (a), while fixed cost remains constant at 50,TVC is increasing at an increasing rate. The rising TVC sets the trend in the total cost(TC). Panel (b) shows the behaviour of AC, MC and AVC in a quadratic cost function.Note that MC and AVC are rising at a constant rate whereas AC declines till output 8and then begins to increase.

Fig. 4.17 Cost Curves Derived from a Quadratic Cost Function

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3. Cubic Cost Function A cubic cost function is of the form

TC = a + bQ – cQ2 + Q3 …(4.19)

where a, b and c are the parametric constants.

From the cost function (4.19), AC and MC can be derived as follows.

AC =TC

Q =

2 3a bQ cQ Q

Q

=a

Q + b – cQ + Q2 and MC =

TC

Q

= b – 2 cQ + 3Q2

Let us suppose that the cost function is empirically estimated as

TC = 10 + 6Q – 0.9Q2 + 0.05Q3 …(4.20)

Note that fixed cost equals 10. TVC can be obtained by subtracting 10—the fixedcost—from TC-function (4.20).

Thus, TVC = 6Q – 0.9Q2 + 0.05Q3 …(4.21)

The TC and TVC, based on Eqs. (4.22) and (4.23) respectively, have beencalculated for Q = 1 to 16 and presented in Table 4.6. The TFC, TVC and TC have beengraphically presented in Fig. 4.18. As the figure shows,TFC remains fixed for the wholerange of output, and hence, takes the form of a horizontal line—TFC. The TVC curveshows that the total variable cost first increases at a decreasing rate and then at anincreasing rate with the increase in the output. The rate of increase can be obtainedfrom the slope of TVC curve. The pattern of change in the TVC stems directly from thelaw of increasing and diminishing returns to the variable inputs. As output increases,larger quantities of variable inputs are required to produce the same quantity of outputdue to diminishing returns. This causes a subsequent increase in the variable cost forproducing the same output.

Fig. 4.18 TC, TFC and TVC Curves

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Table 4.6 Cost-Output Relations

Q FC TVC TC AFC AVC AC MC

(1) (2) (3) (4) (5) (6) (7) (8)

0 10 0.0 10.00 – – – –1 10 5.15 15.15 10.00 5.15 15.15 5.15

2 10 8.80 18.80 5.00 4.40 9.40 3.65

3 10 11.25 21.25 3.33 3.75 7.08 2.45

4 10 12.80 22.80 2.50 3.20 5.70 1.55

5 10 13.75 23.75 2.00 2.75 4.75 0.95

6 10 14.40 24.40 1.67 2.40 4.07 0.65

7 10 15.05 25.05 1.43 2.15 3.58 0.65

8 10 16.00 26.00 1.25 2.00 3.25 0.95

9 10 17.55 27.55 1.11 1.95 3.06 1.55

10 10 20.00 30.00 1.00 2.00 3.00 2.45

11 10 23.65 33.65 0.90 2.15 3.05 3.65

12 10 28.80 38.80 0.83 2.40 3.23 5.15

13 10 35.75 45.75 0.77 2.75 3.52 6.95

14 10 44.80 54.80 0.71 3.20 3.91 9.05

15 10 56.25 66.25 0.67 3.75 4.42 11.45

16 10 70.40 80.40 0.62 4.40 5.02 14.15

From equations (4.20) and (4.21), we may derive the behavioural equations forAFC, AVC and AC. Let us first consider AFC.

Average Fixed Cost (AFC) As already mentioned, the costs that remain fixed for acertain level of output make the total fixed cost in the short-run. The fixed cost isrepresented by the constant term ‘a’ in Eq. (4.19) and a = 10 in Eq. (4.20). We knowthat

AFC =TFC

Q…(4.22)

Substituting 10 for TFC in Eq. 4.22, we get

AFC =10

Q…(4.23)

Equation (4.23) expresses the behaviour of AFC in relation to change in Q. Thebehaviour ofAFC forQ from 1 to 16 is given in Table4.6 (Col. 5) and presented graphicallyby the AFC curve in Fig. 4.19. The AFC curve is a rectangular hyperbola.

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Fig. 4.19 Short-run Cost Curves

Average Variable Cost (AVC). As defined above, AVC =TVC

Q

Given the TVC function [Eq. (4.21)], we may express AVC as follows.

AVC =2 36 0.9 0.05Q Q Q

Q

= 6 – 0.9 Q + 0.05Q2 ...(4.24)

Having derived the AVC function in Eq. (4.24), we may easily obtain the behaviourof AVC in response to change in Q. The behaviour of AVC for output fromQ = 1 to 16 is given in Table4.6 (Col. 6), and graphically presented in Fig.4.19 by the AVCcurve.

Critical Value of AVC The critical value of Q (in respect of AVC) is one thatminimizes AVC. From Eq. (4.24), we may compute the critical value of Q in respect ofAVC. The AVC will be minimum when its (decreasing) rate of change equals zero. Thiscan be accomplished by differentiating Eq. (4.24) and setting it equal to zero. Thus,critical value of Q can be obtained as follows.

Critical value of Q = QAVC

= – 0.9 + 0.10Q = 0

0.10 Q = 0.9

Q = 9

In our example, the critical value of Q = 9. This can be verified from Table 4.6.The AVC is minimum (1.95) at output 9.

Average Cost (AC) The average cost (AC) is defined as AC =TC

Q.

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Substituting Eq. (4.20) for TC in the above equation, we get

AC =2 310 6 0.9 0.05Q Q Q

Q

=10

Q + 6 – 0.9Q + 0.05Q2 ...(4.25)

The Eq. (4.25) gives the behaviour ofAC in response to change inQ. The behaviourof AC for Q = 1 to 16 is given in Table 4.6 (Col. 7) and graphically presented in Fig. 4.19by the AC curve. Note that AC curve is U-shaped.

Minimization of AC. One objective of business firms is to minimize AC of theirproduct. The level of output that minimizes AC can be obtained by differentiating Eq.(4.25) and setting it equal to zero. Cost-minimizingQ can be obtained as follows.

2

100.9 0.1

ACQ

Q Q

= 0

When we simplify this equation by multiplying it by Q2, it takes the form of aquadratic equation as

10 – 0.9Q2 + 0.1Q3 = 0

When this equation is multiplied by 10, for simplification, it takes the form,

Q3 – 9Q2 – 100 = 0 ...(4.26)

By solving7 equation (4.26), we get Q = 10.

Thus, the critical value of output in respect of AC is 10. That is, AC reaches itsminimum at Q = 10. This can be verified from Table 4.6.

Marginal Cost (MC) The concept of marginal cost (MC) is particularly useful ineconomic analysis. MC is technically the first derivative of the TC function. Given theTC function in Eq. (4.20), the MC function can be obtained as

MC =TC

Q

= 6 – 1.8Q + 0.15Q2 ...(4.27)

Equation (4.27) represents the behaviour of MC. The behaviour of MC forQ = 1 to 16 computed as MC = TC

n– TCn–1

is given in Table 4.6 (Col. 8) and graphicallypresented by the MC curve in Fig. 4.19. The critical value of Q with respect to MC is 6or 7. This can be seen from Table 4.6.

4.6.3 Cost Curves and the Law of Diminishing Returns

We now return to the law of diminishing returns and explain it through the cost curves.Figs. 4.18 and 4.19 present the short-term law of production i.e., the law of diminishingreturns. Let us recall the law: it states that when more and more units of a variable inputare applied, other inputs held constant, the returns from the marginal units of the variableinput may initially increase butthey decrease eventually. The same law can also be interpretedin terms of decreasing and increasing costs. The law can then be stated as, if more andmore units of a variable input are applied to a given amount of a fixed input, the marginalcost initially decreases, but eventually increases. Both interpretations of the law yield the

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same information—one in terms of marginal productivity of the variable input, and theother in terms of the marginal cost. The former is expressed through a production functionand the latter through a cost function.

Fig. 4.19 presents the short-run laws of return to a variable input in terms of costof production. As the figure shows, in the initial stage of production, bothAFC and AVCare declining because of internal economies. SinceAC =AFC + AVC, AC is also declining.This shows the operation of the law of increasing returns in the initial stage of production.But beyond a certain level of output (i.e., 9 units in our example), whileAFC continuesto fall, AVC starts increasing because of a faster increase in the TVC. Consequently, therate of fall in AC decreases. The AC reaches its minimum when output increases to 10units. Beyond this level of output, AC starts increasing which shows that the law ofdiminishing returns comes into operation. The MC curve represents the change in boththe TVC and TC curves due to change in output. A downward trend in the MC showsincreasing marginal productivity of the variable input due mainly to internal economiesresulting from increase in production. Similarly, an upward trend in theMC shows increasein TVC, on the one hand, and decreasing marginal productivity of the variable input, onthe other.

4.6.4 Some Important Cost Relationships

Some important relationships between costs used in analysing the short-run cost-behaviourmay now be summed up as follows:

(a) Over the range of output AFC and AVC fall, AC also falls.

(b) When AFC falls but AVC increases, change in AC depends on the rate of changein AFC and AVC.

(i) if decrease in AFC > increase in AVC, then AC falls,(ii) if decrease in AFC = increase in AVC, AC remains constant and

(iii) if decrease in AFC < increase in AVC, then AC increases.

(c) AC and MC are related in following ways.(i) When MC falls, AC follows, over a certain range of output. When MC is

falling, the rate of fall in MC is greater than that of AC, because while MCis attributed to a single marginal unit,AC is distributed over the entire output.Therefore, AC decreases at a lower rate than MC.

(ii) Similarly, when MC increases, AC also increases but at a lower rate forthe reason given in (i). There is, however, a range of output over which therelationship does not exist. Compare the behaviour ofMC and AC over therange of output from 6 units to 10 units (see Fig.4.19). Over this range ofoutput, MC begins to increase while AC continues to decrease. The reasonfor this can be seen in Table 4.5: when MC starts increasing, it increases ata relatively lower rate that is sufficient only to reduce the rate of decreasein AC—not sufficient to push the AC up.

(iii) MC curve intersects AC curve at its minimum. The reason is, while ACcontinues to decrease, MC begins to rise. Therefore, they are bound tointersect. Also, when AC is at its minimum, it is neither increasing nordecreasing: it is constant. When AC is constant, AC = MC. That is the pointof intersection.

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4.6.5 Output Optimization in the Short-run

The technique of output optimization has already been discussed in last sections.Optimization technique is repeated here for completeness.

Let us suppose that a short-run cost function is given as

TC = 200 + 5Q + 2Q2 …(4.28)

As noted earlier, the level of output is optimized at the level of production at whichMC = AC. In other words, at optimum level of output, AC = MC. Given the cost functionin Eq. (4.20),

AC =2200 5 2Q Q

Q

=200

Q + 5 + 2Q ...(4.29)

and MC =TC

Q

= 5 + 4Q ...(4.30)

By equating AC and MC equations, i.e., Eqs. (4.29) and (4.30), respectively, andsolving them for Q, we get the optimum level of output. Thus,

200

Q + 5 + 2Q = 5 + 4Q = 2Q

2Q2 = 200

Q2 = 100

Q = 10

Thus, given the cost function (4.28), the optimum output is 10.

4.6.6 Long-run Cost-Output Relations

In the context of production theory, long-run is defined as a period in which all the inputsbecome variable. The variability of inputs is based on the assumption that in the long-run,supply of all the inputs, including those (especially capital) held constant in the short-run,becomes elastic. The firms are, therefore, in a position to expand the scale of theirproduction by hiring a larger quantity of all the inputs. The long-run cost output relations,therefore, imply the relationship between the changing scale of the firm and the totaloutput, whereas in the short-run, this relationship is essentially one between the totaloutput and the variable cost (labour). Specifically, long-run cost-output relations refersto the behaviour of TC, AC and MC in response to simultaneous and proportionatecharge in both labour and capital costs.

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Fig. 4.20 Long-run Total and Average Cost Curves

To understand the long-run-cost-output relations and to derive long-run cost curves,it will be helpful to imagine that a long-run is composed of a series of short-run productiondecisions. As a corollary of this, long-run cost curve is composed of a series of short-runcost curves. With this perception of long-run-cost-out relationship, we may now showthe derivation of the long-run cost curves and study their relationship with output.

Long-run Total Cost Curve (LTC)

In order to draw the long-run total cost curve, let us begin with a short-run situation.Suppose that a firm having only one plant has its short-run total cost curve as given bySTC

1, in panel (a) of Fig. 4.20. Let us now suppose that the firm decides to add two

more plants over time, one after the other. As a result, two more short-run total costcurves are added to STC

1, in the manner shown by STC

2 and STC

3in Fig. 4.20 (a). The

LTC can now be drawn through the minimum points ofSTC1, STC

2 and STC

3 as shown

by the LTC curve corresponding to each STC.

Long-run Average Cost Curve (LAC)

Like LTC, long-run average cost curve (LAC) is derived by combining the short-runaverage cost curves (SAC

s). Note that there is one SAC associated with each STC.

The curve SAC1 in panel (b) of Fig. 4.20 corresponds to STC

1 in panel (a). Similarly,

SAC2 and SAC

3 in panel (b) correspond to STC

2 and STC

3 in panel (a), respectively.

Thus, given the STC1, STC

2, STC

3 curves in panel (a) of Fig. 4.20, there are three

corresponding SAC curves as given by SAC1, SAC

2, and SAC

3 curves in panel (b) of

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Fig. 4.20. Thus, the firm has a series ofSAC curves, each having a bottom point showingthe minimum SAC. For instance, C

1Q

1 is minimum AC when the firm has only one plant.

The AC decreases to C2Q

2 when the second plant is added and then rises to C

3Q

3 after

the addition of the third plant. The LAC curve can be drawn through the SAC1, SAC

2and

SAC3 as shown in Fig.4.20 (b). The LAC curve is also known as the ‘Envelope Curve’

or ‘Planning Curve’ as it serves as a guide to the entrepreneur in his plans to expandproduction.

The SAC curves can be derived from the data given in the STC schedule, fromSTC function or straightaway from the LTC curve.8 Similarly, LAC curve can be derivedfrom LTC-schedule, LTC function or from LTC-curve.

The relationship between LTC and output, and between LAC and output can nowbe easily derived. It is obvious from the LTC that the long-run cost-output relationship issimilar to the short-run cost-output relation. With the subsequent increases in the output,LTC first increases at a decreasing rate, and then at an increasing rate. As a result,LACinitially decreases until the optimum utilization of the second plant and then it begins toincrease. These cost-output relations follow the ‘laws of returns to scale’. When thescale of the firm expands, unit cost of production initially decreases, but ultimatelyincreases as shown in Fig. 4.20 (b). The decrease in unit cost is attributed to the internaland external economies and the eventual increase in cost, to the internal and externaldiseconomies. The economies and diseconomies of scale are discussed in the followingsection.

Long-run Marginal Cost Curve (LMC)

The long-run marginal cost curve (LMC) is derived from the short-run marginal costcurves (SMCs). The derivation of LMC is illustrated in Fig. 4.21 in which SACs, SMC

s

and LAC are the same as in Fig.4.20 (b). To derive the LMC, consider the points oftangency between SACs and the LAC, i.e., points A, B and C. In the long-run productionplanning, these points determine the output at the different levels of production. Each ofthese outputs has an SMC. For example, if we draw a perpendicular from point A, itintersects SMC

1 at point M determining SMC at MQ

1. The same process can be repeated

for points B and C to find out SMC at outputs Q2 and Q

3. Note that points B and C

determine SMC at BQ2 and CQ

3 respectively. A curve drawn through points M, B and

N, as shown by the LMC, represents the behaviour of the marginal cost in the long-run.This curve is known as the long-run marginal cost curve, LMC. It shows the trends inthe marginal cost in response to the changes in the scale of production.

Some important inferences may be drawn from Fig. 4.20. The LMC must beequal to SMC for the output at which the corresponding SAC is tangent to the LAC. Atthe point of tangency,LAC =SAC. Another important point to notice is thatLMC intersectsLAC when the latter is at its minimum, i.e., point B. There is one and only one short-runplant size whose minimum SAC coincides with the minimum LAC. This point is B where

SAC2 = SMC

2 = LAC = LMC

Optimum Plant Size and Long-Run Cost Curves

The short-run cost curves are helpful in showing how a firm can decide on theoptimumutilization of the plant—the fixed factor, or how it can determine the output level thatminimizes cost. Long-run cost curves, on the other hand, can be used to show how afirm can decide on the optimum size of the firm.

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Fig. 4.21 Derivation of LMC

Conceptually, the optimum size of a firm is one which ensures the most efficientutilization of resources. Practically, the optimum size of the firm is one that minimizes theLAC. Given the state of technology over time, there is technically a unique size of thefirm and level of output associated with the least-cost concept. In fig. 4.21, the optimumsize of the firm consists of two plants represented by SAC

1 and SAC

2. The two plants

together produce OQ2 units of a product at minimum long-run average cost (LAC) of

BQ2. The downtrend in the LAC indicates that until output reaches the level of OQ

2,

the firm is of less than optimal size. Similarly, expansion of the firm beyond productioncapacity OQ

2, causes a rise in SMC and, therefore, in LAC. It follows that given the

technology, a firm aiming to minimize its average cost over time must choose a plantthat gives minimum LAC where SAC = SMC = LAC = LMC. This size of plant assuresthe most efficient utilization of the resources. Any change in output level—increase ordecrease—will make the firm enter the area of inoptimality.

4.7 SUMMARY

The law of supply is, expressed generally in terms of price-quantity relationship.The law of supply can be stated as follows: The supply of a product increaseswith the increase in its price and decreases with decrease in its price, other thingsremaining constant.

Time period is the most important factor in determining the elasticity of the supplycurve. In a very short period, the supply of most goods is fixed and inelastic. Inthe short run, the supply tends to remain inelastic. In the long run, the supply of allthe products gains its maximum elasticity because of increase in and expansion offirms, new investments, improvement in technology, and a greater availability ofinputs.

Production function is a mathematical representation of input-output relationship.More specifically, a production function states the technological relationshipbetween inputs and output in the form of an equation, a table or a graph.

The laws of production state the relationship between output and input. In theshort-run, input-output relations are studied with one variable input (labour), otherinputs (especially, capital) held constant. The laws of production under these

Check Your Progress

8. What are theelements that makeup short-run totalcost?

9. What is therelationshipbetween optimumplant size and long-run cost curves?

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conditions are called the ‘Laws of Variable Proportions’ or the ‘Laws of Returnsto a Variable Input’.

The term ‘isoquant’ has been derived from the Greek word iso meaning ‘equal’and Latin word quantus meaning ‘quantity’. The ‘isoquant curve’ is, therefore,also known as ‘Equal Product Curve’ or ‘Production Indifference Curve’.

The specific form of the cost function depends on whether the time frameworkchosen for cost analysis is short-run or long-run. It is important to recall here thatsome costs remain constant in the short-run while all costs are variable in thelong-run.

The short-run cost curves are helpful in showing how a firm can decide on theoptimum utilization of the plant—the fixed factor, or how it can determine theoutput level that minimizes cost. Long-run cost curves, on the other hand, can beused to show how a firm can decide on the optimum size of the firm.

4.8 KEY TERMS

Law of supply: The supply of a product increases with the increase in its priceand decreases with decrease in its price, other things remaining constant.

Price elasticity of supply: It is the measure of responsiveness of the quantitysupplied of a good to the changes in its market price.

Production function: It states the technological relationship between inputs andoutput in the form of an equation, a table or a graph.

Law of diminishing returns: The law of diminishing returns states that whenmore and more units of a variable input are used with a given quantity of fixedinputs, the total output may initially increase at increasing rate and then at aconstant rate, but it will eventually increase at diminishing rates.

Marginal revenue productivity: It is the value of product resulting from themarginal unit of variable input (labour).

Isoquant curve: It can be defined as the locus of points representing variouscombinations of two inputs—capital and labour—yielding the same output.


1 As per the law of supply, the supply of a product increases with the increase in itsprice and decreases with decrease in its price, other things remaining constant. Itimplies that the supply of a commodity and its price are positively related. Thisrelationship holds under the assumption that “other things remain the same”. “Otherthings” include technology, price of related goods (substitute and complements),and weather and climatic conditions in case of agricultural products.

2. Short and long periods are not fixed in terms of days, months or years. It variesdepending on the nature of the product. For example, for the supply of perishablecommodities like milk and fish in a city, a week’s time may be a short period. Foragricultural products, 6 months may be a short period. But in regard to the localsupply of petroleum products in India, a period of five years or even more may beregarded as a short period.

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3. A real-life production function is generally very complex. It includes a wide rangeof inputs, viz., (i) land and building; (ii) labour including manual labour, engineeringstaff and production manager, (iii) capital, (iv) raw material, (v) time, and (vi)technology. All these variables enter the actual production function of a firm.

4. The law of diminishing returns states that when more and more units of a variableinput are used with a given quantity of fixed inputs, the total output may initiallyincrease at increasing rate and then at a constant rate, but it will eventually increaseat diminishing rates. That is, the marginal increase in total output decreaseseventually when additional units of a variable factor are used, given quantity offixed factors.

5. In case of factor employment, the concept of Marginal Revenue Productivity(MRP) is used. The marginal revenue productivity is the value of product resultingfrom the marginal unit of variable input (labour). In specific terms, marginal revenueproductivity (MRP) equals marginal physical productivity of labour multiplied bythe price of the product.

6. An isoquant curve can be defined as the locus of points representing variouscombinations of two inputs—capital and labour—yielding the same output.

7. The economists have devised a method of measuring the degree of substitutabilityof factors, called the Elasticity of Factor Substitution. The elasticity of substitution(s) is formally defined as the percentage change in the capital-labour ratio (K/L)divided by the percentage change in marginal rate of technical substitution(MRTS).

8. The short-run TC is composed of two major elements: (i) total fixed cost (TFC),and (ii) total variable cost (TVC).

9. The short-run cost curves are helpful in showing how a firm can decide on theoptimum utilization of the plant—the fixed factor, or how it can determine theoutput level that minimizes cost. Long-run cost curves, on the other hand, can beused to show how a firm can decide on the optimum size of the firm.



1. What is the price elasticity of supply? Give the equation for calculating it.

2. Which are the two types of production functions and what is the difference betweenthem?

3. What are the assumptions on which the law of diminishing returns is based?

4. Briefly describe the various types of isoquants.

5. What are the causes of diminishing returns to scale?


1. Identify the determinants of the price elasticity of supply.

2. What is a production function? What is its significance? How is it calculated?

3. How is the law of diminishing returns applied in business decisions?

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4. Discuss isoquant curves and their properties in detail.

5. Identify the factors behind increasing returns to scale.







Salvantore, Dominick. 2001. Managerial Economics in a Global Economy, FourthEdition. Australia: Thomson-South Western.


Endnotes

1. Koutsoyiannis, A. op. cit., p. 70.

2. Supply of capital may, of course, be elastic in the short-run for an individual firm underperfect competition but not for all the firms put together. Therefore, for the sake ofconvenience in explaining the laws of production, we will continue to assume that, in theshort-run, supply of capital remains inelastic.

3. This production function was constructed first by Paul H. Douglas in his book TheTheory of Wages (Macmillan, NY, 1924). The function was developed further by C.W.Cobb and Paul H. Douglas in their joint paper “A Theory Production” in Am. Eco. Rev.,March 1928. Since then this production function is known as Cobb-Douglas ProductionFunction.

4. The concept of economic region is discussed in detail in the next section.

5. The ‘economies of scale’ are discussed in detail in the following section.6. There may be some nominal payment for the use of public utilities in the form of tax, which

may not cover the full cost thereof.

7. One method of solving quadratic equation is to factorize it and find the solution. Thus,

Q3 – 9Q2 – 100 = 0(Q – 10) (Q2 + Q + 10) = 0

For this to hold, one of the terms must be equal to zero. Suppose

(Q2 + Q + 10) = 0

Then, Q – 10 = 0 and Q = 10.

8. The SAC curves can be obtained by measuring the slope of STC at different levels ofoutput. For a simple exposition of the method, see Leftwich, R.H., The Price System, andResource Allocation (The Dryden Press, Illinois), 4th edn., Appendix to Ch. 8.

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Price and OutputDetermination

NOTES

UNIT 5 PRICE AND OUTPUTDETERMINATION

Structure5.0 Introduction5.1 Unit Objectives5.2 Competition and Market Structures

5.2.1 Features of Perfect Competition5.2.2 Price and Output Determination under Perfect Competition

5.3 Monopoly5.3.1 Demand and Revenue Curves under Monopoly5.3.2 Cost and Supply Curves under Monopoly5.3.3 Profit Maximization under Monopoly5.3.4 Absence of Supply Curve in a Monopoly5.3.5 Price Discrimination in a Monopoly5.3.6 Measures of Monopoly Power

5.4 Oligopoly, Non-Price Competition5.4.1 Oligopoly: Meaning and Characteristics5.4.2 Duopoly Models5.4.3 Oligopoly Models5.4.4 Game Theory Approach to Oligopoly


5.0 INTRODUCTION

Apart from objectives, another factor that plays an important role in a firm’s choice ofprice and output is the market structure. The term ‘market structure’ refers to theorganizational features of an industry that influence the firm’s behaviour in its choice ofprice and output. Market structure is an economically significant feature of the market.It affects the behaviour of firms in respect of their production and pricing behaviour. Itis classified on the basis of organizational features of the industry, more specifically, onthe basis of degree of competition among firms. In general, the organizational featuresinclude the number of firms, distinctiveness of their products, elasticity of demand andthe degree of control over the price of the product.

In this unit, we present a brief description of the market structure—the playingfield of firms. In contrast to perfect competition, monopoly is the extreme opposite formof a product market. In case of perfect competition, the number of sellers is so large thatno one has any power whatsoever to influence the market price. A monopoly firm, onthe other hand, has the sole power to influence the market price. While under perfectcompetition no seller can afford to discriminate between the buyers of different categories,the monopolists practice price discrimination as a matter of policy. You will also learn, inthis unit, about the sources of monopoly, price and output determination in the short and

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long run, price discrimination and comparison of price and output under perfect competitionand monopoly.

In this unit, you will also learn about price and output determination in a marketstructure which is more realistic in the modern business world—called oligopoly.Oligopoly is similar to monopolistic competition with two very important differences:(i) under monopolistic competition, the number of sellers is very large and underoligopoly it is a few, and (ii) under oligopoly, the competition between firms is muchmore intensive.

5.1 UNIT OBJECTIVES

After going through this unit, you will be able to:• Understand the degrees of competition and market structure• Understand the process of price and output determination under perfect

competition• Explain the definition, sources and features of monopoly• Describe price discrimination in a monopoly• Describe the measures of monopoly power• Understand the meaning and characteristics of an oligopoly• Analyse duopoly models• Discuss oligopoly models• Describe the game theory approach to oligopoly

5.2 COMPETITION AND MARKET STRUCTURES

The market structure is generally classified on the basis of the degree of competition asfollows:

(i) Perfect competition(ii) Imperfect competition

(a) Monopolistic competition(b) Oligopoly with and without product differentiation(c) Duopoly

(iii) MonopolyThe basic features of these kinds of market are summarized below. However, a

brief description of each kind of market is given follow.

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Table 5.1 Types of Markets

Type of Market No. of Nature of Product Firm’sFirms Over Price Control

(i) Perfect Competition Very Homogeneous (wheat Nonelarge sugar, vegetables....)

(ii) Imperfect Competition(a) Monopolistic Many Real or perceived Some

Competition (most retail trade) difference in product(b) Oligopoly Few (i) Product without Some

differentiation,e.g., aluminium, steel,and chemicals, etc.

(ii) Differentiatedproducts (tea, TVRefrigerator,toothpastes,soaps, detergents,automobiles)

(iii) Monopoly Single Products without close Full butsubstitutes, like gas, usuallyelectricity and regulatedwater supply.

Perfect Competition

Perfect competition is a market situation in which a large number of producers offer ahomogeneous product to a very large number of buyers of the product. The number ofsellers is so large that each seller offers a very small fraction of the total supply, andtherefore, has no control over the market price. Likewise, the number of buyers is solarge that each buyer buys an insignificant part of the total supply and has no controlover the market price. Both buyers and sellers are ‘price takers’, not ‘price makers’.The price of a commodity is determined in this kind of markets by the market demandand market supply. Each seller faces a horizontal demand curve (with e = ∞), whichimplies that a seller can sell any quantity at the market determined price.

This kind of market is, however, more of a hypothetical nature rather thanbeing a common or realistic one. Some examples of a perfectly competitive marketinclude stock markets, vegetable markets, wheat and rice where goods are soldby auction.

Imperfect Competition

Perfect competition, in strict sense of the term, is a rare phenomenon. In reality, marketsfor most goods and services have imperfect competition. Imperfect competition is saidto exist when a number of firms sell identical or differentiated products with somecontrol over the price of their product. Barring a few goods like shares and vegetablemarkets, you name any commodity, its market is imperfect. In spite of a large number ofdealers (arhatias) in the wheat market, the Food Corporation of India is the biggestbuyer and seller of wheat in India, with a great degree of control over wheat prices.

Imperfect competition creates two different forms of markets with different numberof producers and with different degrees of competition, classified as (a) monopolisticcompetition, (b) oligopoly (c) monopoly.

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(a) Monopolistic Competitions: Monopolistic competition is a kind of market inwhich a large number of firms supply differentiated products. The number ofsellers is so large that each firm can act independently of others, without itsactivities being watched and countervailed by others. Besides, it is not onlyextremely difficult to keep track of competitors’ strategy, but also it is not of anyavail. In this respect, it is similar to perfect competition. It differs from perfectcompetition in that the products under monopolistic competition are somewhatdifferentiated whereas they are identical under perfect competition. There is freeentry and free exit.

(b) Oligopoly: Oligopoly is an organizational structure of an industry in which asmall number of firms supply the entire market, each seller having a considerablemarket share and control over the price. Most industries in our country areoligopolistic. A small number of companies supply the entire tea, medicines,cosmetics, refrigerators, TV and VCRs, cars, trucks, jeeps, and so on. Theproducers of all these goods have some control over the price of their products.Their products are somewhat differentiated, at least made to look different in theconsumers’ perception. Therefore, demand curve for their product has highelasticity, but less than infinity, unlike under perfect competition.

(c) Monopoly: Monopoly is the market of a single seller with control over his priceand output. Monopoly is antithesis of perfect competition. Absolute monopoliesare rare these days. They are found mostly in the form of government monopolisesin public utility goods, e.g., electricity, radio broadcasting, water, rail and postalservices.

Why are Markets Imperfect?

Imperfect competition arises mainly from the barriers to entry. Barriers to entry arecreated by several factors.

(i) The large size firms which enjoy economies of scale can cut down their pricesto the extent that can eliminate new firms or prevent their entry to the industry, if they sodecide.

(ii) In some countries, like India, licencing policy of the government creates barrierfor the new firms to enter an industry.

(iii) Patenting of rights to produce a well-established product or a new brand of acommodity prevents new firms from producing that commodity.

(iv) Sometimes entry of new firms to an industry is prevented by a law with aview to enabling the existing ones to have economies of scale so that prices are low.

5.2.1 Features of Perfect Competition

A perfectly competitive market is characterized by complete absence of rivalry amongthe individual firms. In fact, under perfect competition as conceived by the economists,competition among the individual firms is so widely dispersed that it amounts to nocompetition. Perfect competition is characterized by the following assumptions.

1. Large Number of Buyers and Sellers. Under perfect competition, the numberof sellers is assumed to be so large that the share of each seller in the total supplyof a product is so small that no single firm can influence the market price bychanging its supply. Therefore, firms are price-takers not price-makers. Similarly,the number of buyers is so large that the share of each buyer in the total demand

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is so small that no single buyer or a group of buyers can influence the marketprice by changing their individual or group demand for a product.

2. Homogeneous Product. The commodities supplied by all the firms of anindustry are assumed to be homogeneous or approximately identical. Homogeneityof the product implies that buyers do not distinguish between products supplied bythe various firms of an industry. Product of each firm is regarded as a perfectsubstitute for the products of other firms. Hence, no firm can gain any competitiveadvantage over the other firms. This assumption limits the power of any firm tocharge a price which is even slightly higher than the market price.

3. Perfect Mobility of Factors of Production. Another important characteristicof perfect competition is that the factors of production (especially, labour andcapital) are freely mobile between the firms. Labour can freely change the firmsas there is no barrier on labour mobility—legal, language, climate, skill, distanceor otherwise. There is no trade union. Capital can also move freely from one firmto another. No firm has any kind of monopoly over any industrial input. Thisassumption guarantees that factors of production—labour, capital, and entrepren-eurship—can enter or quit a firm or the industry whenever it is found desirable.

4. Free Entry and Free Exit. There is no legal or market barrier on entry ofnew firms to the industry. Nor is there any restriction on exit of the firms from theindustry. That is, a firm may enter the industry and quit it at its will. Thus, whennormal profit of the industry increases, new firms enter the industry and if profitsdecrease and better opportunities are available, firms leave the industry.

5. Perfect Knowledge about the Market Conditions. There is perfectknowledge about the market conditions. All the buyers and sellers have fullinformation regarding the prevailing and future prices and availability of thecommodity. As Marshall puts it, ‘... though everyone acts for himself, his knowledgeof what others are doing is supposed to be generally sufficient to prevent himfrom taking a lower or paying a higher price than others are doing.’1 Informationregarding market conditions is available free of cost. There is no uncertainty.

6. No Government Interference. Government does not interfere in any waywith the functioning of the market. There are no taxes or subsidies; no licencingsystem, no allocation of inputs by the government, or any kind of other directcontrol. That is, the government follows the free enterprise policy. Where thereis intervention by the government, it is intended to correct the market imperfections.

7. Absence of Collusion and Independent Decision-Making. Perfectcompetition assumes that there is no collusion between the firms, i.e., they are notin league with one another in the form of guild or cartel. Nor are the buyers incollusion between themselves. There are no consumers’ associations, etc. Thiscondition implies that buyers and sellers take their decisions independently andthey act independently.

Perfect vs Pure Competition

Sometimes a distinction is made between perfect competition and pure competition.The difference between the two is a matter of degree. While ‘perfect competition’ hasall the features mentioned above, ‘pure competition’ does not assume perfect mobilityof factors and perfect knowledge. That is, perfect competition less perfect mobilityand knowledge is pure competition. ‘Pure competition’ is ‘pure’ in the sense that ithas absolutely no element of monopoly.

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The perfect competition, as characterized above, is considered as a rarephenomenon in the real business world. However, the actual markets that approximatethe conditions of perfectly competitive market include the security markets for stocksand bonds, and agricultural markets like local vegetable markets. Despite its limitedscope, perfect competition model has been the most popular model used in economictheories due to its analytical value.

5.2.2 Price and Output Determination under Perfect Competition

Under perfect competition, market price in a perfectly competitive market is determinedby the market forces, viz., demand and supply. Here, market demand refers to thedemand for the industry as a whole. It is equal to the sum of the quantity demanded bythe individuals at different prices. Similarly, market supply is the sum of quantity suppliedby the individual firms in the industry at a given price. The market price is thereforedetermined for the industry as a whole and is given for each individual firm and for eachbuyer. Thus, every seller in a perfectly competitive market is a ‘price-taker’, not a‘price-maker’.

In a perfectly competitive market, therefore, the main problem of a firm is not todetermine the price of its product but to find its output at the given price so that profit ismaximized.

The role of market forces and the mode of price determination depends on thetime taken by supply position to adjust itself to the changing demand conditions. Pricedetermination is analysed under three different time periods: (i) Market period or veryshort-run; (ii) short-run; and (iii) long-run.

I. Price Determination in the Market Period or Very Short-Run

The market period or very short-run refers to a time period in which quantity supplied isabsolutely fixed or, in other words, supply response to change in price is nil. In themarket period, therefore, the total output of the product is fixed. Each firm has a givenquantity of commodity to sell. The aggregate supply of all the firms makes the marketsupply. The supply curve is perfectly inelastic, as shown by line SQ in Fig. 5.1. In thissituation, price is determined entirely by the demand conditions. For instance, supposethat the number of marriage-houses (or tents) available per month in a city is given atOQ (Fig. 5.1), so that the supply curve takes the shape of a vertical straight line SQ. Letus also suppose that the monthly demand curve for marriage-houses is given by thedemand curve, D1.

Demand and supply curves intersect each other at point M, determining therental at MQ. Let us now suppose that during a particular month demand for marriage-houses suddently increases because a relatively large number of parents decide tocelebrate the marriage of their daughters and sons due to, say, non-availability of auspiciousdates for some time to come. Consequently, the demand curve shifts upward to D2. Thedemand curve D2 intersects the supply curve at point P. The equilibrium rate of rental isthus determined at PQ. This becomes parametric price for all the buyers. Note that therise in the rental from MQ to PQ is caused by the upward shift in the demand curve andthat market supply curve remains perfectly inelastic in the market period. The otherexample of very short-run markets may be of perishable commodities like fish, milk,vegetable, etc. and of non-perishable commodities like shares and bonds.

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Fig. 5.1 Determination of Market Price

II. Price Determination in the Short-Run

While in market period (or very short-run), supply is absolutely fixed, in the short-run itis possible to increase (or decrease) the supply by increasing (or decreasing) the variableinputs. In the short-run, therefore, supply curve is elastic, unlike a straight vertical line inthe market period. Supply curve in the short-run approximates the SMC curve.

Under competitive conditions the process of price determination and outputadjustment in the short-run is given in Fig. 5.2(a) and 5.2(b). Figure 5.2(a) shows demandcurve DD and supply curve SS intersect at point P determining the price at OP1. Thisprice is fixed for all the firms in the industry.

Given the price PQ (= OP1), in Fig. 5.2(a), an individual firm can produce and sellany quantity at this price. But any quantity will however not yield maximum profit. Thefirms will have to adjust their output to the price OP1. The process of output determinationis presented through Fig. 5.2(b).

(a) (b)

Fig. 5.2 Pricing under Perfect Competition: Short-run

Since a firm can sell any quantity at price OP1, the demand for the firm’s productis given by a horizontal straight line, AR = MR. Price being constant, its average revenue(AR) and marginal revenue (MR) are equal. Firm’s upward sloping MC curve beyond its

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AVC curve represents its supply curve. Firm’s MR and MC curves intersect each otherat point E. This is the firm’s equilibrium point. The perpendicular EM determines theprofit-maximizing output at OM. At this output, firm’s MR = MC, which satisfies boththe first order and the second order conditions of maximum profit. The total maximumprofit is shown by the area P1 TNE. The total profit (η) may be calculated as

η = (AR – AC)QIn Fig. 5.2(b),

AR = EMAC = NM

and Q = OMBy substituting the values from Fig. 5.2(b), we get

η = (EM – NM) OMSince EM – EN = EN

η = EN × OMThis is the maximum profit that a firm can make, given the cost and revenue

conditions as presented in Fig. 5.2(b).Now, if price falls to OP2 due to downward shift in the demand curve to D′D′, the

firm will be in equilibrium at point E′. Here again the firm’s AR′ = MR′ = MC. But itsAR < AC. Therefore, the firm incurs loss. But, in the short-run, it may not be desirable toclose down so long as it covers its MC.

III. Price Determination in the Long Run

Unlike in the short-run, the supply curve in the long-run is supposed to be more elastic.Long-run brings in two additional factors in operation which make the supply curvemore elastic. First, in the long-run, it becomes possible for the existing firms to increasetheir output by increasing the size of their plant. Second, and what is more important,new firms may enter and some existing ones may leave the industry. Entry and exit offirms bring about the long-run variation in the output. If cost and revenue conditions inthe long-run are such that some firms are making losses and are not able to adjust theirplant-size and cost structure to the market price, such firms leave the industry. Thismakes the market supply curve shift leftward causing a rise in the price. The increase inmarket price increases the excess profit of the profit-making firms. Under the conditionsof the perfect competition (i.e., free entry and exit), the pure profit would invite manynew firms to the industry. This will make supply curve shift rightward, causing a decreasein the price, which will eventually take away the excess or pure profits. All firms earnonly normal profit. Let us now explain the price and output determination in the long-run and also the equilibrium of the firm and of the industry.

As in the short-run, market price is determined in the long-run by the marketforces of demand and supply. Let us suppose that the market demand curve is given byDD′ which is relevant for both short-run and long-run, and short-run supply curve isgiven by SS1 in Fig. 5.3(a). The market demand curve DD′ and market supply curve SS1intersect each other at point P1 and the short-run market price is determined at OP0. Atthis price, the firms find their short-run equilibrium at point E1 and each of them produces2

output OQ1. The total market supply equals OQ1 × No. of firms = ON1 [in panel (a) of

Fig. 5.3] and the industry is in short-run equilibrium.

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Given the cost and revenue conditions in Fig. 5.3(b), the firms are making supernormal profit of E1M per unit. The existence of super normal profit in the short-run leadsto increase in the market supply on two accounts: one, new firms will enter the industryattracted by the super normal profits, and two, the existing firms would expand theirplant-size because returns to scale would increase as shown by the LAC. As a result, themarket supply would increase so that supply curve shifts rightward to SS2 [Fig. 5.3(a)].The shift in supply curve brings down the market price to OP′ which is the long-runequilibrium price. Thus, equilibrium price is once again determined in the market.

( a ) ( b )

Fig. 5.3 Long-run Equilibrium of the Firm

Equilibrium of the Firm in the Long Run

The firms are in equilibrium in the long-run when theirAR = MR = LMC = LAC = SMC = SAC

It means the firms of an industry reach their equilibrium position in the long-runwhere both a short-run and long-run equilibrium conditions coincide. In a perfectlycompetitive market, the cost and revenue conditions are given for the firms. What thefirms can do, therefore, is to adjust their output to the given revenue and cost conditionsin order to maximize their profit. Let us now illustrate the process of adjustment ofoutput so as to reach the equilibrium in the long-run.

Suppose that the firms are in equilibrium at point E1 in Fig. 5.3(a) where theymake excess profits AR – SAC1 = EM per unit. This gives incentives to the firms toexpand their scale of production, i.e., they add more plants to the existing ones. As aresult, market supply increases. Besides, supply also increases because new firms enterthe industry. Therefore, the market supply curve SS1 tends to shift rightward causing afall in price to OP´. On the other hand, due to increase in demand for inputs, cost tendsto rise. But so long as economies of scale are greater than the diseconomies of scale, theLAC tends to decrease and it pays firms to expand their plant-size. When a stage isarrived where P < LAC, firms incur losses. The firms which are not able to makeadjustment in the plant-size or scale of production leave the industry. This works in twodirections. On the one hand, supply decreases and price increases, and on the other,demand for inputs decreases which causes a decrease in the input prices. This processof adjustment continues until LAC is tangent to P = AR = MR for each firm in theindustry.

Check Your Progress

1. Define perfectcompetition and listits characteristics.

2. What are the threedifferent degrees ofcompetition createdby imperfectcompetition?

3. What is ‘short run’from the pricingpoint of view?

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5.3 MONOPOLY: DEFINITION, SOURCES ANDFEATURES

The term pure monopoly signifies an absolute power to produce and sell a productwhich has no close substitute. In other words, a monopoly market is one in which thereis only one seller of a product having no close substitute. The cross-elasticity of demandfor a monopolized product is either zero or negative. In a monopolized market structure,the industry is a single-firm-industry. Firm and industry are identical in a monopoly setting.

Moreover, the precise definition of monopoly has been a matter of opinion andpurpose. For instance, in the opinion of Joel Dean,3 a monopoly market is one in which ‘aproduct of lasting distinctiveness is sold’. The monopolized product has distinct physicalproperties recognized by its buyers and the distinctiveness lasts over many years. Sucha definition is of practical importance if one recognizes the fact that most commoditieshave their substitutes varying in degree and it is entirely for the consumers or users todistinguish between them and to accept or reject a commodity as the substitute. Anotherconcept of pure monopoly has been advanced by D.H. Chamberlin4 who envisages thecontrol of all goods and services by the monopolist. But such a monopoly has hardly everexisted, hence his definition is unrealistic. In the opinion of some others, any firm facinga sloping demand curve is a monopolist. This definition, however, includes all kinds offirms except those under perfect competition.5 We will, however, adopt for our purposehere a general definition of a pure monopoly: a pure monopoly means an absolute powerto produce and sell a commodity which has no close substitute.Some important features of monopoly are the following:

1. There is a single seller of a product which has no close substitute.2. A monopoly firm is a price maker, not a price taker.3. Under monopoly, there is absence of supply curve.4. A monopoly makes a single-firm industry.

Sources and Kinds of Monopolies

The emergence and survival of a monopoly is attributed to the factors which prevent theentry of other firms into the industry. The barriers to entry are therefore the sources ofmonopoly power. The major sources of barriers to entry to a monopolized market aredescribed here briefly.

(i) Legal Restrictions. Some monopolies are created by the law in the publicinterest. Most state monopolies in the public utility sector, including postal, telegraphand telephone services, radio, generation and distribution of electricity, railways,airlines and state roadways, etc. are public monopolies that are created by thepublic law. The state may create monopolies in the private sector also by restrictingentry of other firms by law or by granting patent rights. Such monopolies areintended to reduce cost of production to the minimum by enlarging the size andinvesting in technological innovations. Such monopolies are known as franchisemonopolies.

(ii) Control over Key Raw Materials. Some firms acquire monopoly powerbecause of their traditional control over certain scarce and key raw materials,which are essential for the production of certain other goods, e.g., bauxite, graphite,

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diamond, etc., Aluminium Company of America, for instance, had monopolizedthe aluminium industry before the World War II because it had acquired controlover almost all sources of bauxite supply.6 Such monopolies are often called ‘rawmaterial monopolies’. The monopolies of this kind emerge also because ofmonopoly over certain specific knowledge or technique of production.

(iii) Efficiency. A primary and technical reason for growth of monopolies is theeconomies of scale. In some industries, long-run minimum cost of production orthe most efficient scale of production almost coincides with the size of the market.Under this condition, the large-size firm finds it profitable in the long-run to eliminatethe competition by cutting down its price for a short period. Once monopoly isestablished, it becomes almost impossible for the new firms to enter the industryand survive. Monopolies existing on account of this factor are known as naturalmonopolies. A natural monopoly emerges either due to technical efficiency or iscreated by the law on efficiency grounds.

(iv) Patent Rights. Another source of monopoly is the patent right of the firm fora product or for a production process. Patent rights are granted by the governmentto a firm to produce a commodity of specified quality and character or to use aspecified technique of production. Patent rights gives a firm exclusive rights toproduce the specified commodity or to use the specified technique of production.Such monopolies are called patent monopolies.

5.3.1 Demand and Revenue Curves under Monopoly

The nature of revenue curves under monopoly depends on the nature of demand curvea monopoly firm faces. We have noted earlier that in a perfectly competitive market,firms face a horizontal, straight-line demand curve. It signifies that an individual firm ofan industry can sell any quantity at the prevailing price. Under monopoly, however, thereis no distinction between the firm and the industry. The monopoly industry is a single-firm industry. The monopoly firm is, therefore, capable of influencing the industry priceby changing the level of its production which is eventually the industry output. Besides,a monopoly firm is free to choose between price-quantity combination. It can fix higherprice and sell a lower quantity and vice versa. For these reasons, a monopoly firmfaces a demand curve with a negative slope. What is important in the context ofmonopoly pricing is the relation between firm’s average revenue (AR) curve and itsmarginal revenue (MR) curve. The analysis is therefore repeated here for ready reference.

Relation between AR and MR Curves

The relationship between AR and MR curves plays an important role in price and outputdetermination under monopoly. Therefore, before we explain price and outputdetermination, let us look at technical relationship between AR and MR. The relationshipbetween AR (= P) and MR can be specified in the following way:

Recall that total revenue, TR, equals P times Q, i.e.,TR = P·Q

and marginal revenue, MR, is obtained by differentiating TR = P·Q with respect to P.Thus,

MR = ∂∂

= +∂∂

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= +∂∂

FHG

IKJ ...(5.1)

Note that Q PP Q

is the reciprocal of the elasticity..

Thus, Q PP Q

= –

By substituting − for ⋅∂∂

in Eq. 5.1, we get

MR = P −FHG

IKJ ...(5.2)

or MR = P – ...(5.3)

Since P = AR

MR = AR – ...(5.4)

This relationship between MR and AR can be derived geometrically. Consider theAR and MR curves in Fig. 5.4.

Fig. 5.4 Relationship between AR and MR Curves

Let us suppose that price is given at PQ (=BO). The elasticity at point P on theAR curve can be expressed as:

e = = =

where e = elasticity of demand curve.Since OB = PQ

∴ e = ...(5.5)

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It can be proved7 that AB = PT. By substituting PT for AB in Eq. 5.5, we get

e = ...(5.6)

Since PT = PQ – TQ, Eq. 5.6 may be written as

e = − ...(5.7)

It can be seen from Fig. 5.4 that at price OB, PQ = AR and TQ = MR. Therefore,Eq. 5.7 can be expressed as:

e = −

and MR = AR – ...(5.8)

Note that Eq. 5.4 is the same as Eq. 5.8.Given the Eq. 5.7, AR can be easily obtained.

Since MR = AR –

or MR = AR 11e

...(5.9)

AR =−

or AR = MR 1e 1

...(5.10)

The general relationships between AR and MR are given by Eq. (5.9) and Eq.(5.10). A general pattern of relations between AR and MR can be easily obtained fromEq. (5.9) as follows. Given the negative slope of the demand curve,

∴∴

∞∴

∞,

An important aspect of relation between AR and MR curves that needs to benoted is that the slope of the MR curve is twice that of the AR curve.8

5.3.2 Cost and Supply Curves under Monopoly

In the short-run, cost conditions faced by a monopoly firm are, for all practical purposes,identical to those faced by a firm under perfect competitions, particularly when a monopolyfirm is a competitive buyer in the input market. But in case a monopoly firm uses specifiedinputs9 for which there is no general market and holds the position of a monopolist in theinput-market, then the price of the inputs depends on the monopolist’s demand for it,given the supply condition. The monopoly firm may then face a positively sloping supply

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curve in the input market, and its cost curves would be different from those of firmsunder perfect competition. In fact, the monopoly firm would face a rising supply priceand its cost curves would rise rapidly. In general, however, most monopoly firms useunspecified inputs, and they are one among many buyers of the inputs. In the short-run,therefore, a monopoly firm is faced with usual U-shaped AC and MC curves.

We have noted that under perfect competition, the MC curve forms the basis offirm’s supply curve. It is important to note here that the MC curve is not themonopolist’s supply curve. In fact, under monopoly, there is no unique relation betweenmarket price and quantity supplied. Therefore, there is no supply curve under monopoly.

5.3.3 Profit Maximization under Monopoly

The objective of a monopoly firm, like all other firms, is assumed to be profit maximization.Profit maximization is, however, not necessarily the sole objective of the firm. Themonopoly firm may seek to maximize its utility function,10 particularly where managementof the firm is divorced from its ownership. But, as mentioned earlier, most commonobjectives of business firm assumed in traditional theory of pricing is profit maximization.We will therefore explain the equilibrium of monopoly firm in short run and long-rununder profit maximization hypothesis.

Monopoly Equilibrium in the Short Run

Like any other firm, a monopoly firm reaches its equilibrium where it maximizes its totalprofits. As noted earlier, profits are maximum where the two following conditions arefulfilled: (i) that MC = MR—the necessary condition, and (ii) that the MC curve mustintersect the MR curve from below under increasing cost condition—the supplementarycondition. The monopoly firm fixes its price and output in accordance with the theseconditions.

Fig. 5.5 Price Determination under Monopoly: Short-run

The price and output determination under monopoly, and also the firm’s equilibrium,are demonstrated in Fig. 5.5. The AR = D and MR curves show the revenue conditions,while SMC and SAC present the short-run cost conditions faced by the monopoly firm.Given the revenue and cost curves, the decision rule for selecting profit maximizingoutput and price is the same as for a firm in the competitive industry, i.e., firm’s MR =MC and slope of MC > the slope of MR. Therefore, the monopoly firm chooses a price-output combination for which MR = SMC. The MR and SMC curves intersect eachother at point N. Thus, the profit maximizing output for the firm is OQ, since at this

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output firm’s MR = SMC. Given the demand curve AR = D, the output OQ can be soldper time unit at only one price, i.e., PQ(= OP1). Thus, the determination of equilibriumoutput simultaneously determines the price for the monopoly firm. Once price and outputare determined, the total profits are also simultaneously determined.

At output OQ and price PQ, the monopoly firm maximizes its profit. Its per unitmonopoly or super-normal profit (i.e., AR – SAC) is (PQ – MQ) = PM. Its total profit π= OQ × PM. Since OQ = P2M, π = P2M × PM, as shown by the shaded area. Since inthe short-run cost and revenue conditions are not expected to change, the equilibrium ofthe monopoly firm will remain stable.

Two Common Misconceptions

There are two common misconceptions about monopoly firm which must be clearedbefore we proceed.

One of the misconceptions is that a monopoly firm necessarily makes super normalprofits. There is, however, no guarantee that monopoly firm will always make profits inthe short run. In fact, whether a monopoly makes profits or losses in the short rundepends on its revenue and cost conditions. It is quite likely that its SAC lies above its ARas shown in Fig. 5.6. The monopoly firm then makes losses to the extent ofPM × OQ = P2MPP1. The firm may yet continue to produce and sell in the hope ofmaking profits in the long-run. The monopoly firm, like a competitive firm, will, however,stick to the maximization rules (i.e., MR = MC) in order to minimize its losses.

Another common misconception about monopoly is that the demand curve facedby a monopoly firm is perfectly inelastic so that it can charge any price it likes. In fact,the demand curve faced by a monopolist is both firm’s and industry’s demand curve.And, most market demand curves are negatively sloped being highly elastic towardstheir upper end and highly inelastic towards their lower end. The equilibrium output ofthe monopolist that maximizes his profits will always be within the elastic region of thedemand curve, if his MC ≠ 0.

Fig. 5.6 Monopoly Equilibrium in the Short-run: Losses

Monopoly Equilibrium in the Long Run

The long-run conditions faced by a monopolist are different from those faced bycompetitive firms in an important respect, i.e., the entry of new firms into the industry.While in a competitive industry, there is free entry of new firms to the industry, a monopolyfirm is protected from competition by the barriers to entry.

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Protected by barriers to entry, a monopoly firm gets an opportunity to expand thesize of its plant with a view to maximizing its long-run profits. The expansion of theplant-size may, however, be subject to such conditions as (a) size of the market; (b)expected economic profits; and (c) risk of inviting legal restrictions. Assuming none ofthese conditions limits the expansion of monopoly firm, the general case of monopolyequilibrium in the long-run is illustrated in Fig. 5.7. The AR and MR curves show themarket demand and marginal revenue conditions faced by the monopoly firm. The LACand LMC curves show the long-run cost conditions. The profit maximizing monopolyfirm equalises its LMC and MR at output OQ2. The price at which the total output OQ2can be sold is P2Q2. Thus, in the long-run equilibrium, price is P2Q2 and equilibriumoutput is OQ2. This output-price combination maximizes the monopolist’s long-run profits.The total monopoly profit is shown by the area LP2SM.

Fig. 5.7 Monopoly Equilibrium in the Long-run

It may be noted at the end that if there are barriers to entry, the monopoly firmwould not reach the optimal scale of production in the long-run, nor will it make the fulluse of its existing capacity. This case can be verified from Fig. 5.7. The optimum size ofthe plant is given by point B, i.e., at the minimum LAC. But the monopoly firm settles atless than optimal output because optimum size of the plant will not yield the maximumprofit.

Also, if the size of the market and the cost conditions permit, a profit maximizingmonopoly firm may even exceed the optimum size of the plant and overutilize its long-run capacity. Figure 5.8 depicts the more-than-optimal size of the plant and itsoverutilisation. The optimum size of the plant is given at point B, the point of intersectionbetween LAC and LMC, whereas the monopoly firm chooses output at M where hisprofit is maximum. Alternatively, the monopoly firm may find its equilibrium just at theoptimum size of the plant. This is possible only when the market-size is just large enoughto permit optimization and full utilization of the plant size. This possibility has been illustratedin Fig. 5.9.

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B

Fig. 5.8 Monopoly Equilibrium: Overutilization of Point Size

Fig. 5.9 Monopoly Equilibrium at Optimal Size of the Plant

5.3.4 Absence of Supply Curve in a Monopoly

As already explained, there is no unique or precise supply curve under monopoly. Let usnow examine this fact by using the concept of equilibrium output. We know that supplycurve presents a unique relationship between price and quantity demanded. This uniquerelationship between market price and quantity supplied does not exist under monopoly.The reason is, that a profit-maximizing monopoly firm does not determine its outputwhere P = MC or where AR = MC. Rather, it determines its equilibrium output whereMR = MC. Therefore, a unique relationship between price (AR = P) and quantity suppliedcannot be traced. It is therefore quite possible to trace (i) that given the MC, the sameoutput is supplied at different prices, and (ii) that at a given price, different quantities aresupplied if the two downward sloping demand curves have different elasticities. Thetwo cases are illustrated in Figs. 5.10 and 5.11, respectively.

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Fig. 5.10 The Same Quantity Supplied at Two Different Prices

As Fig. 5.10 shows, given the MC, the same quantity OQ can be supplied at twodifferent prices—OP1 when demand curve is D1 and OP2 when demand curve is D2.Obviously, there is no unique relationship between price and quantity supplied.

Figure 5.11 presents the case of two different quantities supplied at the sameprice, OP. Given the MC, quantity OQ1 is supplied when demand curve is D1 and quantityOQ2 is supplied when demand curve is D2 at the same price OP. Inthis case too, there is no unique relationship between price and quantity supplied. It isthus clear that there is no unique supply curve under monopoly.

Fig. 5.11 Different Quantities Supplied at the Same Price

5.3.5 Price Discrimination in a Monopoly

The theory of pricing under monopoly, as discussed above, gives the impression thatonce a monopoly firm fixes up the price of its product, the same price is charged from allthe consumers. This however may not be the case. A monopolist, simply by virtue of itsmonopoly power, is capable of charging different prices from different consumers orgroups of consumers. When the same (or slightly differentiated) product is sold at differentprices to different consumers, it is called price discrimination. When a monopolist sellsthe same product at different prices to different buyers, the monopoly is called adiscriminatory monopoly.

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Consumers are discriminated in respect of prices on the basis of their incomes orpurchasing powers, geographical location, age, sex, quantity they purchase, theirassociation with the sellers, frequency of visits to the shop, the purpose of the use of thecommodity or service, and on other grounds which the seller may find suitable.

A common example of consumers being discriminated on the basis of their incomesis found in medical and legal professions. Consulting physicians and lawyers (havingexcess capacity) charge different fees from different clients on the basis of their payingcapacity. Delhi Vidyut Board charges different rates of tariffs for different grades andpurpose of units of electricity consumed. Price discrimination on the basis of age isfound in railways, roadways and airways: children below 15 years are charged only halfthe adult-rates. Price discrimination on the basis of quantity purchased is very common.It is generally found that private businessmen charge lower price (or give discount)when bulk-purchase is made. In case of public utility services, however, lower rates arecharged when commodity or service is consumed in smaller quantity, for example, lowerrates on the first few calls by the telephone owners, and no surcharge on electricity uptocertain level of consumption. The most common practice of price discrimination is foundin cinema shows, musical concerts, game-shows, etc.

For the purpose of price discrimination, the product or service in question may beidentical or slightly modified. Services of consulting physicians and lawyers, for example,are identical. The services of railways, roadways and entertainment shows may beslightly modified by providing more comfortable seats for the purpose of pricediscrimination. The modification in service may involve some additional cost. But pricedifferentials are much more than is justified by cost differentials.

Although price discrimination is the most common practice under monopoly, itshould not mean that this practice exists only under monopoly. Price discrimination isalso quite common in other kinds of market structures, particularly where marketimperfection exists. Most business firms discriminate between their customers on thebasis of personal relationship, quantity purchased, duration of their association with thefirm as buyers, and so on.

Necessary Conditions for Price Discrimination

First, the market for different class of consumers must be separable so that buyers oflow-price market are not in a position to resell the commodity in the high-price marketfor such reason as (i) geographical distance involving high cost of transportation, e.g.,domestic versus foreign markets; (ii) exclusive use of the commodity, e.g., doctor’sservices, entertainment shows, and (iii) lack of distribution channels, e.g., transfer ofelectricity and gas.

Second, if market is divided into submarkets, the elasticity of demand must bedifferent in each submarket. The purpose of price-discrimination is to maximize theprofit by exploiting the markets with different price elasticities. It is the difference inprice-elasticities that provides opportunity for price discrimination. If price-elasticities ofdemand in different markets are the same, price discrimination would not serve theobjective of profit maximization.

Third, the seller must possess some monopoly over the supply of the product tobe able to distinguish between different classes of consumers, and to charge differentprices.

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Degrees of Price Discrimination

The degree of price discrimination refers to the extent to which a seller can divide themarket and can take advantage of it in extracting the consumer’s surplus. According toPigou,11 there are three degrees of price-discrimination practised by the monopolists: (i)first degree price discrimination; (ii) second degree price discrimination; and (iii) thirddegree price discrimination.

(a) First Degree Price Discrimination.12 The discriminatory pricing that attemptsto take away the entire consumers’ surplus is called first degree discrimination.First degree discrimination is possible only when a seller is in a position to knowthe price each buyer is willing to pay. That is, he knows his buyer’s demand curvefor his product. Under perfect price discrimination, the seller sets the price at thehighest possible level at which all those who are willing to buy the product at thatprice buy at least one unit each. When the consumer’s surplus of this sectionof consumers is exhausted, he gradually lowers down the prices so that theconsumer’s surplus of the users of the subsequent units can be extracted.This method of pricing is continued until the whole consumer’s surplus availableat the price where MR = MC is extracted. Also consider the case of services ofexclusive use, e.g. medical services. A doctor who knows or can guess the payingcapacity of his patients can charge the highest possible fee from presumably therichest patient and the lowest fee from the poorest one. The first degree of pricediscrimination is the limit of discriminatory pricing.

(b) Second Degree Price Discrimination. Under the second degree ofdiscriminatory pricing, the firm charges different prices from different class ofconsumers— high, middle and low income consumers. The monopolist adoptingthe second degree price discrimination intends to siphon off only the major partof the consumer’s surplus, rather than the entire of it. The second degree pricediscrimination is feasible where (i) the number of consumers is large and pricerationing can be effective, as in case of utility services like telephones and naturalgas; (ii) demand curves of all the consumers are identical; and (iii) a single rate isapplicable for a large number of buyers. As shown in Fig. 5.12, a monopolist usinga second degree price discrimination charges price OP1 for the first few units,OQ1 and price OP2 for the next O1Q2, units, and price OP3 for the next additionalpurchase of Q2Q3 units. Thus, by adopting a block-pricing system, the monopolistmaximizes his total revenue (TR) as:

TR = (OQ1·AQ1) + (Q1Q2 · BQ2) + (Q2Q3 · CQ3)

Fig. 5.12 Second Degree Price Discrimination

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If a monopolist is restrained from price discrimination and is forced to choose anyone of the three prices, OP1, OP2, or OP3, his total revenue will be much less.

(c) Third Degree Price Discrimination. When a profit maximizing monopolysets different prices in different markets having demand curves with differentelasticities, it is using third degree price discrimination. When a monopolist isfaced with two or more markets, completely separated from each other—eachhaving a demand curve with different elasticity—a uniform price cannot be setfor all the markets without loosing profits. The monopolist is therefore required toallocate total output between the different markets so that profit can be maximizedin all the markets. The profit in each market would be the maximum only whenthe MR = MC in each market. The monopolist therefore divides total outputbetween the markets so that in all the markets MR = MC. The process of allocationof output and determination of price for different markets is illustrated in Fig.5.13. Suppose that a monopolist has to sell goods in only two markets, A and B.The two markets are so separated that resale of commodity is not possible. Thedemand curve (Da) and marginal revenue curve (MRa) given in Fig. 5.13(a)represent the AR and MR curves in market A and curves Da and MRb, in Fig.5.13(b) represent AR and MR curves, respectively, in market B. The horizontalsummation of demand curves Da and Db gives the total demand curve for the twomarkets, as shown by the curve AR = D, and horizontal summation of MRa andMRb is given by the curve MR (Fig. 5.13). The firm’s marginal cost is shown bythe curve MC which intersects MR at point E. Thus, optimum level of output forthe firm is determined at OQ. At this level of output, MR = MC. Since the wholeof OQ cannot be profitably sold in any one market because of their limited size,the firm has to allocate the output between the two markets.

The monopolist allocates output OQ between the two markets in suchproportions that the necessary condition of profit maximization is satisfied in boththe markets. That is, in both the markets MC = MR. The profit maximizing outputfor each market can be obtained by drawing a line from point E and parallel toX-axis, through MRb and MRa. The points of intersection on curves MRa andMRb at points a and b, respectively, determine the optimum share for each market.As shown in Fig. 5.13, the monopoly firm maximizes its revenue in market A byselling OQa units at price AQa, and by selling OQb units in market B at price BQb.

Fig. 5.13 Third Degree Price Discrimination

(a)(b)

(c)

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The firm’s total equilibrium output OQ = OQa + OQb. Since at OQa, MRb = MCin market A, and at OQb, MRb = MC in market B,

MC = EQ = MRa = MRb

Thus, the equilibrium condition is satisfied in both market segments, and themonopoly firm adopting the third degree method of price discrimination maximizes itsprofits.

The third degree method of price discrimination is most suitable where the totalmarket is divided between the home and foreign markets. However, it need not belimited only to domestic and foreign markets. It may be suitably practised between anytwo or more markets separated from each other by any or more of such factors asgeographical distance, transport barriers or cost of transportation, legal restrictions onthe inter-regional or interstate transportation of commodities by individuals, etc.

Is Price Discrimination Justified?

Price discrimination has been condemned as illegal and immoral. The objection is: whycharge higher price from some and lower price from others while there is no extraadvantage to those who pay higher price or why benefit some at the cost of someothers? In the United Kingdom and the United States, railways were prohibited fromcharging discriminatory rates.13 Discriminatory pricing has also been criticised as adestructive tool in the hands of a monopoly. For, in the past, large corporations hadsought to use price discrimination to prevent the growth of competition. Besides, pricediscrimination may cause malallocation of resources and, hence, may be deterrent tosocial welfare. This is, however, not the case always. In some cases price discriminationsis socially advantageous. In fact as Lipsey has observed, ‘whether an individual judgesprice discrimination to be good or bad is likely to depend upon the details of the case aswell as upon his own personal value judgements.’ He adds, ‘Certainly there is nothing ineconomic theory to suggest that price discrimination is always in some sense worse thannon-discrimination under conditions of monopoly or oligopoly.’14

Price discrimination is, however, considered to be desirable in certain specificcases on the following grounds:

First is the case of goods and services which are essential for the society as awhole but their production is uneconomic in the sense that long-run average cost curve(LAC) lies much above the aggregated market demand curve as shown inFig. 5.14. Such goods and services cannot be produced. But, production of such goodsand services can be possible if price discrimination is permitted. Price discriminationthus becomes essential for the survival of the industry.

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Fig. 5.14 Price Discrimination for Industry’s Survival

Suppose, for example, (i) that there are two markets I and II, (ii) that individualdemand curves for the two markets, I and II, are given as D1 and D2, (iii) marketdemand curve is given by ABC, and (iv) the long-run average cost curve is given by LAC(Fig. 5.14). Note that LAC lies throughout above the total demand curve ABC. Therefore,production is not possible if one price is to be charged. But, if price discrimination isadopted and prices are so charged in the two markets that the total revenue exceedsLAC at some level of output, then monopoly may profitably survive to the advantage ofthe society. Let us suppose that the monopolist sets price OP1 in the market I in whichdemand is less elastic and OP2 in market II in which demand is highly elastic. He wouldsell OQ1 units at price OP1 in market I and OQ2 at price OP2 in market II. His totaloutput would then be at OQ = OQ1 + OQ2. His total revenue (TR) would be:

TR = (OP1 × OQ1) + (OP2 × OQ2)and suppose

AR = (OP1 × OQ1 + OP2 × OQ2)/OQ = OPa

At output OQ, the LAC is OT. Thus his total cost,TC = OQ × OT = OQST

and his total revenue,TR = OQ × OPa = OQRPa

Since OQRPa > OQST, the monopoly firms not only covers its cost but alsomakes excess profit. Its total profit,

π = OQRPa – OQST = PaRSTThis kind of situation arises mostly in public utility services, like railways, roadways,

post and telegraph services, etc., in which high paying sector of the market subsidisesthe low paying sector. But, if low-paying sector is not subsidised, no production would bepossible.

Second, discriminatory pricing can be adopted with justification where a uniform,single profitable price is likely to restrict the output and deprive many (particularly thepeople of lower income groups) of the essential goods or service. If doctors in privatepractice, for example, who often change discriminatory price for their services, are

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asked to charge a uniform fee from all the patients, they would charge a fee high enoughto maintain the level of their income. The high fee may deprive the poor of the doctor’sservice and may force them to opt for inferior or inadequate treatment. The result of theuniform high fee will be that the rich patients who can pay a still higher fee gain as theypay a price lower than what they could afford, and on the other hand, poor patients aredeprived of proper medical service.

Third, there may be cases where a section of consumers gains more than thepeople of other sections from the use of the same product. From the use of electricity,for example, factory-owners gain more than the households. In such cases, uniformprice would be unjustified from a normative point of view, provided theobjective is not to restrain the domestic consumption of electricity and spare it forproductive purposes. There is, on the other hand, full justification for discriminatorypricing of electricity.

Government Regulation of Monopoly Prices

The existence of monopolies in a market economy is criticised on the grounds that theyrestrict production and consumption, widen income and wealth disparities, exploitconsumers and employees, cause distortions in allocation of resources, reduce the prospectof employment, and cause loss of social welfare. In most countries, therefore, there isgeneral apathy towards the monopolies. Consequently, governments in the marketeconomies attempt to control and regulate monopolies to the advantage of the society.There are various measures—direct, indirect, legal and otherwise—to control and regulatethe monopolies. However, we discuss here only the price regulation of natural monopolies.

Price regulation is a common feature in case of natural monopolies. When thesize of the market is small relative to the optimum size of the firm, market size cannotsupport more than one firm of optimal size. The monopoly in such a market is a naturalmonopoly. The natural monopoly is thus protected by market size itself. The governmentmay either nationalize such monopolies or regulate their prices so as to eliminate theexcess profits. If the government intends to regulate the monopoly price, the questionarises: what price should be fixed for the monopolist to charge? The two alternativeprices that have been suggested are: one that allows some excess profit to the monopolist,and the second that allows only normal profit to the monopolist. Both the alternativeprices, along with their repercussion on output, are illustrated in Fig. 5.15. An unregulatedmonopoly would produce OQ1 units, charge price OP3, and make excess profit of MT =MQ1 – TQ1 per unit. If monopoly price is regulated, one possible price is given at pointP where LMC = AR, the price being OP2 (= PQ2). Alternatively, price may be fixed atpoint C where AR = LAC and price = OP1 (= CQ3). When OP1 is the price set for themonopolist, only a normal profit is allowed to the firm, but output is maximum possibleunder the given cost and revenue conditions. If price is fixed at OP2, the monopolist getssome excess profit, but the output is less than that at price OP1. In both the cases,however, the total output under regulated monopoly is much higher than that underunregulated monopoly. Which of the two alternative prices (OP1 and OP2) is moreappropriate is a matter of debate.

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O

M

PC

LMCLAC

AR=DMR

T

Output

P1

P2

P3

Q1 Q2 Q3

Fig. 5.15 Government Regulated Monopoly

5.3.6 Measures of Monopoly Power

It is only in rare cases that monopolies have absolute power. Monopoly power variesfrom industry to industry. The degree of monopoly power matters a great deal in pricingand output decisions of a monopolist. Besides, measuring monopoly power is requiredalso in connection with control and regulation of monopolies. We discuss here the variousmeasures of monopoly power.

Measuring monopoly power has been a difficult proposition. The efforts to devisea measure of monopoly power have not yielded any universal or non-controversialmeasure. As Hunter has observed, ‘The idea of devising a measure of monopoly power,with reference both to its general incidence and to particular situation has been andprobably always will remain an attractive prospect for economists who wish to probe inthis field.’15 If not for any other reason, then for ‘sheer intellectual curiosity’, economytheorists feel compelled to work on this problem, as they ‘could not with good consciencego on talking about ‘great’ or ‘little’ monopoly power or about various degrees of monopolywithout trying to ascertain the meaning of these words.’16

Therefore, to devise at least a ‘conceivable’ measure of monopoly, even if ‘practical’measurement is impossible, continues to interest the economists, for at least two reasons.First, apart from intellectual curiosity people would like to know about the economy inwhich they live, its industrial structure, and the industries from which they get theirsupplies. Second, growth of monopolies has forced governments of many countries toformulate policies and devise legislative measures to control and regulate monopolies. Ifthe government is to succeed in its policy of restraining monopoly, it must have at leastsome practicable measure of monopoly and monopolistic trade practices.

Although economists have devised a number of devices to measure the degree ofmonopoly power, none of the measures is free from flaws. Yet, the various measures doprovide an insight into the monopoly power and its impact on the market structure.Besides, they also help in formulating an appropriate public policy to control and regulatethe existing monopolies. We discuss here briefly the various measures of monopolypower suggested by the economists.

1. Number-of-Firms Criterion. One of the simplest measures of degree ofmonopoly power is to count the number of firms in an industry. The smallerthe number of firms, the greater the degree of monopoly power of each

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firm in the industry, and conversely, the larger the number of firms, greaterthe possibility of absence of monopoly power. As a corollary of this, if thereis a single firm in an industry, the firm has an absolute monopoly power. Thiscriterion seems to have been derived from the characteristics of the perfectcompetition in which the number of firms is so large that each firm suppliesonly an insignificant proportion of the market and no firm has any control onthe price.

This criterion has, however, a serious drawback. The number of firmsalone does not reveal much about the relative position of the firms withinthe industry because (i) ‘firms are not of equal size,’ and (ii) their numberdoes not indicate the degree of control each firm exercises in the industry.Therefore, the numerical criterion of measuring monopoly power is of littlepractical use.

2. Concentration Ratio. The concentration ratio is one of the widely usedcriteria used for measuring monopoly power. The concentration ratio isobtained by calculating the percentage share of the largest group of thefirms in the total output of the industry. ‘The number of firms chosen forcalculating the ratio usually depends on some fortuitous element—normallythe census of production arrangements of the country concerned.’17 InBritain, the share of the largest three firms of a census industry, and in theUSA, the share of the largest four firms is the basis of calculatingconcentration ratio.18 Apart from the share of the largest firms in the industry-output, ‘[the] size of the firm and the concentration of control in the industrymay be measured...in terms of production capacity, value of assets, numberof employees or some other characteristics.’19

These measures too are, however, not free from drawbacks as theyinvolve statistical and conceptual problems. Production capacity, for example,may not be straightaway used as it may include ‘unused, obsolete or excesscapacity’; the value of assets involves valuation problem as accountingmethod of valuation and market valuation of assets may differ. Employmentfigures may not be relevant in case of capital intensive industries. The useof such figures may be misleading. The two other convenient measures are‘gross output value’ or ‘net output’ (value added). But the former involvesthe risk of double counting, while the latter, involves the omission of inter-establishment transfers.20

Another important objection to these measures of degree of monopolypower is that they do not take into account the size of the market. Size ofthe market may be national or local. A large number of firms supplying thenational market may be much less competitive than the small number offirms supplying the local market. For, it is quite likely that the national marketis divided among the thousand sellers so that each seller has status of amonopolist in his own area.

The most serious defect of concentration ratio as an index of monopolypower is that it does not reflect the competition from other industries. Thedegree of competition is measured by the elasticity of substitution betweenthe products of different industries. The elasticity of substitution may bedifferent under different classification of industries. Therefore, an industrywith concentration ratio under one classification of industries may have avery low elasticity of substitution and hence a high degree of monopoly.

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But, if classification of industries is altered, the same industry with a highconcentration ratio may have a very low elasticity of substitution, and hence,may show a low degree of monopoly.

3. Excess Profitability Criteria. J.S. Bain and, following him, many othereconomists have used excess profit as a measure of monopoly power. Ifprofit rate of a firm continues to remain sufficiently higher than all opportunitycosts required to remain in the industry, it implies that neither competitionamong sellers nor entry of new firms prevents the firm from making a pureor monopoly profit. While calculating the excess profit, the opportunity costof owner’s capital and margin for the risk must be deducted from the actualprofit made by the firm. Assuming no risk, the degree of monopoly may beobtained by calculating the divergence between the opportunity costs (O)and the actual profit, (P), as (P – O)/P. If [(P – O)/P] = O, there exists nomonopoly, and if [(P – O)/P] > O, there is monopoly. The higher the value of(P – O)/P, the greater the degree of monopoly.

Another measure of degree of monopoly based on excess profitabilityhas been provided by A.P. Lerner.21 According to him, the degree of monopolypower (MP) may be measured as:

MP = −

where P = price, MC = marginal cost. Since for a profit maximizingfirm, MR = MC, Lerner’s measure of monopoly power, MP, may also beexpressed as:

MP = −

Since P/(P – MR) = e, (P – MR)/P = 1/e, i.e., MP equals to the reciprocalof elasticity. Thus, Lerner’s measure of monopoly power may be expressedalso as MP = 1/e. It may thus be inferred that lower the elasticity, thegreater the degree of monopoly, and vice versa. According to Lerner’sformula, monopoly power may exist even if firm’s AR = AC and it earnsonly normal profit.

Lerner’s formula of measuring the degree of monopoly power isconsidered to be theoretically most sound. Nevertheless, it has been criticisedon the following grounds.

First, it is suggested that any formula devised to measure degree ofmonopoly power should bring out the difference between the monopolyoutput and competitive output or the ‘ideal’ output under the optimumallocation of resources. The divergence between P and MC used in Lerner’sformula does not indicate the divergence between the monopoly and the‘ideal’ output. Lerner has possibly used the divergence between P and MCas the substitute for the divergence between monopoly and ‘ideal’output. ‘This substitution of a price-cost discrepancy for a difference betweenactual and ‘ideal’ output is probably the greatest weakness of formula whichis supposed to measure deviation from the optimum allocation ofresources.’22

Second, price-cost discrepancy may arise for reasons other thanmonopoly, and price and cost may be equal or close to each other in spite ofmonopoly power.

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Third, since data on MC are hardly available, this formula is of littlepractical use for policy purposes.

4. Triffin’s Cross-Elasticity Criterion. Triffin’s criterion seems to have beenderived from the definition of monopoly itself. According to this criterion,cross-elasticity is taken as the measure of degree of monopoly—the lowerthe cross-elasticity of the product of a firm, the greater the degree of itsmonopoly power. However, this criterion is based on the inter-relationshipsbetween the individual firms and indicates only the relative power of eachfirm. It does not furnish a single index of monopoly power.

5.4 OLIGOPOLY, NON-PRICE COMPETITION

5.4.1 Oligopoly: Meaning and Characteristics

Oligopoly23 is a form of market structure in which a few sellers sell differentiated orhomogeneous products. ‘How few are the sellers’ is not easy to define numerically inthe oligopolistic market structure. The economists are not specified about a definitenumber of sellers for the market to be oligopolistic in its form. It may be two,24 three,four, five or more. In fact, the number of sellers depends on the size of the market.Given the size of the market, if number of sellers is such that each seller has commandover a sizeable proportion of the total market supply25 then there exists oligopoly in themarket.

The products traded by the oligopolists may be differentiated or homogeneous.Accordingly, the market may be characterized by heterogeneous oligopoly orhomogeneous (or pure) oligopoly. In automobile industry, Maruti Zen, Hyundai’s Santro,Daewoo’s Matis, Fiat’s Palio and Tata’s Indica, etc., are the outstanding examples ofdifferentiated oligopoly. Similarly, cooking gas of Indane and of Burshane are the examplesof homogeneous oligopoly. Differentiated oligopolies include automobiles, cigarettes,refrigerators, TV industries. Pure oligopoly includes such industries as cooking gas,cement, baby food, cable wires, dry batteries, etc. Other examples of oligopolistic industriesare aluminium, paints, tractors, steel, tyres and tubes.

Characteristics of Oligopoly

The basic characteristics of oligopolistic market structure are the following:1. Intensive Competition. The characteristic fewness of their number brings

oligopolist in intensive competition with one another. Let us compare oligopolywith other market structures. Under perfect competition, competition is non-existentbecause the number of sellers is so large that no seller is strong enough to makeany impact on market conditions. Under monopoly, there is a single seller and,therefore there is absolutely no competition. Under monopolistic competition,number of sellers is so large that degree of competition is considerably reduced.But, under oligopoly, the number of sellers is so small that any move by one sellerimmediately affects the rival sellers. As a result, each firm keeps a close watchon the activities of the rival firms and prepares itself with a number of aggressiveand defensive marketing strategies. To an oligopolist, business is a ‘life’ of constantstruggle as market conditions necessitate making moves and counter-moves. Thiskind of competition is not found in other kinds of market. Oligopoly is the highestform of competition.

Check Your Progress

4. What are theimportant featuresof monopoly?

5. How does a profit-maximizingmonopoly firmdetermine its priceand output?

6. What are pricediscrimination anddiscriminatorymonopoly?

7. On what bases areconsumersdiscriminatedagainst in respect ofprices?

8. What are themeasures ofmonopoly power?

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2. Interdependence of Business Decisions. The nature and degree ofcompetition among the oligopolists makes them interdependent in respect ofdecision-making. The reason for inter-dependence between the oligopolists isthat a major policy change made by one of the firms affects the rival firms seriouslyand immediately, and forces them to make counter-moves to protect their interest.Therefore, each oligopolist, while making a change in his price, advertisement,product characteristics, etc. takes it for granted that his actions will cause reactionby the rival firms. Thus, interdependence is the source of action and reaction,moves and counter-moves by the competing firms. An illuminating example ofstrategic manoeuvering by the oligopoly firm has been given by Robert A. Meyer.26

To quote the example, one of the US automobile companies announces inSeptember27 an increase of $180 in the list price of its new car model. Followingit, a few days later, a second company announces an increase of only $80 and athird announces increase of $91. The first company makes a counter-move: itsuddenly reduces the increase in list price to $71 from $180 announced earlier.One can now expect that other firms will follow the first in price-cutting. Obviously,there is a good deal of uncertainty in the behaviour of firms.

3. Barrier to Entry. An oligopolistic market structure is also characterized, in thelong run, by strong barriers to entry of new firms to the industry. If entry is free,new firms attracted by the super-normal profits, if it exists, enter the industry andthe market eventually becomes competitive. Usually barriers to entry do exist inan oligopolistic market. Some common barriers to entry are economies of scale,absolute cost advantage to old firms, price-cutting, control over important inputs,patent rights and licencing, preventive price and existence of excess capacity.Such factors prevent the entry of new firms and preserve the oligopoly.

Oligopoly Models: An Overview

The uncertainty in respect of behaviour pattern of a oligopoly firms arising out of theirunpredictable action and reaction makes systematic analysis of oligopoly extremelydifficult. Under the circumstances, a wide variety of behaviour pattern has been observed:they may come in collusion with each other or ‘may try to fight each other to the death’.The agreement may last or may break-down soon. Indeterminateness of price and outputtherefore becomes the basic feature of oligopolistic markets. In accordance with thevariety of behaviours, economists have developed a variety of analytical models basedon different behavioural assumptions. Among notable models are Cournot’s Duopolymodel (1838), Bertrand’s model (1883), Edgeworth’s model (1897), Stackelberg’sleadership model (1930), Hotelling’s model (1930s), Chamberlin’s model (1933), Sweezy’skinked-demand curve model (1939), Neumann and Morgenstern’s game theory model(1944), and Baumol’s sales maximization model. None of these models, however, providesa universally acceptable analysis of oligopoly, though these models do provide insightinto the behavioural pattern of oligopolists. Moreover, these models are studied for theirpedagogic importance.

The analytical models of oligopoly, suggested by the economists, may be classifiedunder two broad categories:

(i) Duopoly models(ii) General oligopoly models

The oligopoly models may be further sub-classified as (a) Non-collusive models,and (b) Collusive models.

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5.4.2 Duopoly Models

When there are only two sellers of a product, there exists duopoly, a special case ofoligopoly. Duopoly is a special case in the sense that it is the limiting case of oligopoly asthere must be at least two sellers to make the market oligopolistic in nature. Here wewill discuss some classical models of douploy.

I. Cournot’s Duopoly Model

Augustin Cournot,28 a French economist, was the first to develop a formal duopolymodel in 1838. To illustrate his model, Cournot assumed:

(a) two firms, A and B, each owning an artesian mineral water wells;(b) both operate their wells at zero marginal cost;29

(c) both face a downward sloping straight line demand curve;(d) each seller acts on the assumption that his competitor will not react to his decision

to change his output and price. This is Cournot’s behavioural assumption.On the basis of this model, Cournot has concluded that each seller ultimately

supplies one-third of the market and both the sellers charge the same price. And, one-third of the market remains unsupplied.

Cournot’s duopoly model is presented in Fig. 5.16. To begin the analysis, supposethat A is the only seller of mineral water in the market. In order to maximize his profitsor revenue, he sells quantity OQ at which his MC = O = MR, at price OP1. His totalprofit is OP1PQ.

Fig. 5.16 Price and Output Determination under Doupoly: Cournot’s Model

Now let B enter the market. The part of market open to him equals QM which ishalf of the total market.30 Note that QM is the part of the market left unsupplied by A. Itmeaus that B can sell his product in the remaining half of the market, PM being therelevant part of demand curve for him. B assumes that A will not change his price andoutput because he is making the maximum profit. That is, B assumes that A will continueto sell OQ at price OP1. Thus, the market available to him is QM and the relevantdemand curve is PM. When he draws his MR curve, PN, it bisects QM at point N whereQN = NM. In order to maximize his revenue, B sells QN at price OP2 = P′N. His totalrevenue is maximum at QRP′N. Note that B supplies only QN = 1/4 = 1/2 × 1/2 of themarket.

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With the entry of B, price falls to OP2. Therefore, A’s expected profit falls toOP2RQ. Faced with this situation, A attempts to adjust his price and output to the changedconditions. He assumes that B will not change his output QN and price OP2 as he (B) ismaking the maximum profit. Accordingly, A assumes that B will continue to supply 1/4 ofthe market and, therefore, he has 3/4 = 1 – 1/4 of the market available to him. Tomaximize his profit, A will supply 1/2 (3/4) = 3/8 of the market. Note that A’s marketshare has fallen from 1/2 to 3/8.

Now it is B’s turn to react. Following Cournot’s assumption, B assumes that A willcontinue to supply only 3/8 of the market and the market open to him equals 1 – (3/8) =5/8. To maximize his profit under the new conditions, B will supply1/2 (5/8) = 5/16 of the market. It is now for A to reappraise the situation and adjust hisprice and output accordingly.

This process of action and reaction continues in successive periods. In the process,A continues to loose his market share and B continues to gain. Eventually, a situation isreached when their market share equals at 1/3 each. Any further attempt to adjustoutput produces the same result. The firms, therefore, reach their equilibrium positionwith each supplying 1/3 of the market and 1/3 of the market remaining unsupplied.

The process through which firm reach their equilibrium, according to Cournot’smodel, may be illustrated as presented in the following table.

Table 5.2 Market Sharing in Cournot’s Model

=1 1 12 2 4

1 1 312 4 8

1 3 512 8 16

1 5 1112 16 32

1 11 2112 32 64

1 21 4312 64 128

1 43 8512 128 256

1 1 112 3 3

1 1 112 3 3

Cournot’s equilibrium solution is stable. For, given the action and reaction, it is notpossible for any of the two sellers to increase their market share. Cournot’s model ofduopoly can be extended to the case of general oligopoly. For example, suppose thereare three sellers, the industry and firms will be in equilibrium when each firm supplies1/4 of the market. The three sellers together supply 3/4 = 3 (1/4) of the market, 1/4 ofthe market remaining unsupplied. The formula for determining the share of each seller inan oligopolistic market is Q ÷ (n + 1), where Q = market size, and n = number of sellers.

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Algebra of Cournot’s Model

Cournot’s duopoly model may also be presented algebraically. Let us suppose that marketdemand function is given by a linear function as:

Q = 90 – P …(5.10)We have noted above that, under zero cost condition, profit is maximum where

MC = MR = 0 and profit-maximizing output equals Q/2.Thus, when firm A is a monopolist in the market, his profit-maximizing output

(OA), according to the profit-maximizing rule under zero cost condition, is given byQA = 1/2 (90 – P) …(5.11)

When another firm, B, enters the market, its profit-maximizing output equalsQB = 1/2[1/2(90 – P)] …(5.12)

Thus, the respective share of firms, A and B is fixed at QA and QB. The division ofmarket output may be expressed as:

Q = QA + QB = 90 – P ….(5.13)The demand function for the firm A may now be expressed as:

QA = (90 – QB) – P …(5.14)and for the firm B as:QB = (90 – QA) – P …(5.15)Given the demand function (5.14), the market open to firm A (at P = 0) is

90 – QB. The profit-maximizing output for A can be written as:

QA = −

...(5.16)

and for B, as:

QB =−

...(5.17)

The Eqs. (5.16) and (5.17) represent the reaction functions of firms A and B,respectively. For example, consider Eq. (5.16). The profit-maximizing output of firm Adepends on the value of QB, i.e., the output which firm B is assumed to produce. If firmB chooses to product 30 units, (i.e., QB = 30), then A’s output = 30[= (90 – 30)1/2]. If firm B chooses to produce 60 units, A’s output = 15 (= 90 – 60) 1/2).Thus, Eq. (5.16) is the reaction function of firm A. It can be similarly shown that Eq.(5.17) is the reaction function of firm B.

Criticism

Although Cournot’s model yields a stable equilibrium, it has been criticised on the followinggrounds:

First, Cournot’s behavioural assumption [assumption (d), mentioned earlier] isnaive to the extent that it implies that firms continue to make wrong calculations aboutthe competitor’s behaviour. That is, each seller continues to assume that his rival will notchange his output even though he repeatedly observes that his rival firm does change itsoutput.

Second, Cournot’s assumption of zero cost of production is unrealistic thoughdropping this assumption does not alter his model.

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II. Bertrand’s Duopoly Model

Betrand, a French mathematician, criticised Cournot’s model and developed his ownmodel of duopoly in 1883. His model differs from that of Cournot in respect of itsbehavioural assumption. While under Cournot’s model, each seller assumes his rival’soutput to remain constant, under Bertrand’s model, each seller determines his price onthe assumption that his rival’s price, rather than his output, remains constant.

Bertrand’s model concentrates on price-competition. His analytical tools arereaction functions of the duopolists. Reaction functions of the duopolists are derived onthe basis of iso-profit curves. An iso-profit curve, for a given level of profit, is drawn onthe basis of various combinations of prices charged by rival firms. Assuming two firmsA and B, the two axis of the plane on which iso-profit curves are drawn measure oneeach the prices of the two firms. Iso-profit curves of the two firms are convex to theirrespective price axis, as shown in Figs. 5.17. and 5.18. Iso-profit curves of firm A areconvex to its price-axis PA (Fig. 5.17) and those of firm B are convex to PB (Fig. 5.18).

Fig. 5.17 A’s Reaction Curve Fig. 5.18 B’s Reaction Curve

To explain the implication of an iso-profit curve, consider curve A in Fig. 5.17. Itshows that A can earn a given profit from the various combinations of its own and itsrival’s price. Price combinations at points a, b and c, gor example, on iso-profit curve A1,yield the same level of profit. If firm B fixes its price PB1, firm A has two alternativeprices, PA1 and PA2, to make the same level of profits. When B reduces its price, A mayeither raise its price or reduce it. A will reduce its price when he is at point c and raise itsprice when he is at point a. But there is a limit to which this price adjustment is possible.This point is given by point b. So there is a unique price for A to maximize its profits. Thisunique price lies at the lowest point of the iso-profit curve. The same analysis applies toall other iso-profit curves. If we join the lowest points of the iso-profit curves A1, A2 andA3, we get A’s reaction curve. Note that A’s reaction curve has a rightward slant. This isso because, iso-profit curve tend to shift rightward when A gains market from its rival B.

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Fig. 5.19 Duopoly Equilibrium: Bertand’s Model

Following the same process, B’s reaction curve may be drawn as shown in Fig.5.18. The equilibrium of duopolists suggested by Bertrand’s model may be obtained byputting together the reaction curves of the firms A and B as shown in Fig. 5.19. Thereaction curves of A and B intersect at point E where their expectations materialize.Point E is therefore equilibrium point. This equilibrium is stable. For, if anyone of thefirms deviates from the equilibrium point, it will generate a series of actions and reactionsbetween the firms which will lead them back to point E.

Criticism

Bertrand’s model has, however, been criticised on the same grounds as Cournot’s model.Bertrand’s implicit behavioural assumption that firms never learn from their pastexperience is naive. Furthermore, if cost is assumed to be zero, price will fluctuatebetween zero and the upper limit of the price, instead of stabilizing at a point.

III. Edgeworth’s Duopoly Model

Edgeworth31 developed his model of duopoly in 1897. Edgeworth’s model followsBertrand’s assumption that each seller assumes his rival’s price, instead of his output, toremain constant. His model is illustrated in Fig. 5.20.

Let us suppose that there are two sellers, A and B, in the market. The entiremarket M′M in Fig. 5.20 is equally divided between the two sellers who face identicaldemand curves. A has his demand curve as DA and B as DB. Let us also assume thatseller A has a maximum capacity of output OM and B has a maximum output capacity ofOM′. The ordinate OD measures the price.

To begin the analysis of Edgeworth’s model, let us suppose that A is the onlyseller in the market. Following the profit-maximizing rule of a monopoly seller, he sellsOQ and charges a price, OP2. His monopoly profit, under zero cost, equals OP2EQ.Now, B enters the market and assumes that A will not change his price since he ismaking maximum profit. With this assumption, B sets his price slightly below A’s price(OP2) and is able to sell his total output and also to capture a substantial position of A’smarket.

Seller A now realizes the reduction in his sale. In order to regain his market, Asets his price slightly below B’s price. This leads to price-war between the sellers. Theprice-war takes the form of price-cutting which continues until price reaches OP1. Atthis price both A and B are able to sell their entire output A sells OM and B sells OM′.The price OP1 could, therefore, be expected to be stable. But, according to Edgeworth,price OP1 should not be stable.

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Fig. 5.20 Edgeworth’s Model of Duopoly

The reason is that, once price OP1 is set in the market, the sellers observe aninteresting fact. That is, each seller realizes that his rival is selling his entire output andhe will therefore not change his price, and each seller thinks that he can raise his price toOP2 and can make pure profit. This realization forms the basis of their action and reaction.Let seller A, for example, take the initiative and raise his price to OP2. Assuming A toretain his price OP2, B finds that if he raises his price to a level slightly below OP2, hecan sell his entire output at a higher price and make greater profits. Therefore, B raiseshis price according to his plan.

Now it is A’s turn to appraise the situation and react. A finds that his price ishigher than that of B’s. His total sale falls. Therefore, assuming B to retain his price, Areduces his price slightly below B’s price. Thus, the price-war between A and B beginsonce again. This process continues indefinitely and price keeps moving up and downbetween OP1 and OP2. Obviously, according to Edgeworth’s model of duopoly,equilibrium is unstable and indeterminate since price and output are never determined.In the words of Edgeworth, there will be an indeterminate tract through which the indexof value will oscillate, or, rather will vibrate irregularly for an indefinite length of time.’32

Edgeworth’s model, like Cournot’s and Bertrand’s model is based on a naïveassumption, i.e., each seller continues to assume that his rival will never change his priceor output even though they are proved repeatedly wrong. But, Hotelling remarked thatEdgeworth’s model is definitely an improvement upon Cournot’s model in that it assumesprice, rather than output, to be the relevant decision variable for the sellers.

IV. Stackelberg’s Leadership Model

Stackelberg,33 a German economist, developed his leadership model of duopoly in 1930.His model is an extension of Cournot’s model. Stackelberg assumes that one of theduopolists (say A) is sophisticated enough to play the role of a leader and the other(say B) acts as a follower. The leading duopolist A recognizes that his rival firm B has adefinite reaction function which A uses into his own profit function and maximises hisprofits.

Suppose market demand function is given as in (5.10), i.e., Q = 90 – P and B’sreaction function is given as in Eq. (5.18), i.e.,

QB = −

…(5.18)

Now, let A incorporate B’s reaction function into the market function and formulatehis own demand function as:

QA = 90 – QB – P …(5.19)

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Since QB = (90 – QA)/2, Eq. (15.9) may be written as

QA = −−

−

or QA = + −

or 2QA = 90 + QA – 2P …(5.20)QA = 90 – 2P

Thus, by knowing B’s reaction function, A is able to determine his own demandfunction. Following the profit-maximization rule, A will fix his output at 45 units(= 90/2), i.e., half of the total demand at zero price.

Now, if seller A produces 45 units and seller B sticks to his own reaction function,he will produce:

QB = −

= 22.5 units ...(5.21)

Thus, the industry output will be45 + 22.5 = 67.5.

The problem with Stackelberg’s model is that it does not decide as to which of thefirms will act as leader (or follower). If each firm assumes itself to be the leader and theother to be the follower, then Stackelberg’s model will be indeterminate with unstableequilibrium.

5.4.3 Oligopoly Models

We have already mentioned that there are two kinds of oligopoly models: (i) non-collusivemodels and (ii) collusive models. We will first discuss the non-collusive models and thenthe collusive models. The non-collusive models of oligopoly explain the price and outputdetermination in a market structure in which oligopolists recognize their interdependence.Chamberlin’s non-collusive model of oligopoly, i.e., ‘small group’ model, is considered amajor contribution to the theory of oligopoly. Another famous model of this category isSweezy’s kinked demand curve model.

I. Non-Collusive Models of Oligopoly

(a) Chamberlin’s Model of Oligopoly: The ‘Small Group’ Model: The classicalmodels of duopoly assumed independent action by the rival firms in their attemptto maximize their profits. Chamberlin rejected the assumption of independentaction by the competing firms. He developed his own model of oligopoly assuminginterdependence between the competitors. He argued that firms do not actindependently. They do recognize their mutual interdependence. Firms are not as‘stupid’ as assumed in the models of Cournot, Edgeworth and Bertrand. In hisown words, ‘When a move by one seller evidently forces the other to make acounter-move, he is very stupidly refusing to look further than his nose if heproceeds on the assumption that it will not.’34 Chamberlin suggests that eachseller seeking to maximize his profit reflects well and looks into the consequencesof his move.35 The total consequence of a seller’s move consists of both its directand indirect effects. The direct effects are those which results from a seller’sown action, rival sellers not reacting to his action. The indirect effects are thosewhich result from the reaction of the rival sellers to the moves made by a seller.

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Chamberlin suggests in his model that, if rival firms are assumed to recognizetheir interdependence and act accordingly, a stable equilibrium can be reachedwhere each firm charges monopoly price. When all firms are in equilibrium, industryprofit is maximized. Chamberlin’s oligopoly model of ‘small group’ can be bestunderstood if presented in the framework of Cournot’s duopoly model sinceChamberlin follows Cournot to develop his own model.

Cournot’s model is reproduced in Fig. 5.21, except the ordinate JK. Assumingthere are two firms, A and B, let A first enter the market as a monopolist. Followingthe profit maximization rule, firm A will produce OQ and charge monopoly priceOP2 (= PQ). When firm B enters the market, it considers that PM is its demandcurve. Under Cournot’s assumption, firm B will sell output QN at price OP1. As aresult, market price falls from OP2 to OP1. It is now A’s turn to appraise thesituation. At this point, Chamberlin deviates from Cournot’s model. According toCournot’s model, firm A does not recognize their interdependence and actsindependently. Chamberlin, however, assumes that firm A does recognize theinterdependence between them and it does recognize the fact that B will react toits decisions. Therefore, firm A decides to compromise with the existence of firmB, and decides to reduce its output to OK which is half of the monopoly output,OQ. Its output OK equals B’s output QN (= KQ). In its turn, firm B also recognizestheir interdependence. It realizes that KQ is the most profitable output for it.Thus, the industry output is OQ which is the same as monopoly output, and marketprice is OP2 (= PQ) which equals monopoly price. Thus, according to Chamberlin,by recognizing their interdependence, the firms reach an equilibrium which is thesame as monopoly equilibrium and share the market equally. One of the firmssupplies OK and the other supplies KQ where OK + KQ = OQ, the profitmaximising monopoly output. This equilibrium is stable because under the conditionof interdependence, firms do not gain by changing their price and output.

Chamberlin’s model is regarded as an improvement over the earlier models,at least in respect of its behavioural assumption of interdependence. His modelhas, however, been criticised on the grounds that his idea of joint profit maximizationis beset with problems of estimating demand and cost functions. Unless demandand cost functions are fully known to the competitors, joint profit maximization isdoubtful.

Fig. 5.21 Chamberlin’s Model of Stable Oligopoly Equilibrium

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(b) Sweezy’s Kinked-Demand Curve Model of Oligopoly: The origin of kinked-demand curve can be traced in Chamberlin’s theory of monopolistic competition.Later, Hall and Hitch36 used kinked-demand curve to explain rigidity of prices inoligopolistic market. However, neither Chamberlin nor Hall and Hitch used kinked-demand curve as a tool of analysis in their respective theories. It was Paul M.Sweezy37 who used the kinked-demand curve in his model of price stability inoligopolistic market.

The kinked-demand curve model developed by Paul M. Sweezy has featurescommon to most oligopoly pricing models. This is the best known model to explainrelatively more satisfactorily the behaviour of the oligopolistic firms. The kinked-demand curve analysis does not deal with price and output determination. Instead,it seeks to establish that once a price-quantity combination is determined, anoligopoly firm will not find it profitable to change its price even in response to thesmall changes in the cost of production. The logic behind this proposition is asfollows. An oligopoly firm believes that if it reduces the price of its product, therival firms would follow and neutralize the expected gain from price reduction.But, if it raises the price, the firms would either maintain their prices or evenindulge in price-cutting, so that the price-raising firms stand to lose, at least, a partof its market share. This behaviour is true for all the firms. The oligopoly firmswould, therefore, find it more desirable to maintain the prevailing price and output.

To look more closely at the kinked-demand curve analysis, let us look intothe possible actions and reactions of the rival firms to the price changes made byone of the firms.

There are three possible ways in which rival firms may react to change inprice by one of the firms: (i) the rival firms follow the price changes, both cut andhike; (ii) the rival firms do not follow the price changes; (iii) rival firms do notreact to price-hikes but they do follow the price-cutting. If rival firms react inmanners (i) an oligopoly firm taking lead in changing prices will face demandcurve dd´ in Fig. 5.22. If rival firms react in manner (ii), the firm faces demandcurve DD´. The demand curve dd′ which is based on reaction (i) is less elasticthan the demand curve DD′ which is based on reaction (ii). Demand curve dd′ isless elastic because changes in demand in response to changes in price arerestrained by the counter-moves by the rival firms.

Fig. 5.22 Kinked-demand Analysis

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Given the two demand curves, let point P represent the equilibrium price-quantitycombination of an oligopolist. Let us now introduce reaction (iii), i.e., rival firms followthe oligopolist leading in price-cutting when he reduces his price but do not follow himwhen he increases his price. This asymmetrical behaviour of the rival firms makes onlya part of each of the two demand curves relevant for the oligopolist. This can be establishedby allowing an oligopolist to alternatively increase and decrease his price. If an oligopolistincreases his price and his rivals do not follow him, he loses a part of his market to hisrivals. The demand for his product decreases considerably indicating a greater elasticity.The oligopolist is, therefore, forced down from demand curve dP to DP. Thus, therelevant segment of demand curve for the oligopolist is DP.

On the other hand, if an oligopolist decreases his price, the rival firms, react bycutting down their prices by an equal amount or even more. This counter move by thecompetitors prevents the oligopolist from taking full advantage of price-cut along thedemand curve DD′. Therefore, his demand curve below point P rotates down. Thus, therelevant segment of demand curve for the oligopolist (below point P) is Pd′. If the tworelevant segments of the two demand curves are put together, the relevant demandcurve for the oligopolist is DPd′ which has a kink at point P. Therefore, it is called a‘Kinked-demand curve’.

Consider now the relationship between AR (=D) and MR. We know thatMR = AR–AR/e. The MR curve, drawn on the basis of this relationship, will take ashape as shown by DJKL in Fig. 5.22. It is discontinuous between point J and K, atoutput OQ. Suppose that the original marginal cost curve resembles MC1 which intersectsMR at point K. Since at output OQ, the necessary condition of maximum profit(MR = MC) is satisfied, the oligopolist is earning maximum profit. Now, if marginal costcurve shifts upwards to MC2 or to any level between points J and K, his profit would notbe affected. Therefore, he has no motivation for increasing or decreasing his price. It isalways beneficial to stick to the price and output. Thus, both price and output are stable.

The oligopolists will think of changing their price and output only if MC risesbeyond point J or decreases below point K (Fig. 5.22). But, even if it so happens, priceand output would tend to stabilize. Suppose that the general level of costs rises for theindustry so that MC moves above point J. The oligopolists will ultimately find it profitableto raise the price. When one of the oligopolists raises his price, his competitors match theprice increase. As a result, the kinked-demand curve shifts upward to a new positionand the point of kink shifts rightward and horizontally. Again, at the new price there is noincentive for any oligopolist to raise his price. Therefore, price tends to stabilize.

Alternatively, if MC moves down below point K, firms get incentive to reducetheir price. When one firm cuts its price, others follow with matching price-reduction.There is a possibility of competitors reducing their prices by a greater margin. The onlyway to prevent this situation is that the oligopolist must keep his costs as low as possible,at least lower than that of his competitors. This is the reason why there is keentechnological competition in an oligopolistic market. In other words, there is incentive foroligopoly finds to use new and efficient technique of production, to introduce new products,to make innovations, to increase their productivity or to reduce their cost of production tothe possible minimum. They find it safe to concentrate on efficiency rather than toindulge in price-war.

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Some Implications of Sweezy’s Model

According to Sweezy, his model for price stability in an oligopolistic market has thefollowing implications:

First, since elasticity of the demand curve below point P is assumed to be lessthan unity and MR beyond a point is negative, the conditions of short-run equilibrium arenot precise. That is, profit maximization rule, MC= MR, cannot be applied to the short-run conditions.

Second, since MC can shift up and down between the finite points J and K (Fig.5.21), MR remaining the same, his model deviates from the marginal productivity theory,i.e., factor prices do not equal their marginal revenue productivity.

Third, any short-term disturbance in MC will not affect the equilibrium price oroutput and the total profits. Thus, the general belief that a successful strike by the tradeunions reduces profits gets little theoretical support from Sweezy’s model.

Criticism

The major criticism against this model is that it explains only the stabilization of outputand price. It does not tell, why and how the initial price is fixed at a certain level. TheSweezy’s thesis must therefore be regarded as an ex-post rationalization rather than asan ex-ante explanation of market equilibrium.38

Besides, Sweezy’s claim of price stability does not stand the test of empiricalverification: there is a surprising lack of price rigidity. Monopoly prices have been foundmore stable than oligopoly prices. However, economists are divided on the issue of pricerigidity. While Stigler39 doubts the existence of kinked-demand curve and price rigidity,40

Liebhafsky41 finds considerable evidence of price rigidity in the US. Cohen and Cyertargue that kink in the demand curve and price rigidity may exist for a brief period forlack of inter-firm information, particularly when new and unknown rivals enter the market.They are of the opinion that kink is clearly not a stable long-run equilibrium.42

IV. Collusive Models of Oligopoly

From the non-collusive models, we now turn to the collusive models of the oligopolytheory. In the non-collusive models, oligopoly firms are assumed to act independently. Inthe collusive models, however, firms are assumed to act in unison, i.e., in collusion withone another. This assumption is based on empirical facts, rather than being conjectural.

Why Collusion?

There are at least three major factors which bring collusion between the oligopolisticfirms. First, collusion reduces the degree of competition between the firms and helpsthem act monopolistically in their effort of profit maximization. Second, collusion reducesthe oligopolistic uncertainty surrounding the market since cartel members are not supposedto act independently and in the manner that is detrimental to the interest of other firms.Third, collusion forms a kind of barrier to the entry of new firms.

Collusion between oligopoly firms may take many forms depending on their relativestrength, their objective and legal status of collusion.43 There are, however, two maintypes of collusion (a) Cartels; and (b) Price leadership.

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(a) Cartels under Oligopoly

A cartel is a formal organization of the oligopoly firms in an industry. Cartels are theperfect form of collusion. A general purpose of cartels is to centralize certain managerialdecisions and functions of individual firm in the industry with a view to promoting commonbenefits. Cartels may be in the form of open collusion or secret collusion. Whetheropen or secret, cartel agreements are explicit and formal in the sense that agreementsare enforceable on member firms trying to pursue an independent pricing policy. Cartelsare therefore regarded as the perfect form of collusion. Cartels and cartel type agreementsbetween the firms in manufacturing and trade are illegal in most countries. Yet, cartels inthe broader sense of the term exist in the form of trade associations, professionalorganizations and the like.

A cartel performs a variety of services for its members. The two typical servicesof central importance are (i) fixing price for joint maximization of industry profits; and(ii) market-sharing between it members.

Cartels and Profit Maximization

Let us suppose that a group of firms producing a homogeneous commodity forms acartel aiming at joint profit maximization. The firms appoint a central management boardwith powers to decide the following aspects:

(i) the total quantity to be produced;(ii) the price at which the product has to be sold; and(iii) share of each firm in the total output.

The central management board is provided with cost figures of individual firms.Besides, it is supposed to obtain the necessary data required to formulate the marketdemand (AR) curve. The management board calculates the marginal cost (MC) andmarginal revenue (MR) for the industry. Furthermore, the management board holds theposition of a multiplant monopoly. It determines the price and output for each firm in themanner a multiplant monopoly determines the price and output for each plant.

The model of price and output determination for each is presented in Fig. 5.23. Itis assumed for the sake of convenience that there are only two firms, A and B, in thecartel. Their respective cost curves are given in the first two panels of Fig. 5.23. In thethird panel, the AR and MR curves represent the revenue conditions of the industry.The MC curve is the summation of MC curves of the individual firms. The MC and MRintersect at point C determining the industry output at OQ. The market price is determinedat PQ. The industry output OQ is so allocated between firms A and B that for each ofthem MC = MR. The share of each firm in the industry output, OQ, can be determinedby drawing a line from point C and parallel to X-axis through MC2 and MC1. The pointsof intersection C1 and C2 determine the level of output for firms A and B, respectively.Thus, the share of each of the two firms A and B, is determined at Oq1 and Oq2,respectively, where Oq1 + Oq2 = OQ. Their respective profit can be computed as (Pm –firm’s ac) × firm’s output, which is maximum. The total profit of each firm may bedifferent. But there is no motivation for changing price-quantity combination, since theirindividual profit is maximum.

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Fig. 5.23 Price and Output Determination under Cartel

Critical Appraisal

Although monopoly solution to joint profit maximization by cartels looks theoreticallysound, William Fellner gives the following reasons why joint profits may not be maximized.

First, it is difficult to estimate market demand curve accurately since each firmthinks that the demand for its own product is more elastic than the market demand curvebecause its product is a perfect substitute for the product of other firms.

Second, similarly an accurate estimation of industry’s MC curve is highlyimprobable for lack of adequate and correct cost data. If industry’s MC is incorrectlyestimated, industry output can be only incorrectly determined. Hence, joint profitmaximization is doubtful.

Third, cartel negotiations take a long time. During the period of negotiation, thecomposition of the industry and its cost structure may change. This may render theestimates irrelevant, even if they are correct. Besides, if the number of firms increasebeyond 20 or so, cartel formation becomes difficult, or even if it is formed, it soon breaksdown.

Fourth, there are ‘chiselers’ who have a strong temptation to give secretconcessions to their customers. This tendency in the members reduces the prospect ofjoint profit maximization.

Fifth, if cartel price, like monopoly price, is very high, it may invite governmentattention and interference. For the fear of government interference, members may notcharge the cartel price.

Sixth, another reason for not charging the cartel price is the fear of entry of newfirms. The high cartel price which yields monopoly profit may attract new firms to theindustry. To prevent the entry of new firms, some firms may decide on their own not tocharge the cartel price.

Finally, another reason for not charging the cartel price is the desire to build apublic image or good reputation. Some firms may, to this end, decide to charge only a fairprice and realize only a fair profit.

Cartel and Market Sharing

The market-sharing cartels are more common because this kind of collusion permits aconsiderable degree of freedom in respect of style of the product, advertising and otherselling activities. There are two main methods of market allocations: (i) non-pricecompetition, and (ii) quota system.

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(i) Non-price Competition

The non-price competition agreements are usually associated with loose cartels. Underthis kind of arrangement between the firms, a uniform price is fixed and each firm isallowed to sell as much as it can at the cartel price. The only requirement is that firmsare not allowed to reduce the price below the cartel price.

The cartel price is a bargain price. While low-cost firms press for a low price, thehigh-cost firms press for a higher price. But the cartel price is so fixed by mutual consentthat all member firms are able to make some profits. But the firms are allowed tocompete with one another in the market on a non-price basis, i.e., they are allowed tochange the style of their product, innovate new designs, and to promote their sales byadvertising.

Whether this arrangement works or breaks down depends on the cost conditionsof the individual firms. If some firms expect to increase their profits by violating theprice agreements, they will indulge in cheating by charging lower price. This may lead toa price-war and cartel may break-down.

(ii) Quota System

The second method of market-sharing is quota system. Under this system, the cartelfixes a quota of market-share for each firm. There is no uniform principle for fixingquota. In practice, however, the main considerations are: (i) bargaining ability of a firmand its relative importance in the industry, (ii) the relative sales of the firms in pre-cartelperiod, and (iii) production capacity of the firm. The choice of base period depends onthe bargaining ability of the firm.

Another popular basis of market-sharing is the geographical division of market.Examples of this kind of market-sharing are mostly found in the case of internationalmarkets.

Unequal Quota for Unequal Firms. Fixation of quota is a difficult proposition.Nevertheless, some theoretical guidelines for market-sharing have been suggested bythe economists: (i) unequal quota for unequal firms, i.e., firms with different cost curves,and (ii) equal quota for equal firms—firms with identical cost and revenue curves.

A reasonable criterion of ideal market-sharing can be to share the total marketbetween the cartel members in such proportions that the industry’s marginal cost equalsthe marginal cost of individual firms. This criterion is illustrated in Fig. 5.24. The profitmaximizing output of the industry is OQ. The industry output OQ is shared between thetwo firms A and B, as Oq1 and Oq2, respectively. Note that OQ = Oq1 + Oq2. At outputOq1, mc of firm A equals industry’s marginal cost, MC, and at output Oq2, mc of firm Bequals MC. Thus, under quota system, the quota for firms A and B may be fixed as Oq1and Oq2, respectively. Given the quota allocation, the firm may set different prices fortheir product depending on the position and elasticity of their individual demand curves.This criterion is identical to the one adopted by a multiplant monopolist in the short-run,to allocate the total output between the plants.

Equal Quota for Equal Firms. Another reasonable criterion for market-sharingunder quota system is equal market-share for equal firms. This criterion is applicablewhere all have identical cost and revenue curves. This criterion also leads to a monopolysolution. It also resembles Chamberlin’s duopoly model.

To illustrate the quota allocation, let us assume that there are only two firms, Aand B. Their AR, MR and MC curves are given as shown in Fig. 5.24(a) and (b). The

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market revenue and cost curves, which are obtained by adding up individual revenueand cost curves, respectively, are presented in part (c) of the figure. The industry outputis determined at OQM. The quota for each firm, which maximizes their profits, is sodetermined that OQM = OQA + OQB. Given the identical cost and revenue conditions,OQA = OQB. That is, market is divided equally between firms A and B. This result canbe obtained also by drawing an ordinate from point R where price line (PM) intersectsthe MR.

Fig. 5.24 Quota Allocation under Cartel Agreements

It may be mentioned at the end that cartels do not necessarily create the conditionsfor price stability in an oligopolistic market. Most cartels are loose. Cartel agreementsare generally not binding on the members. Cartels do not prevent the possibility of entryof new firms. On the contrary, by ensuring monopoly profits, cartels in fact createconditions which attract new firms to the industry. Besides, chiselers and free-riderscreate conditions for instability in price and output.

(b) Price Leadership Models of Oligopoly

Collusion through price leadership is another form of collusion between oligopoly firms.Price leadership is an informal position of a firm in an oligopolistic setting to lead otherfirm in fixing price of their product. This leadership may emerge spontaneously due totechnical reasons or out of tacit or explicit agreements between the firms to assignleadership role to one of them.

The spontaneous price leadership may be the result of such technical reasons assize, efficiency, economies of scale or firm’s ability to forecast market conditionsaccurately or a combination of these factors. The most typical case of price leadershipis the leading role played by the dominant firm, the largest firm in the industry. Thedominant firm takes lead in price changes and the smaller ones follow. Sometimes priceleadership is barometric. In the barometric price leadership, one of the firms, notnecessary the dominant one, takes lead in announcing change in price, particularly whensuch a change is due but is not affected due to uncertainty in the market.

The price leadership is possible under both product homogeneity and productdifferentiation or heterogeneity. There may be, however, price differentialscommensurating with product differentiation. Price differentials may also exist on accountof cost differentials.

Another important aspect of price leadership is that it often serves as a means toprice discipline and price stabilization. Achievement of this objective establishes aneffective price leadership. Such price leadership can, however, exist only when

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(i) number of firms is small; (ii) entry to the industry is restricted; (iii) products are, byand large, homogeneous; (iv) demand for industry is inelastic or has a very low elasticity;and (v) firms have almost similar cost curves.

The three common types of price leaderships are:(i) Price leadership by a low-cost firm;(ii) Price leadership by a dominant firm; and(iii) Barometric price-leadership.

(i) Price Leadership by a Low-cost Firm

How price and output decisions are taken under price leadership of a low-cost firm isillustrated in Fig. 5.25. Suppose all the firms face identical revenue curves as shown byAR = D and MR. But the largest firm or the low-cost firm, has its cost curves as shownby AC1 and MC1 whereas all other rival firms, smaller in size have their cost curves asshown by AC2 and MC2. The largest firm has the economies of scale and its cost ofproduction is lower than that of other firms. Given the cost and revenue conditions, thelow-cost firm would find it most profitable to fix its price at OP2(= LQ2) and sell quantity OQ2. Since at this level of output its MC = MR, its profit will bemaximum. On the other hand, the high-cost firms would be in a position to maximizetheir profit at price OP3 and quantity OQ1. However, if low-cost firms charge profitmaximizing price OP3, they would lose their customers to the low-cost firm charging alower price OP2. The high-cost firms are, therefore, forced to accept the price OP2 andrecognize the price leadership of the low-cost firm. Note that the low-cost firm caneliminate other firms and become a monopolist, by cutting its price down to OP1. Atprice OP1, the low-cost firm can sell the same quantity OQ2 and make, of course, onlynormal profit as its AC = price OP1. But, it may not do so for the fear of anti-monopolylaws.

Fig. 5.25 Price Leadership by a Low-cost Firm

(ii) Price Leadership by the Dominant Firm

Price leadership by the dominant firm is more common than by a low-cost firm. In theanalysis of price leadership by a dominant firm, it is assumed that there exists a large-size firm in the industry which supplies a large proportion of the total market. Thedominance of the large firm is indicated by the fact that it could possibly eliminate all itsrival firms by price-cutting. But then the large firm gains the status of a monopoly whichmay create legal problems. The dominant firm, therefore, compromises with the existenceof rival firms in the market. It uses its dominance to set its price so as to maximize its

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price. The smaller firms have no alternative but to accept the price set by the dominantfirm. The smaller firms recognize their position and behave just like a firm in a perfectlycompetitive market. That is, smaller firms assume that their demand curve is a straighthorizontal line.

The price leadership and market sharing between the dominant firm and the otherfirms as a group is illustrated in Fig. 5.26. Suppose that the market demand curve isgiven by DDM in part (a) of the figure. The problem confronting the dominant firm is todetermine its price and output that will maximise its profits, leaving the rest of the marketto be jointly supplied by the small firms. Now the dominant firm has to find its owndemand curve. Given the market demand curve (DDm) and joint supply curve of smallfirms (SSs), the dominant firm finds its demand curve by deducting from the marketdemand the quantity supplied jointly by the small firms below the equilibrium price. Thepart of the market demand not supplied by the small firms will be its own share. Thus,the market share of the dominant firm equals the market demand less the share of smallfirms.

Suppose, for example, equilibrium price is set at OP3, the total supply by thesmaller firms is P3E which equals the market demand. Therefore, at price OP3, themarket left for the dominant firm is zero. When price is market demand is outof which is supplied by smaller firms. The market unsupplied by the smaller firms isAB. Thus, at price the demand for dominant firm’s product equals:

− =

Similarly, when price is reduced to OP2, the demand for dominant firm’s productis CF. Following this process, the market-share of the dominant firm at other prices canbe easily obtained.

The information so derived and plotted graphically gives P3DL as the demandcurve for the dominant form [Fig. 5.26(b)]. Since the relation between AR and MR isknown, the MR curve for the dominant firm can be derived as MRL [Fig. 5.26(b)]. If theMC curve of the dominant firm is assumed to be given as MCL, its profit maximizingoutput will be OQL and price = PQL.

Once the dominant firm sets its price at the market demand curve for thesmall firms is the horizontal straight line because they can sell, at this price, as muchas they can produce. But, in order to maximize their joint profits, small firms will produceonly Recall that given the price, the line is the same as their AR = MR line andtheir supply curve P1SS, intersects AR = MR at point A. For small firms, therefore,profit-maximizing output is

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(a) Small Firms (b) Dominant Firm

Fig. 5.26 Price Determination by the Dominant Firm

Finally, the dominant firm sets its price at which is accepted by the smallfirms. Thus, the dominant firm plays the role of a price leader. If it wants to eliminate thesmall firm, it may set its price at OP1 (though at a loss in the short run) at which smallfirms would not be able to survive. But, for the legal reason already mentioned, thedominant oligopoly firm would not do so. It would prefer, and be content, with its positionof a price leader.

(iii) Barometric Price Leadership

Another form of price leadership is barometric price leadership. In this form of priceleadership, a firm initiates well publicised changes in price that are generally followed bythe rival firms in the industry. The price leader may not necessarily be the largest firm ofthe industry. The barometric firm is, however, supposed to have a better knowledge ofprevailing market conditions and has an ability to predict the market conditions moreprecisely than any of its competitors. This qualification of the barometric firm shouldhave been established in the past. Price decisions by a firm having the qualifications ofprice leadership is regarded as a barometer which reflects the changes in businessconditions and environment of the industry. The price changes announced by the barometricfirm serves as a barometer of changes in demand and supply conditions in the market.

The barometric leadership evolves for various reasons of which the major onesare the following.

First, the rivalry between the larger firms may lead to cut-throat competition tothe disadvantage of all the firms. On the other hand, rivalry between the larger firmsmay make them unacceptable as a leader. So a firm which has better predictive abilityemerges as price leader.

Second, most firms in the industry may have neither the capacity nor the desireto make continuous calculations of cost, demand and supply conditions. Therefore, theyfind it advantageous to accept the price changes made by a firm which has a provenability to make reasonably good forecasts.

Third, Kaplan44 et. al. state that barometric price leadership often develops as areaction to a long economic warfare in which all the firms are losers.

Critical Appraisal of the Price Leadership Model

The price leadership model, yields a stable solution to the problem of oligopoly pricingand output determination, only if small firms faithfully follow the leader, i.e., small firms

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produce a right quantity and charge the price set by the dominant firm. Besides, themodel requires that the dominant firm should be both a large and low-cost firm. For, if afirm does not enjoy the advantages of being large enough and, consequent upon it, theadvantages of its low cost, it cannot act as a price leader.

In practice, however, one finds many cases of price leadership by a firm which isneither a large nor a low-cost firm. But such cases are found mostly under recessionaryconditions when a relatively smaller firm reduces its price to survive in the market.

Furthermore, if a leading firm loses its cost advantages, it also loses its leadership.Such cases are frequent in the real business world. Leadership also changes followingthe innovations of products and techniques of production by the smaller firms.

Besides, where there are many large firms of equal size and have some costadvantage, price leadership of any firm or group of firms becomes less probable,particularly when number of small firms is smaller than that of large firms. Under suchconditions, barometric leadership emerges.

Lastly, it is assumed that entry of new firms is prevented either by low-cost or byinitial high cost. In practice, however, many firms having the capacity to diversify theirproducts enter the industry with relatively initial low-cost.

For these reasons, leadership model is not a realistic one as it is based on unrealisticassumptions. For the same reasons, the solution given by leadership model may not bestable.

Concluding Remarks on Oligopoly Models

Most oligopoly models concentrate on price competition. In reality, however, as it isobvious from the above discussion that oligopolists may be reluctant to wage price-warand encroach upon each other’s market-share. It means that there is an absence ofprice-competition in the oligopolistic market structure. The absence of price-competitionshould not mean the absence of competition among oligopoly firms. In fact, the competitionamong oligopoly firms takes the form of non-price competition. The forms of non-price competition are diverse. Yet, there are two most important methods of non-pricecompetition.

First, non-price competition involves product differentiation which is intendedto attract new customers by creating preference for the new design and variety ofproduct.

Second, perhaps the most important technique of non-price competition isadvertisement. The primary objective of advertising is to make the demand curve forthe product shift upward. The sellers try to encroach on the markets of other sellersthrough advertising. Advertising is also necessary to retain the market-share if there istough competition between the firms.

5.4.4 Game Theory Approach to Oligopoly

We have discussed in this unit so far the classical non-collusive models of oligopoly firmsand collusive models, i.e., price and output determination under cartel system. Theconclusion that emerges from the classical models is that none of the models discussedso far explains satisfactorily the actions and reactions of oligopoly firms and price andoutput determination in an oligopoly market. However, the search for a reasonableexplanation of the behaviour of the oligopoly firms does not end here. The classicaltheories show, in fact, only the beginning of the effort to analyse firms’ behaviour in an

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oligopoly market. In recent years, economists have attempted to use a mathematicaltechnique called game theory to explain the collusion among the oligopoly firms. Thegame theory approach was developed45 in 1944 by a mathematician John von Neumann(1903–57), and an economist Oscar Margenstern (1902–77). In recent times, the gametheory approach is regarded as ‘economists’ most widely used approach to analyseoligopoly behaviour’.46

The game theory approach uses the apparatus of game theory—a mathematicaltechnique—to show how oligopoly firms play their game of business. The game theoryapproach uses two fundamental tools—strategic actions by the firms and pay-offmatrix of their actions—to find the optimum solution. As already mentioned, the firstsystematic attempt was made in this field by von Neumann and Margenstern. Thoughtheir work was followed by many others, Martin Shubik47 is regarded as the ‘mostprominent proponent of the game-theory approach’ who seems to believe that the onlyhope for the development of a general theory of oligopoly is the games theory.48 Thoughhis hope does not seem to be borne out by further attempts in this area, the usefulness ofgame theory in revealing the intricate behavioural pattern of the oligopoly firms cannotbe denied. Here, we present an elementary description of the game theory as applied tooligopoly.49 We will first illustrate the nature of the problem faced by the oligopoly firmsin their strategy formulation.

Nature of the Problem: Prisoners’ Dilemma

The nature of the problem faced by the oligopoly firms is best explained by the Prisoners’Dilemma Game. To illustrate prisoners’ dilemma, let us suppose that there are twopersons, A and B who are partners in a case of kidnapping for ransom. On a tip-off, theCBI arrests A and B on suspicion of their involvement in kidnapping a person. They arearrested and lodged in separate jails with no possibility of communication between them.They are being interrogated separately by the CBI officials with following conditionsdisclosed to them in isolation.

1. If you confess your involvement in kidnapping, you will get a five-yearimprisonment.

2. If you deny your involvement and your partner denies too, you will be set free forlack of evidence.

3. If one of you confesses and turns approver, and other does not, then one whoconfesses gets a two-year imprisonment, and one who does not confess getsten-year imprisonment.Given these conditions, each suspect has two options open to him: (i) to confess,

and (ii) not to confess. Now, both A and B face a dilemma on how to decide whether ornot to confess. While taking a decision, both have a common objective, i.e., to minimizethe period of imprisonment. Given this objective, the option is quite simple that both ofthem deny their involvement in kidnapping. But, there is no certainty that if one denies,the other will also deny: the other may confess and turn approver, with this uncertainty,the dilemma in making a choice still remains. If A denies, for example, his involvement,and B confesses (settles for a two-year imprisonment), then A gets a ten-year jail term.So is the case with B. If they both confess, then they get a five-year jail term each. Thenwhat to do? That is the dilemma. The nature of their problem of decision-making isillustrated in the Table 5.3 in the form of a ‘pay-off matrix’. The pay-off matrix showsthe pay-offs of their different options in terms of the number of years in jail.

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Given the conditions, it is quite likely that both the suspects may opt for ‘confession’,because neither A knows what AR will do nor B knows what A will do. When they bothconfess, each gets a 5-year jail term. This is the second best option. For his decision toconfess, A might formulate his strategy in the following manner. He argues to himself: IfI confess (though I am innocent), I will get a maximum of five years’ imprisonment. But,if I deny (which I must) and B confesses and turns approver, I will get ten years’imprisonment. And, that will be the worst of the worst. It is quite likely that suspect Balso reasons out in the same manner, even if he too is innocent. If they both confess,they would avoid 10 year’s imprisonment, the maximum possible jail sentence under thelaw. This is the best they could achieve under the given conditions.

Table 5.3 Prisoner’s Dilemma

Relevance of Prisoners’ Dilemma to Oligopoly

The prisoners’ dilemma illustrates the nature of problems oligopoly firms are confrontedwith in the formulation of their business strategy with respect to strategic advertising,price-cutting and cheating in case of a cartel. Look at the nature of problems an oligopolyfirm is confronted with when it plans to increase its advertisement expenditure (ad-expenditure for short). The basic issue is whether or not to increase the ad-expenditure.If the answer is ‘do not increase’, then the questions are: will the rival firms increase ad-expenditure or will they not? And if they do, what will be the consequences for the firmunder consideration? And, if the answer is ‘increase’, then the following questions arise:what will be the reaction of the rival firms? Will they increase or will they not increasetheir ad-expenditure? What will be the pay-off if they do not and what if they do? If therival firms do increase their advertising, what will be the pay-off to the firm? Will thefirm be a net gainer or a net loser? The firm will have to find the answer to these queriesunder the conditions of uncertainty. It will have to anticipate actions, reactions andcounteraction by the rival firms and chalk out to own strategy. It is in case of suchproblems that the case of prisoners’ dilemma becomes an illustrative example.

Application of Game Theory to Oligopoly

Let us now apply the game theory to our example of ‘whether or not to increase ad-expenditure’, assuming that there are only two firms, A and B, i.e., the case of a duopoly.We know that in all the games, the players have to anticipate the move made by theopposite player(s) and formulate their own strategy to counter the different possiblemoves by the rival. To apply the game theory to the case of ‘whether or not to increasead-expenditure’ the firm needs to know or anticipate the following:

(i) Counter moves by the rival firm in response to increase in ad-expenditure by thisfirm, and

(ii) The pay-offs of this strategy when (a) the rival firm does not react, and (b) therival firm does make a counter move by increasing its ad-expenditure.

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After this data is obtained, the firm will have to decide on the best possible strategyfor playing the game and achieving its objective of, say, increasing sales and capturing alarger share of the market. The best possible strategy in game theory is called the‘dominant strategy’. A dominant strategy is one that gives optimum pay-off, no matterwhat the opponent does. Thus, the basic objective of applying the game theory is toarrive at the dominant strategy.

Table 5.4 Pay-off Matrix of the Ad-Game(Increase in sales in million Rs)

Suppose that the possible outcomes of the ad-game under the alternative movesare given in the pay-off matrix presented in Table 5.4.

As the matrix shows, if Firm A decides to increase its ad-expenditure, and Firm Bcounteracts A’s move by increasing its own ad-expenditure, Firm A’s sales go up by`20 million and that of Firm B by ̀ 10 million. And, if Firm A increases its advertisementand B does not, then Firm A’s sales gain is ̀ 30 million and there is no gain to Firm B. Onecan similarly find the pay-offs of the stategy ‘Don’t increase’ in case of both the firms.

Given the pay-off matrix, the question arises what strategy should Firm A chooseto optimize its gain from extra ad-expenditure, irrespective of counteraction by the rivalFirm B. It is clear from the pay-off matrix that Firm A will choose the strategy ofincreasing the ad-expenditure because, no matter what Firm B does, its sales increaseby at least ̀ 20 million. This is, therefore, the dominant strategy for Firm A. A bettersituation could be that when Firm A increases its expenditure on advertisement, Firm Bdoes not. In that case, Firm A’s sales could increase by ̀ 30 million and sales of Firm Bdo not increase. But there is a greater possibility that Firm B will go for counter-advertisingin anticipation of losing a part of its market to Firm A in future. Therefore, a strategybased on the assumption that Firm B will not increase its ad-expenditure involves a greatof uncertainty.

Nash Equilibrium. In the preceding description, we have used a very simpleexample to illustrate the application of game theory to an oligopolistic market setting,with the simplifying assumptions: (i) that strategy formulation is a one-time affair, (ii)that one firm initiates the competitive warfare and other firms only react; and (iii) thatthere exists a dominant strategy—a strategy which gives an optimum solution. Thereal-life situation is, however, much more complex. There is a continuous one-to-oneand tit-for-tat kind of warfare. Actions, reactions and counteractions are regularphenomena. Under these conditions, a dominant strategy is often non-existent. Toanalyse this kind of situation, John Nash,50 an American mathematician, developed atechnique, known as Nash equilibrium technique, which seeks to establish that eachfirm does the best it can, given the strategy of its competitors and a Nash equilibrium isone in which none of the players can improve their pay-off given the strategy ofthe other players. In case of our example, Nash equilibrium can be defined as one in

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which none of the firms can increase its pay-off (sales) given the strategy of the rivalfirm.

The Nash equilibrium can be illustrated by making some modifications in the pay-off matrix given in Table 5.4. Now we assume that action and counter action betweenFirms A and B is a regular phenomenon and the pay-off matrix that appears finally isgiven in Table 5.5. The only change in the modified pay-off matrix is that if neither FirmA nor Firm B increases its ad-expenditure, then pay-offs change from (15, 5) to (25, 5).

It can be seen from the pay-off matrix (Table 5.5) that Firm A has no more adominant strategy. Its optimum decision depends now on what Firm B does. If Firm Bincreases its ad-expenditure, Firm A has no option but to increase its advertisementexpenditure. And, if Firm A reinforces its advertisement, Firm B will have to follow thesuit. On the other hand, if Firm B does not increase its ad-expenditure, Firm A does thebest by increasing its ad-expenditure. Under these conditions, the conclusion that boththe firms arrive at is to increase ad-expenditure if the other firm does so, and ‘don’tincrease’, if the competitor ‘does not increase’. In the ultimate analysis, however, boththe firms will decide to increase the ad-expenditure. The reason is that if none of thefirms increases advertisement, Firm A gains more in terms of increase in its sales (`25million) and the gain of Firm B is much less (`5 million only). And, if Firm B increasesadvertisement expenditure, its sales increase by ̀ 10 million. Therefore, Firm B would dobest to increase its ad-expenditure. In that case, Firm A will have no option but toincrease its ad-expenditure, Thus, the final conclusion that emerges is that both thefirms will go for advertisement war. In that case, each firm finds that it is doing the bestgiven what the rival firm is doing. This is the Nash equilibrium.

Table 5.5 Pay-off Matrix of the Ad-Game(Increase in sales in million Rs)

However, there are situations in which there can be more than one Nash equilibrium.If we change the pay-off, for example, in the south-east corner from (25, 5) to (22, 8)each firm may find it worthless to wage advertisement war and may settle for ‘don’tincrease’ situation. Thus, there are two possible Nash equilibria.

Concluding Remarks

What we have presented here is an elementary introduction to the game theory. It canbe used to find equilibrium solution to the problems of oligopolistic market setting underdifferent assumptions regarding the behaviour of the oligopoly firms and market conditions.However, despite its merit of revealing the nature and pattern of oligopolistic warfare,game theory often fails to provide a determinate solution.51

Check Your Progress

9. What is anoligopoly?

10. According toChamberlin, whatare the effects ofsellers move?

11. How are collusivemodels differentfrom non-collusivemodels ofoligopoly?

12. How is quotadetermined underthe collusive modelof oligopoly?

13. Why is game theoryapplied tooligopoly analysis?

14. What is the essenceof the Nashequilibrium?

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5.5 SUMMARY

• Perfect competition is a market situation in which a large number of producersoffer a homogeneous product to a very large number of buyers of the product.The number of sellers is so large that each seller offers a very small fraction ofthe total supply, and therefore, has no control over the market price.

• Imperfect competition creates two different forms of markets with different numberof producers and with different degrees of competition, classified as (a)monopolistic competition, (b) oligopoly (c) monopoly.

• A perfectly competitive market is characterized by complete absence of rivalryamong the individual firms. In fact, under perfect competition as conceived by theeconomists, competition among the individual firms is so widely dispersed that itamounts to no competition.

• Under perfect competition, market price in a perfectly competitive market isdetermined by the market forces, viz., demand and supply. Here, market demandrefers to the demand for the industry as a whole.

• The term pure monopoly signifies an absolute power to produce and sell a productwhich has no close substitute. In other words, a monopoly market is one in whichthere is only one seller of a product having no close substitute. The cross-elasticityof demand for a monopolized product is either zero or negative.

• The nature of revenue curves under monopoly depends on the nature of demandcurve a monopoly firm faces. We have noted earlier that in a perfectly competitivemarket, firms face a horizontal, straight-line demand curve.

• The objective of a monopoly firm, like all other firms, is assumed to be profitmaximization. Profit maximization is, however, not necessarily the sole objectiveof the firm. The monopoly firm may seek to maximize its utility function, particularlywhere management of the firm is divorced from its ownership.

• For the purpose of price discrimination, the product or service in question may beidentical or slightly modified. Services of consulting physicians and lawyers, forexample, are identical. The services of railways, roadways and entertainmentshows may be slightly modified by providing more comfortable seats for the purposeof price discrimination.

• The existence of monopolies in a market economy is criticised on the groundsthat they restrict production and consumption, widen income and wealth disparities,exploit consumers and employees, cause distortions in allocation of resources,reduce the prospect of employment, and cause loss of social welfare.

• When there are only two sellers of a product, there exists duopoly, a special caseof oligopoly. Duopoly is a special case in the sense that it is the limiting case ofoligopoly as there must be at least two sellers to make the market oligopolistic innature.

• A cartel is a formal organization of the oligopoly firms in an industry. Cartels arethe perfect form of collusion. A general purpose of cartels is to centralize certainmanagerial decisions and functions of individual firm in the industry with a view topromoting common benefits.

• Collusion through price leadership is another form of collusion between oligopolyfirms. Price leadership is an informal position of a firm in an oligopolistic setting to

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lead other firm in fixing price of their product. This leadership may emergespontaneously due to technical reasons or out of tacit or explicit agreementsbetween the firms to assign leadership role to one of them.

• The game theory approach uses the apparatus of game theory—a mathematicaltechnique—to show how oligopoly firms play their game of business. The gametheory approach uses two fundamental tools—strategic actions by the firms andpay-off matrix of their actions—to find the optimum solution.

5.6 KEY TERMS

• Market structure: It refers to the organizational features of an industry thatinfluence the firm’s behaviour in its choice of price and output.

• Perfect competition: It is a market situation in which a large number of producersoffer a homogeneous product to a very large number of buyers of the product.

• Imperfect competition: It refers to the condition when a number of firms sellidentical or differentiated products with some control over the price of their product.

• Monopolistic competition: It is a kind of market in which a large number offirms supply differentiated products.

• Oligopoly: It is an organizational structure of an industry in which a small numberof firms supply the entire market, each seller having a considerable market shareand control over the price.

• Monopoly: It is the market of a single seller with control over his price andoutput. Monopoly is antithesis of perfect competition.

• Pure competition: Perfect competition, less perfect mobility and knowledge ispure competition.

• Market demand: It refers to the demand for the industry as a whole. It is equalto the sum of the quantity demanded by the individuals at different prices.

• Market supply: It is the sum of quantity supplied by the individual firms in theindustry at a given price.

• Market period or very short-run: It refers to a time period in which quantitysupplied is absolutely fixed or, in other words, supply response to change in priceis nil.

• Pure monopoly: It means the absolute power to produce and sell a commoditywhich has no close substitute.

• Franchise monopolies: Monopolies which are intended to reduce cost ofproduction to the minimum by enlarging the size and investing in technologicalinnovations are known as franchise monopolies.

• Price discrimination: When the same (or slightly differentiated) product is soldat different prices to different consumers, it is called price discrimination.

• Discriminatory monopoly: When a monopolist sells the same product at differentprices to different buyers, the monopoly is called a discriminatory monopoly.

• Cartel: It is a formal organization of the oligopoly firms in an industry. Cartelsare the perfect form of collusion.

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• Price leadership: It is an informal position of a firm in an oligopolistic setting tolead other firm in fixing price of their product.


1. Perfect competition is a market situation in which a large number of producersoffer a homogeneous product to a very large number of buyers of the product. Ina perfect competition, both buyers and sellers are price takers, not price makers.The price of a commodity is determined in this kind of market by market demandand market supply. Each firm is in competition with such a large number of firmsthat there is virtually no competition. This kind of market is more of a hypotheticalnature than a common or realistic one.

2. The three different degrees of competition created by imperfect competition are:(i) monopolistic competition (ii) oligopoly (iii) monopoly.

3. Short-run refers to a period of time during which (i) the price of the product isgiven in the market and the firm can sell any quantity at the prevailing price; (ii)plant-size of the firm is given; and (iii) the firm is faced with given short-run costcurves.

4. The important features of monopoly are:(i) There is a single seller of a product which has no close substitute.(ii) A monopoly firm is a price maker, not a price taker.(iii) Under monopoly, there is absence of supply curve.(iv) A monopoly makes a single-firm industry.

5. A monopoly firm reaches its equilibrium where it maximizes its total profits. Profitsare maximum where the two following conditions are fulfilled: (i) that MC=MR –the necessary condition; and (ii) that the MC curve must intersect the MR curvefrom below under increasing cost condition – the supplementary condition. Themonopoly firm fixes its price and output in accordance with these conditions.

6. A monopolist, simply by virtue of its monopoly power, is capable of chargingdifferent prices from different consumers or groups of consumers. When thesame (or slightly differentiated) product is sold at different prices to differentconsumers, it is called price discrimination. When a monopolist sells the sameproduct at different prices to different buyers, the monopoly is called adiscriminatory monopoly.

7. Consumers are discriminated in respect of prices on the basis of their incomes orpurchasing powers, geographical location, age, sex, the quantity they purchase,their association with the sellers, frequency of visits to the shop, the purpose ofthe use of the commodity or service, and on other grounds that the seller may findsuitable.

8. The measures of monopoly power are:(i) number-of-firms criterion(ii) concentration ratio(iii) excess profitability criteria(iv) Triffin’s cross-elasticity criterion

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9. Oligopoly is a form of market structure in which a few sellers sell differentiatedor homogeneous products. The basic characteristics of oligopoly are:

(i) intensive competition(ii) interdependence of business decisions(iii) barrier to entry

10. According to Chamberlin, the total consequence of a seller’s move consists ofboth its direct and indirect effects. The direct effects are those which result froma seller’s own action, rival sellers not reacting to his action. The indirect effectsare those which result from the reaction of the rival sellers to the moves made bya seller.

11. In the non-collusive models, oligopoly firms are assumed to act independently. Inthe collusive models, however, firms are assumed to act in unison, i.e. in collusionwith one another.

12. There is no uniform principle for fixing quota under the collusive model of oligopoly.In practice, however, the main considerations are: (i) bargaining ability of a firmand its relative importance in the industry, (ii) the relative sales of the firms in thepre-cartel period, and (iii) production capacity of the firm.

13. The classical non-collusive models of oligopoly and collusive models do notsatisfactorily explain the actions and reactions of oligopoly firms and price andoutput determination in an oligopoly market. This is why in recent years, economistshave attempted to use a mathematical technique called game theory to explainthe collusion among oligopoly firms.

14. The Nash equilibrium technique seeks to establish that each firm does the best itcan, given the strategy of its competitors. A Nash equilibrium is one in which noneof the players can improve their pay-off given the strategy of other players.



1. What are the characteristics of perfect competition? Distinguish between perfectand pure competition.

2. What is the relative position of a firm in a perfectly competitive industry? Howdoes it choose its price and output?

3. What is monopoly? What are the sources of monopoly?4. How is pricing under monopoly different from that under perfect competition?

Can a monopoly firm fix any price for its product?5. State the conditions under which price discrimination is (a) possible, and (b)

profitable.6. What is a discriminating monopoly? What are the conditions which help the

monopolist in practising price discrimination?7. Why should the government control a monopoly price? Under what conditions is

monopoly economically desirable?8. What are the characteristic features of an oligopolistic industry? How does it

differ from monopolistic competition?

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9. (a) How does the Kinked-Demand Curve model explain price rigidity underoligopoly?

(b) What are cartels? How do they attempt joint profit maximisation?10. Discuss Paul Sweezy’s kinked-demand curve model of oligopoly. Does this model

offer a reasonable explanation to price rigidity?


1. Under what market conditions a firm is a price-taker? What would happen to afirm if it becomes price-maker?

2. Discuss the importance of AR, AC, MR and MC in determining a firm’s equilibriumunder perfect competition.

3. Explain the short-run equilibrium of a competitive firm. Under what conditionswould a competitive firm close down its business in the short-run?

4. For a profit-maximising monopoly, price is greater than marginal cost and it remainsso over a large range of output. Why does then a monopolist not produce morethan where its MC = MR?

5. Unlike a firm under perfect competition, a monopolist does not have a supplycurve. Discuss.

6. ‘There is no supply curve of a monopoly firm’. Do you agree with this statement?Give reasons.

7. What is price discrimination? What are the prerequisities of price discrimination?How does a discriminating monopolist allocate his output in different markets tocharge different prices?

8. Explain how discriminating monopolist’s equilibrium price-output configurationcompares with that of a simple monopolist’s equilibrium behaviour?

9. Discuss the equilibrium of a discriminating monopolist if one of the markets isperfectly competitive.

10. How is oligopoly different from monopolistic competition? Explain pricedetermination under conditions of oligopoly.

11. Discuss the structure of market under oligopoly. What problems are posed bysuch a structure in the theory of oligopoly?

12. (a) What is meant by a kinked-demand curve?(b) Distinguish between the kinked-demand curves in the seller’s and buyer’s

market.(c) How does the existence of the kink in the demand curve affect the behaviour

of oligopolistic pricing?13. (i) Discuss the features of oligopoly market structures. What problems are posed

by such structures in the theory of oligopoly?(ii) Discuss anyone of the following models of oligopoly.

(a) Cournot’s model(b) Chamberlin’s model(c) Price leadership model

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14. Discuss the market structure under oligopoly. Explain the following models ofoligopoly:

(i) Cournot’s Model,(ii) Sweezy’s kinked-demand curve model.

15. Distinguish between the nature of the kink in the demand curve when the oligopolistis selling in (a) a buyer’s market and (b) a seller’s market.

16. Explain how price is determined under oligopoly under conditions of priceleadership.

5.9 FURTHER READING

Adhikary, M. 2000. Business Economics. New Delhi: Excel Books.Baumol, W.J. 1996. Economic Theory and Operations Analysis, 3rd edition. New

Jersey: Prentice-Hall.Chopra, O.P. 1985. Managerial Economics. New Delhi: Tata McGraw-Hill.Keat, Paul G. and Philips K.Y. Young. 1996. Managerial Economics. New Jersey:

Prentice-Hall.Kautsoyiannis, A 1991. Modern Microeconomics. NewYork: Macmillan.

Endnotes

1. Marshall, Alfred. 1920. Principles of Economics. London: Macmillan, p. 341.2. It is assumed that the firms have identical cost curves.3. Dean, Joel. 1951. Managerial Economics. New York: Prentice-Hall.4. The Theory of Monopolistic Competition. 1933. Massachussets: Harvard University

Press.5. D.S. Watson. 1967. Price Theory and its Uses, (Delhi: Calcutta Scientific Book Agency, p.

294.6. C.E. Ferguson. 1972. Microeconomic Theory, Illinois: Richard D. Irwin. p. 286.7. Proof. At price PQ, the total revenue = PQ × OQ which equals the area OBPQ. Considering

from MR angle, the total revenue at output OQ is given by the area OATQ. Thus, OBPQ =OATQ. It can be observed from Fig. 5.4 that OBHTQ is common. Therefore, area of ∆ABH= area of ∆TPH. Note that line AT is common to both the triangles and it intersects BP atpoint H. Therefore, ∆AHB = ∆THP. Note also that ∆ABH and ∆TPH are right angles.Therefore, ∆BAH = ∆PTH and therefore ∆ABH = ∆TPH. The identity of triangles ensuresthat their corresponding sides are equal. Therefore, BH = HP, AH = HT, and AB = PT.

8. Proof. Let us assume a linear demand (or price) equation as P = a – bQ, where b is slopeof demand curve (= AR). The total revenue equation will be:

TR = Q·P = Q (a – bQ) = aQ – bQ2

Since MR is equal to the first derivative of the TR equation.

MR = ∂∂ = a – 2bQ

Obviously, the slope of MR curve is – 2b against the slope of AR (= – b). Thus the rate offall in MR is double that of AR or elasticity of MR is half of AR.

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9. For example, a specific kind of labour, like electric engineers in electricity companies,TV technologists in TV manufacturing company, computer technologists and programmersin computer centres.

10. For details, see Section 5.4.11. Pigou, A.C. The Economies of Welfare, 1946, p. 27912. John Robinson calls it ‘perfect discrimination’ from a monopolist point of view.13. See Lipsey, R.G. 1979. Introduction to Positive Economics. London: Weidenfeld &

Necolson, p. 269.14. R.G. Lipsey, op. cit.15. Hunter, A. 1970. ‘Measurement of Monopoly Power,’ in Monopoly and Competition (ed.),

Penguin Books, p. 92.16. Machlup, Fritz. 1952. The Political Economy of Monopoly, Baltimore: The Johns Hopkins

Press, p. 470.17. A. Hunter, op. cit., p. 101.18. Ibid.19. Fritz Machlup, op. cit., p. 477.20. A. Hunter, op. cit., p. 102.21. Lerner, A.P. 1934. “The Concept of Monopoly and the Measure of Monopoly Power’.

Review of Economic Studies, June.22. Fritz Machlup, op. cit., p. 511.23. The term ‘oligopoly’ has been derived from Greek words, oligi meaning ‘few’ and polein

meaning ‘sellers’.24. In case there are only two sellers, there exists, duopoly, which is the limiting case of

oligopoly.25. For instance, about 80 per cent of the total cigarette production is controlled by four

foreign-owned companies, viz., India Tobacco, Godfrey Philips, Vazir Sultan and Marcopolo.26. Meyer, Robert A. 1976. Microeconomic Decisions. Boston: Houghton Mifflin Company.

p. 249.27. The month in which automobile manufacturers introduce new models.28. Cournot, Augustin. 1897. Researches into the Mathematical Principles of the Theory of

Wealth (translation by) Nathaniel T. Bacon New York: Macmillan.29. Under zero cost conditions, the total revenue is the same as the total profit.30. Note that where MR = 0, demand elasticity, e = 1, i.e., PM/PD = 1 = QM/OQ. It means PM

= PD, and QM = QQ.31. F.Y. Edgeworth, wrote his paper in 1897. Its English translation ‘The Pure Theory of

Monopoly’ was reprinted in Edgeworth: Papers Relating to Political Economy. London:Macmillan, 1925.

32. F.Y. Edgeworth, op. cit., p. 118.33. Heinrich von Stackelberg, The Theory of the Market Economy, translated by A.T. Peacock.

New York: Oxford University Press, 1952.34. Chamberlin, Edward H. 1929. Qly. Jl. of Eco. November.35. Chamberlin, Edward H. The Theory of Monopolistic Competition, 7th edition, pp. 46–47.36. Hall, R.L. and C.I. Hitch. 1939. ‘Price Theory and Business Behaviour’, Oxford Economic

Papers, pp. 12–45.37. Sweezy. Paul Mo. 1939. ‘Demand under Conditions of Oligopoly,’ Journal of Political

Economics, pp. 568–73.38. op. cit., p. 347.

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39. George J. Stigler. 1947 ‘The Kinky Oligopoly Demand Curve and Rigid Prices,’ Journal ofPolitical Economics, 55, reprinted in Readings in Price Theory, eds., George J. Stigler andKenneth E. Buolding. Illinois: Richard D. Irwin, 1952, pp. 410–39.

40. For a summary, see K. J. Cohen and R. M. Cyert. 1976. Theory of the Firm. New Delhi:Prentice-Hall of India, pp. 254–55.

41. Liebhafsky, H.H. 1963. The Nature of the Price Theory. Illinois: The Dorsey Press.42. Cohen and Cyert, op. cit., pp. 255–58.43. For a detailed classification, see Fritz Machlup, ‘The Economics of Sellers’ Competition.

Baltimore: The Johns Hopkins Press, 1952.44. A.D.H. Kaplan, Joel B. Dirlam, and Robert F. Lanzillotti, Pricing in Big Business. Washington,

D.C.: The Brooking Institution, 1958, p. 206. Quoted in Cohen and Cyret, op. cit.45. Neumann, John von and Oscar Margenstern. 1944. Theory of Games and Economic

Behaviour.46. William J. Baumol and Allen S. Blinder. 1999. Economics: Principles and Policy, 8th

edition. New York: Harcourt Brace Jovanovich, p. 260.47. See Martin Shubik. Strategy and Market Structure (John Wiley, 1959) and his Game

Theory in the Social Sciences (Cambridge, Mass: MIT Press, 1982).48. Koutsoyiannis, A. 1979. Modern Macroeconomic’s, 2nd edition. London: Macmillan, p.

404.49. For a comprehensive discussion on the game theory and its application to oligopolistic

behaviour, see James W. Friedman, Game Theory with Application to Economics (NewYork, Oxford University Press, 1990) and David Krepps, A Course in MicroeconomicTheory (N.J., Princeton University Press, 1990). For a brief discussion on and applicationof game theory to oligopoly, see Robert S. Pindyck and Daniel L. Rubinfeld, Microeconomics(Prentice-Hall of India, New Delhi, 1995), Third Edn., Unit 13, and F.M. Scherer. IndustrialMarket Structure and Economic Performance (Chicago, Rand McNally, 1980),pp. 160–64.

50. The technique of finding equilibrium where there is no ‘dominant strategy’, called ‘Nashequilibrium’ was developed by John Nash, an American Mathematician, in 1951.

51. Browning, E.K. and Browning, J.K. 1989. Microeconomic Theory and Application, 3rdedition. London: Scott, Foresman & Co., p. 413.

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Measurement of Profitand Profit Policy

NOTES

UNIT 6 MEASUREMENT OF PROFITAND PROFIT POLICY

Structure6.0 Introduction6.1 Unit Objectives6.2 The Meaning of Pure Profit6.3 Theories of Profit

6.3.1 Walker’s Theory of Profit: Profit as Rent of Ability6.3.2 Clark’s Theory of Profit: Profit as Reward for Dynamic Entrepreneurship6.3.3 Hawley’s Risk Theory of Profit: Profit as Reward for Risk-Bearing6.3.4 Knight’s Theory of Profit: Profit as a Return to Uncertainty Bearing6.3.5 Schumpeter’s Innovation Theory of Profit: Profit as Reward for Innovations


6.0 INTRODUCTION

In the long-run competitive equilibrium, the reward for each factor, including the rewardfor ‘entrepreneurship’ equals the value of its marginal product. It implies that, accordingto the marginal productivity theory, ‘profit’, which is the reward for “entrepreneurship”equals the value of its marginal product. There are however a number of other profittheories developed by various economists over time. In this unit, we will briefly reviewsome important profit theories. We will however have first a brief look into the meaningof ‘pure profit’ and the question ‘to whom belongs the pure profit’.

6.1 UNIT OBJECTIVES

After going through this unit, you will be able to:• Explain the meaning of pure profit• Discuss the various theories related to profit

6.2 THE MEANING OF PURE PROFIT

The meaning and source of ‘profit’ have always been a centre of controversy. “Theword ‘profit’ has different meanings to businessmen, accountants, tax collectors, workersand economists...”1 For example, ‘profit to a layman means all incomes that go to thecapitalist class’. To an accountant, profit means the excess of revenue over all paid-outcosts including both manufacturing and overhead expenses. For all accounting purposes,businessmen also use accountants’ definition of profit. But, on the question as to whethera businessman should stay in his present business or move to another, his concept ofprofit differs from the one used in accountancy. The term ‘profit’ in the accountingsense does not include the opportunity cost— the earning that a businessman foregoes

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to earn a given profit in his present occupation. But a businessman does consider hisopportunity cost in his calculation of his satisfactory profit that must be large enough tocover his opportunity cost. All such costs are termed as ‘opportunity costs’. Essentially,it includes all the expected incomes which he might earn from the second best alternativeuse of his own resources—labour and capital.Concept of Pure Profit. Economists’ concept of profit is of ‘pure profit’. It is alsocalled ‘economic profit’ or ‘just profit’. The word ‘profit’ in this chapter means ‘pureprofit’. ‘Pure profit’ is a return over and above opportunity cost, i.e., the payment thatwould be “necessary to draw forth the factors of production from their most remunerativealternative employment.” Pure profit may thus be defined as “a residual left over afterall contractual costs have been met, including the transfer costs of management, insurablerisks, depreciation, and payments to shareholders sufficient to maintain investment at itscurrent level.”2 In other words, pure profit equals net profit3 less opportunity costs ofmanagement, insurable risk, depreciation of capital, necessary minimum payments toshareholders than can prevent them from withdrawing their capital from its current use.The pure profit, so defined, may not be necessarily positive for a single firm in a singleyear; rather there may be negative profit (i.e., loss). What is important is the return overtime. In the long-run, in a competitive system, however, pure profit is presumed to beequal to zero. That is, pure profit is non-existent in the long-run. “To discover whethersuch profit exists, take the revenue for the firm and deduct the costs of all factors ofproduction other than capital. Then deduct the pure return on capital and any risk premiumnecessary to compensate the owner of capital for the risks associated with its use in thisfirm and industry. Anything that remains is pure profit.”4

An important question regarding ‘pure profit’ is ‘to whom does it belong and inwhat form?’ It is common knowledge that pure profit belongs to the entrepreneur, theowner of the firm. But the question arises: how does it accrue to the entrepreneur? For,if an entrepreneur is treated as a separate factor of production, pure profit must equalthe value of its marginal product. But marginal value of product cannot be logicallyequated to pure profit, because as concluded above, pure profit is a ‘residual’.5 In fact,this problem has been the source of controversy which led to various profit theories. Wenow turn to discuss the various theories of profit.

6.3 THEORIES OF PROFIT

In this section, we will discussed some important theories of profit. Profit theories reveal,in fact, only the source of profit, not the determination of profit rate.

6.3.1 Walker’s Theory of Profit: Profit as Rent of Ability

One of the most widely known theories advanced to explain the nature of profit wasformulated by F.A. Walker. According to him, profit is rent of the exceptional abilitiesthat an entrepreneur may possess over the least entrepreneur. Just as rent on land is thedifference between the yields of the least fertile and super lands, pure profit is thedifference between the receipts of the least efficient entrepreneur and that of those withgreater efficiency or managerial ability.Assumptions. In formulating his profit theory, Walker visualized a state of perfectcompetition in which all firms (or entrepreneurs) are presumed to possess equal managerialability or entrepreneurship. There being no barrier to prevent the entry of new firms tothe industry, the number of firms would increase until the remuneration of each was just

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enough to keep them in the industry. Each firm would then receive only the wages ofmanagement which, in Walker’s view, formed no part of (pure) profit. He regardedwages of management as ordinary wages. Thus, under perfectly competitive conditions,there would be no pure profits and all firms would be no-profit firms.

However, when one departs from the realm of perfect competition, one finds, inalmost every economic activity, some firms making only a bare living while other firms inthe same industry are making pure profits. Walker regarded profits of profit-makingfirms arising from what a more efficient firm is able to produce over and above what theleast efficient firm i.e., able to produce with same amount of capital and labour.6 Walkerattributed this surplus wholly to the greater efficiency of a firm, which distinguishes itfrom the least efficient ones.

Thus, to Walker, profit is reward for exceptional business ability over and abovethe ordinary ability required for management of the organization which could be rewardedby a wage or salary. Just as rent is a reward for a higher productivity of land, so is theprofit reward for superior managerial ability of an entrepreneur.

A natural corollary of this view is that profit did not enter the cost of production asis the case with rent. Therefore, according to Walker, profit does not enter the pricedetermination. The logic that Walker gives for his argument runs as follows. Marketprice is determined by the cost of production of that portion of supply which is producedby the least efficient firms. Prices so determined make allowance for only wages ofmanagement not the surplus that accrues to the firms with greater efficiency.

6.3.2 Clark’s Theory of Profit: Profit as Reward for DynamicEntrepreneurship

The dynamic theory of profit is associated with the name of J.B. Clark,7 which hepropounded in 1900. According to Clark, profits accrue in a dynamic world, not in astatic world.The Static World. As visualized by Clark, a static world is one in which there existsabsolute freedom of competition; but population and capital are stationary; there are noinventions; production process does not change; and the goods continue to remainhomogeneous. Besides, in a static state there is perfect mobility of factors of productionbut there is no motion because marginal products of labour and capital are equal in allgroups of industries. Also, in a static state, there is no uncertainty and hence, no risk.Whatever risks might arise due to natural calamities are covered by insurance.No Profit in Static Society. To show how profits were eliminated in a static state,Clark draws a distinction between the work of an entrepreneur and that of a manager ofbusiness. He believed that the task of a manager could be described as labour which canbe paid for by wage.8 In a static state, profit would not arise because competition wouldnot permit any business manager to earn more than his actual wages which would beequal to marginal value of his product. Therefore, there would be no surplus availablewhich could be called as profit.The Dynamic World. In contrast to static word, dynamic world is one in which thefactors that remain constant in a static world undergo the process of change. Clarkindicated certain generic changes that mark the transition of a society from a static to adynamic state. Briefly speaking, generic changes include:

(a) Increase in population;(b) Increase in capital;

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(c) Improvement in production techniques;(d) Changes in forms of business organization; and(e) Multiplication of consumer’s wants.

Profit as Reward for Dynamic Enterprise. In Clark’s view, the major functions ofan entrepreneur in a dynamic society are related to these changes, i.e., to take theadvantage of generic changes, promote their business, expand their sales, and reducetheir cost of production. The typical changes that emerge out of this special effort ofsome entrepreneur are inventions and improvement in the methods of production. Suchchanges lead to increase in production given the costs or reduction in costs given theoutput, which results in emergence of profits to the initial inventors.Profits in Dynamic World are not There for Ever. With the passage of time,profits resulting from the inventions and improvements in production methods disappear.What happens, in fact, is that competition forces other entrepreneurs to imitate or innovatethe new technology. This leads to rise in demand for labour and capital. Consequently,wages and interest rise and cost of production increases. On the other hand, with largeremployment of labour and capital, production increases leading to fall in product prices.The ultimate result is that profits disappear. In Clark’s own words, “profit is an elusivesum which entrepreneurs grasp but cannot hold. It slips through their figures and bestowsitself on all members of the society.”Profits Disappear to Reappear. This however should not mean that, in a dynamicsociety, profits arise only once and disappear never to emerge again. In fact, underdynamic conditions, the generic changes continue to take place: it is a continuous process.The process of dynamic change gives entrepreneurs opportunities time and again toadjust their business to the changing conditions, make inventions and improve productionmethods, with a view to make pure profit. In fact, emergence and disappearance ofprofits is a continuous process.

On the question of risk involved in making inventions and improving productionmethods, Clark was of the view that profit docs not arise due to risk. If risk is there, itaffects capitalists because risk-income accrues to them. Profit, on the other hand, is theresult of entrepreneurial functions under dynamic conditions. Therefore, profit does notresult from risk-bearings.

To sum up, according to J.B. Clark, profit is a reward for coordinating managerialfunctions of entrepreneurs under dynamic conditions. It is a reward for dynamism. It isnot a reward for risk bearing. Pure profit, according to him, is a residue that remainsafter interest and wages are paid. That is, the difference between the gross receipts andpayments for wages and interest represents profit.

Criticism of Clark’s Theory

Clark’s theory, though impressive, has failed to win unqualified acceptance and has beencriticised on the following grounds.

First, to some economists the division of firm’s earning between the wage ofmanagement and profits is not acceptable. It has been contended, for instance, that eventhe routine conduct of a business calls for a prudent judgement and administrative abilityjust as these qualities are calls for in the exploitation of a new invention or in any othermanifestation of economic change. Clark’s definition was therefore a matter of phraseologyand no clear line could be drawn to show the functions which give wages of managementand those which were remunerated by profits.

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Secondly, even if it is accepted that profits are accounted for by the coordinatingfunctions of entrepreneur, it poses special difficulties in explaining the profits in thepractical world. For instance, profits of companies are mainly paid to the shareholders.But these shareholders exercise no coordinating functions. One may say, for the sake ofargument, that shareholders receive only a fair interest on their investment and that theprofit is what remains after paying this ‘interest’. Still, this sum after deducting the‘interest’ paid to shareholders would continue to be their property, because they are theowners of retained earnings. Thus, Clark’s theory fails to explain the profits in practice.

Thirdly, the basic tenet of Clark’s theory is that profits result from change inbusiness conditions and are reward for dynamism and Clark’s entrepreneur is the pioneerof this change. But in practice, one finds that profit exists under different conditions.There are many profitable business concerns engaged in forms of activity in whichdynamic stage is long since past and in which no change takes place. In many lines ofactivity business has settled down to almost routine conditions and yet profits continue tobe made despite competition.

Fourthly, it has been argued by F.H. Knight that all changes would not give riseto profits. Certain changes are predictable and others are not. So far as predictablechanges are concerned they pose no managerial problems or uncertainty. Therefore,such changes cannot give rise to profit. Only the unpredictable changes would requirethe use of managerial talent and, hence, give rise to uncertainty. Clark’s theory thusmisses an important element of uncertainty and risk and their relation to profit.

6.3.3 Hawley’s Risk Theory of Profit: Profit as Reward for Risk-Bearing

The risk theory of profit was propounded by F.B. Hawley in 1893. Hawley regardedrisk-taking as the inevitable accompaniment of dynamic production. and those who takerisk have a sound claim to a separate reward, known as profit. Thus, according toHawley, profit is simply the price paid by society for assuming business risks. In hisopinion, businessmen would not assume risk without expecting an adequate compensationin excess of acturial value. That is, the entrepreneur would always look for a return inexcess of the expected losses. The reason why Hawley maintains that profit is over andabove the acturial risk is that the assumption of risk is irksome; it gives rise to trouble,anxiety and disutilities of various kinds, which gives a claim to reward for all these painsin excess of acturial value of risk. Profit, according to Hawley, consists of two parts:one, represents compensation for acturial or average loss incidental to the various classesof risks necessarily assumed by the entrepreneur; and second the remaining partrepresents, an inducement to suffer the problems of being exposed to the risk.

Hawley recognises that the coordination which Clark spoke of was important, buthe believes that profit is attendant upon profit only when coordination happens to be anincident of ownership; and that profit arises from ownership only so long as ownershipinvolves risk. Thus, risk has to be assumed to qualify for profit. If an entrepreneur shiftshis risks by insuring against them, he would cease to be an entrepreneur and would notreceive any profit. It is only from the uninsured risks that profits arise, and until theuncertainty ends with the sale of entrepreneur’s products, the amount of the rewardcannot be determined. Profit, therefore, is a residue. Hawley’s theory is also called as aresidual theory of profit.

Hawley was conscious that his theory did not offer a full explanation of all thegains arising from business activities. In monopoly undertakings, for example, many a

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time profit could not be attributed to the risks which were undertaken: profits in monopolyfirms arise from the very fact of not undertaking the risks. Thus, monopoly gains falloutside his theory. To meet this flaw he placed monopoly gains in a distinct, separatecategory of business gains which might arise to other factors also. According to hisview, monopoly gains could occur also to labour, landlords, capital suppliers. But sincetheir respective incomes—wages, rent and interest—do not arise from the operation ofproductive forces, these are merely economic gains.

Criticism of Hawley’s Theory

Perhaps no other theory of profit has attracted so much attention and generated somuch discussion as Risk Theory of Profit. It ranks today as one of the most widelyaccepted theories of profits. Nevertheless, Hawley’s risk theory of profit has beencriticised on the following grounds.

First, in his reaction to risk theory of profit, Clark remarked that the profit visualisedby Hawley was nothing but an interest on capital. Risk, in Clark’s view, was risk of lossof capital. Therefore, the reward for assuming risk (of loss of capital) was interest: it isnot profit.

Secondly, it has also been argued that Hawley stressed only the risk in terms ofloss of capital: he did not give due consideration to the fact that risks arise also in the useof factors of production other than capital.

Thirdly, Hawley’s theory of profit concentrates only on risk-bearing element,and ignores other entrepreneurial functions, viz., organisation and coordination, whichalso lead to emergence of profit.

Fourthly, Hawley fails to make a distinction between predictable and unpredictablerisks. While predictable (or foreseeble) risks are insurable, unpredictable (orunforeseeable) risk are not. Since predictable risks can be insured, such risks do not giverise to profit because the risk is shifted on to the insurer. As Knight put it, it is in fact theuninsurable risk, which is uncertain and gives rise to profit. Thus, in his view, profit is areward for uncertainty bearing rather than a reward for risk-bearing.

Fifthly, Carver observed that profits are reward for avoiding risk and not forbearing risk, because only those entrepreneurs who are able to avoid risk make profits.

Finally, if profits were the reward for risk bearing, then the greater the riskundertaken, the greater the profits. But, there is no empirical support to this inferencewhich can be drawn from Hawley’s theory.

6.3.4 Knight’s Theory of Profit: Profit as a Return to UncertaintyBearing

Frank H. Knight9 treated profit as a residual return to uncertainty bearing—not to riskbearing. Obviously, Knight made a distinction between risk and uncertainty. He dividedrisks into calculable and non-calculable risks. Calculable risks are those whose probabilityof occurrence can be statistically calculated on the basis of available data, e.g., risks dueto fire, theft, accidents, etc. Such risks are insurable. There remains, however, an areaof risks in which probability of risk occurrences cannot be calculated. For instance,there may be a certain element of cost which may not be accurately calculated; and thestrategies of the competitors may not be accurately guessed. The risk element of suchincalculable events are not insurable. The area of incalculable risks is thus marked by‘uncertainty’. It is in this area of uncertainty that decision becomes a peculiar responsibility

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of an entrepreneur. If his decisions are proved right by the subsequent events, theentrepreneur makes profit, and vice versa. Obviously, profit arises from the decisionstaken and implemented under the conditions of uncertainty, as visualised by Knight. Theprofits may arise as a result of (a) decisions concerning the state of market;(b) decisions which result in increasing the degree of monopoly; (c) decisions with respectto holding stocks that give rise to windfall gains when prices increase; and (d) decisionstaken to introduce new techniques or innovations that give rise to profit.

Criticism of Knight’s Theory of Profit

Several objections have been raised against Knight’s theory of profit too.First, it has been contended that Knight’s uncertainty theory lacks scientific precision.Uncertainty is a difficult concept to handle. Tausig, for instance, has shown that thoughcertain risks are in the area of uncertainly, many are not. For example, suppose that aperson is betting in a horse race. If he has the knowledge of age, training, rearing, etc.,of different horses and their jockeys, he would be operating in the region of risk. And, ifhe does not have the knowledge about the horses and jockeys participating in the race,he would be regarded as operating in the area of uncertainty. But, if he has someknowledge about the horses and/or jockeys, it will be difficult to decide whether theperson is operating in the area of risk or in the area of uncertainty.Secondly, by considering profit as a reward exclusively for uncertainty bearing, Knighthas implicitly accorded it (uncertainty bearing) the status of a factor of production,whereas it is simply an element of real cost as distinguished from money cost. Therefore,uncertainty bearing cannot be accepted as a factor of production, and hence the solecause of profit.Thirdly, Knight’s attempt to explain profits only by ‘uncertainty’ makes his theoryunconvincing if one examines it in the light of real experience of the business world. Ifhis theory is accepted, it would mean the greater the degree of uncertainty, the greaterthe profits, and vice versa. But there are enterprises, e.g., agriculture, which are knownfor their high uncertainty and low returns.

6.3.5 Schumpeter’s Innovation Theory of Profit: Profit as Rewardfor Innovations

The Innovation Theory of Profit was developed by Joseph A. Schumpeter.10 Throughouthis life as an economist, he was preoccupied with the study of economic evaluation anddevelopment in capitalist system. He was of the opinion that issues like interest, profit,trade cycles and many others were only incidental to a distinct process of economicdevelopment: and certain principles which could explain this process would also explainthese economic variables. His theory of profit is thus embedded in his theory of economicdevelopment.The Stationary Equilibrium: The Starting Point. To explain the phenomenon ofeconomic development (and therefore of profit) Schumpeter starts from the state ofstationary equilibrium which is characterised by full equilibrium in all the spheres. Heassumes a closed, commercially organized, capitalist economy in which private property,division of labour and free competition prevail, along with constant population level.Everybody sells all his produce and insofar as be himself consumes, he is his own customer.The productive services may also be included in the same category of marketable thingswhich are sold. But anyone who wants to purchase these goods or productive servicesmust also have his own products or services to offer. Thus all goods and services are

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exchanged for one another. “Hence it follows that somewhere in the economic systema demand is, so to say, ready awaiting every supply, and nowhere in the system are therecommodities without complements...”11 It, therefore, follows that sellers of all thecommodities appear as buyers to acquire the goods. This maintains their consumptionand also productive capacity in the next period at the existing level. As a result, thereemerges, “an unchanging economic process which flows on at constant rates in timeand merely reproduces itself.”12

Profit as the Reward for Innovations. Under these conditions of stationaryequilibrium, total receipts from the business are exactly equal to the total outlay: there isno profit. Profit can be made by introducing innovations in manufacturing and methodsof supplying the goods. Innovations include:

(i) introduction of a new good or a new quality of good;(ii) introduction of a new method of production;(iii) creating or finding a new market;(iv) finding new sources of raw material; and(v) organising the industry in a different manner.

When an entrepreneur introduces an innovation, there will be a surplus over cost providedfollowing conditions are fulfilled.

1. When a new supply comes forth as a result of innovation, the price of commodityshould not fall to such an extent that it eliminates all the gains from the largerproduct.

2. The cost per unit of output with new technique should be less than that of oldermethod.

3. The increase in demand for the productive services due to innovation should notlead to such a rise in remuneration to the productive services that it pushes perunit cost of the commodity beyond the expected revenue per unit.If these conditions are fulfilled, the surplus realised will ipso facto become a net

profit.Profits Disappear Due to Imitation. The profits resulting from innovations existonly temporarily. This is so because when an entrepreneur introduces an innovation,others are likely to imitate it for its profitability. First a few and then many follow thelead, and produce the commodity in the same manner. This causes a keen competitionfor the productive services to be employed with the new techniques. Their supplyremaining the same, their remuneration tends to increase. As a result, cost of productionincreases. On the other hand, with other firms adopting the innovations, supply of goodsand services increases resulting in fall in their prices. Thus, on the one hand, cost per unitof output goes up and, on the other, revenue per unit decreases. Ultimately, a time comeswhen the difference between cost and receipt disappears. So the profit disappears. Inthe process, however, the economy reaches higher level of stationary equilibrium.

It is however quite likely that profits exist in spite of the process of profits beingwiped out. Such profits are in the nature of quasi-rent arising due to some specialcharacteristics of productive services. Furthermore, where profits arise due to factorslike patents, trusts, cartels, etc., such profits would be in the nature of monopoly revenuerather than entrepreneurial profits.

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It may be inferred from the above that profit is the child as well as victim ofeconomic development. Economic development consists of increase in national output.When innovations occur the national output increases because the same output can beproduced at lower costs, or what is the same thing, with the same amount of resourcesgreater output can be produced. But producing at lower cost or producing more outputwith the same total cost results in profits. Thus, economic development gives birth toprofits. But, when other producers also adopt the technique introduced by the innovator,the total national output increases, i.e., economic development catches pace. Thewidespread use of innovation, however, results in wiping out of profits, as was explainedearlier. Hence, economic development itself is responsible for the disappearance ofprofits.

Criticism of Innovation Theory of Profit

The major criticism against Schumpeter’s innovation theory of profit is that he ignoresthe risk and uncertainty, the two major sources of profit as shown in the traditionaltheories of profits. Although in his book Capitalism, Socialism and Democracy, headmits that innovations are made by the risk-taking entrepreneurs, he ignores uncertaintyaltogether. Besides, it has also been argued that innovation is not the only function of theentrepreneurs. As delineated in the dynamic theory of profit, entrepreneur’s functionsinclude organisational and coordinational activities also in response to the changingconditions and needs of the society.

Does Profit Enter the Cost of Production?

From the above description of profit theories, one is tempted to infer that profits do notenter the cost of production. In fact, whether profits enter the cost of production or notdepend on the concept of profit under reference. Generally two different concepts ofprofits are used in economic literature, viz., normal profit and pure profit. Before weanswer the question, let us look into these concepts of profit.

We have already described the meaning of pure profit, in the beginning of thischapter. We describe here briefly the meaning of ‘normal profit’. Normal profit is theminimum rate of return that a firm must earn to remain in the industry. In other words,normal profit equals the transfer earning. Normal profit is also referred to as thewages of management. Marshall calls it the supply price of average business ability. Theconcept of normal profit is related to the concept of long run. It refers to the long-termearning of the entrepreneurs under competitive conditions. Under competitive conditions,in the long-run, the earnings of all the entrepreneurs of an industry tends to equalise.Besides, the concept of normal profit is also related to the state of equilibrium in whichthere is no risk or uncertainty involved, nor is there any tendency of firms to enter or toleave the industry. That is, in a static equilibrium all firms earn only normal profit, or whatKnight calls, the wages of management.

Let us now return to the question whether profits enter the cost of production.When reference is made to normal profit, undoubtedly, it enters the cost of production, inthe same way as rent, interest and wages. For, normal profit is treated simply as thewages of management. But, when reference is made to pure profit, it does not enter thecost of production. Pure profit is rather a surplus over and above the cost of production.

Check Your Progress

1. How does Walkerdefine profit?

2. Why can there beno profit in thestatic world, asdefined by Clark?

3. Which theory isalso known asresidual theory ofprofit?

4. State any onecriticism ofKnight’s theory ofprofit.

5. What is one majorcriticism ofSchumpeter’stheory profit?

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6.4 SUMMARY

• ‘Pure profit’ is a return over and above opportunity cost, i.e., the payment thatwould be “necessary to draw forth the factors of production from their mostremunerative alternative employment.” Pure profit may thus be defined as “aresidual left over after all contractual costs have been met, including the transfercosts of management, insurable risks, depreciation, and payments to shareholderssufficient to maintain investment at its current level.

• One of the most widely known theories advanced to explain the nature of profitwas formulated by F.A. Walker. According to him, profit is rent of the exceptionalabilities that an entrepreneur may possess over the least entrepreneur.

• The dynamic theory of profit is associated with the name of J.B. Clark, which hepropounded in 1900. According to Clark, profits accrue in a dynamic world, not ina static world.

• The risk theory of profit was propounded by F.B. Hawley in 1893. Hawley regardedrisk-taking as the inevitable accompaniment of dynamic production and thosewho take risk have a sound claim to a separate reward, known as profit. Thus,according to Hawley, profit is simply the price paid by society for assumingbusiness risks.

• Frank H. Knight treated profit as a residual return to uncertainty bearing—not torisk bearing. Obviously, Knight made a distinction between risk and uncertainty.He divided risks into calculable and non-calculable risks.

• To explain the phenomenon of economic development (and therefore of profit)Schumpeter starts from the state of stationary equilibrium which is characterisedby full equilibrium in all the spheres.

• The profits resulting from innovations exist only temporarily. This is so becausewhen an entrepreneur introduces an innovation, others are likely to imitate it forits profitability.

6.5 KEY TERMS

• Pure profit: It is the residual left over after all contractual costs have been met,including the transfer costs of management, insurable risks, depreciation, andpayments to shareholders sufficient to maintain investment at its current level.

• Static world: As visualized by Clark, it would be one in which exists absolutefreedom of competition, but population and capital are stationary, there are noinventions, production process does not change and the goods continue to remainhomogenous.

• Calculable risks: These are those whose probability of occurrence can becalculated on the basis of available data, such as risks due to fire, theft, accidentsetc. and these risks are insurable.


1. According to him, profit is rent of the exceptional abilities that an entrepreneurmay possess over the least entrepreneur. Just as rent on land is the difference

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between the yields of the least fertile and super lands, pure profit is the differencebetween the receipts of the least efficient entrepreneur and that of those withgreater efficiency or managerial ability.

2. In a static state, profit would not arise because competition would not permit anybusiness manager to earn more than his actual wages which would be equal tomarginal value his product. Therefore, there would be no surplus available whichcould be called as profit.

3. Hawley’s risk theory of profit is also known as residual theory of profit.4. By considering profit as a reward exclusively for uncertainty bearing, Knight has

implicitly accorded it (uncertainty bearing) the status of a factor of production,whereas it is simply an element of real cost as distinguished from money cost.

5. The major criticism against Schumpeter’s innovation theory of profit is that heignores the risk and uncertainty, the two major sources of profit as shown in thetraditional theories of profits. Although in his book Capitalism, Socialism andDemocracy, he admits that innovations are made by the risk-taking entrepreneurs,he ignores uncertainty altogether.



1. Define pure profit.2. Who does pure profit belong to?3. What are the assumptions in Walker’s theory of profit?4. Differentiate between uncertainty and risk as done in Knight’s theory of profit.


1. As per Clark’s theory of profit, what is the difference between the static and thedynamic world and how do these differences affect profit?

2. Discuss the criticism garnered by Clark’s theory.3. Explain Hawley’s risk theory of profit and the criticism it attracted from its

contemporaries.4. Explain how profit serves as reward for innovation, as per Schumpeter.

6.8 FURTHER READING




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Endnotes

1. Dean, Managerial Economics (Mumbai, Asia Publishing House, 1960), Indian Edn., p. 36.2. Mark Blaug, op. cit., p. 467.3. Defined as total sales revenue minus all contractual payments.4. R.G. Lipsey An Introduction to Positive Economics, 5th Edn., pp. 208–09.5. According to Lipsey (fn. 4), pure profit belongs to the owner of the firm “as on additional

return on the capital” (p. 209).6. J.A. Walker, “The Source of Business Profits, “Qly. Jl. of Eco., April 1887.7. J.B. Clark, “The Distribution of Wealth,” Reprinted in Economic Classics (New York,

Augustin M. Kelly, 1965).8. J.B. Clark, “Distribution as Determined by Law of Rent.” Qly. Jl. of Eco., April 1891.9. Frank H. Knight, Risk, Uncertainty and Profit (New York, Houghton Mifflin Company,

Boston, 1957).10. Joseph. J.A. Schumpeter, Theory of Economic Development, (Massachusetts Harvard

University Press, Cambridge, 1934).11. J.A. Schumpeter, op. cit., p. 8.12. J.A. Schumpeter, Business Cycles (New York and London, McGraw-Hill Book Company

Inc., 1939).

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Macroeconomic Concept

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UNIT 7 MACROECONOMICCONCEPT

Structure7.0 Introduction7.1 Unit Objectives7.2 National Income

7.2.1 Measures of National Income7.2.2 Choice of Methods7.2.3 Theory of National Income Determination7.2.4 Aggregate Supply and Aggregate Demand

7.3 Consumption Function7.4 Shift in Aggregate Demand Function and the Multiplier7.5 Summary7.6 Key Terms7.7 Answers to ‘Check Your Progress’7.8 Questions and Exercises7.9 Further Reading

7.0 INTRODUCTION

National income is the final outcome of all economic activities of a nation valued interms of money. National income is the most important macroeconomic variable anddeterminant of the business level and economic status of a country. The level of nationalincome determines the level of aggregate demand for goods and services. Its distributionpattern determines the pattern of demand for goods and services, i.e., how much ofwhat kinds of goods and services are demanded and produced. The trend in nationalincome determines the trends in aggregate demand and also the economic prospects.Therefore, business decision-makers and economic analysts need to keep in mind theseaspects of national income, especially those having long-run implications. National incomeor a relevant component of it is an indispensable variable considered in economicforecasting.

In this unit, we will discuss basic concepts of national income used in businessanalysis and business decisions, methods of measuring national income and the trendand the growth rates in India’s national income. We will also discuss the multiplier effectand effective demand.

7.1 UNIT OBJECTIVES

After going through this unit, you will be able to:• Discuss the concept of national income and its measurement• Describe the concept of multiplier effect• Analyse effective demand

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7.2 NATIONAL INCOME

Conceptually, national income is the money value of all final goods and services producedin a country during a period of one year. Economic activities generate a large number ofgoods and services and make net addition to the national stock of capital. These togetherconstitute the national income of a ‘closed economy’—an economy which has no economictransactions with the rest of the world. In an ‘open economy’, national income alsoincludes the net results of its transactions with the rest of the world (i.e., exports lessimports).

Economic activities should be distinguished from the non-economic activities froma national point of view. Broadly speaking, economic activities include all human activitieswhich create goods and services that can be valued at market price. Economic activitiesinclude production by farmers (whether for household consumption or for market),production by firms in the industrial sector, production of goods and services by thegovernment enterprises, and services produced by business intermediaries (wholesalersand retailers), banks and other financial organizations, universities, colleges and hospitals,and professionals like medical practitioners, lawyers, consultants, etc. On the other hand,non-economic activities are those which produce goods and services that do not haveany market value. Non-economic activities include spiritual, psychological, social andpolitical services. The non-economic category of activities also includes hobbies, serviceto self, services of housewives, services of members of family to other members andexchange of mutual services between neighbours.

National Income as Money Flow

We have defined national income from the angle of product flows. The same can bedefined in terms of money flows. While economic activities generate flow of goods andservices, on the one hand, they generate money flows, on the other, in the form of factorpayments—wages, interest, rent, profits, and earnings of self-employed. Thus, nationalincome may also be estimated by adding the factor earnings and adjusting the sum forindirect taxes and subsidies. The national income thus obtained is known as nationalincome at factor cost. It is related to money income flows.

The concept of national income is linked to the society as a whole. It differsfundamentally from the concept of private income. Conceptually, national income refersto the money value of the entire volume of final goods and services resulting from alleconomic activities of the country. This is not true of private income. Also from thecalculation point of view, there are certain receipts of money or of services and goodsthat are not ordinarily included in private incomes but are included in the national incomes,and vice versa. National income includes, for example, employer’s contribution to thesocial security and welfare funds for the benefit of employees, profits of public enterprisesand services of owner occupied houses. But it excludes the interest on warloans, socialsecurity benefits and pensions. These items are, however, included in the private incomes.The national income is, therefore, not merely an aggregation of the private incomes.

7.2.1 Measures of National Income

Gross National Product (GNP)

Of the various measures of national income used in national income analysis, GNP is themost important and widely used measure of national income. It is the most comprehensive

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measure of the national productive activities in an open economy. The GNP is defined asthe value of all final goods and services produced during a specific period, usuallyone year, plus incomes earned abroad by the nationals minus incomes earned locallyby the foreigners. The GNP so defined is identical to the concept of gross national income(GNI). Thus, GNP = GNI. The difference between the two is only of procedural nature.While GNP is estimated on the basis of product-flows, GNI is estimated on the basis ofmoney income flows, (i.e., wages, profits, rent, interest, etc.).

Gross Domestic Product (GDP)

The Gross Domestic Product (GDP) is defined as the market value of all final goodsand services produced in the domestic economy during a period of one year, plus incomeearned locally by the foreigners minus incomes earned abroad by the nationals. Theconcept of GDP is similar to that of GNP with a significant procedural difference. Incase of GNP, incomes earned by the nationals in foreign countries are added and incomesearned locally by the foreigners are deducted from the market value of domesticallyproduced goods and services. But, in case of GDP, the process is reversed—incomesearned locally by foreigners are added and incomes earned abroad by the nationals arededucted from the total value of domestically produced goods and services.

Net National Product (NNP)

NNP is defined as GNP less depreciation, i.e.,NNP = GNP – Depreciation

Depreciation is that part of total productive assets which is used to replace the capitalworn out in the process of creating GNP. Briefly speaking, in the process of producinggoods and services (including capital goods), a part of total stock of capital is used up.‘Depreciation’ is the term used to denote the worn out or used up capital in the processof production. An estimated value of depreciation is deducted from the GNP to arrive atNNP.

The NNP, as defined above, gives the measure of net output available forconsumption by the society (including consumers, producers and the government). NNPis the real measure of the national income. NNP = NNI (net national income). In otherwords, NNP is the same as the national income at factor cost. It should be noted thatNNP is measured at market prices including direct taxes. Indirect taxes are, however,not a part of actual cost of production. Therefore, to obtain real national income, indirecttaxes are deducted from the NNP. Thus, NNP less indirect taxes = National Income.

Some Accounting Definitions

(a) Accounting Identities at Market PriceGNP = GNI (Gross National Income)GDP = GNP less net income from abroadNNP = GNP less depreciationNDP (Net Domestic Product) = NNP less net income from abroad

(b) Some Accounting Indentities at Factor CostGNP at factor cost = GNP at market price less net indirect taxesNNP at factor cost = NNP at market price less net indirect taxesNDP at factor cost = NNP at market price less net income from abroad

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NDP at factor cost = NDP at market price less net indirect taxesNDP at factor cost = GDP at market price less depreciation

Methods of Measuring National Income1

National income of a country is generated by its people participating in different kinds ofeconomic activities and producing goods and services. For measuring national income,an economy is viewed from three different angles.

1. The national economy is considered as an aggregate of productive units ofdifferent sectors such as agriculture, mining, manufacturing, trade and commerce,services, etc.

2. The whole national economy is viewed as a combination of individuals andhouseholds owning different kinds of factors of production which they usethemselves or sell factor-services to make their livelihood.

3. The national economy may also be viewed as a collection of consuming, savingand investing units (individuals, households, firms and government).

Following these notions of a national economy, national income may be measured bythree different corresponding methods:

1. Net product method—when the entire national economy is considered as anaggregate of producing units;

2. Factor-income method—when national economy is considered as combinationof factor-owners and users;

3. Expenditure method—when national economy is viewed as a collection ofspending units.The procedures which are followed in measuring the national income in a closed

economy—an economy which has no economic transactions with the rest of the world—are briefly described here. The measurement of national income in an open economyand adjustment with regard to income from abroad will be discussed subsequently.

Net Output or Value Added Method

The net output method is also called the value added method. In its standard form, thismethod consists of three stages: “(i) estimating the gross value of domestic output in thevarious branches of production; (ii) determining the cost of material and services usedand also the depreciation of physical assets; and (iii) deducting these costs and depreciationfrom gross value to obtain the net value of domestic output...”2. The net value of domesticproduct thus obtained is often called the value added or income product which is equalto the sum of wages, salaries, supplementary labour incomes, interest, profits, and netrent paid or accrued. Let us now describe the stages (i) and (ii) in some detail.

(a) Measuring Gross Value. For measuring the gross value of domestic product,output is classified under various categories on the basis of the nature of activitiesfrom which they originate. The output classification varies from country to countrydepending on (i) the nature of domestic activities; (ii) their significance in aggregateeconomic activities and (iii) availability of requisite data. For example, in the US,about seventy-one divisions and subdivisions are used to classify the nationaloutput; in Canada and the Netherlands, classification ranges from a dozen to ascore; and in Russia, only half a dozen divisions are used. According to the CSOpublication, fifteen sub-categories are currently used in India.

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After the output is classified under the various categories, the value of grossoutput is computed in two alternative ways: (i) by multiplying the output of eachcategory of sector by its respective market price and adding them together or(ii) by collective data about the gross sales and changes in inventories from theaccount of the manufacturing enterprises and computing the value of GDP on thebasis thereof. If there are gaps in data, some estimates are made thereof andgaps are filled.

(b) Estimating Cost of Production. The next step in calculating the net nationalproduct is to estimate the cost of production including depreciation. Estimatingcost of production is, however, a relatively more complicated and difficult taskbecause of non-availability of adequate and requisite data. Much more difficult isthe task of estimating depreciation since it involves both conceptual and statisticalproblems. For this reason, many countries adopt factor-income method forestimating their national income.However, countries adopting net-product method find some ways and means tocalculate the deductible cost. The costs are estimated either in absolute terms(where input data are adequately available) or as an overall ratio of input to thetotal output. The general practice in estimating depreciation is to follow the usualbusiness practice of depreciation accounting. Traditionally, depreciation is calculatedat some percentage of capital, permissible under the tax-laws. In some estimatesof national income, the estimators deviate from the traditional practice and estimatedepreciation as some ratio of the current output of final goods.Following a suitable method, deductible costs including depreciation are estimatedfor each sector. The cost estimates are then deducted from the sectoral grossoutput to obtain the net sectoral products. The net sectoral products are thenadded together. The total thus obtained is taken to be the measure of net nationalproduct or national income by net product method.

Factor-Income Method

This method is also known as income method and factor-share method. Under thismethod, the national income is calculated by adding up all the “incomes accruing to thebasic factors of production used in producing the national product”. Factors of productionare conventionally classified as land, labour, capital and organization. Accordingly, thenational income equals the sum of the corresponding factor earnings. Thus,

National income = Rent + Wages + Interest + ProfitHowever, in a modern economy, it is conceptually very difficult to make a distinction

between earnings from land and capital, on the one hand, and between the earningsfrom ordinary labour and entrepreneurial functions, on the other. For the purpose ofestimating national income, therefore, factors of production are broadly grouped as labourand capital. Accordingly, national income is supposed to originate from two primaryfactors, viz., labour and capital. In some activities, however, labour and capital are jointlysupplied and it is difficult to separate the labour and capital contents from the totalearnings of the supplier. Such incomes are termed as mixed incomes. Thus, the totalfactor-incomes are grouped under three categories; (i) labour incomes, (ii) capital incomesand (iii) mixed incomes.

(a) Labour Incomes. Labour incomes included in the national income have threecomponents: (a) wages and salaries paid to the residents of the country including

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bonus and commission, and social security payments; (b) supplementary labourincomes including employer’s contribution to social security and employee’s welfarefunds, and direct pension payments to retired employees;3 (c) supplementarylabour incomes in kind, e.g., free health and education, food and clothing, andaccommodation, etc. Compensations in kind (food and clothes) to domestic servantsand such other free-of-cost services provided to the employees are included inlabour income. War bonuses, pensions, service grants are not included in labourincome as they are regarded as ‘transfer payments’. Certain other categories ofincome, e.g., incomes from incidental jobs, gratuities, tips, etc., are ignored forlack of data.

(b) Capital Incomes. According to Studenski, capital incomes include the followingkinds of earnings:

(a) dividends excluding inter-corporate dividends;(b) undistributed before-tax-profits of corporations;(c) interest on bonds, mortgages, and saving deposits (excluding interests on

war bonds, and on consumer-credit);(d) interest earned by insurance companies and credited to the insurance policy

reserves;(e) net interest paid out by commercial banks;( f) net rents from land, buildings, etc., including imputed net rents on owner-

occupied dwellings;(g) royalties and(h) profits of government enterprises.

The data for the first two items are obtained mostly from the firms’ books ofaccounts submitted for taxation purposes. But the definition of profit for nationalaccounting purposes differs from that employed by taxation authorities. Someadjustments in income tax data therefore, become, necessary. The data adjustmentsgenerally pertain to (i) excessive allowance of depreciation made by the firms;(ii) elimination of capital gains and losses since these items do not reflect thechanges in current income and (iii) elimination of under or over-valuation ofinventories on book-value.

(c) Mixed Income. Mixed incomes include earnings from (a) farming enterprises,(b) sole proprietorship (not included under profit or capital income) and (c) otherprofessions, e.g., legal and medical practices, consultancy services, trading andtransporting, etc. This category also includes the incomes of those who earn theirliving through various sources as wages, rent on own property, interest on owncapital, etc.All the three kinds of incomes, viz., labour incomes, capital incomes and mixed

incomes, added together give the measure of national income by factor-income method.

Expenditure Method

The expenditure method, also known as final product method, measures national incomeat the final expenditure stages. In estimating the total national expenditure, any one ofthe two following methods are used: first, all the money expenditures at market priceare computed and added up together and second, the value of all the products finallydisposed off are computed and added up, to arrive at the total national expenditure. Theitems of expenditure which are taken into account under the first method are (a) private

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consumption expenditure; (b) direct tax payments; (c) payments to the non-profit-makinginstitutions and charitable organizations like schools, hospitals, orphanages, etc. and(d) private savings. Under the second method, the following items are considered: (a)private consumer goods and services, (b) private investment goods, (c) public goods andservices and (d) net investment abroad. The second method is more extensively usedbecause the data required in this method can be collected with greater ease and accuracy.Treatment of Net Income from Abroad. We have so far discussed methods ofmeasuring national income of a ‘closed economy’. But most economies are open in thesense that they carry out foreign trade in goods and services and financial transactionswith the rest of the world. In the process, some nations make net income through foreigntrade while some lose their income to foreigners. The net earnings or losses from foreigntrade change the national income. In measuring the national income, therefore, the netresult of external transactions is adjusted to the total. Net incomes from abroad areadded to, and net losses from the foreign transactions are deducted from the total nationalincome arrived at through any of the above three methods.

Briefly speaking, all exports of merchandise and of services like shipping, insurance,banking, tourism, and gifts are added to the national income. And, all the imports of thecorresponding items are deducted from the value of national output to arrive at theapproximate measure of national income. To this is added the net income from foreigninvestment. These adjustments for international transactions are based on the internationalbalance of payments of the nations.

7.2.2 Choice of Methods

As discussed above, there are three standard methods of measuring national income,viz., net product (or value added) method, factor-income or factor cost method andexpenditure method. All the three methods give the same measure of national income,provided requisite data for each method is adequately available. Therefore, any of thethree methods may be adopted to measure the national income. But all the three methodsare not suitable for all the economies simply for non-availability of necessary data andfor all purposes of estimating national income. Hence, the question of choice of methodarises.

Two main considerations on the basis of which a particular method is chosen are:(i) the purpose of national income analysis and (ii) availability of necessary data. If theobjective is to analyse the net output or value added, the net output method is moresuitable. In case the objective is to analyse the factor-income distribution, the suitablemethod for measuring national income is the income method. If the objective at hand isto find out the expenditure pattern of the national income, the expenditure or final productsmethod should be applied. However, availability of adequate and appropriate data is arelatively more important consideration is selecting a method of estimating national income.

Nevertheless, the most common method is the net product method because(i) this method requires classification of the economic activities and output thereof whichis much easier than classifying income or expenditure; and (ii) the most common practiceis to collect and organize the national income data by the division of economic activities.Thus, the easy availability of data on economic activities is the main reason for thepopularity of the output method.

It should be, however, borne in mind that no single method can give an accuratemeasure of national income since the statistical system of no country provides the totaldata requirements for a particular method. The usual practice is, therefore, to combine

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two or more methods to measure the national income. The combination of methodsagain depends on the nature of data required and sectoral break-up of the available data.

Measurement of National Income in India

In India, a systematic measurement of national income was first attempted in 1949.Earlier, many attempts were made by some individuals and institutions. The first attemptto estimate India’s national income was made by Dadabhai Naoroji in1867–68. The first systematic attempt was made by Prof. V.K.R.V. Rao to estimateIndia’s national income for the year 1931–32. Many other attempts were subsequentlymade, mostly by the economists and the government authorities, to estimate India’snational income.4 These estimates differ in coverage, concepts and methodology andare not comparable. Besides, earlier estimates were mostly for one year, only someestimates covered a period of 3 to 4 years. It was therefore not possible to construct aconsistent series of national income and assess the performance of the economy over aperiod of time.

In 1949, a National Income Committee (NIC) was appointed withP.C. Mahalanobis as its Chairman, and D.R. Gadgil and V.K.R.V. Rao as members.The NIC not only highlighted the limitations of the statistical system of that time but alsosuggested ways and means to improve data collection systems. On the recommendationof the Committee, the Directorate of National Sample Survey was set up to collectadditional data required for estimating national income. The NIC estimated the country’snational income for the period from 1948–49 to 1950–52. In its estimates, the NIC alsoprovided the methodology for estimating national income, which was followed till 1967.

In 1967, the task of estimating national income was assigned to the CentralStatistical Organization (CSO). Till 1967, the CSO had followed the methodology laiddown by the NIC. Thereafter, the CSO adopted a relatively improved methodology andprocedure which had become possible due to increased availability of data. Theimprovements pertain mainly to the industrial classification of the activities. The CSOpublishes its estimates in its publication, Estimates of National Income.Methodology. Currently, output and income methods are used by the CSO to estimatethe national income of the country. The output method is used for agriculture andmanufacturing sectors, i.e., the commodity producing sectors. For these sectors, thevalue added method is adopted. Income method is used for the service sectors includingtrade, commerce, transport and government services. In its conventional series of nationalincome statistics from 1950–51 to 1966–67, the CSO had categorized the income in 13sectors. But, in the revised series, it had adopted the following 15 break-ups of thenational economy for estimating the national income; (i) Agriculture; (ii) Forestry andlogging; (iii) Fishing; (iv) Mining and quarrying; (v) Large-scale manufacturing;(vi) Small-scale manufacturing; (vii) Construction; (viii) Electricity, gas and water supply;(ix) Transport and communication; (x) Real estate and dwellings, (xi) Public administrationand defence; (xii) Other services and (xiii) External transactions. The national incomeis estimated at both constant and current prices.

Estimates of India’s GNP and NNP

The estimates of India’s GNP and NNP, both at factor cost at current prices and atconstant prices of 1999-2000 are given in Table 7.1. Growth rates of GNP and NNP forthe period from 1999-00 to 2005-06 are given in Table 7.2.

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Table 7.1 Estimates of India’s GNP, NNP and Per capita Income at Factor Cost(At current prices and at 1999-2000 prices)

Gross National Product Net National Product Per Capita NNP(` in Crore) (` in Crore) (`)

Year At Current At At Current At At Current AtPrices Constant Prices Constant Prices Constant

Prices Prices Prices

1999-00 1771094 1771094 1585501 1585501 15839 15839

2000-01 1902682 1842228 1696387 1643998 16648 16133

2001-02 2080119 1952241 1847667 1739876 17800 16762

2002-03 2248614 2028928 1993846 1801430 18899 17075

2003-04 2531168 2204746 2246465 1959599 20936 18263

2004-05 P 2833558 2367711 2501067 2103350 22946 19297

2005-06 Q 3225963 2580761 2846762 2295243 25716 20734

P = Provisional Q = Quick EstimatesSource: Central Statistical Organization

Table 7.2 Annual Average Growth Rate of India’s GNP and NNP(At current prices and at 1999-2000 prices)

Gross National Product Net National Product Per Capita NNP(` in Crore) (` in Crore) (`)

Year At Current At At Current At At Current AtPrices Constant Prices Constant Prices Constant

Prices Prices Prices

1999-00 10.3 — 10.5 — 8.5 —

2000-01 7.4 4.0 7.0 3.7 5.1 1.9

2001-02 9.3 6.0 8.9 5.8 6.9 3.9

2002-03 8.1 3.9 7.9 3.5 6.2 1.9

2003-04 12.6 8.7 12.7 8.8 10.8 7.0

2004-05 P 11.9 7.4 11.3 7.3 9.6 5.7

2005-06 Q 13.8 9.0 13.8 9.1 12.1 7.4

P = Provisional Q = Quick EstimatesSource: Central Statistical Organization

7.2.3 Theory of National Income Determination

In the preceding section, we have discussed the basic concepts and measures ofnational income. In this section, we will discuss a problem of theoretical nature, i.e.,the problem of national income determination. The two major questions with whichwe shall be concerned here are: (i) What factors determine the level of nationalincome and (ii) How is the equilibrium level of national income determined? Thesequestions were first answered by J.M. Keynes, in 1936, in his book The GeneralTheory of Employment, Interest and Money. We will outline here the Keynesiantheory of income determination.

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Keynesian Theory of National Income Determination

Assumptions

To explain the Keynesian theory of income determination, the entire economy is dividedinto four sectors, viz.,

1. Household sector2. Firms or the business sector3. Government sector4. Foreign sector

The Keynesian theory of income determination is present in the following threemodels: (i) Two-sector model including only the household and the business sectors;(ii) Three-sector model including household, business and government sectors and(iii) Four-sector model including foreign sector with the three-sector model.

For the sake of simplicity and systematic exposition of the Keynesian theory ofincome determination, we will first discuss income determination in a two-sector modelinvolving only the household and firm sectors.

Determination of National Income: Two-Sector Model

The following simplifying assumptions are made to specify the two-sector model of ahypothetical simple economy.

First, the hypothetical simple economy has only two sectors: households andfirms. The households own the factors of production and they sell factor services to thefirms to earn their living in the form of factor payments—wages, rent, interest andprofits. Also, households are the consumers of all final goods and services. The firms, onthe other hand, hire factor services from the households and produce goods and serviceswhich they sell to the households.

Secondly, there is no government. Or, if government is there, it does not performany economic function; it does not tax, it does not spend and it does not consume.

Thirdly, the economy is a closed one: there is no foreign trade. It implies thatthere is no outflow or inflow of goods and services to and from foreign countries.

Fourthly, there are no corporate savings or undistributed (or retained) corporateprofits, i.e., the total corporate profit is distributed as dividends.

Finally, prices of all goods and services, supply of labour and capital, and thestate of production technology remain constant.

According to Keynes, national income of a country is determined by two factors:(i) aggregate demand (AD) and (ii) aggregate supply (AS) of goods and services. And,the equilibrium level of national income is determined where AD equals AS. Before weillustrate graphically the determination of national income, let us explain the concepts ofaggregate demand and aggregate supply.

7.2.4 Aggregate Supply and Aggregate Demand

(i) Aggregate Supply. The aggregate supply (AS) refers to the total value ofgoods and services produced and supplied in an economy per unit of time. Aggregatesupply includes both consumer goods and producer goods. The goods and servicesproduced per time unit multiplied by their respective (constant) prices give the

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total value of the national output. This is the aggregate supply in terms of moneyvalue.Aggregate Supply Schedule. The Keynesian aggregate supply schedule oraggregate supply curve is drawn on the assumption that total income is alwaysspent – no part of it is retained or withheld. That is, total income always equalstotal expenditure. This relationship between income and expenditure is shown bya 45° line in Fig. 7.1. This line is also called aggregate supply schedule. In theKeynesian theory of income determination, aggregate income equals consumption(C) plus savings (S). Therefore, AS schedule is generally named as C + S schedule.The aggregate supply (AS) curve is also sometimes called ‘aggregate expenditure’(AE) curve.

Aggregate Income (Y)

Aggr

egat

e E

xpen

ditu

re (A

E)

AS = AE

45°

Fig. 7.1 The Aggregate Supply Curve

(ii) Aggregate Demand. The aggregate demand is an ex-post concept. It implieseffective demand which equals actual expenditure. The aggregate effective demandmeans the aggregate expenditure made by the society per unit of time, usually,one year. It is also referred to as effective demand sometimes. Aggregate demand(AD) consists of two components:

(i) aggregate demand for consumer goods (C) and(ii) aggregate demand for capital goods (I).

Thus, AD = C + I ...(7.1)Aggregate Demand ScheduleThe aggregate demand AD schedule is also called C + I schedule. In the Keynesianframework, investment (I) is assumed to remain constant in the short-run. But,consumption (C) is treated to be a function of income (Y). Pending detaileddiscussion on the consumption function till the next section, let us assume that theconsumption function is given as

C = a + bY ...(7.2)where a is a constant denoting C when Y = 0 and b is the proportion of incomeconsumed, i.e., b = ΔC/ΔY.By substituting Eq. (7.2) in Eq. (7.1), AD function can be expressed as

AD = a + bY + I ...(7.3)Let us now illustrate the construction of the C + I schedule by assuming:

(i) C = 50 + 0.5Y, and (ii) I = ̀ 50 billion

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The AD function given in Eq. (7.3) can now be written asAD = 50 + 0.5Y + 50 = 100 + 0.5Y

An aggregate demand schedule based on the above assumptions is given in Table7.3. The C + I schedule is plotted in Fig. 7.2.

Table 7.1 Aggregate Demand Schedule

(` in billion)Income (Y) C = 50 + 0.5Y I = 50 C + I Schedule

0 50 + 0 = 50 50 10050 50 + 25 = 75 50 125

100 50 + 50 = 100 50 150150 50 + 75 = 125 50 175200 50 + 100 = 150 50 200250 50 + 125 = 175 50 225300 50 + 150 = 200 50 250350 50 + 175 = 225 50 275400 50 + 200 = 250 50 300

National Income Determination: Graphical Presentation

Having explained the concept and derivation of aggregate supply and aggregate demandcurves, we now turn to the question of income determination. In the above table, the lastcolumn represents the aggregate demand and the first column represents the aggregatesupply. It can be seen in the table that AS and AD are equal only at one level of incomeand expenditure, i.e., at ̀ 200 billion. The equilibrium level of the national income istherefore determined at ̀ 200 billion. If for some reason, AD exceeds AS or AS exceedsAD, an adjustment process will bring them back in balance at ̀ 200 billion. The informationcontained in Table 7.3 can be used to illustrate income determination graphically.

The data contained in Table 7.3 is presented graphically in Fig. 7.2. The AS scheduleis drawn on the assumption that total income (Y) is always equal to total expenditure (E).The AS schedule has, therefore, a constant slope of 1. The C + I schedule is the verticalsummation of the C and I schedules.

As Fig. 7.2 shows, C + I and C + S schedules intersect at point E determining theequilibrium level of income at ̀ 200 billion. Note that at point E,

AD = ASC + I = C + S150 + 50 = 200

Thus, the equilibrium level of national income is determined at ̀ 200 billion.

Why Not Equilibrium at Any other point?

Note that beyond the equilibrium point, E, AD < AS or (C + I) < (C + S). It means that atany point on the AS schedule beyond point E, the firms would be producing more thanwhat households demand. If firms produce goods and services worth more than ̀ 200billion, they will find that they have produced in excess of aggregate demand and theirunsold stocks are piling up. For example, suppose firms produce goods and servicesworth ̀ 250 billion. As Table 7.1 shows, this level of output (AS) exceeds the aggregate

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demand (AD) by ̀ 25 billion. Note that at output or Y = ̀ 250 billion, AD equals ̀ 225billion (see Table 7.3). Therefore, firms’ unsold stock equals goods and services worth ̀25 billion. Hence, they reduce their production and cut down their expenditure on inputs.As a result, the demand for factors of production decreases. This reduces householdincomes and, thererfore, their expenditure on goods and services. This process continuesuntil the equilibrium level of income reaches ̀ 200 billion.

100 200 300 4000

50

100

200

300

400

Income ( in billion)`

Exp

endi

ture

( in

bill

ion)

`

C

C+I=AD

AS=C+S

E

45°

I

Fig. 7.2 National Income Determination

Similarly, below ̀ 200 billion level of national income, aggregate demand exceedsaggregate supply. The firms, therefore, find that their output is less than what the societyis willing to consume. They realize that they could make a greater income by producingand selling a larger output. For example, if firms produce goods worth only ̀ 150 billion,they find AD exceeding AS by ̀ 25 billion. That is, demand worth ̀ 25 billion remainsunsupplied. They are, therefore, encouraged to produce more and generate more incometo the society. The society, in its turn, spends more as its income increases. The processcontinues until the equilibrium level of national income is reached. Once the equilibriumlevel of national income is determined, it is supposed to remain stable.

Having described the theory of national income determination in two-sector model,let us now discuss in detail the relationship between C and Y and betweenS and Y with a view to understanding the process of national income determination. Letus first look into the relationship between income and consumption, generally expressedthrough consumption function.

7.3 CONSUMPTION FUNCTION

Consumption function is a mathematical expression of the relationship between aggregateconsumption expenditure and aggregate disposable income, expressed asC = f (Y). The private demand for goods and services accounts for the largest proportionof the aggregate demand in an economy and plays a crucial role in the determination ofnational income. The total volume of private expenditure in an economy depends, accordingto Keynes, on the total current disposable income of the people and the proportion of

Check Your Progress

1. What are open andclosed economies?

2. What is nationalincome at factorcost?

3. How does thefactor-incomemethod work?

4. What kind ofearnings do capitalincomes include?

5. What are the basesfor selecting amethod ofmeasuring nationalincome?

6. What methods areused for calculatingnational income inIndia?

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income which they decide to spend on consumer goods and services. As mentionedabove, this relationship between aggregate consumption demand and the aggregatedisposable income is expressed through a ‘consumption function’ expressed as

C = a + bY ...(7.4)where C = aggregate consumption expenditure; Y = total disposable income; a is aconstant term; and b = ΔC/ΔY, i.e., the proportion of marginal income spent onconsumption.

The consumption function given in Eq. (7.4) is based on the assumption that thereis a constant relationship between consumption and income, as denoted by constant‘b’denoting ‘marginal propensity consumer’.

It may be added here that the original Keynesian function assumes a decreasingratio between consumption and income. According to Keynes, the consumption functionstems from a ‘fundamental psychological law’. The law states that propensity to consume(ΔC/ΔY) decreases with the increase in income in the short-run. This law implies thattotal consumption increases but not by an equal amount of increase in income. ThisKeynesian hypothesis of income-consumption relationship was later termed as theabsolute income hypothesis. Some early empirical studies5 based on cross-section andtime-series data have supported the hypothesis.

However, the economists have found empirically that Keynesian consumptionfunction may be applicable to individual consumption behaviour but not for the aggregateconsumption expenditure. They have found empirically that, at the aggregate level,consumption function is of linear type. It is now a convention to use a linear consumptionfunction6 at the aggregate level, as given in Eq. (7.4).

The propensity to consume refers to the proportion of the total and the marginalincomes which people spend on consumer goods and services. The proportion of themarginal income consumed is called ‘Marginal Propensity to Consume’ (MPC), and theproportion of the total income consumed is called ‘Average Propensity to Consume’(APC). Let us now discuss these concepts in detail.

(a) The Marginal Propensity to Consume (MPC). The concept of MPC isrelated to the marginal consumption-income relationship. In other words,MPC refers to the relationship between change in consumption (ΔC) andthe change in income (ΔY). Symbolically, MPC = ΔC/ΔY.As mentioned above, according to the consumption function envisaged byKeynes, marginal propensity to consume (ΔC/ΔY) decreases with increasein income. In the theory of income determination, however, a constantmarginal propensity to consume is assumed. For example, suppose thatincome increases from ̀ 200 to ̀ 300, and as a result, consumption increasesfrom ` 250 to ` 325, as shown in Fig. 7.3. Thus, the change in incomeΔY = 300 – 200 = 100, and change in consumption, ΔC = 325 – 250 = 75.Thus,

MPC = ΔC/ΔY = 75/100 = 0.75

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Con

sum

ptio

n E

xpen

ditu

re (C

) `

Fig. 7.3 Income Consumption Relationship

Similarly, if income increases from ` 300 to ` 400, and consumptionexpenditure rises from ̀ 325 to ̀ 400, the MPC = 75/100 = 0.75. This kindof relationship between income and consumption is expressed through alinear consumption function, as shown by the line marked C in Fig. 7.3.The MPC can be derived from the consumption function as follows. Giventhe consumption function in Eq. (7.4),

C = a + bY,Let Y increase by ∆Y so that

C + ∆C = a + b(Y + ∆Y) = a + bY + b∆Yand ∆C = – C + a + bY + b∆YSince C = a + bY, by substituting a + bY for C, we get

∆C = – (a + bY) + a + bY + b∆Y∆C = b∆Y ...(7.5)

By dividing both sides of Eq. (7.5) by Y, we get

MPC = CY

∆∆

= b

According to the Keynesian theory of aggregate consumption, ∆C/∆Y = b isalways less than unity, but greater than zero, i.e., 0 < b < 1. This fundamentalrelationship between income and consumption plays a crucial role in theKeynesian theory of income determination.

(b) Average Propensity to Consume (APC). Average Propensity to Consumeis defined as the proportion of total income spent on consumer goods andservices, i.e.,

APC = CY

where C is total consumption expenditure and Y is total disposable income.Given the consumption function, C = a + bY, APC can be obtained as

APC = CY =

a bYY+

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If consumption function is given as

C = bY then APC = bYY

= b

Note that if consumption function is C = bY (i.e., without constant term ‘a’),then APC = b = MPC.

Properties of Consumption Function

The Keynesian consumption function has the following properties.1. It states the relationship between consumption expenditure and disposable income.

If consumption function is empirically estimated for a country, total consumptionexpenditure can be predicted if growth rate of income is known and incomedistribution is given.

2. It states that income-consumption relation is given by the MPC (denoted by b),while 0 < b < 1.

3. Consumption function of the form, C = a + bY or C = bY implies a linear relationshipbetween consumption and income, i.e., a constant MPC.

4. Consumption function implies a saving function. That is, if consumption functionis known, the saving function can easily be obtained.

Derivation of Saving Function

Having explained the Keynesian aggregate consumption function, we turn to derive theKeynesian saving function in this section. Like consumption, saving (S) is also the functionof income (Y), i.e.,

S = f (Y)Since Y = C + S, consumption and saving functions are counterparts of each

other. Therefore, if one of these functions is known, the other can be easily obtained.For example, if consumption function is given as C = a + bY, then saving function can bederived as follows.

We know that S = Y – C ...(7.6)By substituting consumption function, C = a + bY for C in Eq. (7.6), we get

S = Y – (a + bY) = – a + (1 – b)Y ...(7.7)

Equation (7.7) gives the saving function in which ‘1 – b’ is marginal propensity tosave (MPS). It can be proved as follows:

Since Y = C + S ∴ ∆Y = ∆C + ∆SDividing both sides by Y, we get

1 = C SY Y

∆ ∆+

∆ ∆or

SY

∆∆

= 1 – CY

∆∆

Since CY

∆∆

= b, by substitution, we get

MPS =SY

∆∆

or MPS = 1 – b

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Numerical Example. Let us now show the derivation of saving function through anumerical example. Let consumption function be given as

C = 100 + 0.75 Y ...(7.8)Given the Eq. (7.8), Eq. (7.6) can be written as

S = Y – (100 + 0.75Y) = Y – 100 – 0.75Y = – 100 + (1 – 0.75)Y = – 100 + 0.25Y ...(7.9)

100100 200 300 400 500 600 700 800

Disposable Income ( )`

–200

–100

0

100

200

300

400

500

600

700

Y = C + S

C = 100 + 0.75 Y

C

Saving

Dissav

ing

S = – 100 + 0.25Y

45°

Fig. 7.4 Income, Consumption and Savings Schedules

The consumption and saving functions are graphed in Fig. 7.4. The 45° line showsincome-consumption relation with Y = C at all levels of income. In the analysis of nationalincome determination, it also shows the total sales proceeds, i.e., the value of the totalplanned output. The schedule C = 100 + 0.75Y gives the income-consumptionrelationship—consumption being a linear function of income. The schedule S = –100 +0.25Y is the saving schedule derived from the consumption schedule. The saving scheduleshows the income-saving relationship.

Two-sector Model of National Income Determination

In preceding sections, we have presented the Keynesian theory of income determinationin its simplest form and have derived the consumption and saving functions. In thissection, we present the two-sector model of income determination in its formal form.

As stated above, equilibrium level of national income is determined at a stagewhere aggregate demand for output (C + I) is equal to aggregate supply of incomes(C + S). Thus, equilibrium condition of national income is given as

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Aggregate Demand = Aggregate Supply,or C + I = C + S ...(7.10)

Since C is common to both the sides, the equilibrium conditions can also be stated asI = S ...(7.11)

Given these conditions of equilibrium, there are two alternative ways to show thedetermination of national income:

(i) by using aggregate demand (C + I) and aggregate supply (C + S) schedules and(ii) by using only saving (S) and investment (I) schedules.

The two approaches are known as income-expenditure approach and saving-investment approach respectively. Let us now explain in detail the determination ofnational income by the two approaches.

Income-Expenditure Approach

According to the income-expenditure approach or, what is also called ‘aggregate demandand aggregate supply approach’, the equilibrium of national income is determined through

C + I = C + SSince C + S = Y, the national income equilibrium condition can also be restated as

Y = C + ISince at equilibrium, C = a + bY, by substitution, we get national income equilibrium

condition asY = a + bY + I or Y(1 – b) = a + I

Therefore, Y = ( 1)1

I ab

...(7.12)

Suppose empirical consumption function is given as C = 100 + 0.75Y and I = 100.Then

Y = 100 + 0.75Y + 100 = 1 100 1001 – 0.75

= 1 2000.25

= 800

Thus, given the consumption function, as in Eq. (7.8) and investment at 100, thenational income equilibrium is determined at ̀ 800.

Determination of equilibrium level of national income by aggregate demand andaggregate supply approach is also presented graphically in Fig. 7.5. The C + S schedulerepresents the aggregate supply of income and C and I schedules represent, consumptionand investment functions respectively. The C + I schedule, i.e., the aggregate demandschedule, is formed by vertical summation of C and I schedules. The C + I and C + Sschedules intersect at point E which is the equilibrium point. At this point,

Y = C + I800 = 700 + 100

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0Income ( )`

100 200 300 400 500 600 700 800 900 1000

100

200

300

400

500

600

700

800

900

1000

Exp

endi

ture

()`

I

C + SC + I

C

E

E

45°

I = S = 100

C = 100

Fig. 7.5 Determination of National Income: Income-Expenditure Approach

Once national income is determined, it will remain stable in the short-run. Anyproduction in excess of or below the equilibrium output will create conditions for theincome and expenditure to return to the equilibrium position, E. For, the expectations ofbusinessmen are realized only when aggregate expenditure equals aggregate income.While aggregate supply (C + S) represents the aggregate value (or price) expected bybusiness firms, aggregate demand (C + I) represents their realized value. At equilibrium,expected value equals realized value. As mentioned above, production (or supply ofincomes) in excess of equilibrium output will result in undesired accumulation of inventorieswhich reduces profits. For example, if goods and services worth ̀ 1,000 are produced,the unsold stock will equal ̀ 50, because, at this level of income, society plans to spendonly ̀ 950.7 This will force the business firms to cut down their output and, return to thepoint of equilibrium output through the process of reverse multiplier.8 Similarly, whenproduction is below the equilibrium level, realized value exceeds the expected value.This gives incentive to produce more and make larger profit, and to reach the equilibriumlevel through the process of multiplier.

Saving-Investment Approach

The determination of national income can also be explained by saving-investment approach,i.e., by using only saving (S) and investment (I) schedules. We have noted that nationalincome equilibrium is determined where I = S. Given our earlier assumptions thatI = 100, and consumption function as,

C = 100 + 0.75Ysaving function can be written as

S = – 100 + 0.25YGiven the saving function and investment, equilibrium of national income will be

determined where I = S, i.e., where100 = – 100 + 0.25Y ...(7.13)

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Solving Eq. (7.13) for Y, we get national income equilibrium atY = 800

Obviously, the saving-investment approach determines the same equilibrium levelof national income (` 800) as the income-expenditure approach.

Determination of national income by saving-investment approach is illustrated inFig. 7.6. S-schedule has been drawn by plotting the saving function, S = – 100 + 0.25Y,and I-schedule by plotting the investment function, I = 100.

–300

–200

–100

0

100

200

300

400

Sav

ing

and

Inve

stm

ent (

)`

100 200 300 400 500 600 700 800 900 1000

Income ( )`

S = –100 + 0.25Y

EI

Fig. 7.6 Determination of National Income: Saving and Investment Approach

The S and I schedules intersect at point E where planned saving equals plannedinvestment and equilibrium of national income is determined at ̀ 800 which is the sameas one determined by income-expenditure approach.

7.4 SHIFT IN AGGREGATE DEMAND FUNCTIONAND THE MULTIPLIER

We have explained in the preceding section the determination of national incomeequilibrium under the condition of a given aggregate demand schedule, C + I. In thissection, we will explain the effect of shifts in the aggregate demand schedule on theequilibrium level of national income confining our analysis only to a two-sector model. Ashift in the aggregate demand schedule, in a two-sector economy may be caused by ashift in consumption schedule or in investment schedule or both. Consumption expenditureis, how-ever, found to be more stable because it is a function of income whereas investmentmay change due to autonomous factors. It is, therefore, generally assumed that the shiftin the aggregate demand schedule takes place due to a shift in the investment schedule.Let us assume that aggregate demand schedule shifts upward due to a permanent upwardshift in the investment schedule. The increase in investment may be the result of anautonomous investment in some adventure.

Check Your Progress

7. What is MPC?8. Which are the two

alternative ways toshow thedetermination ofnational income?

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E1

E2

I + I

I

C + S

C + I + I

C + I

C = a + by

45ºY

I

Y10 Y2Income

Fig. 7.7 Shift in Aggregate Demand Function and Increase in National Income

The economy being in equilibrium, an upward permanent shift in aggregate demandschedule causes an upward shift in the equilibrium of national income. That is, an upwardpermanent shift in the aggregate demand schedule leads to an increase in national income,as shown in Fig. 7.7. The initial aggregate demand schedule is shown by C + I schedule.It intersects aggregate supply schedule (C + S) at point E1 where the equilibrium level ofnational income is Y1. Let us suppose now that I increases causing an upward shift ininvestment schedule from I to I + ∆I. This causes an upward shift in aggregate demandschedule from C + I to C + I + ∆I. With the shift in aggregate demand schedule, theequilibrium point of national income shifts from E1 to E2 and national income increasesfrom Y1 to Y2. The increase in national income (∆Y) may be obtained as

∆Y = Y2 – Y1

The increase in the national income, ∆Y, is the result of ∆I. A question arises here:‘Is there any definite relationship between ∆Y and ∆I?’ If yes, what determines thatrelationship? These questions take us to the theory of multiplier.

Theory of Multiplier

To understand the theory of multiplier, let us first look at the relationship between ∆Y and∆I. This can be done by comparing the two equilibrium levels of national income.

At equilibrium point E1, Y1 = C + ISince C = a + bY, by substitution, we get

Y1 = a + bY1 + I

= ( )11

a Ib

+−

...(7.14)

Similarly, at equilibrium E2,Y2 = C + I + ∆I = a + bY2 + I + ∆I

= ( )11

a I Ib

+ + ∆−

...(7.15)

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By subtracting Eq. (21.14) from Eq. (21.15), we get

∆Y = ( ) ( )1 11 1

a I I a Ib b

+ + ∆ − +− −

∆Y = 11

Ib

∆−

...(7.16)

Equation (7.16) gives the relationship between ∆Y and ∆I. It reveals that ∆Y is1/(1 – b) times ∆I. Therefore, 1/(1 – b) is the multiplier (m). The value of multiplier canbe obtained by dividing both sides of Eq. (7.16) by ∆I. That is,

YI

= 1

1 – b ...(7.17)

Thus, multiplier (m) = 1

1 – b ...(7.18)

The multiplier may thus be defined as the ratio of the change in nationalincome due to change in investment. Since ∆Y is the result of ∆I, the multiplier sodefined is called investment multiplier.

Determinant of Investment Multiplier

Note that in Eq. (7.18) ‘b’ stands for the MPC (i.e., b = ∆C/∆Y). It may, therefore, beconcluded that MPC is the determinant of the value of the multiplier. The higher theMPC, the greater the value of multiplier. This relationship can be tabluted as shown.

MPC m

0.00 1.000.10 1.110.50 2.000.75 4.000.80 5.000.90 10.001.00 ∞

MPS and the Multiplier

The value of multiplier can also be obtained through the marginal propensity to save,i.e., MPS. In Eq. (7.18), 1 – b is the same as 1 – MPC.

We know that 1 – MPC = MPS. Therefore,

m = 1 11 MPC MPS

...(7.19)

Numerically, if MPC = 0.75, MPS = 0.25, then multiplier,

m = 1 1 41 0.25MPC

= =−

The multiplier may, therefore, be defined also as the reciprocal of MPS. If MPSis known, multiplier (m) can be easily obtained.

Sometimes, from application point of view, a distinction is made between staticmultiplier and dynamic multiplier. In this section, we explain the difference betweenthe static and dynamic multipliers and also describe the process of dynamic multiplier.

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Static and Dynamic Multiplier

Static multiplier is also known as ‘comparative static multiplier’, ‘simultaneous multiplier’,‘logical multiplier’, ‘timeless multiplier’ or ‘lagless multiplier’. The concept of staticmultiplier assumes that the change in investment and the resulting change in income aresimultaneous. There is no time lag between the change in investment and the resultingchange in income. In other words, the shift of national income equilibrium from point E1(in Fig. 7.7) to point E2 due to change in investment (ΔI) has no time-lag. Static multiplieralso assumes that there is no change in MPC at the aggregate level as the economymoves from one equilibrium position to another. It ignores the process by which changesin income and consumption expenditure lead to a new equilibrium. Also, static multiplierassumes income distribution and consumers’ preferences to remain unchanged.

The concept of dynamic multiplier, or what is also known as period multiplier or‘sequence’ multiplier, does not make the assumptions of the static multiplier. Dynamicmultiplier traces the process by which equilibrium of national income shifts from oneposition to another. In real life, income level does not increase instantly when anautonomous investment is made because there is a time-lag between increase in incomeand consumption expenditure.

The process of dynamic multiplier may be described as follows. Suppose thatautonomous investment increases by ` 100, i.e., ΔI = ` 100. Assume also thatMPC = 0.8, and there is no expenditure other than the consumption expenditure.

When autonomous investment increases by ̀ 100, it subsequently increases theincome of the recipients by ̀ 100, i.e., in the first round of expenditure-income process,ΔI = 100 = Δy1. The recipients of ̀ 100 spend ̀ 80 (= 100 × 0.8) on consumer goods andservices. In the second round, those who supply goods and services worth ̀ 80, receivean additional income of ̀ 80. That is, Δy2 = 80. Of this, they spend ̀ 64 (= 80 × 0.8).This results in an additional income (Δy3) of ̀ 64 to those who supply consumer goodsand services. This process continues till the value of Δy → 0. Note that the value of Δydecreases in the subsequent rounds of income and expenditure, i.e., Δy1 > y2 > y3.... Thewhole series of Δy generated by ΔI = 100 may be written as

ΔY = Δy1 + Δy2 + Δy3 ... Δyn–1

ΔY = 100 + 100(0.8) + 100(0.8)2 + 100(0.8)3... + 100(0.8)n–1

= 100 + 80 + 64 + 51.20......→ 0 = 499.999 = 500After having calculated the income (ΔY) generated over time, the value of multiplier

(m) can be obtained as

m = 500100

YI

= 5

The process of dynamic multiplier may be generalized as follows. The wholeseries of additional incomes caused by ΔI over time may be written as

ΔY = Δy + Δy(b) + Δy(b)2 + Δy(b)3 ... Δy(b)n–1

= Δy(1 + b + b2 + b3 . . . bn–1)...

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= *1

1 –y

b ∆

...(7.20)

Since ∆y = ∆I, we may rewrite Eq. (7.20) as

∆ = 11 –

Ib

∆ ...(7.21)

From this equation, the multiplier (m) may be obtained as

m = 1

1 –YI b

∆=

∆...(7.22)

Note that dynamic multiplier is the same as static multiplier.

Limitations of Multiplier

Despite its important uses in macroeconomic analysis, the concept of multiplier hascertain limitations, which should be borne in mind while using this concept.First, the limitation of the multiplier theory is related to the rate of MPC. If the rate ofMPC is lower in an economy, the rate of multiplier will also be lower. As a corollary ofthis, since MPC in a less developed country is comparatively higher, the multiplier theremust be higher than in the developed countries. This may, however, not be true in realpractice because of other limitations of multiplier.Secondly, the working of multiplier assumes that those who earn income as a result ofcertain autonomous investment would continue to spend a certain percentage of theirnewly earned income on consumption and that therer are no leakages in the expenditureprocess. This assumption may not hold in real practice since people may like to spend apart or whole of their additional income on

(i) payment of past debts;(ii) purchase of existing durable goods and other assets, like old houses, second hand

cars, etc.(iii) purchase of shares and bonds from the shareholders or bond-holders and(iv) purchase of imported goods.

These are known as leakages in the consumption flows, which reduce the rateof multiplier. For example, let us suppose that a building contractor earns ̀ 50,000 from

* Proof. The series of incomes is given as∆Y = ∆y + ∆y(b) + ∆y(b)2 + ∆y(b)3 ... ∆y(b)n–1 ...(i)

Now let the terms inside the bracket be summed up asS = 1 + b + b2 + b3 + ... bn–1 ...(ii)

By multiplying both sides of this equation by b, we getS.b = b + b2 + b3 + b4 + ... bn ...(iii)

If Eq. (iii) is substracted from Eq. (ii), all terms, except 1 and bn, on the right hand side of Eq. (iii)cancel out.Then S – S.b = 1 – bn or S(1 – b) = 1 – bn

S = 1 –1–

nbb

...(iv)

When n → ∞, bn → 0. It can, therefore, be omitted. Then S = 11– b

...(v)

By substituting Eq. (iv) into Eq. (i) for the terms in the bracket, we get 1

1Y y

b

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a contract, which he pays to his creditor. His creditor buys an old house. The personwho sells the house buys an imported car. The money thus keeps circulating but is neverspent in the manner that can generate demand for new consumer goods. In that case,multiplier will be 1. The other leakages are holding idle cash, deposits in foreign banks,etc.Thirdly, the working of multiplier is based on the assumption that the goods and servicesare always available in adequate supply. But, if goods and services are in scarcity, theactual consumption expenditure will be reduced whatever the rate of MPC. Consequently,the multiplier will be reduced. If expenditure continues to increase in face of scarcity, itgenerates inflation, while real income does not increase.Finally, under the condition of full-employment, the theory of multiplier will not workbecause additional goods and services cannot be produced or additional real incomecannot be generated.

Despite its limitations, the concept of multiplier is an important tool in analyzingthe process and the forces of economic fluctuations in an economy. In addition, theconcept of multiplier is useful in analyzing the impact of public expenditure, taxation andforeign trade on the economy.

7.5 SUMMARY

• National income is the most important macroeconomic variable and determinantof the business level and economic status of a country. The level of nationalincome determines the level of aggregate demand for goods and services. Itsdistribution pattern determines the pattern of demand for goods and services, i.e.,how much of what kinds of goods and services are demanded and produced.

• Economic activities should be distinguished from the non-economic activities froma national point of view. Broadly speaking, economic activities include all humanactivities which create goods and services that can be valued at market price.

• Of the various measures of national income used in national income analysis,GNP is the most important and widely used measure of national income. It is themost comprehensive measure of the national productive activities in an openeconomy.

• Depreciation is that part of total productive assets which is used to replace thecapital worn out in the process of creating GNP. Briefly speaking, in the processof producing goods and services (including capital goods), a part of total stock ofcapital is used up.

• The expenditure method, also known as final product method, measures nationalincome at the final expenditure stages. In estimating the total national expenditure,any one of the two following methods are used: first, all the money expendituresat market price are computed and added up together and second, the value of allthe products finally disposed of are computed and added up, to arrive at the totalnational expenditure.

• In India, a systematic measurement of national income was first attempted in1949. Earlier, many attempts were made by some individuals and institutions. The

Check Your Progress

9. What are static anddynamicmultipliers?

10. State any onelimitation ofmultiplier.

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first attempt to estimate India’s national income was made by Dadabhai Naorojiin 1867–68.

• The private demand for goods and services accounts for the largest proportion ofthe aggregate demand in an economy and plays a crucial role in the determinationof national income. The total volume of private expenditure in an economy depends,according to Keynes, on the total current disposable income of the people and theproportion of income which they decide to spend on consumer goods and services.

7.6 KEY TERMS

• National income: It is the final outcome of all economic activities of a nationvalued in terms of money.

• Gross National Product (GNP): It is defined as the value of all final goods andservices produced during a specific period, usually one year, plus incomes earnedabroad by the nationals minus incomes earned locally by the foreigners.

• Depreciation: It is that part of total productive assets which is used to replacethe capital worn out in the process of creating GNP.

• Gross Domestic Product (GDP): It is defined as the market value of all finalgoods and services produced in the domestic economy during a period of oneyear, plus income earned locally by the foreigners minus income earned abroadby the nationals.

• Aggregate supply: It refers to the total value of goods and services producedand supplied in an economy per unit of time.

• Consumption function: It is a mathematical expression of the relationshipbetween aggregate consumption expenditure and aggregate disposable income.


1. Economic activities generate a large number of goods and services and make netaddition to the national stock of capital. These together constitute the nationalincome of a ‘closed economy’—an economy which has no economic transactionswith the rest of the world. In an ‘open economy’, national income also includesthe net results of its transactions with the rest of the world (i.e., exports lessimports).

2. National income may also be estimated by adding the factor earnings and adjustingthe sum for indirect taxes and subsidies. The national income thus obtained isknown as national income at factor cost. It is related to money income flows.

3. This method is also known as income method and factor-share method. Underthis method, the national income is calculated by adding up all the “incomes accruingto the basic factors of production used in producing the national product”. Factorsof production are conventionally classified as land, labour, capital and organization.

4. According to Studenski, capital incomes include the following kinds of earnings:(a) Dividends excluding inter-corporate dividends;(b) Undistributed before-tax-profits of corporations;

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(c) Interest on bonds, mortgages, and saving deposits (excluding interests onwar bonds, and on consumer-credit);

(d) Interest earned by insurance companies and credited to the insurance policyreserves;

(e) Net interest paid out by commercial banks;(f) Net rents from land, buildings, etc., including imputed net rents on owner-

occupied dwellings;(g) Royalties(h) Profits of government enterprises.

5. Two main considerations on the basis of which a particular method is chosen are:(i) the purpose of national income analysis and (ii) availability of necessary data.If the objective is to analyse the net output or value added, the net output methodis more suitable. In case the objective is to analyse the factor-income distribution,the suitable method for measuring national income is the income method. If theobjective at hand is to find out the expenditure pattern of the national income, theexpenditure or final products method should be applied.

6. Currently, output and income methods are used by the CSO to estimate the nationalincome of the country. The output method is used for agriculture and manufacturingsectors, i.e., the commodity producing sectors. For these sectors, the value addedmethod is adopted. Income method is used for the service sectors including trade,commerce, transport and government services.

7. The concept of MPC is related to the marginal consumption-income relationship.In other words, MPC refers to the relationship between change in consumptionand the change in income.

8. The two approaches are known as income-expenditure approach and saving-investment approach.

9. Static multiplier is also known as ‘comparative static multiplier’, ‘simultaneousmultiplier’, ‘logical multiplier’, ‘timeless multiplier’ or ‘lagless multiplier’. Theconcept of static multiplier assumes that the change in investment and the resultingchange in income are simultaneous.Dynamic multiplier traces the process by which equilibrium of national incomeshifts from one position to another.

10. The working of multiplier is based on the assumption that the goods and servicesare always available in adequate supply. But, if goods and services are in scarcity,the actual consumption expenditure will be reduced whatever the rate of MPC.



1. What kind of activities of a nation are considered economic activities?2. How can national income be defined as money flow?3. Which are the three ways in which the economy is viewed for measuring the

national income?4. When did the measurement of national income begin in India and who were the

pioneers to do it?

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1. Identify and describe the three main measures of national income.2. Which are some of the methods used for measuring national income?3. Discuss the two-sector model of determination of national income.4. State the properties of the consumption function.5. Identify the limitations of multiplier.

7.9 FURTHER READING








Footnote1. This section is based mostly on Paul Studenski’s, The Income of Nations (Part Two),

Theory and Methodology (University Press, New York, 1958).2. Studenski, Paul, op. cit.3. Conventionally, pension to the retired employees is considered to be a ‘transfer payment’

and is excluded from the labour income and national income accounting. In the US,however, this item is included in national income (See Studenski, op. cit., pp. 11 and118–20).

4. Some often quoted estimates were made by Atkinson, F.J. (1875 and 1895); Major Baring(1881); W. Digby, (1898–99); Curzon (1901); E.A. Home, (1911); C.N. Vakil and S.K.Muranjan (1891–94 and 1911–14); Findlay Shirras (1911 and 1921); K.T. Shah and K.J.Khambata (1900–14 annual and 1921–22); V.K.R.V. Rao (1925–29 and 1931–32);Commerce, Journal (1938–39, 1942–43 and 1947–48). (Year in the parentheses are thereference years).

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5. Tobin, James, ‘Relative Income, Absolute Income and Saving,” in Money, Trade andEconomic Growth, (Macmillan, 1951); and Arthur Smithies, “Forecasting PostwarDemand: I,” Econometrica, January 1945.

6. We shall also assume a linear consumption function, i.e., a constant marginal propensityto consume.

7. When Y = ` 1,000, C + I = 100 + 0.75 (1000) + 100 = 950.8. The concept and theory of multiplier is discussed in the next section.

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