Microeconomics

CHAPTER-I :Concepts and Methodology of Economics

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 economics was first studied in ancient Greece.What was the study of
household management to Greek philosophers like Aristotle (384-322 BC) was the
“study of wealth” to the mercantilists in Europe between the sixteenth and eighteenth
centuries. Economics, as a study of wealth, received great support from the Father
of economics, Adam Smith, in the late eighteenth century.

Adam Smith’s Wealth Definition:

The formal definition of economics can be traced back to the days of Adam Smith
(1723-90) — 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.

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.”

Samuelson’s Final and Compromise Definition (Growth definition)

Perhaps the most acceptable definition comes from Paul Samuelson. According to
him, “Economics is the study of how men and society end up choosing with or
without the use of money to employ scarce productive resources that could have
alternative uses to produce various commodities and distribute them for
consumption, now or in the future, among various people and groups in the society.
It analyses the costs and benefits of improving pattern of resource allocation”.
Samuelson's definition is known as a modern definition of economics.

Methodology of Micro Economics

Economics Models
Simplified representations of the real world used as the basis for predictions or
explanations.
– Real world data is used to evaluate the usefulness of a model.

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 – Models are useful if they predict economic phenomena.
– Economic models predict how people react, not how they think.
Economics Theories
● A Theory is a hypothesis that has been tested and proved.
● A hypothesis is an intelligent guess (a supposition or an assumption) the
validity of which is to be tested.
Two Main Streams
• The study of Economics is divided into two parts on the basis of looking the
system as whole or in terms of its innumerable decision-making units
– Micro Economics
• It is also called Price Theory
– Macro Economics
• It is also called Income Theory
Positive Economics
– Purely descriptive statements or scientific predictions; “If A, then B,”
– a statement of what is
– Positive economics deals with facts (and theories about these facts)
and avoids value judgments. Attempts to set out scientific statements
about economic behaviour
– It describes what exists and how it works.
Normative Economics
• Normative Economics are based upon someone’s value judgments about
what the economy should be like or what particular policy action should be
recommended, based on a given economic generalisation or relationship.
• It is also called policy economics, analyzes outcomes of economic behavior,
evaluates them as good or bad, and may prescribe courses of action.
• It embodies subjective feeling about ‘what ought to be’
• Normative economics is concerned about welfare propositions.

Methods of Economics
• Like other sciences Economics also uses scientific methods. These methods
are:
– Deductive Method
– Inductive Method
Proper Method
Deductive Method
• Economists of Classical School tried to build up the science of Economics
from few simple generalizations
• Classical economists by and large supported this method
• Reasoning from assumptions to conclusions
by testing a hypothesis
• Starts from General and moves to the particular

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 • Begin with general assumptions and moves to particular conclusion
• Develops a theory, and then examine the facts to see if they follow the theory
• Researcher begins with a hypothesis/ theory,
• Then makes observations or collects data to test that hypothesis.
• Based on empirical evidence from the study,
The researcher then decides whether to accept or reject the hypothesis.
The deductive methodology, in short, tests theories and hypotheses
Inductive Method
Starts from the particular and moves to the general
Begin with particular observation and moves to the general explanation
Collect the observation , then the develops a theory to fit the facts
Introduced by Historic school
This method insists on the examination of facts and then laying down general
principles
Here we go from “particulars” to “generals”
Under this methodology,
• Social scientists observe social phenomena,
• Identify patterns
• Then analyze them to reach broad conclusions
• Develop new theories based on research findings

Proper Method

• The modern economist does not rely on one method. He uses both. It is said

– “Induction and Deduction are both needed for scientific thought as the
right and left foot are both needed for walking”

– The deductive method seems to be more suitable in the field of pure

theory and inductive method for formulating practical policies

CHAPTER-II : Demand Analysis

Meanings and Definition of Demand:

● The word 'demand' is so common and familiar with every one of us that it
seems superfluous to define it. The need 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 good supported by
willingness and ability to pay for it.
● A desire which is backed by willingness and ability to pay for a commodity in
order to obtain it.

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Law of Demand:

Definition and Explanation of the Law:

● 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.

● 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".

Formula For Law of Demand:

Qdx = f (Px, M, Po, T,..........)

Here the M, Po, and T 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.
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.

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 ● In the figure (4.1), 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.
● When the price of a good rises, the quantity demanded decreases and when
its price decreases, quantity demanded increases, ceteris paribus.
● Demand, thus, is a negative relationship between price and quantity.

Limitations/Exceptions of Law of Demand:

(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.

Types of Demand

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Joint demand :means two or more goods are demanded together. To consume one
good, you need another good. In other words they are complements.
Eg: printers and ink cartridges.

Alternative demand: Alternative demand is derived from the changes in the price of
substitutes. When the price of a good goes down, people who have been using other
goods with similar or exact same use (substitutes) may move to buying that
particular good.
Income Demand:
Let us now study income demand which indicates the relationship between income
and the quantity of commodity demanded

Cross Demand:
Let us now take the case of related goods and how the change in the price of one
affects the demand of the other. This is known as cross demand and is written as D
= f (pr). Related goods are of two types, substitutes and complementary.

Derived demand- Demand for labour - demand for any factor is a demand derived
from the final product which that factor helps to produce- is derived demand.
Composite / Rival demand – multi uses commodities/services
Composite demand happens when goods or services have more than one use so
that an increase in the demand for one product leads to a fall in supply of the other.

Individual's and Market Demand for a Commodity:

"The individuals demand for a commodity is the amount of a commodity which

the consumer is willing to purchase at any given price over a specified period of
time".

Market Demand for a Commodity:

● The market demand for a commodity is obtained by adding up the total

quantity demanded at various prices by all the individuals (lateral summation)
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.
.
Changes in Demand : Movement Vs Shifts of Demand Curve:

(1) Movement Along the Demand Curve:

(Simultaneous and Opposite direction only due to price )

Horizontal summation is the process of adding the quantities demanded by each individual consumer
at each price level to determine the total quantity demanded in the market. It's used to derive the
6 market demand curve from various individual demand curves. Horizontal summation is different for
public goods, where the market demand is equal to the demand of an individual. This is because the
availability of a public good applies to all consumers in the market. For example, the demand for a
national highway by one consumer is the same as the demand by ten consumers.
 Horizontal Summation: Total quantity demanded at each price (focus on quantity).
Vertical Summation: Total willingness to pay for each quantity (focus on price).

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.

(2) Shifts in Demand Curve:

( Keeping price or quantity constant, or simultaneous and same direction and
also opposite direction )

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.

Determinants of Demand:
(i) Changes in population: If the population of a country increase account of
immigration or through high birth rate or on account of these factors, the demand for
various kinds of goods will increase even the prices remains the same. The demand
curve will shift upward to the right.

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The nature of the commodities .demanded will depend up to taste of the
consumers. If due to high net production rate, the percentage of children to the total
population increases in a country, there will greater demand for toys, children food,
etc.
(ii) Changes in tastes: Demand for a commodity may change due to changes in
tastes and fashions.
(iii) Changes in income: When the income of consumers increases generally leads
to an increase in the demand for some commodities and a decrease in the demand
for other commodities.

(iv) Changes in the distributions of wealth: If an equal distribution of wealth is

brought about in a country, then there will be less demand for expensive luxuries
goods. There will be more demand for necessaries and comfort items.

(v) Changes in the price of substitutes: if the price of a particular commodity rises,
people may stop further purchase of that commodity and spend money on its
substitute which is available at a lower price. Thus we find, a change in demand can
also be brought about by a change in the price of the substitute.

(vi) Changes in the state of trade: The total quantity of goods demanded is also
affected by the cyclical fluctuations in economic activities.
(vii) Climate and weather conditions: The climate and weather conditions have an
important bearing on the demand of a commodity. For instance, the consumer's
demand for woolen clothes increases in winter and decreases in summer.

Demand Curve is Negatively Sloped:

The fundamental reasons for demand curve to slope downward are as follows:

(i) Law of diminishing marginal utility:

● The law of demand is based on the law of diminishing marginal
utility.
● According to the cardinal utility approach, when a consumer
purchases more units of a commodity, its marginal utility declines.
(ii) Income effect:
● Other things being equal, when the price of a commodity
decreases, the real income or the purchasing power of the
household increases.
● When at a lower price, there is a greater demand for a commodity
by the households, the demand curve is bound to slope downward
from left to right.
Lower Price, Higher Demand: When the price of a good decreases, consumers are more
willing to buy more units. This is because the lower price makes each additional unit more
"affordable" in terms of the satisfaction it provides. Even though the marginal utility of each
extra unit is declining, the lower price offsets this decline.
8 * Higher Price, Lower Demand: Conversely, when the price of a good increases, consumers
are less willing to buy more units. This is because the higher price makes each additional
unit less "worth it" in terms of the satisfaction it provides. The declining marginal utility is
amplified by the higher price.
(iii) Substitution effect: The demand curve slopes downward from left to right also
because of the substitution effect. For instance, the price of meat falls and the prices
of other substitutes say poultry and beef remain constant.
(iv) Entry of new buyers: When the price of a commodity falls, its demand not only
increases from the old buyers but the new buyers also enter the market.
What is Price Elasticity of Demand?
● Price elasticity of demand measures the degree of responsiveness of the
quantity demanded of a good to a change in its price. It is also defined as:
● "The ratio of proportionate change in quantity demanded caused by a given
proportionate change in price".
Formula For Calculation:

Price elasticity of demand is computed by dividing the percentage change in quantity

demanded of a good by the percentage change in its price.

Symbolically price elasticity of demand is expressed as under:

Ed = Percentage Change in Quantity Demanded

Percentage Change in Price

Simple formula for calculating the price elasticity of demand:

%∆𝑄 𝑄
Ed = %∆𝑃
𝑥 𝑃

Degrees of Elasticity of Demand:

(1) Perfectly Elastic Demand:

A demand is perfectly elastic when a small increase in the price of a good its quantity
to zero. Perfect elasticity implies that individual producers can sell all they want at a
ruling price but cannot charge a higher price. If any producer tries to charge even
one penny more, no one would buy his product.

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It shows that the demand curve DD/ is a horizontal line which indicates that the
quantity demanded is extremely (infinitely) response to price. Even a slight rise in
price (say $4.02), drops the quantity demanded of a good to zero. The curve DD/ is
infinitely elastic. This elasticity of demand as such is equal to infinity.

(2) Perfectly Inelastic Demand:

When the quantity demanded of a good dose not change at all to whatever change
in price, the demand is said to be perfectly inelastic or the elasticity of demand is
zero.

For example, a 30% rise or fall in price leads to no change in the quantity demanded
of a good.

Ed = 0/30%, Ed = 0

In figure 6.2 a rise in price from OA to OC or fall in price from OC to OA causes no

change (zero responsiveness) in the amount demanded.

Ed = 0
Δp Ed = 0

(3) Unitary Elasticity of Demand:

When the quantity demanded of a good changes by exactly the same percentage as
price, the demand is said to has a unitary elasticity.

For example, a 30% change in price leads to 30% change quantity demand = 30% /
30% = 1.

One or a one percent change in price causes a response of exactly a one percent
change in the quantity demand.

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 ● The percentage change in price brings about an exactly equal percentage in
quantity at all points a, b. The demand curve of elasticity is, therefore, a
rectangular hyperbola.

Ed = 1

(4) Elastic Demand:

● If a one percent change in price causes greater than a one percent change in
quantity demanded of a good, the demand is said to be elastic.

Alternatively, we can say that the elasticity of demand is greater than. For example, if
price of a good change by 10% and it brings a 20% change in demand, the price
elasticity is greater than one.

Ed = 2

Ed > 1

(5) Inelastic Demand:

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When a change in price causes a less than a proportionate change in quantity
demand, demand is said to be inelastic.

The elasticity of a good is here less than I or less than unity. For example, a 30%
change in price leads to 10% change in quantity demanded of a good, then:

Ed = 1/3, Ed = <1

Measurement of Price Elasticity of Demand:

There are three methods of measuring price elasticity of demand:

(1) Total Expenditure Method.

(2) Geometrical Method or Point Elasticity Method.
(3) Arc Method.
(4) Linear demand curve method.
These four methods are now discussed in brief:

(1) Total Expenditure Method/Total Revenue Method:

The price elasticity can be measured by noting the changes in total expenditure
brought about by changes in price and quantity demanded.
(i) When with a percentage fall in price, the quantity demanded increases so much
that it results in the increase in total expenditure, the demand is said to be
elastic (Ed > 1).

Quantity Total Expenditure

Price Per Unit ($)
Demanded ($)
20 10 Pens 200.0
10 30 Pens 300.0

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Note:
As the demand curve slopes downward, therefore, the coefficient of price
elasticity of demand is always negative. The economists for convenience sake,
omit the negative sign and express the price elasticity of demand by positive number.
(2) Geometric Method/Point Elasticity Method:
"The measurement of elasticity at a point of the demand curve is called point
elasticity".
The point elasticity of demand is defined as "The proportionate change in the
quantity demanded resulting from a very small proportionate change in price".

The elasticity at each point on the demand curve can be traced with the help of point
method as:
Ed = Lower Segment
Upper Segment
Summing up, the elasticity of demand is different at each point along a linear
demand curve. At high prices, demand is elastic. At low prices, it is inelastic. At the
midpoint, it is unit elastic.

(ii) Measurement of Elasticity on a Non Linear Demand Curve:

If the demand curve is non linear, then elasticity at a point can be measured by
drawing a tangent at the particular point. This is explained with the help of a figure
given below:

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In figure 6.10, the elasticity on DD/ demand curve is measured at point C by drawing
a tangent. At point C:

Ed = BM = BC = 400 = 2 (>1).
MO CA 200
Here elasticity is greater than unity. Point C lies above the midpoint of the demand
curve DD/. In case the demand curve is a rectangular hyperbola, the change in price
will have no effect on the total amount spent on the product. As such, the demand
curve will have a unitary elasticity at all points.

(3) Arc Elasticity:

● Normally the elasticity varies along the length of the demand curve. If we are
to measure elasticity between any two points on the demand curve, then
the Arc Elasticity Method, is used.
● Arc elasticity is a measure of average elasticity between any two points on the
demand curve.
● is defined as: "The average elasticity of a range of points on a demand
curve".
Formula:
Arc elasticity is calculated by using the following formula: Ed = Δq/∆p x P1+P2/q1 + q2

Here: ∆q denotes change in quantity, ∆p denotes change in price, q1 signifies initial

quantity, q2 denotes new quantity, P1 stands for initial price,P2 denotes new price.
Graphic Presentation of Measuring Elasticity Using the Arc Method:

(2) Income Elasticity of

Demand:
● "The ratio of percentage change in
the quantity of a good purchased,
per unit of time to a percentage

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 change in the income of a consumer".
● The formula for measuring the income elasticity of demand is the percentage
change in demand for a good divided by the percentage change in income.
Putting this in symbol gives.

Ey = Percentage Change in Demand

Percentage Change in Income
Types:

For normal goods, the value of elasticity is equal to one.

Goods with an income elasticity of less than 0 are called inferior goods. For
example, people buy less food than earlier as their income rises .
For Luxury goods, the value of elasticity is greater than one.
For necessary goods, the value of elasticity is less than one.

(3) Cross Elasticity of Demand:

Definition and Explanation:

● The concept of cross elasticity of demand is used for measuring the
responsiveness of quantity demanded of a good to changes in the price of
related goods.
● Cross elasticity of demand is defined as:
"The percentage change in the demand of one good as a result of the percentage
change in the price of another good".
Exy = % Change in Quantity Demanded of Good X
% Change in Price of Good Y
(i) Substitute Goods. When two goods are substitute of each other, such as coke
and Pepsi, an increase in the price of one good will lead to an increase in demand
for the other good. The numerical value of goods is positive.

(ii) Complementary Goods. However, in case of complementary goods such as car

and petrol, cricket bat and ball, a rise in the price of one good say cricket bat by 7%
will bring a fall in the demand for the balls (say by 6%). The cross elasticity of
demand which are complementary to each other is, therefore, 6% / 7% = 0.85
(negative).

(iii) Unrelated Goods. The two goods which a re unrelated to each other, The
elasticity is zero of unrelated goods.

Cardinal Utility Analysis/Approach:

Definition and Explanation:

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Concept of Utility:

Utility is defined as: "The power of a commodity or service to satisfy human want".
Utility is thus the satisfaction which is derived by the consumer by consuming the
goods.

Assumptions of Cardinal Utility Analysis:

The main assumption or premises on which the cardinal utility analysis rests are as
under.
(i) Rationality. The consumer is rational. He seeks to maximize satisfaction from the
limited income which is at his disposal.
(ii) Utility is cardinally measurable. The utility can be measured in cardinal
numbers such as 1, 3, 10, 15, etc. The utility is expressed in imaginary cardinal
numbers tells us a great deal about the preference of the consumer for a good.
(iii) Marginal utility of money remains constant. Another important premise of
cardinal utility of money spent on the purchase of a good or service should remain
constant.
(iv) Diminishing marginal utility. It is also assumed that the marginal utility
obtained from the consumption of a good diminishes continuously as its consumption
is increased.
(v) Independent utilities. According to the Cardinalist school, the utility which is
derived from the consumption of a good is a function of the quantity of that good
alone. If does not depend at all upon the quantity consumed of other goods. The
goods, we can say, possess independent utilities and are additive.
(vi) Introspection method. The Cardinalist school assumes that the behavior of
marginal utility in the mind of another person can be judged with the help of self
observation.

Total Utility and Marginal Utility:

Total Utility (TU):

"Total utility is the total satisfaction obtained from all units of a particular
TUx = ∑MUx

Marginal Utility (MU):

"Marginal utility means an additional or incremental utility. Marginal utility is the
change in the total utility that results from unit one unit change in consumption of the
commodity within a given period of time".
MU = ∆TU /∆Q

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Law of Diminishing Marginal Utility:

Definition and Statement of the Law:

The law of diminishing marginal utility states that: “As a consumer consumes
more and more units of a specific commodity, the utility from the successive units
goes on diminishing”.
Mr. H. Gossen, a German economist, was first to explain this law in 1854. Alfred
Marshal later on restated this law in the following words:
“The additional benefit which a person derives from an increase of his stock of
a thing diminishes with every increase in the stock that already has”.

Assumptions of Law of Diminishing Marginal Utility:

The law of diminishing marginal utility is true under certain assumptions. These
assumptions are as under:
(i) Rationality: In the cardinal utility analysis, it is assumed that the consumer is
rational. He aims at maximization of utility subject to availability of his income.
(ii) Constant marginal utility of money: It is assumed in the theory that the
marginal utility of money based for purchasing goods remains constant..
(iii) Diminishing marginal utility: Another important assumption of utility analysis is
that the utility gained from the successive units of a commodity diminishes in a given
time period.
(iv) Utility is additive: In the early versions of the theory of consumer behavior, it
was assumed that the utilities of different commodities are independent. The total
utility of each commodity is additive.

U = U1 (X1) + U2 (X2) + U3 (X3)………. Un (Xn)

Limitations/Exceptions of Law of Diminishing Marginal Utility:

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There are some exceptions or limitations to the law of diminishing utility.
(i) Case of intoxicants: Consumption of liquor defies the low for a short period. The
more a person drinks, the more likes it. However, this is truer only initially. A stage
comes when a drunkard too starts taking less and less liquor and eventually stops it.
(ii) Rare collection: If there are only two diamonds in the world, the possession of
2nd diamond will push up the marginal utility.
(iii) Application to money: The law equally holds good for money. It is true that
more money the man has, the greedier he is to get additional units of it.

Equilibrium of the Consumer Through the Law of Equi-Marginal Utility

Other Names of this Law:

● Law of Substitution or Law of Maximum Satisfaction or Law of
Indifference or Proportion Rule or Gossen's Second Law.
Definition and Statement of Law of Equi-Marginal Utility:
The law of equi-marginal utility is simply an extension of law of diminishing
marginal utility to two or more than two commodities.
A consumer will be in equilibrium with a single commodity symbolically:
MUx = Px

The consumer will maximize total utility from his income when the utility from the last
rupee spent on each good is the same. Algebraically, this is:

MUa / Pa = MUb / Pb = MUc /Pc = MUn /Pn

Here: (a), (b), (c)…. (n) are various goods consumed.

Theory of Ordinal Utility/Indifference Curve Analysis:

Definition and Explanation:

● The indifference curve indicates the various combinations of two goods

which yield equal satisfaction to the consumer.
● The indifference curve analysis approach was first introduced by Slustsky,
a Russian Economist in 1915. Later it was developed by J.R. Hicks and
R.G.D. Allen in the year 1928.

Assumptions:

The ordinal utility theory or the indifference curve analysis is based on four
main assumptions.

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(i) Rational behavior of the consumer: It is assumed that individuals are rational in
making decisions from their expenditures on consumer goods.
(ii) Utility is ordinal: Utility cannot be measured cardinally. It can be, however,
expressed ordinally. In other words, the consumer can rank the basket of goods
according to the satisfaction or utility of each basket.
(iii) Diminishing marginal rate of substitution: In the indifference curve analysis,
the principle of diminishing marginal rate of substitution is assumed.
(iv) Consistency in choice: The consumer, it is assumed, is consistent in his
behavior during a period of time. For insistence, if the consumer prefers
combinations of A of good to the combinations B of goods, he then remains
consistent in his choice.
An Indifference Map:
● A graph showing a whole set of indifference curves is called an indifference
map. An indifference map, in other words, is comprised of a set of indifference
curves.
● Each successive curve further from the original curve indicates a higher level
of total satisfaction

Marginal Rate of Substitution (MRS):

● The concept of marginal rate substitution (MRS) was introduced by Dr. J.R.
Hicks and Prof. R.G.D. Allen to take the place of the concept of diminishing
marginal utility.
● The rate or ratio at which goods X and Y are to be exchanged is known as
the marginal rate of substitution (MRS). In the words of Hicks:

● “The ratio of exchange between small units of two commodities, which are
equally valued or preferred by a consumer”.

Formula: MRSxy = ∆Y/ ∆X = MUx/MUy

Properties/Characteristics of Indifference Curve:

(1) Indifference Curves are Negatively Sloped:

● The indifference curves must slope down from left to right.
● It slopes downward because as the consumer increases the consumption of X
commodity, he has to give up certain units of Y commodity in order to
maintain the same level of satisfaction.
(2) Higher Indifference Curve Represents Higher Level:
A higher indifference curve that lies above and to the right of another indifference
curve represents a higher level of satisfaction and combination on a lower
indifference curve yields a lower satisfaction.

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(3) Indifference Curve are Convex to the Origin:
This is an important property of indifference curves. They are convex to the origin
(bowed inward). This is equivalent to saying that as the consumer substitutes
commodity X for commodity Y, the marginal rate of substitution diminishes of X for Y
along an indifference curve.
(4) Indifference Curve Cannot Intersect Each Other:
Given the definition of indifference curve and the assumptions behind it, the
indifference curves cannot intersect each other. It is because at the point of
tangency, the higher curve will give as much as of the two commodities as is given
by the lower indifference curve. This is absurd and impossible.
(5) Indifference Curves do not Touch the Horizontal or Vertical Axis:
One of the basic assumptions of indifference curves is that the consumer purchases
combinations of different commodities.

Price Line or Budget Line:

● "A budget line or price line represents the various combinations of two
goods which can be purchased with a given money income and assumed
prices of goods".

Shifts in Budget Line:

● The price line is determined by the income of the consumer and the prices of
goods in the market.

● If there is a change in the income of the consumer or in the prices of goods

(i) Income changes: When there is change in the income of the consumer, the
prices of goods remaining the same, the price line shifts from the original
position.
● It shifts upward or to the right hand side in a parallel position with the
rise in income.

20
(ii) Price changes. Now let us consider that there is a change in the price of one
good. The income of the consumer and price of other good is held constant

Consumer's Equilibrium Through Indifference Curve Analysis:

● "The term consumer’s equilibrium refers to the amount of goods and

services which the consumer may buy in the market given his income
and given prices of goods in the market".
"A consumer is said to be in equilibrium at a point where the price line is touching
the highest attainable indifference curve from below".

Conditions:

Thus the consumer’s equilibrium under the indifference curve theory must meet the
following two conditions:
First: A given price line should be tangent to an indifference curve or marginal rate
of satisfaction of good X for good Y (MRSxy) must be equal to the price ratio of the
two goods. i.e. MRSxy = Px / Py

Second: The second order condition is that indifference curve must be convex to the
origin at the point of tangency.

(1) Changes in Consumer's Equilibrium (Income Effect):

21
 ● In the consumer’s equilibrium analysis, it is primarily assumed that the
price of the goods X and Y and the income of the consumer remains
constant.
● If the prices of goods, tastes and preferences of the consumer
remains constant and there a change in his income, it will directly
affect consumer’s demand.
● This effect on the purchase due to change in income is called
the income effect.

● If these, equilibrium points K, L, T are joined together by a dotted line passing

through the origin, we get income consumption curve ICC.
(2) Changes in Consumer’s Equilibrium (Price Effect):

● We now discuss the reaction of the consumer to the changes in the price of a
good while his money income, tastes, preferences and prices of other goods
remain unchanged.
● When there is change in the price of a good shown on the two axes of an
indifference map, there takes place a change in demand in response to a
change in price of a commodity, other things remaining the same, is
called price effect.

22
The price effect on the consumption of a normal good is negative. If we join the
equilibrium points PUS, we get price consumption curve (PCC) of the consumer for
the commodity wheat.

Hicks-Allen Substitution Effect:

● In the Hicksian method, price changes is accompanied by so much change

in money income that the consumer is neither better off nor worse off than
before.
● The money income is changed by an amount which keeps the consumer on
the same indifference curve.

● For instance, the price of good say X falls, and that of good Y remains
unchanged. With this fall in the price of good X, then the real income of the
consumer would increase.

● This increase in the real income of the consumer is so withdrawn that he is

neither better off nor worse off than above. The amount by which the money
income is reduced is called compensating variation in income.

● The type of movement from point Q to T on the same indifference represents

the substitution effect.

Slutsky Substitution Effect

● The concept of substitution effect put forward by J.R. Hicks. There is another
important version of substitution effect put forward by E. Slutsky.
● The treatment of the substitution effect in these two versions has a significant
difference.

23
 ● In Slutsky’s version of substitution effect when the price of good changes and
consumer’s real income or purchasing power increases.

● That is, the income is changed by the difference between the cost of the
amount of good X purchased at the old price and the cost of purchasing the
same quantity if X at the new price.
● Income is then said to be changed by the cost difference. Thus, in Slutsky
substitution effect, income is reduced or increased not by compensating
variation as in case of the Hicksian substitution effect but by the cost
difference.

Preference Hypothesis and Strong Ordering:

● Prof. Samuelson’s revealed preference theory has Preference Hypothesis as
a basis of his theory of demand.

● According to this hypothesis when a consumer is observed to choose a

combination A out of various alternative combinations open to him, then he
‘reveals’, his preference for A over all other alternative combinations which he
could have purchased.

Strong Form of Preference Hypothesis:

● It should be carefully noted that Prof. Samuelson’s revealed preference theory
is based upon the strong form of preference hypothesis.

● In other words, in revealed preference theory, strong-ordering preference

hypothesis has been appliedStrong ordering implies that there is definite
ordering of various combinations in consumer’s scale of preferences

Consumer's Surplus:
● The concept of consumer’s surplus was introduced by Alfred Marshall.
According to him:
● "A consumer is generally willing to pay more for a given quantity of good
than what he actually pays at the price prevailing in the market".

24
 ● “Consumer’s surplus is equal to the difference between the amount of
money that consumer actually pays to buy a certain quantity rather than go
without it”.

Consumer Equilibrium and Corner Solutions

● In case of concave indifference curves, the consumer will not be

in equilibrium at the point of tangency between budget line and indifference
curve, that is, in this case interior solution will not exist.
● Instead, we would have corner solution for consumer's equilibrium. The
equilibrium position at the point of tangency which lies within commodity
space between the two axes is often called interior solution.
Corner Equilibrium and Concave Indifference Curves:
● Concavity of the indifference curves implies that the marginal rate of
substitution of X for y increases when more of X is substituted for Y.
● In case of concave indifference curves, the consumer will not be in equilibrium
at the point of tangency between budget line and indifference curve.
● that is, in this case interior solution will not exist. Instead, we would have
corner solution for consumer’s equilibrium.

Corner Solution in Case of Perfect Substitutes and Perfect Complements:

In this case budget line would cut the straight-line indifference curves.

Two possibilities can be visualized:

Either the slope of the budget line BL can be greater than the slope of indifference
curves, as in Fig. 8.25 or the slope of the budget line can be less than the slope of
indifference curve, as in Fig. 8.26.

25
 ● If the slope of the budget line is greater than the slope of indifference
curves, B would lie on a higher indifference curve than L and the consumer
will buy only Y.

● If the slope of the budget line is less than the slope of indifference
curves, L would lie on a higher indifference curve than B and the consumer
will buy only X. It is thus manifest that even in case of perfect substitutes,
the consumer will succumb to monomania.

Another non-normal case is of perfect complementary goods, is depicted to

Figure 8.27. Indifference curves of perfect complementary goods have a right-angled
shape. In such a case the equilibrium of the consumer will be determined at the
corner Fig.8.27.

Cobweb theorem

The cobweb theorem is an economic model used to explain how small economic
shocks can become amplified by the behaviour of producers. 1.Convergent
Cobweb

26
 The convergence would be obtained if the demand curve is flatter than
the supply curve. This type of Convergent Cobweb is called Dynamic
Equilibrium with insulated adjustment.

2.Divergent Cobweb

The price fluctuations tend to become larger and larger and the market is subject to
explosive oscillations, i.e., here price diverges away from equilibrium and the market
is unstable. As already obtained, this will be the case if the demand curve is steeper
than the supply curve.

3.Continuous Cobweb

The cobwebs may be constant intensified with continually fluctuating

prices and volume (continuous oscillation between a particular range)

27
Choice under Risk in Economics
Utility Theory and Attitude toward Risk
“The attitude toward risk we will consider a single composite commodity, namely,
money income. An individual’s money income represents the market basket of goods
that he can buy. It is assumed that the individual knows the probabilities of making or
gaining money income in different situations. But the outcomes or payoffs are
measured in terms of utility rather than rupees”.

RISK:

The quantitative probability of different future outcome occurring. The assignment of

probabilities can be subjective (based on a "feeling") or objective (based on historical
data).

Risk Preferences

Different people have different views, perspectives, and preferences about risk.
Some people enjoy a risky situation and others do not.

● Risk Aversion: This exists when a person has decreasing marginal utility of
income. In this case you prefer the certain income to the risky income.
● Risk Loving: This exists when a person has increasing marginal utility of
income. With increasing marginal utility of income you obtain more utility from
the income won than the income lost.
● Risk Neutrality: This exists when a person has constant marginal utility of
income. With constant marginal utility of income you obtain the same utility
from the income won as the income lost.
● Risk Aversion: A preference for risk in which a person prefers guaranteed or
certain income over risky income.

Risk Pooling:

● The process of combining the risks facing individuals into larger

groups. This process can be used effectively to transfer individual risks
to the entire group.
● This makes it possible to calculated the risk for the group. Risk pooling
is the standard technique that enables the provision of insurance
services.

Risk spreading: spreads the risk of a venture among multiple sub insurers.

28
The logic is similar to participating in an office Super-Bowl lottery.

RISK PREMIUM:

The difference between a guaranteed or certain income and a risky income that
generate the same level of utility. Risk premium is the amount of income that a risk
adverse person is willing to pay to avoid the risk.

Theory of Consumer Choice under Risk in Economics

● The modern utility analysis is the outcome of the failure of the indifference
curve technique to explain consumer behaviour among risky or uncertain
choices.

● The traditional utility analysis is also concerned with consumer behaviour

among riskless choices.

The Bernoulli’s Hypothesis:

The neo-classical theory assumes that the consumer is a rational human being who
does not indulge in gambling or even in fair bet with 50-50 odds. The reason why
people were unwilling to stake even at fair bets was provided by Daniel Bernoulli, the
18th century Swiss mathematician.

Staying in St. Petersburg in 1732 for some time, Bernoulli found that Russians were
unwilling to make bets even at better than 50- 50 odds knowing fully that their
mathematical expectations of winning money in a particular kind of gamble were
greater the more money they bet. This contradiction is known as St. Petersburg
Paradox.

The Neumann-Morgenstern Method of Measuring Utility:

J. Von Neumann and O. Morgenstem in their book Theory’ of Games and

Economic Behaviour evolved the method of cardinal measurement of expected utility
from risky choices which are found in gambling, lottery tickets, etc. For this, they
constructed a utility index which is called the N-M utility index.
The N-M utility index is based on the following assumptions:
(1) The individual behaves in risky situations in order to maximise expected utility.
(2) His choices are transitive: if he prefers A prize (win) to В prize and В to C, then
he prefers A to C.
(3) There is probability P which lies between 0 and 1 (0< P< 1) such that the
individual is indifferent between prize A which is certain and the lottery tickets
offering prizes С and В with probability P and 1 – P respectively.

29
(4) If two lottery tickets offer the same prizes, the individual prefers the lottery ticket
with the higher probability of winning.
(5) The individual can completely order probability combinations of uncertain
choices. (6) Uncertainty or risk does not possess utility or disutility of its own.

Given the assumptions, it is possible to derive a cardinal utility index based on the
above formula.Suppose there are the three events (lotteries) С, A, B. Out of these,
event (lottery) A is certain, С has probability P, and В probability (1-P), and if their
respective utilities are Ua ,Ub and Uc then
Ua =PUc + (1-P)Ub

The Friedman-Savage Hypothesis:

● The Neumann-Morgenstern method is based on the expected values of

utilities and therefore, does not refer to whether the marginal utility of money
diminishes or increases.
● In this respect, this method of measuring utility is incomplete. When a person
gets an insurance policy, he pays to escape or avoid risk. But when he buys a
lottery ticket, he gets a small chance of a large gain.
● It states that marginal utility of money diminishes for incomes below some
level, it increases for incomes between that level and some higher level of
income, and again diminishes for all incomes above that higher level.
● This is illustrated in Figure 2 in terms of the total utility curve TU where utility
is plotted on the vertical axis and income on the horizontal axis.

The Markowitz Hypothesis:

30
 ● Prof. Markowitz found the Friedman-Savage hypothesis contrary to common
observations.
● According to him, it is not correct to say that the poor and the rich are
unwilling to gamble and take risks except at favourable odds. Rather, both
purchase lotteries and gamble on horse races.
● According to Markowitz, when income increases by a small increment, it leads
to increasing marginal utility of income.
● But large increases in income lead to diminishing marginal utility of income.
● That is why at higher levels of income people are reluctant to indulge in
gambling even at fair bets and people in slowly rising income groups indulge
in gambling to improve their position.
● On the other hand, when there are small decreases in income, the marginal
utility of income rises.
● But large decreases in income lead to diminishing marginal utility of income.
That is why people insure against small losses but indulge in gambling where
large losses are involved.
● This is called the Markowitz hypothesis which is explained in Figure 3 where
Markowitz takes three inflexion points M, N and P in the upper portion of the
diagram with present income at the middle point N on the TU curve of income.

The Theory of Market Demand (Recent Developments)

A. The Pragmatic Approach to Demand Analysis:
● Many writers have followed a pragmatic approach to the theory of demand.

31
 ● They accepted the fundamental ‘law of demand’ on trust, and formulated
demand functions directly on the basis of market data without reference to the
theory of utility and the behaviour of the individual consumer.

● Demand is expressed as a multivariate function, and is estimated with various

econometric methods.

● Such demand functions refer obviously to the market behaviour of the

consumers, that is, to the behaviour of all consumers as a group, and not to
the behaviour of single individuals.

● Furthermore, in most cases the demand functions refer to a group of

commodities, e.g. demand for food, demand for consumer durables, etc.

The constant-elasticity demand function:

The most commonly used form of demand function in applied research has
been the ‘constant-elasticity’ type:
Qx = b0 – Pxb1. P0b2. Yb3. eb4t
Where Qx = quantity demanded of commodity x
Px = price of x
P0 = prices of other commodities
Y = consumers’ aggregate income

eb4t = a trend factor for ‘tastes’ (e = base of natural logarithms)

b1 = price elasticity of demand
b2 = cross-elasticity of demand
b3 = income elasticity of demand
The term ‘constant elasticity demand function’ is due to the fact that in this form the
coefficients b1, b2, b3 are elasticity’s of demand which are assumed to remain
constant.
Dynamic versions of demand functions: Distributed-lag models of demand:

● A recent development in demand studies is the expression of demand

functions in dynamic form.

● Dynamic demand functions include lagged values of the quantity demanded

and of income as separate variables influencing the demand in any particular
period.

● Dynamisation of the demand functions expresses the generally accepted idea

that current purchasing decisions are influenced by past behaviour.

32
Nerlove’s ‘stock-adjustment principle’:

The model as applied to consumer durables results in a demand function of the form

Q(t) = a1 Y(t) + a2 Q(t – 1)

The model is derived as follows. There is a desired level of durables Q*(t), which is
determined by the current level of income:
Q*(t) = b Y(t)

Houthakker’s and Taylor’s dynamic model:

● Their model is based on Nerlove’s formulation. They extended the idea of
stock adjustment to non-durables.

● The current demand for durables depends on, among other things, the stock
of such commodities (stock- adjustment process).

● The current demand for non-durables depends on, among other things, the
purchases of the commodities in the past, because by consuming a certain
commodity we get accustomed to it (habit-formation process). Stocks S,
however, cannot be measured:

B. Linear Expenditure Systems:

● These are models which deal with groups of commodities rather than
individual commodities.

● Such groups, when added, yield total consumer expenditure.

● Linear expenditure systems are thus of great interest in aggregate

econometric models, where they provide desirable disaggregation of the
consumption function.

● One of the earliest linear expenditure models was suggested by R. Stone

(Economic Journal, 1954).

● However, LES differ in that they are applied to ‘groups of commodities’

between which no substitution is possible, while the indifference-curves
approach is basically designed for handling commodities which are
substitutes.

33
Characteristics demand theory

● Characteristics demand theory states that consumers derive utility not from
the actual contents of the basket but from the characteristics of the goods in it.

● This theory was developed by Kelvin Lancaster in 1966 in his working paper
“A New Approach to Consumer Theory”.

● This approach allows us to predict how preferences will change when we

change the options or baskets presented to consumers by studying how these
vary according to the change in the characteristics that make them up.

Motivation Approach of Demand Analysis

Demonstration Effect:
By emphasising relative income as a determinant of consumption, the relative
income hypothesis suggests that individuals or households try to imitate or copy the

34
consumption levels of their neighbours or other families in a particular community.
This is called demonstration effect or Duesenberry effect

Two things follows from this. This is because if incomes of all families increase in the
same proportion, distribution of relative incomes would remain unchanged and
therefore the proportion of consumption expenditure to income which depends on
relative income will remain constant.

Ratchet Effect:
The other significant part of Duesenberry’s relative income hypothesis is that it
suggests that when income of individuals or households falls, their consumption
expenditure does not fall much. This is often called a ratchet effect.
Veblen effect
Abnormal market behavior where consumers purchase the higher-priced goods
whereas similar low-priced (but not identical) substitutes are available. It is caused
either by the belief that higher price means higher quality, or by the desire for
conspicuous consumption (to be seen as buying an expensive, prestige item).
Named after its discoverer, the US social-critic Thorstein Bunde Veblen
(1857-1929).

Network Externalities: Bandwagon Effect and Snob Effect

Network externalities may be positive or negative. Network externalities are a special

kind of externalities in which one individual’s utility for a good depends on the
number of other people who consume the commodity.

Bandwagon Effect:
The existence of positive network externalities gives rise to Bandwagon effect.
Bandwagon effect refers to the desire or demand for a good by a person who wants
to be in style because possession of a good is in fashion and therefore many others
have it.

35
In due course of time people come to know how many people actually buy the good.
However, in addition to the bandwagon effect, the quantity demanded of the good
depends on the price of the good.
Snob Effect:
● In case network externalities are negative, snob effect arises. Snob effect
refers to the desire to possess a unique commodity having a prestige value.
Snob effect works quite contrary to the bandwagon effect.
● The quantity demanded of a commodity having a snob value is greater, the
smaller the number of people owning its.
● Rare works of art, specially designed sport cars, specially designed clothing
made to order, very expensive luxury cars.

It is important to note that snob effect makes the demand curve less elastic.

CHAPTER-III : Theory of Production and the Production Function

● A firm’s objective is profit maximisation. If, in the short run, its total output
remains fixed (due to capacity constraints) and if it is a price-taker (i.e., cannot
fix the price or change price on its own as in a purely competitive market) its
total revenue will also remain fixed.

● Moreover, supply depends on cost of production. The firm’s cost, in its turn,
depends on two main factors:
(1) the technical relation between inputs and output (i.e., how outputs vary as inputs
vary), and

(2) factors price’s (i.e., the price of labour or the wage, the price of capital or
the interest rate, etc.).

The Production Function:

36
The production function shows the relation between input changes and output
changes.

The production function is expressed as:

Q = f (K, L, etc.)

The Short-Run and the Long-Run:

The distinction between the short-run and the long-run is based on the difference
between fixed and variable factors.

The Short-Run:
● The short-run refers to the period of time over which one (or more) factor(s) of
production is (are) fixed.

● In the real world, land and capital (such as plant and equipment) are usually
treated as fixed factors.

The Long-Run:
On the other hand the long- run is defined as the period over which all factors of
production can be varied, within the confines of existing technology.

Production Isoquants:
An isoquant is a curve or locus of points showing all possible combinations of inputs
physically capable of producing a certain fixed level of output.
Iso-Quant Curve: Definitions, Assumptions and Properties!
The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant =
quantity or product = output.

The marginal rate of technical substitution (MRTS):

The rate at which one input can be substituted for another along an
isoquant is called the marginal rate of technical substitution (MRTS),
defined as:
MRTSL for K = – ∆K/∆L
The minus sign is added in order to make MRTS a positive number, since
∆K/∆L, the slope of the isoquant, is negative. ∆K/∆L = MPL/MPK = MRTSL for K

Properties of Iso-Product Curves:

1. Iso-Product Curves Slope Downward from Left to Right:

They slope downward because MTRS of labour for capital diminishes. When we
increase labour, we have to decrease capital to produce a given level of output.

37
2. Isoquants are Convex to the Origin:
Like indifference curves, isoquants are convex to the origin. In order to understand
this fact, we have to understand the concept of diminishing marginal rate of technical
substitution (MRTS), because convexity of an isoquant implies that the MRTS
diminishes along the isoquant.
diminishing MRTS causes the isoquant

It can be expressed as: to bow inwards towards the origin,

creating the characteristic convex shape.

MRTSLK = – ∆K/∆L = dK/ dL

.

3. Two Iso-Product Curves Never Cut Each Other:

As two indifference curves cannot cut each other, two iso-product curves cannot cut
each other. In Fig. 6, two Iso-product curves intersect each other. Both curves IQ1
and IQ2 represent two levels of output. But they intersect each other at point A. Then
combination A = B and combination A= C. Therefore B must be equal to C. This is
absurd. B and C lie on two different iso-product curves. Therefore two curves which
represent two levels of output cannot intersect each other.

38
4. Higher Iso-Product Curves Represent Higher Level of Output:
A higher iso-product curve represents a higher level of output as shown in the
figure 7 given below:

5. Isoquants Need Not be Parallel to Each Other:

It so happens because the rate of substitution in different isoquant schedules need

not be necessarily equal.

39
6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being produced with
the help of labour alone without using capital at all.

Different Shapes of Isoquants

Right Angle Iso-quant Curve:

● This is one of the types of Iso-quant curves, where there is a strict
complementarity with no substitution between the factors of production.
● According to this, there is only one method of production to produce any one
commodity.

This curve is also known as Leontief

Iso-quant, input-output isoquant and is a
right angled curve.i.e., the two inputs should
always be used in a particular ratio, then the
IQs would be L-shaped.

Linear Iso-quant Curve:

● This curve shows the perfect substitutability
between the factors of production.
● This means that any quantity can be produced either employing only capital or
only labor or through “n” number of combinations between these two.
● The MRTS between the inputs is a constant, then the IQs would be negatively
sloped straight lines.

40
Kinked iso-quant Curve:
● This curve assumes, that there is a limited substitutability between the factors
of production.
● This shows that substitution of factors can be seen at the kinks since there
are a few processes to produce any one commodity.
Kinked iso-quant curve is also known as activity analysis programming
iso-quant or linear programming iso-quant.

Each Isoquant is Oval-Shaped.

It means that at some point it begins to recede from each axis. This shape is a
consequence of the fact that if a producer uses more of capital or more of labour or
more of both than is necessary, the total product will eventually decline.

Ridge Lines:
One knows from the iso-quant curves the extent to which production should
be carried out. Lines which represent the limits of the economic region of
production are called ridge lines.

41
Iso-Cost Line:

The iso-cost line is similar to the price or budget line of the indifference curve
analysis. It is the line which shows the various combinations of factors that will result
in the same level of total cost.

Iso-Cost Curves:
After knowing the nature of isoquants which represent the output possibilities of a
firm from a given combination of two inputs. We further extend it to the prices of the
inputs as represented on the isoquant map by the iso-cost curves.

Producer’s Equilibrium or Optimum Combination of Factors or Least Cost

Combination:

● In simple words, producer’s equilibrium implies to that situation in which

producer maximizes his profit.

● In short, the producer is producing given amount of output with least cost
combination of factors. It is also known as optimum combination of the
factors.

For producer’s equilibrium or optimum combination, it must fulfill following

two conditions as:
(i) At the point of equilibrium the iso-cost line must be tangent to isoquant curve.

42
(ii) At point of tangency i.e., iso-quant curve must be convex to the origin or
MRTSLk must be falling.
Optimal Combination of Resources:
Output Maximisation subject to Cost Constraint:
A rational producer, whose objective is output maximisation subject to cost
constraint, will always try to reach the highest attainable isoquant permitted by the
isocost line.

At point E the slope of the isoquant or MRTS is equal to the slope of the
isocost line:

Expansion Path:

By using different combinations of factors a firm can produce different levels

of output. Which of the optimum combinations of factors will be used by the
firm is known as Expansion Path. It is also called Scale-line.
“Expansion path is that line which reflects least cost method of producing different
levels of output.” Stonier and Hague

43
The Law of Variable Proportions:
The Law states that “when increasing quantities of a variable factor are used in
combination with a fixed factor, the marginal and average product of the
variable factor will eventually decrease.”

we can identify three stages of the production process in the short-run:

(1) In the first stage, when additional units of labour are employed, TP increases
more than proportionately and MP also increases. This is the stage of increasing
return to the variable factor (labour).

(2) In the second stage TP increases no doubt, but not proportionately. In other
words, the rate of increase of TP falls. This means that MP diminishes. This is the
stage of diminishing return to the variable factor (labour). This is perhaps the most
important stage of the production process in the short run.

(3) In the third stage, TP itself diminishes and the MP is negative. This is the stage of
negative return to the variable factor (labour).

Three points may be noted in this context:

1. So long as MP exceeds AP, the AP must be rising.

2. Thus, it follows as a corollary of this that only when MP falls below the level of AP,
does AP fall.

3. Since MP rises when MP is exceeding AP, while AP falls where MP is less than
AP, it follows that where AP is at a maximum, it is equal to MP. This is why; the MP
curve intersects the AP curve at the latter’s maximum point. (The relation between
the margin and the average is mathematical.) In this context we may note that MP
can be zero or negative, but AP can never be so.

44
Returns to Scale:

Returns to Variable Factors in the Long Run:

● The long run, however, refers to a period of time over which all the factors of
production can be varied.

The Laws of Returns to Scale:

● The laws of returns to scale can also be explained in terms of the isoquant
approach.

● The laws of returns to scale refer to the effects of a change in the scale of
factors (inputs) upon output in the long-run when the combinations of factors
are changed in some proportion.

● The returns to scale can be shown diagrammatically on an expansion path “by

the distance between successive ‘multiple-level-of-output’ isoquants,

Increasing Returns to Scale:

Figure 24.11 shows the case of increasing returns to scale where to get equal
increases in output, lesser proportionate increases in both factors, labour and
capital, are required.

Increasing Returns to Scale:

A situation of increasing returns to scale can be attributed to two considerations
indivisibilities of some factors and advantages of specialisation.

1. Indivisibilities:
The inability to divide certain factor units into smaller units without either complete
loss of usefulness in production or partial loss in efficiency results in a relatively low
output per unit of input when operations are conducted on a very small scale.

2. Specialisation:

45
 ● The other and closely related cause of increasing returns to scale is the
advantage offered by specialisation.

● In a very small business, employees must perform a wide variety of tasks.

Constant Returns to Scale:

● It means that if units of both factors, labour and capital, are doubled, the
output is doubled. To treble output, units of both factors are trebled.

Decreasing Returns to Scale:

As a firm continues to expand its scale of operations, beyond a certain point there is
apparently a tendency for returns to scale to decrease, and thus a given percentage
increase in the quantities of all factors will bring about a less than proportional
increase in output.

Technological Progresses and the Production Functions

● As knowledge of new and more efficient methods of production become

available, technology changes.

● Furthermore new inventions may result in the increase of the efficiency of all
methods of production. At the same time some techniques may become
inefficient and drop out from the production function.

46
 ● These changes in technology constitute technological progress.

● Graphically the effect of innovation in processes is shown with an upward shift

of the production function (figure 3.27), or a downward movement of the
production isoquant (figure 3.28).

● This shift shows that the same output may be produced by less factor inputs,
or more output may be obtained with the same inputs.

Capital-deepening technical progress:

● Technical progress is capital-deepening (or capital-using) if, along a line on
which the K/L ratio is constant, the MRSL K increases.
● This implies that technical progress increases the marginal product of capital
by more than the marginal product of labour.
● The ratio of marginal products (which is the MRSL K) decreases in absolute
value; but taking into account that the slope of the isoquant is negative, this
sort of technical progress increases the MRSL K.
● The slope of the shifting isoquant becomes less steep along any given radius.
The capital-deepening technical progress is shown in figure 3.29.

Labour-deepening technical progress:

● Technical progress is labour-deepening if, along a radius through the origin
(with constant K/L ratio), the MRSL, K increases.
● This implies that the technical progress increases the MPL faster than the
MPK. Thus the MRSL ,K, being the ratio of the marginal products
[(∂X/∂L)]/[(∂X/∂K)], increases in absolute value (but decreases if the minus
sign is taken into account).

47
 ● The downwards-shifting isoquant becomes steeper along any given radius
through the origin. This is shown in figure 3.30.

Neutral-technical progress:
● Technical progress is neutral if it increases the marginal product of both
factors by the same percentage, so that the MRSL K (along any radius)
remains constant. The isoquant shifts downwards parallel to itself.
This is shown in figure 3.31.

production–possibility frontier (PPF) or production possibility curve (PPC)

● Is the possible tradeoff of producing combinations of goods with constant

technology and resources per unit time.
● One good can only be produced by diverting resources from other goods, and
so by producing less of them.
● A PPF illustrates several economic concepts, such as scarcity of resources
(the fundamental economic problem that all societies face), opportunity
cost (or marginal rate of transformation), productive efficiency, allocative
efficiency, and economies of scale.

Cobb-Douglas Production Function and Its Properties

● Charles W. Cobb and Paul H. Douglas studied the relationship of inputs and
outputs and formed an empirical production function, popularly known as
Cobb-Douglas production function.

48
 ● Originally, C-D production function applied not to the production process of an
individual firm but to the whole of the manufacturing production.
● The Cobb-Douglas production function is expressed by

Q = ALαKβ
● where Q is output and L and A’ are inputs of labour and capital respectively.

● A, α and β are positive parameters where α > 0, β > 0. The equation tells that
output depends directly on L and K and that part of output which cannot be
explained by L and К is explained by A which is the ‘residual’, often called
technical change.

In other words, this function characterises the returns to scale thus:

α + β >1: Increasing returns to scale

α + β =1: Constant returns to scale

α +β <1: Decreasing returns to scale.

Properties of C-D Production Function:

(i) There are constant returns to scale.

(ii) Elasticity of substitution is equal to one.

(iii) α and β represent the labour and capital shares of output respectively.

(iv) α and β are also elasticities of output with respect to labour and capital
respectively.

(v) If one of the inputs is zero, output will also be zero.

(vi) The expansion path generated by C-D function is linear and it passes through
the origin.

(vii) The marginal product of labour is equal to the increase in output when the labour
input is increased by one unit.

(viii) The average product of labour is equal to the ratio between output and labour
input.

49
(ix) The ratio α /β measures factor intensity. The higher this ratio, the more labour
intensive is the technique and the lower is this ratio and the more capital intensive is
the technique of production.

The CES Production Function:

● Arrow, Chenery, Minhas and Solow in their new famous paper of 1961
developed the Constant Elasticity of Substitution (CES) function.
● This function consists of three variables Q, С and L, and three parameters A,
α and l-α.

It may be expressed in the form:

Q = A [α C-θ+ (l-α)L-θ] -1/θ
where Q is the total output, С is capital, and L is labour. A is the efficiency parameter
indicating the state of technology and organisational aspects of production.

Its Properties:
The CES production function possesses the following properties:
1. The CES function is homogenous of degree one. If we increase the inputs С and L
in the CES function by n-fold, output Q will also increase by n-fold.

Thus like the Cobb-Douglas production function, the CES function displays constant
returns to scale.

2. In the CES production function, the average and marginal products in the
variables С and L are homogeneous of degree zero like all linearly homogeneous
production functions.

3. From the above property, the slope of an isoquant, i.e., the MRTS of capital for
labour can be shown to be convex to the origin.

4. The parameter (theta) in the CES production function determines the elasticity of
substitution. In this function, the elasticity of substitution,

σ = 1/ 1 + θ

This shows that he elasticity of substitution is a constant whose magnitude depends

on the value of the parameter θ. If θ =0, then σ = 1. If θ = ∞, then σ =0. If θ = -1, then
σ =∞.

This reveals that when σ = 1, the CES production function becomes the
Cobb-Douglas production function. Thus the isoquants for the CES production

50
function range from right angles to straight lines as the elasticity substitution ranges
from 0 to1.

5. As a corollary of the above, if L and С inputs are substitutable ∞ for each other an
increase in С will require less of L for a given output. As a result, the MP of L will
increase. Thus, the MP of an input will increase when the other input is increased.

CHAPTER-4

Cost concepts

Accounting and Economic Costs: Money costs are the total money expenses
incurred by a firm in producing a commodity. They include wages and salaries of
labour; cost of raw materials; expenditures on machines and equipment;

Production Costs:
The total costs of production of a firm are divided into total variable costs and total
fixed costs. The total variable costs are those expenses of production which change
with the change in the firm’s output

Market Cost

The total cost associated with delivering goods or services to customers. The
marketing cost may include expenses associated with transferring title of goods to a
customer, storing goods in warehouses pending delivery, promoting the goods or
services being sold, or the distribution of the product to points of sale.

Nominal or Money Cost:

Nominal cost is the money cost of production. It is also called expenses of
production. These expenses are important from the point of view of the producer.

Actual Costs and Opportunity Costs:

Actual costs refer to the costs which a firm incurs for acquiring inputs or producing a
good and service such as the cost of raw materials, wages, rent, interest, etc. The
total money expenses recorded in the books of accounts are the actual costs.

Opportunity cost is the cost of sacrifice of the best alternative foregone in the
production of a good or service.

Explicit Costs and Implicit Costs:

● Explicit costs are those payments that must be made to the factors hired from
outside the control of the firm.
● They are the monetary payments made by the entrepreneur for purchasing or
hiring the services of various productive factors which do not belong to him.

51
 ● Implicit costs refer to the payments made to the self-owned resources used in
production.
● Are the earnings of owner’s resources employed in their best alternative uses.

The Cost Function:

The cost function expresses a functional relationship between total cost and factors
that determine it. Usually, the factors that determine the total cost of production (C)
of a firm are the output (0, the level of technology (T), the prices of factors (Pf) and
the fixed factors (F). Symbolically, the cost function becomes
C=f (Q, T, Pf, F)
Thus the total cost function is expressed as: C=f (Q)
Which means that the total cost (C) is a function if) of output (Q), assuming all other
factors as constant. The cost function is shown diagrammatically by a total cost (TC)
curve.

The Traditional Theory of Costs:

The traditional theory of costs analyses the behaviour of cost curves in the short run
and the long run and arrives at the conclusion that both the short run and the long
run curves are U-shaped but the long-run cost curves are flatter than the short-run
cost curves.

(A) Firm’s Short-Run Cost Curves:

Short-Run Total Costs:
The scale of organisation being fixed, the short-run total costs are divided into
total fixed costs and total variable costs: TC = TFC + TVC
Total Costs or TC:
Total costs are the total expenses incurred by a firm in producing a given quantity of
a commodity.

Total Fixed Costs or TFC:

Are those costs of production that do not change with output. They are independent
of the level of output.

52
Total Variable Costs or TVC:
Are those costs of production that change directly with output. They a rise when
output increases, and fall when output declines.

Short-Run Average Costs:

. The short-run average costs of a firm are the average fixed costs, the average
variable costs, and the average total costs.

Average Fixed Costs or AFC equal total fixed costs at each level of output
divided by the number of units produced:
AFC = TFC /Q

The average fixed costs diminish continuously as output increases. Thus the AFC
curve is a downward sloping curve which approaches the quantity axis without
touching it, as shown in Figure 3. It is a rectangular hyperbola.

Short-Run Average Variable Costs (or SAVC) equal total variable costs at each
level of output divided by the number of units produced:
SAVC = TVC/Q

The average variable costs first decline with the rise in output as larger quantities of
variable factors is applied to fixed plant and equipment. But eventually they begin to
rise due to the law of diminishing returns. Thus the SAVC curve is U-shaped, as
shown in Figure 3.

Short Run Marginal Cost:

53
A fundamental concept for the determination of the exact level of output of a firm is
the marginal cost.

Marginal cost is the addition to total cost by producing an additional unit of

output:
SMC = ∆ТС/∆Q

Algebraically, it is the total cost of n + 1 units minus the total cost of n units of output
MCn = TCn+1 – TCn.

(B) Firm’s Long-Run Cost Curves:

In the long run, there are no fixed factors of production and hence no fixed costs.

The long run average total cost or LAC curve of the firm shows the minimum
average cost of producing various levels of output from all-possible short-run
average cost curves (SAC). Thus the LAC curve is derived from the SAC curves.

● The LAC curve is known as the “envelope” curve because it envelopes all the
SAC curves.

● According to Prof. Chamberlin, “It is composed of plant curves; it is the plant

curve. But it is better to call it a “planning” curve because the firm plans to
expand its scale of production over the long run.”

● The long-run marginal cost (LMC) curve of the firm intersects SAC1 and LAC
curves at the minimum point E.

The Modern Theory of Costs:

● The modem theory of costs differs from the traditional theory of costs with
regard to the shapes of the cost curves.

54
 ● In the modem theory which is based on empirical evidences, the short-run
SAVC curve and the SMC curve coincide with each other and are a horizontal
straight line over a wide range of output.
● So far as the LAC and LMC curves are concerned, they are L-shaped rather
than U-shaped.

(1) Short-Run Cost Curves:

● As in the traditional theory, the short-run cost curves in the modem theory of
costs are the AFC, SAVC, SAC and SMC curves.
● But in the modem theory, the SAVC and SMC curves have a saucer-type
shape or bowl-shape rather than a U-shape.
● As the AFC curve is a rectangular hyperbola, the SAC curve has a U-shape
even in the modem version.

The saucer-shaped SAVC and SMC curves are shown in Figure 7. To begin with,
both the curves first fall upto point A and the SMC curvelies below the SAVC curve.
“The falling part of the SAVC shows the reduction in costs due to the better utilisation
of the fixed factor and the consequent increase in skills and productivity of the
variable factor (labour).

● With better skills, the wastes in raw materials are also being reduced and a
better utilisation of the whole plant is reached.”
● The reason for the saucer-shaped SAVC curve is that the fixed factor is
divisible.
● Over that range, SMC and SAVC are equal and are constant per unit of
output. The firm will, therefore, continue to produce within Q1Q2 reserve
capacity of the plant, as shown in Figure 7.

(2) Long-Run Cost Curves:

● Empirical evidence about the long-run average cost curve reveals that the
LAC curve is L-shaped rather than U-shaped.

● In the beginning, the LAC curve rapidly falls but after a point “the curve
remains flat, or may slope gently downwards, at its right-hand end.”

55
 ● Economists have assigned the following reasons for the L-shape of the LAC
curve.

1. Technical Progress:
Another reason for the existence of the L-shaped LAC curve in the modern theory of
costs is technical progress. The traditional theory of costs assumes no technical
progress while explaining the U-shaped LAC curve.

2. Learning:
● Another reason for the
L-shaped long- run average
cost curve is the learning
process. Learning is the
product of experience.

● If experience, in this context,

can be measured by the
amount of a commodity
produced, then higher the production is, the lower is per unit cost.

Economies of Scale - Meaning and Types

Introduction

● The scale of production has an important bearing on the cost of production. It

is a common experience of every producer that costs can be reduced by
increased production.

● These economies are broadly classified into two types:

1. Internal Economies
2. External Economies

56
Internal Economies

● When a firm expands its scale of production, the economies, which accrue to
this firm, are known as internal economies.

● According to Cairncross, “Internal economies are those which are open to a

single factory or a single firm independently of the action of other firms.

External Economies

● External economies refer to gains accruing to all the firms in an industry due
to the growth of that industry.

● All the firms in the industry irrespective of their size can enjoy external
economies. The emergence of external economies is due to localization.

Real Economies and Pecuniary Economies of Scale

● Economies of scale are distinguished into real economies and strictly

pecuniary economies of scale by Pigou.
● Pecuniary economies are economies realized from paying lower prices for the
factors used in the production and distribution of the product, due to
bulk-buying by the firm as its size increases.

● Real economies are those associated with a reduction in the physical quantity
of inputs, raw materials, various types of labour and various types of capital,
(fixed or circulating capital).

Economies of Scope

● Economies of Scope refers to the reduction in the average cost per unit, by
increasing the variety of products produced.
● In this technique, the total cost of producing two products (related or
unrelated) is less than the cost of producing each item individually.
● Economies of Scope focuses on better utilisation of the firm’s resources and
common assets.

57
 CHAPTER 5: MARKET STRUCTURE

On the basis of competition, a market can be classified in the following ways:

1. Perfect Competition
2. Monopoly
3. Monopolistic Competition
4. Oligopoly
5. Duopoly
1. Perfect Competition Market:

● The concept of perfect competition was first introduced by Adam Smith in

his book "Wealth of Nations". Later on, it was improved by Edgeworth.
● However, it received its complete formation in Frank Kight's book "Risk,
Uncertainty and Profit" (1921).
The following are the conditions for the existence of perfect competition:
(1) Large Number of Buyers and Sellers:
● The first condition is that the number of buyers and sellers must be so large
that none of them individually is in a position to influence the price and output
of the industry as a whole.
● He is a “price taker”.
(2) Freedom of Entry or Exit of Firms:
It implies that whenever the industry is earning excess profits, attracted by these
profits some new firms enter the industry.
(3) Homogeneous Product:
● Each firm produces and sells a homogeneous product so that no buyer has
any preference for the product of any individual seller over others.
(4) Absence of Artificial Restrictions:
● The next condition is that there is complete openness in buying and selling of
goods.
● Sellers are free to sell their goods to any buyers and the buyers are free to
buy from any sellers.
(5) Profit Maximisation Goal:
Every firm has only one goal of maximising its profits.
(6) Perfect Mobility of Goods and Factors:
Another requirement of perfect competition is the perfect mobility of goods and
factors between industries
(7) Perfect Knowledge of Market Conditions:
This condition implies a close contact between buyers and sellers. Buyers and
sellers possess complete knowledge about the prices at which goods are being
bought and sold, and of the prices at which others are prepared to buy and sell.
(8) Absence of Transport Costs:

58
Another condition is that there are no transport costs in carrying of product from one
place to another..
(9) Absence of Selling Costs:
Under perfect competition, the costs of advertising, sales-promotion, etc. do not arise
because all firms produce a homogeneous product.
Perfect Competition vs Pure Competition:
Perfect competition is often distinguished from pure competition, but they differ only
in degree. The first five conditions relate to pure competition while the remaining four
conditions are also required for the existence of perfect competition.

Equilibrium of the Firm Under Perfect Competition

Or Marginal Revenue = Marginal Cost (MR = MC) Rule:

● A firm under perfect competition faces an infinitely elastic demand curve or we

can say for an individual firm, the price of the commodity is given in the
market.

In the figure (15.2) quantity of output is measured along OX axis and marginal cost
and marginal revenue on OY axis. The marginal cost curve cuts the marginal
revenue curve at two points K and T.

● The competitive firm is in equilibrium, at both these points as marginal cost

equals marginal revenue.
● The firm will not produce OM quantity of good because for OM output, the
marginal cost is higher than marginal revenue. Marginal cost curve cuts the
marginal revenue curve from above.
● The marginal cost curve cuts the marginal revenue curve from below at point
T. The shaded portion between M to S level of output shows profit on
production.
● When a firm produces OS quantity of output; it earns maximum profit. The
point T where MR = MC is the point of maximum profit.
Long Run Normal Price and
the Adjustment of Market Price to the Long Run Normal Price:

● In the long run, the price will be determined at a point where the demand
curve and the long run supply curve intersect each other.

59
 ● The shape of the long run supply curve will, however, be different with
different industries.
● "All the firms in a competitive industry achieve long run equilibrium when
market price or marginal revenue equals marginal cost equals minimum
of average total cost."

Formula:
Price = Marginal Cost = Minimum Average Total Cost
● When the period is long and profit level of the competitive industry is high,
then new firms enter the industry.
● If the profit level is below the competitive level, the firm then leave the
industry.
● When all the competitive firms earn normal profit, then there is no tendency
for the new firms to enter or leave the industry. The firms are then in the long
run equilibrium.
● The case of long-run equilibrium of a firm can be easily explained with .the
help of a diagram given below:

At price OP, all the identical firms to the industry earn only normal profit. There is no
tendency for the new firms to enter or leave the industry provided

Price = MR = MC = Minimum of LATC

Monopoly
● Monopoly is from the Greek word meaning one seller. It is the polar opposite
of perfect competition.
● Monopoly is a market structure in which one firm makes up the entire market.
Monopoly and competition are at the two extremes.
● According to D. Salvatore, “Monopoly is the form of market organisation in
which there is a single firm selling a commodity for which there are no close
substitutes.”
● Thus the monopoly firm is itself an industry and the monopolist faces the
industry demand curve.

60
 ● The demand curve for his product is, therefore, relatively stable and slopes
downward to the right, given the tastes, and incomes of his customers.
● It means that more of the product can be sold at a lower price than at a higher
price. He is a price-maker who can set the price to his maximum advantage.
The main features of monopoly are as follows:
1. Under monopoly a firm itself is an industry.
2. A monopoly may be individual proprietorship or partnership or joint stock company
or a cooperative society or a government company.
3. A monopolist has full control on the supply of a product.
4. There is no close substitute of a monopolist’s product in the market. Hence, under
monopoly, the cross elasticity of demand for a monopoly product with some other
good is very low.
5. There are restrictions on the entry of other firms in the area of monopoly product.
6. A monopolist can influence the price of a product. He is a price-maker, not a
price-taker.
7. Pure monopoly is not found in the real world.
8. Monopolist cannot determine both the price and quantity of a product
simultaneously.
9. Monopolist’s demand curve slopes downwards to the right. That is why, a
monopolist can increase his sales only by decreasing the price of his product and
thereby maximise his profit.
● The marginal revenue curve of a monopolist is below the average revenue
curve and it falls faster than the average revenue curve.
● This is because a monopolist has to cut down the price of his product to sell
an additional unit.

Short Run Equilibrium Price and Output Under Monopoly:

Short Run Equilibrium of the Monopoly Firm:

● In the short period, the monopolist behaves like any other firm. A monopolist
will maximize profit or minimize losses by producing that output for which
marginal cost (MC) equals marginal revenue (MR).

61
 ● Whether a profit or loss is made or not depends upon the relation between
price and average total cost (ATC).

(a) Short Run Monopoly Equilibrium With Positive Profit:

● As regards the price, the monopolist is a price maker.
● There is a greater tendency for the monopolist to have a price which earns
positive profits.
● This can only be possible if the price (AR) is higher than average total cost
(ATC). The short run profit earned by the monopolist is now explained with the
help of the diagram (16.3) below.

Long Run Equilibrium Under Monopoly:

● The monopolist creates barriers of entry for the new firms into the industry.
● The entry into the industry is blocked by having control over the raw materials
needed for the production of goods or he may hold full rights to the production
of a certain good (patent) or the market of the good may be limited.
● If new firms try to enter in the field, it lowers the price of the good to such on
extent that it becomes unprofitable for new firms to continue production etc.
The long run equilibrium of a monopoly firm is now explained with the help
of the following diagram.
Diagram/Curve:

62
 ● A monopoly firm will maximize profit at that level of output for which long run
marginal cost (MC) is equal to marginal revenue (MR) and the LMC curve
intersects the MR curve from below.
● In the figure (16.6), the monopoly firm is in equilibrium at point E where LMC =
MR and LMC cuts MR curve from below. QP is the equilibrium price and OQ
is the equilibrium output.
Monopoly Price Discrimination:

Definition of Price Discrimination:

The practice on the part of the monopolist to sell the identical goods at the same
time to different buyers at different prices when the price difference is not Justified by
difference in costs in called price discrimination. In the words of Mrs. Joan
Robinson:

Degrees of Price Discrimination:

There are three main degrees of price discrimination: (1) First degree price
discrimination, (2) Second degree price discrimination and (3) Third degree price
discrimination.

(1) First degree price discrimination.

● The monopolist charges a different price equal to the maximum amount for
each unit of the commodity from each consumer separately.
● The price of each unit is equal to its demand price so that the consumer is
unable to enjoy any consumer surplus. Such prices are charged by doctors,
lawyers etc.
(2) Second degree price discrimination. Here the monopolist divides his market
into different groups of customers and charges each group the highest price which
the marginal consumer belonging to that group is willing to pay.
The railway, airlines etc.,
(3) Third degree price discrimination. In the third degree price discrimination, the
monopolist divides the entire market into a few sub-markets and charges different
prices for the same commodity in different sub-markets.
The division here is among classes of consumers and not among individual
consumers.
● Third degree price discrimination is possible only if the classes of consumers
can be kept separate.
● Secondly, the various groups of customers must have different elasticities of
demand for his commodity.
● The segment with a less elastic demand pays a higher price than the
segment with a more elastic demand.

63
 Conditions of Price Discrimination:
Price discrimination can only be possible if the following three essential conditions
are fulfilled.
.
(1) Segregation by price. There should be no possibility, of transferring a unit of
commodity supplied from the low priced to the high priced market.
(2) Segregation by market. Another essential characteristic of price discrimination
is that there should be no possibility of transferring one unit of demand from the high
priced to the low priced market. (3) Segregation by demand. Price discrimination
can be possible if there is difference in the elasticity of demand in different markets.

Measures of Monopoly Power:

● The monopolist is the only seller in the market of his product.

● As the only seller, he possesses a monopolistic dominance or monopoly
power in the market.
● But the degree of monopoly power is not the same in the case of all
monopolies.
That is, the degree of monopoly power depends upon the numerical
coefficient of the price-elasticity of demand for the monopolist’s product—a higher
degree of monopoly power would be obtained at a smaller value of e and a
lower degree of monopoly power at a larger value of e. This idea is supported by
the formula given by Prof. A. P. Lerner (1903-82) for measuring the degree of
monopoly power.
● According to Prof. Lerner, degree of monopoly power in perfect competition is
zero. At the equilibrium point of a competitive firm, we have p = AR = MR =
MC, or p = MC, or p – MC = 0.
● On the other hand, at the equilibrium point of a monopolistic firm, we have p =
AR > MR = MC, or, p > MC, or, p – MC = positive.
● Prof. Lerner thinks that the larger the positive value of p – MC as a proportion
of p, the larger would be the degree of monopoly power.

Therefore, his formula for the degree of monopoly power is

Lerner’s Index of monopoly power = p – MC/p

Concentration Ratios as Measures of Monopoly Power:

● In an industry, usually there exist some smaller firms and some larger firms in
the sense that smaller firms have relatively smaller shares in total industry
sales (or profits or assets), and the larger firms have relatively larger shares.

64
 ● The concentration ratio may act as a measure of monopoly power because in
a competitive industry, sales are more evenly distributed among
firms—concentration of sales is more or less absent.
● On the other hand, in a monopolistic industry, sales tend to concentrate in a
few large firms—in the limiting case, sales are concentrated in only one firm
when we have the case of a pure monopoly.

Monopolistic Competition:
● Monopolistic competition refers to a market situation where there are many
firms selling a differentiated product.
● “There is competition which is keen, though not perfect, among many firms
making very similar products.”
● No firm can have any perceptible influence on the price-output policies of the
other sellers nor can it be influenced much by their actions.
● Thus monopolistic competition refers to competition among a large number of
sellers producing close but not perfect substitutes for each other.

It’s Features:
The following are the main features of monopolistic competition:
(1) Large Number of Sellers:
● In monopolistic competition the number of sellers is large. They are
“many and small enough” but none controls a major portion of the
total output.
● No seller by changing its price-output policy can have any
perceptible effect on the sales of others and in turn be influenced by
them.
● Thus there is no recognised interdependence of the price-output
policies of the sellers and each seller pursues an independent
course of action.
(2) Product Differentiation:
● One of the most important features of the monopolistic
competition is differentiation.
● Product differentiation implies that products are different in
some ways from each other. Products are close substitutes with
a high cross-elasticity and not perfect substitutes.
● Product “differentiation may be based upon certain
characteristics of the products itself, such as exclusive patented
features; trade-marks; trade names; peculiarities of package or
container, if any; or singularity in quality, design, colour, or style.
It may also exist with respect to the conditions surrounding its
sales.”

65
(3) Freedom of Entry and Exit of Firms: Another feature of monopolistic
competition is the freedom of entry and exit of firms.
(4) Nature of Demand Curve:

● Under monopolistic competition no single firm controls more than a small

portion of the total output of a product.
● Therefore, the demand curve (average revenue curve) of a firm under
monopolistic competition slopes downward to the right. It is elastic but not
perfectly elastic within a relevant range of prices of which he can sell any
amount.
(5) Independent Behaviour:
● In monopolistic competition, every firm has independent policy.
● Since the number of sellers is large, none controls a major portion of the total
output.
(6) Product Groups:
● There is no any ‘industry’ under monopolistic competition but a ‘group’ of firms
producing similar products.
● Chamberlin lumps together firms producing very closely related products and
calls them product groups, such as cars, cigarettes, etc.
(7) Selling Costs:
● Under monopolistic competition where the product is differentiated, selling
costs are essential to push up the sales.
● Besides, advertisement, it includes expenses on salesman, allowances to
sellers for window displays, free service, free sampling, premium coupons and
gifts, etc.
(8) Non-price Competition:
● Under monopolistic competition, a firm increases sales and profits of his
product without a cut in the price.
● The monopolistic competitor can change his product either by varying its
quality, packing, etc. or by changing promotional programmes.

Short Run Equilibrium Under Monopolistic/Imperfect Competition:

● Monopolistic competition refers to the market organization where there are a

fairly large number of firms which sell somewhat differentiated products.

● The demand curve (AR curve) of the monopolistic firm is therefore, highly
elastic and is downward sloping.
● As regards the marginal revenue curve, it slopes downward and lies below the
demand curve because price is lowered of all the units to sell more output in
the market.

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Firm's Equilibrium Price and Output:
In the short-run, the number of firms in the 'product group' remains the same. The
size of the plant of each firm remains unaltered. The firm whether operating under
perfect competition, or monopoly wants to maximize profits.

In the figure (17.1), the downward sloping demand curve (AR curve) is quite elastic.
The MR curve lies below-the average curve except at point N. The SMC curve which
includes advertising and sales promotional costs is drawn in the usual fashion. The
firm sells output OK at OE/KM per unit price..

Equilibrium Price and Output in the Long Run Under Monopolistic/Imperfect

Competition:

Long Run Zero Economic Profits:

● In the long run, the firms are able to alter the scale of plant according to the
changed conditions of demand for a product in the market.
● They can also leave or enter the industry. If the firms are earning abnormal
profits in the short run, then new firm will enter the 'product group' (industry).
● The tendency of the new firms to enter the industry continues till the
abnormal profits are competed away and the firms economic profits are zero
and vice versa.

● The firm is earning only zero or normal economic profits.

● As the monopolistically competitive firm sets a price higher than
that minimum average cost in the long-run, the firm therefore produces a
smaller output.

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Oligopoly:

● Oligopoly is a market situation in which there are a few firms selling

homogeneous or differentiated products.
● It is difficult to pinpoint the number of firms in ‘competition among the few.’
With only a few firms in the market, the action of one firm is likely to affect the
others.
● The former is called pure or perfect oligopoly and the latter is called imperfect
or differentiated oligopoly.
Characteristics of Oligopoly:

(1) Interdependence:
There is recognised interdependence among the sellers in the oligopolistic market.
Each oligopolist firm knows that changes in its price, advertising, product
characteristics, etc. may lead to counter-moves by rivals. (2) Advertisement:
● The main reason for this mutual interdependence in decision making is that
one producer’s fortunes are dependent on the policies and fortunes of the
other producers in the industry.

● It is for this reason that oligopolist firms spend much on advertisement and
customer services.
(3) Competition:
This leads to another feature of the oligopolistic market, the presence of competition.
Since under oligopoly, there are a few sellers, a move by one seller immediately
affects the rivals.
(4) Barriers to Entry of Firms:
● As there is keen competition in an oligopolistic industry, there are no barriers
to entry into or exit from it.
● However, in the long run, there are some types of barriers to entry which tend
to restraint new firms from entering the industry.

(5) Lack of Uniformity:

Another feature of oligopoly market is the lack of uniformity in the size of firms. Finns
differ considerably in size. Some may be small, others very large.
(6) Demand Curve:
● It is not easy to trace the demand curve for the product of an oligopolist.
● Thus a complex system of crossed conjectures emerges as a result of the
interdependence among the rival oligopolists which is the main cause of the
indeterminateness of the demand curve.
(7) No Unique Pattern of Pricing Behaviour:

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 ● The rivalry arising from interdependence among the oligopolists leads to two
conflicting motives.
● Each wants to remain independent and to get the maximum possible profit.
Three Important Models of Oligopoly:

Three Important Economic Models of Oligopoly are as:

(1) Price and output determination under non-collusive oligopoly.

(2) Price and output determination under collusive oligopoly.

(3) Price leadership model.

Non-Collusive Oligopoly:

Sweezy’s Kinked Demand Curve Model:

● One of the important features of oligopoly market is price rigidity.
● And to explain the price rigidity in this market, conventional demand curve is
not used.
● The idea of using a non-conventional demand curve to represent
non-collusive oligopoly (i.e., where sellers compete with their rivals) was best
explained by Paul Sweezy in 1939.
Sweezy uses kinked demand curve to describe price rigidity in oligopoly market
structure.
● If a seller increases the price of his product, the rival sellers will not follow him
so that the first seller loses a considerable amount of sales.
● In other words, every price increase will go unnoticed by rivals.
● On the other hand, if one firm reduces the price of its product other firms will
follow the first firm so that they must not lose customers.
● As a result of this behavioural pattern, the demand curve will be kinked at the
ruling market price.
Suppose, the prevailing price of an oligopoly product in the market is QE or OP of
Fig. 5.19. If one seller increases the price above OP, rival sellers will keep the prices
of their products at OP. As a result of high price charged by the firm, buyers will shift
to products of other sellers who have kept their prices at the old level. Consequently,
sales of the first seller will drop considerably.

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The MR curve has two segments :
● At output less than OQ the MR curve (i.e., dA) will correspond to DE portion of
AR curve, and, for output larger than OQ, the MR curve (i.e., BMR) will
correspond to the demand curve ED.
● Thus, discontinuity in MR curve occurs between points A and B. In other
words, between these two points, MR curve is vertical.
● Equilibrium is achieved when MC curve passes through the discontinuous
portion of the MR curve. Thus the equilibrium output is OQ, to be sold at a
price OP.

(2)Price and Output Determination Under Collusive Oligopoly:

The term 'collusion' implies to 'play together'. When firms under oligopoly agree
formally not to compete with each other about price or output, it is called collusive
oligopoly.
Price Leadership Model:
In fact, firms enter into pricing agreements with each other instead of adopting
competition or price war with each other. Such agreement—both explicitly (or formal)
and implicit (or informal)—may be called collusion.
Types of Price Leadership:
Price leadership helps in stabilizing prices and maintaining price discipline. There are
three major types of price leadership, which are present in industries over a passage
of time.
These three types of price leadership are explained as follows:
i. Dominant Price Leadership:
● Refers to a type of leadership in which only one organization dominates the
entire industry.
● Under dominant price leadership, other organizations in the industry cannot
influence prices.
● The dominant organization uses its power of monopoly to maximize its profits
and other organizations have to adjust their output with the set price.
ii. Barometric Price Leadership:
● Refers to a leadership in which one organization declares the change in
prices at first and assumes that other organizations would accept it.

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 ● The organization does not dominate others and need not to be the leader in
the industry. Such type of organization is known as barometer.

iii. Aggressive Price Leadership:

● Implies a leadership in which one organization establishes its supremacy by
threatening the organizations to follow its leadership.
● In other words, a dominant organization establishes leadership by following
aggressive price policies and forces other/organizations to follow the prices
set by it.

Classical Models of Oligopoly

● A model of oligopoly was first of all put forward by Cournot a French

economist, in 1838.
● Cournot’s model of oligopoly is one of the oldest theories of the behaviour of
the individual firm and relates to non-collusive oligopoly.
● In Cournot model it is assumed that an oligopolist thinks that his rival will keep
their output fixed regardless of what he might do.
● That is, each oligopolist does not take into account the possible reactions of
his rivals in response to his actions.

Cournot’s Duopoly Model:

Let us first state the assumptions which are made by Cournot in his analysis of price
and output under duopoly.
First, Cournot takes the case of two identical mineral springs operated by two
owners who are selling the mineral water in the same market. Secondly,in Cournot’s
model, cost of production is taken as zero; only the demand side of the market is
analysed.
● It may be noted that the assumption of zero cost of production is made only to
simplify the analysis.
Thirdly, The market demand for the product is assumed to be linear, that is, market
demand curve facing the two producers is a straight line.
Lastly, Cournot assumes that each duopolist believes that regardless of his actions
and their effect upon market price of the product, the rival firm will keep its output
constant, that is, it will go on producing the same amount of output which it is
presently producing.

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Cournot’s Duopoly Equilibrium:
It will be seen from Fig. 29A.1 that when each producer is producing 1/3 OD (that is,
when producer A is producing OC and producer B equal to CT), the best that his
rival can do is to produce 1/3 OD = OC – CT. Thus, when each producer is producing
1/3 OD so that the total output of the two together is 2/3 OD, no one will expect to
increase his profits by making any- further adjustment in output. Thus, in Cournot’s
model of duopoly, stable equilibrium is reached when total output produced is 2/3rd
of OD and each producer is producing 1/3rd of OD.
To sum up, under Cournot’s duopoly equilibrium, output is two thirds of the
maximum possible output (i.e., perfectly competitive output) and price is
two-thirds of the most profitable price (i.e., monopoly price).

Cournot Equilibrium as Nash Equilibrium:

John F. Nash, a noted American Mathematician and a Nobel Prize winner in
economics, has put forward the concept of equilibrium known as Nash Equilibrium.
Cournot duopoly equilibrium is an example of Nash equilibrium.
According to Nash equilibrium, competing firms reach their equilibrium state when
each of them thinks that it is doing its best that is, maximising its profits in response
to the given strategy adopted by others which think they are also maximising their
profits with the given strategies. As a result, no one has a tendency to change its
strategy.

Bertrand’s Duopoly Model:

● Joseph Bertrand, a French mathematician, criticized Cournot’s duopoly
solution and put forward a substitute model of duoply.
● According to Betrand, there was no limit to the fall in price since each
producer can always lower the price by underbidding the other and increasing
his supply of output until the price becomes equal to his unit cost of
production.
● There are some important differences in assumptions of Bertrand and
Cournot’s models of duopoly. In Bertrand’s model, producers do not produce
any output and then sell whatever price it can bring in.

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 ● Instead, the producers first set the price of the product and then produce the
output which is demanded at that price.
● Thus, in Bertrand’s model adjusting variable is price and not output.
In Bertrand’s model each producer believes that his rival will keep his price constant
at the present level whatever price he might himself set.

Edgeworth Duopoly Model:

● F.Y. Edgeworth, a famous French economist, also attacked Cournot’s duopoly

solution.
● He criticised Cournot’s assumption that each duopolist believes that his rival
will continue to produce the same output irrespective of what he himself might
produce.
● According to Edgeworht (as in Bertrand’s model), each duopolist believes that
his rival will continue to charge the same price as he is just doing irrespective
of what price he himself sets.
The main difference between Edgeworth’s model and Bertrand’s model is that
whereas in Bertrand, productive capacity of each duopolist is practically unlimited so
that he could satisfy any amount of demand but in Edgeworth’s model, the
productive capacity of each duopolist is limited so that neither duopolist can meet
entire demand at the lower price ranges.

Chamberlin’s Oligopoly Model:

● In his now famous work “The Theory of Monopolistic Competition” Chamberlin

made an important contribution to the explanation of pricing and output under
oligopoly.
● His oligopoly model makes an advance over the classical models of Cournot,
Edgeworth and Bertrand in that, in sharp contrast to above classical models,

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 his model is based on the assumption that the oligopolists recognise their
interdependence and act accordingly.
● Chamberlin criticises the behavioural assumption of Cournot, Bertrand and
Edgeworth that the oligopolists behave independently in the sense that they
ignore their mutual dependence and while ‘deciding about their output or price
assume that their rivals will keep their output or price constant at the present
level.
● According to him, oligopolists behave quite intelligently as they recognise their
interdependence and learn from the experience when they find that their
action in fact causes the rivals to react and adjust their output level.
● This realisation of mutual dependence on the part of the oligopolists leads to
the monopoly output being produced jointly and thus charging of the
monopoly price.
● In this way, according to Chamberlin, maximisation of joint profits and stable
equilibrium are achieved by the oligopolists even though they act in a
non-collusive manner. Given identical costs, they will also equally share these
monopoly profits.

Stackelberg’s Duopoly Model

● This model was developed by the German economist Heinrich von

Stackelberg and is an extension of Cournot’s model.
● It is assumed, by von Stackelberg, that one duopolist is sufficiently
sophisticated to recognise that his competitor acts on the Cournot
assumption.
● This recognition allows the sophisticated duopolist to determine the reaction
curve of his rival and incorporate it in his own profit function, which he then
proceeds to maximise like a monopolist.
Limit Pricing Models

Bain’s Models for Limit-Pricing

● Bain formulated his ‘limit-price’ theory in an article published in 1949, several
years before his major work Barriers to New Competition which was published
in 1956.
● His aim in his early article was to explain why firms over a long period of time
were keeping their price at a level of demand where the elasticity was below
unity, that is, they did not charge the price which would maximize their
revenue.
● However, the price, Bain argued, did not fall to the level of LAC in the long run
because of the existence of barriers to entry, while at the same time price was
not set at the level compatible with profit maximization because of the threat
of potential entry.

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 ● Actually he maintained that price was set at a level above the LAC (= pure
competition price) and below the monopoly price (the price where MC = MR
and short-run profits are maximized).
● This behaviour can be explained by assuming that there are barriers to entry,
and that the existing firms do not set the monopoly price but the ‘limit price’,
that is, the highest price which the established firms believe they can charge
without inducing entry.
● Bain, in his 1949 article, develops two models of price setting in oligopolistic
markets.

The Model of Sylos-Labini of Limit-Pricing

● Sylos-Labini developed a model of limit-pricing based on scale-barriers to

entry.
● His model is clumsy, due to its unnecessarily stringent assumptions and the
use of arithmetical examples.
● However, his analysis of the economies-of-scale barrier is more thorough than
that of Bain.
● He highlighted the determinants of the limit price and discussed their
implications, thus providing the basis for Modigliani’s more general model of
entry-preventing pricing.
● Sylos-Labini concentrated his analysis on the case of a homogeneous
oligopoly whose technology is characterised by technical discontinuities and
economies of scale

CHAPTER:6
Game Theory

● Game theory attempts to take into consideration the interactions between the
participants and their behavior to study the strategic decision-making between
rational individuals.
● It tries to find out the actions that a “player” should perform which would
maximize his chances of success mathematically and logically.
● John von Neumann is the pioneer of the field of game theory.

The Prisoner’s Dilemma

The Prisoner's Dilemma is a simple game which illustrates the choices facing
oligopolies. As you read the scenarios, you can play the part of one of the prisoners.
The scenario
Robin and Tom are prisoners: They have been arrested for a petty crime, of which
there is good evidence of their guilt – if found guilty they will receive a 2 year
sentence.

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During the interview the police officer becomes suspicious that the two prisoners are
also guilty of a serious crime, but is not sure he has any evidence.
Robin and Tom are placed in separate rooms and cannot communicate with each
other. The police officer tries to get them to confess to the serious crime by offering
them some options, with possible pay-offs.
The options
Each is told that if they both confess to the serious crime they will receive a sentence
of 3 years. However, each is also told that if he confesses and his partner does not,
then he will get a light sentence of 1 year, and his partner will get 10 years. They
know that if they both deny the serious offence they are certain to be found guilty of
the lesser offence, and will get a 2 year sentence.
Types of strategy
Minimax
A minimax strategy is one where the player attempts to earn the maximum possible
benefit available. This means they will prefer the alternative which includes the
chance of achieving the best possible outcome – even if a highly unfavourable
outcome is possible.
This strategy, often referred to as the best of the best is often seen as ‘naive’ and
overly optimistic strategy, in that it assumes a highly favourable environment for
decision making.
Maximin
● A maximin strategy is where a player chooses the best of the worst pay-off.
This is commonly chosen when a player cannot rely on the other party to keep
any agreement that has been made –
● therefore the best of the worst is to confess.
.
Dominant strategy
A dominant strategy is the best outcome irrespective of what the other player
chooses, in this case it is for each player to confess - both the optimistic minimax
and pessimistic maximin lead to the same decision being taken.
Nash equilibrium
Nash equilibrium, named after Nobel winning economist, John Nash, is a solution to
a game involving two or more players who want the best outcome for themselves
and must take the actions of others into account. When Nash equilibrium is reached,
players cannot improve their payoff by independently changing their strategy.

CHAPTER 7: Theories of Firm

Baumol’s Single Period Sales (Revenue) Maximization subject to Profit

Constraint:

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 ● One alternative to profit maximization has been suggested by W.J. Baumol
that firms operating in oligopoly will seek to maximize sales revenue subject to
a profit constraint.
His argument is largely, if not entirely, based on “public statements by
businessmen and on a number of a priori arguments as to the disadvantages
of declining sales, for example, fear of customers shunning a less popular
product, less favourable treatment from banks, loss of distributors and a
poorer ability to adopt a counter strategy against a competitor.”

Total profit is maximized when the firm produces OQ* units of output (as in Figure
7.1)
Sales maximization, on the other hand, refers to maximization of total revenue ( = P
x Q ), rather than maximization of Π (It is because if a firm quotes zero price it can
sell an astronomical amount but its total revenue will be zero.) Total revenue is
maximum when MR = 0, and MR = 0 when the demand for a company’s product is
unitary elastic.
In Figure 7.4 we observed that if the firm wishes to maximize total revenue (without
profit constraint) it will choose output Q’s, where TR is maximum (i.e., the slope of
the TR curve is zero or MR = 0). However, Baumol has argued that, a constraint
operates from shareholders. They require a minimum sum as dividend which would
keep them content.

Williamson’s Model and Maximization of Management Utility:

● In his article, ‘Management Discretion and Business Behaviour’ in American
Economic Review (1863), O.E. Williamson presents a model of managerial
discretion.
● His model is based on the same assumption as Baumol’s: a weak competitive
environment, a divorce of ownership from control, and a minimum profit
constraint imposed by the shareholders.

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 ● He argues that managers of such large firms conduct the affairs of the firm to
serve their own interests.
● In other words, managers are concerned with the goodwill of the firm only to
the extent that it favours their own personal motives and ambitions.
● He argues that the most important motives of businessmen are desires for
salary, security, dominance and professional excellence. All these yield
additional utility or satisfaction to the manager.
● These can be gained by incurring additional expenditure on staff, managerial
emoluments and discretionary investment.
● Williamson argues that managers have discretion in pursuing policies which
maximize their own utility rather than seeking the maximization of profits
which maximize the utility of most shareholders (i.e., the owners of the
company).
● In Williamson’s model, each manager is supposed to have a utility function —
i.e., a set of factors which provide managerial satisfaction. Such utility arises
from certain aspects of the management task — e.g. responsibility, prestige,
status, power, salary, etc.

Marris’s Model of Managerial Enterprise:

● An alternative managerial theory of the firm has been developed by Robin
Marris.
● It also stems from the so-called dichotomy between ownership and control.
● He suggests that a possible goal which has connections with both sales and
profits is that of growth of the firm. So managers will have varying objectives
apart from profit.
● These non-profit objectives are strongly correlated with the size of the firm,
examples being salary, power and status. An important exception is that of
security, since in recent years managers, even in larger firms, have found
themselves declared redundant.
However, Marris suggests that there are certain factors which operate within
the firm to limit the growth process such as:
(1) The ability of managers to cope with and administer a rapidly growing
organization without any loss of control,
(2) The ability of managers to develop and introduce new products to neutralize the
losses inflicted by products experiencing falling market shares and
(3) The ability of the research and development expenditure to generate an
expanding flow of potential new products.

The Behavioural Theory of the Firm:

● In their book A Behavioural Theory of the Firm (1963), Cyert and March go a
step ahead of Simon in making an in-depth study of the way in which
decisions are made in the large modern (multi- product) firm (characterized by

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 divorce of ownership from management) under uncertainty in an imperfect,
market.
● They have expressed more concern in the decision making process than in
the objectives or motivations of such firms (e.g., profit/sales maximization and
satisficing).
● At the outset Cyert and March declare that if we are to develop a theory
that predict and explain business decision making behaviour, the
following two points have to taken note of:
(i) People (i.e., individuals) like organizations have goals,
(ii) In order to define a theory of organizational decision making, we need something
analogous — at the organizational level — to individual goals at the individual level.
Five Goals:
Cyert and March go a step further and postulate that the firm may be pursuing
the following five basic common goals:
(a) Production goal:
This goal will be set as a target for the period and will have two aspects: level and
smoothness.
(b) Inventory goal:
Business firms have to hold inventories because production and sales do not always
coincide. It is absolutely essential to hold sufficient stocks of finished goods to meet
consumer demand (as and when it arises). (c) Sales goal:
This goal may be specified for the future either in volume or in value terms. Moreover
it may again be expressed in terms of a level and/or range.
(d) Market share goal:
● The firm may set a target related to its share of the market (i.e., the industry of
which it is a part for the product concerned).
● In some cases this may be a substitute for the sales goal, but in other cases it
may be a supplementary goal.
(e) Profit goal:
The purpose of setting this goal is twofold: to measure the effectiveness of
management and to act as a source of payment of dividends to shareholders.

CHAPTER 8 : Market Failures in Markets with Asymmetric Information

Adverse selection
● Adverse selection is a case of asymmetric information. It occurs when both
parties assign or are subject to a different probability of a same (normally
adverse) event occurring.
● In this case, the agent that has the best information is clearly at an advantage.
We say that this advantage is ex-ante because, contrary to moral hazard, the
advantage occurs before the ‘contract’ (real or otherwise) is signed.

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 ● In order to clarify this concept, let’s take a quick look at an example: insurance
premiums.
● The person taking out an insurance policy is at an advantage versus the
insurer, who therefore charges a premium for the risk derived from
their imperfect information, aside from any mark-up designed purely in order
to generate benefits.
The Market for Lemons
● “The Market for ‘Lemons’” is a key article written by George Akerlof in 1970,
which aims to explain some of the market failures derived from imperfect
information, in this case asymmetry.
We are presented with the problem of someone who wants to buy a car, and decides
to scout the used car market for a bargain. The market itself is composed of two
types of cars: those that are being sold in good faith and those that are being sold off
because they are known to be unreliable: these are the ‘lemons’ (in US slang). The
seller, of course, knows how good the car is: they’ve had time to decide. The buyer,
however, comes to the market blind: all they have to go on is the average quality of
the used car market (which Akerlof defines as μ) and the price of the car, p.
Obviously, all similar models of cars need to be sold for an identical price, p.
Screening
● Screening is one of the main strategies for combating adverse selection.
● It is often confused with signalling, but there is one main difference: in both,
‘good’ agents (the cherries of this world) are set apart from the ‘bad’ agents,
or lemons, which are weeded out. In signalling, it is the uninformed agent (the
victim of asymmetric information) who moves first, and comes up with a
strategy to weed out the lemons. In signalling, however, it is the cherries, the
informed agents, who make the first move to set themselves apart. The
analysis of screening processes was put forward by Michael Spence in his
article “Job Market Signaling”, 1973.
● There are two basic types of screening: in the first, the ‘victim’ of asymmetric
information simply sets about finding out as much as possible about the other
agent. For example, carrying out a health check before offering health
insurance, or running a background check before offering a job.
● The second option is using game theory to set up the terms of a contract so
that they only interest the cherries. Something as simple as copayment in
case of a claim (for example, paying a small percentage of the claim amount
in case a car is damaged) can help to weed out those who are not risk
adverse.
Signalling
● Signalling is similar to screening, except it is the agent with complete
information who decides to move first to mark themselves out as a ‘good’
agent, as a cherry.

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 ● The most cited example is generally in the job market. When we examine
most qualified positions, we realise that those carrying out those jobs
generally have some form of higher education.
● Eg: education certificate, experience certificate, aptitiude test

Moral hazard
● Moral hazard is a case of asymmetric information.
● It occurs when both parties (usually an agent and a principal) assign or are
subject to a different probability of a same (normally adverse) event occurring.
● The behaviour of the agent changes ex-post, after a contract is signed and as
a consequence of their new, advantageous position. As economist Paul
Krugman puts it, moral hazard refers to “any situation in which one person
makes the decision about how much risk to take, while someone else bears
the cost if things go badly”.
● Moral hazard also appears in other markets, such as in the credit market. In
their article about credit rationing, economists Joseph E. Stiglitz and Andrew
Weiss explain how raising interest rates will make indebted people take
higher risks.

CHAPTER 9 : Welfare Economics

Introduction to Welfare Economics:
● The utilitarian’s were the first to talk of welfare in terms of the formula, ‘the
greatest happiness of the greatest number’.
● Vilfredo Pareto considered the question of maximising social welfare

Meaning of Welfare Economics:

Welfare economics has been defined by Scitovsky as “that part of the general
body of economic theory which is concerned primarily with policy.”

Criteria of Social Welfare (6 Major Criteria)

To evaluate alternative economic situations we need some criterion of social well-
being or welfare. Various criteria of social welfare have been suggested by
economists at different times.

1. Growth of GNP as A Criterion of Welfare:

● Adam Smith implicitly accepted the growth of the wealth of a society, that is,
the growth of the gross national product, as a welfare criterion.

● He believed that economic growth resulted in the increase of social welfare

because growth increased employment and the goods available for
consumption to the community.

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 ● To Adam Smith, economic growth meant bringing W (actual wealth ) closer to
W* (potential wealth ).

2. Bentham’s Criterion:
● Jeremy Bentham, an English economist, argued that welfare is improved
when ‘the greatest good (is secured) for the greatest number’.

● Implicit in this dictum is the assumption that the total welfare is the sum of the
utilities of the individuals of the society.

● The application of Bentham’s ethical system to economics has serious

shortcomings.

● To illustrate the pitfalls in Bentham’s criterion let us assume that the society
consists of three individuals, A, B, and C, so that W = UA + UB + UC

3. A ‘Cardinalist’ Criterion:
● Several economists proposed the use of the ‘law of diminishing marginal
utility’ as a criterion of welfare.

● In fact cardinal welfare theorists would maintain that social welfare would be
maximised if income was equally distributed to all members of the society.

● The cardinalist approach to welfare has a serious flaw: it assumes that all
individuals have identical utility functions for money, so that with an equal
income distribution all would have the same marginal utility of money.
● This assumption is too strong. Individuals differ in their attitudes towards
money. A rich person may have a utility for money function that lies far above
the utility (for money) function of poorer individuals.

4. The Pareto-Optimality Criterion:

● This criterion refers to economic efficiency which can be objectively

measured. It is called Pareto criterion after the famous Italian economist
Vilfredo Pareto (1848-1923).

● According to this criterion any change that makes at least one individual
better-off and no one worse-off is an improvement in social welfare.
Conversely, a change that makes no one better-off and at least one worse-off
is a decrease in social welfare.

● The criterion can be stated in a somewhat different way: a situation in which it

is impossible to make anyone better-off without making someone worse-off is
said to be Pareto-optimal or Pareto-efficient.

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For the attainment of a Pareto-efficient situation in an economy three marginal
conditions must be satisfied:
(a) Efficiency of distribution of commodities among consumers (efficiency in
exchange);

(b) Efficiency of the allocation of factors among firms (efficiency of production);

(c) Efficiency in the allocation of factors among commodities (efficiency in the

product-mix, or composition of output).

5. The Kaldor-Hicks ‘compensation criterion’: (New Welfare Economics)

● Nicholas Kaldor and John Hicks suggested the following approach to
establishing a welfare criterion.

● Assume that a change in the economy is being considered, which will benefit
some (‘gainers’) and hurt others (‘losers’).

● One can ask the ‘gainers’ how much money they would be prepared to pay in
order to have the change, and the ‘losers’ how much money they would be
prepared to pay in order to prevent the change.

● If the amount of money of the ‘gainers’ is greater than the amount of the
‘losers’, the change constitutes an improvement in social welfare, because the
‘gainers’ could compensate the ‘losers’ and still have some ‘net gain’.

● Thus, the Kaldor-Hicks ‘compensation criterion’ states that a change

constitutes an improvement in social welfare if those who benefit from it could
compensate those who are hurt, and still be left with some ‘net gain’.

6. The Bergson criterion: the social welfare function:

● Bergson suggested the use of an explicit set of value judgements in the form
of a social welfare function.

● A social welfare function is analogous to the individual consumer’s utility

function. It provides a ranking of alternative states (situations, configurations)
in which different individuals enjoy different utility levels.

● If the economy consists of two individuals the social welfare function could be
presented by a set of social indifference contours (in utility space) like the
ones shown in figure 23.3. Each curve is the locus of combinations of utilities
of A and B which yield the same level of social welfare.

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 ● The further to the right a social indifference contour is, the higher the level of
social welfare will be. With such a set of social indifference contours
alternative states in the economy can be unambiguously evaluated. For
example a change which would move the society from point b to point c (or d)
increases the social welfare. A change moving the society from a to b leaves
the level of social welfare unaltered.

Conditions of Pareto Optimality

1. Efficiency in Exchange:
The first condition for Pareto optimality relates to efficiency in exchange. The
required condition is that “the marginal rate of substitution between any two products
must be the same for every individual who consumes both.”
It means that the marginal rate of substitution (MRS) between two consumer goods
must be equal to the ratio of their prices. Since under perfect competition every
consumer aims at maximising his utility, he will equate his MRS for two goods, X and
Y to their price ratio (Px/Py).
2. Efficiency in Production:
● The second condition for Pareto optimality relates to efficiency in production.
There are three allocation rules for demonstrating efficiency in production
under perfect competition. Rule one relates to the optimum allocation of
factors.
● It requires that the marginal rate of technical substitution (MRTS) between any
two factors must be the same for any two firms using these factors to produce
the same product.
● The slope of an isoquant is the MRTS of labour and capital, and the slope of
the iso-cost line is the ratio of the prices of labour and capital. Thus the
condition of equilibrium for firm A is AMRTSLK. = PL/PK, and that of firm В
is BMRTSLK, = PLPK. Therefore, rule one for efficiency in production
is AMRTSLK = BMRTSLK= PL/PK.
Efficiency in Exchange and Production (Product Mix):
● Pareto optimality under perfect competition also requires that the marginal
rate of substitution (MRS) between two products must equal the marginal rate

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 of transformation (MRT) between them. It means simultaneous efficiency in
consumption and production.
● Since the price ratios of the two products to consumers and firms are the
same under perfect competition, the MRS of all individuals will be identical
with MRT of all firms consequently, the two products will be produced and
exchanged efficiently. Symbolically, MRSXY = PX/PY, and MRTxy = Px/Py.
Therefore, MRSXY = MRTxy.

Scitovsky Paradox:

● Scitovsky pointed out an important limitation of Kaldor-Hicks criterion that it

might lead to contradictory results.
● He showed that, if in some situation, position B is shown to be an
improvement over position A on Kaldor-Hicks criterion, it may be possible that
position A is also shown to be an improvement over B on the basis of the
same criterion.
● For getting consistent results when position B has been revealed to be
preferred to position A on the basis of a welfare criterion, then position A must
not be preferred to position B on the same criterion.
According to Scitovsky, Kaldor- Hicks criterion involves such contradictory and
inconsistent results. Since Scitovsky was the first to point out this paradoxical
result in Kaldor-Hicks criterion, it is known as ‘Scitovsky Paradox’.

The Social Welfare Function: The Bergson Criterion:

● The concept of social welfare function was first introduced by Prof. Bergson
and later on developed by Samuelson, Tintner and Arrow. They are of the
view that no meaningful propositions can be made in welfare economics
without introducing value judgments.
● The concept of social welfare is an attempt at providing a scientifically
normative study of welfare economics.
● A social welfare function shows the factors 011 which the welfare of a society
is supposed to depend. Bergson defines it “as a function either of the welfare
of each member of the community or of the quantities of products consumed
and services rendered by each member of the community.”

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 ● It is a function which establishes a relation between social welfare and all
possible variables which affect each individual’s welfare, such as a services
and consumption of each individual.
● It is an ordinal index of society’s welfare and is a function of individual utilities.
It is expressed as
● W = F (U1,.U2, Un)

Assumptions:
(a) It assumes that social welfare depends on each individual’s wealth and income
and each individual’s welfare depends, in turn, on his wealth and income and on the
distribution of welfare among the members of the society.
(h) It assumes the presence of external economies and diseconomies with their
consequent effects.
(c) It is based on ordinal ranking of combinations of those variables which influence
individual welfare.
(d) Interpersonal comparisons of utility involving value judgments are freely
permissible.

Arrow’s Impossibility Theorem:

● K.J. Arrow in his Social Choice and Individual Values has demonstrated the
impossibility of obtaining the social welfare function even if individual
preferences are consistent.
● He suggests five minimum conditions or criteria which social choices must
satisfy in order to reflect preferences of individuals.
They are as follows:
1. Collective Rationality:
All possible alternatives must be derived from social choices which, in turn, must be
based on rationality. The rule for making a social choice can be derived from an
ordering of all possible alternatives open to society. This ordering must obey two
conditions, of consistency and transitivity.
2. Responsiveness to Individual Preferences:
Social choices must be directly related to individual preferences. It implies that social
choices must change in the same direction as individual choices. Individual choices
must be derived within the society. But it is not possible to derive such alternatives
which affect the socially desirable alternatives.
3. Non-imposition:
Social choices must not be imposed by customs or from outside the society. It must
be derived from individual preferences. For instance, if the majority of individuals do
not prefer to B, then the society should not follow it.

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4. Non-dictatorship:
Social choices must not be dictatorial. They must not be imposed by one individual
within the society. In other words, social choices must not be based on any single
individual’s ordering.
5. Independence of Irrelevant Alternatives:
Social choices must be independent of irrelevant alternatives. In other words, if any
one alternative is excluded, it will not affect the ranking of other alternatives. Arrow
demonstrates that it is not possible to satisfy all these five conditions and obtain a
transitive social choice for each set of individual preferences without violating at least
one condition.

Grand Utility Possibility Frontier and Position of Constrained Bliss:

● As shall be explained below, a grand utility possibility frontier is a locus of the

various physically attainable utility combinations of two persons when the
factor endowments, state of technology and preference orders of the
individuals are given.
● In other words, every point on the grand utility possibility curve represents the
optimum position with regard to the allocation of the products among the
consumers, allocation of factors among different products and the direction of
production.
● Thus every point on the grand utility possibility curve represents a Pareto
optimum and as we move from one point to another on it the utility of one
individual increases while that of the other falls.

Theory of Second Best

● Kelvin Lancaster and Richard G. Lipsey, in their article “The General Theory
of Second Best”, 1956, following an earlier work by James E. Meade, treated
the problem of what to do when certain optimality conditions (which must be
considered in order to arrive at a Paretian optimum solution in a general
equilibrium system) cannot be satisfied.
● The main idea in this article is that, when a constraint prevents the fulfilment
of one of these conditions, the other conditions are in general no longer

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 desirable. The optimum situation in this case can be attained only by
neglecting the other conditions. Indeed, this new optimum is called “second
best” because a Paretian optimum cannot be attained.

● This can be easily understood using the diagram depicted in the article. We
start by considering a typical optimization problem, with a given production
possibility frontier (PPF) considered as a boundary condition, indifference
curves (green curves, in this case representing a welfare function, ω) and the
optimum where the PPF is tangent to ω (point P). Since this points lies on the
transformation line and an indifference curve, it defines the production and

consumption o

The segment MN is technically more efficient than R, but since the points on this
segment cannot be attained, R is the second best solution.

John Rawls Views on the Theory of Justice

● John Rawls is a top political scientist and academician of United States. He

was born in 1921 and passed away in 2002.
● His most famous work is A Theory of Justice first published in 1970 and its
revised edition was published in 1990.
● In the revised edition, Rawls claims, some important sections and views have
been revised.
Definition of Justice:
● John Rawls has viewed justice in the background of society and for this
reason he says that the main concern of the subject matter of justice is social
structure which is the core of the society. That is justice deals with the basic
social structure. The social institutions are very important in the sense that
they take the responsibility of distributing the fundamental rights and duties
efficiently.

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 ● It is also the important task of the social institutions to allocate judiciously the
privileges and advantages for the people of society. Constitution, social,
political and economic arrangements are included into these social
institutions.

● Thus justice may conveniently be regarded as a social principle which

determines the ways and procedure of distributing the rights and duties for the
members of society.
Justice as Fairness:
The main theme of Rawls’ theory of justice is it is interpreted as fairness. The
dictionary meaning of fairness is appropriateness or just: In Rawls’ conception that
arrangement can be called just or appropriate which does not create any scope of
partiality or inappropriate. The principles for the distribution of rights, duties and
advantages will be applied in such manner as will give no controversy.

CHAPTER 10
Introduction to Theory of Factor Pricing OR Theory of Distribution:

Definition and Explanation of Theory of Factor Pricing:

● The theory of distribution or the theory of factor pricing deals with the
determination of the share prices of four factors of production, viz., land, labor,
capital and organization.
● In the theory of distribution, we are chiefly concerned wrath the principles
according to which the price of each factor of production is determined and
distributed.

Marginal Productivity Theory (Neo-Classical Version-J.B Clark):

● The marginal productively theory is an attempt to explain the determination

of the rewards of various factors of production in a competitive market.
● The marginal productivity theory of resource demand was the work of many
writers, it was widely discussed by many economists like J.B. Clark, Walras,
Barone, Ricardo, Marshall.
● It was improved, amended and modified later on. The final version of the
theory as stated by Neo Classical economists is given below.

Definition and Meaning:

By marginal productively theory of a factor is meant the value of the marginal

physical product of the factor. It is worked out by multiplying the price of the output
per unit by units of output.

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Formula: VMP = MP x P

Value of Marginal Product (VMP) = Marginal Physical Product x Price

The marginal productivity theory contends that in a competitive market, the price or
reward of each factor of production tends to be equal to its marginal productivity.

In the figure 18.1, the supply of labor is perfectly elastic. The wage (W) is equal to
average wage (AW) and marginal wage, (MW) = W = AW = MW. At point E, the MRP
of labor is equal to marginal wage (MW). The producer is-in equilibrium at point E.
He will employ ON units of labor because when ON units of labor are employed, the
marginal revenue productivity of labor MRPL = Wage.
Assumptions: The theory of marginal productivity is based on the following
assumptions:
(i) Factor identical: It assumes that all the units of a factor are exactly alike and so
can be substituted to any extent.
(ii) Factors can be substituted: It is assumed that the various factors of production,
which help in the production of particular commodity can also be substituted for one
another. We can use more of labor or less of land or more of labor and less of
capital.
(iii) Perfect mobility of factors: It is assumed that the various factors of production
can be moved from one use to another.
(iv) Application of law of diminishing return: The theory rests en the assumption
that the law of diminishing returns applies also to the organization of a business.
(v) Perfect competition: It is based on the assumption that the reward of each
factor of production is determined under conditions, of perfect competition and full
employment.

Firm's Equilibrium in the Factor Market Under Perfect Competition:

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 ● In a perfectly competitive market, an individual firm cannot influence the
market price of a factor by increasing or decreasing its demand.
● So it has to hire units of a factor at its prevailing price in the market. Same is
the case with the supplier of a factor.
● As the supplier of a factor sells an insignificant quantity of the total supply, it is
therefore not in a position to alter the market price of a factor by its own
individual action.
● Since a firm in a perfect competitive factor market is a price taker, so the
marginal product of the factor (MP) and the average product (AP) are the
same and their curves coincide.
● They are a horizontal straight time and parallel to the X-axis.

Equilibrium of the Firm:

● When a factor of product is to be hired by a firm, it compares the marginal
revenue productivity of the factor (MRP) with that of its marginal cost (MC).
● When the marginal revenue productivity of a factor is equal to the marginal
cost of the factor, the firm will be in equilibrium and its profits maximized MRP
= MC.
Formula For Firm's Equilibrium:

Marginal Revenue Productivity of Labour = Marginal Cost of Labour

The equilibrium of the firm in the factor market is explained with the help of a
diagram.

Modern Theory of Factor Pricing Under Perfect Competition:

● The modern economist discard the marginal productivity theory on the ground
that it completely ignores the supply side of a factor of production.

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 ● Just as the price of a commodity in the market, they say, is determined by
matching of demand and supply, similarly the price of an agent of production
is determined by their forces of demand and supply in the factor market.
● Demand For a Factor of Production:
● The demand for factors is a derived demand.
● The demand for a factor of production, like the price of commodity, is a
function of price. How much a factor of production will be demanded in
the market depends upon two parameters:
(1) The Magnitude of Demand:

(i) If a factor of production is very important in the process of production of a

particular commodity or commodities, it will have a higher demand in the factor
market.

(ii) If the demand for final product is expected to be high, then the demand for all the
factors which produce the product will go up.

(iii) If a factor of production has close substitutes, then its demand will not rise even if
the demand for final product in which it is used increase. The reason is that the
employers of factors of production would prefer to engage a substitute which is
available in the market at an attractive price.

(2) Elasticity of Demand for Factors:

● By elasticity of demand for factors is meant the degree of responsiveness of
demand for the various factors to changes in their prices.
● The main propositions on which the elasticity of demand for the factors of
production depends are as follows:
(i) If the price of a factor of production forms a very small proportion in the total costs
of a product, then its demand will be inelastic
(ii) The demand for a factor of production also depends upon the elasticity of
demand for a commodity in which it is used. If the demand for a commodity is fairly
elastic, then the demand for factors which go to make the product will also be elastic
and vice versa.
(iii) If a factor of production is easily substitutable in the market, then its demand will
be fairly elastic. In case, it is indispensable, the demand will be inelastic.

Modern Concept of Rent:

● The modem economists do not use the concept of economic rent in the
restricted some.
● They apply rent to all the factors of production which do not have a perfect
elastic supply. According to them: "Economic rent is a surplus or excess
over the transfer earnings"

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CHAPTER X : Theories of Factor Pricing

Concept of Quasi Rent:

The concept of quasi-rent owes its origin to Dr. Alfred Marshall. Dr. Marshal is of the
opinion that:
"It is not possible for human beings to increase the supply of land. It is fixed by
Nature. If price of a produce rises, the surface of earth cannot be increased and if
price falls, it cannot be decreased. But by appliance of machine which are the
product of human efforts, the supply can be increased or decreased if a fairly long
period of time is allowed".

"Quasi-rent is, thus, a temporary gain which is earned by a factor of production due
to the temporary limitation of its supply".

Modern View of Quasi Rent:

● The modern economists do not place land under a separate category.
● They are of the opinion that when all the factors of production are scarce in a
relation to their demand, the rent can arise from all of them.
● Rent is one of the important members of a large family consisting of wages,
interest and profits, or, in the words of Marshall, we can say:

● "Rent is the leading species of a large genus"

Theories of Wages Determination:

There are various theories of wages which lave been put forward by different
economists from time to time but none of them is free from criticism. The most
important theories of wages determination are:

(1) Subsistence Theory of Wages.

(2) Wage Fund Theory.

(3) Residual Claimant Theory.

(4) Marginal Productivity Theory.

(5) Modern Theory of Supply and Demand.

Let us now explain these theories one by one.

(1) Subsistence Theory of Wages/Iron or Brazen Law of Wages:

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The subsistence theory of wages owes its origin to Physiocratic School of
France. The theory is also named as Iron or Brazen Law of Wages. According
to this theory:

● "The wage in the long run tends to be equal to the minimum level of
subsistence.
● By 'minimum level of subsistence is meant the amount which is just sufficient
to meet the bare necessities of life of the worker and his family".

● Wage Fund Theory:

The theory of wage fund first introduced in Economics by Adam Smith and
later on it was developed by J.S. Mill. The theory briefly explains that:

● "Wages depend upon the proportion between population and capital, or rather
between the number of laboring classes who work for hire and the aggregate
of what may be called the wage fund which consists of that part of circulating
capital which is expanded in the direct hire of labor".

Formula for Wage Fund Theory:

Wage Rate = Wage Fund

Total Number of Workers

Residual Claimant Theory:

Residual claimant theory is associated with the name of American economist

Walker. According to Walker:
o "Wages equal to Whole product minus rent interest and profit".

Marginal Productivity Theory of Wages Under Perfect Competition:

Some of the modern economists explain the determination of wages by

means of marginal productivity analysis.
According to this theory: "Wages in perfect competition tend to be equal to
the marginal net product of a labor. By marginal net product of a labor is
meant net addition or net subtraction made to the value of the total
produce of a firm when one unit is added or withdrawn from it".

Theories of Interest
Definition of Interest:

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"Interest is the price paid by the borrower to the lender for the use of borrowed funds
during a certain period".

(1) Productivity Theory of Interest.

(2) Abstinence or Waiting Theory of Interest.
(3) Austrian or Agio Theory of Interest.
(4) Loanable Fund Theory of Interest.
(5) Liquidity Preference Theory of Interest.
(6) Modern Theory of Interest.

Let us, now, examine these theories, one by one and see how they explain the
economic cause of interest.

(1) Productivity Theory of Interest:

Definition:
● Turgot and other physiocrats were of the opinion that interest is the reward
for the use of capital in production.
● Interest is paid, they say, because capital is productive. The labor assisted by
capital can produce more things than what they can do without it.
(2) Abstinence or Waiting Theory of Interest:

● This theory of interest is associated with the name of Senior. According to the
theory:
● "Interest is a reward for abstinence. When a person saves money from his
income and lends it to somebody else, he in fact makes sacrifice.
● Sacrifice in the sense, that he abstains from consuming the whole of his
income which he could have easily spent.
(3) Austrian or Agio Theory of Interest:

● The Austrian or Agio Theory of interest was first advanced by John Rao in
1834 and later on, it was developed by the Austrian
economist, Bohm-Bowerk.
● According to Bohm-Bowerk: "Interest is the premium or agio which present
goods command over future goods. The reason as to why present goods are
preferred over future goods are as follows:
● Firstly, Future is shrouded in mystery and so is uncertain.
● Secondly, present wants are more urgently felt than the future ones.
● Thirdly, present goods posses a technical superiority over future goods.

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 (4) Loanable Fund Theory of Interest (Neo Classical Version):

● The theory was first put forward by Wicksell and later on it was elaborated
by Ohlin, Robertson and Pigou, Myrdal etc.
● According to the neoclassical economists:
● "The rate of interest is determined by the interaction of the forces of demand
for loanable funds and the supply of it in the credit market".

5) Keynesian Theory of Interest/Liquidity Preference Theory of Interest:

● J.M. Keynes in his epoch-making book the General Theory of employment,

Interest and Money, has put forward a new theory of interest.
● According to him
● Interest is, thus, the reward for parting with liquid control over cash for a
specific period, or we say:
"Interest is the payment for parting with the advantages of liquid control of money
balance".
● It is determined by the interaction of the forces of demand and supply of
money

(6) Modern Theory of Interest/IS-LM Curve Model:

● The Modern Theory of Interest is designated as IS-LM Curves Model.

Hicks-Hansen's, IS-IM curves model seeks to explain a case of joint
determination of equilibrium rate of interest (r) and equilibrium level of
income (y).
● so the intersection of IS curve and LM curve shows the simultaneous
equilibrium in both the commodity market and money market with equilibrium
rate of interest r and equilibrium level of national income y.

theories of profit
(i) Hawley's Risk Bearing Theory of Profit.
(ii) Uncertainty Theory of Profit.
(iii) Rent Theory of Profit.
(iv) Marginal Productivity Theory of Profit.
(v) Dynamic Theory of Profit.
(vi) Monopoly Theory of Profit.

(1) Hawley's Risk Bearing Theory of Profit:

● This risk bearing theory of profit is associated with the name of F.B. Hawley.
● According to him: "Profit is the reward of risk taking in a business.
(2) Uncertainty Theory of Profit:

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According to Professor Knight:
"Profit is the reward for uncertainly-bearing and not of risk-taking in a business".
3) Rent Theory of Profit:
The Rent Theory of Profit is associated with the name of American
economist, Francis A Walker.According to him: "Profits are of the same genius as
rent". The main points of Walker's Theory of Profit can be summed up as such:
(4) Marginal Productivity Theory of Profit:

According to this theory: "The earning of entrepreneur like the reward of other factors
of production can be explained by the marginal productivity analysis".
(5) Dynamic Theory of Profit:
In the world of reality, according to J.B. Clark: "Profit arises only in a dynamic
economy. An economy is said to be dynamic when there is a change in the
population growth or a change in the method of production or a change in the
consumers wants, etc
6) Monopoly Theory of Profit:
Kalecki's theory of monopoly profits
● Another view point of profit is that monopolistic and monopolistic competition
in the market also give rise to profits.
● The firms under monopoly or monopolistic competition have greater control
over the price of the product.
● They are the price makers rather than the price takers. As such they raise
prices by restricting the level of output and thus keep profit at higher level.
● Monopoly power, thus, is the basic sources of business profits.

(7) Schumpeter’s Innovation Theory of Profit

● Definition: The Innovation Theory of Profit was proposed by Joseph. A.
Schumpeter, who believed that an entrepreneur can earn economic profits by
introducing successful innovations.

● In other words, innovation theory of profit posits that the main function of an
entrepreneur is to introduce innovations and the profit in the form of reward is
given for his performance.

● According to Schumpeter, innovation refers to any new policy that an

entrepreneur undertakes to reduce the overall cost of
production or increase the demand for his products.

● This includes all those activities which reduce the overall cost of production
such as the introduction of a new method or technique of production, the

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 introduction of new machinery, innovative methods of organizing the industry,
etc.

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