COURSE FOR LL-B 5-YEARS PROGRAM

SUBJECT: FUNDAMENTAL OF ECONOMICS

INTRODUCTION
What economics is all about? Wealth definition; Welfare definition, Scarcity definition, Subject
matter of economics, Positive and normative economics.
MICROECONOMICS
What is Microeconomics? Scarcity, Choice and Opportunity Cost. The Price Mechanism.
1- DEMAND AND LAW OF DEMAND
Meaning of demand, Market demand, Determinants of demand, Demand schedule and demand
curve, Law of demand, Assumptions of the law, why does the law of demand operate?
Exceptions to the law of demand, Movement along and shifts in demand curve.
2- ELASTICITY OF DEMAND
Meaning of price elasticity of demand, Kinds of price elasticity of demand, Measurement of
price elasticity of demand, Income elasticity of demand, Cross elasticity of demand,
Determinants of price elasticity of demand.
3- SUPPLY AND ITS DETERMINANTS
Meaning of supply, Supply schedule, Supply curve, Market supply, Law of supply, Determinants
of supply, Supply function, Movement along and shifts in supply curve.
4- CONCEPTS OF COST
Cost of production, Short run costs and long run costs, Fixed and variable costs, Total fixed cost,
Total variable cost, Average cost, Average fixed cost, Average variable cost, and Marginal costs.
5- MARKET AND FORMS OF MARKET
Meaning of market, Forms of market, Perfect competition, Monopoly, Monopolistic
Competition.

Recommended Book:
1- The Principles of Microeconomics.

MACROECONOMICS
What is Macroeconomics? Distinction between Microeconomics and Macroeconomics.
Currency, Inflation, Business Cycles, Unemployment, Economic Growth, International Trade,
Macroeconomic Policies and Macroeconomic Schools of Thought.

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 1- NATIONAL INCOME AND RELATED AGGREGATES
Meaning of national income, Circular flow of income, Concepts of GDP, GNP, NDP, NNP (at
market price and factor cost), Private income, Personal income and Personal disposal income,
National disposal income (gross and net). Income from Domestic product accruing to Private
Sector, Transfer payments—Current transfer payments and Capital transfer payments,
Relationship among important national income aggregates.
2- MEASUREMENT OF NATIONAL INCOME—VALUE ADDED METHOD
Measurement of national income—value added method, steps to estimate national income by
value added/product method, Precautions in the estimation of national income by product
method, Difficulties of the product method.
3- MEASUREMENT OF NATIONAL INCOME—INCOME METHOD
Precautions in the estimation of national income by income method, Difficulties of the income
method.
4- MEASUREMENT OF NATIONAL INCOME—EXPENDITURE METHOD
Components of final expenditure, Precautions in the estimation of national income by
expenditure method.
5- AGGREGATE DEMAND AND AGGREGATE SUPPLY
Meaning of aggregate demand, Meaning of aggregate supply.
6- CONSUMPTION AND SAVING FUNCTION
Propensity to consume, Average and marginal propensity to consume and save, Propensity to
save/saving function, Relationship between APC and MPC, Factors influencing consumption
function.
7- EXCESS AND DEFICIENT DEMAND
Meaning of excess demand, Impact of excess demand, meaning of deficient demand, Impact of
deficient demand, Causes of excess and deficient demand.

Recommended Book:
1- The Principles of Macroeconomics.

ECONOMY OF PAKISTAN:
Challenges and Prospects: Causes, Effects and Solutions of Various Problems in Pakistan.

Recommended Book:
1- The Economy of Pakistan.

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Introduction to Economics

What economics is all about?

Economics is a social science that deals with the production, distribution, and consumption of
goods and services. It focuses heavily on the four factors of production, which are land, labor,
capital, and enterprise.
Economics is the study of how societies use scarce resources to produce valuable commodities
and distribute them among different people. Behind this definition are two key ideas
in economics: that goods are scarce and that society must use its resources efficiently.

The following points highlight the top two definitions of Economics.

The definitions are:

1. General Definition of Economics

2. Adam Smith’s Wealth Definition

3. Marshall’s Welfare Definition

4. Robbins’ Scarcity Definition.

1. General Definition of Economics:

The English word economics is derived from the ancient Greek word oikonomia—meaning the
management of a family or a household.

It is thus clear that the subject of economics was first studied in ancient Greece.

Economics, as a study of wealth, received great support from the Father of economics, Adam
Smith, in the late eighteenth century.

Since then, the subject has travelled a long and this Greek or Smithian definition serves our
purpose no longer. Over the passage of time, the focus of attention has been changed. As a result,
different definitions have evolved.

These definitions can conveniently be grouped into three:

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 1- Adam Smith’s Wealth definition;

2- Alfred Marshall’s Welfare definition; and

3- Robbins’ Scarcity definition.

1- Adam Smith’s Wealth Definition:

The formal definition of economics can be traced back to the days of Adam Smith (1723-1790)
the great Scottish economist. Following the mercantilist tradition, Adam Smith and his followers
regarded economics as a science of wealth which studies the process of production, consumption
and accumulation of wealth.

His emphasis on wealth as a subject-matter of economics is implicit in his great book— ‘An
Inquiry into the Nature and Causes of the Wealth of Nations or, more popularly known as
‘Wealth of Nations’—published in 1776.

According to Smith:
“The great object of the Political Economy of every country is to increase the riches and
power of that country.”
To him, wealth may be defined as those goods and services which command value-in- exchange.
Economics is concerned with the generation of the wealth of nations. Economics is not to be
concerned only with the production of wealth but also the distribution of wealth. The manner in
which production and distribution of wealth will take place in a market economy is the Smithian
‘invisible hand’ mechanism or the ‘price system’. Anyway, economics is regarded by Smith as
the ‘science of wealth.’

Other scholars and experts define economics as that part of knowledge which relates to wealth.
John Stuart Mill (1806-73) argued that economics is a science of production and distribution of
wealth. Another classical economist Nassau William Senior (1790-1864) argued “The subject-
matter of the Political Economics is not Happiness but Wealth.” Thus, economics is the science
of wealth.

Criticisms:
Following are the main criticisms of the classical definition:
i. This definition is too narrow as it does not consider the major problems faced by a society or
an individual. Smith’s definition is based primarily on the assumption of an ‘economic man’ who

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is concerned with wealth-hunting. That is why critics condemned economics as ‘the bread-and-
butter science’.

ii. Since Smithian definition led us to emphasise on the material aspect of human life, i.e.,
generation of wealth. On the other hand, it ignored the non-material aspect of human life. Above
all, as a science of wealth, it taught selfishness and love for money. John Ruskin (1819-1900)
called economics a ‘bastard science.’

iii. The central focus of economics should be on scarcity and choice. Since scarcity is the
fundamental economic problem of any society, choice is unavoidable. Adam Smith ignored this
simple but essential aspect of any economic system.

2- Marshall’s Welfare Definition:

Alfred Marshall in his book ‘Principles of Economics published in 1890 placed emphasis on
human activities or human welfare rather than on wealth.

Marshall’s own words: “Political Economy or Economics is a study of mankind in the ordinary
business of life; it examines that part of individual and social action which is most closely
connected with the attainment and with the use of the material requisites of well-being.”

Thus, “Economics is on the one side a study of wealth; and on the other and more important side,
a part of the study of man.” According to Marshall, wealth is not an end in itself as was thought
by classical authors; it is a means to an end—the end of human welfare.

This Marshallian definition has the following important features:

i. Economics is a social science since it studies the actions of human beings.

ii. Economics studies the ‘ordinary business of life’ since it takes into account the money-earning
and money-spending activities of man.

iii. Economics studies only the ‘material’ part of human welfare which is measurable in terms of
the measuring rod of money. It neglects other activities of human welfare not quantifiable in
terms of money. In this connection A. C. Pigou’s (1877- 1959)—another great neo-classical
economist—definition is worth remembering. Economics is “that part of social welfare that can
be brought directly or indirectly into relation with the measuring rod of money.”

iv. Economics is not concerned with “the nature and causes of the Wealth of Nations.” Welfare
of mankind, rather than the acquisition of wealth, is the object of primary importance.
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Criticisms:
Though Marshall’s definition of economics was hailed as a revolutionary one, it was criticized
on several grounds.

They are:
i. Marshall’s notion of ‘material welfare’ came in for sharp criticism at the hands of Lionel
Robbins (later Lord) (1898- 1984) in 1932. Robbins argued that economics should encompass
‘non- material welfare’ also. In real life, it is difficult to segregate material welfare from non-
material welfare. If only the ‘materialist’ definition is accepted, the scope and subject-matter of
economics would be narrower, or a great part of economic life of man would remain outside the
domain of economics.

ii. Robbins argued that Marshall could not establish a link between economic activities of human
beings and human welfare. There are various economic activities that are detrimental to human
welfare. The production of war materials, wine, etc., are economic activities but do not promote
welfare of any society. These economic activities are included in the subject-matter of
economics.

iii. Marshall’s definition aimed at measuring human welfare in terms of money. But ‘welfare’ is
not amenable to measurement, since ‘welfare’ is an abstract, subjective concept. Truly speaking,
money can never be a measure of welfare.

iv. Marshall’s ‘welfare definition’ gives economics a normative character. A normative science
must pass on value judgments. It must pronounce whether a particular economic activity is good
or bad. But economics, according to Robbins, must be free from making value judgment. Ethics
should make value judgments. Economics is a positive science and not a normative science.

v. Finally, Marshall’s definition ignores the fundamental problem of scarcity of any economy. It
was Robbins who gave a scarcity definition of economics. Robbins defined economics in terms
of allocation of scarce resources to satisfy unlimited human wants.

3- Robbins’ Scarcity Definition:

The most accepted definition of economics was given by Lord Robbins in 1932 in his book ‘An
Essay on the Nature and Significance of Economic Science. According to Robbins, neither
wealth nor human welfare should be considered as the subject-matter of economics. His
definition runs in terms of scarcity: “Economics is the science which studies human behaviour as
a relationship between ends and scarce means which have alternative uses.”

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From this definition, one can build up the following propositions:
(i) Human wants are unlimited; wants multiply—luxuries become necessities. There is no end of
wants. If food were plentiful, if there were enough capital in business, if there were abundant
money and time—there would not have been any scope for studying economics. Had there been
no wants there would not have been any human activity. Prehistoric people had wants. Modern
people also have wants. Only wants change—and they are limitless.

(ii) The means or the resources to satisfy wants are scarce in relation to their demands. Had
resources been plentiful, there would not have been any economic problems. Thus, scarcity of
resources is the fundamental economic problem to any society. Even an affluent society
experiences resource scarcity. Scarcity of resources gives rise to many ‘choice’ problems.

(iii) Since the prehistoric days one notices constant effort of satisfying human wants through the
scarcest resources which have alternative uses. Land is scarce in relation to demand. However,
this land may be put to different alternative uses.

A particular plot of land can be either used for jute cultivation or steel production. If it is used for
steel production, the country will have to sacrifice the production of jute. So, resources are to be
allocated in such a manner that the immediate wants are fulfilled. Thus, the problem of scarcity
of resources gives rise to the problem of choice.

Society will have to decide which wants are to be satisfied immediately and which wants are to
be postponed for the time being. This is the choice problem of an economy. Scarcity and choice
go hand in hand in each and every economy: “It exists in one-man community of Robinson
Crusoe, in the patriarchal tribe of Central Africa, in medieval and feudalist Europe, in modern
capitalist America and in Communist Russia.”

In view of this, it is said that economics is fundamentally a study of scarcity and of the problems
to which scarcity gives rise. Thus, the central focus of economics is on opportunity cost and
optimization. This scarcity definition of economics has widened the scope of the subject. Putting
aside the question of value judgement, Robbins made economics a positive science. By locating
the basic problems of economics — the problems of scarcity and choice — Robbins brought
economics nearer to science. No wonder, this definition has attracted a large number of people
into Robbins’ camp.
The American Nobel Prize winner in Economics in 1970, Paul Samuelson, observes:
“Economics is the study of how men and society choose, with or without the use of money, to
employ scarce productive resources which could have alternative uses, to produce various

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commodities over time, and distribute them for consumption, now and in the near future, among
various people and groups in society.”

Criticisms:
This does not mean that Robbins’ scarcity definition is fault free.

His definition may be criticised on the following grounds:

i. In his bid to raise economics to the status of a positive science, Robbins deliberately
downplayed the importance of economics as a social science. Being a social science, economics
must study social relations. His definition places too much emphasis on ‘individual’ choice.
Scarcity problem, in the ultimate analysis, is the social problem—rather an individual problem.
Social problems give rise to social choice. Robbins could not explain social problems as well as
social choice.

ii. According to Robbins, the root of all economic problems is the scarcity of resources, without
having any human touch. Setting aside the question of human welfare, Robbins committed a
grave error.

iii. Robbins made economics neutral between ends. But economists cannot remain neutral
between ends. They must prescribe policies and make value judgments as to what is good for the
society and what is bad. So, economics should pronounce both positive and normative
statements.

iv. Economics, at the hands of Robbins, turned to be a mere price theory or microeconomic
theory. But other important aspects of economics like national income and employment, banking
system, taxation system, etc., had been ignored by Robbins.

Conclusion:
The science of political economy is growing and its area can never be rigid. In other words, the
definition must not be inflexible. Because of modern research, many new areas of economics are
being explored.

That is why the controversy relating to the definition of economics remains and will remain so in
the future. It is very difficult to spell out a logically concise definition. In this connection, Mrs.
Barbara Wotton’s remarks may be noted – ‘Whenever there are six economists, there are seven
opinions!’

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SUBJECT MATTER OF ECONOMICS
Economics can be studied through
(a) traditional approach and
(b) modern approach.

(a) Traditional Approach: Economics is studied under five major divisions namely
consumption, production, exchange, distribution and public finance.
1.Consumption: The satisfaction of human wants through the use of goods and services is called
consumption.
2.Production: Goods that satisfy human wants are viewed as “bundles of utility”. Hence
production would mean creation of utility or producing (or creating) things for satisfying human
wants. For production, the resources like land, labour, capital and organization are needed.
3. Exchange: Goods are produced not only for self-consumption, but also for sales. They are
sold to buyers in markets. The process of buying and selling constitutes exchange.
4. Distribution: The production of any agricultural commodity requires four factors, viz., land,
labour, capital and organization. These four factors of production are to be rewarded for their
services rendered in the process of production. The land owner gets rent, the labourer earns
wage, the capitalist is given with interest and the entrepreneur is rewarded with profit. The
process of determining rent, wage, interest and profit is called distribution.
5. Public finance: It studies how the government gets money and how it spends it. Thus, in
public finance, we study about public revenue and public expenditure.

(b) Modern Approach: The study of economics is divided into:

1- Microeconomics and
2- Macroeconomics.
1. Microeconomics analyses the economic behaviour of any particular decision making unit
such as a household or a firm. Microeconomics focuses on how individual consumers and firm
make decisions; these individuals can be a single person, a household, a business/organization or
a government agency. Analyzing certain aspects of human behavior, microeconomics tries to
explain they respond to changes in price and why they demand what they do at particular price
levels. Microeconomics tries to explain how and why different goods are valued differently, how
individuals make financial decisions. Microeconomics studies the flow of economic resources or
factors of production from the households or resource owners to business firms and flow of
goods and services from business firms to households. It studies the behaviour of individual
decision making unit with regard to fixation of price and output and its reactions to the changes
in demand and supply conditions. Hence, microeconomics is also called price theory.

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2. Macroeconomics studies the behaviour of the economic system as a whole or all the decision-
making units put together. Macroeconomics deals with the behaviour of aggregates like total
employment, gross national product (GNP), national income, general price level, etc. So,
macroeconomics is also known as income theory. Macroeconomics studies an overall economy
on both a national and international level. Its focus can include a distinct geographical region, a
country, a continent, or even the whole world. Topics studied include foreign trade, government
fiscal and monetary policy, unemployment rates, the level of inflation and interest rates, the
growth of total production output as reflected by changes in the Gross Domestic Product (GDP),
and business cycles that result in expansions, booms, recessions, and depressions.

Nature of Economics: Economics as a Science and an Art

There is a great controversy among the economists regarding the nature of economics, whether
the subject ‘economics’ is considered as science or an art.

If it is a science, then either positive science or normative science.

Economics as a Science:
Before we start discussing whether economics is science or not, it becomes necessary to have a
clear idea about science. Science is a systematic study of knowledge and fact which develops the
correlation-ship between cause and effect. Science is not only the collection of facts, according
to Prof. Poincare, in reality, all the facts must be systematically collected, classified and
analyzed.

There are following characteristics of any science subject, such as;

(i) It is based on systematic study of knowledge or facts;

(ii) It develops correlation-ship between cause and effect;

(iii) All the laws are universally accepted

(iv) All the laws are tested and based on experiments;

(v) It can make future predictions;

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(vi) It has a scale of measurement.

On the basis of all these characteristics, Prof. Robbins, Prof Jordon, Prof. Robertson etc. claimed
economics as one of the subject of science like physics, chemistry etc. According to all these
economists, ‘economics’ has also several characteristics similar to other science subjects.

(i) Economics is also a systematic study of knowledge and facts. All the theories and facts
related with both micro and macroeconomics are systematically collected, classified and
analyzed.

(ii) Economics deals with the correlation-ship between cause and effect. For example, supply is a
positive function of price, i.e., change in price is cause but change in supply is effect.

(iii) All the laws in economics are also universally accepted, like, law of demand, law of supply,
law of diminishing marginal utility etc.

(iv) Theories and laws of economics are based on experiments, like, mixed economy to is an
experimental outcome between capitalist and socialist economies.

(v) Economics has a scale of measurement. According to Prof. Marshall, ‘money’ is used as the
measuring rod in economics. However, according to Prof. A.K. Sen, Human Development Index
(HDI) is used to measure economic development of a country.

However, the most important question is whether economics is a positive science or a normative
science? Positive science deals with all the real things or activities. It gives the solution what is?
What was? What will be? It deals with all the practical things. For example, poverty and
unemployment are the biggest problems in India. The life expectancy of birth in India is
gradually rising. All these above statements are known as positive statements. These statements
are all concerned with real facts and information.

On the contrary, normative science deals with what ought to be? What ought to have happened?
Normative science offers suggestions to the problems. The statements dealing with these
suggestions are coming under normative statements. These statements give the ideas about both
good and bad effects of any particular problem or policy. For example, illiteracy is a curse for
Indian economy. The backwardness of Indian economy is due to ‘population explosion’.

Now an important question arises whether economics is a positive science or a normative

science? The economists like Prof. Senior (classical economist) and Prof. Robbins, Prof. Freight-
men (modern economists) claimed that economics is a positive science. However, Prof. Pigou
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(classical economist). Prof. Marshall (neoclassical economist) etc. are of opinion that economics
is a normative science.

Economics and Positive Science:

The following statements can ensure economics as a positive science, such as;

(i) Logically based:

The ideas of economics are based on absolute logical clarifications and moreover, it develops
relationship between cause and effect.

(ii) Labour Specialisation:

Labour law is an important topic of economics. It is based on the law of specialisation of labour
Economists must concern with the causes and effects of labour-division.

(iii) Not Neutral:

Economics is not a neutral between positive and normative sciences. According to most
economists, economics is merely positive science rather than normative science.

Economics and Normative Science:

The following statements can ensure economics as a normative science, such as,

(i) Emotional View:

A rational human being has not only logical view but also has sentimental attachments and
emotional views regarding any activity. These emotional attachments are all coming under
normative statements. Hence, economics is a normative science.

(ii) Welfare Activity:

Economics is a science of human welfare, All the economic forwarded their theories for the
development of human standard of living Hence, all the economic statements have their
respective normative views.

(iii) Economic Planning:

Economic planning is one of the main instruments of economic development. Several
economists have given their personal views for the successful implementation of economic plan.
Hence, economics is coming under normative science.

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All these lead us to the conclusion that ‘Economics’ is both positive and normative science. It
does not only tell us why certain things happen however, it also gives idea whether it is right
thing to happen.

Economics as an Art:
According to Т.К. Mehta, ‘Knowledge is science, action is art.’ According to Pigou, Marshall
etc., economics is also considered as an art. In other way, art is the practical application of
knowledge for achieving particular goals. Science gives us principles of any discipline however,
art turns all these principles into reality. Therefore, considering the activities in economics, it can
be claimed as an art also, because it gives guidance to the solutions of all the economic
problems.

Therefore, from all the above discussions we can conclude that economics is neither a science
nor an art only. However, it is a golden combination of both. According to Cossa, science and art
are complementary to each other. Hence, economics is considered as both a science as well as an
art.

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PART ONE: MICROECONOMICS

What is Microeconomics?
Microeconomics is a branch of economics that studies the behavior of individuals and businesses
and how decisions are made based on the allocation of limited resources. Simply put, it is the
study of how we make decisions because we know we don't have all the money and time in the
world to purchase and do everything. Microeconomics examines how these decisions and
behaviors affect the supply and demand for goods and services, which determine the prices we
pay. These prices, in turn, determine the quantity of goods supplied by businesses and the
quantity of goods demanded by consumers.
Microeconomics explores issues such as how families reach decisions about what to buy and
how much to save. It also affects how firms, such as Nike, determine how many shoes to make
and at what price to sell, as well as how competitive different industries are and how that affects
consumers.
Basic Concepts of Microeconomics

• Production theory: This is the study of production — or the process of converting inputs
into outputs. Producers seek to choose the combination of inputs and method of
combining them that will minimize cost in order to maximize their profits.
• Utility theory: Analogous to production theory, consumers will choose to purchase and
consume a combination of goods that will maximize their happiness or “utility”, subject
to the constraint of how much income they have available to spend.
• Price theory: Production theory and utility theory interact to produce the theory of supply
and demand, which determine prices in a competitive market. In a perfectly competitive
market, it concludes that the price demanded by consumers is the same supplied by
producers. That results in economic equilibrium.
• Industrial organization and market structure: Microeconomists study the many ways that
markets can be structured, from perfect competition to monopolies, and the ways
that production and prices will develop in these different types of markets.

SCARCITY

Ever present situation in all markets whereby either less goods are available than the demand for
them, or only too little money is available to their potential buyers for making the purchase. This
universal phenomenon leads to the definition of economics as the “science of allocation of scarce
resources.”

Understanding Scarcity

Scarcity dictates that economic decisions must be made regularly in order to manage the
availability of resources to meet human needs. A commodity is scares, if it does not compete the
demand. For example, there is plenty of water but drinking water is not sufficient to meet the
existing demand for drinking water, so this drinking water is a scarce commodity because it does
not compete the demand.

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Some examples of scarcity include:

1- The gasoline shortage in the 1970’s.

2- Over-fishing can result in a scarcity of a type of fish.
3- Fewer farmers raising cattle can result in scarcity of milk and cheese.
4- Those without access to clean water ae experiencing a scarcity of water.
5- Coal is used to create energy, the limited amount of this resource that can be mined is an
example of scarcity.
6- Water is more in desert and less scarce in rainforest.
7- Dera Ismail Khan is situated at the beach of Indus river but there is scarce of clean and
drinking water.

Choice and Opportunity Costs

The central problem of economics is the scarcity which forces the individual to make choice.
Whenever a choice is made, something is given up. The opportunity cost of a choice is the value
of the best alternative given up. Choices involve trading off the expected value of one
opportunity against the expected value of its best alternative. For example, a farmer has some
land which can be used for cultivation of sugarcane or rice crops because the season of both the
crops is same. Now in this case the farmer has two choices to opt either rice or sugarcane. There
are two wants (to cultivate rice and sugarcane) and one recourse (land). This scarcity of land is
forcing the farmer to make choice to cultivate one crops and to give up the cultivation of the
other crops. So farmer will think economically and use the land efficiently and will cultivate that
crops which gives him greater amount of money. Suppose the farmer makes the choice to
produce rice, then the opportunity of the rice (produced) is the sugarcane (given up). Or in
simple words the price of rice in term of sugarcane is called opportunity cost.

Price Mechanism

In economics, a price mechanism is the manner in which the profits of goods or services affect
the supply and demand of goods and services. A price mechanism affect both buyer and seller
who negotiate prices A price mechanism, part of a market system, comprises various ways to
match up buyers and sellers. Price mechanism is a mechanism where price plays a key role in
directing the activities of producers, consumers, resource suppliers. Generally speaking, when
two parties wish to engage in trade, the purchaser will announce a price he is willing to pay and
seller will announce a price he is willing to accept. The interaction of buyers and sellers in free
markets enables goods, services, and resources to be allocated prices. Relative prices, and
changes in price, reflect the forces of demand and supply and help solve the economic problem.
Resources move towards where they are in the shortest supply, relative to demand, and away
from where they are least demanded.

Whenever resources are particularly scarce, demand exceeds supply and prices are driven
up. The effect of such a price rise is to discourage demand, conserve resources, and spread out
their use over time. The greater the scarcity, the higher the price and the more the resource is
rationed. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this
discourages demand and leads to more oil being conserved than at lower prices. The rationing
function of a price rise is associated with a contraction of demand along the demand curve.

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Price changes send contrasting messages to consumers and producers about whether to enter or
leave a market. Rising prices give a signal to consumers to reduce demand or withdraw from a
market completely, and they give a signal to potential producers to enter a market. Conversely,
falling prices give a positive message to consumers to enter a market while sending a negative
signal to producers to leave a market. For example, a rise in the market price of 'smart' phones
sends a signal to potential manufacturers to enter this market, and perhaps leave another one.
Similarly, the provision of 'free' healthcare may signal to 'consumers' that they can pay a visit to
their doctor for any minor ailment, while potential private healthcare providers will be deterred
from entering the market. In terms of the labour market, a rise in the wage rate, which is the price
of labour, provides a signal to the unemployed to join the labour market. The signaling function
is associated with shifts in demand and supply curves.

An incentive is something that motivates a producer or consumer to follow a course of action or

to change behaviour. Higher prices provide an incentive to existing producers to supply more
because they provide the possibility or more revenue and increased profits. The incentive
function of a price rise is associated with an extension of supply along the existing supply curve.

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CONSUMER’S EQUILIBRIUM–UTILITY MAXIMIZATION
The theory of demand starts with the examination of the behaviour of the consumers. In our
everyday life we behave in different ways while buying and consuming a good or service. The
simple calculations and human reasoning we undertake while doing any transactions have been
transformed into principles which guide us to attain satisfaction or equilibrium in economic
sense. When we go for shopping, we decide beforehand, what good to buy and how much to
spend. It makes sense as we try to get most of what we are spending. In other words, we always
want more of anything and for that purpose we negotiate and come to an agreed price which we
are ready to pay happily. It is therefore, necessary to be first acquainted with the consumer
behaviour, which forms the basis of the demand theory.
It is assumed that consumers are rational. Given his money income and the prices of
commodities, a consumer always tries to maximize his satisfaction. That is, to get the maximum
welfare (state of well-being) by spending the given money on various commodities. It is assumed
that the satisfaction a consumer gets by consuming a good is measurable (measured in terms of
money), though in real life it is not possible to measure satisfaction because it is psychological
entity. We only feel the level of satisfaction and express the same in different ways. We show
our satisfaction by our behaviour like laughing, jumping in excitement or in any other way. Thus,
we cannot measure satisfaction in quantitative terms as we are capable of measuring time in
seconds, weight in kilograms or length in meters. Further, each consumer is also assumed to be
known of what he wants. Moreover, he has all information regarding market—the goods
available, the prices of the goods at a particular point of time and so on. Every consumer uses
this information in such a way as to maximize his total satisfaction. To explain consumer’s
equilibrium i.e., how a consumer attains maximum satisfaction by spending his money income
on certain units of commodities, it is worthwhile to be familiar with certain important terms used
in explaining various concepts and theories of demand. These are explained as under:

Utility Utils' is considered as the measurable 'unit' of utility.

Utility is defined as the power of a commodity or service to satisfy a human want. Economists
have leveled the term satisfaction as utility. It is subjective concept and therefore varies from
person to person. As already stated, it resides in one’s mind and therefore cannot be measured in
quantitative terms. Though utility and satisfaction are used synonymously, we should note that
utility is the expected satisfaction whereas satisfaction implies ‘realized satisfaction’.

Total Utility
It is the amount of utility (satisfaction); a consumer gets by consuming all the units of a
commodity. If there are n units of the commodity, then the total utility is the sum of the utilities
of all n units of the commodity. Thus, if there are four units of a commodity, then total utility is,
U =U1(n1) + U2(n2) + U3(n3) + U4(n4) Where U = total utility; U1…….U4 are the utilities of
n1…..n4 units of the commodity. Thus, if by consuming first apple, a consumer gets 12 utils of
satisfaction, 10 utils from the second apple, 9 utils from the third and 7 utils from the fourth
apple; then his total utility is, U = 12 + 10 + 9 + 7 = 38 Thus utilities of various goods are
additive. This means that utilities of different commodities are independent of one another. The
utility derived from one commodity does not affect that of another.
17
Marginal Utility
Marginal utility is defined as the change in the total utility due to a unit change in the
consumption of a commodity per unit of time. It can also be defined as the addition made to the
total utility by consuming an additional unit of a commodity. For example, if total utility of 3
cups of tea is 18 utils and on consuming the 4th cup it rises to 20; then marginal utility 20-18 = 2
utils. Thus, by consuming one more cup of tea, the additional utility, a consumer gets is 2 utils.
Marginal utility can be expressed as,
MU = ∆TU/∆Q
Where MU = marginal utility; ∆ΤU = change in total utility; ∆Q = change in the quantity
consumed. ‘Utils’ is the term used by Marshall as a measuring unit of utility. The following
expression can also be used to find marginal utility:
MU = TUn – TUn-1
Where, TUn is the total utility of nth unit of the commodity and TUn-1 utility from the n-1th
commodity. Thus, if TU from the second unit (nth unit) of apple is 13 and TU from the previous
unit (n-1) is 7, then MU is 13 – 7 = 6.
The concept of total utility and marginal utility is shown in the utility schedule below:

Units of Apples Totally Utility Marginal Utility

1 7 7–0=7
2 13 13 – 7 = 6
3 18 18 – 13 = 5
4 22 22 – 18 = 4
5 25 25 – 22 = 3
6 27 27 – 25 = 2
7 28 27 – 28 = 1
8 28 28 -28 = 1

When the consumer takes 1st apple, his total utility is 7 and from the 2nd apple he gets 13 and so
on. The third column shows marginal utility, which diminishes as the consumer increases units
of apples. It is seen that when total utility is maximum, marginal utility is zero at 8th unit of
apple. It is also seen that total utility is the sum of the marginal utilities of the 1st, 2nd, 3rd, and
so on. Thus, at 8th unit of apple,
TU = MU1 + MU2 + MU3 + MU4 +…..…+ MUn(8)
28 = 7 + 6 + 5 + 4 +…..…+ 0

LAW OF DIMINISHING MARGINAL UTILITY

One of the very important laws in regard to the satisfaction of human wants is known as law of
diminishing marginal utility. The law explains common feeling of every consumer. Suppose a
person starts consuming apples one after another. The first apple gives him the maximum

18
satisfaction as he might be in mood of taking some food at that time for meeting his appetite. As
he takes the second apple, he gets less satisfaction because by this time he has already met some
level of appetite. The third and more apples yield him lesser satisfaction or utility. It means that
every time the consumer increases his consumption, he gets less and less satisfaction. The
satisfaction also tends to be zero when the consumer feels totally disgusted to take any more
apples. If he takes more, his satisfaction turns negative or utility now becomes disutility.
Thus law of diminishing marginal utility states that additional satisfaction a person derives by
consuming a commodity goes on declining as he consumes more and more of a that commodity.
According to Marshall, “The additional benefit which a person derives from a given increase of
his stock of a thing diminishes with every increase in stock that he already has.”
Two important reasons for diminishing marginal utility are the following:
(a) Each particular want is satiable (can be satisfied): Though there are unlimited wants, a single
want can be satisfied. Thus, when a consumer consumes more and more of a commodity, his
want is satisfied and he does not wish to have any further increase in the commodity. As such his
marginal utility falls when consumption increases.
(b) Goods are imperfect substitutes for one another i.e., one good cannot be exactly used in place
of another: Satisfaction from any two goods is not same. Different goods satisfy different wants.
If a good could be perfectly substituted for another, it would have satisfied other wants. Hence,
its marginal utility would not have fallen but increased.

The law can be explained with the help of a table and diagram below:

Units of Apples TU MU
1 20 20
2 35 15
3 45 10
4 50 5
5 50 0
6 45 -5

In the above table, the total utility obtained from the first apple is 20 utils, which keep on
increasing until we reach our saturation point at 5th apple. On the other hand, marginal utility
keeps on diminishing with every additional apple consumed. When we consumed the 6th apple,
we have gone over the limit. Hence, the marginal utility is negative and the total utility falls.

19
With the help of the schedule, we have made the following diagram:

Saturation Point: The point where the desire to consume the same product anymore becomes
zero.

Disutility: If you still consume the product after the saturation point, the total utility starts to fall.
This is known as disutility.
When the first apple is consumed, the marginal utility is 20. When the second apple is consumed,
the marginal utility increases by 15 utils, which is less than the marginal utility of the 1 st apple –
because of the diminishing rate. Therefore, we have shown that the utility of apples consumed
diminishes with every increase of apple consumed.
Similarly, when we consumed the 5th apple, we are at our saturation point. If we consume
another apple, i.e. 6th apple, we can see that the marginal utility curve has fallen to below X-axis,
which is also known as ‘disutility’.

The law of diminishing MU has certain limitations. These are:

1. If units of a commodity consumed are not of same size and shape, the law does not hold good.
In the illustration explained above, units of apples are assumed to be of same shape and size.
2. The law does not hold good when there is enough time gap between consumption of two units.
For instance, if we take second apple after a long gap of time, we may feel hungry and hence
satisfaction will increase instead of falling.
3. The taste of consumer should not change for the law to hold good. It means that the person
should consume all units of a good by same desire and pleasure.
4. The law does not apply to money as it is said that more money a person has, the more he
wants.
20
5. Change in income of the consumer will falsify the law. If money income of the consumer
increases or decreases during the time of consumption of a particular set of goods, the marginal
utility will not fall as said above.
Exceptions for the Law of Diminishing Marginal Utility:
The law of diminishing marginal utility states that with the consumption of every successive unit
of commodity yields marginal utility with a diminishing rate. However, there are certain things
on which the law of diminishing marginal utility does not apply.
Following are the exceptions for this law:
• Desire for money.
• Desire for knowledge.
• Use of liquor or wine.
• Collection of rare objects.

The law of diminishing marginal (additional) utility explains consumer’s equilibrium in case of a
single commodity. A consumer will go on purchasing successive units of a commodity till the
marginal utility of the commodity is equal to price. Thus, for a single commodity x, a consumer
is in equilibrium when the marginal utility of x is equal to its market price (Px).
Symbolically,
MUx = Px
In case the price goes down, he will buy more and the marginal utility will come down to the
level of price. If price rises, less will be purchased and the marginal utility rises till it reaches the
new level of price. Thus, equality between marginal utility and price indicates the position of
consumer’s equilibrium when a single commodity is being purchased and consumed.

Demand and Law of demand

MEANING OF DEMAND
Demand needs for precise definition arises simply because it is sometimes confused with other
words such as desire, wish, want, etc.

Demand in economics means a desire to possess a commodity/goods supported by willingness

and ability to pay for it. If you have a desire to buy a certain commodity, say a car, but you do
not have the adequate means/money to pay for it, it will simply be a wish, a desire or a want and
not demand. Demand is an effective desire, i.e., a desire which is backed by willingness and
ability to pay for a commodity in order to obtain it.

In the words of Prof. Hibdon: "Demand means the various quantities of goods that would be
purchased per time period at different prices in a given market".

21
Characteristics of Demand:

There are thus three main characteristics of demand in economics.

(i) Willingness and ability to pay. Demand is the amount of a commodity for which a consumer
has the willingness and also the ability to buy.

(ii) Demand is always at a price. If we talk of demand without reference to price, it will be
meaningless. The consumer must know both the price and the commodity. He will then be able
to tell the quantity demanded by him.

(iii) Demand is always per unit of time. The time may be a day, a week, a month, or a year.

For instance, when the milk is selling at the rate of $15.0 per liter, the demand of a buyer for
milk is 10 liters a day. If we do not mention the period of time, nobody can guess as to how
much milk we consume? It is just possible we may be consuming ten liters of milk a week, a
month or a year.

Summing up, we can say that by demand is meant the amount of the commodity that buyers are
able and willing to purchase at any given price over some given period of time. Demand is also
described as a schedule of how much a good people will purchase at any price during a specified
period of time.

The Law of Demand

We have stated earlier that demand for a commodity is related to price per unit of time. It is the
experience of every consumer that when the prices of the commodities fall, they are tempted to
purchase more. Commodities and when the prices rise, the quantity demanded decreases. There
is, thus, inverse relationship between the price of the product and the quantity demanded. The
economists have named this inverse relationship between demand and price as the law of
demand.

Statement of the Law:

Some well-known statements of the law of demand are as under:

According to Prof. Samuelson:

"The law of demand states that people will buy more at lower prices and buy less at higher
prices, other things remaining the same".

E. Miller writes:

"Other things remaining the same, the quantity demanded of a commodity will be smaller at
higher market prices and larger at lower market prices".

22
"Other things remaining the same, the quantity demanded increases with every fall in the price
and decreases with every rise in the price".

In simple we can say that when the price of a commodity rises, people buy less of that
commodity and when the price falls, people buy more of it ceteris paribus (other things
remaining the same). Or we can say that the quantity varies inversely with its price. There is no
doubt that demand responds to price in the reverse direction but it has got no uniform relation
between them. If the price of a commodity falls by 1%, it is not necessary that may also increase
by 1%. The demand can increase by 1%, 2%, 10%, 15%, as the situation demands. The
functional relationship between demanded and the price of the commodity can be expressed in
simple mathematical language as under:

Formula For Law of Demand: Qdx = f( Px, Po, Y, T, De,………….)

Here:

Qdx = A quantity demanded of commodity x.

f = A function of independent variables contained within the parenthesis.

Px = Price of commodity x.

PO = Price of the other commodities.

Y = Income of the Household
T = Taste of the Household
De= Demonstration Effect

The Po, Y, De and T means that they are kept constant. The demand function can also be
symbolized as under:

Qdx = f( Px ) Ceteris Paribus

Ceteris Paribus. In economics, the term is used as a shorthand for indicating the effect of one
economic variable on another, holding constant all other variables that may affect the second
variable.

Schedule of Law of Demand:

The demand schedule of an individual for a commodity is a Iist or table of the different amounts
of the commodity that are purchased the market at different prices per unit of time. An individual
demand schedule for a good say shirts is presented in the table below:

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 Individual Demand Schedule for Shirts:

(In Dollars)
Price per shirt 100 80 60 40 20 10
Quantity demanded per year
5 7 10 15 20 30
Qdx

According to this demand schedule, an individual buys 5 shirts at $100 per shirt and 30 shirts at
$10 per shirt in a year.

Law of Demand Curve/Diagram:

Demand curve is a graphic representation of the demand schedule. According to Lipsey:

"This curve, which shows the relation between the price of a commodity and the amount of that
commodity the consumer wishes to purchase is called demand curve".

It is a graphical representation of the demand schedule.

In the figure, the quantity. demanded of shirts in plotted on horizontal axis OX and "price is
measured on vertical axis OY. Each price- quantity combination is plotted as a point on this
graph. If we join the price quantity points a, b, c, d, e and f, we get the individual demand curve
for shirts. The DD/ demand curve slopes downward from left to right. It has a negative slope
showing that the two variables price and quantity work in opposite direction. When the price of a
good rises, the quantity demanded decreases and when its price decreases, quantity demanded
increases, ceteris paribus.

24
Market Demand for a Commodity:

Definition and Explanation:

The market demand for a commodity is obtained by adding up the total quantity demanded at
various prices by all the individuate over a specified period of time in the market It is described
as the horizontal summation of the individuals’ demand for a commodity at various possible
prices in market.

In a market, there are a number of buyers for a commodity at each price. In order to avoid a
lengthy addition process, we assume here that there are only four buyers for a commodity who
purchase different amounts of the commodity at each price.

Market Demand Schedule:

The horizontal summation of individuals’ demand for a commodity will be the market demand
for a commodity as is illustrated in the following schedule:

A market Demand Schedule in a Four Consumer Market:

Price Quantity Quantity Quantity Quantity Total Quantity

($) Demanded Demanded Demanded Demanded Demanded Per Week (in
First Buyer Second Third Buyer Fourth Buyer thousands)
Buyer
10 10 13 6 11 40
8 15 20 9 16 60
6 25 30 10 20 85
4 40 35 15 30 120
2 60 50 30 40 180

In the above schedule, the amount of commodity demanded by four buyers (which we assume
constitute the entire market) differs for each price When the price of a commodity is $10, the
total quantity demanded is 4C thousand units per week. At price of $2, the total quantity
demanded increases to 180. thousand units.

Market Demand Curve:

Market demand curve for a Commodity is the horizontal sum of individual demand curves of ail
the buyers in a market. This is illustrated with the help of the market demand schedule given
above.

25
The market demand curve DD/ for a commodity, like the individual demand curve is negatively
sloped, (see figure). It shows that under the assumptions (ceteris paribus) other things remaining
the same, there is an inverse relationship between the quantity demanded and its price.

At price of $10, the quantity demanded in the market is 40 thousand units. At price of $2.0. it
increases to 180 thousand units. In. other words, the lower the price of the good X, the greater is
the demand for it ceteris paribus.

Assumptions of Law of Demand:

According to Prof. Stigler and Boulding:

There are three main assumptions of the Law:

(i) There should not be any change in the tastes of the consumers for goods (T).

(ii) The purchasing power of the typical consumer must remain constant (Y).

(iii) The price of all other commodities should not vary (Po).

Example of Law of Demand:

If there is a change, in the above and other assumptions, the law may not hold true. For example,
according to the law of demand, other things being equal quantity demanded increases with a fall
in price and diminishes with rise to price. Now let us suppose that price of tea comes down from
$40 per pound to $20 per pound. The demand for tea may not increase, because there has taken
place a change in the taste of consumers or the price of coffee has fallen down as compared to
tea or the purchasing power of the consumers has decreased, etc., etc. From this we find that
demand responds to price inversely only, if other thing remains constant. Otherwise, the chances
are that, the quantity demanded may not increase with a fall in price or vice-versa.
26
Demand, thus, is a negative relationship between price and quantity.

In the words of Bilas:

"Other things being equal, the quantity demanded per unit of time will be greater, lower the
price, and smaller, higher the price".

Limitations/Exceptions of Law of Demand:

Though as a rule when the prices of normal goods rise, the demand them decreases but there may
be a few cases where the law may not operate.

(i) Prestige goods: There are certain commodities like diamond, sports cars etc., which are
purchased as a mark of distinction in society. If the price of these goods rise, the demand for
them may increase instead of falling.

(ii) Price expectations: If people expect a further rise in the price particular commodity, they
may buy more in spite of rise in price. The violation of the law in this case is only temporary.
(3) Ignorance of the consumer: If the consumer is ignorant about the rise in price of goods, he
may buy more at a higher price.

(iv) Giffen goods: If the prices of basic goods, (potatoes, sugar, etc) on which the poor spend a
large part of their incomes declines, the poor increase the demand for superior goods, hence
when the price of Giffen good falls, its demand also falls. There is a positive price effect in case
of Giffen goods.

Importance of Law of Demand:

(i) Determination of price. The study of law of demand is helpful for a trader to fix the price of
a commodity. He knows how much demand will fall by increase in price to a particular level and
how much it will rise by decrease in price of the commodity. The schedule of market demand
can provide the information about total market demand at different prices. It helps the
management in deciding whether how much increase or decrease in the price of commodity is
desirable.

(ii) Importance to Finance Minister. The study of this law is of great advantage to the finance
minister. If by raising the tax the price increases to such an extend than the demand is reduced
considerably. And then it is of no use to raise the tax, because revenue will almost remain the
same. The tax will be levied at a higher rate only on those goods whose demand is not likely to
fall substantially with the increase in price.

(iii) Importance to the Farmers. Goods or bad crop affects the economic condition of the
farmers. If a goods crop fails to increase the demand, the price of the crop will fall heavily. The
farmer will have no advantage of the good crop and vice-versa.

Summing up we can say that the limitations or exceptions of the law of demand stated above do
not falsify the general law. It must operate.

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Movement Vs Shifts of Demand Curve:

Changes in demand for a commodity can be shown through the demand curve in two ways:

(1) Movement Along the Demand Curve and (2) Shifts of the Demand Curve.

(1) Movement Along the Demand Curve:

Demand is a multivariable function. If income and other determinants of demand such as tastes
of the consumers, changes in prices of related goods, income distribution, etc., remain constant
and there is a change only in price of the commodity, then we move along the same demand
curve.

In this case, the demand curve remains unchanged. When, as a result of change in price, the
quantity demanded increases or decreases, it is technically called extension and contraction in
demand.

The demand curve, which represents various price quantity has a negative slope. Whenever there
is a change in the quantity demanded of a good due to change, in its price, there is a movement
from one-point price quantity combination to another on the
same demand curve. Such a movement from one-point price quantity combination to another
along the same demand curve is shown in figure.

Diagram/Figure:

Here the price of a commodity falls from $8 to $2. As a result, therefore, the quantity demanded
increases from 100 units to 400 units per unit of time. There is extension in demand by 300 units.
This movement is from one-point price quantity combination (a) to another point (b) along a
given demand curve. On the other hand, if the price of a good rises from $2 to $8, there is
contraction in demand by 300 units.
28
We, thus, see that as a result of change in the price of a good, the consumer moves along the
given demand curve. The demand curve remains the same and does not change its position. The
movement along the demand curve is designated as change in quantity demanded.

(2) Shifts in Demand Curve:

Demand, as we know, is determined by many factors. When there is a change in demand due to
one or more than one factors other than price, results in the shift of demand curve.

For example, if the level of income in community rises, other factors remaining the same, the
demand for the goods increases. Consumers demand more goods at each price per period of me
(rise or Increase in demand). The demand curve shifts upward from he original demand curve
indicating that consumers at each price purchase more units of commodity per unit of time.

If there is a fall in the disposable income of the consumers or rise in the prices of close substitute
of a good or decline in consumer taste or non-availability of good on credit, etc, etc., there is a
reduction in demand (fall or decrease in demand). The fall or decrease in demand shifts the
demand curve from the original demand curve to the left. The lower demand curve shows that
consumers are able and willing to buy less of the good at each price than before.

Schedule:

Pdx ($) Qdx Rise in Qdx Fall in Qdx

12 100 300 50
6 250 500 200
4 500 600 300

Diagram/Figure:
29
In this figure, the original demand curve is DD/.

At a price of $12 per unit, consumers purchase 100 units. When price falls to$4 per unit, the
quantity demanded increases to 500 units per unit of time. Let us assume now that level of
income increases in a community. Now consumers demand 300 units of the commodity at price
of $12 per unit and 600 at price of $4 per unit.

As a result, there is an upward shift of the demand curve DD 2. In case the community income
falls, there is then decrease in demand at price of $12 per unit. The quantity demanded of a good
fall to 50 units. It is 300 units at price of $4 unit per period of time. There is a downward shift of
the demand to the left of the original demand curve.

Summing Up:

(i) Extension in demand is due to reduction in price.

(ii) Increase in demand occurs due to changes in factors other than price.

(iii) Contraction in demand is the result of a rise in the price commodity.

(iv) A decrease in demand follows a change in factors other than price.

(v) Changes in demand both increase and decrease are representing shifts in the demand curve.

(vi) Changes in the quantity demanded are represented by move along the same demand curve.

30
ELASTICITY OF DEMAND
INTRODUCTION
We learnt that a fall in price will lead to an increase in quantity demanded and vice versa.
However, given any change in price, in addition to the direction of the change in quantity
demanded, economists are interested to find the magnitude of the change. In other words, they
are interested to find the degree of responsiveness of consumers to a change in price. To measure
this, they use the concept of price elasticity of demand. Furthermore, economists are also
interested to find the degree of responsiveness of consumers to a change in income and a change
in the prices of related goods. To measure this, economists use the concepts of income elasticity
of demand and cross elasticity of demand. This chapter provides an exposition of the concepts of
price elasticity of demand, income elasticity of demand, cross elasticity of demand and price
elasticity of supply.

PRICE ELASTICITY OF DEMAND

Measurement and Interpretation of Price Elasticity of Demand

The price elasticity of demand (PED) for a good is a measure of the degree of responsiveness of
the quantity demanded to a change in the price, ceteris paribus.

The PED for a good is calculated by dividing the percentage change in the quantity demanded by
the percentage change in the price.

% Δ Quantity Demanded
PED = ————————————–
% Δ Price

Due to the law of demand, the PED for a good is always negative. However, the common
practice among economists is to omit the negative sign.

If the PED for a good is greater than one, the demand is price elastic which means that a change
in the price will lead to a larger percentage/proportionate change in the quantity demanded. A
good with a price elastic demand has a relatively flat demand curve. If the PED for a good is less
than one, the demand is price inelastic which means that a change in the price will lead to a
smaller percentage/proportionate change in the quantity demanded. A good with a price inelastic
demand has a relatively steep demand curve. If the PED for a good is equal to one, the demand is
unit price elastic which means that a change in the price will lead to the same
percentage/proportionate change in the quantity demanded. The demand curve for a good with a
unit price elastic demand is a rectangular hyperbola.

Special cases:

If the PED for a good is zero, the demand is perfectly price inelastic which means that a change
in the price will not lead to any change in the quantity demanded. A good with a perfectly price
31
inelastic demand has a vertical demand curve. If the PED for a good is infinity, the demand is
perfectly price elastic which means that a rise in the price will lead to an infinite decrease in the
quantity demanded. In theory, this means that the quantity demanded will fall from infinity to
zero. A good with a perfectly price elastic demand has a horizontal demand curve.

Ep = 0 Ep = ∞ Ep > 1 Ep < 1

Note: It is important to understand that the concept of elasticity is about relative changes and
not about absolute changes. This is because although price is measured in dollars, quantity
demanded is measured in units. Due to the difference in the units of measurement, we can only
compare the changes in price and quantity demanded in relative terms. For example, it is wrong
to say, ‘If demand is price elastic, a fall in price will lead to a large increase in quantity
demanded.’. The correct way to say it is, ‘If demand is price elastic, a fall in price will lead to a
larger percentage/proportionate increase in quantity demanded.’. Students should not confuse
relative changes with absolute changes.

Applications of Price Elasticity of Demand

The concept of PED allows a firm to determine how to change price to increase total revenue.

If the demand for the good produced by a firm is price elastic, the firm can decrease the price to
increase the total revenue as the quantity demanded will increase by a larger percentage.

In the above diagram, the initial total revenue is area A plus area B and the new total revenue is
area B plus area C. Area C is the gain in revenue resulting from the increase in the quantity
demanded (Q) from Q0 to Q1 and area A is the loss in revenue resulting from the fall in the price
(P) from P0 to P1. Since area C is greater than area A, the gain in revenue exceeds the loss and
hence the total revenue rises.

32
If the demand for the good produced by a firm is price inelastic, the firm can increase the price to
increase the total revenue as the quantity demanded will decrease by a smaller percentage.

If the demand for the good produced by a firm is unit price elastic, the firm cannot change the
price to increase the total revenue as the quantity demanded will change by the same percentage.

In addition to firms, the concept of price elasticity of demand may be useful to the government.
The main source of revenue for the government is tax revenue. If the government imposes a tax
on a good, the cost of production will rise which will lead to a decrease in the supply. When this
happens, the price will rise which will lead to a fall in the quantity demanded. If the demand for
the good is price elastic, the quantity demanded is likely to fall by a large extent. As the tax
revenue is the product of the tax per unit of the good and the quantity, a large decrease in the
quantity demanded is likely to limit the amount of tax revenue which the government is able to
collect. Therefore, if the government wants to collect a large amount of tax revenue from
imposing a tax on a good, it should do so for a good with a price inelastic demand. Examples of
goods with a price inelastic demand include tobacco and alcohol due to their addictive nature.
The government may also impose a tax on a good to reduce the consumption. This is generally a
good which society deems undesirable and the government thinks people should be discouraged
from consuming, commonly known as a demerit good. Examples of demerit goods include
tobacco and alcohol. However, due to the addictive nature of tobacco and alcohol which makes
the demand price inelastic, a tax on these goods is likely to lead to a small decrease in the
quantity demanded. Therefore, for a tax on tobacco and alcohol to be effective for reducing the
consumption, the government should ensure that it is sufficiently high.

Note: When we are discussing the effects of a tax on a good on the consumption or tax revenue,
it is wrong to say, ‘If the demand for the good is price elastic, the quantity demanded will fall by
a larger percentage/proportion.’. The correct way to say it is, “If the demand for the good is
price elastic, the quantity demanded will fall by a large extent.’. This is because we are not
comparing the changes in the price and the quantity demanded.

Determinants of Price Elasticity of Demand

Number of Substitutes

The PED for a good will be higher the larger the number of substitutes. Conversely, the PED for
a good will be lower the smaller the number of substitutes. For example, the demand for a brand
of smartphones is likely to be price elastic due to the large number of substitute brands in the
market such as Apple, Samsung, LG, HTC, Sony, BlackBerry, etc. The number of substitutes for
a good depends, in part, on how narrowly, and for that matter, how broadly the good is defined.
The more broadly a good is defined, the smaller the number of substitutes and hence the less
price elastic the demand for the good. Conversely, the more narrowly a good is defined, the
larger the number of substitutes and hence the more price elastic the demand for the good. For
example, the demand for beef is more price elastic than the demand for food because, unlike
food, there are substitutes for beef.

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Closeness of Substitutes

The PED for a good will be higher the closer the substitutes. Conversely, the PED for a good will
be lower the further the substitutes. For example, the demand for residential properties is price
inelastic due to lack of close substitutes, apart from the high degree of necessity. In contrast, the
demand for the mobile network services provided by an operator in Singapore such as SingTel is
likely to be price elastic due to the presence of close substitutes which include the mobile
network services provided by other operators such as M1 and StarHub.

Degree of Necessity

The PED for a good will be higher the lower the degree of necessity. Conversely, the PED for a
good will be lower the higher the degree of necessity. For example, the demand for oil is price
inelastic due to the high degree of necessity, apart from lack of close substitutes.

Proportion of Income Spent on the Good

The PED for a good will be higher the larger the proportion of income spent on the good.
Conversely, the PED for a good will be lower the smaller the proportion of income spent on the
good. For example, the demand for private cars is likely to be price elastic due to the large
proportion of income spent on the goods as they are generally expensive. In contrast, the demand
for stationery is likely to be price inelastic due to the small proportion of income spent on the
good as it is generally cheap, apart from the high degree of necessity.

Time Period

The PED for a good will be higher the longer the time period under consideration. Conversely,
the PED for a good will be lower the shorter the time period under consideration. This is because
consumers need time to adjust their consumption patterns and find substitutes. For example,
given any increase in the price of petrol, the quantity demanded will not fall significantly in the
short run as people need to drive their cars. However, the quantity demanded will fall more
significantly over time as more fuel-efficient cars can be developed and people can switch to
smaller cars which consume less fuel.

INCOME ELASTICITY OF DEMAND

Measurement and Interpretation of Income Elasticity of Demand

The income elasticity of demand (YED) for a good is a measure of the degree of responsiveness
of the demand to a change in income, ceteris paribus.

The YED for a good is calculated by dividing the percentage change in the demand by the
percentage change in income.

34
 % Δ Demand
YED = ———————–
% Δ Income

If the YED for a good is positive, the good is a normal good. A normal good is a good whose
demand rises when consumers’ income rises. There are two types of normal goods: necessity and
luxury. A necessity is a normal good with a YED between zero and one. In other words, the
demand for a necessity is income inelastic. An example of a necessity is agricultural products. A
luxury is a normal good with a YED greater than one. In other words, the demand for a luxury is
income elastic. An example of a luxury is private cars. If the YED for a good is negative, the
good is an inferior good. An inferior good is a good whose demand falls when consumers’
income rises. An example of an inferior good is public transport.

Applications of Income Elasticity of Demand

The concept of YED allows a firm to determine the future size of the market for the good and
hence its production capacity. Suppose that the YED for a good is positive. If a firm predicts an
economic expansion which is a period of time during which national income is rising, it should
increase its production capacity in order to be able to meet the higher demand when the
economic expansion comes. Furthermore, the higher the YED is, the larger will be the increase
in the demand and hence the larger the extent the firm should increase its production capacity.
Conversely, if the firm predicts an economic contraction which is a period of time during which
national income is falling, it should decrease its production capacity to minimize excess capacity
when the economic contraction comes.

The concept of YED may enable a firm to determine how to formulate its marketing strategy.
Suppose that a firm sells two goods. Further suppose that one of the goods is a normal good and
the other good is an inferior good. If the economy is expanding and hence national income is
rising, the firm should focus its marketing strategy on the normal good. Conversely, if the
economy is contracting and hence national income is falling, the firm should focus its marketing
strategy on the inferior good.

Determinants of Income Elasticity of Demand

Degree of Luxury

The YED for a good will be higher the more luxurious the good. Conversely, the YED for a good
will be lower the less luxurious the good. For example, the YED for high-end private cars is
higher than those for mid-range and low-end private cars as high-end private cars are more
luxurious than mid-range and low-end private cars.

Level of Income

The YED for a good will be higher the lower the level of income. Conversely, the YED for a
good will be lower the higher the level of income. For example, the YED for private cars in the
35
Philippines is higher than that in Singapore as the level of income in the Philippines is lower than
that in Singapore.

CROSS ELASTICITY OF DEMAND

Measurement and Interpretation of Cross Elasticity of Demand

The cross elasticity of demand (XED) for a good with respect to another good is a measure of the
degree of responsiveness of the demand for the first good to a change in the price of the second
good, ceteris paribus. Let the two goods be good A and good B.

The XED for good A with respect to good B is calculated by dividing the percentage change in
the demand for good A by the percentage change in the price of good B.

% Δ Demand for Good A

XEDAB = ————————————–
% Δ Price of Good B

If XEDAB is positive, good A and good B are substitutes. Substitutes are goods which are
consumed in place of one another such as Coke and Pepsi. If the price of good B rises,
consumers will buy less of it. Since good A and good B are substitutes, they will buy more good
A. If XEDAB is negative, good A and good B are complements. Complements are goods which
are consumed in conjunction with one another such as car and petrol. If the price of good B rises,
consumers will buy less of it. Since good A and good B are complements, they will buy less
good A.

Applications of Cross Elasticity of Demand

The concept of XED allows a firm to determine how a change in the price of a related good
produced by another firm will affect the demand for its good. For example, if a rival firm
decreases its price, the demand for the good produced by the first firm will fall due to the
positive XED between substitutes. To avoid a decrease in sales, the firm may need to decrease its
price. However, if this is likely to lead to a price war, the firm may consider engaging in non-
price competition such as product promotion and product development instead of decreasing its
price. If a rival firm increases its price, the demand for the good produced by the first firm will
increase if it keeps its price constant. However, the firm may not experience an increase in sales
if it has no or little excess capacity.

The concept of XED may enable a firm that produces two or more goods which are complements
to increase total revenue. For example, a telecommunications firm may reduce the price of its
mobile devices even if the demand is price inelastic. Although the revenue from the sale of its
mobile devices will fall as the quantity demanded will rise by a smaller proportion, the demand
and hence the revenue from the provision of its mobile network services will rise due to the

36
negative XED between mobile network services and mobile devices. Therefore, the total revenue
of the telecommunications firm may increase.

Determinants of Cross Elasticity of Demand

The XED between two goods will be higher the more closely they are related. For example, the
XED between Coke and Pepsi is higher than that between coffee and tea as Coke and Pepsi are
closer substitutes than coffee and tea are.

SUPPLY AND ITS DETERMINANTS

Definition of Supply

Supply is the willingness and ability of producers to create goods and services to take them to
market. Supply is positively related to price given that at higher prices there is an incentive to
supply more as higher prices may generate increased revenue and profits.

Supply is an economic term that refers to the amount of a given product or service that suppliers
are willing to offer to consumers at a given price level at a given period. When the price of a
product is low, the supply is low. When the price of a product is high, the supply is high. This
makes sense because companies are seeking profits in the market place. They are more likely to
produce products with a higher price.

The supply curve shows the quantity supplied of a given product at varying price points, holding
all else constant. Here's a graph of the supply curve:

You'll notice that the x-axis is labeled 'Q', and the y-axis is labeled 'P.' Those stand
for quantity and price. Just like we saw earlier, when the price of a good goes up, the supply
does as well. Each producer has his or her own supply curve for a given product, which can vary
from one producer to another. The exact curve depends on production costs and other variables.

Difference between Stock and Supply:

The terms ‘supply’ and ‘stock’ are often confused. A clear understanding of the difference
between the two is essential. Stock is at the back of supply. It constitutes potential supply.

37
Supply means the quantity actually offered for sale at a certain price, but stock means the total
quantity which can be offered for sale if the conditions are favorable. At any time, the godowns
in the ‘mandi’ may be full of wheat. This is the stock. If the price is low, very little wheat will
come out of the godowns.

The quantity that actually comes out is the supply. The stock will change into supply and vice
versa according as the market price rises or falls. In case of perishable articles, like fresh milk
and vegetables, there is no difference between stock and supply. The entire stock is supply and
has to be sold off for unless it is disposed of quickly, it will perish.

The factors of supply for a given product or service is related to:

• the price of the product or service

• the price of related goods or services
• the prices of production factors
• the price of inputs
• the number of production units
• production technology
• expectations of producers
• government policies
• random, natural or other factors
Supply Schedule

we have a supply schedule of the milkman in a village. We notice that as the price falls, less milk
is being offered for sale, and as price rises, the milkman is prepared to sell more.

Quantity of Milk Offered (in Litres):

Supply Curve of an Individual Seller:

The supply schedule can be represented in the form of a curve, as given below (Fig. 24.1).

38
Quantities of milk offered for sale are measured along OX and prices along OY. The supply
curve SS’ slopes upwards as we go from the left to the right. This means that as the price rises,
more is being offered for sale and vice versa.

Law of Supply:
From a study of the supply schedule and supply curve, we can formulate the law of supply thus:

“In a given market, at any time, the quantity of any goods which people are ready to offer for
sale generally varies directly with the price.”

‘Varies directly means that as price rises the quantity offered increases, and as it falls, the
quantity offered decreases. It should be noted that, in the case of demand, the quantity demanded
varies inversely with the price, i.e., as price rises, demand decreases, and vice versa.

The law of supply may be put in another way. “Other things remaining the same, as the price of a
commodity rises, its supply is extended, and as the price falls, its supply is contracted.”

When prices are low many individuals and firms do not find it worth-while to sell, for their costs
may be high and profits will be low. But, when prices rise, they are in a position to carry on
production with profit and sell more. Higher prices mean higher profits. The desire for larger
profits carries production to the farthest limit yielding a net profit.

Some Exceptions:
There are some exceptions to the law of supply:
(a) In an auction, goods are sold away whatever the bid. It is possible that the seller is badly in
need of money and wants a certain amount of it. As soon as that amount is made up, he will
refuse to sell more. The higher the price, the smaller the quantity he will need to sell in order to
get the required amount. It is also possible that a person wants to get rid of a quantity of goods as
in the case of a person going abroad. In such a case, he will sell away all that he has, whatever
the price offered.

(b) When a further heavy fall in price is expected, the sellers may become panicky. They will sell
more even if the price falls.

These exceptions, however, do not falsify the law of supply enunciated above. Generally the law
holds good. Extension and Contraction of Supply and Increase and Decrease of Supply. As in the
case of demand, so in the case of supply, a distinction must be made between extension and

39
contraction on the one hand, and increase and decrease, on the other. This is in fact a distinction
between a movement along the supply curve and shift of supply Curve.

Extension and Contraction, i.e. Movement along the Supply Curve:

When the quantity offered for sale increases or decreases merely because price has risen or
fallen, we use the terms extension and contraction of supply. The supply schedule is the same
and we travel up and down the same supply curve.

Increase and Decrease, i.e., Shift of the Supply Curve:

If, on the other hand, the change in the quantity offered for sale is caused, not by a change in
price, but by a change in the conditions of supply, we say that supply has increased or decreased
or the supply curve has shifted from its previous position. The change in the condition of supply
implies a change in the technical conditions: perhaps a new process or a new material has been
discovered, a new labour-saving device has been discovered, or raw materials and other factors
have become cheaper.

On account of these new developments, the manufacturer may be able to offer more for sale even
if the price has remained the same or gone down. If the conditions have become unfavorable, he
will not be able to supply the same quantity at the old price. Extension of supply means that
more is offered at a higher price, while increase in supply signifies that either more is offered at
the same price or the same quantity is offered at a lower price.

Contraction and decrease in supply are the opposites of extension and increase in supply
respectively. Contraction of supply means that less is offered at a lower price, but decrease in
supply means that less is offered at the same price or the same quantity is offered at a higher
price.

These changes can be illustrated with the help of diagrams as under:

Prices are measured along OY and quantities offered for sale along OX. SS’ is the old supply
curve and BB’ is the new supply curve. Fig. 24.6 shows extension and contraction of demand. At
PM Price, amount OM is offered, but at the price P’M’ (which is higher than PM), OM’ is
offered, which is more. Fig. 24.7 shows an increase in supply, for OM’ (i.e., more) is offered
instead of OM at the same price (PM = P’M’). Also, the same quantity OM is offered at a lower
price LM. In Fig. 24.8, OM’ (i.e., less) is offered in place of OM, although price is the same
(P’M’=PM). Also, the same quantity OM is offered at a higher price LM. This means a decrease
in supply.

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CONCEPTS OF COSTS

The concept of cost is of great significance in the micro economic theory. It is the cost of
production which determines the production decision of an entrepreneur whose main aim is to
maximize profit. Lower the cost of production, greater is the profit margin.

COST OF PRODUCTION

The expenses incurred on all inputs of production–both factor inputs and non-factor inputs are
known as the cost of production. Land, labour, capital and organization are the factors of
production called factor inputs. Raw materials, fuel, equipments, tools etc are non-factor inputs.
Thus, cost is a function of various factors. Symbolically, cost function can be expressed as under,

C = f (Q, T, Pf )

Where C is the total cost of production, Q is output; T is technology, and P f is the prices of
factors of production.

Short Run Costs and Long Run Costs

Short run is a period of time within which the firm can change its output by changing only the
amount of variable factors, such as labour and raw materials etc. In short period, fixed factors
such as land, machinery etc, cannot be changed. Costs of production incurred in the short run i.e.,
on variable factors are called short run costs. The long run costs are the costs over a period in
which all factors are changeable. Thus, costs of production on all factors (in the long run all
factors become variable) are long run costs.

Fixed/Supplementary and Variable/Prime Costs

The expenses incurred on fixed factors are called fixed costs, whereas those incurred on the
variable factors may be called variable costs.

41
The fixed costs include the costs of:

(a) The salaries and other expenses of administrative staff;

(b) The salaries of staff involved directly in the production, but on a fixed term basis;

(c) The wear and tear of machinery (standard depreciation allowances);

(d) The expenses for maintenance of buildings;

(e) The expenses for the maintenance of the land on which the plant is installed and operates and

(f) Normal profit, which is a lump sum including a percentage return on fixed capital and
allowance for risk.

The variable costs include the cost of:

(a) Direct labour, which varies with output.

(b) Raw materials; and

(c) Running expenses of machinery. The sum of fixed and variable costs constitutes the total cost
of production. Symbolically,

TC = TFC + TVC

Total Fixed Cost (TFC)

Total fixed cost is the sum of expenses incurred on those inputs that remain same at different
levels of output. Total fixed cost is graphically shown in Fig. 8.1. It is a straight line parallel to
output or x-axis. TFC is the total fixed cost curve parallel to x-axis indicating that it remains
constant at all levels of output. Fixed costs are those that do not vary with output and typically
include rents, insurance, depreciation, set-up costs, and normal profit. They are also
called overheads.

Total Variable Cost (TVC)

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Total variable cost is the sum of expenses incurred on those factor inputs whose quantity varies
with a change in the level of output. Total variable cost curve. Variable costs are costs that do
vary with output, and they are also called direct costs. Examples of typical variable costs include
fuel, raw materials, and some labour costs . TVC is shown in the following figure. It has Inverse-
S shape. Total variable costs increase as the level of output increases.

Total Cost (TC)

Its position reflects the amount of fixed costs, and its gradient reflects variable costs. Total cost
to a producer for the various levels of output is the sum of total fixed costs and total variable
costs, i.e.,

TC = TFC+TVC

Average Fixed Cost (AFC)

Average fixed cost is total fixed cost divided by total output. It is per unit cost on fixed factors.
Symbolically,

AFC = TFC/TQ

Where, TQ is the total output.

43
Average fixed cost is shown as under. AFC curve is a rectangular hyperbola, indicating same
magnitude at all points as TFC remains constant throughout. This is shown in the Fig. below:

AVERAGE FIXED COSTS

Average fixed costs are found by dividing total fixed costs by output. As fixed cost is divided by
an increasing output, average fixed costs will continue to fall.

AVERAGE
TOTAL FIXED
OUTPUT FIXED COST
COST (£000)
(£000)

1 100 100

2 100 50

3 100 33.3

4 100 25

5 100 20

6 100 16.6

7 100 14.3

8 100 12.5

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The average fixed cost (AFC) curve will slope down continuously, from left to right.

AVERAGE VARIABLE COSTS

Average variable costs are found by dividing total fixed variable costs by output.

TOTAL AVERAGE
OUTPUT VARIABLE VARIABLE
COST (£000) COST (£000)

1 50 50

2 80 40

3 100 33.3

4 110 27.5

5 150 30

6 220 36.7

7 350 50

8 640 80

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The average variable cost (AVC) curve will at first slope down from left to right, then reach a
minimum point, and rise again.

AVC is ‘U’ shaped because of the principle of variable Proportions, which explains the three
phases of the curve:

1. Increasing returns to the variable factors, which cause average costs to fall, followed by:
2. Constant returns, followed by:
3. Diminishing returns, which cause costs to rise.

AVERAGE TOTAL COST

Average total cost (ATC) is also called average cost or unit cost. Average total costs are a key
cost in the theory of the firm because they indicate how efficiently scarce resources are being
used. Average variable costs are found by dividing total fixed variable costs by output.

AVERAGE AVERAGE AVERAGE

FIXED VARIABLE TOTAL
OUTPUT
COST COST COSTS
(£000) (£000) (£000)

1 100 50 150

2 50 40 90

3 33.3 33.3 67
46
 4 25 27.5 52.5

5 20 30 50

6 16.6 36.7 53.3

7 14.3 50 64.3

8 12.5 80 92.5

Average total cost (ATC) can be found by adding average fixed costs (AFC) and average
variable costs (AVC). The ATC curve is also ‘U’ shaped because it takes its shape from the AVC
curve, with the upturn reflecting the onset of diminishing returns to the variable factor.

AREAS FOR TOTAL COSTS

Total Fixed costs and Total Variable costs are the respective areas under the Average Fixed and
Average Variable cost curves.

MARGINAL COSTS (MC)

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Marginal cost is the cost of producing one extra unit of output. It can be found by calculating
the change in total cost when output is increased by one unit.

MARGINAL
OUTPUT TOTAL COST
COST

1 150

2 180 30

3 200 20

4 210 10

5 250 40

6 320 70

7 450 130

8 740 290

It is important to note that marginal cost is derived solely from variable costs, and not fixed
costs.

The marginal cost curve falls briefly at first, then rises. Marginal costs are derived from variable
costs and are subject to the principle of variable proportions.

THE SIGNIFICANCE OF MARGINAL COST

The marginal cost curve is significant in the theory of the firm for two reasons:

48
 1. It is the leading cost curve, because changes in total and average costs are derived from
changes in marginal cost.
2. The lowest price a firm is prepared to supply at is the price that just covers marginal cost.

ATC AND MC

Average total cost and marginal cost are connected because they are derived from the same basic
numerical cost data. The general rules governing the relationship are:

1. Marginal cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling, and
when marginal cost is above average total cost,average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also
where average total cost (ATC) = marginal cost(MC).

TOTAL COSTS AND MARGINAL COSTS

Marginal costs are derived exclusively from variable costs, and are unaffected by changes in
fixed costs. The MC curve is the gradient of the TC curve, and the positive gradient of the total
cost curve only exists because of a positive variable cost. This is shown below:

49
50
MARKET AND FORMS OF MARKET

Market Structure
Definition: The Market Structure refers to the characteristics of the market either
organizational or competitive, that describes the nature of competition and the pricing policy
followed in the market.

Thus, the market structure can be defined as, the number of firms producing the identical goods
and services in the market and whose structure is determined on the basis of the competition
prevailing in that market.

The term “ market” refers to a place where sellers and buyers meet and facilitate the selling and
buying of goods and services. But in economics, it is much wider than just a place, It is a gamut
of all the buyers and sellers, who are spread out to perform the marketing activities.

Types of Market Structure

1- Perfect Competition Market Structure

2- Monopoly Market Structure
3- Monopolistic Market Structure
4- Oligopoly Market Structure

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 1- Perfect Competition
Definition: The Perfect Competition is a market structure where a large number of buyers and
sellers are present, and all are engaged in the buying and selling of the homogeneous products at
a single price prevailing in the market.

In other words, perfect competition also referred to as a pure competition, exists when there is no
direct competition between the rivals and all sell identically the same products at a single price.

Features of Perfect Competition

1. Large number of buyers and sellers: In perfect competition, the buyers and sellers are large
enough, that no individual can influence the price and the output of the industry. An individual
customer cannot influence the price of the product, as he is too small in relation to the whole
market. Similarly, a single seller cannot influence the levels of output, who is too small in
relation to the gamut of sellers operating in the market.

2. Homogeneous Product: Each competing firm offers the homogeneous product, such that no
individual has a preference for a particular seller over the others. Salt, wheat, coal, etc. are some
of the homogeneous products for which customers are indifferent and buy these from the one
who charges a less price. Thus, an increase in the price would let the customer go to some other
supplier.

3. Free Entry and Exit: Under the perfect competition, the firms are free to enter or exit the
industry. This implies, If a firm suffers from a huge loss due to the intense competition in the
industry, then it is free to leave that industry and begin its business operations in any of the
industry, it wants. Thus, there is no restriction on the mobility of sellers.

4. Perfect knowledge of prices and technology: This implies, that both the buyers and sellers
have complete knowledge of the market conditions such as the prices of products and the latest
technology being used to produce it. Hence, they can buy or sell the products anywhere and
anytime they want.

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5. No transportation cost: There is an absence of transportation cost, i.e. incurred in carrying the
goods from one market to another. This is an essential condition of the perfect competition since
the homogeneous product should have the same price across the market and if the transportation
cost is added to it, then the prices may differ.

6. Absence of Government and Artificial Restrictions: Under the perfect competition, both the
buyers and sellers are free to buy and sell the goods and services. This means any customer can
buy from any seller, and any seller can sell to any buyer.Thus, no restriction is imposed on either
party. Also, the prices are liable to change freely as per the demand-supply conditions. In such a
situation, no big producer and the government can intervene and control the demand, supply or
price of the goods and services.

Thus, under the perfect competition, a seller is the price taker and cannot influence the market
price.

2- Monopoly Market Structure

Monopoly Market

Definition: The Monopoly is a market structure characterized by a single seller, selling the
unique product with the restriction for a new firm to enter the market. Simply, monopoly is a
form of market where there is a single seller selling a particular commodity for which there are
no close substitutes.

Features of Monopoly Market

1. Under monopoly, the firm has full control over the supply of a product. The elasticity of demand
is zero for the products.

2. There is a single seller or a producer of a particular product, and there is no difference between
the firm and the industry. The firm is itself an industry.

3. The firms can influence the price of a product and hence, these are price makers, not the price
takers.
53
4. There are barriers for the new entrants.

5. The demand curve under monopoly market is downward sloping, which means the firm can earn
more profits only by increasing the sales which are possible by decreasing the price of a product.

6. There are no close substitutes for a monopolist’s product.

Under a monopoly market, new firms cannot enter the market freely due to any of the reasons
such as Government license and regulations, huge capital requirement, complex technology and
economies of scale. These economic barriers restrict the entry of new firms.

3- Monopolistic Market Structure

Monopolistic Competition

Definition: Under, the Monopolistic Competition, there are a large number of firms that
produce differentiated products which are close substitutes for each other. In other words, large
sellers selling the products that are similar, but not identical and compete with each other on
other factors besides price.

Features of Monopolistic Competition

1. Product Differentiation: This is one of the major features of the firms operating under the
monopolistic competition, that produces the product which is not identical but is slightly
different from each other. The products being slightly different from each other remain close
substitutes of each other and hence cannot be priced very differently from each other.

2. Large number of firms: A large number of firms operate under the monopolistic competition,
and there is a stiff competition between the existing firms. Unlike the perfect competition, the
firms produce the differentiated products which are substitutes for each other, thus make the
competition among the firms a real and a tough one.

54
3. Free Entry and Exit: With an intense competition among the firms, the entity incurring the loss
can move out of the industry at any time it wants. Similarly, the new firms can enter into the
industry freely, provided it comes up with the unique feature and different variety of products to
outstand in the market and meet with the competition already existing in the industry.

4. Some control over price: Since, the products are close substitutes for each other, if a firm
lowers the price of its product, then the customers of other products will switch over to it.
Conversely, with the increase in the price of the product, it will lose its customers to others.
Thus, under the monopolistic competition, an individual firm is not a price taker but has some
influence over the price of its product.

5. Heavy expenditure on Advertisement and other Selling Costs: Under the monopolistic
competition, the firms incur a huge cost on advertisements and other selling costs to promote the
sale of their products. Since the products are different and are close substitutes for each other; the
firms need to undertake the promotional activities to capture a larger market share.

6. Product Variation: Under the monopolistic competition, there is a variation in the products
offered by several firms. To meet the needs of the customers, each firm tries to adjust its product
accordingly. The changes could be in the form of new design, better quality, new packages or
container, better materials, etc. Thus, the amount of product a firm is selling in the market
depends on the uniqueness of its product and the extent to which it differs from the other
products.

The monopolistic competition is also called as imperfect competition because this market
structure lies between the pure monopoly and the pure competition.

4- Oligopoly Market Structure

Oligopoly Market

Definition: The Oligopoly Market characterized by few sellers, selling the homogeneous or
differentiated products. In other words, the Oligopoly market structure lies between the pure
monopoly and monopolistic competition, where few sellers dominate the market and have
control over the price of the product.

Under the Oligopoly market, a firm either produces:

▪ Homogeneous product: The firms producing the homogeneous products are called as Pure
or Perfect Oligopoly. It is found in the producers of industrial products such as aluminum,
copper, steel, zinc, iron, etc.

▪ Heterogeneous Product: The firms producing the heterogeneous products are called as
Imperfect or Differentiated Oligopoly. Such type of Oligopoly is found in the producers of
consumer goods such as automobiles, soaps, detergents, television, refrigerators, etc.

55
 Features of Oligopoly Market

1. Few Sellers: Under the Oligopoly market, the sellers are few, and the customers are many. Few
firms dominating the market enjoys a considerable control over the price of the product.

2. Interdependence: it is one of the most important features of an Oligopoly market, wherein, the
seller has to be cautious with respect to any action taken by the competing firms. Since there are
few sellers in the market, if any firm makes the change in the price or promotional scheme, all
other firms in the industry have to comply with it, to remain in the competition.

Thus, every firm remains alert to the actions of others and plan their counterattack beforehand, to
escape the turmoil. Hence, there is a complete interdependence among the sellers with respect to
their price-output policies.

3. Advertising: Under Oligopoly market, every firm advertises their products on a frequent basis,
with the intention to reach more and more customers and increase their customer base.This is due
to the advertising that makes the competition intense.

If any firm does a lot of advertisement while the other remained silent, then he will observe that
his customers are going to that firm who is continuously promoting its product. Thus, in order to
be in the race, each firm spends lots of money on advertisement activities.

4. Competition: It is genuine that with a few players in the market, there will be an intense
competition among the sellers. Any move taken by the firm will have a considerable impact on
its rivals. Thus, every seller keeps an eye over its rival and be ready with the counterattack.

5. Entry and Exit Barriers: The firms can easily exit the industry whenever it wants, but has to
face certain barriers to entering into it. These barriers could be Government license, Patent, large
firm’s economies of scale, high capital requirement, complex technology, etc. Also, sometimes
the government regulations favor the existing large firms, thereby acting as a barrier for the new
entrants.

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6. Lack of Uniformity: There is a lack of uniformity among the firms in terms of their size, some
are big, and some are small.

Since there are less number of firms, any action taken by one firm has a considerable effect on
the other. Thus, every firm must keep a close eye on its counterpart and plan the promotional
activities accordingly.

DUOPOLY

A duopoly is a type of oligopoly, characterized by two primary corporations operating in a

market or industry, producing the same or similar goods and services. The key components of a
duopoly are how the firms interact with one another and how they affect one another.

In a duopoly, two companies control the entirety of the market for the goods and services they
produce and sell. While other companies may operate in the same space, the defining feature of a
duopoly is the fact that only two companies are considered major players. These two firms – and
their interactions with one another – shape the market they operate in. Both the firms compete
each other on price or output. The decision of firm effect the other so other retaliates in the same
way.

Examples of Duopoly
• Smartphones: Apple and Android.
• Electronic payments: MasterCard and Visa.
• Soft drinks: Coca-Cola and Pepsi.
• High-end auctions for art and antiques: Sotheby's and Christie's.
• Aircraft manufacture: Boeing and Airbus.

CARTELS

A cartel is a grouping of producers that work together to protect their interests. Cartels are
created when a few large producers decide to co-operate with respect to aspects of their market.
Once formed, cartels can fix prices for members, so that competition on price is avoided. In this
case cartels are also called price rings. They can also restrict output released onto the market,
such as with OPEC and oil production quotas, and set rules governing other aspects of the
behaviour of members. Setting rules is especially important in oligopolistic markets, as predicted
in game theory. A significant attraction of cartels to producers is that they set rules that members
follow, thus reducing risks that would exist without the cartel.

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