CA FOUNDATION

BUSINESS ECONOMICS
PART – I
 CA FOUNDATION
Business Economics
INDEX
(Update: 25.03.2023)

CHAPTER 1 NATURE AND SCOPE OF BUSINESS ECONOMICS

(UNIT - I) INTRODUCTION 1.1 to 1.15
(UNIT - II) BASIC PROBLEMS OF AN ECONOMY & ROLE OF
1.1 to 1.14
PRICE
CHAPTER 2 THEORY OF DEMAND AND SUPPLY
(UNIT - I) THEORY OF DEMAND AND SUPPLY 2.1 to 2.63
(UNIT - II) THEORY OF CONSUMER BEHAVIOUR 2.2 to 2.33
(UNIT - III) SUPPLY 2.1 to 2.18
CHAPTER 3 THEORY OF PRODUCTION AND COST
(UNIT - I) THEORY OF PRODUCTION 3.1 to 3.40
(UNIT - II) THEORY OF COST 3.1 to 3.31
CHAPTER 4 PRICE DETERMINATION IN DIFFERENT MARKETS
(UNIT- I) PRICE DETERMINATION IN DIFFERENT
MARKETS 4.1 to 4.14
(UNIT - II) DETERMINAITON OF PRICES 4.2 to 4.09
(UNIT-III) PRICE OUTPUT DETERMINAITON UNDER
DIFFERENT MARKET FORMS 4.1 to 4.31

CHPATER 5 BUSINESS CYCLES 5.1 to 5.12

 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.1

CHAPTER – 1 NATURE AND SCOPE OF BUSINESS ECONOMICS

NATURE AND SCOPE OF BUSINESS ECONOMICS
UNIT -1: INTRODUCTION

INTRODUCTION
What is Economics ?
 The term ‘Economics’ owes its origin to the Greek word ‘Oikonomia’ which means
‘household’.
 Till 19th century, Economics was known as ‘Political Economy.’
 The book named
 ‘An Inquiry into the Nature and Causes of the Wealth of Nations’ (1776)
 usually abbreviated as ‘The Wealth of Nations’,
 by Adam Smith is considered as the first modern work of Economics.
Since we cannot have everything we want with the resources we have, we are forever forced to
make choices. Therefore, we choose to satisfy only some of our wants leaving many other wants
unsatisfied.
These two fundamental facts that:

(i) ‘Human beings have unlimited wants’; and

(ii) ‘The means to satisfy these unlimited wants are relatively scarce’ form the subject matter
of Economics

Now examine what Economics studies about.

• Economics is the study of the processes by which the relatively scarce resources are
allocated to satisfy the competing unlimited wants of human beings in a society.

• Of course, the available resources will be efficiently used when they are allocated to their
highest valued uses.

• Economics is, thus, the study of how we work together to transform the scarce resources
into goods and services to satisfy the most pressing of our infinite wants and how we
distribute these goods and services among ourselves.

Critical Examination of Definition of Economics ( Modern Economics )

 This definition of Economics, with the narrow focus on using the relatively scarce
resources to satisfy human wants, is the domain of modern neo classical micro economic
analysis.
 Despite being correct, it is incomplete as it brings to our mind the picture of a society with
fixed resources, skills and productive capacity.
 However, two of the most important concerns of modern economies are not fully covered
by this concept.
o On the one hand,
 we find that the productive capacity of modern economies has grown
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.2

tremendously.
 Population and labour force have increased, new sources of raw materials
have been discovered, and new and better plant and equipment have been
made available on farms and in factories and mines.
 Not only has the quantity of available productive resources increased, their
quality has also improved substantially.
 Better education and newly acquired skills have raised the productivity of
labour force, and has led to the discovery of completely new kinds of natural
resources such as shale gas and new alternative greener sources of energy
such as solar and wind power.
 On the other hand,
 we know that the resulting growth in production and income has not been
smooth.
 There have been periods in which output not only failed to grow, but also
actually declined sharply (Global Financial Crisis 2007 and Corona Pandemic
2019).
 During such periods, factories, workers and other productive resources have
remained idle due to insufficient demand.
Conclusion

 Economics, therefore, concerns itself not just with the crucial concern of how a nation
allocates its scarce productive resources to various uses; it also deals with the processes
by which the productive capacity of these resources is increased and with the factors
which, in the past, have led to sharp fluctuations in the rate of utilisation of these
resources.
 The study of Economics will enable us to develop an analytical approach that helps us in
understanding and analysing a wide range of economic issues.
 It would also provide us with a number of models and frameworks that can be applied in
different situations.
 The tools of Economics assist in choosing the best course of action from among the
different alternative courses of action available to the decision maker.
 However, it is necessary to remember that most economic problems are of complex
nature and are affected by several forces, some of which are rooted in Economics and
others in political set up, social norms, etc.
 The study of Economics cannot ensure that all problems will be appropriately tackled; but,
without doubt, it would enable a student to examine a problem in its right perspective and
would help him in discovering suitable measures to deal with the same.
Meaning of Business Economics

 Business Economics, also referred to as Managerial Economics, generally refers to the

integration of economic theory with business practice.
 While the theories of Economics provide the tools which explain various concepts such as
demand, supply, costs, price, competition etc., Business Economics applies these tools in
the process of business decision making.
 Thus, Business Economics comprises of that part of economic knowledge, logic, theories
and analytical tools that are used for rational business decision making.
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.3

 In brief, it is Applied Economics that fills the gap between economic theory and business
practice.
 Business Economics has close connection with Economic theory (Micro as well as Macro-
Economics),
 Operations Research,
 Statistics,
 Mathematics and
 the Theory of Decision-Making.
 A professional business economist has to integrate the concept and methods from all
these disciplines in order to understand and analyse practical managerial problems.
 Business Economics is not only valuable to business decision makers, but also useful for
managers of ‘not-for-profit’ organisations such as NGO, and voluntary organisations.
DEFINITIONS OF BUSINESS ECONOMICS

 Business Economics may be defined as the use of economic analysis to make business
decisions involving the best use of an organization’s scarce resources.
 Joel Dean defined Business Economics in terms of the use of economic analysis in the
formulation of business policies.
 Business Economics is essentially a component of Applied Economics as it includes
application of selected quantitative techniques such as
 linear programming,
 regression analysis,
 capital budgeting,
 break even analysis and cost analysis
NATURE OF BUSINESS ECONOMICS
Economics has been broadly divided into two major parts i.e.
 Micro Economics and
 Macro Economics.
Micro Economics
 Micro Economics is basically the study of the behaviour of different individuals and
organizations within an economic system.
 In other words, Microeconomics examines how the individual units (consumers or
firms) make decisions as to how to efficiently allocate their scarce resources.
 Here, the focus is on a small number of or group of units rather than all the units
combined, and therefore, it does not explain what is happening in the wider economic
environment.
We mainly study the following in Micro-Economics:
(i) Product pricing;
(ii) Consumer behaviour;
(iii) Factor pricing;
(iv) The economic conditions of a section of people;
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.4

(v) Behaviour of firms; and

(vi) Location of industry.
Macro Economics
 Micro Economics, in contrast, is the study of the overall economic phenomena or the
economy as a whole, rather than its individual parts.
 Accordingly, in Macro-Economics, we study the behaviour of the large economic
aggregates, such as, the overall levels of output and employment, total consumption, total
saving and total investment, exports, imports and foreign investment and also how these
aggregates shift over time.
 It analyzes the overall economic environment in which the firms, governments and
households operate and make decisions.
 However, it should be kept in mind that this economic environment represents
the overall effect of the innumerable decisions made by millions of different
consumers and producers.
A few areas that come under Macro Economics are:
(i) National Income and National Output;
(ii) The general price level and interest rates;
(iii) Balance of trade and balance of payments;
(iv) External value of currency;
(v) The overall level of savings and investment; and
(vi) The level of employment and rate of economic growth.
Business Economics with Micro and Macro Economics

 While Business Economics is basically concerned with Micro Economics, Macro

economic analysis also hasgot an important role to play.

 Macroeconomics analyzes the background of economic conditions in an economy

which will immensely influence the individual firm’s performance as well as its
decisions.

 Business firms need a thorough understanding of the macroeconomic environment in

which they have to function.

 For example, knowledge regarding conditions of inflation and interest rates will be
useful for the business economist in framing suitable policies. Moreover, the long-
run trends in the business world are determined bythe prevailing macroeconomic factors.
Having understood the meaning of Micro and Macro Economics, we shall
examine the nature of Business Economics:
Nature of Business Economics

 The economic world is extremely complex as there is a lot of interdependence

among the decisions andactivities of economic entities.

 Economic theories are hypothetical and simplistic in character as they are based on
economic models built on simplifying assumptions.
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.5

 Therefore, usually, there is a gap between the propositions of economic theory and
happenings in the real economic world in which the managers make decisions.

 Business Economics enables application of economic logic and analytical tools to bridge
the gap between theory and practice.
The following points will describe the nature of Business Economics:
 Business Economics is a Science:
 Science is a systematized body of knowledge which establishes cause and effect
relationships.
 Business Economics integrates the tools of decision sciences such as Mathematics,
Statistics and Econometrics with Economic Theory to arrive at appropriate strategies
for achieving the goals of the business enterprises.
• It follows scientific methods and empirically tests the validity of the results.
 Based on Micro Economics:
• Business Economics is based largely on Micro-Economics.
• A business manager is usually concerned about achievement of the predetermined
objectives of his organisation so as to ensure the long-term survival and profitable
functioning of the organization.
• Since Business Economics is concerned more with the decision making problems
of individual establishments, it relies heavily on the techniques of Microeconomics.
 Incorporates elements of Macro Analysis:
• A business unit does not operate in a vacuum. It is affected by the external
environment of the economy in which it operates such as,
• the general price level,
• income and employment levels in the economy and government policies with
respect to taxation,
• interest rates,
• exchange rates,
• industries, prices,
• distribution,
• wages and regulation of monopolies.
All these are components of Macroeconomics.
 A business manager must be acquainted with these and other macroeconomic variables,
present as well as future, which may influence his/ her business environment.
 Business Economics is also an Art
• It involves practical application of rules and principles for the attainment of set
objectives.
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 Use of Theory of Markets and Private Enterprises:

• Business Economics largely uses the theory of markets and private enterprise.
• It uses the theory of the firm and resource allocation in the backdrop of a private
enterprise economy.
 Pragmatic in Approach:
• Micro-Economics is abstract and purely theoretical and analyses economic
phenomena under unrealistic assumptions.
• In contrast, Business Economics is pragmatic in its approach as it tackles practical
problems which the firms face in the real world.
 Interdisciplinary in Nature:
• Business Economics is interdisciplinary in nature as it incorporates tools from
other disciplines such as Mathematics, Operations Research, Management
Theory, Accounting, marketing, Finance, Statistics and Econometrics.
 Normative in Nature:
• Economic theory has developed along two lines – positive and normative.
• A positive or pure science analyses
• cause and effect relationship between variables in an objective and scientific
manner, but it does not involve any value judgement.
• In other words, it states ‘what is’ of the state of affairs and not what ‘ought to be’.
• In other words, it is descriptive in nature in the sense that it describes the
economic behaviour of individuals or society without prescriptions about the
desirability or otherwise of such behaviour.
• As against this, a normative science involves value judgements.
• It is prescriptive in nature and suggests ‘what should be’ a particular course of
action under given circumstances.
• Welfare considerations are embedded in normative science.
Business Economics is generally normative or prescriptive in nature. It suggests the
application of economic principles with regard to policy formulation, decision-making and
future planning.
Thus, Business Economics combines the essentials of normative and positive economic theory.
SCOPE OF BUSINESS ECONOMICS
There are two categories of business issues to which economic theories can be directly applied,
namely:
1. Internal issues or operational issues (this can be solved using Micro
Economics)
2. External issues or environmental issues (this can be solved using Macro
Economics)
Now we will see both of them one by one -
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.7

1. Microeconomics applied to ntIernal or Operational Issues

 Operational issues include all those issues that arise within the organization
and fall within the purview and control of the management.
 These issues are internal in nature. Issues related to choice of business
and its size, product decisions, technology and factor combinations,
pricing and sales promotion, financing and management of investments
and inventory are a few examples of operational issues.
The following Microeconomic theories deal with most of these issues.
 Demand Analysis and Forecasting:
 Demand analysis pertains to the behaviour of consumers in the market.
 It studies the nature of consumer preferences and the effect of changes in the
determinants of demand such as, price of the commodity, consumers’ income,
prices of related commodities, consumer tastes and preferences etc.
 Demand forecasting is the technique of predicting future demand for goods
and services on the basisof the past behaviour of factors which affect demand.
 Accurate forecasting is essential for a firm to enable it to produce the required
quantities at the right time and to arrange, well in advance, for the various factors of
production viz., raw materials, labour, machines, equipment, buildings etc.
 Business Economics provides the manager with the scientific tools which
assist him in forecasting demand.
 Production and Cost Analysis
 Production theory explains the relationship between inputs and output.
 A business economist has to decide on the optimum size of output, given the
objectives of the firm. He has also to ensure that the firm is not incurring undue
costs.
 Production analysis enables the firm to decide on the choice of appropriate
technology and selection of least - cost input-mix to achieve technically
efficient way of producing output, given the inputs.
 Cost analysis enables the firm to recognise the behaviour of costs when
variables such as output, time period and size of plant change.
 The firm will be able to identify ways to maximize profits by producing the desired
level of output at the minimum possible cost.
 Inventory Management:
 Inventory management theories pertain to rules that firms can use to minimise the
costs associated with maintaining inventory in the form of ‘work-in-process,’
‘raw materials’, and ‘finished goods’.
 Inventory policies affect the profitability of the firm.
 Business economists use methods such as ABC analysis, simple simulation
exercises and mathematical models to help the firm maintain optimum stock
of inventories.
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.8

 Market Structure and Pricing Policies:

 Analysis of the structure of the market provides information about the nature and
extent of competition which the firms have to face.
 This helps in determining the degree of market power (ability to determine prices)
which the firm commands and the strategies to be followed in market management
under the given competitive conditions such as, product design and marketing.
 Price theory explains how prices are determined under different kinds of
market conditions and assists the firm in framing suitable price policies.
Resource Allocation:
 Business Economics, with the help of advanced tools such as linear programming,
enables the firm to arrive at the best course of action for optimum utilisation of
available resources.
 Theory of Capital and Investment Decisions:
 For maximizing its profits, the firm has to carefully evaluate its investment
decisions and carry out a sensible policy of capital allocation.
 Theories related to capital and investment provides scientific criteria for choice of
investment projects and in assessment of the efficiency of capital.
 Business Economics supports decision making on allocation of scarce capital
among competing uses of funds.
 Profit Analysis:
 Profits are, most often, uncertain due to changing prices and market
conditions.
 Profit theory guides the firm in the measurement and management of profits
under conditions of uncertainty.
 Profit analysis is also immensely useful in future profit planning.
 Risk and Uncertainty Analysis:
 Business firms generally operate under conditions of risk and uncertainty.
 Analysis of risks and uncertainties helps the business firm in arriving at
efficient decisions and in formulating plans on the basis of past data, current
information and future prediction.
 Macroeconomics applied to External or Environmental Issues
The majormacro-economic factors relate to:
 The type of economic system
 Stage of business cycle
 The general trends in national income, employment, prices, saving and
investment.
 Government’s economic policies like industrial policy, competition
policy, and fiscal policy, foreigntrade policy and globalization policies.
 Working of central banks and financial sector and capital market and their
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.9

regulation.
 Socio-economic organisations like trade unions, producer and consumer unions
and cooperatives.
 Social and political environment.

*************
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.10

QUESTIONS & ANSWERS

1. What implication does resource scarcity have for the satisfaction of wants?
(a) Not all wants can be satisfied.
(b) We will never be faced with the need to make choices.
(c) We must develop ways to decrease our individual wants.
(d) The discovery of new natural resources is necessary to increase our ability to satisfy
wants.

2. Economics is the study of

(a) how society manages its unlimited resources.
(b) how to reduce our wants until we are satisfied.
(c) how society manages its scarce resources.
(d) how to fully satisfy our unlimited wants

3. Economic laws are essentially and .

(a) hypothetical, conditional (b) hypothetical, unconditional
(c) Neutral, rigid (d) neutral, flexible

4. Which of the following can be regarded as law of economics?

(a) Ceteris Paribus, if the price of a commodity rises the quantity demanded of it will fall
(b) Higher the income, greater is the expenditure
(c) Taxes have no relation with the benefits which a person derives from the state
(d) None of the above

5. Which of the following is the best general definition of the study of Economics?
(a) Inflation and unemployment in a growing economy
(b) Business decision making under foreign competition
(c) Individual and social choice in the face of scarcity
(d) The best way to invest in the stock market
6. The meaning of the word 'Economic' is most closely connected with the word :
(a) Extravagant (b) Scarce
(c) Unlimited (d) Restricted

7. Which of the following statements is correct?

(a) Economic laws are mere statement of tendencies
(b) Economics laws are as exact as physical laws
(c) Economics laws are permanent
(d) All of the above
8. Which one in the following is not correct
(a) There are limited wants (b) Means are scarce
(c) Resources have alternative uses (d) Economics is science
9. The law of scarcity:
(a) Does not apply to rich, developed countries.
(b) Applies only to the less developed countries
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.11

(c) Implies that consumers wants will be satisfied in a socialistic system

(d) Implies that consumers wants will never be completely satisfied.
10. Macroeconomics is also called. ......... economies.
(a) Applied (b) Aggregate
(c) Experimental (d) None of the above

11. Economic goods are considered scarce resources because they:

(a) Cannot be increased in quantity
(b) Do not exist in adequate quantity to satisfy social requirements
(c) are not primary importance in satisfying social requirements.
(d) are limited to man made goods

12. Choice is created by the:

(a) Abundance of resources (b) Urgency of needs
(c) Non- availability of resources (d) Scarcity of resources

13. Larger production of. ..........................................goods would lead to higher production in

future.
(a) Consumer goods (b) Capital goods
(c) Agricultural goods (d) Public goods

14. The term 'Economics' owes its origin to the Greek word:
(a) Aikonomia (b) Wikonomia
(c) Oikonomia (d) None of the above
15. Oikonomia means:
(a) Industry (b) Household
(c) Services (d) None of these
16. Adam smith pubilshed his masterpiece "An enquiry into the nature and causes of
wealth or nation" in theyear:
(a) 1776 (b) 1786
(c) 1756 (d) 1766
17. Economics may be defined as the science that explains................
(a) the choices that we make as we cope with scarcity
(b) the decisions made by politicians
(c) the decisions made by households
(d) all human behaviour

18. Scarcity is a situation in which ....

(a) wants exceed the resources available to satisfy them
(b) Something is being wasted
(c) People are poor
(d) None of the above
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.12

19. When productivity increases.......................

(a) Prices rise (b) Living standards improve
(c) There are fewer good jobs (d) living standards deteriorate
20. The task of economic science is to........................
(a) save the earth from the overuse of natural resources
(b) help us to understand how the economic world works
(c) tell us what is good for us
(d) make moral choices about things like drugs
21. A study of how increases in the corporate income tax rate will affect the national
unemployment rate is an example of ------------------.
(a) macro economics. (b) descriptive economics.
(c) micro economics. (d) normative economics.
22. From the national point of view which of the following indicates micro approach?
(a) Per capita income of India.
(b) Underemployment in agricultural sector.
(c) Lock out in TELCO.
(d) Total savings in India.
23. Which of the following is not microeconomic subject matter?
(a) The price of apples.
(b) The cost of producing a fire truck for the fire department of Delhi, India
(c) The quantity of apples produced for the apple market.
(d) The national economy's annual rate of growth.
24. Price theory is an important constituent of Economics.
(a) Micro (b) Macro
(c) Developmental (d) Welfare
25. State which of the following represents macro from the national point of view.
(a) Turnover ratio of Reliance Ltd.
(b) Capital output ratio of Indian Industries
(c) Debt equity ratio of TELCO
(d) All the above
26. Which of the following does not suggest a macro approach for India ?
(a) Determining the GNP of India
(b) Identifying the causes of inflation in India
(c) Finding the causes of failure of X and Co.
(d) Analyse the causes of failure of industry in providing large scale employment
27. Which of the following statements is correct?
(a) Employment and economic growth are studied in micro economics.
(b) Micro economics deals with balance of trade
(c) Economic condition of a section of the people is studied in Micro Economics
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.13

(d) External value of money is dealt with in micro-economics

28. Which of the following falls under Micro Economics ?
(a) National Income (b) General Price level
(c) Factor Pricing (d) National Saving and Investment
29. When we study why saving rates are high or low, we are studying:
(a) Macro Economics (b) Micro Economics
(c) Both (a) and (b) (d) None of the above

30. In Micro Economics we study the Economic behaviour of:

(a) An Individual (b) Firm
(c) Industry (d) All of the above
31. Macro economics is the study of:
(a) Inflation (b) Unemployment A
(c) Growth (d) All of the above
32. Micro economics is also known as______________
(a) Public economics (b) Price theory
(c) Income theory (d) Demand theory
33. The branch of economic theory that deals with the problem of allocation of
resources is :
(a) micro-economic theory (b) macro-economic theory
(c) econometrics (d) none of the above
34. Macro economics is the study of ....................
(a) All aspects of scarcity
(b) The national economy and the global economy as a whole
(c) Big businesses
(d) The decisions of individual businesses and people
35. Which of the following statements would you consider to be a normative one?
(a) Faster economic growth should result if an economy has a higher level of
investment.
(b) Changing the level of interest rates is a better way of managing the economy than
using taxation and government expenditure.
(c) Higher levels of unemployment will lead to higher levels of inflation.
(d) The average level of growth in the economy was faster in the 1990s than the 1980s.

36. Which of the following statements is normative?

(a) Large government deficits cause an economy to grow more slowly.
(b) People work harder if the wage is higher.
(c) The unemployment rate should be lower.
(d) Printing too much money causes inflation.
37. Questions like what should be the level of national income, what should be the
wage rate fall within thescope of:
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.14

(a) Positive Science (b) Normative Science

(c) Both (a) and (b) (d) None of the above
38. Economics is_________ .
(a) Not a normative science
(b) Not a positive science
(c) Partly science and partly art
(d) Neither a normative nor a positive science.
39. Which of the following is a normative statement?
(a) Planned economies allocate resources via government departments
(b) Reducing inequality should be a major priorities for mixed economies
(c) There is greater degree of consumer sovereignty in market economies
(d) Most economies have experienced problems of falling output and rising prices
40. Normative aspect of Economics is given by :
(a) Marshall (b) Robbins
(c) Adam Smith (d) Samuelson
41. Who gave the positive aspect of science?
(a) Alfred Marshall (b) A.C Pigou
(c) Adam Smith (d) Robbins
42. Ram : My corn harvest this year is poor.
Krishan: Don't worry. Price increases will compensate for the fall in quantity supplied.
Vinod: Climate affects crop yield. Some years are bad, others are good.
Madhur : The government ought to guarantee that our income will not fall. In this
conversation, the normative statement is made by:
(a) Ram (b) Krishan
(c) Vinod (d) Madhur
43. Which of the following is not one of the four central questions that the study of
economics is supposed toanswer?
(a) Who produces what? (b) When are goods produced?
(c) Who consumes what? (d) How are goods produced?
44. In Economics, the central economic problem means:
(a) Output is restricted to the limited availability of resources
(b) Consumers do not have as much money as they would wish
(c) There will always be certain level of unemployment
(d) Resources are not always allocated in an optimum way
45. Which of the following is a cause of an economic problem?
(a) Scarcity of Resources (b) Unlimited wants
(c) Alternative uses (d) All of the above
46. The Central problem in economics is that of:
(a) Comparing the success of command versus market economies.
(b) Guaranteeing that production occurs in the most efficient manner.
 NATURE AND SCOPE OF BUSINESS ECONOMICS (UNIT - 1) | 1.15

(c) Guaranteering a minimum level of income for every citizen.

(d) Allocating scarce resources in such a manner that society's unlimited needs or
wants are satisfied as well as possible.
47. Which of the following statements is correct?
(a) Robbins has made economics as a from of welfare economics
(b) The law of demand is always true
(c) all capital is wealth but all wealth is not capital
(d) None of the above
48. Which of the following statements is correct?
(a) As normative science, Economics involves value judgments
(b) Robbins has made economics as a form of welfare economics
(c) The Law of Demand is always true
(d) None of the above
49. When we are studying how a producer fixes the prices of his products we are
studying.
(a) Macro Economics (b) Micro Economics
(c) Both Micro and Macro Economics (d) None of the above

Answer Key
1 a 2 c 3 a 4 a 5 c 6 b 7 a 8 a 9 d 10 b 11 b 12 d 13 b
14 c 15 b 16 a 17 a 18 a 19 b 20 b 21 a 22 c 23 d 24 a 25 b 26 c

27 c 28 c 29 a 30 d 31 d 32 b 33 a 34 b 35 b 36 c 37 b 38 c 39 b
40 a 41 d 42 d 43 b 44 A 45 d 46 d 47 c 48 a 49 b
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.1

CHAPTER – 1 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM

BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM

BASIC PROBLEMS OFAN ECONOMY
 All countries, without exceptions, face the problem of scarcity. Their resources (natural
productive resources, man-made capital goods, consumer goods, money and time
etc.) are limited and these resources have alternative uses.
 For example, coal can be used as a fuel for the production of industrial goods; it can
be used for producing electricity, for domestic cooking purposes and for many other
purposes.
 Similarly, financial resources can be used for many purposes. If the resources were
unlimited, people would be able to satisfy all their wants and there would be no
economic problem.
 Alternatively, if a resource has only a single use, then also the economic problem
would not arise.
Every economic system, be it capitalist, socialist or mixed, has to deal with this central
problem of scarcity of resources relative to the wants for them. This is generally called
‘the central economic problem.
 The central economic problem is further divided into four basic economic problems.
These are:
 What to produce?
 How to produce?
 For whom to produce?
 What provisions (if any) are to be made for economic growth?
 What to produce? :
• Since the resources are limited, every society has to decide which
goods and services should be produced and how many units of
each good (or service) should be produced.
• Not only the society has to decide about what goods are to be
produced, it has also to decide in what quantities each of these goods
would be produced.
• In a nutshell, a society must decide how much wheat, how many
hospitals, how many schools, how many machines, how many
meters of cloths etc. have to be produced.
 How to produce? :
• There are various alternative techniques of producing a commodity.
• For example, cotton cloth can be produced using handlooms,
power looms or automatic looms.
• Production with handlooms involves use of more labour and
production with automatic loom involves use of more machines
and capital.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.2

• A society has to decide whether using

• labour-intensive techniques or
• capital-intensive techniques.
• The choice would depend on
• the availability of different factors of production (i.e. labour and capital) and
• Their relative prices.
• It is in the society’s interest to use those techniques of production that make the
best use of the available resources.
• For whom to produce? :
• A society cannot satisfy each and every want of all the people.
• Therefore, it has to decide on who should get how much of the total output of goods
and services, i.e. How the goods (and services) should be distributed among
the members of the society.
• In other words, it has to decide about the shares of different people in the
national cake of goods and services.
 What provision should be made for economic growth? :
• A society would not like to use all its scarce resources for current
consumption only.
• This is because, if it uses all the resources for current consumption and no provision
is made for future production, the society’s production capacity would not
increase.
• This implies that incomes or standards of living of the people would remain
stagnant, and in future, the levels of living may actually decline.
• Therefore, a society has to decide how much saving and investment (i.e. how
much sacrifice of current consumption) should be made forfuture progress.
Economic System

o An economic system refers to the sum total of arrangements for the production
and distribution of goods and services in a society.
all the economies divide into three broad classifications based on their mode of
production, exchange, distribution and the role which their governments plays in
economic activity. These are:
- Capitalist economy
- Socialist economy
- Mixed economy
CAPITALIST ECONOMY
 Capitalism, the predominant economic system in the modern global economy, is an
economic system in which all means of production are owned and controlled by
private individuals for profit.
 In short, private property is the mainstay of capitalism and profit motive is its driving
force. Decisions of consumers and businessesdetermine economic activity.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.3

 Ideally, the government has a limited role in the management of the economic
affairs under this system.
o Some examples of a capitalist economy may include United States and United
Kingdom, Hong Kong, South Korea etc.

o An economy is called capitalist or a free market economy or laissez- faire

economy if it has the following characteristics:

1) Right to private property:

• the right to private property means that productive factors such as land, factories,
machinery, mines etc. can be under private ownership.

• The owners of these factors are free to use them in any manner in which they
like and bequeath it as they desire.

• The government may, however, put some restrictions for the benefit of the
society in general.

2) Freedom of enterprise

 Each individual, whether consumer, producer or resource owner, is free to engage

in any type of economic activity.

 For example, a producer is free to set up any type of firm and produce goods
and services of his choice.

3) Freedom of economic choice

 A: ll individuals are free to make their economic choices regarding
consumption, work, production, exchange etc.

4) Profit motive:
 Profit motive is the driving force in a free enterprise economy and directs all
economic activities.

 Desire for profits induces entrepreneurs to organize production so as to earn

maximum profits.

5) Consumer Sovereignty:
 Consumer is supposed to be the king under capitalism.

 Consumer sovereignty means that buyers ultimately determine which goods

and services will be produced and in what quantities.

 Therefore, producers have to produce goods and services which are preferred by the
consumers.

 In other words, based on the purchases they make, consumers decide how the
economy's limited resources are allocated.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.4

6) Competition:
 Competition is the most important feature of the capitalist economy.

 Competition brings out the best among buyers and sellers and results in efficient use
of resources.

7) Absence of Government Interference

 A: purely capitalist economy is not centrally planned, controlled or
regulated by the government.

 In this system, all economic decisions and activities are guided by self-interest
and price mechanism which operates automatically without any direction and
control by the governmental authorities.

How do capitalist economies solve their central problems?

 A capitalist economy economy uses the impersonal forces of market demand and
supply or the price mechanism to solve its central problems.

Deciding ‘what to produce’

 The aim of an entrepreneur is to earn as much profits as possible. This causes
businessmen to compete with one another to produce those goods which consumers wish
to buy.

 Thus, if consumers want more cars, there will be an increase in the demand for cars and as
a result their prices will increase. A rise in the price of cars, costs remaining the
same, will lead to more profits. This will induce producers to produce more
cars.

 On the other hand, if the consumers’ demand for cloth decreases, its price would
fall and profits would go down. Therefore, business firms have less incentive to
produce cloth and less of cloth will be produced.
 Thus, more of cars and less cloth will be produced in such an economy.

 In a capitalist economy (like the USA, UK and Germany) the question regarding what
to produce is ultimately decided by consumers who show their preferences by
spending on the goods which they want.

Deciding ‘how to produce’:

 An entrepreneur will produce goods and services choosing that technique of production
which renders his cost of production minimum.
 If labour is relatively cheap, he will use labour- intensive method and if labour is
relatively costlier he will use capital-intensive method.
 Thus, the relative prices of factors of production help in deciding how to produce.

Deciding ‘for whom to produce’:

 Goods and services in a capitalist economy will be produced for those who have
buying capacity.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.5

 The buying capacity of an individual depends upon his income.

 How much income he will be able to make depends not only on the amount of work he
does and the prices of the factors he owns, butalso on how much property he owns.
 Higher the income, higher will be his buying capacity and higher will be his
demand for goods in general.

Deciding about consumption, saving and investment:

 Consumption and savings are done by consumers and investments are done by
entrepreneurs.
 Consumers’ savings, among other factors, are governed by the rate of interest
prevailing in the market. Higher the level of income and interest rates, higher will
be the savings.
 Investment decisions depend upon the rate of return on capital. The greater the profit
expectation (i.e. the return on capital), the greater will be the investment in a capitalist
economy.
 The rate of interest on savings and the rate of return on capital are nothing but the
prices of capital.

Merits of Capitalist Economy

1. Capitalism is self-regulating and works automatically through price mechanism.
2. The existence of private property and the driving force of profit motive result in greater
efficiency and incentive to work.
3. The process of economic growth is likely to be faster under capitalism. This is because
the investors try to invest in only those projects which are economically feasible.
4. Resources are used in activities in which they are most productive. This results in
optimum allocation of the available productive resources of the economy.
5. There is usually high degree of operative efficiency under the capitalist system.
6. Cost of production is minimized as every producer tries to maximize his profit by
employing methods of production which are cost-effective.
7. Capitalist system offer incentives for efficient economic decisions and their
implementation.
8. Consumers are benefitted as competition forces producers to bring in a large variety of
good quality products at reasonable prices. This, along with freedom of choice, ensures
maximum satisfaction to consumers. This also results in higher standard of living.
9. Capitalism offers incentives for innovation and technological progress. The country as
a whole benefits through growth of business talents, development of research, etc.
10. Capitalism preserves fundamental rights such as right to freedom and right to private
property. Therefore, the participants enjoy maximum amount of autonomy and
freedom.
11. Capitalism rewards men of initiative and enterprise and punishes the imprudent and
inefficient.
12. Capitalism usually functions in a democratic framework.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.6

13. The capitalist set up encourages enterprise and risk taking and emergence of an
entrepreneurial class willing to take risks.
Demerits of Capitalism
1. There is vast economic inequality and social injustice under capitalism.
2. Inequalities reduce the aggregate economic welfare of the society as a whole and split the
society into two classes namely the 'haves' and the 'have-nots', sowing the seeds of social
unrest and class conflict.
3. Under capitalism, there is precedence of property rights over human rights.
4. Economic inequalities lead to wide differences in economic opportunities and perpetuate
unfairness in the society.
5. The capitalist system ignores human welfare because, under a capitalist set up, the aim is
profit and not the welfare of the people.
6. Due to income inequality, the pattern of demand does not represent the real needs of the
society.
7. Exploitation of labour is common under capitalism. Very often this leads to strikes and
lock outs. Moreover, there is no security of employment. This makes workers more
vulnerable.
8. Consumer sovereignty is a myth as consumers often become victims of exploitation.
Excessive competition and profit motive work against consumer welfare.
9. There is misallocation of resources as resources will move into the production of luxury
goods. Less wage goods will be produced on account of their lower profitability.
10. Less of merit goods like education and health care will be produced. On the other hand, a
number of goods and services which are positively harmful to the society will be produced
as they are more profitable.
11. Due to unplanned production, economic instability in terms of over production, economic
depression, unemployment etc., is very common under capitalism. These result in a lot of
human misery.
12. There is enormous waste of productive resources as firms spend huge amounts of money
on advertisement and sales promotion activities.
13. Capitalism leads to the formation of monopolies as large firms may be able to drive out
small ones by fair or foul means.
14. Excessive materialism as well as conspicuous and unethical consumption leads to
environmental degradation.
SOCIALIST ECONOMY
• The concept of socialist economy was propounded by Karl Marx and Frederic Engels
in their work ‘The Communist Manifesto’ published in 1848.
• In this economy, the material means of production i.e. factories, capital, mines etc.
are owned by the whole community represented by the State.
• All members are entitled to get benefit from the fruits of such socialised planned
production on the basis of equal rights.
• A socialist economy is also called as “Command Economy” or a “Centrally Planned
Economy”.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.7

• Here, the resources are allocated according to the commands of a central planning
authority and therefore, market forces have no role in the allocation of resources.
• Under a socialist economy, production and distribution of goods are aimed at
maximizing the welfare of the community as a whole.
Some important characteristics of this economy are:
(i) Collective Ownership:
• There is collective ownership of all means of production except small farms,
workshops and trading firms which may remain in private hands.
• As a result of social ownership, profit- motive and self- interest are not the driving
forces of economic activity as it is in the case of a market economy.
• The resources are used to achieve certain socio-economic objectives.
(ii) Economic planning:
• There is a Central Planning Authority to set and accomplish socio- economic goals;
that is why it is called a centrally planned economy.
• The major economic decisions, such as what to produce, when and how much to
produce, etc., are taken by the central planning authority.
(iii) Absence of Consumer Choice
• Freedom from hunger is guaranteed, but consumers’ sovereignty gets restricted by
selective production of goods.
• The range of choice is limited by planned production.
• However, within that range, an individual is free to choose what he likes most.
• The right to work is guaranteed, but the choice of occupation gets restricted
because these are determined by the central planning authority on the basis of
certain socio-economic goals before the nation.
(iv) Relatively Equal Income Distribution
• A: relative equality of income is an important feature of Socialism.
• Among other things, differences in income and wealth are narrowed down by lack
of opportunities to accumulate private capital.
• Educational and other facilities are enjoyed more or less equally; thus the basic
causes of inequalities are removed.
(v) Minimum role of Price Mechanism or a Market forces:
• Price mechanism exists in a socialist economy; but it has only a secondary role,
e.g., to secure the disposal of accumulated stocks.
• Since allocation of productive resources is done according to a predetermined
plan, the price mechanism as such does not influence these decisions.
• In the absence of the profit motive, price mechanism loses its predominant role in
economic decisions.
• The prices prevailing under socialism are ‘administered prices’ which are set by
the central planning authority on the basis of socio-economic objectives.
(vi) Absence of Competition:
• Since the state is the sole entrepreneur, there is absence of competition under socialism.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.8

The erstwhile U.S.S.R. was an example of socialist economy from 1917 to 1990. In today’s
world there is no country which is purely socialist. Other examples include Vietnam, China and
Cuba. North Korea, the world’s most totalitarian state, is another example of a socialist
economy.
Merits of Socialism

1. Equitable distribution of wealth and income and provision of equal opportunities for
all help to maintain economic and social justice.
2. Rapid and balanced economic development is possible in a socialist economy as the
central planning authority coordinates all resources in an efficient manner according to
set priorities.
3. Socialist economy is a planned economy. In a socialistic economy, there will be better
utilization of resources and it ensures maximum production. Wastes of all kinds are
avoided through strict economic planning. Since competition is absent, there is no
wastage of resources on advertisement and sales promotion.
4. In a planned economy, unemployment is minimised, business fluctuations are
eliminated and stability is brought about and maintained.
5. The absence of profit motive helps the community to develop a co-operative mentality
and avoids class war. This, along with equality, ensures better welfare of the society.
6. Socialism ensures right to work and minimum standard of living to all people.
7. Under socialism, the labourers and consumers are protected from exploitation by the
employers and monopolies respectively.
8. There is provision of comprehensive social security under socialism and this makes
citizens feel secure.
Demerits of Socialism

1. Socialism involves the predominance of bureaucracy and the resulting inefficiency

and delays. Moreover, there may also be corruption, red tapism, favouritism, etc.
2. It restricts the freedom of individuals as there is state ownership of the material
means of production and state direction and control of nearly all economic activity.
3. Socialism takes away the basic rights such as the right of private property.
4. It will not provide necessary incentives to hard work in the form of profit.
5. Administered prices are not determined by the forces of the market on the basis of
negotiations between the buyers and the sellers. There is no proper basis for cost
calculation. In the absence of such practice, the most economic and scientific
allocation of resources and the efficient functioning of the economic system are
impossible.
6. State monopolies created by socialism will sometimes become uncontrollable. This
will become more
7. difficult to regulate than the private monopolies under capitalism.
8. Under socialism, the consumers have limited freedom of choice. Therefore, what the
state produces has to be accepted by the consumers.
9. No importance is given to personal efficiency and productivity. Labourers are not
rewarded according to their efficiency. This acts as a disincentive to work.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.9

10. The extreme form of socialism is not at all practicable.

THE MIXED ECONOMY
 The mixed economic system depends on both markets and governments for allocation of resources.
 In fact, every economy in the real world makes use of both markets and governments and
therefore is mixed economy in its nature.
 In a mixed economy, the aim is to develop a system which tries to include the best features of both the
controlled economy and the market economy while excluding the demerits of both.
 It appreciates the advantages of private enterprise and private property with their emphasis on self-
interest and profit motive.
 Vast economic development of England, the USA etc. is due to private enterprise.
 At the sametime, it is noticed that private property, profit motive and self-interest of
the market economy may not promote the interests of the community as a whole
and as such, the Government should remove these defects of private enterprise.
 For this purpose, the Government itself must run important and selected industries
and eliminate the free play of profit motive and self-interest.
 Private enterprise which has its own significance is also allowed toplay a positive role in
a mixed economy.
 However, the state imposes necessary measures to control and to regulate the
private sector to ensure that they function in accordance with the welfare objectives
of the nation.

Features of Mixed Economy

Co-existence of private and public sector

 The first important feature of a mixed economy is the co-existence of both private and
public enterprise.
In fact, in a mixed economy, there are three sectors of industries:
(a) Private sector:
 Production and distribution in this sector are managed and controlled by
private individuals and groups.
 Industries in this sector are based on self-interest and profit motive.
 The system of private property exists and personal initiative is given full
scope.
 However, private enterprise may be regulated by the government directly
and/or indirectly by a number of policy instruments.
(b) Public sector:
 Industries in this sector are not primarily profit-oriented, but are set up
by the State forthe welfare of the community.
(c) Combined sector:
 A sector in which both the government and the private enterprises have equal
access, and join hands to produce commodities and services, leading to the
establishment of joint sectors.
Mixed economy has the following merits available to capitalist economies and socialist
economies.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.10

1. Economic freedom and existence of private property which ensures incentive to

work.
2. Price mechanism and competition forces the private sector to promote efficient
decision- making and better resource allocation.
3. Consumers are benefitted through consumers’ sovereignty and freedom of choice.
4. Appropriate incentives for innovation and technological progress.
5. Encourages enterprise and risk taking.
6. Advantages of economic planning and rapid economic development on the basis of
plan priorities.
7. Comparatively greater economic and social equality and freedom from exploitation due
to greater state participation and direction of economic activities.
8. Disadvantages of cut-throat competition averted through government’s legislative
measures such as environment and labour regulations.
 However, mixed economy is not always a ‘golden path’ between capitalism and
socialism. It could also suffer from substantial uncertainties.
 Mixed economy, sometimes, is characterised by excessive controls by the state
resulting
o in reduced incentives and constrained growth of the private sector,
o poor implementation of planning,
o higher rates of taxation,
o lack of efficiency,
o corruption,
o wastage of resources,
o undue delays in economic decisions and poor performance of the public
sector.
 Moreover, it is very difficult to maintain a proper balance between the public and
private sectors.
 In the absence of strong governmental initiatives, the private sector is likely to grow
disproportionately. The system would then resemble capitalism with all its
disadvantages.
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.11

QUESTIONS AND ANSWERS

1. Consider the following and decide which, if any, economy is without scarcity:
(a) The pre-independence Indian economy, where most people were farmers.
(b) A mythical economy where everybody is a billionaire.
(c) Any economy where income is distributed equally among its people.
(d) None of the above.
2. An example of positive economic analysis would be:
(a) an analysis of the relationship between the price of food and the quantity purchased
(b) determining how much income each person should be granted
(c) determining the fair price for food
(d) deciding how to distribute the output of the economy
3. Which of the following is correct?
(a) Normative economics is not concerned with value judgment.
(b) A market is a process that reconciles consumer decision, production decisions and
labour decisions.
(c) A mixed economy has a certain level of government intervention in the economy
along with private sector ownership of the economy.
(d) (b) and (c).
4. Which of the following is incorrect?
(a) The central problem in economics is that of allocating scarce resources in such a
manner that society's unlimited needs are satisfied as well as possible.
(b) In mixed economy, the government and the private sector interact in solving the
basic economic questions.
(c) Microeconomics best describes the study of the behaviour of individual agents.
(d) An important theme in economics is that market systems are better than command
(socialistic) economies.
5. Which of the following statements is correct?
(a) In a two-good economy, the production possibilities frontier reflects the maximum
amount of one good that can be produced when a given amount of the other good is
produced.
(b) Microeconomics is the study of the behaviour of the economy as a whole.
(c) Positive economics focuses on welfare of the people of a society.
(d) None of the above.
6. Which of the following statements is correct?
(a) Unlike normative economics, positive economics is based on objective analysis of
economic issues.
(b) The opportunity cost of a good is the quantity of other goods sacrificed to get
another unit of that good.
(c) Microeconomics emphasizes interactions in the economy as a whole.
(d) None of the above.
7. What is one of the future consequences of an increase in the current level of
consumption in the India?
(a) Slower economic growth in the future
(b) Greater economic growth in the future
(c) No change in our economic growth rate
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.12

(d) Greater capital accumulation in the future

8. Capital intensive technique would get chosen in a
(a) labour surplus economy (b) capital surplus economy
(c) developed economy (d) developing economy
9. Labour intensive technique would get chosen in a :
(a) Labour surplus economy (b) Capital surplus economy
(c) Developed economy (d) Developing economy
10. Identify the correct statement:
(a) In capitalist economy people are not free to spend their income as they like
(b) In socialist economy the right to work is guaranteed but the choice of occupation
gets restricted
(c) In socialist economy a relative inequality in income is an important feature.
(d) In today's world only U.S.A. is a purely socialist country
11. In a free market-economy, when consumer decrease their purchase of a good and
the level of ___________________ exceeds ___________________ then prices tend to fall.
(a) Prices, demand (b) Profits supply
(c) Demand supply (d) Supply, demand
12. Which of the following is not one of the features of capitalist economy?
(a) Right of private property
(b) Freedom of choice by the consumers
(c) No profit, No Loss motive
(d) Competition
13. Which of the following statements is incorrect in case of capitalist economy?
(a) There is equality of income among people in the economy
(b) Profit-motive gets precedence over social motive
(c) Freedom of enterprise about what to produce
(d) Right to own property
14. An economy achieves " productive efficiency" when:
(a) The best quality goods are produced
(b) The highly skillful resources in the country are fully employed
(c) All resources are utilized and goods and services are produced at least cost
(d) None of the above
15. Economic goods are goods which:
(a) Cannot be increased in quantity
(b) Obey the law of Micro Economics
(c) Are limited in supply and are scarce
(d) Are limited to man-made goods.
16. Which economy is now a myth only, as no country in the world is having that type of
economy
(a) Capitalist Economy (b) Socialist Economy
(c) Mixed Economy (d) None of the above
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.13

17. Full employment is the level at which there is:

(a) Normal rate of unemployment (b) Zero unemployment
(c) Least supply of labour (d) None of the above
18. Right to own private property is found in:
(a) Socialism (b) Capitalism
(c) Mixed Economy (d) Both (b) and (c)
19. A capital economy uses _______________ as the principle means of allocation of resource :
(a) Demand (b) Supply
(c) Efficiency (d) Price
20. In which type of economy do consumers and producer make their choice based on
the market forces of demand and supply ?
(a) Open Economy (b) Controlled Economy
(c) Command Economy (d) Market Economy
21. Under a free economy prices are :
(a) Regulated
(b) Determined through free interplay of demand and supply
(c) Party regulated
(d) None of these
22. A Free Market economy solves its Central Problems through _____________________
(a) Planning Authority. (b) Market Mechanism
(c) Both (d) None
23. Which one is not the characteristic of capitalistic economy ?
(a) Profit motive (b) Income inequality
(c) Free employment (d) Collective ownership
24. Mixed economy means
(a) All economic decisions are taken by Central Authority
(b) All economic decisions are taken by private entrepreneurs
(c) Economic decisions state and partly by private entrepreneurs
(d) None of these
25. A developed economy uses_____________________ technique in production.
(a) Labour intensive (b) Capital intensive
(c) Home based (d) Traditional
26. Inequalities of income do not perpetuate in ________________________
(a) Socialism (b) Mixed Economy
(c) Capitalism (d) None
27. In a free market economy the allocation or resources is a determined by:
(a) Votes taken by consumers (b) a central planning authority
(c) Consumer preference (d) The level of profits of firms
28. Which of the following would be considered a disadvantage of allocating resources
using a market system?
(a) Income will tend to be unevenly distributed
 BASIC PROBLEMS OF AN ECONOMY AND ROLE OF PRICE MECHANISM (unit - II) |1.14

(b) Significant unemployment may occur.

(c) It cannot prevent the wastage of scarce economic resources.
(d) Profits will tend to be low
29. In an economy people have the freedom to buy or not to buy the goods offered in the
market place, and this freedom to choose what they buy dictates what producers
will ultimately produce. The key term defining this condition is:
(a) Economic power of choice (b) Consumer sovereignty
(c) Positive economy (d) Producer sovereignty
30. Socialist economy is a:
(a) Planned economy (b) Mixed economy
(c) Profit oriented economy (d) None fo these
31. Freedom of choice is the advantage of:
(a) socialism (b) Capitalism
(c) Mixed economy (d) Communism
32. Capitalistic economy uses ___________________ as principal means of allocating resources
(a) Demand (b) Supply
(c) Price (d) All of the above
33. Mixed economy means:
(a) Co-existence of small and large industries
(b) Promoting both agriculture and industries in the economy
(c) Co-existence of both private and public sectors
(d) Co- existence of both rich and poor
34. In which economic system all the means of production are owned and controlled by
private individuals for profit.
(a) Socialism (b) Capitalism
(c) Mixed economy (d) Communism

Answer Key
1 d 2 a 3 d 4 d 5 a 6 b 7 a 8 b 9 a 10 b 11 D 12 c 13 a
14 c 15 c 16 b 17 a 18 d 19 d 20 d 21 B 22 b 23 d 24 c 25 b 26 a
27 c 28 a 29 b 30 a 31 b 32 c 33 C 34 B
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.1

CHAPTER – 2 (UNIT -1) LAW OF DEMAND AND ELASTICITY OF DEMAND

CHAPTER – 2
LAW OF DEMAND AND ELASTICITY OF DEMAND

MEANING OF DEMAND

 The term ‘demand’ refers to the quantity of a good or service that buyers are willing
and able to purchase at various prices during a given period of time.
 It is to be noted that demand, in Economics, is something more than the desire to
purchase, though desire is one element of it.
 For example, people may desire much bigger houses, luxurious cars etc. But there
are also constraints that they face such as prices of products and limited means to
pay.
 Thus, wants or desires together with the real world constraints determine what they buy.
 The effective demand for a thing depends on
o desire
o Means to purchase and
o willingness to use those means for that purchase.

 Unless desire is backed by purchasing power or ability to pay and willingness to

pay, it does not constitute demand.
 Effective demand alone would figure in economic analysis and business decisions.
Two things are to be noted about the quantity demanded.
(i) The quantity demanded is always expressed at a given price. At different prices
different quantities of a commodity are generally demanded.
(ii) The quantity demanded is a flow. We are concerned not with a single isolated
purchase, but with a continuous flow of purchases and we must therefore express
demand as ‘so much per period of time’ i.e., one thousand dozens of oranges
per day, seven thousand dozens of oranges per week and so on.
In short “By demand, we mean the various quantities of a given commodity or service
which consumers would buy in one market during a given period of time, at various
prices, or at various incomes, or at various prices of related goods”.
WHAT DETERMINES DEMAND
Knowledge of the common determinants of demand for a product or service and the nature of
relationship between demand and its determinants are essential for a business firm for
estimating the market demand for its products.
 There are a number of factors which influence the demand for a commodity. All these
factors are not equally important.
The important factors that determine demand are given below.

(i) Price of the commodity

 the good’s own price is a key determinant of its demand.
 Ceteris paribus i.e. other things being equal, the demand for a commodity is
inversely related to its price.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.2

 It implies that a rise in the price of a commodity brings about a fall in the quantity
purchased and vice-versa.
 This happens because of income and substitution effects.
(ii) Price of related commodities
 Related commodities are of two types:
o complementary goods and
o competing goods or substitutes.
 Complementary goods and services are those that are bought or consumed
together or simultaneously.
 Examples are: tea and sugar, automobile and petrol and pen and ink.
Relation
 The increase in the demand for one causes an increase in the demand for the other.
 When two commodities are complements, a fall in the price of one (other
things being equal) will cause the demand for the other to rise.
 For example, a fall in the price of petrol-driven cars would lead to a rise in the
demand for petrol.
 Similarly, computers and computer software are complementary goods. A fall
in the price of computers will cause a rise in the demand for software.
 The reverse will be the case when the price of a complement rises. Thus, we find
that, there is an inverse relation between the demand for a good and the price
of its complement.
Substitute Goods
 Two commodities are called competing goods or substitutes when they satisfy
the same want and can be used with ease in place of one another.
 For example, tea and coffee, ink pen and ball pen, different brands of toothpaste
etc. are substitutes for each other and can be used in place of one another easily.
 When goods are substitutes, if the price of a product being purchased goes up,
buyers may switch to a cheaper substitute.
 This decreases the demand for the product at a given price, but increases the
demand for the substitute.
 Similarly, a fall in the price of a product (ceteris paribus) leads to a fall in the
quantity demanded of its substitutes.
 For example, if the price of tea falls, people will try to substitute it for coffee
and demand more of it and less of coffee i.e. the demand for tea will rise and
that of coffee will fall. Therefore, there is direct or positive relation between the
demand for a product and the price of its substitutes.
(iii) Disposable Income of the consumer:
 The purchasing power of a buyer is determined by the level of his disposable
income.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.3

 Other things being equal, the demand for a commodity depends upon the disposable
income of the potential purchasers.
 In general, increase in disposable income tends to increase the demand for
particular types of goods and services at any given price.
 A decrease in disposable income generally lowers the quantity demanded at all
possible prices.
The nature of relationship between disposable income and quantity demanded
depends upon the nature of goods.
Normal goods
 Normal goods are those that are demanded in increasing quantities as
consumers’ income increases.
 Most goods and services fall under the category of normal goods.
 Household furniture, clothing, automobiles, consumer durables and semi durables
etc. fall in this category. When income is reduced (for example due to
recession), demand for normal goods falls.
Inferior goods
 There are some commodities for which the quantity demanded rises only up to a
certain level of income and decreases with an increase in money income beyond
this level.
 These goods are called inferior goods.
Essential consumer
 Essential consumer goods such as food grains, fuel, cooking oil, necessary clothing
etc. satisfy the basic necessities of life and are consumed by all individuals in a
society.
Business managers should be fully aware of the nature of goods which they produce (or the
nature of need which their products satisfy) and the nature of relationship of quantities
demanded with changes in buyers’ incomes.
For assessing the current as well as future demand for their products, they should also
recognize the movements in the macro economic variables that affect buyers’ incomes.
(iv) Tastes and preferences of buyers:
 The demand for a commodity also depends upon the tastes and preferences of
buyers and changes in them over a period of time.
 Goods which are modern or more in fashion command higher demand than goods
which are of old design or are out of fashion.
 Consumers may perceive a product as obsolete and discard it before it is fully
utilized and then prefer another good which is currently in fashion.
 For example, there is greater demand for the latest digital devices and trendy
clothing and we find that more and more people are discarding these goods
currently in use even though they could have used it for some more years.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.4

 External effects on utility such as' demonstration effect',' bandwagon effect’,

Veblen effect and ‘snob effect’ do play important roles in determining the
demand for a product.
Demonstration effect
 Demonstration effect, a term coined by James Duesenberry, refers to the desire of
people to emulate the consumption behaviour of others.
 In other words, people buy or have things because they see that other people
are able to have them.
 For example,
o An individual’s demand for cell phone may be affected by his seeing a new
model of cell phone in his neighbour’s or friend’s house, either because he
likes what he sees or because he figures out that if his neighbour or friend can
have it, he too can.
Bandwagon effect
 Bandwagon effect refers to the extent to which the demand for a commodity is
increased due to the fact that others are also consuming the same commodity.
 It represents the desire of people to purchase a commodity in order to be
fashionable or stylish or to conform to the people they wish to be associated with.
snob effect’
 By ‘snob effect’ we refer to the extent to which the demand for a consumers'
good is decreased owing to the fact that others are also consuming the same
commodity.
 This represents the desire of people to be exclusive; to be different; to dissociate
themselves from the "common herd."
 For example, when a product becomes common among all, some people decrease
or altogether stop its consumption.
Veblen effect
 Highly priced goods are consumed by status seeking rich people to satisfy
their need for conspicuous consumption.
 This is called ‘Veblen effect’ (named after the American economist Thorstein
Veblen).For example, expensive cars and jewels.
 The distinction between the snob effect and the Veblen effect is that the
former is a function of the consumption of others and the latter is a function of
price.
 We conclude that people have tastes and preferences and these do change -
sometimes, due to external and sometimes due to internal causes - and
influence demand.
(v) Consumers’ Expectations
 Consumers’ expectations regarding future prices, income, supply conditions etc.
influence current demand.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.5

 If the consumers expect increase in future prices, increase in income and

shortages in supply, more quantities will be demanded.

 If they expect a fall in price or fall in income they will postpone their purchases of
nonessential commodities and therefore, the current demand for them will fall.

 Levels of consumer and business confidence about their future economic

situations also affect spending and demand.
Other factors: Apart from the above factors, the demand for a commodity depends upon the
following factors:
(a) Size of population:
 Generally, larger the size of population of a country or a region, larger would be
the number of buyers and the quantity demanded in the market would be higher
at every price.
 The opposite is the case when population is less.
(b) Age Distribution of population:
 If a larger proportion of people belong to older age groups relative to younger age
groups, there will be increased demand for geriatric care services, spectacles,
walking sticks, etc and less demand for children’s books.
 Similarly, if the population consists of more of children, demand for toys, baby
foods, toffees, etc. will be more.
 Likewise, if there is migration from rural areas to urban areas, there will be
decrease in demand for goods and services in rural areas.
(c) The level of National Income and its Distribution
 the level of national income is a crucial determinant of market demand. Higher the
national income, higher will be the demand for all normal goods and
services.
 The wealth of a country may be unevenly distributed so that there are a few
very rich people while the majority is very poor.
 Under such conditions, the propensity to consume of the country will be
relatively less, because the propensity to consume of the rich people is less than
that of the poor people.
 Consequently, the demand for consumer goods will be comparatively less.
 If the distribution of income is more equal, then the propensity to consume of the
country as a whole will be relatively high indicating higher demand for goods.
(d) Consumerc- redit facility and interest rates
 availability of credit facilities induces people to purchase more than what
their current incomes permit them.
 Credit facilities mostly determine the demand for investment and for durable
goods which are expensive and require bulk payments at the time of purchase.
 Low rates of interest encourage people to borrow and therefore demand will
be more.
(e) Government policies and regulation
 the governments influence demand through its taxation, purchases, expenditure,
and subsidy policies.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.6

 While taxes increase prices and decrease the quantity demanded, subsidies
decrease the prices and increase the quantity demanded.
 For example taxes on luxurious goods and subsidies for solar panels. Similarly total
bans, restrictions and higher taxes may be used by government to restrict the
demand for socially undesirable goods and services.
 Government’s policy on international trade also will affect the domestic
demand for goods and services.
Apart from above, factors such as

 weather conditions,
 business conditions,
 stage of business cycle,
 wealth, levels of education,
 marital status,
 socioeconomic class,
 group membership,
 habits of the consumer,
 social customs and conventions,
 sales manship and advertisements also play important roles in influencing demand.
THE DEMAND FUNCTION
 A function is a symbolic statement of a relationship between the dependent
and the independent variables.
 The demand function states in equation form, the relationship between the
demand for a product (the dependent variable) and its determinants (the
independent or explanatory variables).
 Any other factors that are not explicitly listed in the demand function are assumed
to be irrelevant or held constant.
 A simple demand function may be expressed as follows:
Qx = f (PX, Y, Pr,)

Where Qx is the quantity demanded of product

PX is the price of the commodity

Y is the money income of the consumer, and Pr is the price of related goods

 For example; we may write Qx = 45 + 2y + 1 Pr, – 2 P. In this unit, we will be

studying demand as a function of only price, keeping everything else constant.
THE LAW OF DEMAND
Prof. Alfred Marshall defined the Law thus: “The greater the amount to be sold, the smaller
must be the price at which it is offered in order that it may find purchase or in other
words the amount demanded increases with a fall in price and diminishes with a rise in
price”
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.7

 The law of demand states that other things being equal, when the price of a good rises the
quantity demanded of the good will fall.
 Thus, there is an inverse relationship between price and quantity demanded,
ceteris paribus.
 The ‘other things’ which are assumed to be equal or constant are the prices of related
commodities, income of consumers, tastes and preferences of consumers, and all factors
other than price which influence demand.
 If these factors which determine demand also undergo a change, then the inverse price-
demand relationship may not hold good.
 For example, if incomes of consumers increase, then an increase in the price of a
commodity, may not result in a decrease in the quantity demanded of it. Thus, the
constancy of these ‘other factors’ is an important assumption of the law of demand.
The Law of Demand may be illustrated with the help of a demand schedule and a demand curve.
The Demand Schedule
 A demand schedule is a table showing the quantities of a good that buyers would
choose to purchase at different prices, per unit of time, with all other variables held
constant.
 To illustrate the relation between the quantity of a commodity demanded and its price,
we may take a hypothetical data for prices and quantities of ice-cream.
 A demand schedule is drawn upon the assumption that all the other influences
remain unchanged. It thus attempts to isolate the influence exerted by the price of the
good upon the amount sold
Table 1: Demand Schedule of an Individual Buyer
Quantity of ice-cream demanded
Price per cup of ice-cream
(per week)
(in Rupees) (Cups)

A 60 0
B 50 2

C 40 4

D 30 6

E 20 8

F 10 10

G 0 12

The Demand Curve

 A demand curve is a graphical presentation of the demand schedule. By convention,
the vertical axis of the graph measures the price per unit of the good.
 The horizontal axis measures the quantity of the good, which is usually expressed
in some physical measure per time period. By plotting each pair of values as a point on
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.8

a graph and joining the resulting points, we get the individual’s demand curve for a
commodity.
 It shows the relationship between the quantities of a good that buyers are willing to buy
and the price of the good. We can now plot the data from Table 1 on a graph.

Fig. 1 : Demand Curve for Ice-cream

 The slope of a demand curve is - ∆P/∆Q (i.e the change along the vertical axis
divided by the change along the horizontal axis). The negative sign of this slope is
consistent with the law of demand.
 The demand curve for a good does not have to be linear or a straight line; it can be
curvilinear- meaning its slope may vary along the curve.
 If the change in quantity demanded does not follow a constant proportion, then the
demand curve will be non linear. However, linear demand curves provide a convenient
tool for analysis.
Market Demand Schedule
 The market demand for a commodity gives the alternative amounts of the
commodity demanded per time period, at various alternative prices, by all the
buyers in the market.
 The market demand for a commodity thus depends on all the factors that determine the
individual’s demand and, in addition, on the number of buyers of the commodity in the
market.
 When we add up the various quantities demanded by different consumers in the market,
we can obtain the market demand schedule.
Market Demand Schedule of Good X (per day)
Quantity demanded by

Price of Good X in A B Total Market

(Rs) Demand
0 3 2 5
10 2 1 3
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.9

20 1 0 1
30 0 0 0

The Market Demand Curve

 The market demand curve for good X represents the quantities of good X demanded by all
buyers in the market for good X.
 The market demand curve is obtained by horizontal summation of all individual
demand curves.
 If we plot the market demand schedule on a graph, we get the market demand curve. The
two consumers A and B have different individual demand curves corresponding to their
different preferences for good X.
 The market demand curve, like the individual demand curve, slopes downwards to
the right because it is nothing but the lateral summation of individual demand
curves.
 The straight-line demand curve where we hold everything else constant is
described by a linear demand function. We can write a demand function as follows:
Q = a- bP,
For example, a demand function Q = 100 – 2P,
a Q Q
P= – : P=50–
b b 2
Rationale of the Law of Demand
(1) Price Effect of a fall in price:
 The price effect which indicates the way the consumer's purchases of good X
change, when its price changes, is the sum of its two components namely:
substitution effect and income effect.
(a) Substitution effect:
 Hicks and Allen have explained the law in terms of substitution effect and income effect.
 The substitution effect describes the change in demand for a product when its
relative price changes.
 When the price of a commodity falls, the price ratio between items change and it becomes
relatively cheaper than other commodities.
 Assuming that the prices of all other commodities remain constant, it induces
consumers to substitute the commodity whose price has fallen for other
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.10

commodities which have now become relatively expensive.

 The result is that the total demand for the commodity whose price has fallen increases.
This is called substitution effect.
 When the price falls, the substitution effect is always positive; i.e it will always cause
more to be demanded. The substitution effect will be stronger when:
 the goods are closer substitutes
 there is lower cost of switching to the substitute good
 there is lower inconvenience while switching to the substitute good
(c) Income effect:
 The increase in demand on account of an increase in real income is known as
income effect.
 When the price of a commodity falls, the consumer can buy the same quantity of the
commodity with lesser money or he can buy more of the same commodity with the
same amount of money.
 In other words, as a result of fall in the price of the commodity, consumer’s real
income or purchasing power increases.
 A part or whole of the resulting increase in real income can now be used to buy
more of the commodity in question, given that the good is normal.
 Therefore, the demand for that commodity (whose price has fallen) increases.
 However, there is one exception. In the case of inferior goods, the income effect
works in the opposite direction to the substitution effect. In the case of inferior
goods, the expansion in demand due to a price fall will take place only if the
substitution effect outweighs the income effect.
(2) Utility maximizing behaviour of Consumers:
 A consumer is in equilibrium (i.e. maximizes his satisfaction) when the marginal
utility of the commodity and its price equalize.
 According to Marshall, the consumer has diminishing utility for each additional
unit of a commodity and therefore, he will be willing to pay only less for each
additional unit.
 A rational consumer will not pay more for lesser satisfaction. He is induced to
buy additional units only when the prices are lower.
 The operation of diminishing marginal utility and the act of the consumer to
equalize the utility of the commodity with its price result in a downward sloping
demand curve.
(3) Arrival of new consumers:
 When the price of a commodity falls, more consumers start buying it because
some of those who could not afford to buy it earlier may now be able to buy it.
 This raises the number of consumers of a commodity at a lower price and hence the
demand for the commodity in question increases.
(4) Different uses:
 Many commodities have multiple uses.
 When the price of such commodities are high (or rises) they will be put to limited
uses only.
 If the prices of such commodities fall, they will be put to more number of uses
and therefore their demand will increase. Thus, the increase in the number of
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.11

uses, consequent to a fall in price make the buyer demand more of such
commodities making the demand curve slope downwards. For example: Electricity
Exceptions to the Law of Demand
The following are the important exceptions to the law of demand.
(i) Conspicuous goods:
 Articles of prestige value or snob appeal or articles of conspicuous consumption are
used by the rich people as status symbol for enhancing their social prestige or /and
for displaying wealth.
 These articles will not conform to the usual law of demand as they become
more attractive only if their prices are high or keep going up.
 This was found out by Veblen in his doctrine of “Conspicuous Consumption” and
hence this effect is called Veblen effect or prestige goods effect.
 Veblen effect takes place as some consumers measure the utility of a
commodity by its price i.e., if the commodity is expensive they think that it has
got more utility.
 As such, they buy less of this commodity at low price and more of it at high price.
 Diamonds are often given as an example of this case. Higher the price of
diamonds, higher is the prestige value attached to them and hence higher is
the demand.
(ii) Giffen goods:
 Sir Robert Giffen, a Scottish economist and statistician, was surprised to find out
that as the price of bread increased, the British workers purchased more bread and
not less of it.
 This was something against the law of demand. Why did this happen?
o The reason given for this is that, when the price of bread went up, it caused
such a large decline in the purchasing power of the poor people that they
were forced to cut down the consumption of meat and other more
expensive foods.
 Since bread, even when its price was higher than before, was still the cheapest food
article, people consumed more of it and not less when its price went up.
 Such goods which exhibit direct price-demand relationship are called ‘Giffen
goods’.
 Generally those goods which are inferior, with no close substitutes available
and which occupy a substantial place in consumers’ budget are called ‘Giffen
goods’.
 All Giffen goods are inferior goods; but all inferior goods are not Giffen goods.
Examples of Giffen goods are coarse grains like bajra, low quality rice and
wheat etc.
(iii) Conspicuous necessities:
 The demand for certain goods is affected by the demonstration effect of the
consumption pattern of a social group to which an individual belongs.
 These goods, due to their constant usage, become necessities of life.
 For example, in spite of the fact that the prices of television sets, refrigerators, air-
conditioners etc. have been continuously rising, their demand does not show any
tendency to fall.
(iv) Future expectations about prices:
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.12

 It has been observed that when the prices are rising, households, expecting that the
prices in the future will be even higher, tend to buy larger quantities of such
commodities.
 For example, when there is wide-spread drought, people expect that prices of food
grains would rise in future. They demand greater quantities of food grains even
as their price rises.
 On the contrary, if prices are falling and people anticipate further fall, rather than
buying more, they postpone their purchases.
 However, it is to be noted that here it is not the law of demand which is
invalidated. There is a change in one of the factors which was held constant while
deriving the law of demand, namely change in the price expectations of the people.
(v) Incomplete information and irrational behavior
 The law has been derived assuming consumers to be rational and knowledgeable
about market-conditions.
 However, at times, consumers have incomplete information and therefore
make inconsistent decisions regarding purchases.
 Similarly, in practice, a household may demand larger quantity of a commodity even
at a higher price because it may be ignorant of the ruling price of the
commodity. Under such circumstances, the law will not remain valid.
(vi) Demand for necessaries:
 The law of demand does not apply much in the case of necessaries of life.
 Irrespective of price changes, people have to consume the minimum quantities
of necessary commodities.
(vii) Speculative goods
 In the speculative market, particularly in the market for stocks and shares, more
will be demanded when the prices are rising and less will be demanded when
prices decline.
 The law of demand will also fail if there is any significant change in other
factors on which demand of a commodity depends.
EXPANSIONAND CONTRACTION Of DFEMAND
 The demand schedule, demand curve and the law of demand all show that when
the price of a commodity falls, its quantity demanded increases, other things
being equal.
 When, as a result of decrease in price, the quantity demanded increases, , we say
that there is an expansion of demand and when, as a result of increase in price,
the quantity demanded decreases, we say that there is a contraction of demand.
 For example
o Suppose the price of apples is Rs 100/ per kilogram and a consumer buys
one kilogram at that price. Now, if other things such as income, prices of
other goods and tastes of the consumers remain the same but the price of
apples falls to Rs 80 per kilogram and the consumer now buys two
kilograms of apples, we say that there is a change in quantity demanded or
there is an expansion of demand.
o On the contrary, if the price of apples rises to Rs 150 per kilogram and the
consumer then buys only half a kilogram, we say that there is a contraction of
demand.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.13

‘a fall in quantity demanded’ or ‘contraction of demand’ or ‘an upward movement along

the same demand curve’. Similarly, as a result of fall in price to OPI, the quantity
demanded rises to ON, we say that there is an ‘expansion of demand’ or ‘a rise in quantity
demanded’ or ‘a downward movement on the same demand curve.’

Expansion and Contraction of Demand

Increase and Decrease in Demand

 It should be noted that expansion and contraction of demand take place as a result
of changes in the price while all other determinants of price viz. income, tastes,
propensity to consume and price of related goods remain constant.

 There are factors other than price (non-price factors) or conditions of demand
which might cause either an increase or decrease in the quantity of a particular
good or service that buyers are prepared to demand at a given price.

 What happens if there is a change in consumers’ tastes and preferences, income, the
prices of the related goods or other factors on which demand depends? As an example, let
us consider what happens to the demand for commodity X if the consumer’s income
increases:

Two demand schedules for commodity X

Quantity of ‘X’ demanded Quantity of ‘X’ demanded when

Price
when average household average household income
(Rs) income is R 5,000 per is
month Rs 10,000 per month
A 5 10 15 A1
B 4 15 20 B1

C 3 20 25 C1
D 2 35 40 D1
E 1 60 65 E1
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.14

Figure Showing Two Demand Curves at Different Incomes

 Any change that increases the quantity demanded at every price shifts the demand
curve to the right and is called an increase in demand.
 Any change that decreases the quantity demanded at every price shifts the
demand curve to the left, and is called a decrease in demand.

Fig. 5(a): Rightward shift in the Fig. 5(b): Leftward shift in the
demand Curve demand Curve
The table below summarises the effect of non - price determinants on demand

Changes in determinants other than price Changes in determinants other than price that
that cause increase in demand cause Decrease in Demand (Leftward shift of
demand curve when less is demanded at
(Rightward shift of demand curve when each price)
more is demanded at each price)

Rise in income in the case of normal goods A fall in income in case of normal goods, and a
rise in income in case of inferior goods

Increase in wealth in the case of normal Decrease in wealth in case of normal goods,
goods and an increase in wealth in case of inferior
goods
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.15

Rise in the price of a substitute good Fall in the price of a substitute good

Fall in the price of a complement Rise in the price of a complement

An increase in the number of buyers A decrease in the number of buyers
A change in tastes in favour of the A change in tastes against the commodity
commodity
A redistribution of income to groups of Redistribution of income away from groups of
people who favour the commodity people who favour the commodity.

An expectation that price will rise in the An expectation that price will fall in the future
future
Government policies encouraging Government regulations discouraging
consumption of the good . Eg. Grant of consumption e.g. ban on cigarette smoking /
consumer subsidies ban on consumption.
Movements along the Demand Curve vs. Shift of Demand Curve
 A movement along the demand curve indicates changes in the quantity demanded
because of price changes, other factors remaining constant.
 A shift of the demand curve indicates that there is a change in demand at each possible
price because one or more other factors, such as incomes, tastes or the price of some
other goods, have changed.
 Thus, when we speaks of an increase or a decrease in demand, it refers to a shift of the
whole curve because one or more of the factors which were assumed to remain
constant earlier have changed.
 When we speak of change in quantity demanded it means movement along the same
curve (i.e., expansion or contraction of demand) which has happened due to fall or rise
in price of the commodity.
In short ‘change in demand’ represents shift of the demand curve to right or left resulting
from changes in factors such as income, tastes, prices of other goods etc. and ‘change in
quantity demanded’ represents movement upwards or downwards on the same demand
curve resulting from a change in the price of the commodity.
ELASTICITY OF DEMAND
 The elasticity of demand measures the relative responsiveness of the amount
purchased per unit of time to a change in any one of these independent variables
while keeping others constant.
 In general, the coefficient of elasticity is defined as the proportionate change in the
dependent variable divided by the proportionate change in the independent
variable.
 Elasticity of demand is defined as the responsiveness of the quantity demanded of a
good to changes in one of the variables on which demand depends.
We may find different measures of elasticity such as
 price elasticity,
 cross elasticity,
 income elasticity,
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.16

 advertisement elasticity
It is to be noted that when we talk of elasticity of demand, unless and until otherwise
mentioned, we talk of price elasticity of demand. In other words, it is price elasticity of
demand which is usually referred to as elasticity of demand.
Price Elasticity of Demand
Perhaps, the most important measure of elasticity of demand is the price elasticity of demand
which measures the sensitivity of quantity demanded to ‘own price’ or the price of the good
itself.
The concept of price elasticity of demand is important for a firm for two reasons.
 Knowledge of the nature and degree of price elasticity allows firms to predict the
impact of price changes on its sales.
 Price elasticity guides the firm’s profit-maximizing pricing decisions.
 Price elasticity of demand expresses the responsiveness of quantity demanded of a
good to a change in its price, given the consumer’s income, his tastes and prices of
all other goods.

 In other words,
• it is measured as the percentage change in quantity demanded divided by the
percentage change in price, other things remaining equal.
• The price elasticity of demand (also referred to as PED) tells us the percentage
change in quantity demanded for each one percent (1%) change in price. That is,

% change in quantity demanded

Price Elasticity = Ep =
% change in Price
The percentage change in a variable is just the absolute change in the variable divided by the
original level of the variable.

Therefore,

Change in quantity
 100
Original quantity
Ep=
Change in Price
 100
Original Price

 A negative sign on the elasticity of demand illustrates the law of demand: less
quantity is demanded as the price rises.

 Notice that the change in quantity was due solely to the price change. The other factors
that potentially could affect sales (income and the competitor’s price) did not
change
 The greater the value of elasticity, the more sensitive quantity demanded is to price.
 Strictly speaking, the value of price elasticity varies from minus infinity to approach
q
zero. This is because has a negative sign. since price and quantity are inversely
p
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.17

related (with a few exceptions) price elasticity is negative.

 While interpreting the coefficient of price elasticity, we consider only the magnitude of
the price elasticity- i.e. its absolute size. For example, if Ep = -1.22, we say that the
elasticity is 1.22 in magnitude. That is, we ignore the negative sign and consider only the
numerical value of the elasticity.
 Thus if a 1% change in price leads to 2% change in quantity demanded of good A and 4%
change in quantity demanded of good B, then we get elasticity of A and B as 2 and 4
respectively, showing that demand for B is more elastic or responsive to price changes
than that of A.
 Had we considered minus signs, we would have concluded that the demand for A is more
elastic than that for B, which is not correct. Hence, by convention, we take the absolute
value of price elasticity and draw conclusions.
A numerical example for price elasticity of demand:
Illustration 1
The price of a commodity decreases from Rs 6 to Rs 4 and quantity demanded of the good
increases from 10 units to 15 units. Find the coefficient of price elasticity.
Solution
Price elasticity = (–)q/p×p/q=5/2×6/10=(–)1.5
Illustration 2

A 5% fall in the price of a good leads to a 15% rise in its demand. Determine the elasticity and
comment on its value.

Solution

% change in quantity demanded

Price Elasticity = EP =
% change in Price

=15%/5% = 3

Comment: The good in question has elastic demand

Illustration 3
The price of a good decreases from ` 100 to ` 60 per unit. If the price elasticity of demand for it
is 1.5 and the original quantity demanded is 30 units, calculate the new quantity demanded.
Solution
q p
Ep= 
p q
q 100
Here, 1.5 =   18
40 30
Therefore new quantity demanded = 30+18 = 48 units
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.18

Illustration 4
The quantity demanded by a consumer at price Rs 9 per unit is 800 units. Its price falls by 25%
and quantity demanded rises by 160 units. Calculate its price elasticity of demand.
Solution
Change in quantity demanded = 160
Therefore, % change in quantity demanded = = 20%
% change in price = 25%
%change in q
Ed 
% chage in p
20
 Ea   0.8
25
Illustration 5
A consumer buys 80 units of a good at a price of Rs 4 per unit. Suppose price elasticity of
demand is - 4. At what price will he buy 60 units?
Solution
q p
Ed = 
p q
20 4
Or 4 
x – 4 80
1
Or 4
x–4
Point Elasticity
 The point elasticity of demand is the price elasticity of demand at a particular point
on the demand curve.
 The concept of point elasticity is used for measuring price elasticity where the change
in price is infinitesimal.
 Price elasticity is a key element in applying marginal analysis to determine optimal prices.
Since marginal analysis works by evaluating “small” changes taken with respect to
an initial decision, it is useful to measure elasticity with respect to an infinite to small
change in price.
Point elasticity makes use of derivative rather than finite changes in price and quantity. It may
be defined as:
–dq p
Ep= 
dp q
dq
Where is the derivative of quantity with respect to price at a point on the demand curve,
dp
and p and q are the price and quantity at that point. Economists generally use the word
“elasticity” to refer to point elasticity.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.19

price and quantity at that point. Economists generally use the word “elasticity” to refer to point
elasticity.

Fig 6: Point Elasticity

Point elasticity is, therefore, the product of price quantity ratio at a particular point on the
demand curve and the reciprocal of the slope of the demand line.
Measurement of Elasticity on a Linear Demand CurvGee–ometric Method
 By definition, the price elasticity of demand is the change in quantity associated
with a change in price (∆Q/∆P) times the ratio of price to quantity (P/Q).
 Therefore, .the price elasticity of demand depends not only on the slope of the demand
curve but also on the price and quantity.
 The elasticity, therefore, varies along the curve as price and quantity change. The
slope of a linear demand curve is constant.
 However, the elasticity at different points on a linear demand curve would be different.
When price is high price is high and quantity is small, the elasticity is high.
 The elasticity becomes smaller as we move down the curve.
Given a straight line demand curve tT, point elasticity at any point say R can be found by using
the formula
RT lower segment

Rt upper segment

Using the above formula we can get elasticity at various points on the demand curve.

Fig .7: Elasticity at Different Points on the Demand Curve

Thus, we see that as we move from T towards t, elasticity goes on increasing. At the mid-point it
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.20

is equal to one, at point t, it is infinity and at T it is zero.

Arc-Elasticity
 Often we may be required to calculate price elasticity over some portion of the
demand curve rather than at a single point.
 In other words, the elasticity may be calculated over a range of prices. When price and
quantity changes are discrete and large we have to measure elasticity over an arc of the
demand curve.
 Therefore, in order to avoid confusion, rather than choose the initial or the final price
and quantity, the mid-point method is used i.e. the averages of the two prices and
quantities are taken as (i.e. original and new) base.
 The midpoint formula is an approximation to the actual percentage change in a
variable, but it has the advantage of consistent elasticity values when price moves
in either directions.

Arc Elasticity
The arc elasticity can be found out by using the formula: We drop the minus sign and use the
absolute value.
Q2 – Q1
(Q  Q1 ) / 2
Ep= 2
P2 – P1
(P2  P1 ) / 2
Q2 – Q1 P2  P1
Ep= 
Q2  Q1 P2 – P1

Where P1, Q1are the original price and quantity and P2, Q2are the new ones.

Thus, if we have to find elasticity of demand for headphones between:

P1= Rs.500 Q1= 100
P2 = Rs. 400 Q2= 150
We will use the formula
Q2 – Q1 P2  P1
Ep= 
Q2  Q1 P2 – P1

50 900
Or Ep= 
250 100
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.21

Or Ep = 1.8

The arc elasticity will always lie somewhere (but not necessarily in the middle) between the
point elasticities calculated at the lower and the higher prices.
Interpretation of the Numerical Values of Elasticity of Demand
 Since we draw demand curves with price on the vertical axis and quantity on the
horizontal axis, ∆Q/∆P = (1/slope of curve).
 As a result, for any price and quantity combination, the steeper the slope of the
curve, the less elastic is demand.
The numerical value of elasticity of demand can assume any value between zero
and infinity.
Elasticity is zero, (Ep= 0)
 if there is no change at all in the quantity demanded when price changes i.e. when
the quantity demanded does not respond at all to a price change.
 In other words, any change in price leaves the quantity demanded unchanged and
consumers will buy a fixed quantity of a good regardless of its price.
 Perfectly inelastic demand is as an extreme case of price insensitivity and is
therefore only a theoretical category with less practical significance.
 The vertical demand curve represents perfectly or completely inelastic demand,
Elasticity is one, or unitary, (Ep= 1)
 if the percentage change in quantity demanded is equal to the percentage change in
price.
 In case of unit-elastic demand, where the demand curve is a rectangular hyperbola.
Elasticity is greater than one (Ep > 1)
 when the percentage change in quantity demanded is greater than the percentage
change in price. In such a case, demand is said to be elastic.
 In other words, the quantity demanded is relatively sensitive to price changes. When
drawn, the elastic demand line is fairly flat.
Elasticity is less than one (Ep < 1)
 when the percentage change in quantity demanded is less than the percentage
change in price. In such a case, demand is said to be inelastic.
 In this situation, when price falls the buyers are unable or unwilling to significantly
contract demand.
 In other words, the quantity demanded is relatively insensitive to price changes.
When drawn, the inelastic demand line is fairly steep.
Elasticity is infinite, (Ep= ∞)
 when a ‘small price reduction raises the demand from zero to infinity.
 The demand curve is horizontal at the price level (where the demand curve touches the
vertical axis).
 Moving back and forth along this line, we find that there is a change in the quantity
demanded but no change in the price.
 If there is a slight increase in price, they would not buy anything from the particular
seller.
 That is, even the smallest price rise would cause quantity demanded to fall to zero.
 Roughly speaking, when we divide a number by zero, we get infinity, denoted by
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.22

the symbol∞.
 So a horizontal demand curve implies an infinite price elasticity of demand. This type of
demand curve is found in a perfectly competitive market.
 The horizontal demand curve in represents perfectly or infinitely elastic demand,

Elasticity Measures, Meaning and Nomenclature

Numerical measure of Verbal description Terminology

elasticity
ero Quantity demanded does not change as Perfectly (or
price changes completely) inelastic
Greater than zero, but less Quantity demanded changes by a Inelastic
than one smaller percentage than does price
One Quantity demanded changes by Unit elasticity
exactly the same percentage as does
price
Greater than one, but less Quantity demanded changes by a Elastic
than infinity larger percentage than does price
Infinity Purchasers are prepared to buy all Perfectly (or infinitely)
they can obtain at some price and elastic
none at all at an even slightly higher
price
Total Outlay Method of Calculating Price Elasticity
 The price elasticity of demand for a commodity and the total expenditure or outlay
made on it are significantly related to each other.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.23

 As the total expenditure (price of the commodity multiplied by the quantity of that
commodity purchased) made on a commodity is the total revenue received by the seller
(price of the commodity multiplied by quantity of that commodity sold of that
commodity), we can say that the price elasticity and total revenue received are closely
related to each other.
 By analysing the changes in total expenditure (or total revenue) in response to a change in
the price of the commodity, we can know the price elasticity of demand for it.
 Price Elasticity of demand equals one or Unity: When,
 as a result of the change in price of a good, the total expenditure on the good or
the total revenue received from that good remains the same, the price elasticity
for the good is equal to unity.
 This is because the total expenditure made on the good can remain the same only if
the proportional change in quantity demanded is equal to the proportional
change in price.
 Thus, if there is a given percentage increase (or decrease) in the price of a good and
if the price elasticity is unitary, total expenditure of the buyer on the good or
the total revenue received from it will remain unchanged.
 Price elasticity of demand is greater than unity:
 When, as a result of increase in the price of a good, the total expenditure made
on the good or the total revenue received from that good falls or
 when as a result of decrease in price, the total expenditure made on the good
or total revenue received from that good increases, we say that price elasticity
of demand is greater than unity.
 In our example of headphones, as a result of fall in price of headphones from Rs 500
to Rs 400, the total revenue received from headphones increases from Rs 50,000
(500 x 100) to Rs 60,000 (400 x 150), indicating elastic demand for headphones.
 Similarly, had the price of headphones increased from Rs 400 to Rs 500, the
demand would have fallen from 150 to 100 indicating a fall in the total revenue
received from Rs 60,000 to Rs 50,000 showing elastic demand for headphones.
 Price elasticity of demand is less than unity:
 When, as a result of increase in the price of a good, the total expenditure made
on the good or the total revenue received from that good increases or
 when as a result of decrease in its price, the total expenditure made on the
good or the total revenue received from that good falls, we say that the price
elasticity of demand is less than unity.
 In the example of wheat above, as a result of fall in the price of wheat from Rs 20
per kg. to Rs 18 per kg. the total revenue received from wheat falls from Rs 10,000
(20 x 500) to Rs 9360 (18 x 520) indicating inelastic demand for wheat.
 Similarly, we can show that as a result of increase in the price of wheat from Rs 18
to Rs 20 per kg, the total revenue received from wheat increase from Rs 9360 to Rs
10,000 indicating inelastic demand for wheat.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.24

 The main drawback of this method is that by using this we can only say whether the
demand for a good is elastic or inelastic; we cannot find out the exact coefficient of
price elasticity.
REASON
 The reason is that the degree of elasticity of demand predicts how changes in the price of a
good will affect the total revenue earned by the producers from the sale of that good.
 The total revenue is defined as the total value of sales of a good or service. It is equal to
the price multiplied by the quantity sold.
Except in the rare case of a good with perfectly elastic or perfectly inelastic demand, when a
seller raises the price of a good, there are two effects which act in opposite directions on
revenue.
 Price effect:
After a price increase (decrease), each unit sold sells at a higher (lower) price, which tends to
raise (lower) the revenue.

 Quantity effect:
After a price increase (decrease), fewer (more) units are sold, which tends to lower (increase)
the revenue.
 What will be the net effect on total revenue? It depends on which effect is stronger.
 If the price effect which tends to raise total revenue is the stronger of the two
effects, then total revenue goes up.
 If the quantity effect, which tends to reduce total revenue, is the stronger, then total
revenue goes down.
The price elasticity of demand tells us what happens to the total revenue when price changes:
its size determines which effect, the price effect or the quantity effect, is stronger.
CASE-1
If demand for a good is unit-elastic an increase in price or decrease in price does not
change total revenue. In this case, the quantity effect and the price effect exactly balance each
other. When price rises from P to P1, the gain in revenue (Area A ) is equal to loss in revenue due
to lost sales( Area B)

Total revenue when Elasticity = 1

 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.25

CASE-2

If demand for a good is inelastic (the price elasticity of demand is less than one), a higher
price increases total revenue. In this case, the quantity effect is weaker than the price effect.

On the contrary, when demand is inelastic, a fall in price reduces total revenue because
the quantity effect is dominated by the price effect.

CASE-3
If demand for a good is elastic (the price elasticity of demand is greater than one), an
increase in price reduces total revenue and a fall in price increases total revenue.
In this case, the quantity effect is stronger than the price effect..
Table below summarizes the relationship between price elasticity and total revenue.
The Relationship between Price elasticity and Total Revenue (TR)
Demand
Elastic Unitary Elastic Inelastic

Price increase TR Decreases TR remains same TR Increases

Price decrease TR Increases TR remains same TR Decreases

Determinants of Price Elasticity of Demand

(1) Availability of substitutes:
More Substitutes
 One of the most important determinants of elasticity is the degree of
substitutability and the extent of availability of substitutes.
 Some commodities like butter, cabbage, car, soft drink etc. have close substitutes.
These are margarine, other green vegetables, other brands of cars, other brands of
cold drinks respectively.
 A change in the price of these commodities, the prices of the substitutes remaining
constant, can be expected to cause quite substantial substitution – a fall in price
leading consumers to buy more of the commodity in question and a rise in
price leading consumers to buy more of the substitutes.
Less Substitutes
 Commodities such as salt, housing, and all vegetables taken together, have few
substitute, if any, satisfactory substitutes and a rise in their prices may cause a
smaller fall in their quantity demanded.
Thus, we can say that goods which typically have close or perfect substitutes have highly
elastic demand curves.
Moreover, wider the range of substitutes available, the greater will be the elasticity.
For example, toilet soaps, toothpastes etc have wide variety of brands and each brand is a close
substitute for the other.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.26

Generic good and branded goods

 It should be noted that while as a group, a good or service may have inelastic demand,
but when we consider its various brands, we say that a particular brand has elastic
demand.
 Thus, while the demand for a generic good like petrol is inelastic, the demand for
Indian Oil’s petrol is elastic.
 Similarly, while there are no general substitutes for health care, there are substitutes for
one doctor or hospital. Likewise, the demand for common salt and sugar is inelastic
because good substitutes are not available for these.
(2) Position of a commodity in the consumer’s budget:
 The greater the proportion of income spent on a commodity; generally the
greater will be its elasticity of demand and vice- versa.
 The demand for goods like common salt, matches, buttons, etc. tend to be highly
inelastic because a household spends only a fraction of their income on each
of them.
 On the other hand, demand for goods like rental apartments and clothing tends
to be elastic since households generally spend a good part of their income on
them.
 When the good absorbs a significant share of consumers’ income, it is worth
their time and effort to find a way to reduce their demand when the price goes
up.
(3) Nature of the need that a commodity satisfies:
 In general, luxury goods are price elastic because one can easily live without a
luxury. In contrast, necessities are price inelastic.
 Thus, while the demand for a home theatre is relatively elastic, the demand for
food and housing, in general, is inelastic. If it is possible to postpone the
consumption of a particular good, such good will have elastic demand.
 Consumption of necessary goods cannot be postponed and therefore, their
demand is inelastic.
(4) Number of uses to which a commodity can be put:
 The more the possible uses of a commodity, the greater will be its price
elasticity and vice versa.
 When the price of a commodity which has multiple uses decreases, people
tend to extend their consumption to its other uses.
 To illustrate, milk has several uses. If its price falls, it can be used for a variety of
purposes like preparation of curd, cream, ghee and sweets.
 But, if its price increases, its use will be restricted only to essential purposes
like feeding the children and sick persons.
(5) Time period:
 The longer the time-period one has, the more completely one can adjust.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.27

 Time gives buyers the opportunity to find alternatives or substitutes, or change

their habits.
 A simple example of the effect can be seen in motoring habits.
 In response to a higher petrol price, one can, in the short run, make fewer trips by
car.
 In the longer run, not only can one make fewer trips, but he can purchase a car with
a smaller engine capacity when the time comes for replacing the existing one.
Hence one’s demand for petrol falls by more when one has made long term
adjustments to higher prices.
(6) Consumer habits:
 If a person is a habitual consumer of a commodity, no matter how much its
price change, the demand for the commodity will be inelastic.
 If buyers have rigid preferences demand will be less price elastic.
(7) Tied demand:
 The demand for those goods which are tied to others is normally inelastic as
against those whose demand is of autonomous nature.
 For example printers and ink cartridges.
(8) Price range:
 Goods which are in very high price range or in very low price range have
inelastic demand, but those in the middle range have elastic demand.
(9) Minor complementary items:
 The demand for cheap, complementary items to be used together with a
costlier product will tend to have an inelastic demand.
Importance of elasticity
 It helps them recognize the effect of a price change on their total sales and revenues.
 Firms aim to maximize their profits and their pricing strategy, knowledge of the price
elasticity of demand for the goods firms sell helps them in arriving at an optimal
pricing strategy.
 If the demand for a firm’s product is relatively elastic, the managers need to recognize
that lowering the price would expand the volume of sales and result in an increase in
total revenue.
 On the contrary, when the demand is elastic, they have to be very cautious about
increasing prices because a price increase will lead to a decline in total revenue as
fall in sales would be more than proportionate.
 If the firm finds that the demand for their product is relatively inelastic, the firm may
safely increase the price and thereby increase its total revenue as they can be assured of
the fact that the fall in sales on account of a price rise would be less than proportionate.
 Knowledge of price elasticity of demand is important for governments while
determining the prices of goods and services provided by them, such as, transport
and telecommunication.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.28

 Further, it also helps the governments to understand the nature of responsiveness of

demand to increase in prices on account of additional taxes and the implications of
such responses on the tax revenues.
 Elasticity of demand explains why the governments are inclined to raise the indirect
taxes on those goods that have a relatively inelastic demand, such as alcohol and
tobacco products.
Income Elasticity of Demand
 The income elasticity of demand is a measure of how much the demand for a good is
affected by changes in consumers’ incomes.
 Estimates of income elasticity of demand are useful for businesses to predict the
possible growth in sales as the average incomes of consumers grow over time.
Income elasticity of demand is the degree of responsiveness of the quantity demanded of a good
to changes in the income of consumers. In symbolic form,
Percentge change in demand
Ei =
Percentge chage in income
This can be given mathematically as follows:
Q Y
Ei  
Q Y
Q Y
 
Q Y
Q Y
Ei  
Y Q
Ei = Income elasticity of demand
∆Q = Change in demand
Q = Original demand
Y = Original money income
∆Y = Change in money income
There is a useful relationship between income elasticity for a good and the proportion of income
spent on it.
1. If the proportion of income spent on a good remains the same as income increases,
then income elasticity for that good is equal to one.
2. If the proportion of income spent on a good increase as income increases, then the
income elasticity for that good is greater than one. The demand for such goods increase
faster than the rate of increase in income. it shows that the good bulks larger in
consumer’s expenditure as he becomes richer. Such goods are called luxury goods.
3. If the proportion of income spent on a good decrease as income rises, then income
elasticity for the good is positive but less than one. The demand for income-inelastic
goods rises, but substantially slowly compared to the rate of increase in income.
Necessities such as food and medicines tend to be income- inelastic.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.29

4. If income elasticity is zero, it signifies that the demand for the good is quite
unresponsive to changes in income.
5. When income elasticity is greater than zero or positive, then an increase in income
leads to an increase in the demand for the good. This happens in the case of most of the
goods and such goods are called normal goods.
For all normal goods, income elasticity is positive. However, the degree of elasticity varies
according to the nature of commodities.
6. When the income elasticity of demand is negative, the good is an inferior good. In
this case, the quantity demanded at any given price decreases as income increases.
The reason is that when income increases, consumers choose to consume superior
substitutes.
The following examples will make the above concepts clear:
(a) The income of a household rises by 10%, the demand for wheat rises by 5%.
(b) The income of a household rises by 10%, the demand for T.V. rises by 20%.
(c) The incomes of a household rises by 5%, the demand for bajra falls by 2%.
(d) The income of a household rises by 7%, the demand for commodity X rises by 7%.
(e) The income of a household rises by 5%, the demand for buttons does not change at all.
Using formula for income elasticity,

Percentage change in demand

Ei=
Percentage change in income
We will find income-elasticity for various goods. The results are as follows:

Income-elasticity for
S. No. Commodity the household Remarks

5% Since 0 < .5 < 1, wheat is a

a Wheat  .5(E i <1)
10% normal good and fulfils a
necessity.
20%
b T.V.  2(E i >1) Since 2 > 1, T.V. is a luxurious
10% commodity.
(–)2% Since –.4 < 0, Bajra is an inferior
c Bajra  (–).4(E i | 0)
5% commodity in the eyes of the
household.
7%
d X  1(E i  1) Since income elasticity is 1, X
7% has unitary income elasticity.
0% Buttons have zero income-
e Buttons  0(E i  0) elasticity.
5%
It is to be noted that the words ‘luxury’, ‘necessity’, ‘inferior good’ do not signify the strict
dictionary meanings here.
An important feature of income elasticity is that income elasticities differ in the short run
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.30

and long run. For nearly all goods and services the income elasticity of demand is larger
in the long run than in the short run
Importance of income elasticity
 Knowledge of income elasticity of demand is very useful for a business firm in estimating
the future demand for its products.
 Knowledge of income elasticity of demand helps firms measure the sensitivity of sales
for a given product to incomes in the economy and to predict the outcome of a
business cycle on its market demand.
 For instance, if EY = 1, sales move exactly in step with changes in income.
 If EY >1, sales are highly cyclical, that is, sales are sensitive to changes in income.
 For an inferior good, sales are countercyclical, that is, sales move in the opposite direction
of income and EY < 0.
 This knowledge enables the firm to carry out appropriate production planning and
management
ILLUSTRATION 6
Income Elasticity of Demand
A car dealer sells new as well as used cars. Sales during the previous year were as follows;
Car type Price Quantity (Nos)
New 6 .5 lakhs 400
Used 60,000 4000
During the previous year, other things remaining the same, the real incomes of the customers
rose on average by 10%. During the last year sales of new cars increased to 500, but sales of
used cars declined to 3,850.
What is the income elasticity of demand for the new as well as used cars? What inference do you
draw from these measures of income elasticity?
SOLUTION
Income Elasticity of demand for new cars
Percentage change in income = 10%, given
Percentage change in quantity of new cars demanded = (∆ Q/Q) X 100 = (100/400 ) X100 = 25%
Income elasticity of demand = 25%/ 10% = + 2.5
New car is therefore income elastic. Since income elasticity is positive, new car is a normal good.
Income Elasticity of demand for used cars
Percentage change in income = 10%, given
% change in quantity of used cars demanded = (∆ Q/Q )X 100 =( -1 50/4000 ) x100 = -
3.75%Income elasticity of demand = – 3.75/ 10= –.375
Since income elasticity is negative, used car is an inferior good.
CROSS- PRICE ELASTICITY OF DEMAND
Price of Related Goods and Demand
 The demand for a particular commodity may change due to changes in the prices of
related goods. These related goods may be either complementary goods or substitute
goods.
 This type of relationship is studied under ‘Cross Demand’.
 Cross demand refers to the quantities of a commodity or service which will be purchased
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.31

with reference to changes in price, not of that particular commodity, but of other inter-
related commodities, other things remaining the same.
 It may be defined as the quantities of a commodity that consumers buy per unit of time, at
different prices of a ‘related article’, ‘other things remaining the same’.
 The assumption ‘other things remaining the same’ means that the income of the
consumer and also the price of the commodity in question will remain constant.
(a) Substitute Products and Demand
 In the case of substitute commodities, the cross demand curve slopes upwards
(i.e. positively) showing that more quantities of a commodity, will be demanded
whenever there is a rise in the price of a substitute commodity.

Substitutes
 In the above, quantity demanded of tea is given on the X axis.
 Y axis represents the price of coffee which is a substitute for tea.

 When the price of coffee increases, due to the operation of the law of demand,
the demand for coffee falls.
 The consumers will substitute tea in the place of coffee.

 The price of tea is assumed to be constant.

 Therefore, whenever there is an increase in the price of one commodity, the

demand for the substitute commodity will increase.
(b) Complementary Goods
 In the case of complementary goods, as shown in the below, a change in the price
of a good will have an opposite reaction on the demand for the other
commodity which is closely related or complementary.

 For instance, an increase in demand for solar panels will necessarily increase the
demand for batteries.

 The same is the case with complementary goods such as bread and butter; car
and petrol, electricity and electrical gadgets etc.

 Whenever there is a fall in the demand for solar panels due to a rise in their prices,
the demand for batteries will fall, not because the price of batteries has gone up, but
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.32

because the price of solar panels has gone up.

 So, we find that there is an inverse relationship between price of a commodity
and the demand for its complementary good (other things remaining the
same).

Fig. 11: Complementary Goods

We shall now look into the cross - price elasticity of demand.
 The cross-price elasticity of demand between two goods measures the effect of the change
in one good’s price on the quantity demanded of the other good.
 Here, we consider the effect of changes in relative prices within a market on the pattern of
demand.
 It is equal to the percentage change in the quantity demanded of one good divided by the
percentage change in the other good’s price.
Percentage change in quantity demanded of good X
Ec=
Percentage change in price of good Y
Symbolically, (mathematically)
q x p y
Ec 
qx py
q x p y
Ec 
p y q x
Where,
Ec Stands for cross elasticity.
qx stands for original quantity demanded of X.
∆qx stands for change in quantity demanded of X
py stands for the original price of good Y.
∆py stands for a small change in the price of Y.
In the case of the cross-price elasticity of demand, the sign (plus or minus) is very
important: it tells us whether the two goods are complements or substitutes.
When Goods Are Substitutes
 When two goods X and Y are substitutes, the cross-price elasticity of demand is positive: a
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.33

rise in the price of Y increases the demand for X and causes a rightward shift of the
demand curve.
 When the cross-price elasticity of demand is positive, its size is a measure of how closely
substitutable the two goods are.
 Greater the cross elasticity, the closer is the substitute. Higher the value of cross
elasticity, greater will be the substitutability.
• If two goods are perfect substitutes for each other, the cross elasticity between
them is infinite.
• If two goods are close substitutes, the cross-price elasticity will be positive and
large.
• If two goods are not close substitutes, the cross-price elasticity will be positive
and small.
• If two goods are totally unrelated, the cross-price elasticity between them is zero.
When Goods Are complimentary
 When two goods are complementary (tea and sugar) to each other, the cross elasticity
between them is negative.
 So that a rise in the price of one leads to a fall in the quantity demanded of the other
causing a leftward shift of the demand curve.
 The size of the cross-price elasticity of demand between two complements tells us how
strongly complementary they are:
o if the cross-price elasticity is only slightly below zero, they are weak
complements;
o if it is negative and very high, they are strong complements.
However, one need not base the classification of goods on the basis of the above
definitions. While the goods between which cross elasticity is positive can be called
substitutes, the goods between which cross elasticity is negative are not always
complementary. This is because negative cross elasticity is also found when the income
effect of the price change is very strong.
Importance Of Cross Elasticity
 The concept of cross elasticity of demand is useful for a manager while making decisions
regarding changing the prices of his products which have substitutes and
complements.
 If cross elasticity to change in the price of substitutes is greater than one, the firm
may lose by increasing the prices and gain by reducing the prices of his products.
 With proper knowledge of cross elasticity, the firm can plan policies to safeguard
against fluctuating prices of substitutes and complements.
Cross- price elasticity of demand
ILLUSTRATION 7
A shopkeeper sells only two brands of note books Imperial and Royal. It is observed that when
the price of Imperial rises by 10% the demand for Royal increases by 15%.What is the cross
price elasticity for Royal against the price of Imperial?
SOLUTION
Precentage change in quantity demanded of good X
Ec=
Percentage change in price of good Y
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.34

15%
Ec=  1.5
10%
The two brands of note book Imperial and Royal are substitutes with significant
substitutability
ILLUSTRATION 8
The cross price elasticity between two goods X and Y is known to be - 0.8. If the price of good Y
rises by 20%, how will the demand for X change?
SOLUTION
Inserting the values in the formula:
-0.8 = X/ 20%
% change in quantity demanded of X = 20% x - 0.8 = - 16%
Since cross elasticity is negative, X and Y are complementary goods
ILLUSTRATION 9
The price of 1kg of tea is Rs 30. At this price 5kg of tea is demanded. If the price of coffee rises
from Rs 25 to Rs 35 per kg, the quantity demanded of tea rises from 5kg to 8kg. Find out the
cross price elasticity of tea.
SOLUTION

q x p y
Cross elasticity =  Here x = tea
p y q x
y = coffee

8–5 25 3 25
Ec=     1.5
10 5 10 5
The elasticity of demand of tea is +1.5 showing that the demand of tea is highly elastic with
respect to coffee. The positive sign shows that tea and coffee are substitute goods.
ILLUSTRATION 10
The price of 1 kg of sugar is Rs 50. At this price 10 kg is demanded. If the price of tea falls from
Rs 30 to Rs 25 per kg, the consumption of sugar rises from 10 kg to 12 kg. Find out the cross
price elasticity and comment on its value.
SOLUTION

q x p y x = Suger
Cross elasticity =  Here
p y q x y = Tea

2 30
   (–)1.2
–5 10
Since the elasticity is -1.2, we can say that sugar and tea are complementary in nature.

ADVERTISEMENT ELASTICITY
 Advertisement elasticity of sales or promotional elasticity of demand is the
responsiveness of a good’s demand to changes in the firm’s spending on
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.35

advertising.
 The advertising elasticity of demand measures the percentage change in demand that
occurs given a one percent change in advertising expenditure.
 Advertising elasticity measures the effectiveness of an advertisement campaign in
bringing about new sales.
 Advertising elasticity of demand is typically positive.
 Higher the value of advertising elasticity greater will be the responsiveness of
demand to change in advertisement.
 Advertisement elasticity varies between zero and infinity.
It is measured by using the formula;
% Change in quantity demanded
Ea=
% change in spending on advertising
Qd/Qd
Ea=
A/A
Where ∆ Qd denotes increase in demand
∆ A denotes additional expenditure on advertisement
Qd denotes initial demand
A denotes initial expenditure on advertisement
Elasticity Interpretation

Ea = 0 Demand does not respond at all to increase in advertisement expenditure

Ea >0 but < 1 Increase in demand is less than proportionate to the increase in
advertisement expenditure
Ea = 1 Demand increase in the same proportion in which advertisement
expenditure increase
Ea> 1 Demand increase at a higher rate than increase in advertisement
expenditure
As far as a business firm is concerned, the measure of advertisement elasticity is useful in
understanding the effectiveness of advertising and in determining the optimum level of
advertisement expenditure.
DEMAND FORECASTING
Meaning
 Forecasting, in general, refers to knowing or measuring the status or nature of an
event or variable before it occurs.
 Forecasting of demand is
o the art and science of
o predicting the probable demand
o for a product or a service at some future date
o on the basis of certain past behaviour patterns of some related events and the
prevailing trends at present.
 It should be kept in mind that demand forecasting is not simple guessing, but it
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.36

refers to estimating demand scientifically and objectively on the basis of certain

facts and events relevant to forecasting.
Usefulness
 Forecasting of demand plays a vital role in the process of planning and decision-
making, whether at the national level or at the level of a firm.
 The effectiveness of the plans of business managers depends upon the level of
accuracy with which future events can be predicted.
 The importance of demand forecasting has increased all the more on account of
mass production and production in response to demand.
 A good forecast enables the firm to perform efficient business planning.
 Forecasts offer information for budgetary planning and cost control in functional
areas of finance and accounting.
 Good forecasts help in efficient production planning, process selection, capacity
planning, facility layout and inventory management.
 A firm can plan production scheduling well in advance and obtain all necessary
resources for production such as inputs and finances.
 Capital investments can be aligned to demand expectations and this will check the
possibility of overproduction and underproduction, excess of unused capacity and
idle resources.
 Marketing personnel often rely on sales forecasting in making key decisions.
 Demand forecasts also provide the necessary information for formulation of suitable
pricing and advertisement strategies.
However
 It is said that no forecast is completely fool-proof and correct.
Scope of Forecasting
 Demand forecasting can be at the national or international level depending upon the
area of operation of the given economic institution.
 It can also be confined to a given product or service supplied by a small firm in a
local area.
 The scope of the forecasting task will depend upon the area of operation of the firm in
the present as well as what is proposed in future.
 Much would depend upon the cost and time involved in relation to the benefit of the
information acquired through the study of demand.
Types of Forecasts
(i) Macro-level forecasting deals with the general economic environment prevailing in the
economy as measured by
• the Index of Industrial Production (IIP),
• national income and
• general level of employment etc.
(ii) Industry- level forecasting is concerned with the demand for the industry’s products as
a whole.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.37

 For example, demand for cement in India.

(iii) Firm- level forecasting refers to forecasting the demand for a particular firm’s product,
 For example, the demand for ACC cement
Based on time period, demand forecasts may be short term demand forecasting and long
term demand forecasting.
(i) Short term demand forecasting covers
 a short span of time, depending of the nature of industry.
 It is done usually for six months or less than one year and is generally useful in
tactical decisions.
(ii) Long term forecasts covers
 for longer periods of time, say two to five years and more.
 It provides information for major strategic decisions of the firm such as
expansion of plant capacity.

Demand Distinctions

Before we analyse the different methods of forecasting demand, it is important for us to

understand the demand distinctions which are as follows:
(a) Producer’s goods and Consumer’s goods
(b) Durable goods and Non-durable goods
(c) Derived demand and Autonomous demand
(d) Industry demand and Company demand
(e) Short-run demand and Long-run demand
(a) Producer’s goods and Consumer’s goods

 Producer’s goods are those which are used for the production of other goods- either
consumer goods or producer goods themselves.

 Examples of producer goods are machines, plant and equipments. Consumer’s

goods are those which are used for final consumption.

 Examples of consumer’s goods are readymade clothes, prepared food, residential

houses, etc.

(b) Demand for Durable goods and Non-durable goods

 Goods may be further sub-divided into durable and non-durable goods.

 Non durable goods are those which cannot be consumed more than once.

o Raw materials, fuel and power, packing items etc are examples of non durable
producer goods. Beverages, bread, milk etc are examples of non-durable
consumer goods. These will meet only the current demand.

 On the other hand, durable goods do not quickly wear out, can be consumed
more than once and yield utility over a period of time.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.38

o Examples of durable consumer goods are: cars, refrigerators and mobile

phones. Building, plant and machinery, office furniture etc are durable
producer goods.

o The demand for durable goods is likely to be derived demand. Further,

there are semi- durable goods such as, clothes and umbrella.

(c) Derived demand and Autonomous demand

 The demand for a commodity that arises because of the demand for some other
commodity called ‘parent product’, ‘is called derived demand.

o For example, the demand for cement is derived demand, being directly
related to building activity.

o In general, the demand for producer goods or industrial inputs is derived

demand. Also the demand for complementary goods is derived demand.

 If the demand for a product is independent of the demand for other goods,
then it is called autonomous demand.
o It arises on its own out of desire of the consumer to consume or to possess the
commodity.
o But this distinction is purely arbitrary and it is very difficult to find out
which product is entirely independent of other products.
(d) Demand for firm’s product and industry demand

 The term industry demand is used to denote the total demand for the products of a
particular industry, e.g. the total demand for steel in the country.

 On the other hand, the demand for firm’s product denotes the demand for the
products of a particular firm, i.e. the quantity that a firm can dispose off at a given
price over a period of time. E.g. demand for steel produced by the Tata Iron and
Steel Company.

 The demand for a firm’s product when expressed as a percentage of industry

demand signifies the market share of the firm.
(e) Short - run demand and Long-run demand

 Short run demand refers to demand with its immediate reaction to changes in
o product price and
o prices of related commodities,
o income fluctuations,
o ability of the consumer to adjust their consumption pattern,
o their susceptibility to advertisement of new products etc.
 Long-run demand refers to demand which exists over a long period. Most generic
goods have long term demand.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.39

o Long term demand depends on long term income trends,

o availability of substitutes,
o credit facilities etc.
 In short, long run demand is that which will ultimately exist as a result of changes in
pricing, promotion or product improvement, after enough time is allowed to let the
market adjust to the new situation.
 For example, if electricity rates are reduced, in the short run, the existing users will
make greater use of electric appliances. In the long run, more and more people will
be induced to buy and use electric appliances.
Factors Affecting Demand for Non-Durable Consumer Goods
 Non durables are purchased for current consumption only.
 From a business firm’s point of view, demand for non durable goods gets
repeated depending on the nature of the non durable goods.

There are three basic factors which influence the demand for these goods:
(i) Disposable income:
Other things being equal, the demand for a commodity depends upon the disposable
income of the household.
 Disposable income is found out by deducting personal taxes from personal income.
(ii) Price:
 Other things being equal, the demand for a commodity depends upon its own price
and the prices of related goods (its substitutes and complements).
 While the demand for a good is inversely related to its own price and the price of
its complements, it is positively related to the price of its substitutes.
(iii) Demography:
 This involves the characteristics of the population, human as well as non-
human, using the product concerned.
 For example, it may pertain to the number and characteristics of children in a study
of demand for toys and characteristics of automobiles in a study of the demand for
tyres or petrol.
Factors Affecting the Demand for Durable-Consumer Goods
Demand for durable goods has certain special characteristics. Following are the important
factors that affect the demand for durable goods.
(i) A consumer can postpone the replacement of durable goods. Whether a consumer will
go on using the good for a long time or will replace it depends upon factors like his
social status, prestige, level of money income, rate of obsolescence etc.
(ii) These goods require special facilities for their use e.g.
 roads for automobiles, and
 electricity for refrigerators and radios.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.40

 The existence and growth of such factors is an important variable that determines
the demand for durable goods
(iii) As consumer durables are used by more than one person, the decision to purchase
may be influenced
 by family characteristics like income of the family,
 size, age distribution and sex composition.
 Likely changes in the number of households should be considered while
determining the market size of durable goods.
(iv) Replacement demand is an important component of the total demand for durables.
 Greater the current holdings of durable goods, greater will be the replacement
demand.
(v) Demand for consumer durables is very much influenced by their prices and credit
facilities available to buy them.
Factors Affecting the Demand for Producer Goods
 Since producers’ goods or capital goods help in further production, the demand for them
is derived demand, derived from the demand of consumer goods they produce.
 The demand for them depends upon the rate of profitability of user industry and the size
of the market of the user industries.
 Hence data required for estimating demand for producer goods (capital goods) are:
(i) growth prospects of the user industries;

(ii) norms of consumption of capital goods per unit of installed capacity.

 An increase in the price of a substitutable factor of production, say labour, is likely to

increase the demand for capital goods.
 On the contrary, an increase in the price of a factor which is complementary may cause a
decrease in the demand for capital.
 Higher the profit making prospects, greater will be the inducement to demand capital
goods. If firms are optimistic about selling a higher output in future, they will have greater
incentive to invest in producer goods.
 Advances in technology enabling higher efficiency at reduced cost on account of higher
productivity of capital will have a positive impact on investment in capital goods.
 Investments in producer goods will be greater when lower interest rates prevail as firms
will have lower opportunity cost of investments and lower cost of borrowing.
Methods of Demand Forecasting
 There is no easy method or simple formula which enables an individual or a business to
predict the future with certainty or to escape the hard process of thinking.
 The firm has to apply a proper mix of judgment and scientific formulae in order to
correctly predict the future demand for a product.
 The following are the commonly available techniques of demand forecasting:
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.41

(i) Survey of Buyers’ Intentions:

 The most direct method of estimating demand in the short run is to ask
customers what they are planning to buy during the forthcoming time period,
usually a year.
 This method involves direct interview of potential customers.
 Depending on the purpose, time available and costs to be incurred, the survey may
be conducted by any of the following methods:
• Complete enumeration method where nearly all potential customers are
interviewed about their future purchase plans

• Sample survey method under which only a scientifically chosen sample of

potential customers are interviewed

• End–use method, especially used in forecasting demand for inputs, involves

identification of all final users, fixing suitable technical norms of
consumption of the product under study, application of the norms to the
desired or targeted levels of output and aggregation.

 Thus, under this method the burden of forecasting is put on the customers.

Drawback

 It would not be wise to depend wholly on the buyers’ estimates and they should
be used cautiously in the light of the seller’s own judgement.
 A number of biases may creep into the surveys.
 The customers may themselves misjudge their requirements, may mislead the
surveyors or their plans may alter due to various factors which are not identified
or visualised at the time of the survey.
 In the case of household customers, this method may not prove very helpful for
several reasons viz.
o irregularity in customers’ buying intentions,
o their inability to foresee their choice when faced with multiple alternatives,
and
o the possibility that the buyers’ plans may not be real, but only wishful
thinking.
Useful
 This method is useful when bulk of sale is made to industrial producers who
generally have definite future plans.
(ii) Collective opinion method:
 This method is also known as sales force opinion method or grass roots
approach.
 Firms having a wide network of sales personnel can use the knowledge, experience
and skills of the sales force to forecast future demand.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.42

 Under this method, salesmen are required to estimate expected sales in their
respective territories.
 The rationale of this method is that salesmen being closest to the customers
are likely to have the most intimate feel of the reactions of customers to changes in
the market.
 These estimates of salesmen are consolidated to find out the total estimated sales.
 These revised estimates are further examined in the light of factors like
o proposed changes in selling prices,
o product designs and advertisement programmes,
o expected changes in competition and changes in secular forces like
purchasing power,
o income distribution,
o employment, population, etc.
 The final sales forecast would emerge after these factors have been taken into
account.
Drawbacks
 Although this method is simple and based on first hand information of those who
are directly connected with sales, it is subjective as personal opinions can
possibly influence the forecast.
 Moreover salesmen may be unaware of the broader economic changes which
may have profound impact on future demand.
 Therefore, forecasting could be useful in the short run, for long run analysis
however, a better technique is to be applied.
(iii) Expert Opinion method:
 In general, professional market experts and consultants have specialised
knowledge about the numerous variables that affect demand.
 Information is elicited from them through appropriately structured unbiased
tools of data
 collection such as interview schedules and questionnaires.
 The Delphi technique, developed by Olaf Helmer at the Rand Corporation of
the USA, provides a useful way to obtain informed judgments from diverse
experts by avoiding the disadvantages of conventional panel meetings.
 Under this method, instead of depending upon the opinions of buyers and
salesmen, firms solicit the opinion of specialists or experts through a series of
carefully designed questionnaires.
 Experts are asked to provide forecasts and reasons for their forecasts.
 Experts are provided with information and opinion feedbacks of others at
different rounds without revealing the identity of the opinion provider.
 These opinions are then exchanged among the various experts and the process
goes on until convergence of opinions is arrived at.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.43

 The following chart shows the Delphi process.

The Delphi process

 For example, the method may be used for forecasting national energy demand 50
years from now, long term transportation needs, environmental issues and long
term human resource forecasting to mention a few.
 Delphi technique is widely accepted due to its broader applicability, absence of
group pressure, capability to tap collective human expertise and intelligence and
ability to address complex questions. It also has the advantages of speed and
cheapness.
(iv) Statistical methods:
 statistical methods have proved to be very useful in forecasting demand.
 Forecasts using statistical methods are considered as superior methods because they
are more scientific, reliable and free from subjectivity.
 The important statistical methods of demand forecasting are:
(a) Trend Projection method:
 This method, also known classical method, is considered as a ‘naive’ approach to demand
forecasting.
 A firm which has been in existence for a reasonably long time would have
accumulated considerable data on sales pertaining to different time periods.
 Such data, when arranged chronologically, yield a ‘time series’.
 The time series relating to sales represent the past pattern of effective demand for a
particular product. Such data can be used to project the trend of the time series.
 The popular techniques of trend projection based on time series data are; graphical
method and fitting trend equation or least square method.

Graphical Method:
 This method, also known as ‘free hand projection method’ is the simplest and least
expensive.
 This involves plotting of the time series data on a graph paper and fitting a free-hand
curve to it passing through as many points as possible.
 The direction of the curve shows the trend.
 This curve is extended into the future for deriving the forecasts. The direction of this free
hand curve shows the trend.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.44

 The main draw-back of this method is that it may show the trend but the
projections made through this method are not very reliable.
Fitting trend equation:
 Least Square Method:
o It is a mathematical procedure for fitting a line to a set of observed data points
in such a manner that the sum of the squared differences between the
calculated and observed value is minimised.
o This technique is used to find a trend line which best fit the available data.
o This trend is then used to project the dependant variable in the future.
o This method is very popular because it is simple and in-expensive.
o Moreover, the trend method provides fairly reliable estimates of future demand.
o The least square method is based on the assumption that the past rate of change
of the variable under study will continue in the future.
o The forecast based on this method may be considered reliable only for the period
during which this assumption holds.
o The major limitation of this method is that it cannot be used where trend is
cyclical with sharp turning points of troughs and peaks.
o Also, this method cannot be used for short term forecasts.
(b) Regression analysis:
 This is the most popular method of forecasting demand.
 Under this method, a relationship is established between the quantity demanded
(dependent variable) and the independent variables (explanatory variables) such as
income, price of the good, prices of related goods etc.
 Once the relationship is established, we derive regression equation assuming
the relationship to be linear.
 The equation will be of the form Y = a + bX. There could also be a curvilinear
relationship between the dependent and independent variables.
 Once the regression equation is derived, the value of Y i.e. quantity demanded
can be estimated for any given value of X.
(v) Controlled Experiments:
 Under this method, future demand is estimated by conducting market studies
and experiments on consumer behaviour under actual, though controlled,
market conditions.
 This method is also known as market experiment method.
 An effort is made to vary separately certain determinants of demand which can be
manipulated, for example, price, advertising, etc., and conduct the
experiments assuming that the other factors would remain constant.
 Thus, the effect of demand determinants like price, advertisement, packaging, etc.,
on sales can be assessed by either varying them over different markets or by
varying them over different time periods in the same market.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.45

 The responses of demand to such changes over a period of time are recorded
and are used for assessing the future demand for the product.
 For example, different prices would be associated with different sales and on that
basis the price-quantity relationship is estimated in the form of regression equation
and used for forecasting purposes.
 It should be noted however, that the market divisions here must be
homogeneous with regard to income, tastes, etc.
Drawbacks
 The method of controlled experiments is used relatively less because this
method of demand forecasting is expensive as well as time consuming.
 Moreover, controlled experiments are risky too because they may lead to
unfavourable reactions from dealers, consumers and competitors.
 It is also difficult to determine what conditions should be taken as constant
and what factors should be regarded as variable so as to segregate and measure
their influence on demand.
 Besides, it is practically difficult to satisfy the condition of homogeneity of
markets.
Market experiments can also be replaced by ‘controlled laboratory experiments’
or ‘consumer clinics’ under which consumers are given a specified sum of
money and asked to spend in a store on goods with varying prices , packages,
displays etc.
(vi) Barometric method of forecasting:
 All the above methods are based on past experience and try to project the past
into the future.
 Such projection is not effective where there are economic ups and downs.
 As mentioned above, the projection of trend cannot indicate the turning point
from slump to recovery or from boom to recession.
 Therefore, in order to find out these turning points, it is necessary to find out
the general behaviour of the economy.
 Just as meteorologists use the barometer to forecast weather, the economists
use economic indicators to forecast trends in business activities.
 This information is then used to forecast demand prospects of a product,
though not the actual quantity demanded.
 For this purpose, an index of relevant economic indicators is constructed.
Movements in these indicators are used as basis for forecasting the likely
economic environment in the near future.
There are leading indicators, coincidental indicators and lagging indicators.
The leading indicators
 leading indicators move up or down ahead of some other series.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.46

 For example, the heavy advance orders for capital goods give an advance
indication of economic prosperity.
 Increase in the number of construction permits for new houses will be
reflected in corresponding increase in the number of sheets of glass ordered
several months later.
The coincidental indicators,
 coincidental indicators however, move up and down simultaneously and are
witnessed at around the same time the changes they signal occur.
 Since these happen almost in real time, they do not offer much predictive
insight, but provide a fair reading of the current scenario.
 For example, Figures on retail sales, rate of unemployment and Index of
Industrial Production (IIP).
The lagging indicators
 lagging indicators follow a change after some time lag.
 The heavy household electrical connections confirm the fact that heavy
construction work was undertaken during the past with a lag of some time.

*********************
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.47

QUESTIONS & ANSWER

1. Which of the following pairs of goods is an example of substitutes?
(a) Tea and sugar. (b) Tea and coffee.
(c) Pen and ink. (d) Shirt and trousers.
2. ___________________________ pair of commodities is an example of substitutes.
(a) Coffee and milk (b) Diamond and cow
(c) Pen and ink (d) Mustard oil and coconut oil
3. When the price of a substitute of X commodity falls, the demand for X ………………….
(a) Rises (b) Falls
(c) Remains unchanged (d) Any of the above.
4. In the case of a Giffen good, the demand curve will be …………………. .
(a) horizontal. (b) downward-sloping to the right.
(c) vertical (d) upward-sloping to the right.
5. Giffen goods are those goods ……………………. .
(a) For which demand increases as price increases
(b) Which have a high income elasticity of demand
(c) Which are in short supply
(d) None of these
6. If an increase in the price of blue jeans leads to an increase in the demand for tennis
shoes, then blue jeans and tennis shoes are___________________________ .
(a) complements. (b) inferior goods.
(c) normal goods. (d) substitutes.
7. If an increase in consumer incomes leads to a decrease in the demand for
camping equipment, thencamping equipment is
(a) a normal good. (b) none of these answers.
(c) an inferior good. (d) a substitute good.
8. All of the following are determinants of demand except
(a) tastes and preferences (b) quantity supplied
(c) income (d) price of related goods
9. If the price of good A increases relative to the price of substitute B and C, the demand for:
(a) B will increase (b) C will increase
(c) B and C will increase (d) B and C will decrease
10. If the price of Pepsi decreases relative to the price of Coke and 7-Up, the demand for:
(a) Coke will rise (b) 7-Up will decrease
(c) Coke and 7-Up will increase (d) Coke and 7-Up will decrease
11. An inferior commodity is one which is consumed in smaller quantities when the income
of consumer :
(a) Becomes nil (b) Remains the same
(c) Falls (d) Rises
12. Effective Demand depends on:
(a) Desire (b) Means to purchase
(c) Willingness to use those means for that purchase (d) All of above
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.48

13. Quantity demanded is a:

(a) Flow Concept (b) Stock Concept
(c) Both (a) and (b) (d) None of the above
14. Sir Robert Giffen was surprised to find out relationship of price with two other
goods, which were:
(a) Bread and Rice (b) Meat and Rice
(c) Bread and Meat (d) Cheese and Meat
15. When the price of a substitute of X commodity falls, the demand for X commodity:
(a) Falls (b) Rises
(c) Remains unchanged (d) Any of the above
16. For what type of good does demand fall with a rise in income levels of households ?
(a) Inferior goods (b) Substitutes
(c) Luxuries (d) Necessities
17. The demand of which type of goods do not decrease with increase in its price
(a) Comforts (b) Luxury
(c) Necessities (d) Capital goods
18. Other things remaining constant, if the price of the inferior goods decrease then
what will be the effect?
(a) Demand increases (b) Demand Decreases
(c) Quantity demanded increases (d) Quantity Demand decreases
19. Certain goods for which quantity demanded decreases when income increases are
called
(a) Superior goods (b) Inferior goods
(c) Prestige goods (d) Conspicuous goods
20. Normal goods have_______________ ?
(a) Zero Income elasticity (b) Negative income elasticity
(c) Positive income elasticity (d) Infinite income elasticity
21. Demand for a commodity refers to:
(a) desire for the commodity
(b) need for the commodity
(c) quantity demanded of that commodity
(d) quantity of the commodity demanded at a certain price during any particular period of
time.
22. In the case of a Giffen good, the demand curve will be:
(a) Horizontal (b) Downward-sloping to the right
(c) Vertical (d) Upward-sloping to the right.
23. The good which cannot be consumed more than once is known as:
(a) durable good (b) non-durable good
(c) producer good (d) none of the above
24. A relative price is:
(a) price expressed in terms of money
(b) what you get paid for babysitting your cousin
(c) the ratio of one money price of another
(d) equal to a money price
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.49

25. The quantity demanded of a good or services is the amount that:

(a) consumer plan to buy during a given time period at a given price
(b) firms are willing to sell during a given time period at a given price
(c) a consumer would like to buy but might not be able to afford
(d) is actually bought during a given time period at a given price
26. Demand is the
(a) unlimited wants of consumers
(b) entire relationship between the quantity demanded and the price of a good
(c) willingness to pay for a good if income is larger enough
(d) ability to pay for a good
27. If, as people's income increases, the quantity demanded of a good decreases, the good
is called:
(a) a substitute (b) a normal good
(c) an inferior good (d) a complement
28. The price of tomatoes increases and people buy tomato puree. You infer that tomato
puree and tomatoes are:
(a) normal goods (b) complements
(c) substitutes (d) inferior goods
29. Chicken and fish are substitutes. If the price of chicken increases, the demand for fish
will:
(a) increase or decrease but the demand curve for chicken will not change
(b) increase and the demand curve for fish will shift rightwards
(c) not change but there will be a movement along the demand curve for fish
(d) decrease and the demand curve for fish will shift leftwards

30. Potato chips and popcorn are substitutes. A rise in the price of potato chips will.
………….. …… the demand for popcorn and the quantity of popcorn will...............
(a) increase; increase (b) increase; decrease
(c) decrease; decrease (d) decrease; increase
31. An increase in the demand for computers and an increase in the number of sellers on
computer will:
(a) increase the number of computers bought
(b) decrease the price but increase the number of computers bought
(c) increase the price of a computer
(d) increase the price and the number of computers bought
32. The goods that exhibit direct price-demand relationship are called:
(a) Giffen goods (b) Complementary goods
(c) Substitute goods (d) none of the above
33. Comforts lies between the:
(a) inferior goods and necessaries (b) luxuries and inferior goods
(c) necessaries and luxuries (d) none of the above
34. The law of demand refers to --------------------- --.
(a) price-supply relationship (b) price-cost relationship
(c) price-demand relationship (d) price-income relationship.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.50

35. In a typical demand schedule, quantity demanded:

(a) varies directly with price. (b) varies proportionately with price.
(c) varies inversely with price. (d) is independent of price.
36. The total effect of a price change of a commodity is
(a) substitution effect plus price effect.
(b) substitution effect plus income effect.
(c) substitution effect plus demonstration effect.
(d) substitution effect minus income effect.
37. The exception to law of demand are: ----------
(a) Veblen goods (b) Giffen goods
(c) Both (a) & (b) (d) none
38. Demand curve in most cases slopes
(a) downward towards right (b) vertical and parallel to Y-axis
(c) upward towards left (d) horizontal and parallel to X-axis
39. The 'substitution effect' takes place due to change in
(a) income of the consumer (b) prices of the commodity
(c) relative prices of the commodities (d) all of the above
40. Under income effect, consumer
(a) moves along the original indifference curve
(b) moves to higher or lower indifference curve
(c) always purchases higher quantities of both the commodities
(d) none of the above
41. All but one of the following are assumed to remain the same while drawing an
individual's demand curvefor a commodity. Which one is it?
(a) The preference of the individual (b) His monetary income
(c) price (d) price of related goods
42. The Law of Demand, assuming other things to remain constant, establishes the
relationship between:
(a) income of the consumer and the quantity of a good demanded by him
(b) price of a good and the quantity demanded
(c) price of a good and the demand for its substitute
(d) quantity demanded of a good and the relative prices of its complementary goods
43. If regardless of changes in its price, the quantity demanded of a good remains
unchanged, then the demand curve for the good will be:
(a) horizontal (b) vertical
(c) positively sloped (d) negatively sloped
44. The law of demand is:
(a) a quantitative statement
(b) a qualitative statement
(c) both a quantitative and a qualitative statement
(d) neither a quantitative nor a qualitative statement
45. When total demand for a commodity whose price has fallen increases, it is due to:
(a) income effect (b) substitution effect
(c) complementary effect (d) price effect
46. With a fall in the price of a commodity:
(a) consumer's real income increase
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.51

(b) consumer's real income decreases

(c) there is no change in the real income of the consumer
(d) none of the above
47. With an increase in the price of diamond, its demand also increases. This is because it
is a :
(a) substitute good (b) complementary good
(c) conspicuous good (d) none of the above
48. In Economics when demand for a commodity increases with a fall in its price it is
known as:
(a) contraction of demand (b) expansion of demand
(c) no change in demand (d) none of the above
49. An increase in the demand can result from:
(a) a decline in market price.
(b) an increase in income.
(c) a reduction in the price of substitutes.
(d) an increase in the price of complements.
50. Suppose consumer tastes shift toward the consumption of apples. Which of the
following statements is an accurate description of the impact of this event on the
market for apples?
(a) There is an increase in the quantity demanded of apples and in the supply for apples.
(b) There is an increase in the demand and supply of apples.
(c) There is an increase in the demand for apples and a decrease supply of apples.
(d) There is an increase in the demand for apples and an increase quantity supplied.
51. Contraction of demand is the result of
(a) decrease in the number of consumers
(b) increase in the price of the good concerned
(c) increase in the prices of other goods
(d) decrease in the income of purchasers

52. If increasing air fares increase revenues and decreasing them decrease revenues, then
the demand for air travel has a price elasticity of:
(a) Zero
(b) Greater than zero but less than one
(c) one
(d) Greater than one
53. As the price of Bananas rises:
(a) The quantity demanded for bananas increases
(b) The demand curve for bananas shifts to the right
(c) The quantity demanded for bananas decreases
(d) The demand curve far bananas shifts to the left
54. Expansion & contraction of Demand curve occurs due to
(a) Change in the price of commodity
(b) Change in price of substitute or complementary goods
(c) Change in income
(d) None
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.52

55. If the price of any complement goods rises :

(a) Demand curve shifts to left (b) Demand curve shifts to right
(c) Demand curve moves downwards (d) Demand curve moves upward

56. A movement along the demand curve for soft drinks is best described as:
(a) An increase in demand (b) A decrease in demand
(c) A change in quantity demanded (d) A change in demand

57. A decrease in price will result in an increase in total revenue if:

(a) the percentage change in quantity demanded in less than the percentage change in
price.
(b) the percentage change in quantity demanded in greater than the percentage change in
price
(c) demand in inelastic
(d) the consumer in operating along a linear demand curve at a point at which the price is
very low and the quantity demanded is very high.

58. An increase in price will result in an increase in total revenue if:

(a) the percentage change in quantity demanded is less than the percentage change in
price.
(b) the percentage change in quantity demanded in greater than the percentage change in
price.
(c) demand is elastic
(d) the consumer is operating along a liner demand curve at a point at which the price is
very high and the quantity demanded is very low.

59. Movement along the same demand curve shows

(a) Expansion of demand (b) Expansion of supply
(c) Expansion and contraction of demand (d) Increase and decrease of demand

60. An increase in demand can result from

(a) A decline in the market price
(b) An increase in income
(c) A reduction in the prices of substitutes
(d) An increase in the prices of complements

61. When price remains constant and quantity demanded changes, then the demand
curve will be:
(a) Veritical to X axis (b) Horizontal to X axis
(c) Either (a ) or (b) (d) None of these

62. For a commodity with a unitary elastic demand curve if the price of the commodity
rises, then the consumer's total expenditure on this commodity would :
(a) Increase (b) Decrease
(c) Remain constant (d) Either increase or decrease
63. Suppose a department store has a sale on its silverware. If the price of a place-setting
is reduced from Rs. 300 to Rs.200 and the quantity demanded increases from 3,000
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.53

place-settings to 5,000 place-settings, what is the price elasticity of demand for

silverware?
(a) .8 (b) 1.0
(c) 1.25 (d) 1.50

64. A discount store has a special offer on CDs. It reduces their price from Rs.150 to
Rs.100. Suppose the store manager observes that the quantity demanded increases
from 700 CDs to 1,300 CDs. What is the price elasticity of demand for CDs?
(a) .8 (b) 1.0
(c) 1.25 (d) 1.50
65. If the local pizzeria raises the price of a medium pizza from Rs.60 to Rs.100 and
quantity demanded falls from 700 pizzas a night to 100 pizzas a night, the price
elasticity of demand for pizzas is:
(a) .67 (b) 1.5
(c) 2.0 (d) 3.0
66. If the railways are making losses on passenger traffic they should lower their fares.
The suggested remedy would only work if the demand for rail travel had a price
elasticity of -------------
(a) Zero
(b) Greater than zero but less than one.
(c) One
(d) Greater than one

67. If R point bisects the demand curve in two equal parts, then elasticity at R equals -----
---------.
(a) Zero (b) Five
(c) Two (d) One
In Econoville, there is one grocery shop, Ecoconvenience. It used to sell fresh milked Rs.20
per litre, at which price 400 litres of milk were sold per month. After sometime, the price was
raised to Rs 30 per liter. Following the price rise:
- Only 200 liters of milk was sold every month.
- The number of boxes of cereal customers bought went down from 280 to 240.
- The number of packets of powered milk customers bought went up from 90 to 220 per
month. Now answer Questions number 70 - 75
68. The price elasticity of demand when fresh milk's price increases from Rs. 20 per litre
to Rs 30 per litre is equal to:
(a) 2.5 (b) 1.0
(c) 1.66 (d) 2 .66
69. The cross elasticity of monthly demand for cereal when the price of fresh milk
increases from Rs 20 to Rs.30 is equal to:
(a) -0.38 (b) + 0.25.
(c) -0.19. (d) + 0.38.
70. The cross elasticity of monthly demand for powdered milk when the price of fresh
milk increases from Rs 20 to Rs 30 per litre is equal to:
(a) + 1.05. (b) -1.05.
(c) -2.09. (d) + 2.09.
71. What can be said about the price elasticity of demand for fresh milk?
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.54

(a) It is perfectly elastic. (b) It is elastic.

(c) It is perfectly inelastic. (d) It is inelastic.
72. Suppose income of the residents of Ecoville increases by 50% and the quantity of
fresh milk demanded increases by 30%. What is income elasticity of demand for fresh
milk?
(a) 0.5 (b) 0.6
(c) 1.25 (d) 1.50
73. We can say that fresh milk in economics sense is a/an:
(a) luxury good (b) inferior good
(c) normal good (d) nothing can be said.
Read the following data and answer Questions number 74 - 79
A shopkeeper sells gel pen at Rs10 per pen. At this price he can sell 120 per month.
After some time, heraises the price to Rs 15 per pen. Following the price rise:
– Only 60 pens were sold every month.
– The number of refills bought went down from 200 to 150.
– The number of ink pen customers bought went up from 90 to 180 per month.
74. The price elasticity of demand when gel pen's price increases from Rs. 10 per pen to Rs
15 per pen is equalto:
(a) 2.5 (b) 1.0
(c) 1.66 (d) 2 .66
75. The cross elasticity of monthly demand for refills when the price of gel pen increase
from Rs 10 to Rs.15 is equal to:
(a) -0.71 (b) + 0.25.
(c) -0.19. (d) + 0.38.
76. The cross elasticity of monthly demand for ink pen when the price of gel pen increases
from Rs 10 to Rs 15 is equal to:
(a) + 1.66. (b) -1.05.
(c) -2.09. (d) + 2.09.
77. What can be said about the price elasticity of demand for pen?
(a) It is perfectly elastic. (b) It is elastic.
(c) It is perfectly inelastic. (d) It is inelastic.
78. Suppose income of the residents of locality increases by 50% and the quantity of gel
pens demanded increases by 20%. What is income elasticity of demand for gel pen?
(a) 0.4 (b) 0.6
(c) 1.25 (d) 1.50
79. We can say that gel pen in economics sense is a/an
(a) luxury good (b) inferior good
(c) normal good (d) nothing can be said.
80. Suppose the demand for meals at a medium-priced restaurant is elastic. If the
management of the restaurant is considering raising prices, it can expect a
relatively:
(a) large fall in quantity demanded. (b) large fall in demand.
(c) small fall in quantity demanded. (d) small fall in demand.
81. Demand for electricity is elastic because ……………………. .
(a) it is very expensive.
(b) it has a number of close substitutes.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.55

(c) it has alternative uses.

(d) none of the above.
82. A book seller estimates that if she increases the price of a book from Rs.60 to
Rs.67, the quantity of books demanded will decrease from 2 035 to 1 946. The book's
price elasticity of demand is approximately
(a) 0.4 (b) 0.8
(c) 1.0 (d) 2.5
83. If the quantity of blankets demanded increases from 4600 to 5700 in response to a
decrease in their price from Rs 220 to Rs 190, the price elasticity of demand for
blankets is
(a) 0.69 (b) 1.0
(c) 1.46 (d) 2 .66
84. If the elasticity of demand for a commodity is perfectly inelastic then which of the
following is incorrect?
(a) The commodity must be essential to those who purchase it.
(b) The commodity must have many substitutes.
(c) The commodity will be purchased regardless of increase in its price.
(d) The elasticity of demand for this commodity must equal zero.
85. If a good has price elasticity greater than one then:
(a) demand is unit elastic and a change in price does not affect sellers' revenue.
(b) demand is elastic and a change in price causes sellers' revenue to change in the
opposite direction.
(c) demand is inelastic and a change in price causes sellers' revenue to change in the same
direction.
(d) None of the above is correct.
86. Suppose that at a price of Rs 300 per month, there are 30,000 subscribers to cable
television in Small Town. If Small Town Cablevision raises its price to Rs 400 per
month, the number of subscribers will fall to 20,000. Using the midpoint method
for calculating the elasticity, what is the price elasticity of demand for cable TV in
Small Town?
(a) 1.4 (b) 0.66
(c) 0.75 (d) 2.0
87. What is the price elasticity of demand when, price changes from Rs.10 to Rs.12 and
correspondingly demand changes from 6 units to 4 units?
(a) 0.833 (b) 1.6
(c) 2.2 (d) 1.833
88. What is the original price of a commodity when price elasticity is 0.71 and demand
changes from 20 units to 15 units and the new price is Rs. 10?
(a) Rs. 15 (b) Rs. 18
(c) Rs. 20 (d) Rs. 8
89. When as a result of decrease in the price of good, the total expenditure made on it
decreases we say that price elasticity of demand is:
(a) less than unity (b) unity
(c) zero (d) greater than unity
90. The point elasticity at the mid-point on the demand curve is:
(a) one (b) zero
(c) less than one (d) less than zero
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.56

91. If the price of 'X' rises by 10 per cent and the quantity demanded falls by 10 per cent,
'X' has:
(a) In elastic demand (b) Unit elastic demand
(c) Zero elastic demand (d) Elastic demand
92. If the demand for a good is inelastic, an increase in its price will cause the total
expenditure of the consumers of the good to:
(a) Remain the same (b) Increase
(c) Decrease (d) Any of these
93. If the price of apples rises from Rs. 30 per kg to Rs. 40 per kg and the supply increases
from 240 kg to Rs. 300 kg. Elasticity of supply is:
(a) .77 (b) .67
(c) (-) .67 (d) (-) .77
94. If electricity demand is inelastic, and electric rates increase, which of the following is
likely to occur?
(a) Quantity demanded will fall by a relatively large amount
(b) Quantity demanded will fall by a relatively small amount
(c) Quantity demanded will rise in the short run, but fall in the long mn
(d) Quantity demanded will fall in the short mn, but rise in the long mn
95. When quantity demanded changes by larger percentage than does price, elasticity is
termed as:
(a) inelastic (b) perfectly elastic
(c) elastic (d) perfectly inelastic
96. If income elasticity for the household for good A is 2 then it is a:
(a) necessity item (b) inferior goods
(c) luxurious item (d) comfortable item

Read the following data and answer Questions 97 - 102

X, Y and Z are three commodities where X and Y are complementary goods whereas X
and Z are substitutes.
A shop keeper sells commodity X at Rs. 20 per piece. At this price he is able to sell 100
pieces of X per month.
After some time, he decreases the price of X to Rs. 10 per piece. Following the price
decrease. He is able to sell 150 pieces of X per month.
The demand for Y increases from 25 units to 50 units.
The demand for commodity Z decreases from 75 units to 50 units.
97. The price elasticity of demand when price of X decreases from Rs. 20 per piece to Rs.
10 per piece will be equal to:
(a) 0.6 (b) 1.6
(c) 0.5 (d) 1.5
98. The cross elasticity of demand for commodity Y when the price of X decreases from Rs.
20 per piece to Rs. 10 per piece will be equal to:
(a) -1.5 (b) +1.5
(c) +1 (d) -1
99. The cross elasticity of commodity Z when the price of X decreases from Rs. 20 per
piece to Rs. 10 per piece will be equal to:
(a) +1.66 (b) +0.6
(c) -1.66 (d) -0.6
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.57

100. What can be said about the price elasticity of demand for commodity X?
(a) Demand is unit elastic (b) Demand is highly elastic
(c) Demand is inelastic (d) Demand is perfectly elastic
101. Suppose income of the consumers increases by 50% and the demand for commodity X
increases by 20% what will be the income elasticity of demand for commodity X?
(a) .04 (b) 0.4
(c) 4.00 (d) -4.00
102. We can say that commodity X in economic sense is a / an
(a) Inferior foods (b) Giffen Goods
(c) Normal Goods (d) Luxury Goods.
103. If a point on a demand curve of any commodity lies on X Axis then price elasticity of
demand of that commodity at that point will be :
(a) Infinite (b) More than zero
(c) Less than zero (d) zero
104. If the income elasticity is greater than one the commodity is -
(a) Necessity (b) Luxury
(c) Inferior goods (d) None of these
105. The concept of elasticity of demand was developed by :
(a) Alfred Marshall (b) Edwin Camon
(c) Paul Samuelson (d) Fredric Bonham
106. Price elasticity of demand is defined as
Change in quantity demanded
(a)
Change in price
Proportionate changein quantity demanded
(b)
Changeing price
Change in quantiy demanded
(c)
Proportion change in price
Proportion changein quantity demanded
(d)
Proportion change in price
107. The horizontal demand curve parallel to x-axis implies that the elasticity of demand is
(a) Zero
(b) Infinite
(c) Equal to one
(d) Greater than zero but less than infinity
108. If a good is priced at Rs 180 p.u. and its price is increased to Rs. 240 p.u. Now suppose
quantity demanded previously was 100 units and as a result of price increase, the
quantity demanded fell to 80 units. What is the price elasticity?
(a) .777 (b) 1.4
(c) 1 (d) .8
109. Identify the factor which generally keeps the price-elasticity of a demand for a good
high.
(a) Its very high price (b) Its very low price
(c) Large number of substitutes (d) None of the above
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.58

110. Suppose price of fashionable Shirts rises from Rs. 400 per piece to Rs. 700 per
piece. The Shopping Mall manager observes that the rise in price causes
demand for shirts to fall from 500 shirts per week to 300 shirts per week. What
is the price elasticity of demand for shirts?

(a) 0.916 (b) 1.5

(c) 1 (d) 1.667
111. If the local ice-cream shop raises the price of a ice cream cup from Rs. 10 per
cup to Rs. 15 per cup, and quantity demanded falls from 500 cups per day to
300 cups per day, the price elasticity of demand for ice- cream cup is :
(a) 1 (c) 2.5
(c) 2 (d) 1.25
112. Elasticity between two points
(a) Point elasticity (b) Arc elasticity
(c) Cross elasticity (d) None
113. Demand for electricity power is elastic because
(a) it is available at a very high price (b) it is essential for life
(c) it has many uses. (d) it has many substitutes
114. Identify the factor which generally keeps the price-elasticity of demand for a good low:
(a) Variety of uses for that good
(b) Its low price
(c) Close substitutes for that good
(d) High proportion of the consumer's income spent on it.
115. Identify the coefficient of price-elasticity of demand when the percentage increase in
the quantity of a good demanded is smaller than the percentage fall in its price:
(a) Equal to one (b) Greater than one
(c) Smaller than one (d) Zero
116. The price of hot dogs increases by 22% and the quantity of hot dogs demanded falls
by 25%. This indicates that demand for hot dogs is:
(a) Elastic (b) Inelastic
(c) Unitarily elastic (d) Perfectly elastic
117. Given the following four possibilities, which one results in an increase in total
consumer expenditures?
(a) demand is unitary elastic and price falls
(b) demand is elastic and price rises
(c) demand is inelastic and price falls
(d) demand is inelastic and prices rises

118. Suppose the demand for meals at a medium-priced restaurant is elastic. If the
management want to raise price of means than
(a) large fall in quantity demanded (b) large fall in demand
(c) small fall in quantity demanded (d) small fall in demand
119. Point elasticity is useful for which of the following situations?
(a) The bookstore is considering doubling the price of notebooks
(b) A restaurant is considering lowering the price of its most expensive dishes by 50
percent.
(c) An auto producer is interested in determining the response of consumers to the
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.59

price of cars being lowered by Rs. 100.

(d) None of the above

120. Demand for a good will tend to be more elastic if it exhibits which of the following
characteristics?
(a) It represents a small part of the consumer's income.
(b) The good has many substitutes available.
(c) It is a necessity (as opposed to a luxury).
(d) There is little time for the consumer to adjust to the price change.

121. Demand for a good will tend to be more inelastic if it exhibits which of the following
characteristics?
(a) The good has many substrates
(b) The good is a luxury (as opposed to a necessity)
(c) The good is a small part of the consumer's income
(d) There is a great deal of time for the consumer to adjust to the change in prices.
122. Which of the following goods is likely to have perfectly inelastic demand?
(a) Car (b) Salt
(c) Cabbage (d) Sugar
123. If price of air-corditioner increase form Rs. 30,000 to Rs. 30,010 and resultant
change in demand is negligible we use the measure of. to measure elasticity.
(a) point elasticity (b) perfect elasticity
(c) perfect inelasticity (d) price elasticity
124. Which of the following statements is correct?
(a) When the price falls the quantity demanded falls
(b) Seasonal changes do not affect te supply of a commodity
(c) Taxes and subsidies do not influence the supply of the commodity
(d) With lower cost, it is profitable to supply more of the commodity
125. How many types of elasticity of demand are there?
(a) One (b) Two
(c) Three (d) Four
126. In case of an inferior good the income elasticity of demand is:
(a) Zero (b) Positive
(c) Negative (d) None of the above
127. If a good is a luxury, its income elasticity of demand is _________ .
(a) positive and less than 1. (b) negative but greater than -1.
(c) positive and greater than 1. (d) zero.
128. If the quantity of CD demanded increases from 260 to 290 in response to an
increase in income from Rs 9000 to Rs 9800, the income elasticity of demand is
approximately:
(a) 3.4 (b) 0.01.
(c) 1.3 (d) 2.3.
129. If the quantity of good X demanded increases from 8 to 12 in response to an
increase in the price of good Y from Rs 23 to Rs 27, the cross elasticity of demand
for X with respect to the price of Y is approximately:
(a) 0.35 and X and Y are complements. (b) 0.35 and X and Y are substitutes.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.60

(c) 2.5 and X and Y are complements. (d) 2.5 and X and Y are substitutes.
130. Concerned about the poor state of the economy, a car dealer estimates that if
income decreases by 4 per cent, car sales will fall from 352 to 335. Consequently,
the income elasticity of demand for cars is approximately
(a) - 1.2 (b) 0.01
(c) 0.4 (d) 1.2
131. Calculate Income-elasticity for the household when the income of a household rises
by 5% and the demand for bajra falls by 2%
(a) + 2.5 (b) -2.5
(c) - .4 (d) + .4
132. If the proportion of income spent on a goods decreases as income rises then income
elastidty is:
(a) Greater than one (b) Less than one
(c) One (d) Zero
133. The income of a household rises by 20 percent, the demand for computer rises by
50%, this means computer is a/an:
(a) Inferior good (b) Luxury good
(c) Necessity (d) None of the above
134. If the proportion of income spent on a good remains the same as income increases,
then income elasticity for the good in:
(a) More than one (b) One
(c) Less than one (d) Zero
135. If income elasticity of the household for good X is 3 then it is a:
(a) Normal Good (b) Necessity Good
(c) Luxury Good (d) Inferior Good
136. If the proportion of income spent on a good increase as income increases, then
income elasticity for the good is:
(a) Greater than one (b) Less than one
(c) One (d) Infinite
137. Suppose a consumer's income increases from Rs. 30,000 to Rs. 36,000. As a result,
the consumer increases her purchases of compact discs (CDs) from 25 CDs to 30
CDs. What is the consumer's income elasticity of demand for CDs?
(a) 0.5 (b) 1.0
(c) 1.5 (d) 2.0
138. The quantity purchased will remain constant irrespective of the change in income.
This is known as:
(a) negative income elasticity of demand
(b) income elasticity of demand less than one
(c) zero income elasticity of demand
(d) income elasticity of demand is greater than one
139. As income increases, the consumer will go in for superior goods and consequently
the demand for inferior goods will fall. This means inferior goods have:
(a) income elasticity of demand less than one
(b) negative income elasticity of demand
(c) zero income elasticity of demand
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.61

(d) unitary income elasticity of demand

140. When income increases the money spent on necessaries of life may not increase in
the same proportion, This means:
(a) income elasticity of demand is zero
(b) income elasticity of demand is one
(c) income elasticity of demand is greater than one
(d) income, elasticity of demand is less than one
141. The luxury goods like jewellery and fancy articles will have
(a) low income elasticity of demand
(b) high income elasticity of demand
(c) zero income elasticity of demand
(d) none of the above

142. What is income elasticity of demand, when income changes by 20% and demand
changes by 40%
(a) 1/2 (b) 2
(c) 0.33 (d) None
143. A necessity is defined as a good having:
(a) A positive income elasticity of demand
(b) A negative income elasticity of demand
(c) An income elasticity of demand less than 1.
(d) An income elasticity of demand less than 0.
144. Positive income elasticity implies that as income rises, demand for the commodity
(a) Rises (b) Falls
(c) Remains unchanged (d) Becomes zero

145. Calculate income-elasticity for the household when the income of a household
rises by 5% and the demand for bajra falls by 2%
(a) +2.5 (b) -2.5
(c) - . 4 (d) +.4
146. Which of the following is incorrect?
(a) The cross elasticity of demand for two substitutes is positive.
(b) The income elasticity of demand is the percentage change in quantity demanded of
a good due to a change in the price of a substitute.
(c) The cross elasticity of demand for two complements is negative.
(d) The price elasticity of demand is always negative, except for Giffen goods.
147. The cross elasticity of monthly demand for gel pen when the price of refills
increases by 20% and demand for gel pens falls by 30% is equal to:
(a) − 0.71 (b) + 0.25.
(c) − 0.19. (d) −1.5.
148. The cross elasticity of monthly demand for ink pen when the price of gel pen
increases by 25% and demand for ink pen increases by 50% is equal to:
(a) + 2.00. (b) − 2.00.
(c) −2.09. (d) + 2.09.
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.62

149. The elasticity of substitution between two perfect substitutes is:

(a) zero (b) greater than zero
(c) less than infinity (d) infinite

150. Cross elasticity of demand between tea and coffee is:

(a) positive (b) negative
(c) zero (d) infinity
151. If two goods are totally unrelated, then cross elasticity between them is:
(a) Zero (b) One
(c) Infinite (d) None of the above
152. If the price of petrol rises by 25% and demand for car falls by 40% then, cross
elasticity between petrol and car is:
(a) -1.6 (b) 1.6
(c) -2.6 (d) 2.6
153. Cross elasticity of demand in Monopoly market is :
(a) Elastic (b) Zero
(c) Infinite (d) One
154. Cross elasticity of complementary goods is:
(a) Positive (b) Negative
(c) Infinity (d) None of these

155. Bricks for houses is and example of which kind of demand?

(a) Composite (b) Competitive
(c) Joint (d) Derived
156. If the quantity demanded of beef increases by 5% when the price of chicken
increases by 20%, the cross- price elasticity of demand beef and chicken is:
(a) -0.25 (b) 0.25
(c) -4 (d) 4
157. Comforts lies between...........
(a) Inferior goods and necessaries (b) Luxuries and inferior goods
(c) Necessaries and luxuries (d) None
158. The demand for a factor of production is said to be a derived demand because
(a) It is a function of the profitability of an enterprise
(b) It depends on the supply of complementary factors
(c) Its stems from the demand for the final product
(d) IT arises out of mens being scarce in relation to wants

159. If lowering of fares reduced railway's revenues and increasing of fares increasing,
then the demand for rail travel has a price elasticity of ___________ .
(a) Zero
(b) Greater than zero but less then one.
(c) One
(d) Greater than one
160. If as a result of 20 percent fall in the ticket fares the demand for 'watching movie' in
the cinema hall increases by 10 percent, then .
(a) Zero
 LAW OF DEMAND AND ELASTICITY OF DEMAND (Unit - 1) | 2.63

(b) Greater than zero but less then one

(c) One
(d) Greater than one

161. If consumers always spend 15 percent of their income on food, then the income
elasticity of demand for food is .
(a) 1.50 (b) 1.15
(c) 1.00 (d) 0.50
162. Demand curve can be derived from :
(a) MU curve (b) PCC
(c) Both (a) & (b) (d) None
163. The real determinant of the size of market in a county is the
(a) income of its population (b) geographical area
(c) size of its population (d) income of the government
164. If distribution of income is more equal, then the propensity to consumer of the
country is:
(a) Relatively High (b) Relatively Low
(c) Unaffected (d) None of the above
165. If the goods are complementary like car and petrol, their cross elasticity is.
(a) Negative (b) Positive
(c) Zero (d) Infinite
Answer Key
1 b 2 d 3 b 4 d 5 a 6 d 7 c 8 b 9 c 10 d 11 d 12 d 13 a
14 c 15 a 16 a 17 c 18 d 19 b 20 c 21 d 22 d 23 b 24 c 25 a 26 b
27 c 28 c 29 b 30 a 31 a 32 a 33 c 34 c 35 c 36 b 37 c 38 a 39 c
40 b 41 c 42 b 43 b 44 b 45 d 46 a 47 c 48 b 49 b 50 d 51 b 52 b
53 c 54 a 55 a 56 c 57 b 58 a 59 c 60 b 61 b 62 c 63 c 64 d 65 d
66 d 67 d 68 c 59 a 70 d 71 b 72 b 73 c 74 c 75 a 76 a 77 b 78 a
79 c 80 a 81 c 82 a 83 c 84 b 85 b 86 a 87 c 88 a 89 a 90 a 91 b
92 b 93 a 94 b 95 c 96 c 97 a 98 d 99 b 100 c 101 b 102 c 103 d 104 b
15 a 106 d 107 b 108 a 109 c 110 a 111 d 112 b 113 c 114 b 115 c 116 a 117 d
118 a 119 c 120 b 121 c 122 b 123 a 124 d 125 d 126 c 127 c 128 c 129 d 130 d
131 c 132 b 133 b 134 b 135 c 136 a 137 b 138 c 139 b 140 d 141 b 142 b 143 C
144 a 145 c 146 b 147 d 148 a 149 d 150 a 151 a 152 a 153 b 154 b 155 d 156 B
157 c 158 c 159 b 160 b 161 c 162 c 163 a 164 a 165 a
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.1

CHAPTER – 2 (UNIT - 2) THEORY OF CONSUMER BEHAVIOUR

CHAPTER – 2
THEORY OF CONSUMER BEHAVIOUR

NATURE OF HUMAN WANTS

All wants of human beings exhibit some characteristic features.
1. Wants are unlimited in number. All wants cannot be satisfied.
2. Wants differ in intensity. Some are urgent ,others are less intensely felt
3. Each want is satiable
4. Wants are competitive. They compete each other for satisfaction because resources
are scarce in relation to wants
5. Wants are complementary. Some wants can be satisfied only by using more than one
good or group of goods
6. A particular want may be satisfied in alternative ways
7. Wants are subjective and relative.
8. Wants vary with time, place, and person
9. Some wants recur again whereas others do not occur again and again
10. Wants may become habits and customs
11. Wants are affected by income, taste, fashion, advertisements and social norms and
customs
12. Wants arise from multiple causes such as physical and psychological instincts, social
obligations andindividual’s economic and social status.
CLASSIFICATION OF WANTS
In Economics, wants are classified into three categories, viz., necessaries, comforts and luxuries.
Necessaries:
 Necessaries are those which are essential for living.
 Necessaries are further sub-divided into
o necessaries for life or existence,
o necessaries for efficiency and
o conventional necessaries.
Necessaries for life
 Necessaries for life
o Necessaries for life are things necessary to meet the minimum physiological
needs for the maintenance of life such as minimum amount of food, clothing and
shelter.
 Necessaries for efficiency
o Man requires something more than the necessities of life
 to maintain longevity,
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.2

 energy and efficiency of work,

 such as nourishing food,
 adequate clothing, clean water, comfortable dwelling, education,
recreation etc.
 Conventional necessaries
o Conventional necessaries arise either due to pressure of habit or due to
compelling social customs and conventions.
o They are not necessary either for existence or for efficiency.
Comforts:
 While necessaries make life possible comforts make life comfortable and satisfying.
Comforts are less urgent than necessaries.
 For example-
o Tasty and wholesome food,
o good house,
o clothes that suit different occasions,
o audio-visual and labour saving equipments etc. make life more comfortable.
Luxuries:
 Luxuries are those wants which are superfluous and expensive.

 They are not essential for living.

 Items such as
o expensive clothing,
o exclusive vintage cars,
o classy furniture and goods used for vanity etc. fall under this category.

UTILITY
 The concept of utility is used in neo classical Economics to explain the operation of the
law of demand.
 Following Jeremy Bentham, John Stuart Mill, and other nineteenth-century British
economist-philosophers, economists apply the term utility to "that property in any
object, whereby it tends to produce benefit, advantage, pleasure, good, or
happiness”.
 Utility is thus the want satisfying power of a commodity.
 The utility of a consumer is a measure of the satisfaction that the consumer expects to
obtain from consumption of goods and services when he spends money on a stock of
commodity which has the capacity to satisfy his want.
Features of utility
 Utility is thus the anticipated satisfaction by the consumer, and satisfaction is the
tangible satisfaction derived.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.3

 A commodity has utility for a consumer even when it is not consumed.

 Utility is a subjective and relative entity and varies from person to person.
 A commodity has different levels of utility for the same person at different places or at
different points of time.
 It should be noted that utility is not the same thing as usefulness.
 Even harmful things like liquor may be said to have utility because people want them.
Thus, in Economics, the concept of utility is ethically neutral.
 Utility hypothesis forms the basis of the theory of consumer behaviour.
 Two important theories are
o Marginal Utility Analysis propounded by Alfred Marshall, and
o Indifference Curve Analysis propounded by J.R. Hicks and R.G.D.Allen.
THE MARGINAL UTILITY ANALYSIS
 The marginal utility theory, formulated by Alfred Marshall, a British economist, seeks
to explain
o how a consumer chooses to spend his income on different goods and services
so as to maximize his utility.
 According to Marshall, utility is the numerical score in terms of’utils’ representing the
satisfaction that a consumer obtains from the consumption of a particular good.
(Utils refer to the hypothetical measuring unit of utility).
This theory is based on certain assumptions.
(a) Total utility:
 Assuming that utility is quantitatively measurable and additive, total utility may
be defined as the sum of utility derived from different units of a commodity
consumed by a consumer.
 Total utility is the sum of marginal utilities derived from the consumption of
different units i.e.
TU= MU1+MU2+ ........................................................................ +MUn
Where MU1, MU2,. . ,MUn etc are marginal utilities of the successive units of a
commodity.
(b) Marginal utility:

 The marginal utility of a good or service is the change in total utility generated
by consuming one additional unit of that good or service.

 In other words, it is the utility derived from the marginal or one additional unit
consumed or possessed by the individual.
Marginal utility = the addition made to the total utility by the addition of consumption of
one more unit of a commodity.
Symbolically,
MUn = TUn - TUn-1
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.4

Where,
MUn is the marginal utility of the nth unit, TUn is the total utility of the nth unit, and

TUn-1 is the total utility of the (n-1)th unit.

Assumptions of Marginal Utility Analysis

The marginal utility analysis is stated with respect to certain conditions. It simply means that
this law has certain assumptions and without these, the law may not hold true.
(1) Rationality:
 A consumer is rational and attempts to attain maximum satisfaction from his
limited money income.
(2) Cardinal Measurability of Utility:
 According to the neoclassical economists, utility is a cardinal concept i.e.,
utility is a measurable and quantifiable entity.
 It implies that utility can be measured in cardinal numbers and may be assigned
a cardinal number like 1, 2, 3 etc.
 Marshall and some other economists used a psychological unit of
measurement of utility called utils.
 Thus, a person can say that he derives utility equal to 10 utils from the
consumption of 1 unit of commodity A and 5 from the consumption of 1 unit of
commodity B.
 Since a consumer can quantitatively express his utility, he can easily
compare different commodities and express which commodity gives him
greater utility and by how much.
 Utilities from different units of the commodity can be added as well.
(3) According to this theory, money is the measuring rod of utility.
(4) The theory also assumes all the other factors ‘constant’ such as
• price of the commodity,
• tastes and preferences,
• income,
• habits,
• temperament and fashion
(5) The theory assumes continuity in consumption and that there is no time gap or
interval between consumption of different units.
(6) The different units of the commodity consumed are assumed to be homogeneous or
identical in nature.
(7) The different units consumed should consist of standard units. the commodity which
is consumed by the consumer should be divisible in nature
(8) The assumption of constancy of the marginal utility of money holds that the
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.5

marginal utility of money remains constant . If the marginal utility of money changes
as income changes, the measuring-rod of utility becomes unstable and therefore
would be inappropriate for measurement.
(9) The hypothesis of independent utility implies that the total utility which a person gets
from the whole collection of goods purchased by him, this theory ignores
complementarity between goods.
The Law of Diminishing Marginal Utility

One of the important laws under Marginal Utility analysis is the Law of Diminishing
Marginal Utility.
 The law of diminishing marginal utility which states that each successive unit of a good
or service consumed adds less to total utility than the previous unit.

 It is based on an important fact that while total wants of a person are virtually
unlimited, each single want is satiable i.e., each want is capable of being satisfied.

 Since each want is satiable, as a consumer consumes more and more units of a good,
the intensity of his want for the good goes on decreasing.
 Thus, the greater the amount of a good a consumer has, the less an additional unit is worth
to him or her.
Marshall, who was the exponent of the marginal utility analysis, stated the law as follows:
“The additional benefit which a person derives from a given increase in the stock of a thing
diminishes with every increase in the stock that he already has.”In other words, ‘as a
consumer increases the consumption of any one commodity keeping constant the
consumption of all other commodities, the marginal utility of the variable commodity
must eventually decline”.
 This law describes a very fundamental tendency of human nature.
 In simple words, it says that as a consumer consumes more units of a good, the extra
satisfaction that he derives from an extra unit of a good goes on falling.
 It is to be noted that it is the marginal utility and not the total utility which declines
with the increase in the consumption of a good.
Consider Table, in which we have presented the total utility and marginal utility derived by a
person from chocolate bars consumed per day keeping constant all other factors that affect
utility.
Total and Marginal Utility Schedule
Quantity of chocolate
bar consumed per Total utility Marginal
day utility

1 20 20
2 34 14
3 45 11

4 50 5
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.6

5 50 0
6 46 –4

 When one chocolate bar is consumed, the total utility derived by the person is 20 utils
(unit of utility) and the marginal utility derived is also 20 utils.
 With the consumption of 2nd chocolate bar, the total utility rises to 34 and the
corresponding marginal utility is14.
 With the second chocolate bar the consumer enjoys greater total utility: but the extra
utility derived from the second is smaller than that he derived from the first.
 We see that till the consumption of chocolate bars increases to 4, the marginal utility
from the additional chocolate bars goes on diminishing (i.e., the total utility goes on
increasing at a diminishing rate).
 The 5th chocolate bar adds no utility and therefore, the total utility remains the
same at 50.
 At this level of consumption, the consumer reaches the ‘satiation’ point and gets no
extra satisfaction or utility from consuming more of it.
 Once this point of satiation is reached, the consumer would refuse any extra unit
of chocolate even if it were free.
 However, if the chocolate bars consumed increases to 6, instead of giving positive
marginal utility, the sixth chocolate bar gives negative marginal utility or disutility and it
may cause him discomfort.
From Table we also find that there are some well defined relationships between total utility
and marginal utility.
(1) Total utility rises as long as MU is positive, but at a diminishing rate because MU is
diminishing
(2) Marginal utility diminishes throughout
(3) When marginal utility is zero, the total utility is maximum. It is the satiation point.
(4) When marginal utility is negative, total utility is diminishing
(5) MU is the rate of change of total utility or it is the slope of TU curve
(6) MU can be positive ,zero or negative

The information in above can be graphically presented to show the relationship

between total utility and marginal utility (Utility Derived from Chocolates Consumed
Per Day)
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.7

 The marginal utility curve shows how marginal utility depends on the quantity of a
good or service consumed.
 As can be seen from the figure, the marginal utility curve goes on declining
throughout.
Limitations and Exceptions of the Law of Diminishing Marginal Utility
(1) The law of diminishing marginal utility is based on rigorous assumptions such as
 cardinal measurability of utility,
 constancy of marginal utility of money,
 continuous consumption,
 homogeneity of units consumed. The law would operate only when these
unrealistic assumptions are met.
(2) Utility is not in fact independent.
 The shape of the utility curve may be affected by the presence or absence of articles
which are substitutes or complements.
 For example-
o The utility obtained from tea may be seriously affected if no sugar is available and
the utility of bottled soft drinks will be affected by the availability of fresh juice.
(3) The law is not universal.
For example, the law may not apply in the following situations
 The law may not apply in the case of prestigious goods and articles like gold, cash,
diamonds etc. where a greater quantity may increase the utility rather than diminish it.
 The law also may not hold well in the case of hobbies, rare collections etc where, with
every addition to the collection, the marginal utility will go on rising.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.8

 Similarly, people who seek greater knowledge and information will be more
satisfied with every additional information secured by them.
 The law may not be operating in cases such as creative art, painting, music, poetry etc
as more of these would generate greater satisfaction.
 The law does not hold good in the case of habit forming commodities like alcohol,
cigarettes, and computer games etc. because those who are habituated into these may
experience increasing utility with every additional intake.
 The law also fails in the case of people with miserly behaviour as accumulation of every
additional unit of money would give them greater levels of satisfaction.
Consumer Equilibrium in Single Commodity Case
 The Law of diminishing marginal utility helps us to understand how a consumer
reaches equilibrium .in case of a single good.
 It states that as the quantity of a good with the consumer increases, marginal utility
of the good decreases.
 In other words, the marginal utility curve is downward sloping.
 A consumer will go on buying a good till the marginal utility of the good becomes
equal to the market price.
 In other words, the consumer will be in equilibrium (will be deriving maximum
satisfaction) in respect of the quantity ofone good when marginal utility of that good is
equal to its price.

Consumer Equilibrium–Single Commodity Case

 In above ,the consumer is in equilibrium at point E with OQ quantity of commodity .

 We find that at point E, the marginal utility of the good for the consumer is equal to its
price.ie MUx= Px.
 At price P the consumer is at equilibrium at E; MUX = P.
When price falls to P1, the consumer extend his consumption to reach E1 where his
MUX = Px1
𝑴𝑼𝒙
The marginal utility of money spent on x Mum = =1
𝑷𝒙
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.9

law of Equi-Marginal utility : In reality, a consumer spends his income on more than one good.
In such cases, consumer equilibrium is explained with the law of Equi-Marginal utility. According
to this law, the consumer will be in equilibrium when he is spending his money on different
goods and services in such a way that the marginal utility of each good is proportional to its
price and the last rupee spent on each commodity yields him equal marginal utility.
The law states that the consumer is said to be at equilibrium, when the following condition is
met:
𝑴𝑼𝒚
= 𝑴𝑼 𝒙 𝑴𝑼𝒙
𝑷𝒙 = = 𝑷𝒚 = MUx or 𝑴𝑼𝒚 = = 𝑷𝒚 = MUx
𝑷𝒙

CONSUMER SURPLUS
 The concept of consumer surplus was propounded by Alfred Marshall.
 Consumer surplus is a measure of welfare that people gain from consuming goods
and services.
 This concept occupies an important place not only in economic theory but also in
economic policies of government and in decision-making of business firms.
 The demand for a commodity depends on the utility of that commodity to a
consumer. If a consumer gets more utility from a commodity, he would be willing to
pay a higher price and vice-versa.
 The willingness to pay of each individual consumer based on his utility determines the
demand curve. When price is less than or equal to the willingness to pay, the
potential consumer purchases the good.
 This extra satisfaction which consumers get from their purchase of a good is
referred to as consumer surplus by Alfred Marshall.
 Consumer surplus is defined as the difference between the total amount that
consumers are willing and able to pay for a good or service (indicated by the demand
curve) and the total amount that they actually do pay (i.e. the market price).
Marshall defined the concept of consumer surplus as the “excess of the price which a
consumer would be willing to pay rather than go without a thing over that which he
actually does pay”, is called consumers surplus.”

 Thus, consumer surplus =what a consumer is ready to p- wayhat heactually pays.

 The concept of consumer surplus is derived from the law of diminishing marginal
utility.

 As we know, according to the law of diminishing marginal utility, the more of a

thing we have, the lesser the marginal utility it has.

 In other words, as we purchase more of a good, its marginal utility goes on

diminishing.

 The consumer is in equilibrium when the marginal utility of a good is equal to its
price i.e., he purchases that many number of units of a good at which marginal utility is
equal to price (It is assumed that perfect competition prevails in the market).
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.10

 Since the price is the same for all units of the good he purchases, he gets extra utility for
all units consumed by him except for the one at the margin.

 This extra utility or extra surplus for the consumer is called consumer surplus.
Consider following in which we have illustrated the measurement of consumer surplus in case
of commodity X.
There is only one price for a commodity in the market at a particular point of time. The price of
X is assumed to be Rs. 20.

Measurement of Consumer Surplus

Marginal Utility
No. of units Price (`Rs) Consumer
(worth Rs) Surplus
1 30 20 10

2 28 20 8
3 26 20 6
4 24 20 4
5 22 20 2
6 20 20 0
7 18 20 –

 We see from the above table that when the consumer’s consumption increases from 1 to 2
units, his marginal utility falls from 30 to 28.

 His marginal utility goes on diminishing as he increases his consumption of good X.

 Since marginal utility for a unit of good indicates the price the consumer is willing to pay
for that unit, and since market price is assumed to be at Rs.20, the consumer enjoys a
surplus on every unit of purchase till the 6th unit.

 Thus, when the consumer is purchasing 1 unit of X, the marginal utility is worth Rs30 and
price fixed is Rs 20, thus he is deriving a surplus of ` 10.

 Similarly, when he purchases 2 units of X, he enjoys a surplus of 8 [28 – 20].

 This continues and he enjoys consumer surplus equal to 6, 4, 2 respectively from 3rd, 4th
and 5th unit.

 When he buys 6 units, he is in equilibrium because his marginal utility is equal to the
market price or he is willing to pay a sum equal to the actual market price and therefore,
he enjoys no surplus.

 Thus, given the price of Rs 20 per unit, the total surplus which the consumer will get,
is worth 10 + 8 + 6 + 4 + 2 + 0 = 30.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.11

The concept of consumer surplus is closely related to the demand curve for a product. The
demand curve reflects buyer’s willingness to pay; we can also use it to measure consumer
surplus.
The difference between his willingness to pay and the price that he actually pays is the net gain
to the con- sumer, the individual consumer surplus.
The total consumer surplus in a market which is the sum of all individual consumer
surpluses in a market, is equal to the area below the market demand curve but above the
price. The term consumer surplus is often used to refer to both individual and total
consumer surplus.
Thus, the total area below the demand curve and above the price is the sum of the
consumer surplus of all buyers in the market.
The concept of consumer surplus can be illustrated graphically.
 Consider following curve , On the X-axis we measure the amount of the commodity
and on the Y-axis the marginal utility and the price of the commodity.
 MU is the marginal utility curve which slopes downwards, indicating that as the
consumer buys more units of the commodity, its marginal utility falls.
 Marginal utility shows the price which a person is willing to pay for the different units
rather than go without them.
If OP is the price that prevails in the market, then the consumer will be in equilibrium
when he buys OQ units of the commodity, since at OQ units, marginal utility is equal to the
given price OP.
 The last unit, i.e., Qth unit does not yield any consumer surplus because here price paid is
equal to the marginal utility of the Qth unit.
 For all units before the Qth unit, the marginal utility is greater than price and thus
these units fetch consumer surplus to the consumer.

Fig. 15: Marshall’s Measure of Consumer Surplus

 In Figure 15, the total utility is equal to the area under the marginal utility curve up to
point Q i.e. ODRQ.

 But, given the price equal to OP, the consumer actually pays OPRQ.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.12

 The consumer derives extra utility equal to DPR which is nothing but consumer
surplus.

 (The portion of demand curve RD1 is not relevant for our consumer as MUx is less than Px
in this part and therefore, the consumer will not buy any quantity beyond Q.)
Consumer surplus is the buyer's net gain from purchasing a good.
 Graphically, it is the triangular area below the demand curve and above the price
line. The size of the consumer surplus triangle depends on the price of the good.
 A rise in the price of a good reduces consumer surplus; a fall in the price increases
consumer surplus.
Thus, a higher price results in a smaller consumer surplus and a lower price generates a
larger consumer surplus.

Change in Consumer Surplus Due to a Fall In Price

A fall in price from P to P1 increases consumer surplus from APE to A P1F.
The increase in consumer surplus has two components.
(a) The increase in consumer surplus of existing buyers who were earlier paying price P
(the rectangle marked b).
(b) The consumer surplus now available to the new buyers who started buying the
commodity due to lower prices (the triangle c)
Applications
The concept of consumer surplus has important practical applications.
Few such applications are listed below:
 Consumer surplus is a measure of the welfare that people gain from consuming goods
and services.
 It is very important to a business firm to reflect on the amount of consumer surplus
enjoyed by different segments of their customers because consumers who perceive
large surplus are more likely to repeat their purchases.
 Understanding the nature and extent of surplus can help business managers make better
decisions about setting prices.
 If a business can identify groups of consumers with different elasticity of demand
within their market and the market segments which are willing and able to pay higher
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.13

prices for the same products, then firms can profitably use price discrimination.
 Large scale investment decisions involve cost benefit analysis which takes into
account the extent of consumer surplus which the projects may fetch.
 Knowledge of consumer surplus is also important when a firm considers raising its
product prices .
 Customers who enjoyed only a small amount of surplus may no longer be willing to buy
products at higher prices. Firms making such decisions should expect to make fewer
sales if they increase prices.
 Consumer surplus usually acts as a guide to finance ministers when they decide on the
products on which taxes have to be imposed and the extent to which a commodity tax has
to be raised.
 It is always desirable to impose taxes or increase the rates of taxes on commodities
yielding high consumer surplus because the loss of welfare to citizens will be
minimal.
Limitations
It is often argued that this concept of consumer surplus is hypothetical and illusory. In real life,
the surplus satisfaction cannot be measured accurately.
(1) Consumer surplus cannot be measured precisely - because it is difficult to measure the
marginal utilities of different units of a commodity consumed by a person.
(2) In the case of necessaries, the marginal utilities of the earlier units are infinitely large.
In such case the consumer surplus is always infinite.
(3) The consumer surplus derived from a commodity is affected by the availability of
substitutes.
(4) There is no simple rule for deriving the utility scale of articles which are used for their
prestige value (e.g., diamonds).
(5) Consumer surplus cannot be measured in terms of money because the marginal utility of
money changes as purchases are made and the consumer’s stock of money diminishes.
(Marshall assumed that the marginal utility of money remains constant. But this
assumption is unrealistic).
(6) The concept can be accepted only if it is assumed that utility can be measured in terms of
money or otherwise. Many modern economists believe that this cannot be done.
INDIFFERENCE CURVE ANALYSIS
 A very popular alternative and a more realistic method of explaining consumer
demand is the ordinal utility approach.
 This approach uses a different tool namely indifference curve to analyse consumer
behaviour and is based on consumer preferences.
 The approach is based on the belief that that human satisfaction, being a psychological
phenomenon, cannot be measured quantitatively in monetary terms as was
attempted in Marshall’s utility analysis.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.14

 herefore, it is scientifically more sound to order preferences than to measure them in

terms of money.
 The consumer preference approach is, therefore, an ordinal concept based on
ordering of preferences compared with Marshall’s approach of cardinality.
Assumptions Underlying Indifference Curve Aopapcrh
(i) The foundation of consumer behaviour theory is the assumption that the
consumer knows his own tastes and preferences and possesses full information
about all the relevant aspects of economic environment in which he lives.
(ii) The consumer is rational and tends to take rational actions that result in a more
preferred consumption bundle over a less preferred bundle.
(ii) The indifference curve analysis assumes that utility is only ordinally expressible.
(iii) The consumer is capable of ranking all conceivable combinations of goods
according to the satisfaction they yield.
(iv) Thus, if he is given various combinations say A, B, C, D and E, he can rank them as
first preference, second preference and so on.
(v) However, if a consumer happens to prefer A to B, he cannot tell quantitatively
how much he prefers A to B.
(vi) Consumer choices are assumed to be transitive. If the consumer prefers
combination A to B, and B to C, then he must prefer combination A to C.
(vii) If combination A has more commodities than combination B, then A must be
preferred to B.
(viii) This is sometimes referred to as the “more is better” assumption or the assumption
of non-satiation.
Indifference Curves
 The ordinal analysis of demand (given by Hicks and Allen) is based on indifference curve
which represent the consumer’s preferences graphically.
 An indifference curve is a curve which represents all those combinations of two
goods which give same satisfaction to the consumer.
 Since all the combinations on an indifference curve give equal satisfaction to the
consumer, the consumer is completely indifferent among them.
Or, it represents the set of all bundles of goods that a consumer views as being equally desirable.

 In other words, since all the combinations provide the same level of satisfaction the
consumer prefers them equally and does not mind which combination he gets.

 An Indifference curve is also called iso-utility curve or equal utility curve.

 To understand indifference curves, let us consider the example of a consumer who has one
unit of food and 12 units of clothing.
 Now, we ask the consumer how many units of clothing he is prepared to give up to
get an additional unit of food, so that his level of satisfaction does not change.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.15

 Suppose the consumer says that he is ready to give up 6 units of clothing to get an
additional unit of food.
 We will have then two combinations of food and clothing giving equal satisfaction to the
consumer:
 Combination A which has 1 unit of food and 12 units of clothing, and combination B which
has 2 units of food and 6 units of clothing.
 Similarly, by asking the consumer further how much of clothing he will be prepared
to forgo for successive increments in his stock of food so that his level of satisfaction
remains unaltered,
Indifference Schedule
Combination Food Clothing MRS
A 1 12 –
B 2 6 6

C 3 4 2
D 4 3 1

Now, if we plot the above schedule, we will get the following figure.
 In present , an indifference curve IC is drawn by plotting the various combinations given in
the indifference schedule.

 The quantity of food is measured on the X axis and the quantity of clothing on the Y axis.
As in indifference schedule, the combinations lying on an indifference curve will give the
consumer the same level of satisfaction.

A Consumer’s Indifference Curve

Indifference Curve Map

 The entire utility function of an individual can be represented by an indifference curve

map which is a collection of indifference curves in which each curve corresponds to a
different level of satisfaction.

 In short, a set of indifference curves is called an indifference curve map.

 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.16

 Each indifference curve is a set of points and each point shares a common level of
utility with the others.

 Combinations of goods lying on indifference curves which are further from the origin are
preferred to those on indifference curves which are closer to the origin.

 Moving upward and to the right from one indifference curve to the next represents
an increase in utility, and moving down and to the left represents a decrease.

 An indifference curve map thus depicts the complete picture of consumer tastes and
preferences.
In following curve an indifference curve map of a consumer is shown which consists of
three indifference curves.
We have marked good X on X-axis and good Y on Y-axis.

o Indifference Map
 Thus, while all combinations of IC1 give him the same satisfaction, all combinations
lying on IC2 give him greater satisfaction than those lying on IC1.
Marginal Rate of Substitution

 The Marginal Rate of Substitution (MRS) is the rate at which a consumer is prepared to
exchange goods X and Y, holding the level of satisfaction constant (i.e., moving along
an indifference curve).
 The marginal rate of substitution along any segment of an indifference curve refers to
the maximum rate at which a consumer would willingly exchange units of Y for units
of X.
 The MRS at any point on the indifference curve is equal to the (absolute value of) the slope
of the curve at that point.
 When measured at a point, the MRS xy tells us the maximum rate at which a
consumer would willingly trade good Y for a infinitesimal bit more of good X.
Consider Table.

 In the beginning the consumer is consuming 1 unit of food and 12 units of clothing.
 Subsequently, he gives up 6 units of clothing to get an extra unit of food, his level of
satisfaction remaining the same.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.17

 The MRS here is 6.

 Likewise when he moves from B to C and from C to D in his indifference schedule, the
MRS are 2 and 1 respectively.
Thus, we can define MRS of X for Y as the amount of Y whose loss can just be compensated by a
unit gain of X in such a manner that the level of satisfaction remains the same.

Diminishing Marginal Rate of Substitution

 We notice that MRS is falling i.e.,
o as the consumer has more and more units of food, the trade –off or rate of
substitution becomes smaller and smaller; i.e. he is prepared to give up less and less
units of clothing.
 Moving down the indifference curve—reducing consumption of clothing and increasing
food consumption—will produce two opposing effects on the consumer’s total utility:
o reduction in total utility due to reduced consumption of clothing, and
o increase in total utility due to higher food consumption.
 The principle of diminishing marginal rate of substitution thus states that the
more of good Y a person consumes in proportion to good X, the less Y he or she is
willing to substitute for another unit of X.
There are two reasons for this.
1. The want for a particular good is satiable so that when a consumer has more of it, his
intensity of want for it decreases. Thus, in our example,
• when the consumer has more units of food, his intensity of desire for additional
units of food decreases.
2. Most goods are imperfect substitutes of one another. MRS would remain constant if
they could substitute one another perfectly.
We know that along the indifference curve:
(Change in total utility due to lower clothing consumption) = (Change in total utility due to
higher food consumption)
To generalize, the marginal rate of substitution of X for Y (MRSxy) is the slope of the
indifference curve.
𝑴𝑼
MRSxy = 𝑴𝑼𝒙
𝒚
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.18

Properties of Indifference Curves

The following are the main characteristics or properties of indifference curves:
(i) Indifference curves slope downward to the right:
 This property implies that the two commodities can be substituted for each other
and when the amount of one good in the combination is increased, the amount of
the other good is reduced.
 This is essential if the level of satisfaction is to remain the same on an indifference
curve.
(ii) Indifference curves are always convex to the origin :
 It has been observed that as more and more of one commodity (X) is substituted for
another (Y), the consumer is willing to part with less and less of the commodity
being substituted (i.e. Y).
 This is called diminishing marginal rate of substitution. .
 This diminishing marginal rate of substitution gives convex shape to the
indifference curves.
However, there are two extreme situations.
(1) perfect substitutes
 When two goods are perfect substitutes of each other, the consumer is completely
indifferent as to which to consume and is willing to exchange one unit of X for one
unit of Y.
 His indifference curves for these two goods are therefore straight, parallel lines
with a constant slope along the curve, or the indifference curve has a constant
MRS.
(2) perfect complements
 Goods are perfect complements when a consumer is interested in consuming
these only in fixed proportions.
 When two goods are perfect complementary goods (e.g. left shoe and right shoe),
the consumer consumes only bundles like A and B in which both X and Y in equal
proportions.
 With a bundle like A or B, he will not substitute X for Y because an extra piece of the
other good (here a single shoe) is worthless for him.
 The reason is that neither an additional left shoe nor a right shoe without a
paired one of each, adds to his total utility.
 In such a case, the indifference curve will consist of two straight lines with a right
angle bent which is convex to the origin, or in other words, it will be L shaped.
 every interesting fact about this is that in the case of perfect complements, the
marginal rate of substitution is undefined because an individual’s preferences
do not allow any substitution between goods.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.19

Perfect Substitutes perfect Complements

(3) Indifference curves can never intersect each other:
 No two indifference curves will intersect each other although it is not
necessary that they are parallel to each other.
 in case of intersection the relationship becomes logically absurd because it
would show that higher and lower levels are equal, which is not possible.
 In figure21, IC1 and IC2 intersect at A. Since A and B lie on IC1, they give same
satisfaction to the consumer. Similarly since A and C lie on IC2, they give same
satisfaction to the consumer.

Intersecting Indifference Curves

 this implies that combination B and C are equal in terms of satisfaction.
 But a glance will show that this is an absurd conclusion because certainly
combination C is better than combination B because it contains more units of
commodities X and Y.
 Thus we see that no two indifference curves can touch or cut each other.
(iii) A higher indifference curve represents a higher level of satisfaction
 A higher indifference curve represents a higher level of satisfaction than the
lower indifference curve:
 This is because combinations lying on a higher indifference curve contain more
of either one or both
goods and more goods are preferred to less of them.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.20

(iv) Indifference curve will not touch either axis

 Another characteristic feature of indifference curve is that it will not touch the X
axis or Y axis.

 This is born out of our assumption that the consumer is considering different
combination of two commodities.

 If an indifference curve touches the Y axis at a point P as shown in the curve it

means that the consumer is satisfied with OP units of Y commodity and zero units of
X commodity.

 This is contrary to our assumption that the consumer wants both commodities
although in smaller or larger quantities.

 Therefore an indifference curve will not touch either the X axis or Y axis.

Impossible Indifference Curve

 A higher indifference curve shows a higher level of satisfaction than a lower one.

 Therefore, a consumer, in his attempt to maximise satisfaction will try to reach the
highest possible indifference curve.

 But in his pursuit of buying more and more goods and thus obtaining more and more
satisfaction, he has to work under two constraints:

o first, he has to pay the prices for the goods and,

o second, he has a limited money income with which to purchase the goods.
 Consumers almost always have limited income, which constrains how much they can
consume.
 A consumer’s choices are limited by the budget available to him.
 As we know, his total expenditure for goods and services can fall short of the budget
constraint, but may not exceed it.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.21

Algebraically, we can write the budget constraint for two goods X and Y as:
PXQX+ PYQY ≤ B

Where

 PX and PY are the prices of goods X and Y and QX and QY are the quantities of goods X and
Y chosen and B is the total money available to the consumer.

 The requirement illustrated by the equation above that a consumer must choose a
consumption bundle that costs no more than his or her income is known as the
consumer’s budget constraint.

 A consumer’s consumption possibilities are the set of all consumption bundles that can be
consumed given the consumer’s income and prevailing prices.

We assume that the consumer in our analysis uses up his entire nominal money income to
purchase the commodities. So that his budget constraint is

PXQX+ PYQY =B

The following table shows the combinations of Ice cream and chocolates a consumer can buy
spending the entire fixed money income of Rs.100, with the prices Rs 20 and Rs.10 respectively.

Consumption Possibilities
Ice Cream Chocolate
A 0 10
B 1 8
C 2 6
D 3 4
E 4 2
F 5 0
 The budget constraint can be explained by the budget line or price line.
 In simple words, a budget line shows all those combinations of two goods which the
consumer can buy spending his given money income on the two goods at their given
prices.
 All those combinations which are within the reach of the consumer (assuming that he
spends all his money income) will lie on the budget line. The consumer could, of course,
buy any bundle that cost less than Rs 100.(e.g. Point K )
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.22

Fig. 23: Price Line or the Budget Line

 It should be noted that any point outside the given price line, say H, will be beyond
the reach of the consumer and any combination lying within the line, say K, shows
under spending by the consumer.

 The slope of the budget line is determined by the relative prices of the two goods.

 It is equal to ‘Price Ratio’ of two goods. i.e. PX /PY i.e. It measures the rate at
which the consumer can trade one good for the other .

The budget line will shift when there is:

 A change in the prices of one or both products with the nominal income of the buyer
(budget) remaining the same.
 A change in the level of nominal income of the consumer with the relative prices of the
two goods remaining the same.
 A change in both income and relative prices.
Consumer Equilibrium
 Having explained indifference curves and budget line, we are in a position to explain
how a consumer reaches equilibrium position by choosing his optimal consumption
bundle, given the constraints.
 A consumer is in equilibrium when he is deriving maximum possible satisfaction from
the goods and therefore is in no position to rearrange his purchases of goods.
 We assume that:
(i) The consumer has a given indifference map which shows his scale of
preferences for various combinations of two goods X and Y.
(ii) He has a fixed money income which he has to spend wholly on goods X and Y.
(iii) Prices of goods X and Y are given and are fixed.
(iv) All goods are homogeneous and divisible, and
(v) The consumer acts ‘rationally’ and maximizes his satisfaction.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.23

Fig. 24 : Consumer’s Equilibrium

 To show which combination of two goods X and Y the consumer will buy to be in
equilibrium we bring his indifference map and budget line together.
 We know by now, that the indifference map depicts the consumer’s preference scale
between various combinations of two goods and the budget line shows various
combinations which he can afford to buy with his given money income and prices
of the two goods.
 Consider curve, in which IC1, IC2, IC3, IC4 and IC5 are shown together with budget line
PL for good X and good Y.
 Every combination on the budget line PL costs the same.
 Thus combinations R, S, Q, T and H cost the same to the consumer.
 The consumer’s aim is to maximise his satisfaction and for this, he will try to reach the
highest indifference curve.
 Since there is a budget constraint, he will be forced to remain on the given budget
line, that is he will have to choose combinations from among only those which lie
on the given price line.
 A consumer’s optimal choice should satisfy two criteria:
1. It will be a point on his budget line; and
2. It will lie on the highest indifference curve possible
 The consumer can arrive this choice moving down his budget line starting from point R.
 Suppose he chooses R. We see that R lies on a lower indifference curve IC1, when
he can very well afford S, Q or T lying on higher indifference curves.
 Similar is the case for other combinations on IC1, like H.
 Again, suppose he chooses combination S (or T) lying on IC2.
But here again we see that the consumer can still reach a higher level of satisfaction
remaining within his budget constraints i.e., he can afford to have combination Q lying on
IC3 because it lies on his budget line.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.24

 We find that this is the best choice because this combination lies not only on his
budget line but also puts him on the highest possible indifference curve i.e., IC3.
 The consumer can very well wish to reach IC4 or IC5, but these indifference curves are
beyond his reach given his money income.
 Thus, the consumer will be at equilibrium at point Q on IC3.
What do we notice at point Q?
o We notice that at this point, his budget line PL is tangent to the indifference
curve IC3.
o In this equilibrium position (at Q), the consumer will buy OM of X and ON of
Y.
 At the tangency point Q, the slopes of the price line PL and the indifference curve IC3 are
equal.
 The slope of the indifference curve shows the marginal rate of substitution of X for
Y (MRSxy) which is equal to of the price line indicates the ratio between the prices
of two goods i.e., Px /Py
𝑴𝑼 𝑷 𝑴𝑼𝒙 𝑴𝑼𝒚
MRSxy = 𝑴𝑼𝒙 = 𝑷𝒙 i.e. =
𝒚 𝒚 𝑷𝒙 𝑷𝒚

 Thus, we can say that the consumer is in equilibrium position when the price line is
tangent to the indifference curve or when the marginal rate of substitution of goods X and
Y is equal to the ratio between the prices of the two goods.
We have seen that the consumer attains equilibrium at the point where the budget line is
tangent to the indifference curve and
 The indifference curve analysis is superior to utility analysis:
(i) it dispenses with the assumption of measurability of utility
(ii) it studies more than one commodity at a time
(iii) it does not assume constancy of marginal utility of money
(iv) it segregates income effect from substitution effect.
**************
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.25

QUESTIONS & ANSWSERS

1. After reaching the saturation point, consumption of additional units of the commodity
cause:
(a) Total utility to fall and marginal utility to increase.
(b) Total utility and marginal utility both to increase.
(c) Total utility to fall and marginal utility to become negative.
(d) Total utility to become negative and marginal utility to fall.
2. Marginal utility approach to demand was given by _____________ .
(a) J.R. Hicks (b) Alfred Marshall
(c) Robbins (d) A C Pigou

Read the following table and answer

question number 3 -4.Table 3
Number of products Total utility Marginal utility
0 0 -
1 3600 -
2 6800 -
3 9600 -
4 12000 -
5 14000 -
6 15600 -
7 16800 -
8 17600 -
9 18000 -
3. What is marginal utility when consumption increases from 4 units to 5 units?
(a) 3000. (b) 1200.
(c) 2000. (d) 1500.
4 What is marginal utility when consumption increases from 8 units to 9 units?
(a) 3000. (b) 400.
(c) 2000. (d) 1500.

Read the following table and answer question number 5-6. Table 3
Number of products Total utility Marginal
utility
0 0 -
1 1800 -
2 3400 -
3 4800 -
4 6000 -
5 7000 -
6 7800 -
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.26

7 8400 -
8 8800 -
9 9000 -

5. What is marginal utility when consumption increases from 4 units to 5

units?
(a) 3000. (b) 1200.
(c) 1000. (d) 1500.
6. What is marginal utility when consumption increases from 8 units to 9
units?
(a) 3000. (b) 200.
(c) 2000. (d) 1500.
7. Total utility is maximum when:
(a) marginal utility is zero
(b) marginal utility is at its highest point
(c) marginal utility is equal to average utility
(d) average utility is maximum

8. The second glass of lemonade gives lesser satisfaction to a thirsty boy this is
a clear case of:
(a) Law of demand (b) Law of diminishing returns
(c) Law of diminishing marginal utility (d) Law of supply
9. The second slice of bread gives less satisfaction to a hungry boy. This is a
clear case of:
(a) Law of demand (b) Law of diminishing returns
(c) Law of diminishing utility (d) Law of supply
10. Who is the main exponent of Marginal utility analysis ?
(a) Paul Samuelson (b) Hicks
(c) Keynes (d) Marshall
11. Cardinal measure of utility is required in:
(a) Marginal Utility theory (b) Indifference curve
(c) Revealed preference (d) None
12. Which one of the following assumptions is not necessary for the cardinal utility theory
(a) Rationality of the consumer
(b) Constant marginal utility of money
(c) Perfectly competitive market
(d) Additivity of utility

13. The total area under the demand curve of a good measures:
(a) marginal utility (b) total utility
(c) consumers surplus (d) producers' surplus
14. Under marginal utility analysis, utility is assumed to be a
(a) cardinal concept (b) ordinal concept
(c) indeterminate concept (d) none of the above
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.27

15. The utility may be defined as

(a) the power of commodity to satisfy wants (b) the usefulness of a commodity
(c) the desire for a commodity (d) none of the above
16. Marginal utility of a commodity depends on its quantity and is
(a) inversely related to its quantity (b) not proportional to its quantity
(c) independent of its quantity (d) none of the above
17. Consumer stops purchasing the additional units of the commodity when -
(a) marginal utility starts declining
(b) marginal utility become zero
(c) marginal utility is equal to marginal utility of money
(d) total utility is increasing
18. In case of necessaries the marginal utilities of the earlier units are large. In
such cases the consumer surplus will be:
(a) Infinite (b) Zero
(c) Marginally positive (d) Marginally Negative
19. Cardinal Measurability of utility means:
(a) Utility can be measured
(b) Utility cannot be measured
(c) Utility can be ranked
(d) Utility can be measured in some case
20. Which is not the assumption of marginal utility analysis?
(a) Cardinal measurability of utility
(b) Constancy of the marginal utility of money
(c) Rationality of human behaviour
(d) Ordinal Measurability of utility
21. Law of diminishing marginal utility may not apply to:
(a) Money (b) Butter
(c) Pepsi, Coke etc. (d) Ice cream
22. Which is not the assumption of the law of diminishing marginal utility?
(a) The different units consumed should be identifiable in all respects
(b) The different units consumed should consist of standard units
(c) There should be time gap or interval between consumption of one unit and another
unit
(d) The law may not apply to hobbies, music etc.
23. Marginal utility curve of a consumer is also his :
(a) Indifferent curve (b) Total utility curve
(c) Supply curve (d) Demand curve

24. The law of equi marginal utility considers price of money as :

(a) Zero (b) less than one
(c) more than one (d) one
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.28

25. Marginal utility is a ________________ Concept.

(a) Cardinal (b) Ordinal
(c) Both (d) None
26. Cardinal approach is related to :
(a) Indifference curve (b) Equi-marginal utility
(c) Law of diminishing returns. (d) None of these.
27. The law of equal marginal utility is one of the laws within whose parameters
Marginal Utility Analysis is framed. The other one is:
(a) Law of diminishing marginal (b) Law of proportions
(c) Law of consumer surplus (d) Law of increasing returns
28. When economists speak of the utility of a certain good, they are referring to:
(a) the demand for the good
(b) the usefulness of the good in consumption
(c) the satisfaction gained from consuming the good
(d) the rate at which consumers are willing to exchange one good for another
29. Which of the following means an Economic activity?
(a) Production of Goods (b) Production of Services
(c) Consumption of Goods and Services (d) All of the above
30. Consumer surplus means _________________ .
(a) the area inside the budget line.
(b) the area between the average revenue and marginal revenue curves.
(c) the different between the maximum amount a person is willing to pay for a good and
its market price.
(d) none of the above.
31. Consumer surplus is highest in the case of:
(a) Necessities. (b) Luxuries.
(c) Comforts. (d) Conventional necessities.
32. While analyzing Marshall's measure of consumer's surplus one assumes --.
(a) Imperfect competition (b) Perfect competition
(c) Monopoly (d) Monopsony
33. The law of consumer surplus is based on
(a) Indifference curve analysis
(b) Revealed preference theory.
(c) Law of substitution
(d) The law of diminishing marginal utility.
34. Consumer surplus is the area ___________________ ..
(a) below the demand curve and above the price
(b) above the supply curve and below the price.
(c) above the demand curve and below the price.
(d) below the supply curve and above the price.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.29

35. Suppose that the price of a new bicycle is Rs.200. Natalie values a new bicycle at
Rs.400. What is the valueof total consumer surplus if Natalie buys a new bike?
(a) Rs 500 (b) Rs.300
(c) Rs.200 (d) Rs.400
36. If a buyer's willingness to pay for a new car is Rs. 200,000 and she is able to actually buy
it for Rs.180000 herconsumer surplus is
(a) Rs. 18,000. (b) Rs. 20,000.
(c) Rs. 2,000. (d) Rs. 0.
37. Suppose there are three identical vases available to be purchased. Buyer 1 is willing to
pay Rs 30 for one, buyer 2 is willing to pay Rs 25 for one, and buyer 3 is willing to pay Rs
20 for one. If the price is Rs 25, how many vases will be sold and what is the value of
consumer surplus in this market?
(a) Three vases will be sold and consumer surplus is Rs 80.
(b) One vase will be sold and consumer surplus is Rs 5.
(c) One vase will be sold and consumer surplus is Rs30.
(d) Two vases will be sold and consumer surplus is Rs 5.
38. Which among the following is the drawback of consumer surplus (as explained in
marginal utility analysis)?
(a) it is highly hypothetical and imaginary
(b) it ignores the interdependence between the goods
(c) it cannot be measured in terms of money because marginal utility of money changes
(d) all of the above
39. The difference between the price a consumer is willing to pay and the price he
actually pays is called -
(a) Excess price (b) Excess demand
(c) Consumer surplus (d) Exploitation
40. The consumer surplus concept is derived from:
(a) Law of demand (b) Indifference curve analysis
(c) Law of diminishing marginal utility (d) All of above
41. Concept of consumer surplus was evolved by:
(a) Allen and Hicks (b) Adam Smith
(c) Alfred Marshall (d) Robbins

42. The satisfaction which a consumer derives in the consumption of a commodity is

equal to Rs. 320. The price of that commodity is Rs. 180. What will be his consumer
surplus?
(a) 180 (b) 200
(c) 140 (d) 500
43. The way in which rational consumers allocate their expenditure on goods and
services is best described by..................
(a) the law of diminishing marginal utility (b) the law of demand
(c) the theory of value (d) the marginal rate of substitution
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.30

44. The aim of the consumer in allocating his income is to..............

(a) maximize his total utility
(b) maximize his marginal utility
(c) to buy the goods he wants most whatever the price
(d) to buy the goods which he expects to be short in supply
45. An example of a commodity having consumer surplus is:
(a) Salt (b) Machinery
(c) Car (d) Costly Textile
46. The economic analysis expects the consumer to behave in a manner which is:
(a) Rational (b) Irrational
(c) Emotional (d) Indifferent.
47. Which one is not an assumption of the theory of demand based on analysis of
indifference curves?
(a) Given scale of preferences as between different combinations of two goods.
(b) Diminishing marginal rate of substitution.
(c) Constant marginal utility of money.
(d) Consumers would always prefer more of a particular good to less of it, other things
remaining the same.
48. If two goods were perfect substitutes of each other, it necessarily follows that
(a) An indifference curve relating the two goods will be curvilinear.
(b) An indifference curve relating the two goods will be linear.
(c) An indifference curve relating the two goods will be divided into two segments
which meet at a right angle.
(d) An indifference curve relating the two goods will be convex to the origin.
49. The consumer is in equilibrium at a point where the budget line :
(a) is above an indifference curve (b) is below an indifference curve
(c) is tangent to an indifference curve (d) cuts an indifference curve
50. Which of the following is not a property of the indifference curve ?
(a) Indifference curves are convex to the origin
(b) Indifference curves slope downwards from left to right
(c) No two indifference curve can cut each other
(d) None of the above
51. Which of the following statement is incorrect?
(a) An indifference curve slopes downward to the right
(b) Convexity of a curve implies that the slope of the curve diminishes as one moves
from left to right
(c) The elasticity of substitution between two goods to a consumer is zero
(d) The total effect of a change in the price of a good on its quantity demanded is called
the price effect
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.31

52. When indifference curve is L shaped then two goods will be:
(a) Perfect substitute Goods (b) Substitute Goods
(c) Perfect complementary goods (d) Complementary goods
53. Indifference curve is downward slopping
(a) always (b) sometimes
(c) never (d) none of these
54. The IC curve approach assumes :
(a) rationality (b) consistency
(c) transitivity (d) all of the above
55. A higher indifference curve shows :
(a) a higher level of satisfaction (b) a higher level of production
(c) a higher level of income (d) none of the above
56. In the case of two perfect substitutes, the indifference curve will be :
(a) straight line (b) L-shaped
(c) U-shaped (d) C-shaped
57. A consumer is at equilibrium when :
(a) slope of the price line is equal to indifference curve
(b) he saves 10% of his income
(c) borrows an amount equal to his income from the bank
(d) none of the above
58. Indifference curve approach assumes
(a) consumer has full knowledge of all relevant information
(b) all commodities are homogenous and divisible
(c) prices of commodities remain the same throughout the analysis
(d) All of the above
59. ______________________________________ depicts complete picture of consumer's tastes and
preferences
(a) Budget line (b) Average cost curve
(c) Indifference map (d) Marginal revenue curve

60. Indifference Curve analysis is based on

(a) Ordinal utility (b) Cardinal utility
(c) Marginal utility (d) None of the above
61. When two goods are perfect substitutes of each other then
(a) MRS is falling (b) MRS is rising
(c) MRS is constant (d) None of the above
62. Which is not the assumption of Indifference curve Analysis?
(a) The consumer is rational and possesses full information about all the aspects of
economic environment
(b) The consumer is not capable of ranking all combinations
(c) If consumer prefers combination A to B, and B to C, then he must prefer
combination A to C
(d) If combination A has more commodities than combination B, then A must be
preferred to B.
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.32

63. Indifference curve is convex to the origin due to:

(a) Falling MRS (b) Rising MRS
(c) Constant MRS (d) None of the above
64. The indifference curve approach assumes:
(a) Rationality (b) Consistency
(c) Transitivity (d) All of the above
65. The indifference curve approach does not assume:
(a) Rationality on the parts of consumers
(b) Ordinal measurement of satisfaction
(c) Cardinal measurement of satisfaction
(d) Consistent consumption pattern behavior of consumer
66. The other name of Budget line is:
(a) Demand line (b) Price line
(c) Supply line (d) None of the above
67. Indifference curve analysis is propounded by:
(a) Alfred Marshall (b) Adam Smith
(c) Hicks and Allen (d) None of the above
68. Which of the following statements is false?
(a) An indifference curve is concave to the origin
(b) An indifference curve is convex to the origin
(c) A higher indifference curve is better than a lower indifferent curve
(d) An indifference curve is a curve which represents all those combinations of two
goods which give same satisfaction to the consumer.
69. The slope of indifference curve indicates:
(a) Price ratio between two commodities (b) Marginal rate of substitution
(c) Factor substitution (d) Level of indifference
70. At equilibrium the slop of the indifference curve is :
(a) Equal to the slope of budget line
(b) Greater than the slope of budget line
(c) Smaller than the slope off budget line
(d) None
71. Indifference curves between income and pleisure for an individual are generally
(a) Concave to the origin (b) Convex to the origin
(c) Negatively sloped straight lines (d) Positively sloped straight lines
72. Indifference curves never intersect each other due to...........
(a) Different levels of satisfaction (b) Same levels of satisfaction
(c) Convex to origin (d) Concave to origin
73. The case of a right angled indifference curve occurs when
(a) The two goods are perfect complements
(b) The two goods are perfect substitutes
(c) The two goods are inferior
(d) The two goods are normal
 THEORY OF CONSUMER BEHAVIOUR (Unit - 2) | 2.33

74. An indifference curve is always:

(a) Concave to the origin (b) Convex to the origin
(c) L- shaped (d) A vertical straight line
75. A buyer's willingness to pay is that buyer's:
(a) minimum amount they are willing to pay for a good.
(b) producer surplus.
(c) consumer surplus.
(d) maximum amount they are willing to pay for a good.
76. The consumer is in equilibrium when:
(a) When marginal utility is constant
(b) When marginal utility is greater than price of the good
(c) When marginal utility is less than price of the good
(d) When marginal utility is equal to price of the good
77. In economics, what a consumer is ready to pay minus what be actually pays, is
termed as :
(a) Consumer's equilibrium (b) Consumer's surplus
(c) Consumer's expenditure (d) None of the above

Answer Key
1 c 2 b 3 c 4 b 5 c 6 b 7 a 8 c 9 c 10 d 11 a 12 c 13 b
14 a 15 a 16 a 17 c 18 a 19 a 20 d 21 a 22 c 23 d 24 d 25 a 26 b
27 a 28 c 29 d 30 c 31 a 32 b 33 d 34 a 35 c 36 b 37 D 38 d 39 c

40 c 41 c 42 c 43 a 44 a 45 a 46 a 47 c 48 B 49 c 50 d 51 c 52 C
53 a 54 d 55 a 56 a 57 a 58 d 59 c 60 a 61 c 62 b 63 a 64 d 65 c
66 b 67 c 68 a 69 b 70 a 71 b 72 a 73 a 74 b 75 d 76 d 77 b
 SUPPLY(UNIT - 3) | 2.1

CHAPTER – 2 SUPPLY
INTRODUCTION
The term ‘supply’ refers to the amount of a good or service that the producers are
willing and able to offer to the market at various prices during a given period of time.
Three important points apply to supply:
(i) Supply refers to what a firm offer for sale in the market, not necessarily to what they
succeed in selling. What is offered may not get sold.
(ii) Supply requires both willingness and ability to supply. Production cost is often the
primary influence on ability.
(iii) Supply is a flow. Supply is identified for a specified time period. The quantity supplied
is ‘so much’ per unit of time, per day, per week, or per year.

DETERMINANTS OF SUPPLY
(i) Price of the good:
 Other things being equal, the higher the relative price of a good the greater
the quantity of it that will be supplied.
 This is because goods and services are produced by the firm in order to earn
profits and, ceteris paribus, profits rise if the price of its product rises.
(ii) Prices of related goods:
 If the prices of other goods rise, they become relatively more profitable to
the firm to produce and sell than the good in question.
 When a seller can get a higher price for a good, producing and selling it
becomes more profitable. Producers will allocate more resources towards its
production even by drawing resources from other goods they produce.
 For example,
o a rise in the price of comic books will encourage publishers to shift
resources out of the production of other books (such as novels) and use
them in the production of comic books.
o As another example, if price of wheat rises, the farmers may shift their
land to wheat production away from corn and soya beans. It implies
that, if the price of Y rises, the quantity supplied of X will fall.
(iii) Prices of factors of production:
 Cost of production is a significant factor that affects supply.
 A rise in the price of an input causes a decrease in supply.
 When the cost of resources such as wages, raw material prices and interest rates
increase, producers decrease the amount they are willing to supply.
 Lower input costs indeed, make production more profitable, encourage
existing firms to expand production and new firms to enter the market..
 For example,
o a rise in the cost of land will have a large effect on the cost of producing
wheat and a very small effect on the cost of producing automobiles.
 SUPPLY(UNIT - 3) | 2.2

 Thus, a change in the price of one factor of production will cause changes in
the relative profitability of different lines of production and will cause
producers to shift from one line to another and thus supplies of different
commodities will change.
(iv) State of technology:
 The supply of a particular product depends upon the state of technology also.
The use of new technology in an industry (such as automation) increases
production efficiency and reduces production costs.
 Inventions and innovations tend to make it possible to produce more or
better goods with the same resources, and thus they tend to increase the
quantity supplied of some products and to reduce the quantity supplied of
products that are displaced.
 Availability of spare production capacity and the ease with which factor
substitution can be made and the cost of such substitution also determine
supply.
(v) Government Policy:
 Government rules and regulations affect how much firms want to sell or
are allowed to sell.
 The production of a good may be subject to the imposition of commodity taxes
such as excise duty, sales tax and import duties.
Taxes

 These taxes raise

o the cost of production and so the quantity supplied of a good would
increase only when its price in the market rises.
 When government imposes restrictions
o such as import quota on consumer products and inputs, rationing of
input supply etc, production tends to fall.
Subsidies

 Subsidies and other funding programmes to producers, on the other hand,

reduce the cost of production and thus provide an incentive to the firm to
increase supply.
(vi) Nature of competition and size of industry:
 Under competitive conditions, supply will be more than that under monopolized
conditions.
(vii) Expectations:
 Choices of firms in respect of selling the product now or later depends on
expectations of future prices.
 Sellers compare current prices with future prices.
 SUPPLY(UNIT - 3) | 2.3

 An increase in the anticipated future price of a good or service reduces its

supply today; and if sellers expect a fall in prices in future, more will be
supplied now.
(viii) Number of sellers:
 If there are large number of firms in the market, supply will be more. Besides,
entry of new firms, either domestic or foreign, causes the industry supply curve to
shift rightwards.
Other Factors:
 The quantity supplied of a good also depends upon
o government’s industrial and foreign policies,
o goals of the firm, infrastructural facilities,
o natural factors such as weather,
o floods, earthquake and
o man- made factors such as war, labour strikes, communal riots etc.

THE LAW OF SUPPLY

 Supply refers to the relationship of quantity supplied of a good with one or more
related variables which have an influence on the supply of the good.
 Normally, supply is related with price, but it can also be related with other factors such
as the type of technology used, scale of operations etc.
The law of supply can be stated as:
Other things remaining constant, the quantity of a good produced and offered for sale will
increase as the price of the good rises and decrease as the price falls.
 This law is based upon common sense, because the higher the price of the good, the
greater the profits that can be earned and thus greater the incentive to produce the
good and offer it for sale.
 The law is known to be correct in a large number of cases.
 Exception
o If we take the supply of labour at very high wages, we may find that the
supply of labour has decreased instead of increasing.
o Thus, the behaviour of supply depends upon the phenomenon considered and
the degree of possible adjustment in supply.
o The behaviour of supply is also affected by the time period under
consideration.
 In the short run, it may not be easy to increase supply,
 but in the long run supply can be easily adjusted in response to changes
in price.
 The law of supply can be explained through a supply schedule and a supply
curve.
 SUPPLY(UNIT - 3) | 2.4

 A supply schedule is the tabular presentation of the law of supply.

 It shows the different prices of a commodity and the corresponding
quantities that suppliers are willing to offer for sale, with all other
variables held constant.
 Consider the following hypothetical supply schedule of good X.
Table 10: Supply Scheudle of Good ‘X’
Quantity supplied
Price (Rs) (per kg)
(kg)

1 5
2 35
3 45
4 55
5 65
 The table shows the quantities of good X that would be produced and offered for sale at a
number of alternative prices. At Re 1, for example, 5 kilograms of good X are offered for
sale and at Rs. 3 per kg. 45 kg. would be forthcoming for sale.

Fig. 25 : Supply Curve

 The supply curve is a graphical presentation of the supply schedule.

 The supply curve shows the quantity of a good that producers are willing to sell at
a given price, holding constant any other factor that might affect the quantity
supplied.

 The supply curve is thus a relationship between the quantity supplied and
the price. To be more precise, the supply curve shows simultaneously:
(a) the highest quantity willingly supplied by the suppliers at each price and
(b) the minimum price which will induce suppliers to offer the various quantities
for sale
 The supply curve slopes upwards towards right (positive slope) showing that as
price increases, the quantity supplied of X increases and vice-versa.
 SUPPLY(UNIT - 3) | 2.5

 This direct relationship between price and quantity is reflected in the

positive slope of the supply curve.
Market supply
The market supply, like market demand, is the sum of supplies of a commodity made by all
individual firms or their supply agencies.
 The market supply of a commodity gives the amounts of the commodity supplied per time
period at various alternative prices by all the producers of this commodity in the market.
 It is derived by adding the quantity supplied by each seller at different prices.
 The market supply is governed by the law of supply and depends on all the factors that
determine the individual producer’s supply and, in addition, on the number of
producers of the commodity in the market.
MOVEMENTS ON THE SUPPLY CURVE– INCREASE OR DECREASE IN THE QUANTITY
SUPPLIED
 When the supply of a good increase as a result of an increase in its price, we say that
there is an increase in the quantity supplied and there is an upward movement on
the supply curve.
o A rise in market price causes an expansion of supply;
o there is a upward movement on the supply curve and producers offer more for
sale.
o When market price falls, there is contraction of supply as producers have less
incentive to offer products for sale in the market

Change in Quantity Supplied as a Result Price Change

SHIFTS IN SUPPLY CURVE– INCREASE OR DECREASE IN SUPPLY
 While a change in quantity supplied is a movement along a given supply curve, a
change in supply is a shift of the supply curve.
 When the supply curve bodily shifts towards the right as a result of a change in one
of the factors that influence the quantity supplied other than the commodity’s own
price, we say there is an increase in supply.
 When the supply curve shifts to the right, we call it increase in supply. more is offered
for sale at each price.
 In figure we find that at price P, the quantity supplied rises from Q to Q1.
 When the factors other than price change and cause the supply curve to shift to the left,
we call it decrease in supply.
 When the supply curve shifts to the left, less quantity is offered for sale at each price. In
 SUPPLY(UNIT - 3) | 2.6

figure we find that at price P the quantity supplied falls from Q to Q1.

Shifts in Supply Curves

ELASTICITY OF SUPPLY

 The elasticity of supply is defined as the responsiveness of the quantity supplied of a

good to a change in its price.
 Elasticity of supply is measured by dividing the percentage change in quantity
supplied of a good by the percentage change in its price i.e.,

Percentage change in quantity supplied

Es 
Percentage change in Price
Change in quantity supplied
quantity supplied
Or
Change in price
Price
q

q q p
Or  
p p q

p
Where q denotes original quantity supplied
q denotes change in quantity supplied
P denotes original price
p denotes changes in price
Example
Suppose the price of commodity X increases from Rs 2,000 per unit to Rs 2,100 per unit and
consequently the quantity supplied rises from 2,500 units to 3,000 units. Calculate the elasticity
of supply.
q = 500 units p = Rs. 100
P = Rs. 2000 q = 2500 units

500 2000
 Es   4
100 2500
Elasticity of Supply = 4.
 SUPPLY(UNIT - 3) | 2.7

Types of Supply Elasticity

The elasticity of supply can be classified as under:
(i) Perfectly inelastic supply :
 If as a result of a change in price, the quantity supplied of a good remains
unchanged, we say that the elasticity of supply is zero or the good has perfectly
inelastic supply (Es = 0.).
 The vertical supply curve shows that irrespective of price change, the quantity
supplied remains unchanged.
 In other words, the quantity supplied is unaffected by any change in price.
 As the elasticity rises, the supply curve gets flatter, which shows that the
quantity supplied responds more to changes in price.

Supply Curve of Zero Elasticity

(ii) Relatively less-elastic supply:
 If as a result of a change in the price of a good its supply changes less than
proportionately, we say that the supply of the good is relatively less elastic or
elasticity of supply is less than one.
 In this case, the coefficient of elasticity falls in the range 0 < Es < 1.
 The percentage change in quantity is less than the percentage change in price.
 In other words, the quantity is not very responsive to price.
 Figure shows that the relative change in the quantity supplied (∆Q) is less than the
relative change in the price (∆P).

Supply Curve of Zero Elasticity

 SUPPLY(UNIT - 3) | 2.8

(iii) Relatively greate-relastic supply :

 If elasticity of supply is greater than one i.e.,

o when the quantity supplied of a good changes substantially in response to a small
change in the price of the good we say that supply is relatively elastic.
 The percentage change in quantity is greater than the percentage change in price.
 The coefficient of elasticity falls in the range 1 < E < ∞.
 Figure shows that the relative change in the quantity supplied (∆Q) is greater than the
relative change in the price.

Relatively Greater Elastic Supply

(iv) Unit-elastic: In this case, the coefficient of elasticity is one.(Es = 1).

 If the relative change in the quantity supplied is exactly equal to the relative change
in the price, the supply is said to be unitary elastic.
 The percentage change in quantity is equal to the percentage change in price.
 Unit elasticity is essentially a dividing line or boundary between the elastic and
inelastic ranges.
 In the relative change in the quantity supplied (∆Q) is equal to the relative
change in the price (∆P).

Showing Unitary Elasticity

 SUPPLY(UNIT - 3) | 2.9

(v) Perfectly elastic supply:

 it the opposite extreme of zero elasticity supply is perfectly elastic.

 This occurs as the price elasticity of supply approaches infinity and the supply
curve becomes horizontal.
 Elasticity of supply is said to be infinite (E = ∞)or perfectly elastic.
 when nothing is supplied at a lower price and an infinitesimally small change
in price results in an infinitely large change in quantity supplied indicating
that producers will supply any quantity demanded at that price.

Supply Curve of Infinite Elasticity

Industry with Limited Production Capacity
 In some cases, the elasticity of supply is not constant but varies over the supply
curve.
 Figure shows the case of an industry with limited capacity for production.

 For low levels of quantity supplied, firms respond substantially to changes in price.

 When there is a small rise in price from P1 to P2 ,the quantity supplied increases
more than proportionately (Q1 to Q2).

 In this region, firms have idle capacity and therefore when price rises, they respond by
increase in quantity supplied using the idle capacity available.
 SUPPLY(UNIT - 3) | 2.10

 Once firms reach their full capacity, further increase in production is possible only
by building new plants and incurring expenses towards this.

 To induce firms to increase output, price must rise substantially (P3 to P4) and supply
becomes less elastic.
Measurement of supply - elasticity

 The elasticity of supply can be considered with reference to a given point on the
supply curve or between two points on the supply curve.
 When elasticity is measured at a given point on the supply curve, it is called point
elasticity.
 Just as in demand, point-elasticity of supply can be measured with the help of the
following formula:
Determinants of Elasticity of Supply
Following are the general determinants of elasticity of supply:
1. Cost of production
 If increase in production causes substantial increase in costs, producers will
have less incentive to increase quantity supplied in response to increase in
price and therefore, price elasticity of supply would be less.
 If there are constant costs or negligible rise in costs as output increases, supply
will be elastic.
2. Production processes
 Products that involve more complex production processes or require relatively
longer time to produce exhibit lower elasticity of supply.
 For example the supply of aircrafts and cruise ships is less elastic compared to
supply of motor bikes.
3. Time period
 The longer the period of time, the more responsive the quantity supplied to
changes in price and the greater the supply elasticity.
 A shorter time period does not allow sellers sufficient time to find resources
and alternatives and to adjust their production decisions to changes in price.
 In the long run, firms can build new plants or new firms may be able to enter the
market and increase the supply.
4. Number of producers
 Supply is more elastic when there is large number of producers and there is
high degree of competition among them.
 Supply elasticity is also higher when there are fewer barriers of entry into the
market.
 SUPPLY(UNIT - 3) | 2.11

5. Working capacity
 Supply will be elastic if firms are not working to full capacity.
 If spare production capacity is available with the firms, they can increase output
without a rise in costs.
 The greater the spare capacity available, the greater will be the elasticity of
supply.
6. Raw materials and inputs
 If key raw materials and inputs are easily and cheaply available, then supply
will be elastic.
 If drawing productive resources into the industry is easier, the supply curve is
more elastic.
 In case it is difficult to procure resources economically, the cost of
production increases and supply will become less elastic.
7. Adequate stocks of raw materials
 If firms have adequate stocks of raw materials, components and finished products,
they will be able to respond with higher supply as price rises.
 Generally, those commodities which can be easily and inexpensively stored
without losing value may have elastic supply.
8. factor substitution
 The ease with which factor substitution can be made and the costs of such factor
substitution also determine price elasticity of supply.
 If the factors of production used in the production of the commodity are commonly
available and can be easily substituted or increased, then the firms will be able to
produce quickly and respond to an increase in price.
 If a production process involves use of materials which are in short supply,
or those that take longer delivery period or which are highly specialized,
then supply elasticity will be low.
 If the labour employed is scarce or are required to be highly skilled and
specific and if they require longer training period, then elasticity of supply
will be low.
For example, physicians in healthcare industry and chartered accountants in accounting
service.
9. Mobility
 If both capital and labour are occupationally mobile, then the elasticity of supply
for a product is higher than if capital and labour cannot be easily switched.
 For example, a printing press can easily switch between printing magazines and
greeting cards. Similarly falling prices of a particular vegetable encourage farmers to
switch to the production of another.
 Products which are more continuously produced have greater supply elasticity than
those which are produced infrequently.
 SUPPLY(UNIT - 3) | 2.12

10. Expectations about future prices also affect elasticity of supply. Expectation
of substantial rise in prices in future will make the sellers respond less to a
current rise in price.
EQUILIBRIUM PRICE
 The equilibrium price in a market is determined by the intersection between
demand and supply. It is also called the market equilibrium.
 At this price, the amount that the buyers want to buy is equal to the amount
that sellers want to sell.
 The competitive market equilibrium represents the ‘unique’ point at which both
consumers and suppliers are satisfied with price and quantity.
 Equilibrium price is also called market clearing price.
The determination of market price is the central theme of micro economic analysis. Hence,
micro-economic theory is also called price theory.
The following table presents the concept of the equilibrium price
Supply and Demand Schedule
Price Quantity Quantity Impact on
(Rs) Demanded Supplied price

5 6 31 Downward
4 12 25 Downward
3 19 19 Equilibrium
2 25 12 Upward
1 31 6 Upward

 The equilibrium between demand and supply is depicted in the diagram below.
 Demand and supply are in equilibrium at point E where the two curves intersect each
other.
 It means that only at price Rs. 3 the quantity demanded is equal to the quantity supplied.
The equilibrium quantity is 19 units and these are exchanged at price Rs 3.
 If the price is more than the equilibrium level, excess supply will push the price
downwards as there are few takers in the market at this price.
 For example, in Table 11, if price is say Rs5, quantity demanded is 6 units which is
quite less than the quantity supplied (31 units).
 There will be excess supply in the market which will force the sellers to reduce price if
they want to sell off their product.
 Hence the price will fall and continue falling till it reaches the level where the
quantity demanded becomes equal to the quantity supplied.
 Opposite will happen when quantity demanded is more than the quantity supplied at a
particular price.
 SUPPLY(UNIT - 3) | 2.13

Fig.: Equilibrium Price

Market Equilibrium and Social Efficiency

Social efficiency represents the net gains to society from all exchanges that are made in a
particular market.
 It consists of two components: consumer surplus and producer surplus.
 We have already learned that consumer surplus is a measure of consumer
welfare.
 There is welfare gain to producers as well when they participate in the market,
namely producer surplus.
 Producer surplus is the benefit derived by producers from the sale of a unit
above and beyond their cost of producing that unit.
 This occurs when the price they receive in the market is more than the minimum
price at which they would be prepared to supply.
 It is represented by the area above the supply curve and below the price line

Equilibrium Price and Social Efficiency

 For all quantities below OQ, we find that there is a difference between the price that
producers are willing to accept for supplying the good and the price that prevails in
the market (P).

 Producer surplus disappears when market price is at equilibrium i.e the price at
which sellers are willing to offer for sale is equal to the price that they receive.
From figure we find that at price P, when the market is in equilibrium, social efficiency is
achieved with both producers and consumers enjoying maximum possible surplus.
**************
 SUPPLY(UNIT - 3) | 2.14

Questions & Answers

1. Supply of a commodity is a
(a) Stock concept (b) A flow concept
(c) Both stock and flow concept. (d) None of these.
2. The supply of a goods refers to :
(a) Actual production of goods
(b) Total stock of goods
(c) Stock available for sale
(d) Amount of goods offered for sale at a particular price per unit of time
3. Supply refers to quantity supplied at a particular price a particular period of
time :
(a) True (b) False
(c) Suspected (d) None
4. An increase in the supply of a good is caused by:
(a) improvements in its technology
(b) fall in the prices of other goods
(c) fall in the prices of factors of production
(d) all of the above
5. The quantity supplied of a good or service is the amount that:
(a) is actually bought during a given time period at a given price
(b) producers wish they could sell at a higher price
(c) producers plan to sell during a given time period at a given price
(d) people are willing to buy during a given time period at a given price
6. An increase in the number of sellers of bikes will increase the:
(a) the price of a bike (b) demand for bikes
(c) the supply of bikes (d) demand for helmets
7. If the demand is more than supply then the pressure on price will be:
(a) upward (b) downward
(c) constant (d) none of the above
8. Supply is a ……………………. concept
(a) stock (b) flow and stock
(c) flow (d) none of the above
9. Other things remaining constant, the law of supply states:
(a) Supply for commodities is directly related to its price
(b) Price is not related to supply
(c) As supply rises, price also rises
(d) Supply is not related to factors other than price
10. Generally supply curve of industrial products is
(a) Positively sloped (b) Negatively sloped
(c) Both (a) and (b) (d) Parallel to Y axis
11. When supply price increase in the short run, the profit of the producer
(a) Increases (b) Decreases
(c) Remains constant (d) Decreases marginally
12. In a very short period the supply:
(a) can be changed (b) can not be changed
(c) can be increased (d) none of the above
 SUPPLY(UNIT - 3) | 2.15

13. When supply curve moves to the left it means:

(a) smaller supply (b) larger supply
(c) constant supply (d) none of the above
14. When supply curve moves to right it means:
(a) supply increases (b) supply decreases
(c) supply remains constant (d) none of the above
15. Generally supply curve slopes........
(a) Upwards from left to right (b) Downwards from left to right
(c) Parallel to X-axis (d) None of the above
16. A change in quantity of supply of a commodity along with same supply curve
may occur due to :
(a) Change in the price of the commodity
(b) Chang in the prices of related goods
(c) Change in the future, expectation about the price of the good
(d) Change in the cost of inputs
17. Expansion increase in supply refer to a situation when the producers are willing
to supply a :
(a) Larger quantity of the commodity at an increased price
(b) Larger quantity of the commodity due to increased taxation on that commodity
(c) Larger quantity of the commodity at the same price
(d) Larger quantity of the commodity at the decreased price

18. If there is an improvement in the technology, _______________ :

(a) The supply curve to the left
(b) The supply curve shift to the right
(c) Quantity supplied increase
(d) Both (b) and (c)
19. An expansion in the supply of a good is caused by a:
(a) Rise in the price of good
(b) Fall in the prices of other goods.
(c) Fall in the prices of factors of production
(d) All of the above
20. Contraction of supply is the result of:
(a) decrease in the number of producers
(b) decrease in the price of the good concern
(c) increase in the prices of other goods
(d) decrease in the outlay of sellers

21. In the book market, the quantity supply of books will decrease if any of the
following occurs except:
(a) a decrease in the number of book publishers
(b) a decrease in the price of the book
(c) an increase in the future expected price of the book
(d) an increase in the price of paper used
22. If the supply or bottled water decreases, the equilibrium price.............................
and the equilibrium quantity....................
(a) increases; decreases (b) decreases; increases
(c) decreases; decreases (d) increases; increases
 SUPPLY(UNIT - 3) | 2.16

23. A horizontal supply curve parallel to the quantity axis implies that the elasticity
of supply is --------
(a) zero.
(b) infinite.
(c) equal to one.
(d) greater than zero but less than one.
Read table 2 and answer Questions number 24 – 25
% change in price % change in quantity Elasticity
demanded(quantity supplied)
Demand for salt 20 -1 x
Demand for bananas 15 Y 3
Supply of chicken z 1 1
4
24. Refer Table 2 and find the value of x.
(a -20. (b) -0.05.
(c) -1. (d) Can not be determine(d)
25. Refer Table 2 and find the value of y.
(a) -5 (b) 15.
(c) 45 (d) -3.

26. Refer table 2 and find the value of z.

(a) 14 (b) 1
(c) 0.07. (d) 5.

27. If a fisherman must sell all of his daily catch before it spoils for whatever price
he is offered, once the fish are caught the fisherman's price elasticity of supply
for fresh fish is _______________________________.
(a) zero.
(b) infinite.
(c) one.
(d) unable to be determined from this information.
28. If the elasticity of supply is zero then supply curve will be.
(a) Horizontal (b) Downward Sloping
(c) Upward sloping to the right (d) Vertical

29. If as a result of a change in price, the quantity supplied of a good remains

unchanged, we conclude that:
(a) Elasticity of supply is perfectly inelastic
(b) Elasticity of supply is relatively greater-elastic
(c) Elasticity of supply is inelastic
(d) Elasticity of supply is relatively less-elastic
30. A horizontal supply curve parallel to the quantity axis implies that the elasticity
of the supply is:
(a) zero
(b) infinite
(c) equal to one
(d) greater than zero but less than one
31. If as a result of change in price, the quantity supplied of the good remains
unchanged, we say elasticity of supply is:
(A) Zero (b) Between zero and one
(c) Infinite (d) Between one and infinity
 SUPPLY(UNIT - 3) | 2.17

32. Which of the following has the lowest price elasticity of supply?
(a) Luxury (b) Necessities
(c) Salt (d) Perishable goods

33. If the price of Banana rises from Rs 30 per dozen to Rs. 40 per dozen and the
supply increases from 240 dozen to 300 dozens elasticity of supply is:
(a) .7 (b) -.67
(c) .65 (d) .77
34. Which of the following method is not used for measuring elasticity of supply ?
(a) Arc Method (b) Percentage Method
(c) Total outlay Method (d) Point Method
35. If the supply of a commodity is perfectly elastic, an increase in demand will
result in :
(a) Decrease in both price and quantity equilibrium
(b) Increase in both price and quantity at equilibrium
(c) Increase in equilibrium quantity, equilibrium price remaining constant
(d) Increase in equilibrium price, equilibrium quantity remaining constant
36. When change in the quantity supplied is proportionate to the change in the
price, the product is said to have ________________ :
(a) Perfectly elastic supply (b) Relatively elastic supply
(c) Unitary elastic supply (d) Perfectly inelastic supply
37. Elasticity of supply is defined as responsiveness of quantity supplied of a good
to change in _____________________ .
(a) Price of concerned good (b) Price of substitute good
(c) Demand (d) None
38. A vertical supply curve parallel to Y axis implies that the elasticity of supply is:
(a) Zero
(b) Infinity
(c) Equal to one
(d) Greater than zero but less than infinity
39. Elasticity of supply refers to the degree of responsiveness of supply of a good to
changes in its:
(a) demand (b) price
(c) cost of production (d) state of technology
40. If price of computers increases by 10% and supply increases by 25%. The
elasticity of supply is:
(a) 2.5 (b) 0.4
(c) (-) 2.5 (d) (-) 0.4
41. Elasticity of supply is measured by dividing the percentage change in quantity
supplies of a good by........
(a) Percentage change in income
(b) Percentage change in quantity demanded of goods
(c) Percentage change in price
(d) Percentage change in taste and preference
42. Elasticity of supply is zero means:
(a) Perfectly inelastic supply (b) Perfectly elastic supply
(c) Imperfectly elastic supply (d) None of the above
 SUPPLY(UNIT - 3) | 2.18

43. Elasticity of supply is greater than one when:

(a) Proportionate change in quantity supplied is more than the proportionate
change in price.
(b) Proportionate change in price is greater than the proportionate change in
quantity supplied.
(c) Change in price and quantity supplied are equal.
(d) None of the above
44. If the quantity supplied is exactly equal to the relative change in price then the
elasticity of supply is :
(a) Less than one (b) Greater than one
(c) One (d) None of the above
45. If the percentage change in supply is less than the percentage change in price it
is called:
(a) unit elasticity supply (b) perfectly elastic supply
(c) more elastic supply (d) inelastic supply
46. The supply curve for perishable commodities is.................
(a) elastic (b) inelastic
(c) perfectly elastic (d) perfectly inelastic
47. If as a result of 10% increase in price, the quantity supplied does not change at
all, it implies that the elasticity of Supply is:
(a) Zero
(b) Infinite
(c) Equal to one
(d) Greater than Zero but less than one
ANSWER KEY
1 b 2 d 3 a 4 d 5 c 6 c 7 a 8 c 9 a 10 a 11 a 12 b 13 a
14 a 15 a 16 a 17 a 18 b 19 a 20 b 21 b 22 a 23 b 24 b 25 c 26 a
27 a 28 d 29 a 30 b 31 a 32 d 33 d 34 c 35 c 36 c 37 a 38 a 39 b

40 a 41 c 42 a 43 a 44 c 45 d 46 d 47 a
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.1

CHAPTER – 3 (UNIT-I) THEORY OF PRODUCTION AND COST

THEORY OF PRODUCTION AND COST
UNIT -1: THEORY OF PRODUCTION
MEANING OF PRODUCTION
 In common parlance, the term ‘production’ is used to indicate an activity of making
something material.
 The growing of wheat, rice or any other agricultural crop by farmers and manufacturing of
cement, radio-sets, wool, machinery or any other industrial product is often referred to as
production.
 In Economics the word ‘production’ is used in a wider sense to denote the process
by which man utilises resources such as men, material, capital, time etc, working
upon them to transform them into commodities and services so as to make them satisfy
human wants.
 In other words, production is any economic activity which converts inputs into
outputs which are capable of satisfying human wants.
 Whether it is making of material goods or providing a service, it is included in production
provided it satisfies the wants of some people.
 Therefore, in Economics, activities such as making of cloth by an industrial worker,
the services of the retailer who delivers it to consumers, the work of doctors,
lawyers, teachers, actors, dancers, etc. are production.
According to James Bates and J.R. Parkinson “Production is the organized activity of
transforming resources into finished products in the form of goods and services; and the
objective of production isto satisfy the demand of such transformed resources”.
 It should be noted that production should not be taken to mean as creation of matter
because, according to the fundamental law of science, man cannot create matter.
 What a man can do is only to create or add utility to things that already exist in
nature.
 Production can also be defined as creation or addition of utility.
o For example,
 when a carpenter produces a table, he does not create the matter of which
the wood is composed of;
 he only transforms wood into a table. By doing so, he adds utility to wood
which did not have utility before.
Production consists of various processes to add utility to natural resources for gaining
greater satisfaction from them by:
(i) Changing the form of natural resources.
 Most manufacturing processes consist of use of physical inputs such as raw
materials and transforming them into physical products possessing utility,
 e.g., changing the form of a log of wood into a table or changing the form of iron
into a machine. This maybe called conferring utility of form.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.2

(ii) Changing the place

 Changing the place of the resources from a place where they are of little or no use to
another place where they are of greater use. This utility of place can be obtained
by:
• Extraction from earth e.g., removal of coal, minerals, gold and other metal
ores from minesand supplying them to markets.
• Transferring goods from where they give little or no satisfaction, to
places where their utility is more,
• e.g., tin in Malaya is of little use until it is brought to the industrialised
centres where necessary machinery and technology are available to
produce metal boxes for packing.
• Another example is: apples in Kashmir orchards have a little utility to
farmers. But when the apples are transported to markets where human
settlements are thick and crowded like the city centres, they afford more
satisfaction to greater number of people.
(iii) Time utility
 Making available materials at times when they are not normally available e.g.,
harvested food grainsare stored for use till next harvest.
 Canning of seasonal fruits is undertaken to make them available during off-season.
 This may be called conferring of utility of time.
(iv) Making use of personal skills in the form of services, e.g., those of organisers,
merchants, transport workers etc.
Thus, production is nothing but creation of utilities in the form of goods and services.
For example,
 In the productionof a woollen suit, utility is created in some form or the other.
 Firstly wool is changed into woollen cloth at the spinning and weaving mill (utility
created by changing the form).
 Then, it is taken to a place where it is to besold (utility added by transporting it).
 Since woollen clothes are used only in winter, they will be retained until such time when
they are required by purchasers (time utility).
 In the whole process, the services of various groups of people are utilised (as that of mill
workers, shopkeepers, agents etc.) to contribute to the enhancement of utility.
 It should be noted that the production process need not necessarily involve
conversion of physical inputs into physical output.
 For example,
o Production of services such as those of lawyers, doctors, musicians, consultants etc.
involves intangible inputs to produce intangible output.
o But, production does not include work done within a household by anyone out
of love and affection, voluntary services and goods produced for self-
consumption.
Intention to exchange in the market is an essential component of production.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.3

 The money expenses incurred in the process of production, i.e., for transforming
resources into finished products constitute the cost of production.
 Although cost of production is not taken into account for a pure production analysis, it is
an extremely vital matter for any business decision-making.
 Nevertheless, in the theory of production, we would confine ourselves to
o laws of production,
o production function and
o methods of production optimization.
FACTORS OF PRODUCTION
 Factors of production refer to inputs.
 An input is a good or service which a firm buys for use in its production process.
 Production process requires a wide variety of inputs, depending on the nature of
output.
 We may discuss these factors of production briefly in the following.

Land

 The term ‘land’ is used in a special sense in Economics.

 It does not mean soil or earth’s surface alone, but refers to all free gifts of nature
which would include besides land in common parlance, natural resources, fertility
of soil, water, air, light, heat natural vegetation etc.
 Land is a free gift of nature:
o No human effort is required for making land available for production.
o It has no supply price in the sense that no payment has been made to
mother nature for obtaining land.
 Supply of land is fixed:
o Land is strictly limited in quantity.
o It is different from other factors of production in that, no change in
demand can affect the amount of land in existence.
o In other words, the total supply of land is perfectly inelastic from the point of
view of the economy.
o However, it is relatively elastic from the point of view of a firm.
 Land is permanent and has indestructible powers:
o Land is permanent in nature and cannot be destroyed.
FACTORS OF PRODUCTION

o Factors of production refer to inputs.

o An input is a good or service which a firm buys for use in its production process.
o Production process requires a wide variety of inputs, depending on the nature of
output.
We may discuss these factors of production briefly in the following .
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.4

Land
 The term ‘land’ is used in a special sense in Economics.
 It does not mean soil or earth’s surface alone, but refers to all free gifts of nature
which would include besides land in common parlance, natural resources, fertility
of soil, water, air, light, heat natural vegetation etc.
 Land is a free gift of nature:
o No human effort is required for making land available for production.
o It has no supply price in the sense that no payment has been made to mother nature
for obtaining land.
 Supply of land is fixed:
o Land is strictly limited in quantity.
o It is different from other factors of production in that, no change in demand can
affect the amount of land in existence.
o In other words, the total supply of land is perfectly inelastic from the point of
view of the economy.
o However, it is relatively elastic from the point of view of a firm.
 Land is permanent and has indestructible powers:
o Land is permanent in nature and cannot be destroyed.
o According to Ricardo, land has certain original and indestructible powers and
these properties of land cannot be destroyed.
 Land is a passive factor:
o Land is not an active factor.
o Unless human effort is exercised on land, it does not produce anything on its
own.
 Land is immobile:
o in the geographical sense. Land cannot be shifted physically from one place to
another.
o The natural factors typical to a given place cannot be shifted to
other places.
 Land has multiple uses:
o And can be used for varied purposes, though its suitability in all the uses is not the
same.
 Land is heterogeneous:
o No two pieces of land are alike.
o They differ in fertility and situation.
Labour
 The term ‘labour’, means any mental or physical exertion directed to produce goods
or services.
 In other words, it refers to various types of human efforts which require the use of
physical exertion, skill and intellect.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.5

 Anything done out of love and affection, although very useful in increasing human
well-being, is not labour in the economic sense of the term.
 It implies that any work done for the sake of pleasure or love does not represent
labour in Economics.
 It is for this reason that the services of a house-wife are not treated as labour, while
those of a maid servant are treated as labour.
 On the other hand, if a person sings against payment of some fee, then this activity
signifies labour.
Characteristics of labour:
(1) Human Effort:
o It is connected with human efforts whereas others are not directly connected
with human efforts.
o As a result, there are certain human and psychological considerations which may
come up unlike in the case of other factors.
o Therefore, leisure, fair treatment, favourable work environment etc. are
essential for labourers.
(2) Labour is perishable:
o Labour is highly ‘perishable’ in the sense that a day’s labour lost cannot be
completely recovered by extra work on any other day. In other words, a
labourer cannot store hislabour.
(3) Labour is an active factor:
o Without the active participation of labour, land and capital may not produce
anything.
(4) Labour is inseparable from the labourer:
o When a labourer sells his service, he has to be physically present where they
are delivered.
o The labourer sells his labour against wages, but retains the capacity to work.
(5) Labour power differs from labourer to labourer:
o Labour is heterogeneous in the sense that labour power differs from person to
person.
o Labour power or efficiency of labour depends upon the labourers’ inherent and
acquired qualities, characteristics of work environment, and incentive to
work.
(6) All labour may not be productive: (i.e.) all efforts are not sure to produce resources.
(7) Labour has poor bargaining power:
o Labour has a weak bargaining power.
o Labour has no reserve price.
o Since labour cannot be stored, the labourer is compelled to work at
the wages offered by the employers.
o For this reason, when compared to employers, labourers have poor bargaining
power and can be exploited and forced to accept lower wages.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.6

o The labourer is economically weak while the employer is economically powerful

although things have changed a lot in favour of labour during 20th and 21st
centuries.
(8) Labour is mobile:
o Labour is a mobile factor.
o Apparently, workers can move from one job to another or from one place to
another.
o However, in reality there are many obstacles in the way of free movement of labour
from job to job or from place to place.
(9) There is no rapid adjustment of supply of labour to the demand for it:
o The total supply of labour cannot be increased or decreased instantly.
(10) Choice between hours of labour and hours of leisure:
o A labourer can make a choice between the hours of labour and the hours of
leisure.
o This feature gives rise to a peculiar backward bending shape to the supply
curve of labour.
o The supply of labour and wage rate is directly related. It implies that, as the
wage rate increases the labourer tends to increase the supply of labour by reducing
the hours of leisure.
o However, beyond a desired level of income, the labourer reduces the supply of
labour and increases the hours of leisure in response to further rise in the
wage rate.
o That is, he prefers to have more of rest and leisure than earning more money.
Capital
 We may define capital as that part of wealth of an individual or community which is
used for further productionof wealth.
 In fact, capital is a stock concept which yields a periodical income which is a flow
concept.
 It is necessary to understand the difference between capital and wealth.
 Whereas wealth refers to all those goods and human qualities which are useful in
production and which can be passed on for value, only a part of these goods and
services can be characterized as capital because if these resources are lying idle
they will constitute wealth but not capital.
 Capital has been rightly defined as ‘produced means of production’ or ‘man-made
instruments of production’.
 In other words, capital refers to all man made goods that are used for further
production of wealth.
 This definition distinguishes capital from both land and labour because both land and
labour are not produced factors.
 They are primary or original factors of production, but capital is not a primary or
original factor; it is a produced factor of production.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.7

 It has been produced by man by working with nature. Machine tools and instruments,
factories, dams, canals, transport equipment etc., are some of the examples of
capital.
Types of Capital:
 Fixed capital is that which exists in a durable shape and renders a series of services
over a period of time. For example tools, machines, etc.
 Circulating capital is another form of capital which performs its function in
production in a single use and is not available for further use. For example, seeds, fuel,
raw materials, etc.
 Real capital refers to physical goods such as building, plant, machines, etc.
 Human capital refers to human skill and ability. This is called human capital because
a good deal of investment goes into creation of these abilities in humans.
 Tangible capital can be perceived by senses whereas intangible capital is in the form
of certain rights and benefits which cannot be perceived by senses. For example,
copyrights, goodwill, patent rights, etc.
 Individual capital is personal property owned by an individual or a group of individuals.

 Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc.
Capital Formation:

 Capital formation means a sustained increase in the stock of real capital in a country.

 In other words, capital formation involves production of more capital goods like,
machines, tools, factories, transport equipment, electricity etc. which are used for
further production of goods.
 Capital formation is also known as investment.
 The need for capital formation or investment is realized not merely for replacement and
renovation but forcreating additional productive capacity.
 In order to accumulate capital goods, some current consumption has to be sacrificed
and savings of current income are to be made. Savings are also to be channelized into
productive investment.
 The greater the extent that people are willing to abstain from present consumption,
the greater the extent of savings and investment that society will devote to new
capital formation.
 It is prudent to cut down some of the present consumption and direct part of it to the
making of capital goods such as, tools and instruments, machines and transport facilities,
plant and equipment etc.
 Higher rate of capital formation will enhance production and productive capacity,
increase the efficacy of production efforts, accelerate economic growth and add to
opportunities for employment.
Stages of capital formation: There are mainly three stages of capital formation which are as
follows:
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.8

1. Savings:
 The basic factor on which formation of capital depends is the ability to save.
 The ability to save depends upon the income of an individual.
 Higher incomes are generally followed by higher savings.
 This is because, with an increase in income, the propensity to consume comes
down and the propensity to save increases.
 This is true not only for an individual but also for the economy as a whole.
 A rich country has greater ability to save and thereby can get richer quickly
compared to a poor country which has no ability to save and therefore has
limited capacity for growth in national income, given the capital output ratio.
 Moreover, the government can enforce compulsory savings on employed people by
making insurance and provident fund compulsory.
 Government can also encourage saving by allowing tax deductions on income
saved.
 In recent years, business community’s savings and government’s savings are also
becoming important.
2. Mobilization of savings:
 It is not enough that people save money; the saved money should enter into
circulation and facilitate the process of capital formation.
 Availability of appropriate financial products and institutions is a necessary
precondition for mobilization of savings.
 In this process, the state has a very important and positive role to play both in
generating savings through various fiscal and monetary incentives and in
channelizing the savings towards priority needs of the community so that
there is not only capital generation but also socially beneficial type of capital
formation.
3. Investment:
 The process of capital formation gets completed only when the real savings get
converted into real capital assets.
 An economy should have an entrepreneurial class which is prepared to bear the
risk of business and invest savings in productive avenues so as to create new
capital assets.
Entrepreneur
The fourth factor of production, namely, the entrepreneur.
 It is not enough to say that production is a function of land, capital and labour.
 There must be some factor which mobilises these factors, combines them in the
right proportion, initiates the process of production and bears the risks involved in
it.
 This factor is known as the entrepreneur. He has also been called the organizer, the
manager or the risk taker.
 But, in these days of specialization and separation of ownership and management, the
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.9

tasks performed by a manager or organizer have become different from that of the
entrepreneur.
 While organization and management involve decision- making of routine and non-routine
types, the task of the entrepreneur is to initiate production work and to bear the
risks involved in it.
Functions of an entrepreneur: In general, an entrepreneur performs the following functions:
(i) Initiating business enterprise and resource co-ordination:
 An entrepreneur senses business opportunities, conceives project ideas, decides
on scale of operation, products and processes and builds up, downs and
manages his own enterprise.
 The first and the foremost function of an entrepreneur is to initiate a business
enterprise.
 An entrepreneur perceives opportunity, organizes resources needed for exploiting
that opportunity and exploits it.
 He undertakes the dynamic process of obtaining different factors of production such
as land, labour and capital, bringing about co-ordination among them and using
these economic resources to secure higher productivity and greater yield.
 An entrepreneur hires the services of various other factors of production and pays
them fixed contractual rewards:
o labour is hired at predetermined rate of wages,
o land or factory building at a fixed rent for its use and
o capital at a fixed rate of interest.
 The surplus, if any, after paying for all factors of production hired by him, accrues to
the entrepreneur as his reward for his efforts and risk-taking.
 Thus, the reward for an entrepreneur, that is a profit, is not certain or fixed. He
may earn profits, or incur losses.
 Other factors get the payments agreed upon, irrespective of whether the
entrepreneur makes profits or losses.
(ii) Risk bearing or uncertainty bearing:
 The ultimate responsibility for the success and survival of business lies with the
entrepreneur.
 The economy is dynamic and changes occur every day.
o The demand for a commodity,
o the cost structure,
o fashions and tastes of the people and
o government’s policy regarding taxation, credit, interest rate etc. may
change.
 It may happen that as a result of certain broad changes which were not
anticipated by the entrepreneur, the firm has to incur losses.
 Thus, the entrepreneur has to bear these financial risks.
 Apart from financial risks, the entrepreneur also faces technological risks which
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.10

arise due to the inventions and improvement in techniques of production, making

the existing techniques and machines obsolete.
 However, Frank Knight is of the opinion that profit is the reward for bearing
uncertainties.
 An entrepreneur need not bear the foreseeable risks such as of fire, theft,
burglary etc. as these can be insured against.
 Uncertainties are different from risks in the sense that these cannot be
insured against and therefore, the entrepreneur has to bear them.
 For example genuine business uncertainties such as change in tastes, emergence
ofcompetition etc. cannot be foreseen or insured against.
 Thus, an entrepreneur earns profits because he bears uncertainty in a
dynamic economy where changes occur every day.
 While nearly all functions of an entrepreneur can be delegated or entrusted with
paid managers, risk bearing cannot be delegated to anyone.
 Therefore, risk bearing is the most important function of an entrepreneur
(iii) Innovations:
 According to Schumpeter, the true function of an entrepreneur is to introduce
innovations.
 Innovation refers to commercial application of a new idea or invention to better
fulfilment of business requirements.
 According to Schumpeter, the task of the entrepreneur is to continuously
introduce new innovations.
 These innovations may bring in greater efficiency and competitiveness in
business and bring in profits to the innovator.
 A successful innovation will be limitated by others in due course of time.
Therefore, an innovation may yield profits for the entrepreneur for a short time
butwhen it is widely adopted by others, the profits tend to disappear.
 The entrepreneurs promote economic growth of the country by introducing new
innovations from time to time and contributing to technological progress.
 But innovations involve risks and only a few individuals in the society are
capable of introducing new innovations.
 The greater the innovating ability, the greater the supply of entrepreneurs in
the economy, and greater will be the rate of technological progress.
Enterprise’s objectives and constraints
Thus, the objectives of an enterprise may be broadly categorized under the following
heads:
1) Organic objectives
2) Economic objectives
3) Social objectives
4) Human objectives
5) National objectives
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.11

1. Organic objectives:
 The basic minimum objective of all kinds of enterprises is to survive or to stay
alive.
 An enterprise can survive only if it is able to produce and distribute
products or services at aprice which enables it to recover its costs.
 Survival of an enterprise is essential for the continuance of its business activity.
 Once the enterprise is assured of its survival, it will aim at growth and
expansion.
 R.L. Marris’s theory of firm assumes that the goal that managers of a corporate
firm set for themselves is to maximise the firm’s balanced growth rate subject
to managerial and financial constraints.
 It is pointed out that ability or success of the managers is judged by their
performance in promoting the growth or expansion of the firm.
 While owners want to maximise their utility function which relate to profit,
capital, market share and public reputation, the managers want to maximise their
utility function which includes variables such as salary, power, and status and
job security.
 Marris argues that most of the variables incorporated in both of them are
positively related to size of the firm and therefore, the two utility functions
converge into a single variable, namely, a steady growth in the size of the firm.
 The managers do not aim at optimising profits; rather they aim at optimisation
of the balanced rate of growth of the firm which involves optimisation of the rate
of increase of demand for the commodities of the firm and the rate of increase of
capital supply.
2. Economic objectives:
 The profit maximising behaviour of the firm is still at the heart of neo classical
micro economic theory.
 Under this assumption, the firm determines the price and output policy in such a
way as to maximize profits within the constraints imposed upon it such as
technology, finance etc.
 The definition of profits in Economics is different from the accountants’
definition of profits.
Profit,
 Profit, in the accounting sense, is the difference between total revenue and total
costs of the firm.
 Economic profit is the difference between total revenue and total costs, but total costs
here costs include both explicit and implicit costs.
 Accounting profit considers only explicit costs while economic profit reflects explicit
and implicit costs i.e. the cost of self-owned factors used by the entrepreneur in his own
business.
 Since economic profit includes these opportunity costs associated with self-owned
factors, itis generally lower than the accounting profit.
 When the economist speaks of profits, s/he means profits after taking into account the
capital and labour provided by the owners i.e. s/he differentiates between normal profits
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.12

and super normal profits.

 Normal profits include normal rate of return on capital invested by the
entrepreneur, remuneration for the labour and the reward for risk bearing function
of theentrepreneur.
Normal profit (zero economic profit)
 Normal profit (zero economic profit) is a component of costs and therefore what a
business owner considers as the minimum necessary to continue in the business.
 Supernormal profit, also called economic profit or abnormal profit is over and above
normal profits.
 It is earned when total revenue is greater than the total costs. Total costs in this case
include a reward to all the factors, including normal profit.
Profit maximization
 H A Simon argues that firms have ‘satisficing’ behaviour and strive for profits that
are satisfactory.
 Baumol’s theory of sales maximisation holds that sales revenue maximisation rather
than profit maximisation is the ultimate goal of the business firms.
 He cites empirical evidence for his hypothesis that sales rank ahead of profits as the
main objective of the enterprise.
 He, however, points out that in their attempt to maximise sales, businessmen do not
completely ignore costs incurred on output and profits to be made.
Maximization of managerial utility function
 In 1932, A. A. Berle and G.C. Means pointed out that in large business corporations,
management is separated from ownership and therefore the managers enjoy
discretionary powers to set goals of the firm they manage.
 Williamson’s model of maximisation of managerial utility function is an important
contribution to managerial theory of firms’ behaviour.
 The owners (shareholders) of joint stock companies prefer profit maximisation; but
managers maximise their own utility function subject to a minimum profit, rather
than maximizing profit.
3. Social objectives: Since an enterprise lives in a society, it cannot grow unless it meets the
needs of the society. Some of the important social objectives of business are:
 To maintain a continuous and sufficient supply of unadulterated goods and
articles of standard quality.
 To avoid profiteering and anti-social practices.
 To create opportunities for gainful employment for the people in the society.
 To ensure that the enterprise’s output does not cause any type of pollution -
air, water or noise.
An enterprise should consistently endeavour to contribute to the quality of life of its
community in particular and the society in general. If it fails to do so, it may not survive
for long.
4. Human objectives:
 Human beings are the most precious resources of an organisation.
 Some of the important human objectives are:
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.13

 To provide fair deal to the employees at different levels

 To develop new skills and abilities and provide a work climate in which
they will grow as mature and productive individuals.
 To provide the employees an opportunity to participate in decision-making
in matters affecting them.
 To make the job contents interesting and challenging.
o If the enterprise is conscious of its duties towards its employees, it
will be able to secure their loyaltyand support.
5. National objectives:
o Some of the national objectives are:
 To remove inequality of opportunities and provide fair opportunity to all
to work and toprogress.
 To produce according to national priorities.
 To help the country become self-reliant and avoid dependence on other
nations.
 To train young men as apprentices and thus contribute in skill formation
for economic growth and development.
Since all the enterprises have multiple goals, they need to set priorities. This requires
appropriate balancing of the objectives in order to determine the relative importance of
each.
In the pursuit of this objective, an enterprise’s actions may get constrained by many
factors. Important among them are:
 Lack of knowledge and information:
o The enterprise functions in an uncertain world where due to lack of
accurate information, many variables that affect the performance of the firm
cannot be correctly predicted for the current month or the current year,
let alone for the future years.
o Similarly, the firms may not know about the prices of all inputs and the
characteristics of all relevant technologies.
o Under such circumstances, it is very difficult to determine what the profit
maximizing price is.
 There may be other constraints such as restrictions imposed in the public
interest by the state on the production, price and movement of factors.
 In practice, there are several hindrances for free mobility of labour and capital.
 For example, trade unions may place several restrictions on the mobility of labour
or specialized training may be required to enable workers to change occupation.
 these contingencies may make attainment of maximum profits a difficult task.
 There may be infrastructural inadequacies and consequent supply chain
bottlenecks resulting in shortages and unanticipated emergencies.
 For example, there could be frequent power cuts, irregular supply of raw-
materials or non-availability of proper transport.
 This could put limitations on the power of enterprises to maximise
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.14

profits.
 Changes in business and economic conditions which become contagious
due to the highly connected nature of economies, place constraints by
causing demand fluctuations and instability in firms’ sales and
revenues.
 Besides, external factors such as sudden change in government policies
with regard to
 location,
 prices, taxes,
 production, etc. or natural calamities like fire, flood etc. may place
additional burdens on the business firms and defeat their plans.
 When firms are forced to implement policies in response to fiscal
limitations, legal, regulatory, or contractual requirements, these have
adverse consequences on the firms’ profitability and growth plans.
 Events such as
• inflation,
• rising interest rates,
• unfavourable exchange rate fluctuations cause increased raw
material,
• capital and labour costs and affect the budgets and financial plans
of firms. Significant constraints are also imposed by the inability of
firms to find skilled workforce at competitive wages as well as due to
the recurring need for personnel training.
Enterprise’s Problems
An enterprise faces a number of problems from its inception, through its life time and till its
closure. We shall try to get a few insights about them from the following discussion.
 Problems relating to objectives:
o The problem is that the objectives are multifarious and very often conflict with
one another.
o For example, the objective of maximising profits is in conflict with the
objective of increasing the market share which generally involves improving the
quality, slashing the prices etc.
o Thus the enterprise faces the problem of not only choosing its objectives but
also striking a balance among them.
 Problems relating to location and size of the plant:
o An enterprise has to decide about the location of its plant.
o It has to decide whether the plant should be located near the source of raw
material or near the market.
o It has to consider costs such as cost of labour, facilities and cost of
transportation.
o Another problem relates to the size of the firm. It has to decide whether it is
to be a small scale unit or large scale unit.
o Due consideration will have to be given to technical, managerial, marketing and
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.15

financial aspects of the proposed business before deciding on the scale of

operations.
o It goes without saying that the management must make a realistic evaluation of
its strengths and limitations while choosing a particular size for a new unit.
 Problems relating to selecting and organising physical facilities:
o A firm has to make decision on the nature of production process to be employed
and the type of equipments to be installed.
o The choice of the process and equipments will depend upon the design
chosen and the required volume of production.
o As a rule, production on a large scale involves the use of elaborate, specialized
and complicated machinery and processes.
o Such a choice will be based on the evaluation of their relative cost and efficiency.
 Problems relating to Finance:
o An enterprise has to undertake not only physical planning but also expert financial
planning. Financial planning involves
 determination of the amount of funds required for the enterprise with
reference to the physical plans already prepared
 assessment of demand and cost of its products
 estimation of profits on investment and comparison with the profits of
comparable existing concerns to find out whether the proposed investment
will be profitable enough and
 determining capital structure and the appropriate time for financing the
enterprise etc.
 Problems relating to organisation structure:
o An enterprise also faces problems relating to the organisational structure.
o It has to divide the total work of the enterprise into major specialised functions
and then constitute proper departments for each of its specialized functions.
o In the absence of clearly defined roles and relationships, the enterprise may
not be able to function efficiently.
 Problems relating to marketing:
o Proper marketing of its products and services is essential for the survival and
growth of an enterprise.
o For this, the enterprise has to discover its target market by identifying its
actual and potential customers, and determine tactical marketing tools it can
use to produce desired responses from its target market.
o After identifying the market, the enterprise has to make decision regarding 4 P’s
namely,
 Product: variety, quality, design, features, brand name, packaging, associated
services, utility etc.
 Promotion: Methods of communicating with consumers through personal
selling, social contacts, advertising, publicity etc.
 Price: Policies regarding pricing, discounts, allowance, credit terms,
concessions, etc.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.16

 Place: Policy regarding coverage, outlets for sales, channels of distribution,

location and layout of stores, inventory, logistics etc.

 Problems relating to legal formalities:

o A number of legal formalities have to be carried out during the time of
launching of the enterprise as well as during its life time and its closure.
o These formalities relate to
 assessing and paying different types of taxes (corporate tax, excise
duty, sales tax, custom duty, etc.),
 maintenance of records,
 submission of various types of information to the relevant authorities
from to time,
 adhering to various rules and laws formulated by government (for
example, laws relating to location,
 environmental protection and control of pollution, size, wages and
bonus, corporate management licensing, prices) etc.

 Problems relating to industrial relations:

With the emergence of the present day factory system of production, the management
has to devise special measures to win the co-operation of a large number of workers
employed in industry.
o Misunderstanding and conflict of interests have assumed
enormous dimensions that these cannot be easily and promptly
dealt with.
o Various problems which an enterprise faces with regard to industrial relations are –
 the problem of winning workers’ cooperation,
 the problem of enforcing proper discipline among workers,
 the problem of dealing with organised labour and
 the problem of establishing a state of democracy in the industry by
associating workers with the management of industry.
PRODUCTION FUNCTION
 The production function is a statement of the relationship between a firm’s scarce
resources and the output that results from the use of these resources.
 More specifically, it states technological relationship between inputs and output.
 The production function in which the output is the dependent variable and inputs are
the independent variables.
 The equation can be expressed as:
Q = f (a, b, c, d …….n)
Where ‘Q’ stands for the rate of output of given commodity and a, b, c, d…….n, are the
different factors (inputs) and services used per unit of time.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.17

Assumptions of Production Function:

There are three main assumptions underlying any production function.
 First
o we assume that the relationship between inputs and outputs exists for a specific
period of time. In other words, Q is not a measure of accumulated output over time.
 Second,
o it is assumed that there is a given “state-of-the-art” in the production
technology.
o Any innovation would cause change in the relationship between the given inputs and
their output.
o For example, use of robotics in n manufacturing or a more efficient software
package for financial analysis would change the input-outputrelationship.
 Third
o assumption is that whatever input combinations are included in a particular
function, the output resultingfrom their utilization is at the maximum level.
The production function can be defined as:
The relationship between the maximum amount of output that can be produced
and the input required to make that output. It is defined for a given state of technology
i.e., the maximum amount of output that can be produced with given quantities of inputs
under a given state of technical knowledge. (Samuelson)
It can also be defined as the minimum quantities of various inputs that are required to
yield a given quantity of output.
For the purpose of analysis, the whole array of inputs in the production function can be
reduced to two; L and K. Restating the equation given above, we get:
Q = f (L, K). Where

Q = Output

L= Labour

K= Capital
Short-Run Vs Long-Run Production Function
 The production function of a firm can be studied in the context of short period or
long period.
 It is to be noted that in economic analysis, the distinction between short-run and long-run
is not related to any particular measurement of time (e.g. days, months, or years).
 In fact, it refers to the extent to which a firm can vary the amounts of the inputs in
the production process.
 short-run period
o A period will be considered short-run period if the amount of at least one of the
inputs used remains unchanged during that period.
o Thus, short-run production function shows the maximum amount of a good or
service that can be produced by a set of inputs, assuming that the amount of at
least one of the inputs used remains fixed (or unchanged).
o Generally, it has been observed that during the short period or in the short run, a
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.18

firm cannot install a new capital equipment to increase production.

o It implies that capital is a fixed factor in the short run.
o Thus, in the short-run, the production function is studied by holding the
quantities of capital fixed, while varying the amount of other factors (labour,
raw material etc.)
o The behaviour of production when some factors are fixed and some are varied is
the subject matter of the law of variable proportionate.
long run period
o The long run is a period of time (or planning horizon) in which all factors of
production are variable.
o It is a time period when the firm will be able to install new machines and capital
equipments apart from increasing the variable factors of production.
o A long-run production function shows the maximum quantity of a good or
service that can be produced by a set of inputs, assuming that the firm is free to
vary the amount of all the inputs being used.
o The behaviour of production when all factors are varied is the subject matter of the
law of returns to scale.
Cobb-Douglas Production Function
 A famous statistical production function is Cobb-Douglas production function.
 Paul H. Douglas and C.W. Cobb of the U.S.A. studied the production function of the
American manufacturing industries.
 In its original form, this production function applies not to an individual firm but to
the whole of manufacturing in the United States.
 In this case, output is manufacturing production and inputs used are labour and
capital.
 Cobb-Douglas production function is stated as:
Q = KLa C(1-a)
where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital. ‘K’ and ‘a’ are
positive constants.
 The conclusion drawn from this famous statistical study is that labour contributed
about 3/4th and capital about 1/4th of the increase in the manufacturing
production.
 Although, the Cobb-Douglas production function suffers from many shortcomings,
it is extensively used in Economics as an approximation.
The Law of Variable Proportions or The Law of Diminishing Returns
 In the short run, the input output relations are studied with one variable input (labour)
with all other inputs held constant.
 The laws of production under these conditions are known under various names as
the law of variable proportions (as the behaviour of output is studied by changing the
proportion in which inputs are combined) the law of returns to a variable input (as any
change in output is taken as resulting from the additional variable input) or the law of
diminishing returns (as returns eventually diminish).
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.19

 The law states that as we increase the quantity of one input which is combined with
other fixed inputs, the marginal physical productivity of the variable input must
eventually decline.
 In other words, an increase in some inputs relative to other fixed inputs will, in a given
state of technology, cause
o output to increase;
o but after a point, the extra output resulting from the same
addition of extra input will become less and less.
Meaning of total product, average product and marginal product.
Total Product (TP):
 Total product is the total output resulting from the efforts of all the factors of production
combined together at any time.
 If the inputs of all but one factor are held constant, the total product will vary with the
quantity used of the variable factor.

Product Schedule
Quantity of labour Total Product (TP) Average Product Marginal Product
(AP) (MP)
(1) (2) (3) (4)
1 100 100.0 100
2 210 105.0 110
3 330 110.0 120
4 440 110.0 110
5 520 104.0 80
6 600 100.0 80
7 670 95.7 70
8 720 90.0 50
9 750 83.3 30
10 750 75.0 0
11 740 67.3 –10
 We find in above table , that when one unit of labour is employed along with other factors
of production, the total product is 100 units.
 When two units of labour are employed, the total product rises to 210 units.
 The total product goes on rising as more and more units of labour are employed.
 With 9 or 10 units of labour, the total product rises to maximum level of 750 units.
 When 11 units of labour are employed, total product falls to 740 units due to
negative returns from the 11th unit of labour.
 Average Product (AP):
 Average product is the total product per unit of the variable factor.
Total Product
AP=
No. of units of Variable Factor
 When one unit of labour is employed, average product is 100,
 when two units of labour are employed, average product rises to 105.
 This goes on, as shown in Table.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.20

Marginal Product (MP):

 Marginal product is the change in total product per unit change in the quantity of
variable factor.
 In other words, it is the addition made to the total production by an additional unit of
input.
 Symbolically,
MPn  TPn – TPn–1

 For example, the MP corresponding to 4 units is given as 110 units.

 This reflects the fact that an increase in labour from 3 to 4 units, has increased output
from 330 to 440 units.
Relationship between Average Product and Marginal Product:
 Both average product and marginal product are derived from the total product.
 Average product is obtained by dividing total product by the number of units of the
variable factor and marginal product is the change in total product resulting from a
unit increase in the quantity of variable factor.
 The relationship between average product and marginal product can be summed up as
follows:
(i) when average product rises as a result of an increase in the quantity of variable
input, marginal product is more than the average product.
(ii) when average product is maximum, marginal product is equal to average
product. In other words, the marginal product curve cuts the average product
curve at its maximum.
(iii) when average product falls, marginal product is less than the average product.

 The Law of Variable Proportions or the Law of Diminishing Returns examines the
production function with one factor variable, keeping quantities of other
factors fixed.

 In other words, it refers to input-output relationship, when the output is

increased by varying the quantity of one input.

 This law operates in the short run ‘when all factors of production cannot be
increased or decreased simultaneously (for example, we cannot build a plant or
dismantle a plant in the short run).
The law operates under certain assumptions which are as follows:
1. The state of technology is assumed to be given and unchanged.
2. There must be some inputs whose quantity is kept fixed.
3. The law does not apply to those cases where the factors must be used in fixed
proportions to yield output.
4. When the various factors are required to be used in fixed proportions, an increase in one
factor would not lead to any increase in output i.e., marginal product of the variable
factor will then be zero and not diminishing.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.21

5. We consider only physical inputs and outputs and not economic profitability in
monetary terms.
 The behaviour of output when the varying quantity of one factor is combined with a fixed
quantity of the others can be divided into three distinct stages or laws.
 In order to understand these three stages or laws, we may graphically illustrate the
production function with one variable factor.
 The behaviour of these Total, Average and Marginal Products of the variable factor
consequent on the increase in its amount is generally divided into three stages (laws)
which are explained below.
Fig. 1: Law of Variable Proportions

Stage 1: The Stage of Increasing Returns:

 In this stage, the total product increases at an increasing rateupto a point (in figure
upto point F), marginal product also rises and is maximum at the point
corresponding to the point of inflexion and average product goes on rising.
 From point F onwards during the stage one, the total product goes on rising but at a
diminishing rate. Marginal product falls but is positive.
 The stage 1 ends where the AP curve reaches its highest point.
Thus, in the first stage,
 the AP curve rises throughout whereas the marginal product curve first rises and then
starts falling after reaching its maximum.
 It is to be noted that the marginal product although starts declining, remains greater than
the average product throughout the stage so that average product continues to rise.
Explanation of law of increasing returns:

Optimum utilization of resources

 The law of increasing returns operates because in the beginning, the quantity of fixed
factors is abundant relative to the quantity of the variable factor.
 As more units of the variable factor are added to the constant quantity of the fixed factors,
the fixed factors are more intensively and effectively utilised i.e., the efficiency of the
fixed factors increases as additional units of the variable factors are added to them.
 This causes the production to increase at a rapid rate.
 For example,
o if a machine can be efficiently operated when four persons are working on it,
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.22

o and if in the beginning we are operating it only with three persons,

o production is bound to increase if the fourth person is also put to work on the
machine since the machine will be effectively utilised to its optimum.
 This happens because, in the beginning some amount of fixed factor remained unutilised
and, therefore, when the variable factor is increased, fuller utilisation of the fixed
factor becomes possible and it results in increasing returns.
Indivisibility of a factor
 A question arises as to why the fixed factor is not initially taken in a quantity which
suits the available quantity of the variable factor.
 The answer is that, generally, those factors which are indivisible are taken as fixed.
 Indivisibility of a factor means that due to technological requirements, a minimum
amount of that factor must be employed whatever be the level of output.
Thus, as more units of the variable factor are employed to work with an indivisible fixed factor,
output greatly increases due to fuller utilisation of the latter.
Specialisation
 The next reason introduction of division of labour and specialisation becomes possible
with sufficient quantity of the variable factor and these results in higher
productivity.
Stage 2: Stage of Diminishing Returns:
 In stage 2, the total product continues to increase at a diminishing rate until it
reaches its maximum at point H, where the second stage ends.
 In this stage, both marginal product and average product of the variable factor are
diminishing but are positive.
 At the end of this stage i.e., at point M (corresponding to the highest point H of the total
product curve), the marginal product of the variable factor is zero.
 Stage 2, is known as the stage of diminishing returns because both the average and
marginal products of the variable factors continuously fall during this stage.
 This stage is very important because the firm will seek to produce within its range.
Explanation of law of diminishing returns:
 As explained above, increasing returns occur primarily because of more efficient use of
fixed factors as more units of the variable factor are combined to work with it.
 Once the point is reached at which the amount of variable factor is sufficient to
ensure efficient utilisation of the fixed factor, any further increases in the variable
factor will cause marginal and average product to decline because the fixed factor
then becomes inadequate relative to the quantity of the variable factor.
 Continuing the above example,
o when four men were put to work on one machine, the optimum combination was
achieved. Now, if the fifth person is put on the machine, his contribution will be
nil. In other words, the marginal productivity will start diminishing.
 Just as the average product of the variable factor increases in the first stage when better
utilisation of the fixed indivisible factor is being made, so the average product of the
variable factor diminishes in the second stage when the fixed indivisible factor is
being worked too hard.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.23

 Another reason offered for the operation of the law of diminishing returns is the
imperfect substitutability of one factor for another.
Stage 3: Stage of Negative Returns:
 In Stage 3, total product declines, MP is negative, average product is diminishing.
 This stage is called the stage of negative returns since the marginal product of the
variable factor is negative during this stage.
Explanation the law of negative returns:
 As the amount of the variable factor continues to be increased to a constant quantity of the
other, a stage is reached when the total product declines and marginal product becomes
negative.
 This is due to the fact that the quantity of the variable factor becomes too excessive
relative to the fixed factor so that they get in each other’s ways with the result that
the total output falls instead of rising.
In such a situation, a reduction in the units of the variable factor will increase the total output.
Stage of Operation:
 An important question is in which stage a rational producer will seek to produce.
 A rational producer will never produce in stage 3 where marginal product of the variable
factor is negative.
 This being so, a producer can always increase his output by reducing the amount of
variable factor. Even if the variable factor is free of cost, a rational producer stops
before the beginning of the third stage.
 A rational producer will also not produce in stage 1 as he will not be making the best use
of the fixed factors and he will not be utilising fully the opportunities of increasing
production by increasing the quantity of the variable factor whose average product
continues to rise throughout stage 1.
 Even if the fixed factor is free of cost in this stage, a rational entrepreneur will continue
adding more variable factors.
It is thus clear that a rational producer will never produce in stage 1 and stage 3.
These stages are called stages of ‘economic absurdity’ or ‘economic non-sense’.
 A rational producer will always produce in stage 2 where both the marginal
product and average product of the variable factors are diminishing.
Returns to Scale
 In this We study about changes in output when all factors of production in a
particular production function are increased together.
 In other words, we shall study the behaviour of output in response to a change in
the scale.
 A change in scale means that all factors of production are increased or decreased
in the same proportion.
 Change in scale is different from changes in factor proportions.
 It should be kept in mind that the returns to scale faced by a firm are solely
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.24

technologically determined and are not influenced by economic decisions taken by

the firm or by market conditions.
 It is needless to say that this law operates in the long run when all the factors can be
changed in the same proportion simultaneously.
 It should be remembered that increasing returns to scale is not the same as increasing
marginal returns. Increasing returns to scale applies to ‘long run’ in which all inputs
can be changed.
Whereas
 Increasing marginal returns refers to the short run in which at least one input is
fixed. The existence of fixed inputs in the short run gives rise to increasing and later to
diminishing marginal returns.
Constant Returns to Scale:
 constant returns to scale means that with the increase in the scale in some proportion,
output increases in the same proportion.
 Constant returns to scale, otherwise called as “Linear Homogeneous Production
Function”, may be expressed as follows:
kQx = f ( kK, kL)
= k (K, L)
 If all the inputs are increased by a certain amount (say k) output increases in the same
proportion (k).
 It has been found that an individual firm passes through a long phase of constant returns
to scale in its lifetime.
Increasing Returns to Scale:
 Increasing returns to scale means that output increases in a greater proportion than
the increase in inputs.
 When a firm expands, increasing returns to scale are obtained in the beginning.
 For example, a wooden box of 3 ft. cube contains 9 times greater wood than the
wooden box of 1 foot-cube. But the capacity of the 3 foot- cube box is 27 times
greater than that of the one foot cube. Many such examples are found in the real
world.
 Another reason for increasing returns to scale is the indivisibility of factors. Some
factors are available in large and lumpy units and can, therefore, be utilised with utmost
efficiency at a large output.
 If all the factors are perfectly divisible, increasing returns may not occur.
 Returns to scale may also increase because of greater possibilities of specialisation
of land and machinery.
Decreasing Returns to Scale:
 When output increases in a smaller proportion relative to an increase in all inputs,
decreasing returns to scale are said to prevail.
 When a firm goes on expanding by increasing all inputs, decreasing returns to scale set
in.
 Decreasing returns to scale eventually occur because of increasing difficulties of
management, coordination and control.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.25

 When the firm has expanded to a very large size, it is difficult to manage it with the same
efficiency as earlier.
The Cobb-Douglas production function, explained earlier is used to explain “returns to scale” in
production. Originally, Cobb and Douglas assumed that returns to scale are constant. The
function was constructed in such a way that the exponents summed to a+1-a=1. However, later
they relaxed the requirement and rewrote the equation as follows:
Q = K La Cb
Where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital, ‘K’ and ‘a’ and ‘b’
are positive constants.
If a + b > 1 Increasing returns to scale result i.e. increase in output is more than the
proportionate increase in the use of factors (labour and capital).
a + b = 1 Constant returns to scale result i.e. the output increases in the same
proportion in which factors are increased.
a + b < 1 decreasing returns to scale result i.e. the output increases less than the
proportionate increase in the labour and capital.
PRODUCTION OPTIMISATION
 Normally, a profit maximising firm is interested to know what combination of factors of
production (or inputs) would minimise its cost of production for a given output.
 This can be known by combining the firm’s production and cost functions, namely
isoquants and iso-cost lines respectively.
Isoquants:
 Isoquants are similar to indifference curves in the theory of consumer behaviour.
 An isoquant represents all those combinations of inputs which are capable of
producing the same level of output.
 Since an isoquant curve represents all those combination of inputs which yield an
equal quantity of output, the producer is indifferent as to which combination he
chooses.
 Therefore, Isoquants are also called
o equal-product curves,
o production indifference curves or
o iso-product curves.
 The concept of isoquant can be easily understood with the help of the following schedule.
Various combinations of X and Y to produce a given level of output
Factor combination Factor X Factor Y MRTS
A 1 12
B 2 08 4
C 3 05 3
D 4 03 2
E 5 02 1

When we plot the various combinations of factor X and factor Y, we get a curve IQ as shown in
Figure 2.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.26

Fig. 2 : Equal Product Curve or Isoquant

Isoquants have properties similar to indifference curves.

 Isoquants are negatively sloped,
 convex to the origin due to diminishing marginal rate of technical substitution (MRTS)
and
 are non-intersecting.
However, there is one important difference between the two:
 whereas in an indifference curve it is not possible to quantify the level of satisfaction
acquired by the consumer, the level of production acquired by the producer is easily
quantified.
 Thus, while isoquant IQ1 represents 100 units, curves IQ2, IQ3 etc. representing higher
levels of production can be drawn.
 While a curve on the right represents a higher level of output that on the left represents a
lower level of output.
Iso cost or Equal-cost Lines:
 Iso cost line, also known as budget line or the budget constraint line, shows the
various alternative combinations of two factors which the firm can buy with given
outlay.
 Suppose a firm has Rs. 1,000 to spend on the two factors X and Y.
 If the price of factor X is Rs. 10 and that of Y is Rs. 20, the firm can spend its outlay on X
and Y in various ways.
 It can spend the entire amount on X and thus buy 100 units of X and zero units of Y or it
can spend the entire outlay on Y and buy 50 units of it with zero units of X factor.
 In between, it can have any combination of X and Y. Whatever be the combination of
factors the firm chooses, the total cost to the firm remains the same.
 In other words, all points on a budget line would cost the firm the same amount.
We can show the iso-cost line diagrammatically also as shown in figure 3.
 The X-axis shows the units of factor X and Y-axis the units of factor Y. When the entire `
1,000 is spent on factor X, we get OB of factor X and when the entire amount is spent on
factor Y we get OA of factor Y .
 The straight line AB which joins points A and B will pass through all combinations of
factors X and Y which the firm can buy with outlay of ` 1,000.
The line AB is called iso-cost line
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.27

Figure - 3

Figure 3 shows various iso-cost lines representing different combinations of factors with
different outlays. Isoquants, which represent the technical conditions of production for a product
and iso-cost lines which represent various ‘levels of cost or outlay’ (given the prices of two
factors) can help the firm to optimize its production. It may try to minimise its cost for producing
a given level of output or it may try to maximise the output for a given cost or outlay.

Figure 4
Explanation : Figure 4 How a firm will determine least cost output.
 Suppose the firm has decided to produce 1,000 units (represented by iso-quant P).
 These units can be produced by any factor combination lying on P such as A, B, C, D, E, etc.
 The cost of producing 1,000 units would be minimum at the factor combination
represented by point C where the iso-cost line MM1 is tangent to the given isoquant P.
 At all other points such as A, B, D, E the cost is more as these points lie on higher iso- cost lines
Compared to MM1.
 Thus, the factor combination represented by point C is the optimum combination for the
producer.
 It represents the least-cost of producing 1,000 units of output.
 It is thus clear that the tangency point of the given isoquant with an iso-cost line represents
the least cost combination of factors for producing a given output.
*************************
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.28

QUESTIONS & ANSWERS

1. Larger production of ---------------------- goods would lead to higher production in
future.
(a) Consumer goods. (b) Capital goods.
(c) Agricultural goods. (d) Public goods.
2. Production may be defined as an act of _________________ .
(a) creating utility. (b) earning profit.
(c) destroying utility. (d) providing services.
3. Which of the following is considered production in economics?
(a) Tilling of soil
(b) Singing a song before friends
(c) Preventing a child from falling into a manhole on the road
(d) Painting a picture for pleasure
4. Which of the following is an economic activity?
(a) Listening to music on the radio
(b) Teaching one's own son at home
(c) Medical facilities rendered by a charitable dispensary
(d) A housewife doing household duties
5. Which of the following is not an economic activity?
(a) A son looking after his ailing mother
(b) A chartered accountant doing his own practice
(c) A soldier serving at the border
(d) A farmer growing millets
6. Lesser production of ---------------------- would lead to lesser production in future
(a) Public goods (b) Consumer goods
(c) Capital goods (d) Agriculture goods
7. Which of the following is considered production in Economics?
(a) Teaching CA students in CA Institute by a teacher
(b) Singing a song before friends
(c) Flying kite for pleasure
(d) Teaching to friends in a library any concept of Economics
8. Which of the following statements is incorrect?
(a) The services of doctors, lawyers, teachers etc are termed as production
(b) Man cannot create matter
(c) Accumulation of capital does not depend solely on income
(d) None of the above
9. What is Production in Economics:-
(a) Creation / Addition of Utility (b) Production of food grains
(c) Creation of services (d) Manufacturing of goods
10. Which of the following statements is true?
(a) Accumulation of capital depends solely on income
(b) Saving can also be affected by the State
(c) External economies go with size and internal economies with location
(d) The supply curve of labour is an upward slopping curve
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.29

11. Which of the following statements is true?

(a) The services of a doctor are considered production.
(b) Man can create matter.
(c) The services of a housewife are considered production.
(d) When a man creates a table, he creates matter

12. Which of the following is not a characteristic of land?

(a) its supply for the economy is limited (b) it is immobile
(c) its usefulness depends on human efforts (d) it is produced by our forefathers
13. Which of the following statement is correct ?
(a) Land is highly mobile factor of production
(b) Man cannot create matter
(c) The services of housewife are termed as production in economics
(d) None of the above
14. Which of the following is a function of an entrepreneur?
(a) Initiating a business enterprise (b) Risk bearing
(c) Innovating (d) All of the above
15. Which of the following is not the characteristic of Labour?
(a) Labour is highly 'Perishable' in the sense that a day's labour lost cannot be completely
recovered
(b) Labour is inseparable from the labourer himself
(c) Labour has a strong bargaining power
(d) The supply of labour and wage rate are directly related in the initial stages
16. Which is not the function of an entrepreneur?
(a) Initiating a business enterprise and resource co-ordination
(b) Risk bearing or uncertainty bearing
(c) Innovation
(d) Mobilisation of savings
17. Which of the following is not included in the stages of capital formation?
(a) Savings (b) Mobilisation of Income
(c) Mobilisation of Saving (d) Investment
18. The following is not the characteristic of Land:
(a) Land varies in fertility and uses
(b) Land is highly immobile
(c) The supply of land is perfectly elastic from the point of view of the economy
(d) The supply of land is perfectly inelastic from the point of view of the economy
19. Which of the following is not a factor of production?
(a) Man (b) Labour
(c) Capital (d) Entrepreneurs
20. Who has given the concept of Innovative Entrepreneurship ?
(a) Robbins (b) Adam Smith
(c) Schumpeter (d) Sweezy
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.30

21. Labour force wants more ---------------- .

(a) Facility (b) Leisure
(c) Benefit (d) All of the above

22. In the production of wheat, all of the following are variable factors that are used by
the farmer except:
(a) the seed and fertilizer used when the crop is planted
(b) the field that has been cleared of trees and in which the crop is planted.
(c) the tractor used by the farmer in planting and cultivating not only wheat but also corn
and barley.
(d) the number of hours that the farmer spends cultivating the wheat fields.
23. The short run, as economists use the phrase, is characterized by:
(a) at least one fixed factor of production and firms neither leaving nor entering the
industry.
(b) a period where the law of diminishing returns does not hold.
(c) no variable inputs-that is all of the factors of production are fixed
(d) all inputs being variable
24. Which of the following statements is correct?
(a) Supply of land is perfectly elastic
(b) Fertility of land cannot change
(c) Land does not yield any result unless human efforts are employed.
(d) Supply of land can be increase
25. Labour is defined as...................
(a) Any work done without remuneration
(b) Any exertion of mind or body to get some reward
(c) Helping the mother
(d) Helping the friends
26. The most important function of an entrepreneur is to...............
(a) Innovate (b) Bear the sense of responsibility
(c) Finance (d) Earn profit
27. Which one of the following is correct?
(a) Land is produced by man's efforts.
(b) The supply of land is not constant.
(c) Capital is not a result of savings.
(d) Capital refers to the produced means of production.
28. Which one of the following is incorrect?
(a) Land has original and indestructible powers to produce
(b) Labour has poor bargaining power
(c) Risk in a business concern can be insured
(d) The supply of land is not constant
29. In general, most of the production functions measure
(a) The productivity of factors of production.
(b) The relation between the factors of production.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.31

(c) The economies of scale.

(d) The relations between change in physical inputs and physical output.

30. In describing a given production technology, the short run is best described as
lasting
(a) up to six months from now.
(b) up to five years from now.
(c) as long as all inputs are fixed.
(d) as long as at least one input is fixed.
31. The average product of labour is maximized when marginal product of labour
________________.
(a) equals the average product of labour. (b) equals zero.
(c) is maximized. (d) none of the above.

Use Table to answer questions 32 - 34.

Table 3
Hours of Labour Total Output Marginal
Product
0 ----- -----
1 100 100
2 ----- 80
3 240
32. What is the total output when 2 hours of labour are employed?
(a) 80 (b) 100
(c) 180 (d) 200
33. What is the marginal product of the third hour of labour?
(a) 60 (b) 80
(c) 100 (d) 240
34. What is the average product of the first three hours of labour?
(a) 60 (b) 80
(c) 100 (d) 240
35. Increasing returns imply ---------------- --.
(a) constant average cost.
(b) diminishing cost per unit of output.
(c) optimum use of capital and labour.
(d) external economies.
36. A firm's production function :
(a) shows how much output and the level of input required for the firm to maximize profits.
(b) establishes the minimum level of output that can be produced using the available
resources.
(c) shows the maximum output that can be produced with a given amount of inputs with
available technology.
(d) shows labour force which is employed
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.32

37. The law of diminishing returns:

(a) states that beyond some level of a variable input, the average product of that variable
input begins to increase steadily.
(b) assumes that there is technological improvement over time.
(c) states that beyond some level of a variable input, the marginal product of that variable
begins to decrease steadily.
(d) informs a firm whether or not to use a factor input.
38. The law of diminishing returns implies that:
(a) for each extra unit of X consumed, holding constant consumption of other goods, total
utility increases.
(b) total utility remains unchanged regardless of how many units of X are consumed.
(c) marginal utility will increase at a constant rate as more units of X are consumed.
(d) each extra unit of X consumed, holding constant consumption of other goods, adds
successively less to total utility.
39. The following table exhibits:
Number of workers Output
0 0
1 23
2 40
3 50
(a) increasing marginal product of labour.
(b) diminishing marginal product of labour.
(c) increasing returns to scale.
(d) diminishing returns to scale.
40. The marginal product of a variable input is best described as:
(a) total product divided by the number of units of variable input
(b) the additional output resulting from a one unit increase in the variable input
(c) The additional output resulting from a one unit increase in both the variable and fixed
inputs
(d) The ratio of the amount of the variable input that is being used to the amount of the fixed
input that is being used
41. Diminishing marginal returns imply
(a) decreasing average variable costs (b) decreasing marginal costs
(c) increasing marginal costs (d) decreasing average fixed costs
42. To economists, the main difference between the short run and the long run is that:
(a) in the short mn all inputs are fixed, while in the long mn all inputs are variable
(b) in the short run the firm varies all of its inputs to find the least cost combination of inputs
(c) in the short-run, at least one of the firm's input levels is fixed
(d) in the long mn, the firm is making a constrained decision about how to use existing plant
and equipment efficiently
43. When marginal product is negative, then total product is:
(a) Maximum (b) Decreasing
(c) Constant (d) None of the above
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.33

44. ______________shows the relationship of output with given inputs.

(a) Demand Function (b) Production Function
(c) Cost function (d) PPC function
45. Law of increasing return operates due to:
(a) Indivisibility of Fixed Factors (b) Division of Labour and specialization
(c) Both (a) and (b) (d) Misuse of machinery
46. Law of diminishing returns is applicable in :
(a) Manufacturing industry (b) Agriculture
(c) Neither (a) nor (b) (d) Both of above
47. Production activity in the short run is analysed by
(a) Returns to scale (b) Economies of scale
(c) Law of variable proportion (d) None of these
48. Which of the following is the best definition of the "production function"?
(a) The relationship between market price and quantity supplied.
(b) The relationship between the firm's total revenue and the cost of production.
(c) The relationship between the quantities of inputs needed to produce a given level of
output.
(d) The relationship between the quantity of inputs and the firm's marginal cost of
production.
49. The "law of diminishing returns" applies to:
(a) the short run, but not the long run.
(b) the long run, but not the short run.
(c) both the short run and the long run.
(d) neither the short run nor the long run.
50. Diminishing returns occur:
(a) When units of a variable input are added to a fixed input and total product falls.
(b) When units of a variable input are added to a fixed input and marginal product falls.
(c) When the size of the plant is increased in the long run.
(d) When the quantity of the fixed input is increased and returns to the variable input falls.
51. If decreasing returns to scale are present, then if all inputs are increased by 10%
then:
(a) output will also decrease by 10%
(b) output will increase by 10%.
(c) output will increase by less than 10%.
(d) output will increase by more than 10%.
52. The production function is a relationship between a given combination of inputs
and:
(a) Another combination that yields the same output.
(b) The highest resulting output.
(c) The increase in output generated by one-unit increase in one output.
(d) All levels of output that can be generated by those inputs.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.34

53. The average product of labour is maximized when marginal product of labour:
(a) Equals the average product of labour (b) Equals zero
(c) Is maximized (d) None of the above

54. what is a production process?

(a) technical relationship between physical inputs and physical output.
(b) relationship between fixed factors of production and variable factors of production.
(c) relationship between a factor of production and the utility created by it.
(d) relationship between quantity of output produced and time taken to produce the output.
55. Laws of production does not include...........
(a) returns to scale
(b) law of diminishing returns to a factor
(c) law of variable proportions
(d) least cost combination of factors
56. The efficient scale of production is the quantity of output that minimizes
(a) average fixed cost (b) average total cost
(c) average variable cost (d) marginal cost
57. Average product is defined as:
(a) total product divided by the total cost
(b) total product divided by marginal product
(c) total product divided by the variable input
(d) marginal product divided by the variable input
58. The change in the total product resulting from a change in a variable input is :
(a) average cost (b) average product
(c) marginal cost (d) marginal product
59. Marginal product, mathematically, is the slope of the:
(a) total product curve (b) average product curve
(c) marginal product curve (d) implicit product curve
60. Suppose the first four units of a variable input generate corresponding total outputs
of 200, 350, 450, 500. The marginal product of the third unit of input is:
(a) 50 (b) 100
(c) 150 (d) 200
61. The law of diminishing marginal returns indicates that marginal return:
(a) always diminish (b) eventually diminish
(c) always diminish before increasing (d) never diminish before increasing

62. Diminishing marginal returns for the first four units of a variable input is
exhibited by the total product sequence:
(a) 50,50,50,50 (b) 50,110,180,260
(c) 50,100,150,200 (d) 50,90,120,140
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.35

Read Table and answer questions 63 - 67

Labor Input Output Average Product Marginal
Product
0 0 --- ---
2 --- --- 25
4 90 --- ---
6 120 --- ---
8 140 --- ---
10 --- 14
12 --- 10
63. At a labor input of 2, output is:
(a) 25. (b) 30.
(c) 50. (d) 75.
64. At a labor input of 4, output per worker is:
(a) 20. (b) 22.5.
(c) 45. (d) 90.
65. At a labor input of 6, the marginal product of labor is:
(a) 120. (b) 20.
(c) 15. (d) 10.
66. Output per worker is maximized at a labour input of:
(a) 2 (b) 4
(c) 6 (d) 8.

67. The firm's output is at a short run maximum at a labour input of :

(a) 6 (b) 10
(c) 12 (d) 2
68. The law of variable proportions come into being when _____________________.
(a) There are only two variable factors.
(b) There is a fixed factor and a variable factor.
(c) All factors are variable.
(d) Variable factors yield less.
69. At the point of inflexion, the marginal product is --.
(a) Increasing (b) Decreasing
(c) Maximum (d) Negative
Use Table 3 to answer questions 70-71.
Table 3
Hours of Labour Total Output Marginal
Product
0 --- ----
1 200 200
2 --- 160
3 480 ----
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.36

70. What is the total output when 2 hours of labour are employed?
(a) 160 (b) 200
(c) 360 (d) 400
71. What is the marginal product of the third hour of labour?
(a) 120 (b) 160
(c) 200 (d) 480

Use Table to answer questions 72 - 73

Hours of Labour Total Output Marginal Product

0 ---- ----

1 300 300
2 ---- 240

3 720 ----
72. What is the total output when 2 hours of labour are employed?
(a) 160 (b) 200
(c) 360 (d) 540
73. What is the marginal product of the third hour of labour?
(a) 120 (b) 160
(c) 200 (d) 180

Use table to answer questions 74 - 75

Hours of Labour Total output Marginal
output
0 - -
1 35 350
0
2 - 230
3 670 -

74. What is the total output when 2 hrs of labour are employed
(a) 500 (b) 580
(c) 600 (d) 680
75. What is the marginal product if the third hour of labour is employed?
(a) 90 (b) 110
(c) 100 (d) 120
76. In Law of negative returns (Third stage of Law of variable proportions):
(a) Total Product declines, MP is positive
(b) Total Product declines, MP is Zero
(c) Total Product declines, MP is negative
(d) Total Product in constant, MP is constant
77. When is TP maximum?
(a) When AP becomes Zero (b) When MP becomes Zero
(c) At the intersecting point of AP and MP (d) When MP is highest
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.37

78. Law of variable proportion is applicable in:

(a) Short run (b) Long run
(c) Both Short run and Long run (d) Very Short run
79. Which of the following statements is incorrect?
(a) Both AP and MP can be calculated from TP
(b) When AP rises then MP>AP
(c) When AP is maximum then MP = AP
(d) When AP falls, MP also falls but MP>AP
80. _______________________ shows the overall output generated at a given level of input :
(a) Cost function
(b) Production function
(c) Iso cost
(d) Marginal rate of technical substantiation
81. If LAC curve falls as output expands, this is due to :
(a) Law of diminishing retains (b) Economics of scale
(c) Law of variable production (d) Diseconomies of scale
82. The marginal product curve is above the average product curve when the average
product is :
(a) Increasing (b) Decreasing
(c) Constant (d) None
83. Increasing returns to scale can be explained in terms of :
(a) External and internal economies
(b) External and internal diseconomies
(c) External economics and internal diseconomies
(d) All of these

84. If the marginal product of labour is below the average product of labour. It must be
true that :
(a) Marginal product of labour is negative
(b) Marginal product of labour is Zero
(c) Average product of labour is falling
(d) Average product of labour is negative
85. Increase in all input leading to less than proportional increase in output is called
_____________________:
(a) Increase returns to scale
(b) Decrease returns to scale
(c) Constant returns to scale
(d) Both increasing and decreasing returns to scale
86. During IInd stage of law of Diminishing returns :
(a) MP and TP is maximum (b) MP and AP are decreasing
(c) AP is negative (d) TP is negative
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.38

87. In the first stage of law of variable proportions total product increases at the
(a) Decreasing Rate (b) Increasing rate
(c) Constant rate (d) Both A and B
88. Identify the correct statement:
(a) The average product is at its maximum when marginal product is equal to average
product.
(b) The law of increasing returns to scale relates to the effect of changes in factor
proportions.
(c) Economies of scale arise only because of indivisibilities of factor proportions
(d) Internal economies of scale can accrue only to the exporting sector.
89. The marginal, average, and total product curves encountered by the firm producing
in the short run exhibit all of te following relationships except:
(a) When total product is rising, average and marginal product may be either rising or
falling.
(b) When marginal product is negative, total product and average product are falling.
(c) When average product is at a maximum, marginal product equals average product,
and total product is rising.
(d) When marginal product is at a maximum, average product equals marginal product,
and total product is rising.
90. The law of variable proportions is drawn under all of the assumptions mentioned
below except the assumption that:
(a) The technology is changing.
(b) There must be some inputs whose quantity is kept fixed.
(c) We consider only physical inputs and not economically profitability in monetary
terms.
(d) The technology is given and stable.
91. Which of the following is not an assumption of the law of variable proportions:
(a) Only one factor is variable. (b) Technique of production remains
constant.
(c) Proportion of factors of production (d) Units of variable factor are
remains same homogeneous

92. If marginal product is equal to average product, then:

(a) marginal product is increasing (b) marginal product is decreasing
(c) average product is decreasing (d) average product is not changing
93. In the third of the three stages of production:
(a) the marginal product curve has a positive slope
(b) the marginal product curve lies completely below the average product curve
(c) Total product increases
(d) marginal product is positive
94. If one unit of labour and one unit of capital give 200 units of output, two units of
labour and two units of capital give 400 units of output and 5 units of labour and
five units of capital give 1000 units of output then this is a case of:
(a) Constant returns to scale. (b) Increasing returns to scale.
(c) Decreasing returns to scale. (d) None of these.
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.39

95. Isoquants are equal to :

(a) Product Lines (b) Total utility lines
(c) Cost lines (d) Revenue lines

96. You are given the following data:Table 1

Output Total Costs
0 0
1 15
2 35
3 60
4 92
5 140
The above data is an example of:
(a) decreasing returns to scale. (b) constant returns to scale.
(c) increasing returns to scale. (d) positive fixed costs.
97. You are given the following data:
Output Total Costs
0 0
1 15
2 28
3 38
4 46
5 54
The above data is an example of:
(a) decreasing returns to scale. (b) constant returns to scale.
(c) increasing returns to scale. (d) positive fixed costs.
98. An isoquant slopes :
(a) downward to the left (b) downward to the right
(c) upward to the left (d) upward to the right
99. If as a result of 50 per cent increase in all inputs, the output rises by 75 percent, this
is a case of:
(a) increasing returns to a factor (b) increasing returns to scale
(c) constant returns to a factor (d) constant returns to scale
100. If all inputs are trebled and the resultant output is doubled, this is a case of:
(a) constant returns to scale (b) increasing returns to scale
(c) diminishing returns to scale (d) negative returns to scale
101. If as a result of 90 percent increase in all inputs, the output increase by 75 percent
this is a case of
(a) Increasing return to a factor (b) Decreasing return to a factor
(c) Diminishing returns to scale (d) None of the above
102. Returns to scale will said to be in operation when quantity of :
(a) All inputs are changed
(b) All inputs are changed in already established proportion
(c) All inputs are not changed
(d) One inputs is changed while quantity of all other inputs remain the same
 THEORY OF PRODUCTION AND COST (UNIT – I) | 3.40

103. Law of increasing returns is applicable because of

(a) Indivisibility of factors (b) Specialization
(c) Economies of scale (d) All of the above
104. The producer is in equilibrium at a point where the cost line is:
(a) above the isoquant (b) below the isoquant
(c) cutting the isoquant (d) tangent to isoquant
105. In the long run:
(a) all inputs are fixed
(b) all inputs are variable
(c) at least one input is variable and one input in fixed
(d) at most one input is variable and one input is fixed
106. In the long run, if a very small factory were to expand its scale of operations, it is
likely that it would initially experience.
(a) an increase in pollution level (b) diseconomies of scale
(c) economies of scale (d) constant returns to scale
107. External economics are enjoyed
(a) By large producers only (b) As firm expands
(c) Both (a) & (b) (d) None of above

108. External Economies of Scale are obtained by

(a) a firm (b) a group of firm
(c) Small Production (d) Society

Answer Key
1 b 2 a 3 a 4 c 5 a 6 c 7 a 8 d 9 a 10 b 11 a 12 d 13 b
14 d 15 c 16 d 17 b 18 c 19 a 20 c 21 b 22 b 23 a 24 c 25 b 26 a
27 d 28 d 29 d 30 d 31 a 32 c 33 a 34 b 35 b 36 c 37 c 38 d 39 b

40 b 41 c 42 c 43 b 44 b 45 c 46 d 47 c 48 c 49 a 50 b 51 c 52 b
53 a 54 a 55 d 56 b 57 c 58 d 59 a 60 b 61 b 62 d 63 c 64 b 65 c
66 a 67 b 68 b 69 c 70 c 71 a 72 d 73 d 74 b 75 a 76 c 77 b 78 a
79 d 80 b 81 b 82 a 83 a 84 c 85 b 86 b 87 b 88 a 89 d 90 a 91 c
92 d 93 b 94 a 95 a 96 a 97 c 98 b 99 b 100 c 101 c 102 b 103 d 104 d
105 b 106 c 107 c 108 b
 THEORY OF COST (UNIT - II) | 3.1

CHAPTER –3 (UNIT – 2) THEORY OF COST

UNIT 2 : THEORY OF COST

 Cost analysis refers to the study of behaviour of cost in relation to one or more
production criteria, namely,
o size of output,
o scale of operations,
o prices of factors of production and
o other relevant economic variables.
 In other words, cost analysis is concerned with the financial aspects of production
relations as against physical aspects which were considered in production
analysis.
COST CONCEPTS
 Accounting Costs and Economic costs:
 An entrepreneur has to pay price for the factors of production which he employs for
production.
 He thus pays
 wages to workers employed,
 prices for the raw materials,
 fuel and power used,
 rent for the building he hires and
 interest on the money borrowed for doing business.
 All these are included in his cost of production and are termed as accounting costs.
 Accounting costs
 Accounting costs relate to those costs which involve cash payments by the
entrepreneur of the firm.
 Thus, accounting costs are explicit costs and includes all the payments and
charges made by the entrepreneur to the suppliers of various productive
factors.
 Accounting costs are expenses already incurred by the firm.
 Accountants record these in the financial statements of the firm.
 Explicit and implicit cost
 generally it happens that an entrepreneur invests a certain amount of capital in his
business.
 If the capital invested by the entrepreneur in his business had been invested
elsewhere, it would have earned a certain amount of interest or dividend.
 Moreover, an entrepreneur may devote his time to his own work of production and
contributes his entrepreneurial and managerial ability to do business.
 Had he not set up his own business, he would have sold his services to others for
some positive amount of money.
 Accounting costs do not include these costs. These costs form part of economic
cost.
 Thus, economic costs include:
(1) the normal return on money capital invested by the entrepreneur himself in his
own business;
(2) the wages or salary not paid to the entrepreneur, but could have been earned if the
services had been sold somewhere else.
 THEORY OF COST (UNIT - II) | 3.2

 Likewise, the monetary rewards for all factors owned by the entrepreneur himself
and employed by him in his own business are also considered a part of economic
costs.
 Economic costs take into account these accounting costs; in addition, they also
take into account the amount of money the entrepreneur could have earned if he
had invested his money and sold his own services and other factors in the next best
alternative uses.
 Accounting costs are also called explicit costs whereas the cost of factors
owned by the entrepreneur himself and employed in his own business is
called implicit costs.
 Thus, economic costs include both accounting costs and implicit costs.
Therefore, economic costs are useful for businessmen while making decisions.
 The concept of economic cost is important because an entrepreneur must cover his
economic cost if he wants to earn normal profits.
 Normal profit is part of implicit costs.
 If the total revenue received by an entrepreneur just covers both implicit and
explicit costs, then he has zero economic profits.
 Super normal profits or positive economic profits (abnormal profits) are over and
above these normal profits.
 In other words, an entrepreneur is said to be earning positive economic profits
(abnormal profits) only when his revenues are greater than the sum of his
explicit costs and implicit costs.
 Outlay costs and Opportunity costs:
 Outlay costs involve actual expenditure of funds on, say, wages, materials, rent,
interest, etc.
 Opportunity cost, on the other hand, is concerned with the cost of the next best
alternative opportunity which was foregone in order to pursue a certain
action.
 It is the cost of the missed opportunity and involves a comparison between the
policy that was chosen and the policy that was rejected.
 For example, the opportunity cost of using capital is the interest that it can earn in
the next best use with equal risk.
 A distinction between outlay costs and opportunity costs
 A distinction between outlay costs and opportunity costs can be drawn on
the basis of the nature of the sacrifice.
 Outlay costs involve financial expenditure at some point of time and hence are
recorded in the booksof account.
 Opportunity cost is the amount or subjective value that is foregone in choosing
one activity over the next best alternative. It relates to sacrificed alternatives; it
is, in general not recorded in the books of account.
 The opportunity cost concept is generally very useful for business managers and
therefore it has to be considered whenever resources are scarce and a
decision involving choice of one option over other(s) is involved.
 e.g., in a cloth mill which spins its own yarn, the opportunity cost of yarn to the
weaving department is the price at which the yarn could be sold.
 This has to be considered while measuring profitability of the weaving
 THEORY OF COST (UNIT - II) | 3.3

operations.
 In long-term cost calculations also opportunity cost is a useful concept e.g., while
calculating the cost of higher education, it is not the tuition fee and cost of
books alone that are relevant.
 One should also take into account the earnings foregone, other foregone uses
of money which is paid as tuition fees and the value of missed activities etc. as
the cost of attending classes.
 Direct or Traceable costs and Indirect or Non-Traceable costs:
 Direct costs are those which have direct relationship with a component of
operation like manufacturing a product, organizing a process or an activity
etc.
 Since such costs are directly related to a product, process or machine, they may vary
according to the changes occurring in these.
 Direct costs are costs that are readily identified and are traceable to a
particular product, operation or plant.
 Even overhead costs can be direct as to a department; manufacturing costs can be
direct to a product line, sales territory, customer class etc. We must know the
purpose of cost calculation beforeconsidering whether a cost is direct or indirect.
 Indirect costs are those which are not easily and definitely identifiable in relation to
a plant, product, process or department.
Therefore, such costs are not visibly traceable to specific goods, services, operations, etc.;
but
 are nevertheless charged to different jobs or products in standard accounting
practice.
 The economic importance of these costs is that these, even though not directly
traceable to a product, may bear some functional relationship to production
and may vary with output in some definite way.
 Examples of such costs are electric power and common costs incurred for
general operation of business benefiting all products jointly.
 Incremental costs and Sunk costs:
 Incremental costs are related to the concept of marginal cost.
 Incremental cost refers to the additional cost incurred by a firm as result of a
business decision.
 For example, incremental costs will have to be incurred by a firm when it
makes a decision to change its product line, replace worn out machinery, buy a
new production facility or acquire a new set of clients.
 Sunk costs refer to those costs which are already incurred once and for all and
cannot be recovered.
 They are based on past commitments and cannot be revised or reversed if the firm
wishes to do so.
 Examples of sunk costs are expenses incurred on advertising, R& D,
specialised equipment and fixed facilities such as railway lines.
 Sunk costs act as an important barrier to entry of firms into business.
 Historical costs and Replacement costs:
 Historical cost refers to the cost incurred in the past on the acquisition of a
 THEORY OF COST (UNIT - II) | 3.4

productive asset such as machinery, building etc.

 Replacement cost is the money expenditure that has to be incurred for replacing
an old asset.
 Instability in prices make these two costs differ.
 Other things remaining the same, an increase in price will make
replacement costs higher than historical cost.
 Private costs and Social costs:
 Private costs are costs actually incurred or provided for by firms and are
either explicit or implicit.
 They normally figure in business decisions as they form part of total cost and are
internalised by the firm.
 Social cost, on the other hand, refers to the total cost borne by the society on
accountof a business activity and includes private cost and external cost.
 It includes the cost of resources for which the firm is not required to pay price such
as
o atmosphere,
o rivers, roadways etc.
o and the cost in terms of dis-utility created such as air, water and
environment pollution.
 Fixed and Variable costs:
 Fixed or constant costs are not a function of output; they do not vary with
output upto a certain level of activity.
 These costs require a fixed expenditure of funds irrespective of the level of
output, e.g., rent, property taxes, interest on loans and depreciation when
taken as a function of time and not of output.
 Fixed costs cannot be avoided.
 These costs are fixed so long as operations are going on. They can be avoided
only when the operations are completely closed down.
 But, there are some costs which will continue even after the operations are
suspended, as for example, for storing of old machines which cannot be sold in the
market.
 These are called shut down costs.
 Some of the fixed costs such as costs of advertising, etc. are programmed fixed
costs or discretionary expenses, because they depend upon the discretion of
management whether to spend on these services or not.
 Variable costs are costs that are a function of output in the production period.
 For example, wages of casual labourers and cost of raw materials and cost of
all other inputs that vary with output are variable costs.
 Variable costs vary directly and sometimes proportionately with output.
 Over certain ranges of production, they may vary less or more than
proportionately depending on the utilization of fixed facilities and resources
during the production process.
COST FUNCTION
 THEORY OF COST (UNIT - II) | 3.5

 Cost function refers to the mathematical relation between cost of a product and the
various determinants of costs.
 In a cost function, the dependent variable is unit cost or total cost and the
independent variables are the price of a factor, the size of the output or any other
relevant phenomenon which has a bearing on cost, such as technology, level of capacity
utilization, efficiency and time period under consideration.
 Cost function is a function which is obtained from production function and the
market supply of inputs.
 It expresses the relationship between costs and output.
 Cost functions are derived from actual cost data of the firms and are presented through
cost curves.
 The shape of the cost curves depends upon the cost function.
 Cost functions are of two kinds:
o short-run cost functions and
o long-run cost functions.
SHORT RUN TOTAL COSTS
 Total, fixed and variable costs:
o variable factor
 There are some factors which can be easily adjusted with changes in
the level of output.
 A firm can readily employ more workers if it has to increase output.
Similarly, it can purchase more raw materials if it has to expand production.
 Such factors which can be easily varied with a change in the level of
output are called variable factors.
o Fixed factors.
o On the other hand, there are some factors such as building, capital
equipment, or top management team which cannot be so easily varied.
o It requires comparatively longer time to make changes in them. It takes
time to install new machinery.
o Such factors which cannot be readily varied and require a longer
period to adjust are called fixed factors.
 short run and long run periods of time
 Short run is a period of time in which output can be increased or decreased by
changing only the amount of variable factors such as, labour, raw materials,
etc.
 In the short run, quantities of fixed factors cannot be varied in accordance
with changes in output.
 If the firm wants to increase output in the short run, it can do so only by
increasing the variable factors, i.e., by using more labour and/or by buying more
raw materials.
 Thus, short run is a period of time in which only variable factors can be varied,
while the quantities of fixed factors remain unaltered.
 On the other hand, long run is a period of time in which the quantities of all
factors may be varied.
 THEORY OF COST (UNIT - II) | 3.6

 In other words, all factors become variable in the long run.

Fixed costs
 Thus, we find that fixed costs are those costs which are independent of output, i.e.,
they do not change with changes in output.
 These costs are a “fixed amount” which are incurred by a firm in the short run,
whether the output is small or large.
 Even if the firm closes down for some time in the short run but remains in
business, these costs have to be borne by it.
 Fixed costs include such charges as
o contractual rent,
o insurance fee,
o maintenance cost,
o property taxes,
o interest on capital employed,
o managers’ salary, watchman’s wages etc. The fixed cost curve is presented in
figure 5.
Completely Fixed Cost

Variable costs,
 Variable costs, on the other hand are those costs which change with changes in output.
 These costs include payments such as wages of casual labour employed, prices of raw
material, fuel and power used,transportation cost etc.
 If a firm shuts down for a short period, it may not use the variable factors of production
and therefore, will not therefore incur any variable cost.
 Curve represents completely variable cost curve drawn under the assumption that
variable costs change linearly with changes in output.
 THEORY OF COST (UNIT - II) | 3.7

Semi Variable Cost

 There are some costs which may increase in a stair-step fashion, i.e., they remain
fixed over certain range of output; but suddenly jump to a new higher level when
output goes beyond a given limit.

 E.g. Costs incurred towards the salary of foremen will have a sudden jump if another
foreman is appointed when the output crosses a particular limit.

A Stair-step Variable Cost

Short run Total Cost Curves

 The total cost of a business is defined as the actual cost that must be incurred for
producing a given quantity of output.
 The short run total cost is composed of two major elements namely, total fixed cost and
total variable cost. Symbolically TC = TFC + TVC.
 In the diagram above, the total fixed cost curve (TFC) is a horizontal straight line
 THEORY OF COST (UNIT - II) | 3.8

parallel to X-axis as TFC remains fixed for the whole range of output.
 This curve starts from a point on the Y-axis meaning thereby that fixed costs will be
incurred even if the output is zero.
 On the other hand, the total variable cost curve rises upward indicating that as
output increases, total variable cost increases.
 The total variable cost curve starts from the origin because variable costs are zero
when the output is zero.
 It should be noted that the total variable cost initially increases at a decreasing rate
and then at an increasing rate with increases in output.
 This pattern of change in the TVC occurs due to the operation of the law of increasing
and diminishing returns to the variable inputs.
 Due to the operation of diminishing returns, as output increases, larger quantities of
variable inputs are required to produce the same quantity of output.
 Consequently, variable cost curve is steeper at higher levels of output.
 The total cost curve has been obtained by adding vertically the total fixed cost curve and
the total variable cost curve.
 The slopes of TC and TVC are the same at every level of output and at each point the two
curves have vertical distance equal to total fixed cost.
 Its position reflects the amount of fixed costs and its slope reflects variable costs.
Short run average costs
 Average fixed cost (AFC) :
 AFC is obtained by dividing the total fixed cost by the number of units of
TFC
AFC=
output produced Q where Q is the number of units produced.

 Thus, average fixed cost is the fixed cost per unit of output.

 For example, if a firm is producing with a total fixed cost of ` 2,000/-. When output
is 100 units, the average fixed cost will be

 And now, if the output increases to 200 units, average fixed cost will be ` 10.
 Since total fixed cost is a constant amount, average fixed cost will steadily fall as
output increases.
 Therefore, if we draw an average fixed cost curve, it will slope downwards throughout
its length but will not touch the X-axis as AFC cannot be zero.
Average variable cost (AVC) :

 Average variable cost is found out by dividing the total variable cost by the number of
TVC
units of output produced, i.e. AVC= where Q is the number of units produced.
Q
 Thus, average variable cost is the variable cost per unit of output.
 Average variable cost normally falls as output increases from zero to normal
capacity output due to occurrence of increasing returns to variable factors.
 THEORY OF COST (UNIT - II) | 3.9

 But beyond the normal capacity output, average variable cost will rise steeply because
of the operation of diminishing returns.
 If we draw an average variable cost curve, it will first fall, then reach a minimum and
then rise.

Short run Average and Marginal Cost Curves

 Average total cost (ATC):

 Average total cost is the sum of average variable cost and average fixed cost. i.e.,
ATC = AFC + AVC.

 It is the total cost divided by the number of units produced, i.e. ATC = TC/Q.

 The behaviour of average total cost curve depends upon the behaviour of the
average variable cost curve and the averagefixed cost curve.

 In the beginning, both AVC and AFC curves fall, therefore, the ATC curve will also fall
sharply.

 When AVC curve begins to rise, but AFC curve still falls steeply, ATC curve continues to
fall.

 This is because, during this stage, the fall in AFC curve is greater than the rise in
the AVC curve, but as output increases further, there is a sharp rise in AVC which
more than offsets the fall in AFC.

 Therefore, ATC curve first falls, reaches its minimum and then rises. Thus, the average
total cost curve is a “U” shaped curve. (Fig.)
 Marginal cost:
 Marginal cost is the addition made to the total cost by the production of an
additional unit of output.
 In other words, it is the total cost of producing t units instead of t-1 units, where t
is any given number.
 For example, if we are producing 5 units at a cost of ` 200 and now suppose the 6th
unit is produced and the total cost is ` 250, then the marginal cost is ` 250 - 200
i.e., ` 50.
 And marginal cost will be ` 24, if 10 units are produced at a total cost of ` 320 [(320-
 THEORY OF COST (UNIT - II) | 3.10

200) / (10-5)]. It is to be noted that marginal cost is independent of fixed cost.

 This is because fixed costs do not change with output. It is only the variable costs
which change witha change in the level of output in the short run.
 Therefore, marginal cost is in fact due to the changes in variable costs. Symbolically
marginal cost may be written as:
TC
MC=
Q

ΔTC=Change in Total cost

ΔQ= Change in Output or
MCn = TCn – TCn-1

 Marginal cost curve falls as output increases in the beginning.

 It starts rising after a certain level of output.
 This happens because of the influence of the law of variable proportions.
 The MC curve becomes minimum corresponding to the point of inflexion on the total
cost curve.
 The fact that marginal product rises first, reaches a maximum and then
declines ensures that the marginal cost curve of a firm declines first, reaches
its minimum and then rises.
 In other words marginal cost curve of a firm is “U” shaped.
The behaviour of these costs has also been shown in Table.
Various Costs

Units Total Total Total Average Average Average Marginal

of fixed variable cost fixed cost variable total cost cost
outp cost cost cost
ut
0 1000 0 1000 – – – –
1 1000 50 1050 1000.00 50.00 1050.00 50
2 1000 90 1090 500.00 45.00 545.00 40
3 1000 140 1140 333.33 46.67 380.00 50
4 1000 196 1196 250.00 49.00 299.00 56
5 1000 255 1255 200.00 51.00 251.00 59
6 1000 325 1325 166.67 54.17 220.83 70
7 1000 400 1400 142.86 57.14 200.00 75
8 1000 480 1480 125.00 60.00 185.00 80
9 1000 570 1570 111.11 63.33 174.44 90
10 1000 670 1670 100.00 67.00 167.00 100
11 1000 780 1780 90.91 70.91 161.82 110
12 1000 1080 2080 83.33 90.00 173.33 300
The above table shows that:
(i) Fixed costs do not change with increase in output upto a given level.
 THEORY OF COST (UNIT - II) | 3.11

(ii) Average fixed cost, therefore, comes down with every increase in output.
(iii) Variable costs increase, but not necessarily in the same proportion as the increase in
output.
(iv) In the above case, average variable cost comes down gradually till 4 units are
produced. Thereafter it starts increasing.
(v) Marginal cost is the additional cost divided by the additional units produced. This
also comes down first and then starts increasing.
Relationship between Average Cost and Marginal Cost:
The relationship between marginal cost and average cost is the same as that between any
other marginal-average quantities. The following are the points of relationship between the
two.
(1) When average cost falls as a result of an increase in output, marginal cost is less
than average cost.
(2) When average cost rises as a result of an increase in output, marginal cost is more
than average cost.
(3) When average cost is minimum, marginal cost is equal to the average cost.
(4) In other words, marginal cost curve cuts average cost curve at its minimum
point (i.e. optimum point).
LONG RUN AVERAGE COST CURVE
 In other words, whereas in the short run the firm is tied with a given plant, in the long
run the firm can build any size or scale of plant and therefore, can move from one plant
to another; it can acquire a big plant if it wants to increase its output and a small
plant if it wants to reduce its output.
 The long run being a planning horizon, the firm plans ahead to build the most
appropriate scale of plant to produce the future level of output.
 Briefly put, the firm actually operates in the short run and plans for the long run.
 Long run cost of production is the least possible cost of producing any given level
of output when all individual factors are variable.
 A long run cost curve depicts the functional relationship between output and the long
run cost of production.
 In order to understand how the long run average cost curve is derived, we consider
three short run average cost curves as shown in Figure.
 These short run average cost curves (SACs) are also called ‘plant curves’. In the
short run, the firm can be operating on any short run average cost curve, given the size
of the plant.
 Suppose that there are the only three plants which are technically possible.
 Given the size of the plant, the firm will be increasing or decreasing its output by
changing the amount of the variable inputs.
 But in the long run, the firm chooses among the three possible sizes of plants as
depicted by short run average curves (SAC1, SAC2, and SAC3).
 In the long run, the firm will examine with which size of plant or on which short run
average cost curve it should operate to produce a given level of output, so that the total
cost is minimum.
 It will be seen from the diagram that up to OB amount of output, the firm will
operate on the SAC1, though it could also produce with SAC2. Up to OB amount of
 THEORY OF COST (UNIT - II) | 3.12

output, the production on SAC1 results in lower cost than on SAC2.

 For example, if the level of output OA is produced with SAC1, it will cost AL per
unit and if it is produced with SAC2 it will cost AH and we can see that AH is more
than AL.
 Similarly, if the firm plans to produce an output which is larger than OB but less than OD,
then it will not be economical to produce on SAC1.
 For this, the firm will have to use SAC2. Similarly, the firm will use SAC3 for output larger
than OD.
 It is thus clear that, in the long run, the firm has a choice in the employment of
plant and it will employ that plant which yields minimum possible unit cost for
producing a given output.
Short Run Average Cost Curves Long Run Average Cost Curves

 Suppose, the firm has a choice so that a plant can be varied by infinitely small gradations
so that there are infinite number of plants corresponding to which there are numerous
average cost curves.
 In such a case the long run average cost curve will be a smooth curve enveloping
all these short run average cost curves.
 As shown in the long run average cost curve is so drawn as to be tangent to each of the
short run average cost curves.
 Every point on the long run average cost curve will be a tangency point with some
short run AC curve.
 If a firm desires to produce any particular output, it then builds a corresponding plant
and operates on the corresponding short run average cost curve.
 As shown in the figure, for producing OM, the corresponding point on the LAC
curve is G and the short run average cost curve SAC2 is tangent to the long run AC
at this point.
 Thus, if a firm desires to produce output OM, the firm will construct a plant
corresponding to SAC2 and will operate on this curve at point G.
 Similarly, the firm will produce other levels of output choosing the plant which
suits its requirements of lowest possible cost of production.
 It is clear from the figure that larger output can be produced at the lowest cost with
larger plant whereas smaller output can be produced at the lowest cost with smaller
plants.
 For example, to produce OM, the firm will be using SAC2 only; if it uses SAC3, it will
result in higher unit cost than SAC2.
 But, larger output OV can be produced most economically with a larger plant
represented by the SAC3.
 If we produce OV with a smaller plant, it will result in higher cost per unit.
 THEORY OF COST (UNIT - II) | 3.13

 Similarly, if we produce larger output with a smaller plant it will involve higher
costs because of its limited capacity.
 The long run average cost curve is often called as ‘planning curve’ because a firm
plans to produce any output in the long run by choosing a plant on the long run
average cost curve corresponding to the given output.
 The long run average cost curve helps the firm in the choice of the size of the plant for
producing a specific output at the least possible cost.
Explanation of the “U” shape of the long run average cost curve:
 As has been seen in the diagram LAC curve is a “U” shaped curve.
 This shape of LAC curve has nothing to do with the U shaped SAC which is due to
variable factor ratio because in the long run all factors are variable.
 U shaped LAC arises due to returns to scale. when the firm expands, returns to
scale increase. After a range of constant returns to scale, the returns to scale
finally decrease.
 On the same line, the LAC curve first declines and then finally rises. Increasing returns
to scale cause fall in the long run average cost and decreasing returns to scale
result in rise in long run average cost.
 Falling long run average cost and increasing economies of scale result from
internal and external economies of scale and rising long run average cost and
diminishing returns to scale result from internal and external diseconomies of
scale.
 The long run average cost curve initially falls with increase in output and after a certain
point it rises making a boat shape. The long-run average cost (LAC) curve is also called
the planning curve of the firm as it helps in choosing an appropriate a plant on the
decided level of output.
 The long-run average cost curve is also called “Envelope curve”, because it
envelopes or supports a family of short run average cost curves from below.
 Empirical evidence shows modern firms face ‘L-shaped’ cost curve over a considerable
quantity of output.
 The L-shaped long run cost curve implies that initially when the output is
increased due to increase in the size of plant (and associated variable factors), per
unit cost falls rapidly due to economies of scale.
 The long-run average cost curve does not increase even after a sufficiently large scale of
output as it continues to enjoy economies of scale.
ECONOMIES AND DISECONOMIES OF SCALE
The Scale of Production
 Large-scale production offers certain advantages which help in reducing the cost of
production.
 Economies arising out of large-scale production can be grouped into two categories; viz.,
o internal economies and
o external economies.
 Internal economies are those economies of production which accrue to the firm when
it expands its output, so that the cost of production would come down considerably and
place the firm in a better position to compete in the market effectively.
 Internal economies arise purely due to endogenous factors relating to efficiency of
the entrepreneur or his managerial talents or the type of machinery used or the
marketing strategy adopted.
 THEORY OF COST (UNIT - II) | 3.14

 These economies arise within the firm and are available exclusively to the expanding
firm.
 On the other hand, external economies are the benefits accruing to each member
firm of the industry as a result of expansion of the industry.
 Internal Economies and Diseconomies: Internal economies and diseconomies are of
the following main kinds:
(i) Technical economies and diseconomies:
 Large-scale production is associated with economies of superior techniques.
 As the firm increases its scale of operations, it becomes possible to use more
specialised and efficient form of all factors, specially capital equipment and
machinery.
 The firm is able to take advantage of composite technology whereby the whole
process of production of a commodity is done as one composite unit.
 Secondly, when the scale of production is increased and the amount of labour and
other factors become larger, introduction of greater degree of division of
labour and specialization becomes possible and as a result cost per unit
declines.
 The firm can reduce the inconvenience and costs associated with the
dependence on other firms by undertaking various processes from the input
supply stage to the final output stage.
Diseconomies of scale
 However, beyond a certain point, of large scale, a firm experiences net
diseconomies of scale.
 This happens because when the firm has reached a size large enough to allow
utilisation of almost all the possibilities of division of labour and
employment of more efficient machinery, further increase in the size of the
plant will bring about high long-run cost because of difficulties of
management.
 When the scale of operations becomes too large, it becomes difficult for the
management to exercise control and to bring about proper coordination.
(ii) Managerial economies and diseconomies:
 Managerial economies refer to reduction in managerial costs. When output
increases, specialization and division of labour can be applied to
management.
 It becomes possible to divide its management into specialized departments
under specialized personnel, such as production manager, sales manager,
finance manager etc.
 If the scale of production increases further, each department can be further sub-
divided;
o for e.g. sales can be split into separate sections such as for advertising,
exports and customer service.
 THEORY OF COST (UNIT - II) | 3.15

 Since individual activities come under the supervision of specialists,

management’s efficiency and productivity will greatly improve.
 Decentralization of decision making and mechanization of managerial functions
further enhance the efficiency and productivity of managers.
Managerial diseconomies
 However, as the scale of production increases beyond a certain limit, managerial
diseconomies set in.
 Communication at different levels such as between the managers and labourers
and among the managers become difficult resulting in delays in decision
making and implementation of decisions already made.
 Management finds it difficult to exercise control and to bring in coordination
among its various departments.
 The managerial structure becomes more complex and is affected by greater
bureaucracy, red tapism, lengthening of communication lines and so on.
 All these affect the efficiency and productivity of management and that of the firm
itself.
(iii) Commercial economies and diseconomies:
 A large firm is able to place bulk orders for materials and components and enjoy
lower prices for them.
 Economies can also be achieved in marketing of the product. If the sales staff is not
being worked to full capacity, additional output can be sold at little or no extra
cost. Moreover, large firms can benefit from economies of advertising.
 As the scale of production increases, advertising costs per unit of output fall.
 In addition, a large firm may also be able to sell its by-products or process it
profitably; something which might be unprofitable for a small firm.
 There are also economies associated with transport and storage.
These economies become diseconomies after an optimum scale.
For example, advertisement expenditure and other marketing overheads will increase more
than proportionately after the optimum scale.
(iv) Financial economies and diseconomies:
 A large firm has advantages over small firms in matters related to
procurement of finance for its business activities.
 It can, for instance, offer better security to bankers and avail of advances
with greater ease.
 On account of the goodwill enjoyed by large firms, investors have greater
confidence in them and therefore would prefer their shares which can be
readily sold on the stock exchange.
 A large firm can thus raise capital at lower cost.
However, these costs of raising finance will rise more than proportionately after the
optimum scale of production.
 THEORY OF COST (UNIT - II) | 3.16

This may happen because of relatively greater dependence on external finances.

(v) Risk bearing economies and diseconomies:
 It is said that a large business with diverse and multi- production capability is in a
better position to withstand economic ups and downs, and therefore, enjoys
economies of risk bearing.
 However, risk may increase if diversification, instead of giving a cover to
economic disturbances, increases these.
External Economies and Diseconomies:
 External economies and diseconomies are those economies and diseconomies
which accrue to firms
 as a result of expansion in the output of the whole industry and they are not
dependent on the output level of individual firms.
 They are external in the sense that they accrue to firms not out of their internal
situation but from outside i.e. due to expansion of the industry.
These are available to one or more of the firms in the form of:
1. Cheaper raw materials and capital equipment:
 The expansion of an industry may result in exploration of new and cheaper
sources of raw material, machinery and other types of capital equipments.
 Expansion of an industry results in greater demand for various kinds of materials
and capital equipment required by it.
 The firm can procure these on a large scale at competitive prices from other
industries.
 This reduces their cost of production and consequently the prices of their
output.
2. Technological external economies:
 When the whole industry expands, it may result in the discovery of new technical
knowledge and in accordance with that, the use of improved and better
machinery and processes than before.
 This will change the technical co-efficient of production and enhance
productivity of firms in the industry and reduce their cost of production.
3. Development of skilled labour:
 When an industry expands in an area, the labourers in that area are well
accustomed with the different productive processes and tend to learn a good
deal from experience.
 As a result, with the growth of an industry in an area, a pool of trained labour is
developed which has a favourable effect on the level of productivity and cost
of the firms in that industry.
4. Growth of ancillary industries:
 Expansion of industry encourages the growth of a number of ancillary
 THEORY OF COST (UNIT - II) | 3.17

industries which specialise in the production and supply of raw materials, tools,
machinery, components, repair services etc.
 Input prices go down in a competitive market and the benefits of it accrue to all
firms in the form of reduction in cost of production.
 Likewise, new units may come up for processing or recycling of the waste
products of the industry.
 This will tend to reduce the cost of production in general.
5. Better transportation and marketing facilities:
 The expansion of an industry resulting from entry of new firms may make
possible the development of an efficient transportation and marketing
network.
 These will greatly reduce the cost of production of the firms by avoiding the need
for establishing and running these services by themselves.
 Similarly, communication systems may get modernised resulting in better
and speedy
 information dissemination.
6. Economies of Information:
 Necessary information regarding technology, labour, prices and products may be
easily and cheaply made available to the firms on account of publication of
information booklets and bulletins by industry associations or by
governments in public interest.
 However, external economies may cease if there are certain disadvantages
which may neutralise the advantages of expansion of an industry. We call
them external diseconomies.
 External diseconomies are disadvantages that originate outside the firm, especially
in the input markets.
 An example of external diseconomies is rise in various factor prices. When an
industry expands the requirement of various factors of production, such as raw
materials, capital goods, skilled labour etc increases.
 Increasing demand for inputs puts pressure on the input markets.
 This may result in an increase in the prices of factors of production, especially
when they are short in supply.
 Moreover, too many firms in an industry at one place may also result in higher
transportation cost, marketing cost and high pollution control cost.
 The government may also, through its location policy, prohibit or restrict the
expansion of an industry at a particular place.

*******************
 THEORY OF COST (UNIT - II) | 3.18

Questions & Answers

1. Suppose that a sole proprietorship is earning total revenues of Rs.100,000 and is
incurring explicit costs of Rs.75,000. If the owner could work for another company for
Rs.30,000 a year, we would conclude that:
(a) the firm is incurring an economic loss.
(b) implicit costs are Rs.25,000.
(c) the total economic costs are Rs.100,000.
(d) the individual is earning an economic profit of Rs.25,000.
2. Is an implicit cost of production.
(a) Wages of the labour. (b) Charges for electricity.
(c) Interest on owned money capital. (d) Payment for raw material.
3. Which cost increases continuously with the increase in production?
(a) Average cost (b) Marginal cost
(c) Fixed cost (d) Variable cost
Read the following paragraph and answer Questions number 4 - 9
Anisha quit her job at a private company where she earned Rs2,90,000 a year. She withdrew
Rs. 4,00,000 in a savings account that earned 10% interest annually to buy a second hand mini
bus to commune passenger between Can naught Place and Noida. There are 1000
passengers who will pay Rs 4000 a year each for commuter services; Rs 2800 from each
passenger goes for petrol, maintenance, depreciation etc.
4. What is Anisha's total revenue from her commuter service?
(a) Rs. 40,00,000 (b) Rs.2, 90,000
(c) Rs, 28, 00,000 (d) Rs 31, 30,000
5. Calculate Anisha's accounting costs?
(a) Rs. 12, 00,000 (b) Rs. 40, 00,000
(c) Rs.28, 00,000. (d) Rs. 8, 70,000.
6. Calculate Anisha's economic cost?
(a) Rs. 3, 30,000 (b) Rs. 40, 000
(c) Rs.28, 00,000. (d) Rs. 31, 30,000.
7. We can say that Anisha:
(a) earned economic profits but suffered accounting loss.
(b) earned economic profits and accounting profits.
(c) suffered economic loss and accounting loss.
(d) earned accounting profits but suffered economic loss.
8. Calculate Anisha's accounting profit/ loss?
(a) Rs. 40, 00,000 (b) Rs. 12, 00,000.
(c) Rs. 8, 70,000. (d) Rs. 2, 90,000.
9. Calculate Anisha's economic profit/ loss?
(a) Rs. 12, 00,000 (b) Rs. 30,000
(c) Rs. 31, 30,000 (d) Rs. 8, 70,000
10. The following are some of the costs of a clothing manufacturer. State which among them
will you consider as fixed cost?
(a) Cost of cloth. (b) Piece wages paid to workers.
(c) Depreciation on machines owing to time. (d) None of the above
11. The cost that firm incurs in hiring or purchasing any factor of production is referred to
as _________________.
(a) explicit cost (b) implicit cost
 THEORY OF COST (UNIT - II) | 3.19

(c) variable cost (d) fixed cost

12. Which of the following is correct?
(a) Firms that earn accounting profits are economically profitable.
(b) Opportunity cost plus accounting cost equals economic cost.
(c) When a firm's demand curve slopes down marginal revenue will rise as output rises.
(d) Firms increase profits by selling more output than their rivals.
Read the following paragraph and answer questions 13 -16
Nicole owns a small pottery factory. She can make 1,000 pieces of pottery per year
and sell them for Rs.100 each. It costs Nicole Rs 20,000 for the raw materials to
produce the 1,000 pieces of pottery. She has invested Rs 100,000 in her factory and
equipment: Rs 50,000 from her savings and Rs 50,000 borrowed at 10 per cent.
(Assume that she could have loaned her money out at 10 percent, too.) Nicole can
work at a competing pottery factory for Rs 40,000 per year.
13. The accounting cost at Nicole's pottery factory is:
(a) Rs. 25000 (b) Rs.50000
(c) Rs. 80000 (d) Rs 75000
14. The economic cost at Nicole's factory is:
(a) Rs. 75000 (b) Rs. 70000
(c) Rs 80000 (d) Rs 30000
15. The accounting profit at Nicole's pottery factory is:
(a) Rs. 30000 (b) Rs.50000
(c) Rs. 80000 (d) Rs 75000
16. The economic profit at Nicole's factory is:
(a) Rs. 75000 (b) Rs. 35000
(c) Rs 80000 (d) Rs 30000
17. Which of the following is not a determinant of the firm's cost function?
(a) The production function (b) The price of labour
(c) Taxes (d) The price of the firm's output
18. Accounting profit is equal to:
(a) Total Revenue - Total variable cost
(b) Total Revenue - Total direct cost
(c) Total Revenue - Total cost
(d) Total Revenue - Total Explicit cost and Total Implicit Cost.
19. Indicate which of the following is a variable cost?
(a) Payment of rent on building (b) Cost of Machinery
(c) Interest payment on Loan taken from bank (d) Cost of raw material
20. The cost incurred on the factor of production is known as:
(a) Accounting cost (b) Economic cost
(c) Marginal cost (d) Implicit cost
21. Which of the following is considerered as economic cost?
(a) The normal return on money capital invested (b) Salary of entrepreneur
(c) The interest on capital invested (d) All of the above
22. Economic cost means
(a) Accounting cost + Implicit cost (b) Accounting cost + Marginal cost
(c) Cash cost + Opportunity cost (d) Implicit cost
 THEORY OF COST (UNIT - II) | 3.20

23. Variable cost includes the cost of

(a) Buying land and building (b) Hire charges of machinery
(c) Insurance premium (d) Material bought
24. Suppose that a sole proprietor is earning total revenue of Rs. 1,20,000 and is
incurring explicit cost of Rs. 90,000. If the owner could work for another company for
Rs. 50,000 a year, we would conclude that:
(a) The firm is incurring an economic profit
(b) The firm is incurring an economic loss
(c) Total economic cost is Rs 2,10,000
(d) The firm is earning economic profit of Rs. 30,000
25. Suppose that an owner is earning total revenue of Rs.1,00,000 and is increasing
explicit cost of Rs.60,000. If the owner could work for another company for
Rs.30,000 a year, we would conclude that:
(a) The firm is earning economic profit or Rs. 10,000
(b) The firm is earning accounting profit or Rs. 40,000
(c) The firm is earning economic profit of Rs. 40,000
(d) Both (a) and (b)
26. Gopal inherited 1 acre of land from his father in 1960. Today the value of that land is
Rs 90 lakh per acre. What is the opportunity cost to Gopal for keeping that land? His
father paid Rs. 50, 000 for this land.
(a) Nothing, since the land was inherited
(b) Rs.50, 000 which his father paid
(c) Rs.90 lakh, since this amount Gopal is getting now if he sells it
(d) Both (b) and (c)
27. The cost which is not connect with production.
(a) TFC (b) TVC
(c) TC (d) None of these
28. Which of the following is not a fixed cost?
(a) Payment of interest on loan (b) Cost of electricity and fuel
(c) Depreciation on building (d) Rent of go down.
29. Direct cost is also known as:
(a) Indirect Cost (b) Traceable Cost
(c) Opportunity Cost (d) Accounting Cost
30. Fixed cost is known as_____________ cost.
(a) Prime (b) Supplementary
(c) Overhead (d) Both (b) and (c)
31. Which of the following is a variable cost in the short run?
(a) Rent of the factory
(b) Wages paid to the factory labour
(c) Interest payments on borrowed financial capital
(d) Payment on the lease for factory equipment
Use Table to answer questions 32 - 34.
Output (O) 0 1 2 3 4 5 6
Total Cost (TC): Rs.240 Rs.330 Rs.410 Rs.480 Rs.540 Rs.610 Rs.690
 THEORY OF COST (UNIT - II) | 3.21

32. The average fixed cost of 2 units of output is :

(a) Rs.80 (b) Rs.85
(c) Rs.120 (d) Rs.205
33. The marginal cost of the sixth unit of output is:
(a) Rs.133 (b) Rs.75
(c) Rs.80 (d) Rs.450
34. Diminishing marginal returns starts to occur between units:
(a) 2 and 3 (b) 3 and 4
(c) 4 and 5 (d) 5 and 6
35. The vertical difference between TVC and TC is equal to:
(a) MC. (b) AVC.
(c) TFC. (d) None of these.
Use Table to answer questions 36 - 39
"Bozzo's burgers is a small restaurant and a price taker. The table below provides
the data of Bozzo'soutput and costs in Rupees.
Quantity Total Fixed Variable Average Average total Marginal
Cost Cost Cost variable Cost Cost
Cost
0 100 – – – – –
10 210 – – – – –
20 300 – – – – –
30 400 – – – – –
40 540 – – – – –
50 790 – – – – –
60 1060 – – – – –

36. If burgers sell for Rs14 each, what is Bozzo's profit maximizing level of output :
(a) 10 burgers (b) 40 burgers
(c) 50 burgers (d) 60 burgers
37. What is the total variable cost when 60 burgers are produced?
(a) Rs. 690 (b) Rs.960
(c) Rs.110 (d) Rs.440

38. What is average fixed cost when 20 burgers are produced?

(a) Rs. 5 (b) Rs.3.33
(c) Rs. 10 (d) Rs. 2.5

39. Between 10 to 20 burgers, what is the marginal cost (per burger)?

(a) Rs. 11 (b) Rs. 13
(c) Rs 14 (d) Rs. 9

40. Suppose that a sole proprietorship is earning total revenues of Rs.2,00,000 and is
incurring explicit costs of Rs.1,50,000. If the owner could work for another company for
Rs.60,000 a year, we would conclude that:
(a) the firm is incurring an economic loss.
(b) implicit costs are Rs.50,000.
 THEORY OF COST (UNIT - II) | 3.22

(c) the total economic costs are Rs.2,00,000.

(d) the individual is earning an economic profit of Rs.50,000.

41. When __________________________ , we know that the firms must be producing at the minimum
point of the average cost curve and so there will be productive efficiency .
(a) AC=AR (b) MC=AC
(c) MC=MR (d) AR=MR
42. All of the following are U shaped curves except the:
(a) AVC curve. (b) AFC curve.
(c) AC curve. (d) MC curve.
43. The MC curve cuts the AVC and ATC curves
(a) At the falling part of each. (b) At different points.
(c) At their respective minimas. (d) At the rising part of each.

Mr X and Co. operates in a perfectly competitive market. He sells his product at Rs. 8 per unit.
His fixed costs are Rs 100. His other costs are given below. Read the following table and answer
questions 44 -50.
Output Variable Cost Fixed Cost Total Cost Marginal Cost
0 0 - - -
1 5 - - -
2 11 - - -
3 18 - - -
4 26 - - -
5 36 - - -
6 50 - - -
44. What is Mr X and Co's total cost when 4 units are produced?
(a) Rs. 126 (b) Rs 100
(c) Rs. 26 (d) Rs. 8
45. When Mr. X and Co's production increases from 5 to 6 units, his marginal cost becomes?
(a) Rs. 8 (b) Rs. 14
(c) Rs. 10 (d) Rs. 6
46. The average fixed cost of producing 4 units is:
(a) Rs 1.50 (b) Rs 2.25.
(c) Rs. 25 (d) Rs. 3.00.
47. The average total cost of producing 6 units is:
(a) Rs. 2.50. (b) Rs. 3.00.
(c) Rs. 25. (d) Rs. 30.
48. When will Mr X and Co maximize profits?
(a) When 4 units are produced. (b) When 5 units are produced.
(c) When the company shuts down. (d) When 3 units are produced.
49. What is the average total cost in producing 20 units, if fixed cost is Rs.5000 and
Average variable cost is Rs. 2/-?
(a) 250 (b) 260
(c) 258 (d) 252
 THEORY OF COST (UNIT - II) | 3.23

50. For producing 100 units Total variable cost is Rs.500 & Total fixed cost is
Rs.1000.Compute Average Cost.
(a) 10 (b) 15
(c) 5 (d) 20
51. Which of the following cost curves is never 'U' shaped ?
(a) Average cost curve (b) Marginal cost curve
(c) Average variable cost curve (d) Average fixed cost curve
52. In the short run, when the output of a firm increases, its average fixed cost:
(a) increases (b) decreases
(c) remains constant (d) first declines and then rises
53. The cost of one thing in terms of the alternative given up is known as:
(a) production cost (b) physical cost
(c) real cost (d) opportunity cost
54. Which cost increases condnuously with the increase in production?
(a) Average cost (b) Marginal cost
(c) Fixed cost (d) Variable cost
55. A firm's average total cost is Rs. 300 at 5 units of output and Rs. 320 at 6 units of
output the marginal cost of producing the 6th unit is:
(a) Rs. 20 (b) Rs. 120
(c) Rs. 320 (d) Rs. 420
56. Which of the following statements is true of the relationship among the average cost
functions?
(a) ATC = AFC = AVC (b) AVC = AFC+ATC
(c) AFC = ATC + AVC (d) AFC = ATC – AVC

57. A firm's average fixed cost is Rs. 20 at 6 units of output What will it be at 4 units of
output?
(a) Rs. 60 (b) Rs. 30
(c) Rs. 40 (d) Rs. 20
58. The average fixed cost:
(a) remains the same whatever the level of output
(b) increase as output increases
(c) diminishes as output increases
(d) all of the above
59. Average variable cost curve :
(a) slopes downwards at first and then upwards
(b) slopes upwards, then remains constant and then falls
(c) slopes downwards
(d) none of the above
60. If a firm produces zero output in the short period
(a) its total cost will be zero (b) its variable cost will be positive
(c) its fixed cost will be positive (d) its average cost will be zero
 THEORY OF COST (UNIT - II) | 3.24

61. The average total cost of producing 50 units is Rs. 250 and total fixed cost is
Rs.1000. What is the average fixed cost of producing 100 units?
(a) Rs. 10 (b) Rs.30
(c) Rs. 20 (d) Rs. 5
62. The MC curve cuts the AVC and ATC curves
(a) at different points
(b) at the falling parts of the each curve
(c) at their respective minima
(d) at the rising parts of each curve

63. Average fixed cost can not be:

(a) Less than one (b) One
(c) Zero (d) Greater than one
64. If firm's average cost curve is falling then marginal curve must be :
(a) Falling (b) Rising
(c) below average cost curve (d) None of the above
65. Which of the following statements is false?
(a) For equilibrium the main condition is MC=MR
(b) AR curve and Demand curve are same
(c) MC and AC curves are U-shaped in every market
(d) None of the above
66. Marginal costs are closely associated with:
(a) Variable cost (b) Total fixed cost
(c) Average cost (d) Total cost
67. Which of the following is correct?
(a) Marginal cost is always less than the average cost.
(b) Marginal cost is always more than the average cost.
(c) Marginal cost is always equal to the average cost at its minimum point.
(d) Marginal cost is always equal to the average cost
68. When average cost curve is rising then, marginal cost
(a) Must be decreasing
(b) Must be above the average cost curve
(c) Must be constant
(d) Must be equal to average cost

69. A firm has producing 7 units of output has an average total cost of Rs. 150 and has to pay
Rs. 350 to its fixed factors of production whether it produces or not. How much of the
average total cost is made up of variable cost?
(a) 200 (b) 50
(c) 300 (d) 100
70. A firm has variable cost of Rs.1,000 at 5 units of output. If fixed cost are Rs.400, what will
be the average total cost at 5 units of output?
(a) 380 (b) 280
(c) 60 (d) 400
 THEORY OF COST (UNIT - II) | 3.25

71. Use following table to answer questions 71 -75

Quantity Variable Cost Fixed Cost Total Cost AVC ATC MC
0 0 - - - - -
5 25 - - - - -
10 470 - - - - -
15 700 - - - - -
20 980 - - - - -
25 1350 - - - - -
30 1850 - - - - -
35 2520 - - - - -
40 3400 - - - - -
45 4530 - - - - -
50 5950 - - - - -
A firm operating in perfect competition sells as much as of its products as it chooses
at a market price of Rs. 100 per unit. It Fixed cost is Rs. 300 and its Variable cost for
different levels of production are shown inthe above table
72. When production is 40 units, the average cost is :
(a) Rs. 4.40 (b) Rs. 7.50
(c) Rs. 85 (d) Rs. 92.50
73. In the table, marginal cost per unit that corresponds to 40 units of production is:
(a) Rs. 22 (b) Rs. 85
(c) Rs. 176 (d) Rs. 880
74. To maximize profit the firm should produce :
(a) 15 units (b) 30 units
(c) 35 units (d) 50 units
75. If the market price drops from Rs. 100 to Rs. 56 per unit, the firm's short run response
should be
(a) Shut down
(b) Produce 5 units
(c) Produce 20 units
(d) Continue to produce the same number of units as before the drop in price
Use following table to answer question No. 76 to 79
Mohan sweets is a small restaurant and a price taker. The table below provides
the data of Mohan'ilSandwich output and costs in Rupees
Quantity TC TFC TVC AVC AC MC
0 100 - - - - -
10 210 - - - - -
20 300 - - - - -
30 400 - - - - -
40 540 - - - - -
50 790 - - - - -
60 1060 - - - - -
 THEORY OF COST (UNIT - II) | 3.26

76. If Sandwiches are being sold for Rs. 14 each, what is Mohan's profit maximising level of
output?
(a) 10 Sandwiches (b) 40 Sandwiches
(c) 50 Sandwiches (d) 60 Sandwiches
77. What is the total variable cost when 60 sandwiches are produced?
(a) Rs. 690 (b) Rs. 960
(c) Rs. 110 (d) Rs. 440
78. What is average fixed cost when 20 sandwiches are produced?
(a) Rs. 5 (b) Rs. 3.33
(c) Rs. 10 (d) Rs. 2.5
79. Between 10 to 20 sandwiches, what is the marginal cost per sandwich?
(a) Rs. 11 (b) Rs. 13
(c) Rs. 14 (d) Rs. 9
80. In the short run, when the output of a firm increases its average fixed cost:
(a) Increases (b) Decreases
(c) Remains constant (d) First declines then rise
Use the following data to answer questions 81 - 83
Output Total Cost
0 240
1 330
2 410
3 480
4 540
5 610
6 690
81. The Average fixed cost of 2 units of output is:
(a) Rs. 80 (b) Rs. 85
(c) Rs 120 (d) Rs. 205
82. The marginal cost of the sixth unit of output is:
(a) Rs. 133 (b) Rs. 75
(c) Rs. 80 (d) Rs. 450
83. Diminishing marginal returns start to occur between units:
(a) 2 and 3 (b) 3 and 4
(c) 4 and 5 (d) 5 and 6
84. Suppose Mohan & Co. produces 10 units of output and incurs Rs. 30 per unit of variable
cost and Rs. 5 per unit of fixed cost. In this case, total cost is:
(a) Rs. 300 (b) Rs. 35
(c) Rs. 305 (d) Rs. 350
85. Suppose the short run cost function can be written as TC=250+10Q. Average Fixed cost
equals:
(a) 250/Q (c) 250
(c) 10 (d) 250/Q+10
 THEORY OF COST (UNIT - II) | 3.27

86. TCn -TCn-1 = which cost function?

(a) Marginal Cost (b) Average Cost
(c) Total Cost (d) None of the above
87. The relationship between the AC and MC is that
(a) MC will always be less than the AC
(b) MC will be more than AC when MC is falling
(c) MC will be more than AC when AC is rising
(d) None of the above
88. U-shaped average cost curve is based on :
(a) Law of increasing cost (b) Law of decreasing cost
(c) Law of constant returns to scale (d) Law of variable proportions
89. Average fixed cost can be obtained through :
TFC EC
(a) AFC = (b) AFC =
TU TU
TC TFC
(c) AFC = (d) AFC =
PC Q
90. AFC curve is :
(a) Convex & downward sloping (b) Concave & downward sloping
(c) Convex & upward sloping (d) Concave & upward rising
91. When shape of average cost curve is upward, marginal cost :
(a) Must be decreasing (b) Must be constant
(c) Must be rising (d) Any of these
92. Which of the following curves never touch any axes but is downward ?
(a) Marginal cost curve (b) Total cost curve
(c) Average fixed cost curve (d) Average variable cost curve
93. Average Fixed Cost = Rs 20 Quantity Produced = 10 units
What will be the Average Fixed Cost of 20th unit?
(a) Rs. 10 (b) Rs. 20
(c) Rs. 5 (d) None
94. If a firm's output is zero, then
(a) AFC will be positive (b) AVC will be zero
(c) Both of (a) and (b) (d) None of (a) and (b)
95. Calculate total cost of 4 units :
Units Total Cost (Rs) Marginal Cost
(RS)
2 80 40
4 - 30
(a) 140 (b) 120
(c) 50 (d) 40
96. From the following details, find out the average variable cost of 10 units:
OUTPUT : 0 10 20
Total Cost: Rs. 200 Rs. 400 Rs. 800
(a) Rs. 40 (b) Rs. 20
(c) Rs. 200 (d) Rs. 400
 THEORY OF COST (UNIT - II) | 3.28

97. The total cost incurred for 10 units is Rs. 400 and 20 units is Rs. 800. Find the
marginal cost.
(a) Rs. 400 (b) Rs. 40
(c) Rs. 200 (d) Rs. 20
98. Payment made to outsiders for their goods and services are called:
(a) Opportunity Cost (b) Real Cost
(c) Explicit Cost (d) Implicit cost
99. The average fixed cost for producing an output of 6 units of a product by a firm is Rs.
30. The same cost for producing an output of 4 units will be Rs. ________________.
(a) 50 (b) 45
(c) 25 (d) 20
100. Total cost in the short run is classified into fixed costs and variable costs.
Which one of the following is a variable cost?
(a) Cost of raw materials (b) Cost of equipment
(c) Interest payment on past borrowings (d) payment of rent of building
101. Which of the following statement is correct?
(a) When the average cost is rising, the marginal cost must also be rising.
(b) When the average cost is rising, the marginal cost must be falling.
(c) When the average cost is rising, the marginal cost is above the average cost.
(d) When the average cost is falling, the marginal cost must be rising.
102. Which of the following is true of the relationship between the marginal cost
function and the average costfunctions?
(a) If MC is greater than ATC, then ATC is falling.
(b) The ATC curve intersects the MC curve at minimum MC.
(c) The MC curve intersects the ATC curve at minimum ATC.
(d) If MC is less than ATC, then ATC is increasing.
103. Suppose output increases in the short run. Total cost will:
(a) increase due to an increase in fixed costs only.
(b) increase due to an increase in variable costs only.
(c) increase due to an increase in both fixed and variable costs
(d) decrease if the firm is in the region of diminishing returns.

104. Identify the fixed cost from the following:

(a) Labour cost (b) Electricity bill
(c) Salary of watchman (d) Cost of raw materials
105. When marginal costs are below average total costs,
(a) average fixed costs are rising
(b) average total costs are falling
(c) average total costs are rising
(d) average total costs are minimized
106. If the average cost is falling, then:
(a) Marginal cost is rising
(b) Marginal cost is falling
 THEORY OF COST (UNIT - II) | 3.29

(c) Marginal cost is equal to average cost

(d) It is impossible to tell if marginal cost is rising or falling
107. The difference between average total cost and average variable cost:
(a) is constant (b) is total fixed cost
(c) gets narrow as output decreases (d) is the average fixed cost
108. The marginal cost for a firm of producing the 9th unit of output is Rs. 20. Average
cost at the same level of output is Rs. 15. Which of the following must be true?
(a) marginal cost and average cost are both falling.
(b) marginal cost and average cost are both rising.
(c) marginal cost is rising and average cost is falling
(d) It is impossible to tell if either of the curve are rising or falling
109. Which of the following statements is correct.
(a) Fixed costs vary with change in output
(b) If we add total variable cost and total fixed cost we get the average cost
(c) Marginal cost is the result of total cost divided by number of units produced
(d) Total cost is obtained by adding up the fixed cost and total variable cost
110. ___________________________Is also known as planning curve.

(a) Long run average cost curve (b) Short run average cost curve
(c) Average variable cost curve. (d) Average total cost curve.
111. You are given the following data:
Table 1
Output Total Costs
0 0
1 15
2 30
3 45
4 60
5 75
The above data is an example of:

(a) constant returns to scale. (b) decreasing returns to scale.

(c) increasing returns to scale. (d) globalization.
112. Marginal cost is defined as :
(a) the change in total cost due to one unit change in output
(b) total cost divided by output
(c) the change in output due to a one unit change in an input
(d) total product divided by the quantity of input
113. The LAC curve
(a) Falls when the LMC curve falls
(b) Rises when the LMC curve rises
(c) Goes through the lowest point of the LMC curve
(d) Falls when LMC < LAC and rises when LMC > LAC
 THEORY OF COST (UNIT - II) | 3.30

114. Which is the other name that is given to the Long run average cost curve?
(a) Envelope curve (b) Profit curve
(c) Demand curve (d) Supply Curve
115. Long run does not have:
(a) Average Cost (b) Total Cost
(c) Fixed Cost (d) Variable Cost
116. Which of the following statements concerning the long-run average cost curve is false?
(a) It represents the leas-cost input combination for producing each level of output.
(b) It is derived from a series of short-run average cost curves.
(c) The short-run cost curve at the minimum point of the long-run average cost curve
represents the least-cost plant size for all levels of output.
(d) As output increases, the amount of capital employed by the firm increases along the
curve
117. The negatively-sloped (i.e. falling) part of the long-run average total cost curve is
due to which of thefollowing?
(a) Diseconomies of scale
(b) Diminishing returns
(c) The difficulties encountered in coordinating the many activities of a large firm.
(d) The increase in productivity that results from specialization.
118. The positively sloped (i.e. rising) part of the long run average total cost curve is
due to which of the following?
(a) Diseconomies of scale
(b) Increase returns
(c) The firm being able to take advantage of large-scale production techniques as it
expands its output.
(d) The increase in productivity that results from specialization
119. A firm has a variable cost of Rs. 1000 at 5 units of output. If fixed costs are Rs. 400,
what will be the average total cost at 5 units of output?
(a) Rs. 280 (b) Rs. 60
(c) Rs. 120 (d) Rs. 1400
120. Which of the following statement is incorrect?
(a) The LAC curve is also called the planning curve of a firm
(b) Total revenue = price per unit x number of units sold
(c) Opportunity cost is also called alternative cost
(d) If total revenue is dived by the number of units sold we get marginal revenue
121. LAC curve is the 'envelope' of
(a) Short-run AVC curves (b) Short -run AC curves
(c) Short-run MC curves (d) None of these
122. if there are implicit costs of production :
(a) economic profit will be equal to accounting profit
(b) economic profit will be less then accounting profit
(c) economic profit will be zero
(d) economic profit will be more then accounting profit
 THEORY OF COST (UNIT - II) | 3.31

123. Which of the following is not the name of LAC curve?

(a) Planning Curve (b) Enveloping curve
(c) Round curve (d) None of the above
124. Which of the following is incorrect?
(a) The shape of the average cost and marginal cost curve is 'U'
(b) The AR and MR curves of a firm under perfect competition are parallel to X-axis.
(c) At Equilibrium AR = MR
(d) At Equilibrium MC = MR
125. Which of the following is incorrect?
(a) The shape of average cost is U-shaped
(b) MC Curve cuts AC curve at the minimum level of AC
(c) The AR and MR curves of the industry under perfect competition are parallel to X
axis
(d) MC curve cuts AVC curve at the minimum level of AVC.

Answer Key
1 a 2 c 3 d 4 a 5 c 6 d 7 b 8 b 9 d 10 c 11 a 12 b 13 a
14 b 15 d 16 d 17 d 18 c 19 d 20 a 21 d 22 a 23 d 24 b 25 d 26 c
27 a 28 b 29 b 30 d 31 b 32 c 33 c 34 c 35 c 36 b 37 b 38 a 39 d
40 a 41 b 42 b 43 c 44 A 45 b 46 c 47 c 48 a 49 d 50 b 51 d 52 b
53 d 54 d 55 d 56 d 57 b 58 c 59 a 60 c 61 a 62 c 63 c 64 c 65 d
66 a 67 c 68 b 69 d 70 b 71 – 72 d 73 c 74 b 75 c 76 b 77 b 78 a
79 d 80 b 81 c 82 c 83 c 84 d 85 a 86 a 87 c 88 d 89 d 90 A 91 c
92 c 93 a 94 c 95 a 96 b 97 b 98 c 99 b 100 a 101 c 102 c 103 b 104 C
105 b 106 d 107 d 108 b 109 d 110 a 111 a 112 a 113 d 114 a 115 c 116 c 117 d
118 a 119 a 120 d 121 b 122 b 123 c 124 c 125 c
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.1

CHAPTER – 4 PRICE DETERMINATION IN DIFFERENT MARKETS

PRICE DETERMINATION IN DIFFERENT MARKETS

UNIT -1: MEANING AND TYPES OF MARKETS

Concept
 In common parlance, price signifies the quantity of money necessary to acquire a
good or service.
 Price connotes money-value i.e. the purchasing power of an article expressed in terms
of money.
 In other words, price expresses the value of a thing in relation to money i.e. the
quantity of money for which it will be exchanged.
 Value in exchange or exchange value,
o According to Ricardo, means command over commodities in general, or power
in exchange over purchasable commodities in general.
 We need to distinguish between two important concepts namely, ‘value in use’ and
‘value in exchange’.
o Value in use refers to usefulness or utility i.e the attribute which a thing may
have to satisfy human needs.
o Value in exchange or economic value is the amount of goods and services which
we may obtained in the market in exchange of a particular thing.
 In Economics, we are only concerned with exchange value.
o Considerations such as sentimental value mean little in a market economy.
o Sentimental value is subjective and reflects an exaggerated judgment about the
worth of a commodity.
o For example, If a person says to his best friend that I like your car and if you give it
to me then I will be lifetime obliged to you. In this case, lifetime obligation is a
sentimental value and has no meaning as against monetary consideration.
Meaning of Market
 A market is a collection of buyers and sellers with the potential to trade. The actual
or potential interactions of the buyers and sellers determine the price of a product or
service.
 A market need not be formal or held in a particular place.
 Second-hand cars are often bought and sold through newspaper advertisements.
 Second-hand goods may be disposed off by listing it in an online shop or by placing a
card in the local shop window.
 In the present high tech world, goods and services are effortlessly bought and sold
online. Online shopping has revolutionized the business world by making nearly
everything people want available by the simple click of a mouse button
 Market can be defined, where buyers and sellers of a goods services influence
price.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.2

The elements of a market are:-

(a) Buyers & Sellers.
(b) A Product and Service.
(c) Bargaining for a Price.
(d) Knowledge about market conditions.
(e) One price for a product on service at a given time.
Classification of Market:-
On the basis of Area:-
Local Market:-
 When buyers and sellers are limited to a local area or region, the market is called a
local market.
 It's a market for perishable goods like butter, milk, vegetable etc.
 It's economic from point of cost.
 Bulky articles like bricks, sand, stone etc. will have local market.
Regional Market:-
 Regional markets cover a wider area such as a few adjacent cities, parts of states, or
cluster of states.
 The size of the market is generally large and the nature of buyers may vary in their
demand characteristics.
 For eg. Mekhela Chador (Traditional Assamese Saree) is primarily worn by women
in Assam and adjoining areas.
National Market:-
 When the demand for a commodity or service is limited to the national boundaries
of a country, we say that the product has a national market.
 The trade policy of the government may restrict the trading of a commodity to
within the country.
 For example market for durable goods & industrial items.
International Market:-
 A commodity is said to have international market when it is exchanged internationally.
 Usually, high value and small bulk commodities are demanded and traded
internationally.
 For example Gold and Silver are examples of commodities that have international
market.
On the basis of time
Alfred Marshall conceived the “Time” element is marketing.
Very-Short period Market:-
 Market period or very short period refers to a period of time in which supply is fixed and
cannot be increased or decreased.
 Commodities like vegetables, flower, fish, eggs, fruits, milk, etc., which are perishable
and the supply of which cannot be changed in the very short period come under
this category.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.3

 Since supply is fixed, very short period price is dependent on demand. An increase in
demand will raise the prices vice versa.
Short- Period Market:-
 Short period is a period which is slightly longer than the very short period.
 In this period, the supply of output may be increased by increasing the employment of
variable factors with the given fixed factors and state of technology.
 Since supply can be moderately adjusted, the changes in the short period prices on
account of changes in demand are less compared to market period.
Long- Period Market:-
 In the long period, all factors become variable and the supply of commodities may
be changed by altering the scale of production.
 As such, supply may be fully adjusted to changes in demand conditions.
 The supply of commodities may be increased by installation of new machinery, or
establishment of plant.

Very Long Period or Secular Period:-

 is one when secular movements are recorded in certain factors over a period of time.
The period is very long.
 The factors include the size of the population, capital supply, supply of raw
materials etc.
On the basis of Nature of Transactions:-
Spot Market:-
 Spot transactions or spot markets refer to those markets where goods are exchanged
for money payable either immediately or within a short span of time.
 For example, grains sold in the Mandi at the current prices and cash is payable
immediately are thus part of Spot Market.
 It refers to those market where goods are physically transacted on the spot.

Future Market:-
 In this market, transactions involve contracts with a promise to pay and deliver goods at
some future date.
 For example, purchase of foreign currency contract at future rate from bank.
On the basis of Regulation:-
Regulated Market:-
 In this market, transactions are statutorily regulated so as to put an end to unfair
practices.
 Such markets may be established for specific products or for a group of products. For
example, stock exchange.

Unregulated Market:-
 It is also called a free market as there are no stipulations on the transactions.
 For example. Weekly markets (Haat Bazaar).
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.4

On the basis of volume of Business:-

Wholesale Market:-
 The wholesale market is the market where the commodities are bought and sold in bulk
or large quantities.
 Transactions generally take place between traders. i.e. Business to Business (B2B).
Retail Market:-
 When the commodities are sold in small quantities, it is called retail market.
 This is the market for ultimate consumers. i.e. Business to Consumer (B2C).
On the basis of Competitions:–
Perfect competition
Imperfect Competition
TYPES OF MARKET STRUCTURES:-
Perfect Competition:-
 A market where there are large number of buyers & sellers within identical goods.
Monopolistic Competition:-
 There are many sellers of offering differentiated products to many buyers.
Monopoly:-
 A market where a single seller has a control over supply with no substitute on competitive
goods.
Oligopoly:–
 There are a few sellers selling competing products for many buyers.
CONCEPTS OF TOTAL REVENUE, AVERAGE REVENUE AND MARGINAL REVENUE
Total Revenue:
 If a firm sells 100 units for ` 10 each, It realises ` 1,000 (100 x 10), which is
nothing but the total revenue for the firm.
 Symbolically, total revenue may be expressed as TR = P x Q.
Where, TR is total revenue
P is price of a commodity sold.
Q is quantity of a commodity sold.
This may be represented by the following diagrams.
 In figure A, when the price of the product is ` 30, the quantity sold is 40 units.
 The total revenue is P x Q = ` 1200.
 Panel B shows the total revenue curve of a competitive firm having a perfectly elastic
demand curve.
 Since the firm can sell any quantity at market determined prices, the TR curve is linear
and starts from the origin.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.5

Average Revenue:
 Average revenue is the revenue earned per unit of output.
 It is nothing but price of one unit of output because price is always per unit of a
commodity.
 For this reason, average revenue curve is also the firms demand curve.
 Symbolically, average revenue is:
AR= TR/Q
AR = Average revenue
TR = Total revenue
Q = no. of units sold
P×Q
Or AR=
Q
 If, for example, a firm realises total revenue of ` 1,000 by the sale of 100 units, it implies
that the average revenue is ` 10 (1,000/100) or the firm has sold the commodity at a price
of ` 10 per unit.
Marginal Revenue:
 Marginal revenue (MR) is the change in total revenue resulting from the sale of an
additional unit of the commodity.
 Thus, if a seller realises ` 1,000 while selling 100 units and ` 1,200 while selling 101 units,
we say that the marginal revenue is ` 200.
 We can say that MR is the rate of change in total revenue resulting from the sale of an
TR
additional unit of output. MR=
Q
 MRn = TRn– TRn-1
 Where TR is the total revenue when sales are at the rate of n units per period.
 TRn-1 is the total revenue when sales are at the rate of (n – 1) units per period.

Units Total Revenue Average Marginal

Revenue Revenue
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
7 28 4 -2
8 24 3 -4
9 18 2 -6
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.6

In order to understand the above concepts clearly, look at Table -2. In column 1, the
number of units sold of commodity X is given. Column 2 shows the total revenue fetched
by selling different units. Column 3 shows average revenue which is nothing but price per
unit. Column 4 shows marginal revenue which is addition to the total revenue by the sale of
an additional unit of output.
Note that the total revenue is maximum when 5 units of X are sold. It stays constant for one
more unit and then begins to fall. Average revenue keeps on falling showing inverse
relationship between price and quantity demanded. It represents demand function of X to
the firm. Marginal revenue keeps on falling and after becoming zero it becomes negative.
Also note that TR at any particular level of output is the sum of marginal revenues till that
level of output which can be expressed as:-
TR= ∑MR
The question which arises is: why is the marginal revenue due to the third unit (` 6) not
equal to price of ` 8 at which the third unit is sold. The answer is that when price is reduced
for selling an additional unit, the two units which could be sold for ` 9 before will have to be
sold at the reduced price of ` 8 per unit. The total loss on previous two units due to price
fall will be equal to ` 2. Thus, for any falling average revenue (or price) schedule,
marginal revenue is always less than the price. In the case of constant average revenue (or
price) schedule, the marginal revenue is equal to average revenue (or uniform price). If TR
stands for total revenue and q stands for output, marginal revenue (MR) can be expressed
as:
MR = dTR/dQ
dTR/ dQ indicates the slope of the total revenue curve.
When the demand curve of the firm is a normal downward sloping one, there is a well-
defined relationship between average revenue, marginal revenue and total revenue. This
can be shown by the following figure presenting total revenue (TR), average revenue (AR)
and marginal revenue (MR) curves. The average revenue curve in panel B is sloping
downwards depicting the inverse relationship between price and quantity demanded. MR
curve lies below AR curve showing that marginal revenue declines more rapidly than
average revenue. Total revenue increases as long as marginal revenue is positive and
declines (has a negative slope) when marginal revenue is negative. Total revenue curve
initially increases at a diminishing rate due to diminishing marginal revenue and reaches
maximum and then it falls. When marginal revenue becomes zero, the total revenue is
maximum and the slope of TR is zero.

Fig. 2: Total Revenue, Average Revenue and Marginal Revenue Curves of a Firm which
has downward Sloping Demand Curve
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.7

It may be noted that in all forms of imperfect competition, the average revenue curve of
an individual firm slopes downwards as in these market forms, when a firm increases the
price of its product, its quantity demanded decreases and vice versa. Under perfect
competition, however, since the firms are price takers, the average revenue (or price)
curve or demand curve is perfectly elastic. Perfectly elastic average revenue curve means
that an individual firm has constant average revenue (or price). When price remains
constant, marginal revenue will be equal to average revenue and thus AR curve and MR
curve will coincide and will be horizontal curves as shown in figure 3. below.

Fig 3: Average Revenue and Marginal Revenue Curves of a Perfectly Competitive Firm

Relationship between Marginal Revenue, Average Revenue and Elasticity & Demand:-
 MR = AR x e -1/e
 Marginal revenue corresponding to the middle point of the demand curve will be zero.
 If e=1, MR WILL BE Zero.
 If e>1, MRWILL BE positive
 If e<1, MR WILL BE Negative
 MR AR and price elasticity of demand are uniquely related to one another.
 In a straight line demand curve, at middle point ep = 1
 So at middle point MR = 0
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.8

 In a straight line downward falling demand curve, we know that the coefficient of
price elasticity at the middle point is equal to one.
 It follows that the marginal revenue corresponding to the middle point of the demand
curve (or AR curve) will be zero.
 On the upper portion of the demand curve, where the elasticity is more than one,
marginal revenue will be positive and on the lower portion of the demand curve
where elasticity is less than one, marginal revenue will be negative.
Behavioural Principles
 A firm should not produce at all if TR from its product does not equal or exceed to TVC.
 If a firm’s total revenues are not enough to make good even the total variable
costs, it is better for the firm to shut down.
 In other words, a competitive firm should shut down if the price is below AVC.
 In that case, it will minimise loss because then its total cost will be equal to its fixed
costs and it will have an operating loss equal to its fixed cost.
 This means that the minimum average variable cost is equal to the shut-down
price, the price at which the firm ceases production in the short run.

 It will be profitable to the firm to expand output where

 MR > MC and to keep expanding output untill MR = MC.
 MC, should cut MR from below.
 Marginal revenue curve slopes downwards and marginal cost curve slopes
upwards.
 They intersect each other at point E (MC= MR) which corresponds to output Q.* Up
to Q* level of output, marginal revenue is greater than marginal cost and at output
level *Q they are equal.
 The firm will be maximizing profits at E (or at Q* level of output).
 For all levels of output less than Q*, additional units of output add more to revenue
than to cost (as their MR is more than MC) and thus it will be profitable for the firm
to produce them.
 The firm will be foregoing profit equal to the area EFG if it stops at A.
 Similarly profits will fall, if a greater output than OQ is produced as they will add
more to cost than to revenues.
 On the units from Qth to Bth, the firm will be incurring a loss equal to the area
EHI.
 To conclude, the firm will maximize profits at the point at which marginal
revenue is equal to marginal cost.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.9

QUESTIONS & ANSWSERS

1. Which of the following influences most the price level in the very short-run period?
(a) demand (b) supply
(c) cost (d) production
2. Long run price is also called by the name of ____________________
(a) Market price (b) Normal price
(c) Administered price (d) Wholesale price
3. The term market refers to a:
(a) place where buyer and seller bargain a product or service for a price
(b) place where buyer does not bargain
(c) place where seller does not bargain
(d) none of the above
4. Long-run normal prices is that which is likely to prevail
(a) All the times (b) In market period
(c) In short-run period (d) In long-run period
5. Generally, market for perishable like butter, eggs, milk, vegetables etc., will have
(a) regional market (b) local market
(c) national market (d) none of the above
6. Durable goods and industrial items exist in:
(a) local market (b) regional market
(c) national market (d) secular market
7. Secular period is also known as:
(a) very short period (b) short period
(c) very long period (d) long period
8. Stock exchange market is the example for :
(a) unregulated market (b) regulated market
(c) spot market (d) none of the above
9. The market for the ultimate consumer is known as:
(a) whole sale market (b) regulated market
(c) unregulated market (d) retail market
10. Marginal revenue will be negative if elasticity of demand is --.
(a) Less than one. (b) More than one.
(c) Equal to one. (d) Equal to zero.
Use Table to answer questions 11 - 15
The following table provides cost and price information for an individual firm. The
first two columns represent the demand curve that the firm faces. The firm has a
fixed amount of capital equipment, but can change the level of other inputs such as
labour and materials. Calculate the missing values in the table, and use the table to
answer questions 138 to 142. (Make sure you answer each question using the
productionlevel specified.)

Production Price Total Cost Variable Cost Marginal Cost Total Revenue Marginal
per
(Per Unit) Revenue
Unit
(Q) (P) (TC) (VC) (MC) (TR) (MR)
0 130 45 0 - - -
1 124 88 - - - -
2 118 125 - - - -
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.10

3 112 159 - - - -
4 106 193 - - - -
5 100 230 - - - -
6 94 273 - - - -
7 88 325 - - - -
8 82 389 - - - -
9 76 465 - - - -
11. When production equals 4 units, the firm's:
(a) fixed cost is 100 and its variable cost is 93.
(b) fixed cost is 193 and its variable cost is 0.
(c) fixed cost is 0 and its variable cost is 193.
(d) fixed cost is 45 and its variable cost is 148.

12. When production equals 5 units, the firm's total revenue is:
(a) Rs 100 (b) Rs 270
(c) Rs 324 (d) Rs 500
13. When production equals 6 units, the firm's marginal revenue is:
(a) Rs 384 (b) Rs 94
(c) Rs 64 (d) Rs 2.
14. When production equals 7 units, the firm's profit is:
(a) Rs. 0 (b) Rs 41.57
(c) Rs 291 (d) Rs 336
15. To maximize its profit, the firm should produce:
(a) 0 units. (b) 3 units.
(c) 5 units. (d) 7 units.
16. The period of time in which the plant capacity can be varied is known as
(a) The short period (b) The market period
(c) The long period (d) All of the above.
Table provides cost and price information for a firm called Comfy Cushions (CC). The firm
produces and sells cushions using a fixed amount of capital equipment but can change the level of
inputs such as labourand materials. Read Table and answer questions 17-23
Production Price Per Total Average Marginal Total Marginal
Cost Total Cost Cost Revenue Revenue
Unit
(Q) (TC) (ATC) (MC) (TR) (Per Unit)
(P)
(MR)
0 250 500
1 240 730
2 230 870
3 220 950
4 210 1010
5 200 1090
6 190 1230
7 180 1470
8 170 1850
9 160 2410
17. What is the value of fixed cost incurred by CC?
(a) Rs. 250 (b) Rs. 730
(c) Rs.500. (d) can not be determined.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.11

18. What is the average total cost when 5 units are produced?
(a) Rs. 218. (b) Rs.1090.
(c) Rs. 730. (d) Rs.210.

19. What is the marginal revenue (per unit) when production increases from 7 units to
8 units?
(a) 160. (b) 140
(c) 120. (d) 100.
20. What is the marginal cost when production increases from 3 to 4 units?
(a) 140 (b) 80
(c) 60 (d) 240
21. To maximize its profit or minimize its loss, what level of production should CC
choose?
(a) 7 units. (b) 6 units
(c) 4 units. (d) 8 units.
22. At the profit maximizing level, what price should be charged?
(a) Rs. 190 (b) Rs. 200
(c) Rs. 210 (d) Rs. 220
23. Calculate CC's maximum profit or minimum loss.
(a) Loss of Rs. 100 (b) Loss of Rs 60
(c) Profit of Rs. 90 (d) Loss of Rs. 90
24. If a seller realizes Rs. 10,000 after selling 100 units and Rs. 14,000 after selling 120
units. What is the marginal revenue here?
(a) Rs. 4000 (b) Rs. 450
(c) Rs. 200 (d) Rs. 100
25. Which is the other name that is given to the demand curve?
(a) Profit curve (b) Average Revenue curve
(c) Average Cost Curve (d) Indifference Curve
26. Relationship between AR, MR and Price elasticity of demand is
(a) MR = AR + [e -1/e] (b) MR = AR x [e -1/e]
(c) AR = MR x [e -1/e] (d) MR = AR x [e/e -1]
27. If after selling 10 units, a seller realises Rs. 12, 000 and after selling 15 units he
realises Rs. 20, 000 what is the marginal revenue here?
(a) Rs. 1500 (b) Rs. 1600
(c) Rs. 8000 (d) Rs. 2000
28. Assume that when price is Rs.40 quantity demanded is 9 units, and when price is
Rs. 38, quantity demanded is 10 units. Based on this information, what is the
marginal revenue resulting from an increase in output from 9 units to 10 units?
(a) Rs.20 (b) Rs.40
(c) Rs.38 (d) Re. 1
29. Suppose a firm is producing at level of output, such that MR>MC what should be the
firm do to maximise profit?
(a) The firm should increase output (b) The firm should do nothing
(c) The firm should hire less labour (d) The firm should decrease price
30. Marginal Revenue is equal to
(a) Change in quantity, divided by the change in price
(b) Change in price divided by change in output
(c) The change in PxQ due to a one unit change in output
(d) None of above
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.12

31. Assume that when price is Rs.20, quantity demanded in 10 units, and when price is
Rs. 19 quantity demanded in 11 units. Based on this information, what is the
marginal revenue resulting from an increase in output from 10 units to 11 units.
(a) Re. 1 (b) Rs.9
(c) Rs.19 (d) Rs.10

32. Given the relation MR = P (1-1/e), if e<1, then

(a) MR<0 (b) MR>0
(c) MR=0 (d) None of these
33. Assume that when price is Rs. 20, quantity demanded is 9 units, and when price is
Rs. 19, quantity demanded is 10 units. Based on this information, what is the
marginal revenue resulting from an increase in output from 9 units to 10 units.
(a) Rs. 20 (b) Rs. 19
(c) Rs. 10 (d) Rs. 1

34. Assume that when price is Rs. 20, quantity demanded is 15 units, and when price is
Rs. 18, quantity demanded is 16 units. Based on this information, what is the
marginal revenue resulting from an increase in output from 15 units to 16 units?
(a) Rs. 18 (b) Rs. 16
(c) Rs. 12 (d) Rs. 28
35. Suppose that a sole proprietorship is earning total revenues of Rs. 1,00,000 and is
incurring explicit costs of Rs. 75,000. If the owner could work for another company
for Rs. 30,000 a year, we would conclude that:
(a) the firm is incurring an economic loss
(b) implicit costs are Rs. 25,000
(c) the total economic costs are Rs. 1,00,000
(d) the individual is earning an economic profit of Rs. 25,000
36. Which is the other name that is given to the average revenue curve?
(a) Profit curve (b) Demand curve
(c) Average cost curve (d) Indifference curve
37. Total revenue=
(a) price x quantity (b) price x income
(c) income x quantity (d) none of the above
38. Average revenue is the revenue earned :
(a) per unit of input (b) per unit of output
(c) different units of input (d) differnet units of a output
39. AR can be symbolically written as:
(a) MR/Q (b) Price x quantity
(c) TR /Q (d) None of the above
40. AR is also known as:
(a) Price (b) income
(c) revenue (d) none of the above
41. Marginal revenue can be defined as the change in total revenue resulting from the:
(a) Purchase of an additional unit of a commodity
(b) Sales of an additional unit of a commodity
(c) Sale of subsequent unit of a product
(d) None of the above
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.13

42. Which of the following statements is incorrect?

(a) If marginal revenue exceeds marginal cost the firm should increase output.
(b) If marginal cost exceeds marginal revenue the firm should decrease output.
(c) Economic profits are maximized when total costs are equal to total revenue.
(d) Profits are maximized when marginal revenue equals marginal cost.

43. A rational person does not act unless -____________________.

(a) the action is ethical.
(b) the action produces marginal costs that exceed marginal benefits.
(c) the action produces marginal benefits that exceed marginal costs.
(d) the action makes money for the person
44. If marginal revenue exceeds marginal cost, a monopolist should .
(a) increase output.
(b) decrease output.
(c) keep output the same because profits are maximized when marginal revenue
exceeds marginal cost.
(d) raise the price.
45. Profits of the firm will be more at :
(a) MR = MC
(b) Additional revenue from extra unit equals its additional cost
(c) Both of above
(d) None
46. Which is the first order condition for the profit of a firm to be maximum?
(a) AC = MR (b) MC = MR
(c) MR = AR (d) AC = AR
47. It is assumed in economic theory that:
(a) Decision making within the firm is usually undertaken by managers, but never by
the owners.
(b) The ultimate goal of the firm is to maximise profits, regardless of firm size or type of
business organisation.
(c) As the firm's size increases, so do its goals.
(d) The basic decision making unit of any firm is its owners.

48. A firm encounters its "shutdown point" when:

(a) Average total cost equals price at the profit-maximising level of output
(b) Average variable cost equals price at the profit-maximising level of output.
(c) Average fixed cost equals price at the profit-maximising level of output.
(d) Marginal cost equals price at the profit-maximising level of output.

49. Suppose that, at the profit-maximizing level of output, a firm finds that market price
is less than average total cost, but greater than average variable cost. Which of the
following statements is correct?
(a) The firm should shutdown in order to minimise its losses.
(b) The firm should raise its price enough to cover its losses.
(c) The firm should move its resources to another industry.
(d) The firm should continue to operate in the short run in order to minimize its losses.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT - I) | 4.14

50. When price is less than average variable cost at the profit-maximising level of
output, a firm should:
(a) Produce where marginal equals marginal cost if it operating in the short run.
(b) Produce where marginal revenue equals marginal cost if it is operating is the long
run.
(c) Shutdown, since it will lose nothing in that case.
(d) Shutdown, since it cannot even cover its variable costs if it stays in business.
51. Equilibrium price may be determined through:
(a) Only demand (b) Only supply
(c) Both demand & supply (d) None

Answer Key
1 a 2 b 3 a 4 d 5 b 6 c 7 c 8 b 9 d 10 a 11 d 12 d 13 c
14 C 15 d 16 c 17 c 18 a 19 d 20 c 21 b 22 a 23 d 24 c 25 b 26 b
27 b 28 a 29 a 30 c 31 b 32 a 33 c 34 c 35 a 36 b 37 a 38 b 39 c

40 a 41 b 42 c 43 c 44 a 45 c 46 b 47 b 48 b 49 d 50 d 51 c
-
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT-II) | 4.1

CHAPTER – 4 (UNIT -2) PRICE DETERMINATION IN DIFFERENT MARKETS

Unit - 2
DETERMINATION OF PRICES
Introduction
• Price of goods expresses their exchange value.
• Price is determined where total demand equals to total supply.
• Government intervenes and determines either fully or partially.
• It also fixes up procurement prices of wheat, rice, sugarcane etc.
• Govt. of India fixed up prices of petrol, diesel, kerosene, coal, fertilizers etc.
Determination of Prices:- A general view
• In a competitive market, an interaction b/w demand & supply determines price.

DETERMINATION OF PRICES A GENERAL VIEW

CHANGES IN DEMAND & SUPPLY
 An increase in demand:- (shift to right)
 Demand curve shifts to right is an increase in demand without change in supply.
 Equilibrium price will increase from OP to OP1 and equilibrium quantities increase
from OQ to OQ1.

 If income of consumer increases:-

o Demand curve will shift to right.
o Supply remains constant.
 A decrease in demand:-
 Demand curve shifts to left is a decrease in demand without change in supply.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT-II) | 4.2

 Decrease in demand, there is a decrease in the equilibrium price & qty demanded &
supplied.
 If supply exceeds demand, price will go down & equilibrium quantity go down.
 An increase in the supply (Supply curve shift to right) :-
 An increase in the supply may be due to improved technology.

 If supply increase more than demand the equilibrium price will be less than
original price butquantity will increase.
 A decrease in the supply:-

 Decrease in supply causing an increase in the equilibrium price and a fall in

quantity demanded.
 Decrease in the supply means shifts to left side without change in demand.
SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY:-
 There may be cases in which both the supply and demand change at the same time.
 During a war for example, shortage of goals will often decrease supply while full
employment causes high total wage payment increase demand.
 When increase in supply is equal to increase in demand.
 Equilibrium price will not change but Equilibrium quantity will increase.

 When increase in demand is more than increase in supply.

 Equilibrium price will go up and Equilibrium quantity will increase
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT-II) | 4.3

 When increase in demand is less than increase in supply.

 Equilibrium price will go down and Equilibrium quantity will increase.

We can summarise the two possible outcomes when the supply and demand curves shift in
the same direction as follows:
 When both demand and supply increase, the equilibrium quantity increases but
the change in equilibrium price is uncertain.
 When both demand and supply decrease, the equilibrium quantity decreases but
the change in equilibrium price is uncertain.

When demand and supply curves shift in opposite direction:

In general, when supply and demand shift in opposite directions, we cannot predict what the
ultimate effect will be on the quantity bought and sold. What we can say is that a curve that
shifts a disproportionately greater distance than the other curve will have a
disproportionately greater effect on the quantity bought and sold.
We can summarise the two possible outcomes when the supply and demand curves shift in
the opposite directions as follows:
 When demand increases and supply decreases, the equilibrium price rises but nothing
certain can be said about the change in equilibrium quantity.
 When demand decreases and supply increases, the equilibrium price falls but nothing
certain can be said about the change in equilibrium quantity.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT-II) | 4.4

QUESTIONS & ANSWSERS

UNIT - 2
1. In a free market economy, when consumers increase their purchase of a good and the level
of exceeds _____________ then prices tend to rise.
(a) demand, supply. (b) supply, demand
(c) prices, demand (d) profits, supply.

Questions 2 - 6 are based on the demand and supply diagrams in Figure 1. S1 and D1 are
the original demand and supply curves. D2, D3, S2 and S3 are possible new demand and
supply curves. Starting from initial equilibrium point(1) what point on the graph is most
likely to result from each change?

2. Assume X is a normal good. Holding everything else constant, assume that income rises
and the price of a factor of production also increases. What point in Figure 1 is most
likely to be the new equilibrium priceand quantity?
(a) Point 9 (b) Point 5
(c) Point 3 (d) Point 2.
3. We are analyzing the market for good Z. The price of a complement good, good Y,
declines. At the same time, there is a technological advance in the production of
good Z. What point Figure 1 is most likely to be the new equilibrium price and
quantity?
(a) Point 4. (b) Point 5
(c) Point 7 (d) Point 8
4. Heavy rains in Maharashatra during 2005 and 2006 caused havoc with the rice crop.
What point in Figure 1is most likely to be the new equilibrium price and quantity?
(a) Point 6 (b) Point 3
(c) Point 7 (d) Point 8
5. Assume that consumers expect the prices on new cars to significantly increase
next year. What point in Figure 1 is most likely to be the new equilibrium price and
quantity?
(a) Point 6 (b) Point 5
(c) Point 3 (d) Point 8
6. What combinations of changes would most likely decrease the equilibrium quantity?
(a) When supply increases and demand decreases.
(b) When demand increases and supply decreases
(c) When supply increases and demand increases.
(d) When demand decreases and supply decreases.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT-II) | 4.5

Questions 7 to 11 are based on the demand and supply diagrams in Figure 1. D1 and S1
are the original demand and supply curves. D2, D3, S2 and S3 are possible new demand
and supply curves. Starting from initial equilibrium point (1) what point on the graph is
most likely to result from each change?

7. Suppose wage rate of coal miners increases and price of natural gas decreases. (Coal and natural
gas are substitutes).What point in Figure 1 is most likely to be the new equilibrium price and
quantity?
(a) Point 6. (b) Point 4.
(c) Point 3. (d) Point 2.
8. Assume that consumer income has increased. Given that Y is an inferior good, which point in
Figure is most likely to be the new equilibrium price and quantity?
(a) Point 4. (b) Point 6.
(c) Point 5. (d) Point 8.
9. Assume that the government has just removed the 10% excise duty on good X. What point in
Figure 1 is most likely to be the new equilibrium price and quantity?
(a) Point 6. (b) Point 4.
(c) Point 7. (d) Point 8.
10. A government research agency has published outcome of studies which say that the
consumption of good X could cause cancer. In addition, assume that a powerful lobby has
persuaded the government to give subsidy to the manufacturers of good X. What point in Figure
is most likely to be the new equilibrium price and quantity?
(a) Point 6. (b) Point 5.
(c) Point 3. (d) Point 9.
11. An increase in demand and an increase in supply will:
(a) affect equilibrium quantity in an indeterminate way and price will decrease.
(b) affect price in an indeterminate way and quantity will decrease.
(c) affect price in an indeterminate way and quantity will increase.
(d) affect equilibrium quantity in an indeterminate way and price will increase.

12. In the table below what will be equilibrium market price ?

Price (Rs.) Demand (tonnes per annum) Supply (tonnes per annum)
1 1000 400
2 900 500
3 800 600
4 700 700
5 600 800
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT-II) | 4.6

5 600 800
6 500 900
7 400 1000
8 300 1100

(a) Rs.2 (b) Rs.3

(c) Rs.4 (d) Rs.5

13. Which of the following situation does not lead to an increase in equilibrium price?
(a) An increase in demand, without a change in supply.
(b) A decrease in supply accompanied by an increase in demand.
(c) A decrease in supply without a change in demand.
(d) An increase in supply accompanied by a decrease in demand.
Questions 14 to 18 are based on the demand and supply diagrams in Figure 1. D1 and S1
are the original demandand supply curves. D2, D3, S2 and S3 are possible new demand and
supply curves. Starting from initial equilibrium point (1) what point on the graph is most
likely to result from each change?

14. If Figure 1 represents the market for Mars Bars, the initial equilibrium is at the
intersection of S1 and D1. The new equilibrium if there is an increase in cocoa prices
will be:
(a) Point 3. (b) Point 9.
(c) Point 4. (d) Point 2.
15. In Figure 1 (which represents the market for Mars Bars), the initial equilibrium is at the
intersection of S1 and D1. The new equilibrium if there is rapid economic growth and
the government also imposes a tax on mars bars is:
(a) Point 3. (b) Point 9.
(c) Point 2. (d) Point 6.
16. In Figure 1(which represents the market for Mars Bars), the initial equilibrium is at
the intersection of S1 and D1. The new equilibrium if there is a health scare about the
effect mars bars may have is:
(a) Point 2. (b) Point 9.
(c) Point 3. (d) Point 6.
17. In Figure 1(which represents the market for Mars Bars), the initial equilibrium is at
the intersection of S1 and D1. Assuming that mars bars are an inferior good, the new
equilibrium if there is a recession and wages of workersproducing them fall is :
(a) Point 2 (b) Point 7
(c) Point 3 (d) Point 6
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT-II) | 4.7

18. In Figure 1(which represents the market for Mars Bars), the initial equilibrium is at
the intersection of S1 and D1. Assume that the price of sugar falls and at the same
time there is a technological advancement in the production of mars bars. The new
equilibrium will be:
(a) Point 2 (b) Point 7
(c) Point 3 (d) Point 6
19. A draught in India leads to unusually low level of wheat production. This would lead
to a rise in the price of wheat and fall in the quantity of wheat demanded due to:
(a) excess demand at the original price.
(b) excess supply at the original price.
(c) the supply curve shifting to the right.
(d) the demand curve shifting to the left.
20. For ________________ goods increase in income leads to increase in demand
(a) Abnormal (b) Normal
(c) Inferior (d) Superior

Questions 21 to 25 are based on the demand and supply diagrams in Figure 1. D1 and S1
are the original demand and supply curves. D2, D3, S2 and S3 are possible new demand
and supply curves. Starting from initial equilibrium point (1) what point on the graph is
most likely to result from each change?

21. If Figure 1 represents the market for Perk (chocolates), the initial equilibrium is at the
intersection of S1 and D1. The new equilibrium if there is an increase in the price of
Dairy milk (chocolates) will be:
(a) Point 3 (b) Point 5
(c) Point 4 (d) Point 2.
22. In Figure 1 (which represents the market for Perk (chocolates), the initial equilibrium is at the
intersection of S1 and D1. The new equilibrium if there is rapid economic growth but cost of
labour producing Perk also rises:
(a) Point 3. (b) Point 9.
(c) Point 2. (d) Point 6.
23. In Figure 1(which represents the market for Perk), the initial equilibrium is at the intersection of
S1 and D1. The new equilibrium if there is a health scare about the effect chocolates may have is:
(a) Point 2. (b) Point 9.
(c) Point 3. (d) Point 6.
24. In Figure 1(which represents the market for Perk), the initial equilibrium is at the intersection of
S1 and D1. Assuming that there is a new technology for producing Perk, the new equilibrium:
(a) Point 8 (b) Point 7.
(c) Point 3. (d) Point 6.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT-II) | 4.8

25. In Figure 1(which represents the market for Perk), the initial equilibrium is at the intersection of
S1 and D1. Assume that there is an increase in the productivity and at the same time the price of
5 star(chocolates) falls. The new equilibrium will be:
(a) Point 2. (b) Point 9.
(c) Point 3. (d) Point 6.
26. If the quantity of Banana demanded in 100 kg and quantity supplied is 50 kg, then price per kg of
Banana is:
(a) Rs.18 (b) Rs.24
(c) Less than equilibrium price (d) Greater than equilibrium price
27. The market of computers is not in equilibrium, then which of the following statements is
definitely true?
(a) The prices of computer will rise
(b) The prices of computer will fall
(c) The prices of computers will change, but not enough information is given to determine
the direction of the change
(d) None of the above
28. With a given supply curve, a decrease in demand causes:
(a) An overall decrease in price but an increase in equilibrium quantity
(b) An overall increase in price but a decrease in equilibrium quantity
(c) No change in overall price but a reduction in equilibrium quantity
(d) An overall decrease in price and a decrease in equilibrium quantity
29. If price is forced to stay below equilibrium price:
(a) Excess supply exists (b) Excess demand exists
(c) Either (a) or (b) (d) Neither (a) nor (b)
30. _________________________ is the price at which demand for a commodity is equal to its supply :
(a) Normal Price (b) Equilibrium Price
(c) Short run Price (d) Secular Price
31. An increase in supply with demand remaining the same, brings about.
(a) An increase in equilibrium quantity and decrease in equilibrium price.
(b) An increase in equilibrium price and decreases in equilibrium quantity.
(c) Decrease in both equilibrium price and quantity
(d) None of these
32. Assume that consumer's incomes and the number of sellers in the market for good A both
decrease. Based upon this information we can conclude, with certainty, that equilibrium:
(a) Price will increase (b) Price will decrease
(c) Quantity will increase (d) Quantity will decrease
33. Suppose that the supply of cameras increases due to an increase in foreign imports. Which of the
following will most likely occur?
(a) the equilibrium price of cameras will increase.
(b) the equilibrium quantity of cameras exchanged will decrease.
(c) the equilibrium price of camera film will decrease.
(d) the equilibrium quantity of camera film exchange will increase
34. Assume that in the market for good Z there is a simultaneous increase in demand
and the quantity supplied. The result will be:
(a) An increase in equilibrium price and quantity.
(b) A decrease in equilibrium price and quantity.
(c) An increase in equilibrium quantity and uncertain effect on equilibrium price.
(d) A decrease in equilibrium price and increase in equilibrium quantity.
 PRICE DETERMINATION IN DIFFERENT MARKETS (UNIT-II) | 4.9

35. Suppose the technology for producing personal computers improves and, at the
same time, individuals discover new uses for personal computers so that there is
greater utilisation of personal computers. Which of the following will happen to
equilibrium price and equilibrium quantity?
(a) Price will increase; quantity cannot be determined
(b) Price will decrease; quantity cannot be determined
(c) Quantity will increase; price cannot be determined
(d) Quantity will decrease; price cannot be determined

Answer Key
1 a 2 d 3 c 4 b 5 b 6 d 7 b 8 b 9 d 10 d 11 c 1 c 13 d
2
14 a 15 c 16 d 17 b 18 b 19 a 20 b 21 b 22 c 23 d 24 a 2 b 26 c
5
27 c 28 d 29 b 30 b 31 a 32 d 33 d 34 c 35 c

*************
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.1

CHAPTER – 4 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS

PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS

UNIT – III (A Perfect Competition)

PERFECT COMPETITION
 Perfect competition:-
 It's a form of market where there are large numbers of buyers with an identical
product on same price
 Pure competition has following characteristics.
 Large no of buyers & sellers no buyers or seller is in a position to influence the
demand & supply in the market.
 Homogeneous product.
 No Restriction on entry & exit.
 The essential feature of the pure competition is the absence of monopolistic element.
 Perfect competition has following feature:-
 Buyer & sellers have perfect knowledge of the market.
 Facilities exist for the movement of goods, both are indifferent.
 Firms are price taker, and price determined by market forces of demand and
supply.
 Perfectly competitive market has perfect mobility and perfect knowledge.
 Perfect competition has infinite price elasticity (ep =  )
 Ex stock market.
 Perfectly competitive market is a myth.

PRICE DETERMINATION UNDER PERFECT COMPETITION:-

Equilibrium of Industry:-
 Industry consists large number of independent firm and each produces a
homogeneous product.

 Industry is in equilibrium, when total demand & total output is equal to each other.
 It's a price, where no buyer goes dissatisfied and none of the sellers is dissatisfied.
Equilibrium of the Firm:-
 If firm is said to be in equilibrium, when it maximizes profit.
 Equilibrium output, which gives maximum profit to the firm and it has no incentive to
increase on decrease in output.
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.2

 Firms are price takers and industry is price maker because they can't interefere the
price and have to accept price made by industry.
 Demand curve of a firm is horizontal or parallel to OX axis.
Conditions of Equilibrium of Firm:-
 The marginal revenue should be equal to the marginal cost. MC = MR.
 The MC curve should cut MR curve from below or MC should have positive slope.
 Demand curve for the perfect competition is perfectly elastic
 Firms cant increase price, because firm is price taker
 MR is horizontal in perfect market
 Profits are maximum only at the point where MR = MC and MC cuts MR from below.

 Price line or Average Revenue curve is perfectly elastic.

Supply curve of the firm in a competitive market.
 MC curve of the firm is the supply curve in a perfectly competitive market.
 Price below to average variable cost, the firm will supply zero units because now firm
is unable to meet its variable cost.
 When price is equal to AVC, firm has no profit or no loss.
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.3

Can the competitive firm earn profit?

 A firm will attain equilibrium position, and it will have supernormal profit / loss, normal
profit.
In short run firms supernormal profit, supernormal loss and normal profit.
Supernormal Profit:-
 When a firm earns supernormal profit, its AR is a
horizontal one and MC is always 'U' shaped curve.
 Supernormal profit is where AR>AC
 When MR=MC firms are in equilibrium and its
optimum level of output for production

Normal Profit:–
 When the firm average revenue is equal to average total
cost. AR = ATC
 MC = AC = AR = MR = P
 AR=AC is a situation when firm is in normal profit.

Supernormal Loss:-
 It's true, firm is under loss, even its in an equilibrium position because it's a position Where
loss are minimizing
 If firm is able to cover variable cost and a part of fixed cost firm will continue for production
 Firm will have to shut down point, when firm does not even get average variable cost AVC.

LONG RUN EQUILIBRIUM OF THE FIRM:-

 In long run, LAC curve is tangent to demand curve defined by market price.
 In long run, every firm earns normal profit, which is included in average cost.
 When firms are making super-normal profit in short run, others firms get attracted and
therefore it leds to downward shift in demand curve & upward shift of cost curve and it
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.4

goes on till AC equal to demand or AR.

 Firms attain only normal profit in long run because there is no restriction on entry and exit.
Long Run equilibrium Condition:–
LMC = LAC = P
OR
SMC = LMC = SAC = LAC = P = MR
 Firms produces that level of output in long run where MC is equal to price.
 LAC & minimum point implies that plant is worked at its optimal capacity.
Long Run equilibrium of the industry:-
(1) When all firms are earning normal profits (but are in equilibrium)
(2) No further entry or exit.
 Optimum firm is a firm which produces output at optimum cost
 All firms charge minimum possible price, which covers their marginal cost.
 Perfect competition has also a feature of market mechanism.

 MC = AR = Consumers pay the minimum possible price which covers MC.

 If plants are use at full capacity in long run there will be MC = AC.
 LAR = LMR = P = LMC = LAC implies optimum allocation of resources.
 MC=MR when Firms try to maximize profit.
******************
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.5

QUESTIONS & ANSWERS

Unit - 3 (A) Perfect Competition
1. Price-taking firms, i.e., firms that operate in a perfectly competitive market, are said to
be “small” relative tothe market. Which of the following best describes this smallness?
(a) The individual firm must have fewer than 10 employees.
(b) The individual firm faces a downward-sloping demand curve.
(c) The individual firm has assets of less than Rs.20 lakh.
(d) The individual firm is unable to affect market price through its output decisions.
2. Under ----------------------- market condition, firms make normal profits in the long run.
(a) Perfect Competition (b) Monopoly
(c) Oligopoly (d) None of the above.
3. Price taker firms:
(a) Advertise to increase the demand for their products.
(b) Do not advertise because most advertising is harmful for the society.
(c) Do not advertise because they can sell as much as they want at the current price.
(d) Who advertise will get more profits than those who do not.
4. Which of the following is not a characteristic of a “price taker”?
(a) TR = P x Q (b) AR = Price
(c) Negatively - sloped demand (d) Marginal Revenue = Price
Use Table to answer questions 5 – 8
Quantity Average Fixed cost Average Total cost Marginal
cost
0 – – –
1 80.00 100.00 20
2 40.00 58.00 17
3 26.66 44.00 15
4 20.00 36.25 13
5 16.00 31.40 12
6 13.33 28.33 13
7 11.42 26.29 14
8 10.00 26.13 25
9 8.88 26.56 30
10 8.00 27.30 34
11 7.27 28.45 40
12 6.66 30.00 47
13 6.15 31.92 55
5. Refer to Table 1 which lists the average costs of a perfectly competitive firm. If the price of the good is
Rs13, the firm will be produce
(a) 4 units at a loss of Rs. 93 (b) 6 units at a loss Rs. 92
(c) zero units at a loss of Rs. 80 (d) 8 units at a profit of Rs. 9
6. Refer to the competitive firm in Table 1. If the market price is Rs 31, the firm will produce:
(a) 9 units at an economic profit of Rs 40
(b) 10 units at an economic profit of Rs 67
(c) 9 units at an economic profit of Rs 81.
(d) Zero units of output and lose its fixed cost.
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.6

7. In Table 1, if price is Rs 26, the perfectly competitive firm will:

(a) shut down in the short run.
(b) produce 8 units at an economic loss of Rs 9.
(c) produce 9 units at an economic loss of Rs. 5.
(d) produce 8 units at an economic loss of Rs. 1.04.
8. In Table 1, if price is Rs 34, the perfectly competitive firm will:
(a) shut down (b) produce 10 units
(c) produce 11 units (d) produce 13 units.
9. When the perfectly competitive firm and industry are in long run equilibrium then:
(a) P=MR=SAC=LAC. (b) D=MR=SMC=LMC.
(c) P=MR=Lowest point on the LAC curve. (d) All of the above.
10. Which of the following market situations explains marginal cost equal to price for
attaining equilibrium?
(a) Perfect competition. (b) Monopoly
(c) Oligopoly. (d) Monopolistic competition.
11. In the short run if a perfectly competitive firm finds itself operating at a loss, it will:
(a) reduce the size of its plant to lower fixed costs.
(b) raise the price of its product.
(c) shut down.
(d) continue to operate as long as it covers its variable cost.
12. A competitive firm maximizes profit at the output level where:
(a) price equals marginal cost.
(b) the slope of the firm's profit function is equal to zero.
(c) marginal revenue equals marginal cost.
(d) all of the above.
13. In the long run any firm will eventually leave the industry if:
(a) price does not at least cover average total cost.
(b) price does not equal marginal cost.
(c) economies of scale are being reaped.
(d) price is greater than long run average cost.
14. An individual firm in a perfectly competitive market faces a demand curve which is:
(a) downward sloping. (b) relatively inelastic.
(c) perfectly elastic. (d) upward sloping.
A competitive firm sells as much as of its product as it chooses at a market price of Rs 200
per unit. Its fixed cost is Rs 600 and its variable costs (in rupees) for different levels of
production are shown in the following table. Use Table 2 to answer questions 15 - 19.
Quantity Variable Fixed Cost Total cost Average Average Marginal
cost Variable total Cost cost
0 0 – – – – –
5 500 – – – – –
10 940 – – – – –
15 1400 – – – – –
20 1960 – – – – –
25 2700 – – – – –
30 3700 – – – – –
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.7

35 5040 – – – – –
40 6800 – – – – –
45 9060 – – – – –
50 11900 – – – – –
15. When production is 40 units, the average total cost is
(a) Rs. 8.80 (b) Rs.15
(c) Rs. 170 (d) Rs. 185
16. In the table marginal cost per unit that corresponds to 40 units of production is
(a) Rs. 44 (b) Rs.170
(c) Rs.352 (d) Rs.1760
17. To maximize profit, the firm should produce
(a) 15 units (b) 30 units
(c) 35 units (d) 50 units

18. If the market price drops from Rs 200 to Rs 112, the firm's short run response should be
(a) shut down
(b) produce 5 units
(c) produce 20 units
(d) continue to produce the same number of units as before the drop in price.
19. If the market price rises from Rs 200 to Rs 352, the firm's short run response should be
(a) shut down
(b) produce 40 units
(c) produce 20 units
(d) continue to produce the same number of units as before the increase in price.
20. If a competitive firm doubles its output, its total revenue:
(a) doubles.
(b) more than doubles.
(c) less than doubles.
(d) cannot be determined because the price of the good may rise or fall.
21. In the long-run, some firms will exit the market if the price of the good offered for sale is
less than:
(a) marginal revenue. (b) marginal cost.
(c) average total cost. (d) average revenue.
22. Which of the following is not an essential condition of pure competition ?
(a) large number of buyers and sellers (b) homogeneous product
(c) freedom of entry (d) absence of transport cost
23. Under which of the following forms of market structure does a firm have no control over
the price of its product?
(a) monopoly (b) monopolistic competition
(c) oligopoly (d) perfect competition
24. Under which market structure, average revenue of a firm is equal to its marginal revenue
(a) Oligopoly (b) Monopoly
(c) Perfect competition (d) Monopolistic competition
25. What is the shape of the demand curve faced by a firm under perfect competition?
(a) Horizontal (b) Vertical
(c) Positively sloped (d) Negatively sloped
26. Which of the following is not a condition of perfect competition ?
(a) A large number of firms
(b) Perfect mobility of factors
(c) Informative advertising to ensure that consumers have good information
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.8

(d) Freedom of entry and exit into and out of the market
27. Agricultural goods markets depict characteristics close to:
(a) Perfect competition (b) Oligopoly
(c) Monopoly (d) Monopolistic competition
28. In perfect competition the firm's _________________ above AVC has the identical shape of the
firm's supply curve
(a) Marginal revenue curve (b) Marginal loss
(c) Average cost curve (d) None of the above
A compeddve firm sells his product at market price of Rs. 51 per unit. The fixed cost is Rs. 300 and
variable cost for different level of production are shown in the following table 2. Use table No.2 to
answer questions29 - 32.
Quantity Variable Cost Fixed Cost Total Cost AVC ATC MC
0 0
10 470
20 980
30 1850
40 3400
50 5950
29. When production is 30 units, the average variable cost is:
(a) 70.6 (b) 60.6
(c) 61.6 (d) 71.6
30. When production is 50 units, marginal cost is:
(a) 265 (b) 255
(c) 245 (d) 275
31. To maximize profit, the firm should produce
(a) 30 units (b) 10 units
(c) 20 units (d) 40 units
32. If the market price drops from Rs. 51 to Rs. 47 the firm should
(a) Close down (b) produce 10 units
(c) Produce 30 units (d) Produce 20 units
A competitive firm sells as much as of its product it chooses at a market price of Rs. 100 per
unit Its fixed cost is Rs. 300 and its variable costs (in rupees) for different levels of
production are shown in the following table. Use table 1 to answer questions 33 - 36.

Qty. Cost Variable Fixed Cost Total Average Varibale Average Total Marginal
cost Cost cost Cost
0 0 - - - - -
5 270 - - - - -
10 490 - - - - -
15 720 - - - - -
20 1000 - - - - -
25 1370 - - - - -
30 1870 - - - - -
35 2540 - - - - -
40 3420 - - - - -
45 4550 - - - - -.
50 5970 - - - - -
33. When production is 35 units, the average variable cost is:
(a) Rs. 7.25 (b) Rs. 72.25
(c) Rs. 72.57 (d) Rs. 85.50
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.9

34. In the table marginal cost per unit that corresponds to 25 units of production is
(a) Rs. 3.50 (b) Rs. 74
(c) Rs. 450 (d) Rs. 370
35. To maximize output the firm should produce
(a) 30 (b) 35
(c) 45 (d) 50
36. If the market price drops from Rs. 100 to Rs. 74, the firm short run response should
be:
(a) Continue to produce the same number of units as before the drop in price
(b) Produce 10 units
(c) Produce 20 units
(d) Produce 25 units

37. Under perfect competition price of the product:

(a) Can be controlled by individual firm
(b) Cannot be controlled by individual firm
(c) Can be controlled within certain limit by individual firm
(d) None of the above
38. Full capacity is utilized only when there is -
(a) Monopoly (b) Perfect competition
(c) Price discrimination (d) Oligopoly
39. A firm encounters its shut down point when:
(a) Average cost equals price at the profit maximising level of output
(b) Average variable cost equals price at the profit maximising level of output
(c) Average fixed cost equals price at the profit maximising level of output
(d) None of the above
40. In a perfect competitive market:
(a) firm is the price-giver and industry the price taker
(b) Firm is the price taker and industry the price giver
(c) both are the price takers
(d) none of the above
41. One of the essential conditions of perfect competition is -
(a) product differentiation
(b) multiplicity of prices for identical product at any one time
(c) many sellers and few buyers
(d) only one price for identical goods at any one time
42. Under the perfect competition a firm will be in Equilibrium when :
(a) MC = MR (b) MC cuts the MR from below
(c) MC is rising when it cuts the MR (d) All of the above
43. A perfectly competitive firm has control over
(a) price
(b) production as well as price
(c) control over production, price and consumers
(d) none of the above
44. At shut down point:
(a) Price is equal to AVC
(b) Total revenue is equal to TVC
(c) Total loss of the firm is equal to TFC
(d) All of the above
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.10

45. The conditions of long-period equilibrium for the firm operative under perfect
competition are:
(1) MC = MR (2) AR = MR
(3) AC = AR (4) AC = MC
(a) (1) only (b) (1) and (2) only
(c) (1), (2) and (3) only (d) (1), (2), (3) and (4)
46. If the demand curve confronting an individual firm is perfectly elastic, then :
(a) The firm is a price taker.
(b) The firm cannot influence the price
(c) The firms marginal revenue curve coincides with its average revenue curve
(d) All of the above
47. A firm under perfect competition will be making minimum losses (in the short run) at a
point where:
(a) MC > MR (b) MR > MC
(c) MC = MR (d) AC = AR
48. Which of the following is not the feature of Perfect Competition?
(a) Large number of buyers and sellers
(b) Small number of buyers and sellers
(c) Free Entry and Exit
(d) Goods is Homogeneous
49. For the prices- taking firm:
(a) Marginal revenue is less than price
(b) Marginal revenue is equal to price
(c) Marginal revenue is greater than price
(d) The relationship between marginal revenue and price is indeterminate
50. In long run, in perfectly competitive market there will be:
(a) Normal profit (b) Super normal profits
(c) Losses (d) None of the above
51. In perfect competition utilization of resources is
(a) Partial (b) Moderate
(c) Full (d) Over
52. In a perfectly competitive firm, MC curve above AVC is the ____________ Curve of the firm
(a) Average cost (b) Marginal revenue
(c) Demand (d) Supply
53. A purely competitive firm's supply schedule in the short run is determined by:
(a) Its average revenue (b) Its marginal revenue
(c) Its marginal cost curve (d) Marginal utility for money curve
54. When price is less than average variable cost at the profit maximizing level of output, a
firm should:
(a) Shut down, since it cannot recover its variable cost
(b) Produce where MC = MR, if operating in short run
(c) Produce where MC = MR, if operating in long run
(d) None of the above
55. Under which market structure, average revenue of a firm is equal to its marginal revenue
(a) Monopoly (b) Monopolistic competition
(c) Oligopoly (d) None of the above
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.11

56. A condition needed for a perfectly competitive industry to exist is that:

(a) Buyers are able to influence the price of the commodity
(b) Any units of commodity are considered by buyers to be different
(c) Buyer discriminates in their purchases based on non-price factors.
(d) There are no obstacles to the free mobility of resources.
57. Which is not the essential condition of pure competition?
(a) Large number of buyers and sellers
(b) Homogeneous product
(c) Freedom of entry
(d) Perfect knowledge among buyers and sellers
58. Shares traded in the stock market depict characteristics close to ________________ .
(a) Perfect competition
(b) Oligopoly
(c) Monopolistic Competition
(d) Monopoly
59. Which of the following is not a characteristic of a price taker?
(a) Positively sloped demand curve (b) TR = PxQ
(c) AR = Price (d) Marginal Revenue = Price
60. MR curve and AR curves coincide in
(a) Monopoly (b) Monopolistic Competition
(c) Oligopoly (d) Perfect Competition
61. A competitive firm in the short run incure losses. The firm continues production, if :
(a) P > min AVC (b) P = Min AVC
(c) P > = Min AVC (d) P> = AVC
62. What are the conditions for the long run equilibrium of the competitive firm ?
(a) LMC = LAC = P (b) SMC = SAC = LMC
(c) P = MR (d) All of these
63. If under perfect competition, the price line lies below the average cost curve, the firm
would:
(a) Make only normal profits (b) Incur losses
(c) Make abnormal profit (d) Profit cannot be determined
64. A firm will shut down in the short run if :
(a) If is suffering a loss (b) Fixed costs exceeds revenue
(c) Variable costs exceed revenue (d) Total costs exceed revenue
65. ____________ is a ideal Market.
(a) Monopoly (b) Monopolistic
(c) Perfect Competition (d) Oligopoly
66. Price taker firms
(a) Do not advertise their product because it misleads the customers
(b) Advertise their products to boost the level of demand
(c) Do not advertise but give gifts along with the sold items to attract customers
(d) Do not advertise because they can sell as much as they wish at the prevailing price.
67. Excess capacity is not found under _______________ .
(a) Monopoly (b) Monopolistic competition
(c) Perfect competition (d) Oligopoly
68. Which of the following is not a characteristic of a "Price taker"?
(a) TR - P X Q (b) AR = Price
(c) Negatively - sloped demand curve (d) Marginal Revenue = Price
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.12

69. Which of the following is not a condition of perfect competition?

(a) A large number of firms.
(b) Perfect mobility of factors .
(c) Informative advertising to ensure that consumers have good information.
(d) Freedom of entry and exit into and out of the market.
70. Which of the following is not a characteristic of a perfectly competitive market?
(a) Large number of firms in the industry.
(b) Outputs of the firms are perfect substitutes for one another.
(c) Firms face downward-sloping demand curves.
(d) Resources are very mobile
71. The firms in a perfectly competitive market is a price taker. This designation as a price
taker is based on theassumption that:
(a) the firm has some, but not complete, control over its product price.
(b) there are so many buyers and sellers in the market that any individual firm cannot
affect the market.
(c) each firm produces a homogeneous product
(d) there is easy entry into or exit from the market place.
72. Which of the following statements is incorrect?
(a) Even monopolistic can earn losses.
(b) Firms in a perfectly competitive market are price takers.
(c) It is always beneficial for a firm in a perfectly competitive market to discriminate
prices
(d) Kinked demand curve is related to an oligopolistic market
73. In perfect competition in the long run there will be no.............
(a) normal profits (b) supernormal profits
(c) production (d) costs
74. Which of the following markets would most closely satisfy the requirements for a
perfectly competitive market?
(a) electricity (b) Cable television
(c) Cola (d) Milk
75. In perfect competition firm is the..............
(a) price maker and not price taker (b) price taker and not price maker
(c) neither price maker nor price taker (d) none of the above
76. The condition for pure competition is:
(a) large number of buyer and seller, free entry and exist
(b) homogenous product
(c) both (a) and (b)
(d) large number of buyer and seller, homogenous product, perfect knowledge about the
product.
77. Pure oligopoly is based on the__________ products.
(a) differentiated (b) homogeneous
(c) unrelated (d) none of the above
78. MR =AR = Demand curve is a feature of which kind of market?
(a) Perfect competition (b) Monopoly
(c) Monopolistic (d) Oligopoly
79. Price discrimination is not possible in the case of......
(a) Perfect competition (b) Monopoly
(c) Monopolistic competition (d) Nothing can be said
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.13

80. Which of the following statements is false?

(a) For equilibrium the main condition is MC=MR
(b) AR curve and Demand curve are same
(c) MC & AC curves are U-shaped in every market
(d) None of the above
81. In the long run, normal profits are included in the.....
(a) LAC (b) LMC
(c) AFC (d) SAC
A monopolist charges Rs. 30 for his product, he noticed elasticity in market , A=2, elasticity
in market Bis 5.
82. A monopolist charges Rs. 30 for his product, he noticed elasticity in market , A=2,
elasticity in market B is 5. What will be the Marginal Revenue in Market a ?
(a) 10 (b) 20
(c) 15 (d) 25
83. what will be the marginal Revenue in market b?
(a) 5 (b) 12
(c) 24 (d) 10
84. In which market will the monopolist charge a higher price ?
(b) B (b) Can't Say
(c) Same price (d) A
85. The price discriminating monopolist will be in equilibrium when:
(a) MRA= MC (b) MRA= MRB =AMC
(c) MRB = MC (d) MCA= MCB = MRA
86. If in the above case, elasticity was same in both in both the market, the monopolist:
(a) will charge higher from market A than B
(b) will charge higher from market B than A
(c) will not discriminate price
(d) Cant' Say
87. The degree of monopoly power is measured in terms of difference between
(a) Marginal cost and the price
(b) Average cost and average revenue
(c) Marginal cost and average cost
(d) marginal revenue and average cost

Answer Key
1 d 2 a 3 c 4 c 5 c 6 a 7 d 8 b 9 d 10 a 11 d 12 d 13 a
14 c 15 d 16 c 17 b 18 c 19 b 20 a 21 c 22 d 23 d 24 c 25 a 26 c
27 a 28 b 29 c 30 b 31 c 32 b 33 c 34 b 35 a 36 d 37 b 38 b 39 b

40 b 41 d 42 d 43 d 44 d 45 d 46 d 47 c 48 b 49 b 50 a 51 c 52 d
53 c 54 a 55 d 56 d 57 d 58 a 59 a 60 d 61 d 62 d 63 b 64 c 65 c
66 d 67 c 68 c 69 c 70 c 71 b 72 c 73 b 74 d 75 b 76 c 77 b 78 a
79 a 80 d 81 a 82 c 83 c 84 d 85 b 86 c 87 a
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.14

UNIT - 3 (B) MONOPOLY

MONOPOLY
 Monopoly is the state of market in which
 One seller of a commodity
 No close substitutes.
 It generally finds in public utility such as transport, water and electricity, we generaly find
monopoly from of market
Features of Monopoly Market:-
(1) Single Seller of the product:-
 There is only one firm producing or supplying a good and there is no distinction b/w the
firm & industry.
(2) Restriction to Entry:–
 Monopoly market has legal, economic, institutional barriers.
(3) No close substitutes:-
 The cross elasticity of demand for the monopolist is zero or very small.
 The price elasticity of demand for monopolist is less than one.
 It faces downward sloping curve.
 If a seller has control over supply, he would be said as a 'Monopolist.”
 Price discrimination is a feature of monopoly.
 Monopolist have a control over price because:
 No competition
 No close substitute
Monopolist Revenue Curve:-
 Firm demand curve is identical to market demand curve.
 Firm AR & MR curve slopes downward and AR can't be Zero.
 MR is less than price because the firm has to lower the price for selling extra unit. It can be
negative and Zero.
 Firms AR curve is also known as Firm Demand Curve and Firm is a price maker in monopoly.
Relationship b/w AR MR:-
 AR & MR both are negative.
 MR curve lays half way b/w AR & Y axis.
 It cuts the horizontal line between Y axis and AR
into two equal parts.
 AR can't be zero, but MR can be zero or negative.
Profit maximization in a monopolized marked equilibrium on the monopoly firm:-
 Firm are to determine output and price.
 Since, firm has downward sloping demand curve, it has to decrease price in order to sell more
output.
SHORT RUN EQUILIBRIUM:-
Conditions for the equilibrium:-
(i) MC & MR
(ii) MC curve must cut MR from below
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.15

 If monopolist is facing low demand, average cost will be more than average revenue, it implies
loss.
 If monopolist cover AVC and a part of fixed cost he will continue production but if he is unable
to meet AVC, hewill shut down.
LONG RUN EQUILIBRIUM:-
 In long run, monopolist need not produce at optimal level or
need not to reach minimum of LAC and can stop where his
profits are maximum.
 In long run, monopolist has super-normal profit.
 The monopolist will not continues if he makes losses in long
run.
Price Discrimination
 It's a method adopted by monopolist for earning abnormal profit.
 Price discrimination means different prices for different buyers offered by seller for identical
product.
(a) Railways separate high value or relatively small bulk commodities which can bear
higher freight charges fromother categories of goods.
(b) Some countries dump goods at low prices in foreign markets to capture then (dumping)
(c) Some universities charges higher tuition fees from evening class students.
(d) A higher price for vegetables may be charged in push localities inhabited by rich than in
other localities.
Conditions for price discrimination:-
(1) Monopolistic situation :- the seller should have some control over supply.
(2) Separation of Market :- the seller should be able to divide his market into 2 or more sub
markets.
(3) Different elasticity:-
 Price elasticity of the product should be different in markets.
 Producer determines higher price for those buyers whose price elasticity in less than
1.
 Producer determines lesser price for those buyers whose price elasticity is more than
1.
(4) Restrict to sell goods from low price to high price market.
 It should not be possible for the buyers of low price market to resell the product to
the buyer of high period market.
 MR = AR X e-1/e
 If elasticity of demand is higher than other market, MR will also be higher.
 If elasticity or demand is less than other market, MR will also be less.
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.16

Objectives of Price Discrimination

(a) To earn maximum profit.
(b) To dispose surplus stock
(c) To enjoy the economies of scale
(d) To capture foreign market
(e) To secure equity through pricing
 Prof. Pigou clarified three degrees of elasticity:-
 Under the first degree:- Monopolist separates the market into each individual
consumer and charges them the price they are willing and able to pay.
o Monopolist will fix a price which will take the away the entire consumer surplus.
 Under the Second degree:- Different prices are charged for different quantities of
sold
o Monopolist will fix a price which will take away only a part of consumer's surplus
and varies acc to qty sold.
 Under the third degree:-
o Monopolist will fix a price, which varies by attributes such as location, consumer
segment
Examples: Dumping, charging different prices for domestic and commercial
uses, lower prices in railways for senior citizens, etc.
Equilibrium under price discrimination
 The discriminating monopolist has two decisions to be taken:-
 How much should be produce.
 How total output should be distributed and what prices should be charge?
 Discriminating monopolist will maximize profit at the level of output where MC intersects MR
curve.
 MR in the two sub-markets must be equal if the profits are to be maximized and it should also be
equal to marginal cost.
MRa = MRb = AMC
MRa = Marginal Revenue in Market A
MRb = Marginal Revenue in Market B
AMC = Aggregate Marginal Cost
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.17

Questions & Answers

Unit - 3 (B) Monopoly
1. The AR curve and industry demand curve are same:
(a) In the case of monopoly. (b) In the case of oligopoly.
(c) In the case of perfect competition. (d) None of the above.
2. In monopoly, the relationship between average and marginal revenue curves is as
follows:
(a) AR curve lies above the MR curve.
(b) AR curve coincides with the MR curve.
(c) AR curve lies below the MR curve.
(d) AR curve is parallel to the MR curve.
3. A monopolist who is selling in two markets in which demand is not identical will be
unable to maximize his profits unless he
(a) Sells below costs of production in both markets.
(b) Practices price discrimination.
(c) Equates the volume of sales in both markets.
(d) Equates marginal costs with marginal revenue in one market only.
Questions 4 to 8 are based on the Figure

4. Figure represents a
(a) Perfectly competitive firm. (b) Perfectly competitive industry.
(c) Monopolist (d) None of the above.
5. In figure , the firm's marginal revenue curve is curve
(a) E. (b) A
(c) F (d) B
6. In figure , curve E is the firm's:
(a) Marginal cost curve (b) Average cost curve
(c) Demand curve. (d) Marginal revenue curve
7. In figure , the firm's most efficient output is:
(a) K (b) L
(c) M (d) N
8. In figure, the firm's most profitable output is:
(a) K (b) L
(c) M (d) N
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.18

9. Monopolies are allocatively inefficient because:

(a) they restrict the output to keep the price higher than under perfect competition.
(b) they charge a price higher than the marginal cost.
(c) both (a) and (b) are correct.
(d) both (a) and (b) are incorrect.
10. Price discrimination is profitable when:
(a) the elasticity of the product in different markets is same
(b) the elasticity of the product in different market is different
(c) the elasticity of the product in different market is zero
(d) none of the above.
11. All of the following are characteristics of a monopoly except
(a) there is a single firm (b) the firm is a price taker
(c) the firm produces a unique product (d) the existence of some advertising
12. In the case of monopoly:
(a) MR curve cannot be defined (b) AR curve cannot be defined
(c) the short run supply curve cannot be defined (d) none of the above
13. In case of monopoly a firm in the short run can have -
(a) Supernormal profits (b) Normal profits
(c) Losses (d) Any of the above
14. Dumping involves
(a) selling at a price in another market which is lower than the price or cost in your home
market
(b) price discrimination between the two markets
(c) surplus production at lower cost
(d) none of the above
15. The demand curve facing an industrial firm under monopoly is a/an -
(a) horizontal straight line (b) indeterminate
(c) downward sloping (d) upward sloping
16. A monopoly producer usually earns _______________ even in the long run
(a) super normal profits (b) only normal profits
(c) losses (d) none of the above

17. Discriminating monopoly is possible if two markets have :

(a) rising cost curves (b) rising and declining cost curves
(c) different elasticities of demand (d) equal elasticities of demand
18. Consumer's surplus left with the consumer under price discrimination is :
(a) maximum (b) minimum
(c) zero (d) not predictable
19. In long run equilibrium the pure monopolist can make pure profits because of
(a) Blocked entry (b) The high price he charges
(c) The low LAC costs (d) Advertising
20. Which of the following statements is not true about a discriminating monopolist?
(a) He operates in more than one market
(b) He makes more profit because he discriminates
(c) He maximizes his profits in each market
(d) He charges different prices in each market
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.19

21. In the long run under which competition a firm may earn super normal profits?
(a) Monopolistic competition (b) Perfect competition
(c) Oligopoly (d) Monopoly
22. Price discrimination occurs when:
(a) Producer sells a specific commodity or service to different buyers for the same price
(b) Producer sells specific commodity or service to different buyers at two or more
different prices due to differences in cost
(c) Producer sells a specific commodity or service to different buyers at two or more
different prices for reasons not associated with difference in cost
(d) Producer under perfect competition sells different goods to consumers at different
prices
23. MR curve under Monopoly lies between AR and Y-axis because, the rate of decline of the
MR is
(a) Just half of the rate of decline of AR
(b) Just equal to the rate of decline of AR
(c) Just triple the rate of decline of the average revenue
(d) Just double the rate of decline of the average revenue

24. All are features of monopoly except:

(a) There is a single seller (b) The firm is a price taker
(c) The firm produces a unique product (d) The existence of some advertising
25. Monopoly power refers to the firm's ability to:
(a) Earn economic Profit (b) Restrict entry into the industry
(c) Set prices above marginal cost (d) Possess economies of scale
26. Firms in a monopolistic market are price :
(a) Takes (b) Givers
(c) Dictators (d) Acceptors
27. Monopolist can determine:
(a) Price (b) Output
(c) Either price or output (d) None

28. The MR curve cuts the horizontal line between Y axis and demand curve into :
(a) Two unequal parts (b) Two equal pats
(c) May be equal or unequal parts (d) None of these

29. Price discrimination is possible only when

(a) Seller is alone
(b) Goods are homogeneous
(c) Market is controlled by the government (d) None of these

30. When elasticity of demand is Equal to one in monopoly, marginal revenue will be
(a) Equal to one (b) Greater than one
(c) Less than one (d) Zero
31. Monopolist can fix price of goods whose elasticity is ___________________________
(a) Zero (b) More than 1
(c) Elastic (d) Inelastic
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.20

32. By imperfect monopoly, we mean

(a) It is possible to substitute the monopolized product with another monopolized
product
(b) Entry of new firms is possible to produce the same product
(c) The amount of output produced is very small
(d) None of the above
33. Price discrimination is not possible :
(a) under monopoly situation (b) under any market firm
(c) under monopolistic competition (d) under perfect competition
34. All of the following are characteristics of a monopoly except:
(a) there is a single firm (b) the firm is a price taker
(c) the firm produces a unique product (d) the existence of some advertising
35. Monopolistic competition differs from perfect competition primarily because:
(a) in monopolistic competition, firms can differentiate their products.
(b) in perfect competition, firms can differentiate their products
(c) in monopolistic competition, entry into the industry is blocked.
(d) in monopolistic competition, there are relatively few barriers to entry.
36. The long-run equilibrium outcomes in monopolistic competition and perfect competition
are similar, because in both market structures.
(a) the efficient output level will be produced in the long run.
(b) firms will be producing at minimum average cost.
(c) firms will only earn a normal profit.
(d) firms realise all economic of scale
37. A monopolist is able to maximise his profits when:
(a) his output is maximum
(b) he charges a high price
(c) his average cost is minimum
(d) his marginal cost is equal to marginal revenue
38. In which form of the market structure is the degree of control over the price of its product
by a firm very large?
(a) Monopoly (b) Imperfect competition
(c) Oligopoly (d) Perfect competition
39. Discriminating monopoly implies that the monopolist charges different prices for his
commodity:
(a) from different groups of consumers (b) for different uses
(c) at different places (d) any of the above
40. Price discrimination will be profitable only if the elasticity of demand in different market
in which the total market has been divided is:
(a) uniform (b) different
(c) less (d) zero
41. A monopolist is the price:
(a) Maker (b) Taker
(c) Adjuster (d) None of the above
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.21

42. Price discrimination is one of the features of.................

(a) Monopolistic competition (b) Monopoly
(c) Perfect competition (d) Oligopoly
43. Under monopoly, degree of control over price is:
(a) None (b) Some
(c) Very considerable (d) None of the above
44. When the monopolist divides the consumers into separate sub markets and charges
different prices in different sub-markets it is known as:
(a) first degree of price discrimination
(b) second degree of price discrimination
(c) third degree of price discrimination
(d) none of the above
45. Under …………………………… the monopolist will fix a price which will take away the entire
consumer's surplus.
(a) Second degree of price discrimination (b) First degree of price
discrimination
(c) Third degree of price discrimination (d) None of the above

46. Price discrimination is related to:

(a) time (b) size of the purchase
(c) income (d) any of the above
47. The firm and the industry are one and the same in..............
(a) Perfect competition (b) Monopolistic competition
(c) Duopoly (d) Monopoly
48. The demand curve of a monopoly firm will be..............
(a) Upward sloping (b) Downward sloping
(c) Horizontal (d) Vertical
Answer Key
1 a 2 a 3 b 4 c 5 c 6 c 7 d 8 b 9 c 10 b 11 b 12 c 13 d
14 a 15 c 16 a 17 c 18 c 19 a 20 c 21 d 22 c 23 d 24 b 25 b 26 c
27 c 28 b 29 a 30 d 31 d 32 a 33 d 34 b 35 a 36 c 37 d 38 a 39 d

40 b 41 a 42 b 43 c 44 c 45 b 46 d 47 d 48 b
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.22

UNIT 3 (C) IMPERFECT COMPETITION & OLIGOPOLY

IMPERFECT COMPETITION MONOPOLISTIC COMPETITION
 Monopolistic market consists this market contains features of both market :
 Perfect completion
 Monopoly Market
 Its more common market which generally finds in retail trade, grocery shop, soap and
detergent etc.
Features of Monopolistic competition:-
(1) Large no. of sellers:-
 There are large number of buyer & sellers who have small share in the market.
(2) Product differentiation:-
 Product differentiation are generally on the basis of brands.
 All goods are close substitutes but not a perfect substitute.
(3) Freedom of entry or exit:-
 No Restriction on entry & exist.
(4) Non price competition:-
 The market has a non price competition which is a deliberate policy of product
differentiation policy ofproduct differentiation.
 Sellers make high expenditure on publicity & advertisement product development,
better distribution,efficient after sales services.
Price Output determination under Monopolistic competition
Equilibrium of a Firm:-
 Firms have elastic Demand Curve.
 Each firm doesn't have perfectly elastic demand because product is differentiated b/w
firms.
 Firm is a price make and faces downward sloping demand curve but flat demand
curve.
 The less differentiated the product, more elastic demand curve will be.
 Conditions for the Equilibrium of an individual firm:-
(i) MC = MR
(ii) MC curve must cut MR from belong.
 In short run monopolistic seller has two faces of profits:-
 Super-Normal Profit.
 Super Normal Loss.
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.23

 In Long run firm will earn only normal profits because there is no restriction on entry or exist of
firm in short Run.
Long Ran Equilibrium
 In long run an individual firm is in Equilibrium position at a position where it has excess
capacity.
 That is producing lower quantity than its full capacity level.
 In diagram the firm could expand its output from Q1 to Q2 and reduce AC.
 But it does do so because to do so would be to reduce AR even more than AC.
 It implies that firm in monopolistics competition are not of optimum size and there exist excess
capacity (Q1 Q2)
 When AR = AC is equal, there is zero profit.
 Firms in monopolistic competition are not of optimum size and have excess capacity.

OLIGOPOLY
• Oligopoly is an important form of imperfect competition.
• Oligopoly is a market, where there are 2 to 10 sellers in a market selling homogeneous or
differentiated product.
• Acc to prof. Stigler.
“Oligopoly is a situation in which a firm bases its market policy in part on the empted
behavior of a few close rivals.”
• Cold Drink, Automobile are examples of market.
Types of Oligopoly:–
• Pure oligopoly or perfect oligopoly:-
 It's a market when the product is homogeneous in nature.
• Differentiated or imperfect oligopoly:-
 It's a market which is based on product differentiation.
• Open and closed Oligopoly:-
 In the open oligopoly new firms can enter the market and compete with existing
firms.
 In the closed oligopoly entry is restricted.
• Collusive and competitive Oligopoly:-
When few firms of oligopolistic market come to a common understanding or act in collusion
with each other in fixing price and output, its collusive of oligopoly.
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.24

When there is a lack of understanding between the firms and they compete with each other
its called Competitive oligopoly.

• Partial or full Oligopoly:-

Oligopoly is partial when the industry is dominated by one large firm which is considered as
the leader of the group.
Full oligopoly is the market which will be conspicuous by the absence of price leadership.
Syndicated and organized Oligopoly:-
Syndicated oligopoly refers to that situation where the firms sell their products thorough a
centralized syndicate.
Organized oligopoly refers to the market where the firms organized themselves into a central
association for fixing prices, outputs, etc.
Characteristics of Oligopoly Market
(1) Interdependence:-

 It's an important feature of oligopoly.

 Any change in price, output have direct effect on policies of competitive firms.
(2) Importance of Advertising & Selling cost:-

 There is a great importance of advertising and selling cost in market.

 The oligopoly market avoid price cutting and compete on non-price basis.
(3) Group Behaviors:-

 The theory of oligopoly is a theory of group behavior.

 Each oligopoly closely analysis or watches the behavior of other firms.
KINKED DEMAND CURVE
 Many oligopolistic industries prices remain sticky or inflexible for a long time.
 The theory of kinked demand curve given by an American economist Sweezy.
 It's also called Sweezy model.
 The demand curve facing an oligopolist has a 'kink' at the level of the prevailing price.
 The upper segment of the demand curve has high elasticity and lower segment of the
demand curve has low elasticity.
 The price will be kept unchanged for a long time due to stick and inflexible price.
 Firms demand curve is indefinite because of interdependence between firm.
 The sticky price is explained by kinked demand curve.
 Rigid or sticky price are explained with the help of kinked demand theory.
 Each oligipolist believes that can't make any change in prevailing price on kinked price,
because it would be not beneficial for him.
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.25

QUESTIONS & ANSWERS

Unit - 3 (C) Imperfect Competition & Oligopoly
1. When , we know that the firms are earning just
normal profits.
(a) AC=AR (b) MC=MR
(c) MC=AC (d) AR=MR
2. Product differentiation is the most important feature of
(a) Monopolistic competition (b) Monopoly
(c) Oligopoly (d) Perfect Completion
3. The average profit is the difference between __________________.
(a) AC and TC (b) AC and VC.
(c) AC and AR (d) AC and TR
4. In monopolistic competition, a firm is in long run equilibrium _______________________.
(a) at the minimum point of the LAC curve.
(b) in the declining segment of the LAC curve.
(c) in the rising segment of the LAC curve.
(d) when price is equal to marginal cost.
5. The sale of branded articles is common in a situation of __________________ .
(a) excess capacity. (b) monopolistic competition.
(c) monopoly. (d) pure competition.
6. When AR= Rs 10 and AC=Rs 8 the firm makes _________________ .
(a) Normal profit (b) Net profit
(c) Gross profit (d) Supernormal normal profit
7. When a market is in equilibrium:
(a) no shortages exist.
(b) quantity demanded equals quantity supplied.
(c) a price is established that clears the market.
(d) all of the above are correct.
8. “I am making a loss, but with the rent I have to pay, I can't afford to shut down at this
point of time.” If this entrepreneur is attempting to maximize profits or minimize
losses, his behaviour in the short run is:
(a) rational, if the firm is covering its variable cost.
(b) rational, if the firm is covering its fixed costs.
(c) irrational, since plant closing is necessary to eliminate losses.
(d) irrational, since fixed costs are eliminated if a firm shuts down.
9. Which of the following is correct?
(a) If marginal revenue is positive and falling, total revenue will rise at a decreasing rate
(b) Total revenue is equal to price times the quantity sold.
(c) Under perfect competition, total revenue is equal to marginal revenue times the
quantity sold.
(d) All of the above.
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.26

10. A market structure in which many firms sell products that are similar but not
identical is known as
(a) monopolistic competition (b) monopoly
(c) perfect competition. (d) oligopoly.
11. Which of the following statements about price and marginal cost in competitive and
monopolized markets is true?
(a) In competitive markets, price equals marginal cost; in monopolized markets, price
exceeds marginal cost.
(b) In competitive markets, price equals marginal cost; in monopolized markets, price
equals marginal cost.
(c) In competitive markets, price exceeds marginal cost; in monopolized markets, price
exceeds marginal cost.
(d) In competitive markets, price exceeds marginal cost; in monopolized markets, price
equals marginal cost.
12. Which is the first order condition for the profit of a firm to be maximum?
(a) AC = MR (b) MC = MR
(c) MR = AR (d) AC = AR
13. Under which market condition, though the firms earn normal profits in the long run,
there is always excess capacity with them:
(a) Perfect competition (b) Monopoly
(c) Oligopoly (d) Monoplistic competition
14. Which of the following statement is incorrect?
(a) Even monopolist can earn losses
(b) Firms in a perfectly competitive market are price takers
(c) It is always beneficial for a firm in the perfectly competitive market to discriminate
prices
(d) Economic laws are less exact than the laws of physical sciences
15. The structure of the tooth paste industry in India is best described as:
(a) Perfectly competitive (b) Monopolistic
(c) Monopolistically competitive (d) Oligopolistic
16. Price leadership is a form of-
(a) Monopolistic competition (b) Monopoly
(c) Non-collusive Oligopoly (d) Perfect competition
17. A firm under monopolistic competition advertises :
(a) as it has no control over the price of its product
(b) to lower its cost of production
(c) to increase its sales and profit
(d) because it cannot raise price
18. In short run, a firm in monopolistic competition
(a) always earns profits
(b) incurs losses
(c) earns normal profit only
(d) may earn normal profit, super normal profit or incur losses
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.27

19. In long-run, all firms in monopolistic competition

(a) earn super normal profits
(b) earn normal profits
(c) incur losses
(d) may earn super normal profit, normal profit or in incur losses
20. 'Excess Capacity' is the essential characteristic of the firm in the market form of:
(a) Monopoly (b) Perfect competition
(c) Monopolistic competition (d) Oligopoly
21. In both the Chamberlin and kinked demand curve models, the oligopolists
(a) Recognize their independence (b) Do not collude
(c) Tend to keep prices constant (d) All of the above
22. The demand curve is also known as:
(a) Marginal Revenue curve (b) Marginal utility curve
(c) Average Revenue (d) Average utility curve
23. In Imperfect competition:
(a) Excess capacity always exists (b) Excess capacity never exists
(c) Excess capacity may or may not exist (d) None of the above
24. MC=MR and MC cuts MR from below is a true equilibrium condition in:
(a) Short run (b) Long run
(c) Both in short run and long run (d) None of the above
25. Which of the following statements is correct?
(a) Monopolist can earn only profits
(b) Firms in a perfectly competitive market are price maker
(c) Industry in a perfectly competitive market is a price taker
(d) AR curve and demand curve are same
26. Soap industry is an example of:
(a) Oligopoly (b) Perfect competition
(c) Monopolistic competition (d) Monopoly
27. Which of the following is the condition for equilibrium of a firm?
(a) AC = AR (b) MR = AR
(c) MC = MR (d) AC = MR
28. Which of the following is not the feature of an imperfect competition?
(a) Product differentiation (b) Few sellers
(c) Homogeneous products (d) Price wars
29. Which one of the following statement is incorrect?
(a) Competitive firms are price takers and not price makers.
(b) Price discrimination is possible in monopoly only
(c) Duopoly may lead to monopoly
(d) Competitive firm always seeks to discriminate prices.
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.28

30. In monopolistic competition excess capacity in the firm _____________ .

(a) Always Exists (b) Sometimes Exists
(c) Never Exists (d) None of the above
31. Which of the following is not a characteristic of monopolistic competition?
(a) Ease of entry into the industry (b) Product differentiation
(c) A relatively large number of sellers (d) A homogenous product
32. A market structure in which many firms sell products that are similar but not
identical is known as:
(a) Monopolistic competition (b) Monopoly
(c) Perfect competition (d) Oligopoly
33. Under monopolistic competition the cross elasticity of demand for the product of a
single firm would be.......
(a) Infinite (b) Highly elastic
(c) Highly inelastic (d) Zero
34. The market for hand tools (such as hammers and screwdrivers) is dominated by
Draper, Stanley, andCraftsman. This market is best described as:
(a) Monopolistically competitive (b) A monopoly
(c) An oligopoly (d) Perfectly competitive
35. The kinked demand curve model of oligopoly assumes that:
(a) response to a price increase is less than the response to a price decrease
(b) response to a price increase is more than the response to a price decrease
(c) elasticity of demand is constant regardless of whether price increases or decreases
(d) elasticity of demand is perfectly elastic if price increases and perfectly inelastic if price
decreases
36. The kinked demand hypothesis is designed to explain in the context of oligopoly
(a) Price and output determination (b) Price rigidity
(c) Price leadership (d) Collusion among rivals
37. Differentiated oligopoly is one where there are
(a) many sellers producing homogeneous product
(b) few sellers producing homogenous product
(c) many sellers producing differentiated product
(d) few sellers producing differentiated product
38. Kinked demand curve in oligopoly market explains:
(a) Price and output determination
(b) Existence of very few firms in the market
(c) Price rigidity
(d) Price leadership
39. The market structure in which the number of sellers is small and there is inter
dependence in decision making by the firms is known as :
(a) Perfect competition (b) Oligopoly
(c) Monopoly (d) Monopolistic competition
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.29

40. Oligopoly selling identical products is :

(a) Pure oligopoly (b) Imperfect oligopoly
(c) Price leadership (d) Collusion.
41. Kinked demand hypothesis is designed to explain _____________in context of oligopoly.
(a) Price and Output Determination (b) Price Rigidity
(c) Collusion between Firm (d) All of the above
42. In oligopoly, the kink on the demand curve is more due to ____________
(a) Discontinuity in MR
(b) Discontinuity in AR
(c) Fulfilment of the assumption that a price cut is followed by others and a price increased by
a firm is not followed by others.
(d) Price war amongst the firms.
43. Oligopolistic industries are characterized by:
(a) a few dominant firms and substantial barriers to entry.
(b) a few large firms and no entry barriers.
(c) a large number of small firms and no entry barriers.
(d) one dominant firm and low entry barriers.
44. The Kinked demand hypothesis is designed to explain in the context of oligopoly:
(a) Price and output determination (b) Price rigidity
(c) Price leadership (d) Collusion among rivals
45. If firms in the toothpaste industry have the following market shares, which market
structure would best describe the industry?
Market share (% of market)
Toothpaste 18.7
Dentipaste 14.3
Shinibright 11.6
I can't believe its not toothpaste 9.4
Brighter than white 8.8
Pastystuff 7.4
Others 29.8
(a) Perfect competition (b) Monopolistic competition
(c) Oligopoly (d) Monopoly
46. The kinked demand curve model of oligopoly assumes that:
(a) response to a price increase is less than the response to a price decrease.
(b) response to a price increase is more than the response to a price decrease.
(c) elasticity of demand is constant regardless of whether price increases or decreases.
(d) elasticity of demand is perfectly elastic if price increases and perfectly inelastic if price
decreases.
47. One characteristic not typical of oligopolistic industry is:
(a) horizontal demand curve
(b) too much importance to non-price competition
(c) price leadership
(d) a small number of firms in the industry
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.30

48. When the product are sold through a centralized body oligopoly is know as:
(a) organized oligopoly (b) partial oligopoly
(c) competitive oligopoly (d) syndicated oligopoly
49. when an oligopolist individually chooses its level of production to maximize its
profits it charges a price that is:
(a) more than the price charged by either monopoly or a competitive market
(b) less than the price charged by either monopoly or a competitive market
(c) more than the price charged by a monopoly and less than the price charged bya
competitive market
(d) less then the price charged by a monopoly and more than the price charged by a
competitive market.
50. In oligopoly, when the industry is dominated by one large firm which is considered as
leader of the group. This is called:
(a) full oligopoly (b) collusive oligopoly
(c) partial oligopoly (d) syndicated oligopoly
51. Which one of the following is the best example of agreement between oligopolists?
(a) GATT (b) OPEC
(c) WTO (d) UNIDO
52. When. ___________________, we know that the firms are earning just normal profits.
(a) AC = AR (b) MC = MR
(c) MC= AC (d) AR=MR
53. When. ________________, we know that the firms must be producing at the minimum point
of the averge cost curve and so there will be productive efficiency.
(a) AC = AR (b) MC = MR
(c) MC = AC (d) AR = MR
54. When _____________________________________, there will be allocative efficiency meaning
thereby that the cost of the last unit is exactly equal to the price consumers are
willing to pay for it and so that the right goods are being sold to the right people at
the right price.
(a) MC=MR (b) MC=AC
(c) MC=AR (d) AR=MR
55. The competitive firm maximizes profit when if produces output up to the point
where:
(a) price equals average variable cost
(b) marginal revenue equals average revenue
(c) marginal cost equals total revenue
(d) marginal cost equals marginal revenue
56. In the long-run equilibrium of a competitive market, firms operate at:
(a) the intersection fo the marginal cost and marginal revenue
(b) their efficient scale
(c) zero economic profit
(d) all of these answers are correct
 PRICE OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS (UNIT - III) | 4.31

57. In a very short period market

(a) The supply is fixed (b) The demand is fixed
(c) Demand and supply are fixed (d) None of the above
58. Time element was conceived by:
(a) Adam Smith (b) Alfred Marshall
(c) Pigou (d) Lionel Robinson
59. If the average cost a higher than the average revenue then the firm incurs:
(a) Normal profit (b) Abnormal profit
(c) Normal loss (d) Abnormal loss
60. Which of the following statements is correct?
(a) price rigidity is an important features of monopoly
(b) Selling costs are possible under perfect competition.
(c) Under perfect competition factors of production do not move freely as there are legal
restrictions.
(d) An industry consist of many firms.
61. Which of the following statements is incorrect?
(a) Under monopoly there is no difference between a firm and an industry.
(b) A monopolist may restrict the output and raises the price.
(c) Commodities offered for sale under a perfect competition will be heterogeneous.
(d) Product differentiation is peculiar to monopolistic competition.

Answer Key
1 a 2 a 3 c 4 b 5 b 6 d 7 d 8 a 9 d 10 a 11 a 12 b 13 d
14 c 15 c 16 c 17 c 18 d 19 b 20 c 21 d 22 c 23 a 24 c 25 d 26 c
27 c 28 c 29 d 30 a 31 d 32 a 33 b 34 c 35 a 36 b 37 d 38 c 39 b

40 a 41 b 42 c 43 a 44 b 45 c 46 a 47 a 48 d 49 d 50 c 51 b 52 a
53 c 54 c 55 d 56 d 57 a 58 b 59 d 60 d 61 c
 BUSINESS CYCLE | 5.1

CHAPTER – 5 BUSENISS CYCLES

CHAPTER - 5
BUSINESS CYCLES

INTRODUCTION
 Rhythmic fluctuations in aggregate economic activity that an economy experiences over a
period of time are calledbusiness cycles or trade cycles.
 A trade cycle is composed of periods of good trade characterised by rising prices and low
unemployment percentage,altering with periods of bad trade characterised by falling prices and
high unemployment percentages.
 Business cycle refers to alternate expansion and contraction of overall business activity as
manifested in fluctuations in measures of aggregate economic activity, such as, gross national
product, employment and income.
 Characteristic of economic fluctuations is that they are recurrent and occur periodically i.e.
they occur again and againbut not always at regular intervals, nor are they of the same length.
 Some business cycles have been long, lasting for several years while others have been
short ending in two to threeyears

PHASES OF BUSINESS CYCLE

 We have seen above that business cycles or the periodic booms and slumps in economic
activities reflect the upward and downward movements in economic variables.
 A typical business cycle has four distinct phases. These are:
 Wealth oriented economics is a science of wealth.
1. Expansion (also called Boom or Upswing)
2. Peak or boom or Prosperity
3. Contraction (also called Downswing or Recession)
4. Trough or Depression

 The broken line (marked 'trend') represents the steady growth line or the growth of
the economy when there are nobusiness cycles.
 The figure starts with 'trough' when the overall economic activities i.e. production and
employment, are at the lowestlevel.
 As production and employment expand, the economy revives, and it moves into the expansion
path.
 However, since expansion cannot go on indefinitely, after reaching the 'peak', the economy
starts contracting.
 BUSINESS CYCLE | 5.2

 The contraction or downturn continues till it reaches the lowest turning point i.e. 'trough'.
 However, after remaining at this point for some time, the economy revives again and a new
cycle starts.
Expansion:
 The expansion phase is characterised by increase in national output, employment,
aggregate demand, capital and consumer expenditure, sales, profits, rising stock prices and
bank credit.
 This state continues till there is full employment of resources and production is at its
maximum possible level using the available productive resources. Involuntary
unemployment is almost zero and whatever unemployment is there is either frictional (i.e.
due to change of jobs, or suspended work due to strikes or due to imperfect mobility of
labour) or structural (i.e. unemployment caused due to structural changes in the
economy).
 Wealth oriented economics is a science of wealth.
 Prices and costs also tend to rise faster.
 Good amounts of net investment occur, and demand for all types of goods and services
rises.
 There is altogether increasing prosperity and people enjoy high standard of living due to
high levels of consumer spending, business confidence, production, factor incomes, profits
and investment.
 The growth rate eventually slows down and reaches its peak.
Peak:
 The term peak refers to the top or the highest point of the business cycle. In the later
stages of expansion, inputs are difficult to find as they are short of their demand and
therefore input prices increase.
 Output prices also rise rapidly leading to increased cost of living and greater strain on fixed
incomeearners.
 Consumers begin to review their consumption expenditure on housing, durable goods
etc.Actual demand stagnates.
 This is the end of expansion and it occurs when economic growth has reached a point
where it willstabilize for a short time and then move in the reverse direction.

Contraction:
 The economy cannot continue to grow endlessly.
 As mentioned above, once peak is reached, increase in demand is halted and starts
decreasing in certain sectors.
 During contraction, there is fall in the levels of investment and employment. Producers do
not instantaneously recognise the pulse of the economy and continue anticipating higher
levels of demand, and therefore, maintain their existing levels of investment and
production.
 The consequence is a discrepancy or mismatch between demand and supply.
 Supply far exceeds demand. Initially, this happens only in few sectors and at a slow pace,
but rapidly spreads to all sectors.
 Producers being aware of the fact that they have indulged in excessive investment and
over production, respond by holding back future investment plans, cancellation and
stoppage of orders for equipments and all types of inputs including labour.
 This in turn generates a chain of reactions in the input markets and producers of capital
goods and raw materials in turn respond by cancelling and curtailing their orders.
 BUSINESS CYCLE | 5.3

 This is the turning point and the beginning of recession.

 Decrease in input demand pulls input prices down; incomes of wage and interest earners
gradually decline resulting in decreased demand for goods and services.
 Producers lower their prices in order to dispose off their inventories and for meeting their
financial obligations. Consumers, in their turn, expect further decreases in prices and
postpone their purchases.
 With reduced consumer spending, aggregate demand falls, generally causing fall in prices.
 The discrepancy between demand and supply gets widened further.
 This process gathers speed and recession becomes severe.
 Investments start declining; production and employment decline resulting in further
decline in incomes, demand and consumption of both capital goods and consumer goods.
 Business firms become pessimistic about the future state of the economy and there is a fall
in profit expectations which induces them to reduce investments. Bank credit shrinks as
borrowings for investment declines, investor confidence is at its lowest, stock prices fall
and unemployment increases despite fall in wage rates.
 The process of recession is complete and the severe contraction in the economic activities
pushes the economy into the phase of depression.
Trough and Depression:
 Depression is the severe form of recession and is characterized by extremely sluggish
economic activities.
 During this phase of the business cycle, growth rate becomes negative and the level of
national income and expenditure declines rapidly.
 Demand for products and services decreases, prices are at their lowest and decline rapidly
forcing firms to shutdown several production facilities.
 Since companies are unable to sustain their work force, there is mounting unemployment
which leaves the consumers with very little disposable income.
 A typical feature of depression is the fall in the interest rate.
 With lower rate of interest, people's demand for holding liquid money (i.e. in cash)
increases.
 Despite lower interest rates, the demand for credit declines because investors' confidence
has fallen.
 Often, it also happens that the availability of credit also falls due to possible banking or
financial crisis.
 Industries, especially capital and consumer durable goods industry, suffer from excess
capacity.
 Large number of bankruptcies and liquidation significantly reduce the magnitude of trade
and commerce.
 At the depth of depression, all economic activities touch the bottom and the phase of
trough is reached.
Recovery:
 It is a very agonizing period causing lots of distress for all. The great depression of 1929-
33 is still cited for the enormous misery and human sufferings it caused.
 The economy cannot continue to contract endlessly.
 It reaches the lowest level of economic activity called trough and then starts recovering.
 Trough generally lasts for some time and marks the end of pessimism and the beginning of
 BUSINESS CYCLE | 5.4

optimism.
 This reverses the process.
 The process of reversal is initially felt in the labour market.
 Pervasive unemployment forces the workers to accept wages lower than the prevailing
rates.
 The producers anticipate lower costs and better business environment.
 A time comes when business confidence takes off and gets better, consequently they start
to invest again and to build stocks; the banking system starts expanding credit;
technological advancements require fresh investments into new types of machines and
capital goods; employment increases, aggregate demand picks up and prices gradually
rise.
 Besides, price mechanism acts as a self-correcting process in a free enterprise economy.
 The spurring of investment causes recovery of the economy.
 This acts as a turning point from depression to expansion.
 As investment rises, production increases, employment improves, income improves and
consumers begin to increase their expenditure.
 Increased spending causes increased aggregate demand and in order to fulfil the demand
more goods and services are produced.
 Employment of labour increases, unemployment falls and expansion takes place in the
economic activity.
 It is to be reemphasized that no economy follows a perfectly timed cycle and that the
business cycles are anything but regular.
 They vary in intensity and length. There is no set pattern which they follow.
 Some cycles may have longer periods of boom, others may have longer period of
depression.
 Leading Indicator is a measurable economic factor that changes before the economy starts to
follow a particularpattern or trend.
 In other words, those variables that change before the real output changes are called
'Leading indicators'. Leading indicators often change prior to large economic
adjustments.
 For example, changes in stock prices, profit margins and profits, indices such as
housing, interest rates and prices are generally seen as precursors of upturns or
downturns.
 Similarly, value of new orders for consumer goods, new orders for plant and
equipment, building permits for private houses, fraction of companies reporting
slower deliveries, index of consumer confidence and money growth rate are also
used for tracking and forecasting changes in business cycles.
 Leading indicators, though widely used to predict changes in the economy, are not
always accurate.
 Even experts disagree on the timing of these so-called leading indicators. It may be
weeks or months after a stock market crash before the economy begins to show
signs of receding. Nevertheless, it may never happen.
 Lagging indicators reflect the economy's historical performance and changes in
these indicators are observable only after an economic trend or pattern has already
occurred.
 In other words, variables that change after the real output changes are called 'Lagging
indicators'.
 BUSINESS CYCLE | 5.5

 If leading indicators signal the onset of business cycles, lagging indicators

confirm these trends. Lagging indicators consist of measures that change after an
economy has entered a period of fluctuation.
 Some examples of lagging indicators are unemployment, corporate profits, labour
cost per unit of output, interest rates, the consumer price index and commercial
lending activity.
 Coincident economic indicators, also called concurrent indicators, coincide or occur
simultaneously with thebusiness-cycle movements.
 Since they coincide fairly closely with changes in the cycle of economic activity, they
describe the current state of the business cycle. In other words, these indicators give
information about the rate of change of the expansion or contraction of an economy
more or less at the same point of time it happens.
 A few examples of coincident indicators are Gross Domestic Product, industrial
production, inflation, personal income, retail sales and financial market trends such as
stock market prices.
FEATURES OF BUSINESS CYCLES
Different business cycles differ in duration and intensity. But there are certain features which they
commonly exhibit:
(a) Business cycles occur periodically although they do not exhibit the same regularity. The
duration of these cycles vary.The intensity of fluctuations also varies.
(b) Business cycles have distinct phases of expansion, peak, contraction and trough. These
phases seldom display smoothness and regularity. The length of each phase is also not
definite.
(c) Business cycles generally originate in free market economies. They are pervasive as well.
Disturbances in one or more sectors get easily transmitted to all other sectors.
(d) Although all sectors are adversely affected by business cycles, some sectors such as capital
goods industries, durable consumer goods industry etc, are disproportionately affected.
Moreover, compared to agricultural sector, the industrials sector is more prone to the
adverse effects of tradecycles.
(e) Business cycles are exceedingly complex phenomena; they do not have uniform
characteristics and causes.
They are caused by varying factors. Therefore, it is difficult to make an accurate prediction
of trade cycles beforetheir occurrence.
(f) Repercussions of business cycles get simultaneously felt on nearly all economic variables viz.
output, employment, investment, consumption, interest, trade and price levels.
(g) Business cycles are contagious and are international in character. They begin in one country
and mostly spread to other countries through trade relations. For example, the great
depression of 1930s in the USA and Great Britain affected almost all the countries, especially
the capitalist countries of the world.
(h) Business cycles have serious consequences on the well-being of the society.
CAUSES OF BUSINESS CYCLES
 BUSINESS CYCLE | 5.6

Internal Causes:
The Internal causes or endogenous factors which may lead to boom or bust are:

 Fluctuations in Effective Demand

 According to Keynes, fluctuations in economic activities are due to fluctuations in
aggregate effective demand (Effective demand refers to the willingness and ability of
consumers to purchase goods at different prices).
 In a free market economy, where maximization of profits is the aim of businesses, a
higher level of aggregate demand will induce businessmen to produce more.
 As a result, there will be more output, income and employment.
 However, if aggregate demand outstrips aggregate supply, it causes inflation.
 As against this, if the aggregate demand is low, there will be lesser output, income
and employment. Investors sell stocks, and buy safe-haven investments that
traditionally do not lose value, such as bonds, gold and the U.S. dollar.
 As companies lay off workers, consumers lose their jobs and stop buying anything
but necessities.
 That causes a downward spiral.
 The bust cycle eventually stops on its own when prices are so low that those
investors that still have cash start buying again.
 However, this can take a long time, and even lead to a depression.
 The difference between exports and imports is the net foreign demand for goods
and services.
 This is a component of the aggregate demand in the economy, and therefore
variations in exports and imports can lead to business fluctuations as well.
 Thus, increase in aggregate effective demand causes conditions of expansion or boom
and decrease in aggregate effective demand causes conditions of recession or
depression. (You will study about these concepts in detail at Intermediate level in
Economics for Finance).
• Fluctuations in Investment
 According to some economists, fluctuations in investments are the prime cause of
business cycles. Investment spending is considered to be the most volatile
component of the aggregate demand.
 Investments fluctuate quite often because of changes in the profit expectations of
entrepreneurs.
 New inventions may cause entrepreneurs to increase investments in projects which
 BUSINESS CYCLE | 5.7

are cost-efficient or more profit inducing.

 Or investment may rise when the rate of interest is low in the economy.
 Increases in investment shift the aggregate demand to the right, leading to an
economic expansion. Decreases in investment have the opposite effect.
• Variations in government spending:
 Fluctuations in government spending with its impact on aggregate economic activity
result in business fluctuations. Government spending, especially during and after
wars, has destabilizing effects on the economy.
• Macroeconomic policies:
 Macroeconomic policies (monetary and fiscal policies) also cause business cycles.
 Expansionary policies, such as increased government spending and/or tax cuts, are
the most common method of boosting aggregate demand.
 This results in booms. Similarly, softening of interest rates, often motivated by
political motives, leads to inflationary effects and decline in unemployment rates.
 Anti-inflationary measures, such as reduction in government spending, increase in
taxes and interest rates cause a downward pressure on the aggregate demand and
the economy slows down.
 At times, such slowdowns may be drastic, showing negative growth rates and may
ultimately end up in recession.
• Money Supply:
 According to Hawtrey, trade cycle is a purely monetary phenomenon.
 Unplanned changes in supply of money may cause business fluctuation in an
economy.
 An increase in the supply of money causes expansion in aggregate demand and in
economic activities.
 However, excessive increase of credit and money also set off inflation in the economy.
 Capital is easily available, and therefore consumers and businesses alike can borrow
at low rates.
 This stimulates more demand, creating a virtuous circle of prosperity.
 On the other hand, decrease in the supply of money may reverse the process and
initiate recession in the economy.
• Psychological factors:
 According to Pigou, modern business activities are based on the anticipations of
business community and are affected by waves of optimism or pessimism.
 Business fluctuations are the outcome of these psychological states of mind of
businessmen.
 If entrepreneurs are optimistic about future market conditions, they make
investments, and as a result, the expansionary phase may begin.
 The opposite happens when entrepreneurs are pessimistic about future market
conditions.
 Investors tend to restrict their investments.
 With reduced investments, employment, income and consumption also take a
downturn and the economy faces contraction in economic activities.
 According to Schumpeter's innovation theory, trade cycles occur as a result of
innovations which take place in the system from time to time.
 The cobweb theory propounded by Nicholas Kaldor holds that business cycles result
from the fact that present prices substantially influence the production at some
future date.
 BUSINESS CYCLE | 5.8

 The present fluctuations in prices may become responsible for fluctuations in output
and employment at somesubsequent period.
 External Causes:
The External causes or exogenous factors which may lead to boom or bust are:
 Wars:
 During war times, production of war goods, like weapons and arms etc., increases
and most of the resources of the country are diverted for their production.
 This affects the production of other goods - capital and consumer goods.
 Fall in production causes fall in income, profits and employment.
 This creates contraction in economic activity and may trigger downturn in business
cycle.
 Post War Reconstruction:
 After war, the country begins to reconstruct itself.
 Houses, roads, bridges etc. are built and economic activity begins to pick up.
 All these activities push up effective demand due to which output, employment and
income go up.
 Technology shocks
 G rowing technology enables production of new and better products and services.
 These products generally require huge investments for new technology adoption.
 This leads to expansion of employment, income and profits etc. and give a boost to
the economy.
 For example, due to the advent of mobile phones, the telecom industry underwent a
boom and there was expansion of production, employment, income and profits.
 Natural Factors:
 Weather cycles cause fluctuations in agricultural output which in turn cause
instability in the economies, especially those economies which are mainly agrarian.
 In the years when there are draughts or excessive floods, agricultural output is badly
affected.
 With reduced agricultural output, incomes of farmers fall and therefore they reduce
their demand for industrial goods.
 Reduced production of food products also pushes up their prices and thus reduces
the income available for buying industrial goods.
 Reduced demand for industrial products may cause industrial recession.

 Population growth:
 If the growth rate of population is higher than the rate of economic growth, there
will be lesser savings in the economy.
 Fewer saving will reduce investment and as a result, income and employment will
also be less.
 With lesser employment and income, the effective demand will be less, and overall,
there will be slowdown in economic activities.
RELEVANCE OF BUSINESS CYCLES IN BUSINESS DECISION MAKING
 Business cycles affect all aspects of an economy.
 Understanding the business cycle is important for businesses of all types as they
affect the demand for their products and in turn their profits which ultimately
determines whether a business is successful or not.
 Knowledge regarding business cycles and their inherent characteristics is important
for a businessman to frame appropriate policies.
 BUSINESS CYCLE | 5.9

 For example, the period of prosperity opens up new and superior opportunities for
investment, employment and production and thereby promotes business.
 In contrast, a period of recession or depression reduces business opportunities and
profits.
 A profit maximising firm has to consider the nature of the economic environment
while making business decisions, especially those related to forward planning.
 Business cycles have tremendous influence on business decisions.
 The stage of the business cycle is crucial while making managerial decisions
regarding expansion or down-sizing.
 Businesses have to advantageously respond to the need to alter production levels
relative to demand.
 Different phases of the cycle require fluctuating levels of input use, especially labour
input.
 Firms should exercise the capability to expand or rationalize production operations
so as to suit the stage of the business cycle.
 Business managers need to work effectively to arrive at sound strategic decisions in
complex times across the whole business cycle, managing through boom, downturn,
recession and recovery.
 Economy-wide trends can have significant impact on all types businesses.
 However, it should be kept in mind that business cycles do not affect all sectors
uniformly.
 Some businesses are more vulnerable to changes in the business cycle than others.
 Businesses whose fortunes are closely linked to the rate of economic growth are
referred to as "cyclical" businesses.
 These include fashion retailers, electrical goods, house-builders, restaurants,
advertising, overseas tour operators, construction and other infrastructure firms.
 During a boom, such businesses see a strong demand for their products but during a
slump, they usually suffer a sharp drop in demand.
 It may also happen that some businesses actually benefit from an economic down
turn.
 This happens when their products are perceived by customers as representing good
value for money, or a cheaper alternative compared to more expensive products.
 Overcoming the effects of economic downturns and recessions is one of the major
challenges of sustaining a business in the long-term.
 The phase of the business cycle is important for a new business to decide on entry
into the market.
 The stage of business cycle is also an important determinant of the success of a new
product launch.
 Surviving the sluggish business cycles require businesses to plan and set policies
with respect to product, prices and promotion.
 In general, economic forecasts are not perfectly reliable.
 Neither, of course, are the hunches and intuitions of entrepreneurs.
 Understanding what phase of the business cycle an economy is in and what
implications the current economic conditions have for their current and future
business activity, helps businesses to better anticipate the market and to respond
with greater alertness.
 However, taken together and applied carefully, economic forecasts can help
business firms to prepare for changes in the direction of the economy either prior to
or soon after these changes occur.
 BUSINESS CYCLE | 5.10

QUESTIONS & ANSWERS

1. The term business cycle refers to
(a) the ups and downs in production of commodities
(b) the fluctuating levels of economic activity over a period of time
(c) decline in economic activities over prolonged period of time
(d) increasing unemployment rate and diminishing rate of savings
2. A significant decline in general economic activity extending over a period of time is
(a) business cycle (b) contraction phase
(c) recession (d) recovery
3. The trough of a business cycle occurs when hits its lowest point.
(a) inflation in the economy (b) the money supply
(c) aggregate economic activity (d) the unemployment rate
4. The lowest point in the business cycle is referred to as the
(a) Expansion. (b) Boom.
(c) Peak. (d) Trough.
5. A leading indicator is
(a) a variable that tends to move along with the level of economic activity
(b) a variable that tends to move in advance of aggregate economic activity
(c) a variable that tends to move consequent on the level of aggregate economic activity
(d) None of the above
6. A variable that tends to move later than aggregate economic activity is called
(a) a leading variable (b) a coincident variable
(c) a lagging variable (d) a cyclical variable
7. Industries that are extremely sensitive to the business cycle are the
(a) Durable goods and service sectors.
(b) Non-durable goods and service sectors.
(c) Capital goods and non-durable goods sectors.
(d) Capital goods and durable goods sectors.
8. A decrease in government spending would cause
(a) the aggregate demand curve to shift to the right.
(b) the aggregate demand curve to shift to the left.
(c) a movement down and to the right along the aggregate demand curve.
(d) a movement up and to the left along the aggregate demand curve.
9. Which of the following does not occur during an expansion?
(a) Consumer purchases of all types of goods tend to increase.
(b) Employment increases as demand for labour rises.
(c) Business profits and business confidence tend to increase
(d) None of the above.
10. Which of the following best describes a typical business cycle?
(a) Economic expansions are followed by economic contractions.
(b) Inflation is followed by rising income and unemployment.
(c) Economic expansions are followed by economic growth and development.
(d) Stagflation is followed by inflationary economic growth.
 BUSINESS CYCLE | 5.11

11. During recession, the unemployment rate ___________ and output ___________ .
(a) Rises; falls (b) Rises; rises
(c) Falls; rises (d) Falls; falls
12. The four phases of the business cycle are
(a) expansion, peak, contraction and trough
(b) contraction, expansion, trough and boom
(c) expansion contraction, peak, and trough
(d) peak, depression, bust, and boom
13. Leading economic indicators
(a) are used to forecast probable shifts in economic policies
(b) are generally used to forecast economic fluctuations
(c) are indicators of stock prices existing in an economy
(d) are indicators of probable recession and depression
14. When aggregate economic activity is declining, the economy is said to be in
(a) Contraction. (b) an expansion.
(c) a trough. (d) a turning point.
15. Peaks and troughs of the business cycle are known collectively as
(a) Volatility (b) Turning Point
(c) Equilibrium points (d) Real business cycle events
16. The most probable outcome of an increase in the money supply is
(a) interest rates to rise, investment spending to rise, and aggregate demand to rise
(b) interest rates to rise, investment spending to fall, and aggregate demand to fall
(c) interest rates to fall, investment spending to rise, and aggregate demand to rise
(d) interest rates to fall, investment spending to fall, and aggregate demand to fall
17. Which of the following is not a characteristic of business cycles?
(a) Business cycles have serious consequences on the well-being of the society.
(b) Business cycles occur periodically, although they do not exhibit the same regularity.
(c) Business cycles have uniform characteristics and causes.
(d) Business cycles are contagious and unpredictable.
18. Economic recession shares all of these characteristics except.
(a) Fall in the levels of investment, employment
(b) Incomes of wage and interest earners gradually decline resulting in decreased
demand for goods and services
(c) Investor confidence is adversely affected and new investments may not be
forthcoming
(d) Increase in the price of inputs due to increased demand for inputs
19. The different phases of a business cycle
(a) Do not have the same length and severity
(b) expansion phase always last more than ten years
(c) last many years and are difficult to get over in short periods
(d) None of the above
20. Which of the following is not an example of coincident indicator?
(a) Industrial production
(b) inflation
(c) Retail sales
(d) New orders for plant and equipment
 BUSINESS CYCLE | 5.12

21. According to _________ trade cycles occur due to onset of innovations.

(a) Hawtrey (b) Adam Smith
(c) J M Keynes (d) Schumpeter
22. Economic indicators are –
(a) A one stroke solution to check the phase of economy
(b) Indicators showing the movement of economy
(c) Some activities which predict the direction of economy
(d) Just an illusion
23. Which economic indicator is required to predict the turning point of business cycle –
(a) Leading indicator (b) Lagging indicator
(c) Coincident (d) All of the above
24. Business cycle generally originate in free market economies, what is a free market
economy?
(a) The economy where government is in possession of major assets
(b) The economy where private firms control major assets
(c) The economy where decisions of productions are taken by public sector
undertakings
(d) The economy where price is controlled by government.
25. Which of the following statements is correct?
(a) The business cycle largely affects the agricultural sector
(b) The business cycle largely affects small employees
(c) The business cycle generally affects all sectors of economy but business sector in
particular.
(d) The business cycle affects low wages workers

Answer Key
1 B 2 C 3 C 4 D 5 B 6 C 7 D 8 B 9 D 10 A 11 A 12 A 13 B
14 A 15 B 16 C 17 C 18 D 19 A 20 D 21 D 22 C 23 D 24 B 25 C

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