1 MS22103 MANAGERIAL ECONOMICS

UNIT - I INTRODUCTION

The themes of economics – scarcity and efficiency – three fundamental economic

problems –society’s capability – Production possibility frontiers (PPF) – Productive
efficiency Vs economic efficiency - economic growth & stability – Micro economies and
Macro economies – the role of markets andgovernment – Positive Vs negative externalities

Meaning:
The word ‘Economics’ originates from the Greek work ‘Oikonomikos’ which can be divided into two
parts:
(a) ‘Oikos’, which means ‘Home’, and
(b) ‘Nomos’, which means ‘Management’.
Thus, Economics means ‘Home Management’. The head of a family faces the problem of
managing the unlimited wants of the family members within the limited income of the family
Definition:
• It is defined as a social science that studies how individuals, governments, firms and
nations make choices on allocating scarce resources to satisfy their unlimited wants.
Economics can generally be broken down into: macroeconomics, which concentrates
on the behavior of the aggregate economy; and microeconomics, which focuses on
individual consumers.
• Economics is the study of how society chooses to use productive resources that
have alternativeuses, to produce commodities of various kinds, and to distribute them
among different groups.
Evolution of Economics
Economics was developed by several economists with different vision. Generally, the
development ofeconomics is divided into:
• Classical Period (1776-1890)
• Neo-Classical Period (1890-1932)
• Modern Period (1932-onwards)
Classical Period (1776-1890)

The famous economists of this period were Adam Smith, T.R. Malthus, J.B. Say, Devid Ricardo,
etc. These economists are pillar of the classical economics. The study of economics in and around
wealth and its significance.

Neo-Classical Period (1890-1932)

The famous economists of this period were Alfred Marshall, A.C. Pigou, Carl Marx, etc. The
study of economics as the satisfaction or welfare derived from the consumption of material goods.

Modern Period (1932-onwards)

The famous economists of this period were Leonel Robbins, J.M. Keynes, etc. The study of
economics for changing the focus of the study are 'wealth and aspect' and 'material welfare' to
'scarcity and choice' and 'human development'.

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Development of Economics
Economists at different times have emphasized different aspects of economic activities, and have
arrived at different definitions of Economics.
These definitions can be classified into four groups:
1. Wealth definitions,
2. Material welfare definitions,
3. Scarcity definitions, and
4. Growth-centered definitions.
Wealth definition:
Adam Smith, considered to be the founding father of modern Economics, defined Economics
as the study of the nature and causes of nations’ wealth or simply as the study of wealth. The
central point in Smith’s definition is wealth creation. He assumed that, the wealthier a nation becomes
the happier. Thus, it is important to find out, how a nation can be wealthy. Economics is the subject
that tells us how to make a nation wealthy.
Material welfare definition:
Alfred Marshall also stressed the importance of wealth. But he also emphasized the role of
the individual in the creation and the use of wealth. He wrote: “Economics is a study of man in the
ordinary business of life. It enquires how he gets his income and how he uses it. Thus, it is on the
one side, the study of wealth and on the other and more important side, a part of the study of man”.
Marshall’s definition is considered to be material- welfare centered definition of Economics.
Scarcity definition:
The next important definition of Economics was due to Prof. Lionel Robbins. In his book
‘Essays on the Nature and Significance of the Economic Science’, published in 1932, Robbins gave
a definition which has become one of the most popular definitions of Economics. According to
Robbins, “Economics is a science which studies human behaviour as a relationship between ends
and scarce means which have alternative uses”. It is a scarcity based definition of Economics.
Modern Growth-Oriented Definition of Samuelson
Professor Samuelson writes, “Economics is the study of how people 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 over time and distributing them for consumption,
now or in the future, among various persons or groups in society. It analyses costs and benefits of
improving patterns of resource allocation”

Nature of Economics:
• Economic theories can broadly be divided into two parts, viz.,
macroeconomics and microeconomics.
➢ Macroeconomics is concerned with the economic magnitudes relating to the whole economy (such
as national income, national production, etc.)
➢ Microeconomics is concerned with the decision-making of a single economic entity (such as a
business firm) within this system
• Prescriptive in nature: Managerial economics actually prescribes the ways through which a
business firm can achieve its goal within its constraints. It prescribes the policies that should be
undertaken by any business firm for achieving its specific target
• Pragmatic in its approach: Managerial economics is pragmatic in its approach because it
emphasizes on the real-life problems faced by any business firm and their possible solutions

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• Emphasizes on quantitative analysis: Managerial economics is mainly concerned with some of
thequantitative aspects of business decisions. Business decisions relating to
(i) output to be produced,
(ii) inputs to be used,
(iii) prices to be fixed,
(iv) estimated cost and revenue schedules, etc., are expressed in quantitative terms
• Economics aims at providing help in decision making by firms.
• Choice and Allocation:
Economics is concerned with decision-making of economic nature. This implies that economics
deals with identification of economic choices and allocation of scarce resources on the best
alternative.
• Multi-disciplinary:
Economics is an integration of different academic disciplines.
• Normative in Nature:
Normative economics makes value judgments and prescribes what should be done to solve
economicproblems.
• Positive Economics
A positive science explains ''why" and "wherefore" of things. i.e. causes and effects
• Economics is both science as well as art also

Scope of Economics:
‘Scope’ means the sphere of study. We have to consider what economics studies and what lies beyond it.
The scope of economics will be brought out by discussing the following.

a) Subject – matter of economics.

b) Economics is a social science
c) Whether Economics is a science or an art?
d) If Economics is science, whether it is positive science or a normative science?

a) Subject – matter of economics:

Economics studies man’s life and work. It does not study how a person is born, how he grows up and dies,
how human body is made up and functions, all these are concerned with biological sciences, Similarly
Economics is also not concerned with how a person thinks and the human organizations being these are a
matter of psychology and political science. Economics only tells us how a man utilizes his limited resources
for the satisfaction of his unlimited wants, a man has limited amount of money and time, but his wants are
unlimited. He must so spend the money and time he has that he derives maximum satisfaction. This is the
subject matter of Economics.
Economic Activity: A worker is working in factory, a doctor attending the patients, a teacher teaching his
students and so on. They are all engaged in what is called “Economic Activity”. They earn money and
purchase goods. Neither money nor goods is an end in itself. They are needed for the satisfaction of human
wants and to promote human welfare.To fulfill the wants a man is taking efforts. Efforts lead to satisfaction.
Thus wants- Efforts-Satisfaction sums up the subject matter of economics.

b) Economics is a social Science:

In early stage, the society has the connection between wants efforts and satisfaction is close and direct. But
in modern Society things are not so simple and straight. Here man produces what he does not consume and
consumes what he does not produce. When he produces more, he has to sell the excess quantity. Similarly,
he has to buy a product which is not produced by him. Thus, the process of buying and selling which is
called as Exchange comes in between wants efforts and satisfaction. Nowadays, most of the
things we need are made in factories. To make them the worker gives his labour, the land lord his land,
the capitalist his capital, while the businessman organizes the work of all these.

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They all get reward in money. The labourer earns wages, the landlord gets rent the capitalist earns
interest, while the entrepreneur’s (Businessman) reward is profit. Economics studies how these
income— wages, rent interest and profits-are determined. This process in called “Distribution: Thus
we can say that the subject-matter of Economics is
1. Consumption- the satisfaction of wants.
2. Production- i.e. producing things, making an effort to satisfy our wants
3. Exchange- its mechanism, money, credit, banking etc.
4. Distribution – sharing of all that is produced in the country.
In addition, Economics also studies“Public Finance”

Macro Economics – When we study how income and employment is generated and how the level
of country’s income and employment is determined, at aggregated level, it is a matter of macro-
economics. Thus national income, output, employment, general price level economic growth etc. are
the subject matter of macro Economics.
Micro-Economic – When economics is studied at individual level i.e. consumer’s behavior,
producer’s behavior, and price theory etc. it is a matter of micro-economics.
c) Economics, a Science or an Art? Whether Economics is a science or an art? Let us first
understand what is terms ‘science’ and ‘arts’ really means.

A science is a systematized body of knowledge. A branch of knowledge becomes systematized when

relevant facts have been collected and analyzed in a manner that we can trace the effects back to their
and project cases forward to their effects. In other words laws have been discovered explaining facts,
it becomes a science, In Economics also many laws and principles have been discovered and hence
it is treated as a science. An art lays down formulae to guide people who want to achieve a certain
aim. In this angle also Economics guides the people to achieve aims, e.g. aim like removal poverty,
more production etc. Thus Economics is an art also. In short Economics is both science as well as
art also.
d) Economics whether positive or normative science:
A positive science explains ''why" and "wherefore" of things. i.e. causes and effects and
normative science on the other hand rightness or wrongness of the things. In view of this,
Economics is both apositive and. normative science. It not only tells us why certain things happen,
it also says whether it is right or wrong the thing to happen. For example, in the world few people
are very rich while the massesare very poor. Economics should and can explain not only the causes
of this unequal distribution of wealth, but it should also say whether this is good or bad. It might
well say that wealth ought to be fairly distributed. Further it should suggest the methods of doing it.

Factors of Production: It refers to the resources used to produce goods and services in a society.
Economists divide these resources into the four categories described below.
• Land refers to all natural resources. Such things as the physical land itself, water, soil, timber
are all examples of land. The economic return on land is called rent. For example, a person
could own land andrent it to a farmer who could use it to grow crops. A second resource is
labor.
• Labor refers to the human effort to produce goods and services. The economic return on labor
is called wages. Anyone who has worked for a business and collected a paycheck for the work
done understands wages. A third factor of production is capital.
• Capital is anything that is produced in order to increase productivity in the future. Tools,
machines and factories can be used to produce other goods. The field of economics differs from
the field of finance and does not consider money to be capital. The economic return on capital
is called interest.
• Entrepreneurship refers to the management skills, or the personal initiative used to combine
resources in productive ways. Entrepreneurship involves the taking of risks. The economic
return on entrepreneurship is profits
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TWIN THEMES OF ECONOMICS

Scarcity and Efficiency refers to the Twin themes of Economics;

Scarcity occurs where it's impossible to meet all unlimited the desires and needs of the peoples
with limited resources i.e.; goods and services. Society must need to find a balance between
sacrificing one resource and that will result in getting other.
Efficiency denotes the most effective use of a society's resources in satisfying peoples wants and
needs. It means that the economy's resources are being used as effectively as possible to satisfy
people's needs and desires.
Thus, the essence of economics is to acknowledge the reality of scarcity and then figure out how
to organize society in a way which produces the most efficient use of resources.
The essence of economics is to acknowledge the reality of scarcity and then figure out how to
organize society in a way which produces the most efficient use of resources. That is where
economics makes its unique contribution

The economic problem

All societies face the economic problem, which is the problem of how to make the best use
of limited, or scarce, resources. The economic problem exists because, although the needs and wants
of people are endless, the resources available to satisfy needs and wants are limited.
‘‘The economic problem is essentially a problem arising from the necessity of choice; choice of
the manner in which limited resources with the alternative uses are disposed of. The problem of
choice making arising out of limited means and unlimited wants is called economic problem.

Why do Economic Problems Arise?

1. Unlimited wants. Human wants are unlimited. As we satisfy one want, many more new
wants come up. Besides this, one cannot satisfy even one particular want for all times to come
2. Different priorities. All wants are not equally important. Some are more important and
some are less. So, a man can satisfy his different wants in order of his priorities.
3. Limited means. If means would have also been unlimited to satisfy unlimited wants, there
would have been no economic problem. The reality of the life is different i.e., the existing
supply of resources is inadequate in relation to the known desires of individuals. This gives
rise to the problem of scarcity which is the basis of all economic problems.
4. Means having alternative uses. Means are not only limited but they can also be used for
different alternative uses. For example, wood may be used for fuel, furniture, house
construction and many other uses

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BASIC OR CENTRAL OR FUNDAMENTAL PROBLEMS OF ECONOMY

I. Allocation of Resources
The available resources of the society may be used to produce various commodities for
different groups and in different manner. It requires that decisions regarding the following should
be made:

1. What to produce? (Types and amount of commodities to be produced)

Land, labour, capital, machines, tools, equipments and natural means are limited. Every demand of
every individual in the economy cannot be satisfied, so the society has to decide what commodities
are to be produced and to what extent. Goods produced in an economy can be classified as consumer
goods and producer goods. These goods may be further classified as single use goods and durable
goods.

Factors which determine what to produce:

• Consumers’ needs – The producers would have to take into consideration the needs of the
consumers. They have to decide what needs to produce, the quantity and quality of goods and services
required by the consumers.
• Market demand – The demand of a particular set of goods and services by consumers may
encourage producers to produce more of these goods.
• Consumer income – In deciding what to produce, the producer normally take into consideration the
earnings of the consumers in the society. Producers normally ask themselves this question: Are the
consumers earning enough to be able to purchase the goods and services at a given price when
produced.if yes, they go ahead and produce but if no, they may not produce.
• Cost of production – He produces when the cost of production is low to enable him make some profit.
• Availability of resources: When resources of production are available and affordable, the
producers will be encouraged to produce goods and services. Since economic resources are scarce
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or limited, it follows that the producers may not always have enough to produce commodities in
abundance to meet the needsof the consumers.
• Type of economy - The type of economic system in a given society determines the type and quantity
of goods and services to be produced. For example, in a capitalist economy, the price system
determines the type and quantity of goods and services as profit is the major determinant whereas in
a socialist economy, the state controls and directs the allocation of resources hence it decides what
to produce with the sole aim of satisfying the wants of the whole citizens of the society or state.

2. HOW TO PRODUCE? (Problem of the selection of the technique of production)

After the decision regarding the goods to be produced is taken, next problem arises as to what
techniques should be adopted to produce commodity. Goods can be produced in large-scale
industries or in small-scale village and cottage industries.
Factors which determine how to produce:
• Technique of production – This involves the level of involvement of human labour and
machines. The two techniques of labour are (a) labour intensive and (b) capital intensive.
• Technological advancement – The method of production adopted by the individual, firm
or state depends on the level of technological development of the state.
• Production function – This involves any analysis which shows the possible quantity of
goods by using each of the given alternative combination of resources that produces the
largest quantity of output at the lowest unit of cost of production.
• cost of factors of production – The cheaper the relative cost of factors of production, the
more the production of goods and services to satisfy human wants.
3. FOR WHOM TO PRODUCE? (Problem of distribution of income):
Goods and services produced in the economy are consumed by its citizens. The individuals
may belong to economically weaker sectioned or rich class of people. Actually, this is the problem
of distribution. All goods and services produced must get to the final consumers.

Factors which determine who to produce for

• Satisfaction of wants or needs of the consumers.
• Level of income – the higher the level of income of the consumer, the more they are
able to buy goodsand services produced.
• Type of economic system practiced in the society.

II. Fuller Utilization/Employment of Resources (Efficient use)

Out means and resources are limited and scarce, so they should be properly used. There should
not be the wastage of these resources. The problem with the economy is how to use its available
resources i.e., land, labour, capital and other resources, so that maximum production with minimum
efforts and wastages be made possible
III. Growth of Resources (Economic development)
Increase in the population is the common feature of the economy. It becomes necessary that
the rate of economic development must be faster than the rate of increase in the population, so that
the economic development may take place and the reasonable standard of living of the citizens can
be maintained. In this connection, the economy has to decide about the rate of capital formation,
investment and savings
Society’s capability:
• Takes the initiative in combining the resources of land, labour, and capital
• Makes strategic business decisions
• Is an innovator
• Commercializes new products, new production techniques, and even new forms of business
organization
• Takes risk to get profits
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Production Possibility Frontier (PPF) Definition:
The production possibility frontier
Production Possibility Frontier represents the point at which an economy is most
efficiently producing its goods and services and, therefore, allocating its resources in the best way
possible. If the economy is not producing the quantities indicated by the PPF, resources are being
managed inefficiently
Production Possibility Curve
Production Possibility Curve is a curve that shows the possible combinations of any
two economicgoods an economy can produce by using the available scarce resources.

Assumptions of the concept

1. Human wants are unlimited.
2. The resources are limited but which has alternative uses
3. It takes into consideration the production of only two goods. However, in reality the economy
willproduce many goods. The life on the earth is not possible only with two goods.
4. It also assumes that the economy has utilized scarce resources efficiently and fully. In other
words, theeconomy is in full employment.
5. PPC is drawn provided that the state of technology is given and it remains constant over the period.
6. Resources available in the economy (which are called factors of production such as land, labour,
capital and organizer) are fixed and constant. However, resources can be shifted from one
commodity to another.
7. The economy is not able to change the quality of the factors of production. They are also
given andconstant.
8. It is also assumed that the production only related to short-period rather than long period
Explanation of PPF
Imagine an economy that can produce only wine and cotton. According to the PPF, pointsA, B and
C - all appearing on the curve - represent the most efficient use of resources by the economy. Point
X represents an inefficient use of resources, while point Y represents the goals that the economy
cannot attain with its present levels of resources.

As we can see, in order for this economy to produce more wine, it must give up some of the resources
it uses to produce cotton (point A). If the economy starts producing more cotton (represented by
points B and C), it would have to divert resources from making wine and, consequently, it will
produce less wine than it is producing at point A. As the chart shows, by moving production from
point A to B, the economy must decrease wine production by a small amount in comparison to the
increase in cotton output. However, if the economy moves from point B to C, wine output will
be significantly reducedwhile the increase in cotton will be quite small. Keep in mind that A, B, and
C all represent the most efficient allocation of resources for the economy; the nation must decide
how to achieve the PPF and which combination to use. If more wine is in demand, the cost of
increasing its output is proportional tothe cost of decreasing cotton production.
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Point X means that the country's resources are not being used efficiently or, more specifically, that
the country is not producing enough cotton or wine given the potential of its resources. Point Y, as
we mentioned above, represents an output level that is currently unreachable by this economy.
However, if there was changes in technology while the level of land, labor and capital remained the
same, the time required to pick cotton and grapes would be reduced. Output would increase, and the
PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new
efficient allocation of resources

Importance and Application of the Concept:

The concept has got the following importance:

1. Since PPC shows the productive capacity of the economy, it gives reliable answers for
the fundamentaleconomic problems of what to produce?, How to produce?, and To whom to
produce?.

2. Secondly, it illustrates the concept of opportunity cost. Here the country is trying to produce any
two goods. So the production of the one commodity can be increased by reducing the production of
other good. This is due to the fact that economic resources are scarce. Also opportunity cost ratios can
be calculated.

3. Thirdly, it leads to the efficient allocation of scarce economic resources. More resources
should be diverted to the commodity that economy demands more than another commodity.

4. It illustrates the productive potential of the economy. The growth of the economy can be judged
from the shifts in the PPC. Economics growth in both quantitative and qualitative terms can be known
from PPC.

5. It is very useful in order to achieve the social welfare of the community.

6. Last but not least, PPC can be used by the producers to make their decisions regarding the
use of factors ofproduction and it assist in the determination of the costs of the production.

PPC, therefore, shows unemployment of resources, Technological Progress, economic growth and
economicefficiency. According to Professor Dorfman,

PPC explains three efficiencies. They are:

1. Efficient selection of goods to be produced,

2. Efficient allocation of resources in the production of these goods with efficient
choice of method of production, and
3. Efficient allotment of the goods produced among consumers.

Usually this concept is applied for individual countries. Also this concept can be applied to the
individual companies, farms etc. to find out the production possibilities.

B. Opportunity Cost

Opportunity cost is the value of what is foregone in order to have something else. This value is
uniquefor each individual.
You may, for instance, forgo ice cream in order to have an extra helping of mashed potatoes. For you,
the mashed potatoes have a greater value than dessert. But you can always change your mind in the
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future because there may be some instances when the mashed potatoes are just not as attractive as the
ice cream. The opportunity cost of an individual's decisions, therefore, is determined by his or her needs,
wants, time and resources (income). This is important to the PPF because a country will decide how to
best allocate its resources according to its opportunity cost

In the above diagram, when the economy moves from point B to point C, there is an increase
in consumergoods from 60 to 75 units, and a fall in capital goods from 60 to 30. So it could be said
that, to increase the production of consumer goods by 15 units, there is an opportunity cost of 30
units of capital goods, i.e. We have to give up capital goods to produce more consumer goods

C. Trade, Comparative Advantage and Absolute Advantage

Specialization and Comparative Advantage

An economy can focus on producing all of the goods and services it needs to function, but this may
lead to an inefficient allocation of resources and hinder future growth. By using specialization, a
country can concentrate on the production of one thing that it can do best, rather than dividing up
its resources.

For example, let's look at a hypothetical world that has only two countries (Country A and
Country B) and two products (cars and cotton). Each country can make cars and/or cotton. Now
suppose that Country A has very little fertile land and an abundance of steel for car production.
Country B, on the other hand, has an abundance of fertile land but very little steel. If Country A
were to try to produce both cars and cotton, it would need to divide up its resources. Because it
requires a lot of effort to produce cotton by irrigating the land, Country A would have to sacrifice
producing cars. The opportunity cost of producing both cars and cotton is high for Country A, which
will have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity
cost of producing both products is high because the effort required to produce cars is greater than
that of producing cotton.

Each country can produce one of the products more efficiently (at a lower cost) than the other.
Country A, which has an abundance of steel, would need to give up more cars than Country B would
to produce the same amount of cotton. Country B would need to give up more cotton than Country
A to produce the same amount of cars. Therefore, County A has a comparative advantage over
Country B in the production of cars, and Country B has a comparative advantage over Country A in
the production of cotton.

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Absolute Advantage
Sometimes a country or an individual can produce more than another country, even though
countries both have the same amount of inputs. For example, Country A may have a
technological advantage that, with the same amount of inputs (arable land, steel, labor), enables
the country to manufacture more of both cars and cotton than Country B. A country that can
produce more of both goods is said to have an absolute advantage. Better quality resources can
give a country an absolute advantage as can a higher level of education and overall technological
advancement. It is not possible, however, for a country to have a comparative advantage in
everything that it produces, so it will always be able to benefit from trade.

Shifts in Production Possibility Frontier:

An outward shift of a PPF Inward Shift of a PPF

Reasons for an outward shift in the PPF:

• an increase in factor resources
• an increase in the efficiency (or productivity) of factor resources
• an improvement in technology

Reasons for an inward shift in the PPF:

• Investment spending is insufficient to replace worn out capital goods
• Natural disaster (hurricanes, tsunami, floods etc.)
• Civil war

Economic Efficiency :Definition

It is defined as an economic state in which every resource is optimally allocated to serve
each person inthe best way while minimizing waste and inefficiency.
In absolute terms, a situation can be called economically efficient if:
• No one can be made better off without making someone else worse off (commonly
referred to as Paretoefficiency).
• No additional output can be obtained without increasing the amount of inputs.
• Production proceeds at the lowest possible per-unit cost
When an economy is economically efficient, any changes made to assist one person would
harm another. Interms of production, goods are produced at their lowest possible cost, as are the
variable inputs of production

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Types of Economic Efficiency:
1. Productive efficiency: This occurs when the maximum number of goods and services are produced
with a given amount of inputs.

Productive efficiency will also occur at the lowest point on the firms average costs curve. Thus,
Productive efficiency is concerned with producing goods and services with the optimal combination of
inputs to produce maximum output for the minimum cost. To be productively efficient means the
economy must be producing onits production possibility frontier.
• Points A and B are productively efficient.
• Point C is inefficient because you could produce more goods or services with no opportunity cost

2. Technical Efficiency:
Optimum combination of factor inputs to produce a good: related to productive efficiency. Technical
efficiency is the effectiveness with which a given set of inputs is used to produce an output. A firm is
said to be technically efficient if a firm is producing the maximum output from the minimum quantity
of inputs, such as labour, capital and technology.
For example, a firm would be technically inefficient if a firm employed too many workers than was necessary

3. X inefficiency: This occurs when firms do not have incentives to cut costs .
For Example:
Not Finding Cheapest Suppliers. Out of inertia, a firm may continue to source raw materials from a high
cost supplier rather than look for cheaper raw materials.

4. Pareto efficiency is however, a situation where resources are distributed in the most efficient
way. It is defined as a situation where it is not possible to make one party better off without making
another party worse off. Pareto efficiency is said to occur when it is impossible to make one party better
off without making someone worse off. It is an economic state where resources are distributed in the
most efficient way

5. Allocative efficiency:
This occurs when goods and services are distributed according to consumer preferences. An economy
could be productively efficient but produce goods people don’t need this would be allocative inefficient.
Allocative efficiency occurs when the price of the good = the MC of production

6. Static Efficiency:
It is concerned with the most efficient combination of resources at a given point in time. Static efficiency
has two aspects. The first is that there is maximum output of goods given the volume of resources in
the economy. Second, the goods produced must be a preferred combination

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7. Dynamic efficiency: This refers to efficiency over time. Dynamic efficiency involves the
introduction of new technology and working practices to reduce costs over time. With this mind, we
can define dynamic efficiency as an aspect of economic efficiency that measures the speed or the rate
at which the production possibility curve moves from one static equilibrium point to another within a
given period.

8. Distributive Efficiency:
It is concerned with allocating goods and services according to who needs them most. Therefore,
requires an equitable distribution. Distributive efficiency occurs when goods and services are consumed
by those who need them most

9. Social efficiency: is the optimal distribution of resources in society, taking into account all
external costs and benefits as well as internal costs and benefits. Social Efficiency occurs at an output
where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC). Thus, social efficiency occurs
when externalities are taken into consideration and occurs at an output where the social cost of
production (SMC) = the social benefit (SMB).

Economic Growth & Stability:

Meaning:
Economic growth is defined as an increase in the output that an economy produces over a period of
time, the minimum being two consecutive quarters.
Economic growth is an increase in what an economy can produce if it is using all its scarce
resources. Anincrease in an economy’s productive potential can be shown by an outward shift in the
economy’s production possibility frontier (PPF).
An outward shift of a PPF means that an economy has increased its capacity to produce.

Reasons behind Economic Growth:

Employs new technology
• Investment in new technology increases potential output for all goods and services because new
technology is inevitably more efficient than old technology.
• An economy will not be able to grow if an insufficient amount of resources
are allocated tocapital goods.
Employs a division of labour, allowing specialization
• A division of labour refers to how production can be broken down into separate tasks, enabling
machines to be developed to help production, and allowing labour to specialise on a small range of
activities.
• A division of labour, and specialisation, can considerably improve productive capacity, and shift the
PPF outwards.
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Employs new production methods
• New methods of production can increase potential output.
• The widespread use of computer controlled production methods, such as robotics, has dramatically
improved the productive potential of many manufacturing firms.
Increases its labour force
• Growth in the size of the working population enables an economy to increase its potential output.
Discovers new raw materials
Discoveries of key resources, such as oil, increase an economy’s capacity to produce.

Investment

• Allocating scarce funds to capital goods, such as machinery, is referred to as real investment.
• If an economy chooses to produce more capital goods than consumer goods, at point A in
the diagram, then it will grow by more than if it allocated more resources to consumer goods,
at point B, below.
• To achieve long run growth the economy must use more of its capital resources to produce
capital rather than consumer goods
Factor mobility
If workers, or other resources, are moved from one sector to another, then the position of the PPF
will change, with an increase in the maximum output in the industry receiving the resources, and a
fall in the maximum output of the industry losing resources

Policies for Economic GrowthFiscal stabilizers

• Built-in automatic fiscal stabilizers, which include progressive taxes and escalating welfare
payments,provide a shock absorber to stabilize an economy following an economic shock.
• The combined effect of these is to create fiscal drag during periods of unusually strong
growth, and fiscal boost during periods of very weak growth or negative growth.
• Effective policies and institutions the rule of law, and political stability enhance economic growth
• Infrastructure is a key component of an enabling environment for economic growth. Enterprises
need adequate transportation systems from rural roads to airports and ports to access markets for
their goods and services.
• A skilled workforce is an important foundation of sustainable economic growth.
• Women play a central role as income earners, in lifting themselves, their families, and their
communities out of poverty.
• Agriculture is the largest economic sector in many developing countries. It is a significant
generator of employment, contributing to poverty reduction and food security
• sound environmental management: Sustainable and responsible management of natural
resources andappropriate responses to climate impacts that enable the long-term viability of the
economy
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• Technology policy
Technology policy refers to policies where government provides incentives for private firms to
invest into new technology. These incentives could be in the form of grants, cheap loans, or tax
relief.
• Reducing red-tape and de-regulation
A key driver of growth for both developed and developing countries is FDI, and this can be
encouragedby reducing red tape and unnecessary regulation, and opening up markets to overseas
investors.
• Deregulation is when the government reduces or eliminates industry restrictions to improve the ease
of doing business. The government will remove a regulation when businesses complain it interferes
too much with their ability to compete, especially with foreign companies. However, consumer
groups canalso prompt deregulation by pointing out how industry leaders are too cozy with their
regulatory authority
• Providing incentives
National governments can provide incentives for individuals to start their own business and for small
businesses to expand.
• Tax reform
Redesigning the tax and benefit system to increase the labour activity rate and encourage work and
discourage idleness is clearly an important option for countries wishing to improve their supply-side
performance.
• Increasing competitiveness and contestability
Another important stimulus to supply-side growth is to increase the degree of competitiveness in the
micro-economy by promoting contestability, reducing barriers to entry, and by deregulating markets
to encourage new entrants.
• New markets
Sustainability can also be achieved by encouraging the formation of new markets which exploit new
technology or new trading methods. The newly emerging markets for waste and carbon credits, and
the development of carbon offsetting schemes, are recent examples of how new markets can emerge,
with or without government support.
• Infrastructure
Long-term development of infrastructure projects is also central to the promotion of long terms
growthand development in a globalised environment. Better infrastructure enables output to be
transported atlower cost, as well as generating jobs and other positive externalities

Economic Stability
Economic stability refers to an economy that experiences constant growth and low inflation.
Advantages of having a stable economy include increased productivity, improved efficiencies, and
low unemployment. Common signs of an instability are extended time in a recession or crisis, rising
inflation, and volatility in currency exchange rates. An unstable economy causes a decline in consumer
confidence, stunted economic growth, and reduced international investments

Micro economies and Macro economies Micro Economics definition

Microeconomics is that branch of economics which is concerned with the decision-making of a single
unit of an economic system.
• How does an individual (or a family) decide on how much of various commodities
and services toconsume?
• How does a business firm decide how much of its product (or products) to produce?
• Determination of income, employment, etc. in the economic system as a whole is not
the concern ofmicroeconomics.
Thus, microeconomics can be defined as the study of economic decision-making by micro-units.

Importance of Micro Economics

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1. Determination of demand pattern:

It determines the pattern of demand in the economy, i.e., the amounts of the demand for the
different goods and services in the economy, because the total demand for a good or service
is the sum total of the demandsof all the individuals.
2. Determination of the pattern of supply
The pattern of supply in the country as a whole can be obtained from the amounts of goods
and services produced by the firms in the economy. Microeconomics, therefore, determines the
pattern of supply as well.
3. Pricing:
By determining demand and supply, microeconomics helps us in understanding the process of
price determination. The prices of the various goods and services determine the pattern of
resource allocation in the economy.
4. Policies for improvement of resource allocation
Economic development stresses the need for improving the pattern of resource allocation in
the country. Development polices, therefore, can be formulated only if we understand how the
pattern of resource allocation is determined.
5. Solution to the problems of micro-units:
Finally, it goes without saying that, since the study of microeconomics starts with the
individual consumers and producers, policies for the correction of any wrong decisions at the
micro-level are also facilitated by microeconomics. For example, if a firm has to know exactly
what it should do in order to run efficiently, it has to know the optimal quantities of outputs
produced and of inputs purchased

Limitations of Microeconomics
1. Monetary and fiscal policies:
The role of monetary and fiscal policies in the determination of the economic
variables cannot beanalyzed completely without going beyond microeconomics
2. Income determination:
Microeconomics also does not tell us anything about how the income of a
country (i.e., nationalincome) is determined.
3. Business cycles
Microeconomics does not help us in understanding as to why there are fluctuations occurs
in businesscycles and what the remedies are.
4. Unemployment
One of the main economic problems faced by an economy like India is the problem of
unemployment.This, again, is one of the areas on which microeconomics does not shed
much light.

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Macroeconomics
Macroeconomics is the branch of economics that studies the behavior and performance of
an economy as a whole. It focuses on the aggregate changes in the economy such as unemployment,
growth rate, gross domestic product and inflation.

Importance of Macroeconomics
1. Income and employment determination
The determinations of national income and of total employment in the country are vital
concerns of macroeconomics
2. Price level:
The determination of the general price level is discussed in Macroeconomic theories.
Upward movement of the general price level is known as inflation. Thus, if we want to understand
the process of inflation and find ways of controlling it, we must resort to the study of
macroeconomics.
3. Business cycles: The economic booms and depressions in the levels of income and employment
follow one another in a cyclical fashion. While income rises and employment expands during boom
periods, they shrink during depressions. Since depressions bring business failures and unemployment
in their wake, economists have sought remedies to depressions.
4. Balance of payments: The difference between the total inflow and the total outflow of foreign
exchange is known as the balance of payments of a country. When this balance is negative (i.e.,
outflow exceeds inflow), the country faces a lot of economic hardships. The causes and remedies of
such balance of payments problems are discussed in macroeconomics.
5. Government policies: The effects of various government policies on the economic variables like
national income or the general price level are also studied in macroeconomics.
6. Interrelations between markets: Probably, the most important contribution of macroeconomic
theories is to show that different markets of the economic system (for example, the commodity
market, the labour market, the bond market, the money market, etc.) are interrelated. Any disturbance
in one of these markets affects all the others.

Differences between Microeconomics and Macroeconomics

Microeconomics Macroeconomics
It is that branch of economics which deals with It is that branch of economics which deals with
the economic decision-making of individual aggregates and averages of the entire economy,e.g.,
economic agents such as the producer, the aggregate output, national income, aggregate
consumer, etc. savings and investment, etc.
It takes into account small components of the It takes into consideration the economy of any
whole economy. country as a whole
It deals with the process of price determination It deals with general price-level in any
in case of individual products and factors of economy
production
It is concerned with the optimization goals of It is concerned with the optimization of the
individual consumers and producers (e.g., growth process of the entire economy.
individual consumers are utility-maximisers, while
individual producers are profit maximisers.)
Microeconomic theories help us in formulating Macroeconomic theories help us in formulating
appropriate policies for resource allocation at the appropriate policies for controlling inflation (i.e.,
firm level. rising price-level), unemployment, etc.
It takes into account the aggregates over It takes into account the aggregates over
homogeneous or similar products (e.g., the heterogeneous or dissimilar products (say, the
supply of steel in an economy.) Gross Domestic Product of any country during
any year
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Role of Governments in managing the growth in Emerging/Developing Economies

I. Role of Government as a Regulatory and Growth promoting body

1. Monetary and Fiscal Policies

Modern economics is greatly influenced by Keynesian theories propounding the increased
role of governments in regulating and stabilizing markets to ensure stable growth. Keynesian
economics argues that private sector decisions sometimes lead to inefficient macroeconomic
outcomes and therefore advocates active policy responses by the public sector, including monetary
policy actions by the central bank and fiscal policy actions by the government to stabilize output over
the business cycle. In the Keynesian economic model, the government has the very important job of
smoothening out the business cycle bumps. They stress on the importance of measures like
government spending, tax breaks and hikes, etc. for the best functioning of the economy.
Monetary Policy works by lowering the interest rates, which attractive private companies to
invest in real assets which increase the aggregate demand indirectly, by raising the private sector
expenditure. The opposite is also done to reduce the money supply in the economy so that inflationary
tendencies are minimized and economy over-heating is prevented.
Fiscal Policy is more direct, but acts more slowly. It works by increasing demand for goods.
Government does the borrowings to build roads, buildings etc., does the tax cutting, and tries to
put more spending power in the hands of households.
Traditionally, the working of monetary policies can be summed up as: Central Bank lowers
the interest rates as a result injecting liquidity in the financial system. Commercial banks try to
lend the additional money leading to the falling of interest rates further. This leads to the fact that
risky business becomes profitable. Firms and houses, as a result, begin to buy more number of goods,
thereby increasing employment.
The financial tools available in the hands of the Reserve Bank of India to control the monetary and
fiscal policies are:
1. Bank Rate: It is the Discount Rate, rate which the central bank charges on loans and advances to
commercial banks (Short term).
2. Repo Rate: It is the rate at which the RBI lends money to commercial banks, a short term for
repurchase agreement. A reduction in the repo rate will help banks to get money at a cheaper rate. It
is equivalent to the discount rate of US. (Long term).
3. Reverse Repo Rate: It is the rate at which Reserve Bank of India (RBI) borrows money from banks.
4. Cash Reserve Ratio (CRR): It indicates the amount of funds that the banks have to keep with RBI.
If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI
is using thismethod to drain out the excessive money from the banks
5. Statutory Liquidity Ratio (SLR): It is the amount a commercial bank needs to maintain in the
form of cash, or gold or govt. approved securities (Bonds) before providing credit to its customers.
SLR rate is determined and maintained by the RBI in order to control the expansion of bank credit.
Thus, through the use of Monetary and Fiscal policies, the government can effectively control
the money supply and hence the demand fluctuations of the market. This is essential as growth cannot
be uncontrolled. An uncontrolled spiral of growth invariably is built on shaky foundations which are
bound to cave in bringing everything crashing down. Until growth of the economy is backed by
strong fundamentals, the speculativetrading would remain strictly short term with the specter of a
long term crash imminent. The sub-prime mortgage crisis caused by speculative trading in realty is
an apt example of such a scenario. This long term thinking is what stabilizes growth and makes
emerging economies an attractive destination since they have robust fundamentals.
2. Production in Core Sectors
The government steps in for production of goods or services in areas which either are economically
unviable for private enterprise, natural monopolies requiring heavy capital investments or are
restricted from private industry participation. Investment and growth of these sectors are in the best
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interests of the nation. However, some of these industries require very high capital investment and
may achieve break-even after many years. This makes it an unviable project to be invested and
pursued by private enterprise that is mostly answerable to shareholders for their business results. The
role of governments here is to invest in the long term growth and development of the nation. Pandit
Nehru, the first Prime Minister of India, called these as nation building activities which required
state involvement for sharing the fruits of growth and prosperity with the entire society. The
investment of government in such areas as infrastructure also provides a firm foundation for the future
growth of the country. Infrastructure provides connectivity, new untapped markets and a chance to
boost commerce in distant corners of the nation. Secondly, such capital investments provide
employment opportunities as well as a boost to the country’s GDP. This GDP boost also in turn
shows an effect on the valuation of the private firms trading through the stock markets (see Figure
1). Government can also use this as a chance to collaborate with indigenous industries and increase
their growth prospects. Thus, similar to the magic multiplier effect in banks, the government capital
infusion and government controlled industries produce multiple positive effects on the economy thus
producing robust growth prospects.
Sectorial spending patterns of governments reveal that the emphasis is towards promoting areas
having
lower growth as well as empowering disadvantaged sections of the nation to ensure the trickling
down of prosperity in an equitable manner. Additionally, government spending even in developed
countries is seen in such areas such as education, law and judiciary, healthcare, pension schemes and
defense. This shows the central role of government in nation building for the future as well as in
providing services for the betterment of the citizens.
3. Regulatory Responsibilities
The governments in emerging economies also shoulder regulatory responsibilities which
enable it to control various macro-economic aspects of the economy. Through regulation,
government can iron out the inconsistencies and inefficiencies of the market as well as shape the
economic environment as per the shifting global and local trends. Regulations are essential in
certain areas to ensure fair practices, preservation of rights and the empowerment of the citizens.
Government also holds in its grips the tariff regulations which enable it to preserve the indigenous
small scale industries from global competition as well as prevent dumping of inferior goods on local
markets. The presence of multinational companies and low cost markets abroad having incentive
to dump such rejected goods in the market can skew the prices and hence create inefficiencies in the
free market price discovery process as well. This kind of actions can severely affect indigenous
industries and can result in monopolies emerging. The regulation of trade is another key focus area
of policy since unrestricted trade can lead to local markets facing inflation. The working of the SEBI
(Security Exchange Board of India), IRDA (Insurance Regulatory and Development Authority and
other such regulatory bodies working in tandem with central and state government in India ensure
that legal and ethical practices are followed and the general public is given a fair deal.
Overall, we can see the central role taken up by government in controlling and shaping the
growth in emerging economies. While their involvement definitely has its benefits, there needs to be
a balance since open market policies work best when they have minimal intrusions from external
entities so that pure market forces determine the valuations and expectations of the consumers.
Stringent government regulation and high tariff walls lead to protectionist tendencies which can
choke private industries and mar the conducive environment for foreign investment.
4. Providing the economy with a legal structure:
This is the first and most important function a government should provide and without it an
economy may collapse. This function requires the government to ensure property rights, provide
enforcement of contracts, act as a referee and impose penalties for foul play. In order to perform
this function, the government should furnish the economy with regulations, legislations, and means
that ensure product quality, define ownership rights and enforce contracts. Our legal system, the
FDA, The FED and SEC are examples of how the government fulfillsthis task.

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5. Maintaining competition:
Since competition is the optimal and efficient market mechanism that encourages producers
and resource suppliers to respond to price signals and consumer sovereignty, the government
should fight monopoly powerand non-competitive behavior. Thus, anti-monopoly laws (Sherman
Act of 1890; Clayton Act of 1913) are designed to regulate business behavior and promote
competition. It is important to mention here that Microsoft was found guilty of violating these laws
in 2000.
6. Redistribution of income:
The government should strive to provide relief to the poor, dependent, handicapped, and
unemployed. Welfare, Social Security and Medicare programs are examples of programs that
support the poor, sick and elderly. These programs are built on transferring income from the high
income groups to the limited income ones, through progressive taxes. Other means of redistribution
might include price support programs such as the farm subsidy and low interest loans to students
based on their family incomes.
7. Provision of public goods and quasi-public goods:
When the markets fail to provide the needed goods or the correct amounts of certain goods or
services, the government fills in the vacuum. Examples of public goods that the markets do not
provide are defense, security, police protection and the judicial system. Education and health
services are examples of quasi-public (merit) goods that the market does not provide enough of.
The government should provide the first, and help in the provision of the second.
8. Promoting growth and stability:
The government (assisted by the Fed) should promote macroeconomic growth and stability
(increasing the GDP, fighting inflation and unemployment) through changes in its fiscal and
monetary policies. The fiscal policies means the use of taxes and spending and it is managed by the
executive branch represented mainly by the Treasury Department. The monetary policies signifies
the use of interest rates, money supply, reserve requirements, etc. and it is managed by RBI.
9. Providing the Legislative Framework
The government provides a clear and predictable legal framework for businesses. Regulations are
administered in an open and transparent system, and applied fairly to all parties. The government
makes it clear to businesses that it deals with them solely on the merits of their case. There is no
favoured treatment for local companies or for government-linked companies.
10. Providing a Stable Environment for Businesses
Fiscal policy in Singapore is guided by the principle that it should support the private sector as the
engine of growth and ensures that the macro-environment is stable. The Singapore government has
been prudent and conservative in its budgetary policy. It has balanced its budget in nearly every year
for the last 3 decades. Monetary policy is geared towards keeping inflation low and stable for long-
term competitiveness and to ensure that savings are not debased. The government also sets clear and
transparent ground-rules and ensures that markets are competitive, for example, by ensuring that
imports are allowed to come in freely.
11. Investing in Infrastructure and Manpower
The government invests in infrastructure and manpower, areas in which the private sector is likely to
under- invest. It ensures that the education and training system is geared towards the needs of the
economy, with a strong emphasis on providing technical and professional manpower. Similarly, an
efficient infrastructure lowers business costs and makes it attractive for investors to come to
Singapore.
12. Facilitating Businesses
The government facilitates businesses, including foreign investors wishing to come to Singapore.
This function is carried out mainly by promotional agencies like the Economic Development Board
and the International Enterprise Singapore.

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13. Providing Public Goods and Ensuring Positive Externalities
Public goods and externalities (defined below) provide the main theoretical justifications for
government production. Public goods are those that can be enjoyed by an unlimited number of
people without prejudice to one another and without exclusion of others. Some examples include
lighthouses, national defenses, the legal system, and parks. Public goods are also indivisible; they
must be produced in such large units that they cannot ordinarily be sold to individual buyers. Because
of these characteristics, it is not feasible to charge for their consumption; therefore, private suppliers
lack the incentive to supply them.

Externalities, or spillovers, occur when some of the costs or benefits of an economic activity are passed
on (or spill over) to parties other than the immediate seller or buyer. Some externalities have a
beneficial effect on others and are referred to as positive externalities; those that have a detrimental
effect are referred to as negative externalities. Pollution is an example of a negative externality, whereas
investment in research and development, training, and education have positive spillovers and thus are
positive externalities. The market, left on its own, will tend to produce too many goods and services
that carry negative externalities (indicating a need to tax those externalities or impose restrictions on
their emergence) and too few goods and services involving positive externalities (indicating a need to
subsidize them or have them provided publicly)

Role of Market in economy

1. Price Discovery:
Economists have traditionally believed that there exists an invisible hand in a free market
based economy, which bring a state of equilibrium in market and this in-turn result in price
discovery. Advocates of the free market form of economy argue that price discovery is a natural
process that ensures fair, accurate, and responsive pricing. The essential philosophy of price
discovery is that firms maximize their profit and consumers maximize their benefits. The
preconditions for price discovery to happen are the presence of a large number of buyers and sellers,
absence of any buyer/seller having absolute power to influence the market and absence of any form
of information asymmetry among the parties involved. This concept of price discovery is the most
intrinsic feature of a free market based economy. The mechanism of price discovery ensures that
there is an unbiased way to determine the intrinsic value of any good in the market. Through the
presence of a large number of buyers and sellers, the continuous exchange of goods enables all parties
involved to obtain the best value with minimal inaccuracies. This technically ensures that skewed
pricing schemes or incorrect valuation is not followed and every product has a constantly varying
price affected by its quality and the nature of its demand. This dynamicity brings out the competitive
forces in the market and ensures that innovation is always at the forefront of any industry policy.

2. Foreign Investment Opportunities:

A major attraction of following free market policies is its ability to attract foreign investors
into funding growth and development projects in the country. Foreign investors and angel investors
generally look for high growth opportunities to invest their money in as seen by the increasing FII
and FDI inflows into India. With the maturity of developed markets and flat growth seen in such
economies, these developed countries divert large sums of money into such emerging investment
locations offering higher growth rates. The only caveat is the added risk introduced into their
investment profile. For this reason, such investment vehicles generally prefer politically stable and
economically progressive countries which have transparent policies and lower regulations on
investments. Such foreign investments are crucial for augmenting the government spending on key
sectors like education, healthcare, infrastructure, natural resources.
An over dependence on these inflows would leave a country in a sensitive position where
may lead to huge outflows of investment. The onus is firmly on these emerging countries to establish
and maintain a stable environment conducive for investment and presenting a balanced picture of
sustainable growth. There are many instances of economies encountering pricing bubbles and
speculative trading on the back of erratic foreign investments. So not only is it essential that
investment is attracted, but regulations must also be made to limit these inflows to ensure
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sustainable growth. The inflationary tendencies of the economy as well as the speculative valuation
of stocks on the back of FII and FDI inflows are well documented and hence need extra caution to be
exercised.
3. Growth in GDP:
Gross Domestic Product or GDP is a primary measure of the vitality of an economy as it
conveys the dollar value of all the goods and services produced by that country over a specified
period of time. As can be clearly seen, a robust and dynamic market can spur growth in the
investment in private industries which in turn helps fund their growth plans. The highly capital
intensive nature of heavy industries and core sectors requires heavy investments and this is where
markets come into the picture. Through the stock markets as well as foreign investment vehicles,
industries gain the capital required to pursue high growth strategies and scale up their businesses.
This in turn results in increased production of goods and services and hence a robust GDP growth.

4. Rise of the Consumer

The market structure promotes transparency of pricing, infusion of cash for growth
initiatives and provides competitively priced technologically superior products in the hands of the
consumers. In addition to this, the growth impetus provided by market economies results in huge
employment opportunities resulting in increased per capita income. This increased income thus
boosts consumer spending and helps in developing high growth markets internally. The presence
of large number of competitive firms in every sphere helps shift thepower into the hands of the
consumer and empowers him to make informed decisions. Consumer spending accounts for nearly
60% of the total GDP of United States of America and international trends show the importance of
a strong local consumer demand to ensure robust growth patterns.
As we have seen above, there are numerous benefits of an open economy which triggers and sustains
high growth in an economy. However, an area of concern is the formation of asset and valuation
bubbles due to large inflows of investments. Since emerging economies are currently riding high on
consumer sentiments, FIIs and FDIs are reaching unprecedented levels. This is primarily backed by
strong short term profit making interests. An uncontrolled free market structure can result in valuation
bubbles which are basically high valuations built on weak fundamentals. Preventive measures for
such scenarios require a strong presence of regulatory authorities and balancing policy shifts to
ensure that growth is balanced and sustainable

Externality
Definition: An externality is an effect of a purchase or use decision by one set of parties on
others who did not have a choice and whose interests were not taken into account.

PRIVATE AND SOCIAL COSTS

Externalities create a divergence between the private and social costs of production.
Social cost includes all the costs of production of the output of a particular good or service. We
include the third party (external) costs arising, for example, from pollution of the atmosphere.
SOCIAL COST = PRIVATE COST + EXTERNALITY

For example: - a chemical factory emits wastage as a by-product into nearby rivers and into the
atmosphere. This creates negative externalities which impose higher social costs on other firms and
consumers. e.g. clean up costs and health costs.
Another example of higher social costs comes from the problems caused by traffic congestion in
towns, cities and on major roads and motor ways.
It is important to note though that the manufacture, purchase and use of private cars can also generate
external benefits to society. This why cost-benefit analysis can be useful in measuring and putting
some monetary value on both the social costs and benefits of production

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Types of externality
1. Positive Externality in Production.
A farmer grows apple trees. An external benefit is that he provides nectar for a nearby
bee keeper whogains increased honey as a result of the farmers orchard.
2. Negative Externality in Production
Making furniture by cutting down rainforests in the Amazon leads to negative
externalities to other people. Firstly it harms the indigenous people of the Amazon rainforest.
It also leads to higher global warming as there are less trees to absorb carbon dioxide.
3. Positive Externality in Consumption.
If you take a three year training course in IT. You gain skills but also other people in the
economy can benefit from your knowledge.
4. Negative Externality in Consumption:
If you smoke in a crowded room, other people have to breathe in your smoke. This is
unpleasant for them and can leave them exposed to health problems associated with smoking.

Positive consumption externalities

A positive externality is a benefit that is enjoyed by a third-party as a result of an
economic transaction. Third-parties include any individual, organization, property owner, or
resource that is indirectly affected. While individuals who benefit from positive externalities
without paying are considered to be free-riders, it may be in the interests of society to encourage
free-riders to consume goods which generate substantial external benefits.
Most merit goods generate positive consumption externalities, which beneficiaries do not pay
for. For example, with healthcare, private treatment for contagious diseases provides a considerable
benefit to others, for which they do not pay. Similarly, with education, the skills acquired and
knowledge learnt at university can benefit the wider community in many ways.
Unlike the case of negative externalities, which should be discouraged to achieve a socially
efficient allocation of scarce resources, positive externalities should be encouraged.

There are plenty of examples of economic activities that can generate positive externalities:
1. Industrial training by firms: This can reduce the costs faced by other firms and has important
effects on labour productivity. A faster growth of productivity allows more output to be
produced from a given amount of resources and helps improve living standards throughout
the economy. See the revision notes on the production possibility frontier
2. Research into new technologies which can then be disseminated for use by other producers.
These technology spill-over effects help to reduce the costs of other producers and cost savings
might be passed onto consumers through lower prices
3. Education: A well educated labour force can increase efficiency and produce other important
social benefits. Increasingly policy-makers are coming to realise the increased returns that
might be exploited from investment in human capital at all ages.
4. Health provision: Improved health provision and health care reduces absenteeism and creates
a better quality of life and higher living standards.
5. Employment creation by new small firm
6. Flood protection system and spending on improved fire protection in schools and public arenas
7. Arts and sporting participation and enjoyment derived from historic buildings

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Policies to promote positive externalities
One role for government is to implement economic policies that promote positive
externalities. There are two general approaches to promoting positive externalities; to increase the
supply of, and demand for, goods, services and resources that generate external benefits.
• Increasing supply
Government grants and subsidies to producers of goods and services that generate external
benefits will reduce costs of production, and encourage more supply. This is a common remedy
to encourage the supply of merit goods such as healthcare, education, and social housing. Such merit
goods can be funded out of central and local government taxation. Public goods, such as roads,
bridges and airports, also generate considerable positive externalities, and can be built, maintained
and fully, or part, funded out of tax revenue.
• Increasing demand
Demand for goods, which generate positive externalities, can be encouraged by reducing the price
paid by consumers. For example, subsidizing the tuition fees of university students will encourage
more young people to go to university, which will generate a positive externality for future
generations.
The ultimate encouragement to consume is to make the good completely free at the point of
consumption,such as with freely available hospital treatment for contagious diseases.
Government can also provide free information to consumers, to compensate for the information
failure that discourages consumption. If individuals are fully informed about the benefits of
consuming goods and services that generate external benefits, they may develop a better
understanding of the product and demand more of it.For example, public information broadcasts,
such as aids awareness programmes, can reduce ignorance, and encourage the use of condoms.

An additional option is to compel individuals to consume the good or service that generates
the external benefit. For example, if suspected of having a contagious disease, an individual may be
forced into hospital to receive treatment, even against their will. In terms of education, attendance at
school up until the age of 16 is compulsory, and parents may be fined for encouraging their children
to truant.

Negative Externality
There are two types of negative externalities:
1) Negative Production Externality - when a firm's production reduces the well-being of
others who are not compensated by the firm.
Examples:
• The production of smoke from factories may create clean-up costs to reduce air
pollution by nearbyresidents.
• The building of a dam that prevents the fish from swimming upstream, thus destroying the
fishing industry in towns upstream. Note that if the fishermen are compensated by the dam
builders for the full value of their loss, then no negative externality exists. This and other
examples can be found in the article "Environmental Economics: Pollution"
2) Negative consumption externality - when an individual's consumption reduces the well-
being of others who are not compensated by the individual.
Example:
• The consumption of cigarettes in a restaurant that allows smoking decreases the
enjoyment of a non-smoker who is consuming his/her meal at the same restaurant.

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Remedies or solutions to Negative externality

I. Market Based Solutions:

Market-based solutions try to manipulate market forces to reduce the externality, by exploiting the
price mechanism. One such market-based solution is to extend property rights so that third parties
can negotiate with those individuals or organizations that cause the externality. As long as one party
can establish a property right, there will be a bargaining process leading to an agreement in which
externalities are taken into account.
If property rights cannot be established, such as with the air, sea, or roads, then the only two options are:
1. We learn to live with externalities, or:
2. Government intervenes on our behalf through taxes or direct controls and regulations, such as:
➢ Taxing polluters, such as carbon taxes, or taxes on plastic bags.
➢ Subsidizing households or firms to be non-polluters, such as giving grants for
home insulationimprovements.
➢ Selling permits to pollute, which may become traded by the polluters.
➢ Forcing polluters to pay compensation to those who suffer, such as making noise
polluting airportspay for double-glazing.
➢ Road pricing schemes, such as the Electronic Road Pricing (ERP) system in
Singapore, which is a pay-as-you-go, card-based, road-pricing scheme.
➢ Providing more information to consumers and producers, such as requiring that tickets
to travel on polluting forms of transport, especially air travel, should contain
information on how much CO2 pollution will be created from each journey.

II. Negative consumption externalities

When certain goods are consumed, such as demerit goods, negative effects can arise on third parties.
For example, if individuals consume alcohol, get intoxicated and do harm to the property of
innocent third parties, a negative consumption externality has arisen. This reduces the MSB by the
extent of the negative effect on others, so that the socially efficient consumption of alcohol is less
than the free market level of consumption.
Another important example of a negative consumption externality if that of road congestion.
As individuals 'consume' road-space they reduce available road-space and deny this space to others.
There are several remedies for negative consumption externalities, including imposing
indirect taxes, and setting minimum prices, imposing fines for over-consumption, controlling supply
through a licensing system.

Promoting Positive Externalities and Reducing Negative Externalities

• Governments have several methods to reduce the effects of negative externalities and to
promote positive externalities.
• The quantity of goods with negative externalities is greater than what the market equilibrium
would be if the cost of the negative externality was factored into the price of the product. On
the other hand, the quantity of goods that have positive externalities is less than what is
socially desirable, since the people who enjoy the benefits of the product but who do not
participate in the market do not affect the market quantity.
• The government can remedy these situations by taxing products with negative externalities
and subsidizing products with positive externalities.

• Government intervention can generally be divided into 2 types of actions:

➢ command-and-control policies that regulate actions directly and
➢ market-based policies that would provide incentives so that the self-interest of the
market participants would achieve the socially optimized solution.

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• Direct controls are a type of command-and-control policy that prohibits specific activities
that create negative externalities or that require that the negative externality be limited to a
certain level, such as limiting emissions in smokestacks or tailpipes, or limiting toxic wastes,
with specific procedures to clean it up.
• The government can promote positive externalities by paying subsidies to either buyers or
producers,which is a type of market-based policy. Subsidies to buyers would lower the cost
of the product, which would increase demand. Subsidies to producers would lower their cost
of production, thereby increasing supply. The government may also decide that the cost of an
externality is great enough to make it a public good, where the government pays outright for
its production, such as vaccinations against contagious diseases, like smallpox or polio.
• Most government subsidies consists of tax breaks for either the buyers or the suppliers.
Education, for instance, has many positive externalities, and the government subsidizes it by
giving tax breaks for people who save for college.
• Because technology has large spillover benefits, the government sometimes forms an
industrial policythat promotes specific technologies that would have the greatest benefit to
society. However, industrial policies are often criticized because they require that the
government pick winners and losers and, as often happens in governments where the
legislators are more interested in money than in the well-being of their country, well-financed
lobbyists often control how the money is allocated.
• Another common market-based policy to reduce negative externalities is by assessing a
corrective tax, which is a tax that internalizes the externality by incorporating it as a
cost of production. Corrective taxes are also known as Pigovian taxes, named after the
economist Arthur Pigou, who was an early advocate of their use.
• The primary advantage of corrective taxes over regulation is that companies have an incentive
only to satisfy the regulation, whereas corrective taxes will incentivize companies to
continually reduce their negative externalities to lower their costs.
• One of the best examples to show the superiority of a market-based policy over that of a
command-and- control policy is how the government has attempted to regulate the fuel
economy of motor vehicles. A better solution is simply to increase gasoline taxes, which
would motivate many people and businesses to reduce their consumption of gasoline, since it
would cost them more. People would find many creative solutions that would otherwise not
be sought if the government simply stipulated how things should be done. Furthermore,
people would continually strive to reduce their gasoline expense, whereas the auto
manufacturers would just satisfy the law. Gasoline taxes would also reduce congestion,
accidents, and pollution by motivating people to drive slower and to drive less — fuel
economy regulations would have no such effect.
• Government intervenes on our behalf through taxes or direct controls and regulations, such as:
• Taxing polluters, such as carbon taxes, or taxes on plastic bags.
• Subsidising households or firms to be non-polluters, such as giving grants for home
insulationimprovements.
• Selling permits to pollute, which may become traded by the polluters.
• Forcing polluters to pay compensation to those who suffer, such as making noise polluting
airports pay for double-glazing.
• Road pricing schemes, such as the Electronic Road Pricing (ERP) system in Singapore, which
is a pay- as-you-go, card-based, road-pricing scheme.
• Providing more information to consumers and producers, such as requiring that tickets to
travel on polluting forms of transport, especially air travel, should contain information on
how much CO2 pollution will be created from each journey.

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UNIT II
CONSUMER AND PRODUCER BEHAVIOUR

Market – Demand and Supply – Determinants – Market equilibrium – elasticity of demand and supply
– consumer behavior – consumer equilibrium – Approaches to consumer behavior –Production –
Short-run and long-run Production Function – Returns to scale – economies Vs diseconomies of scale
– Analysis of cost – Short-run and long-run cost function – Relation between Production and cost
function

Introduction to Market
When most people think of a market, they think of a physical place, like their neighborhood
supermarket, complete with shoppers and shelves stocked with a wide range of goods. In economics,
however, a market need
not be a physical location. Where you have buyers and sellers of a particular product or service, you
have amarket.
A market is any place where the sellers of a particular good or service can meet with the
buyers of that goods and service where there is a potential for a transaction to take place. The buyers
must have something they can offer in exchange for there to be a potential transaction.
In economics, a market is a group of buyers and sellers of a specific good or service. A market
usuallydoes not refer to a physical location for the buying and selling of products. "Harper Collins
Dictionary of Economics" points out that economists use the word "market" to describe a mechanism
of exchange between buyers and sellers of a good or service.
In a market, sellers offer their goods and services, for which they set a price, often with an eye
towards offering lower prices or better products and services than their competitors. Buyers,
meanwhile, vote with their dollars, purchasing the products they want from the sellers that offer the
best product in terms of price and quality. If a seller raises prices without offering a significantly
better product or service, consumers are free to take their business to a competing firm.

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DEMAND

In Economics, use of the word ‘demand’ is made to show the relationship between the prices of a
commodity and the amounts of the commodity which consumers want to purchase at those price.

Definition of Demand:
“Demand is defines as the want, need or desire which is backed by willingness and ability to buy
aparticular commodity in a given period of time.”
Bober defines, “By demand we mean the various quantities of given commodity or service
which consumers would buy in one market in a given period of time at various prices, or at
various incomes, or at various prices of related goods.”

Demand for product implies:

a) desires to acquire it,
b) willingness to pay for it, and
c) Ability to pay for it.
All three must be checked to identify and establish demand. For example : A poor
man’s desires to stay ina five-star hotel room and his willingness to pay rent for that room is
not ‘demand’, because he lacks the necessary purchasing power; so it is merely his wishful
thinking. Similarly, a miser’s desire for and his ability to pay for a car is not ‘demand’, because
he does not have the necessary willingness to pay for a car. One may also come across a well-
established person who processes both the willingness and the ability to pay for higher
education. But he has really no desire to have it, he pays the fees for a regular cause, and
eventually does not attend his classes. Thus, in an economics sense, he does not have a
‘demand’ for higher education degree/diploma.
It should also be noted that the demand for a product–-a commodity or a service–has
no meaning unless it is stated with specific reference to the time, its price, price of is related
goods, consumers’ income and tastes etc. This is because demand, as is used in Economics,
varies with fluctuations in these factors.
To say that demand for an Atlas cycle in India is 60,000 is not meaningful unless it
is stated in terms of the year, say 1983 when an Atlas cycle’s price was around Rs. 800,
competing cycle’s prices were around the same, a scooter’s prices was around Rs. 5,000. In
1984, the demand for an Atlas cycle could be different if any of the above factors happened to
be different. For example, instead of domestic (Indian), market, one may be interested in
foreign (abroad) market as well. Naturally the demand estimate will be different. Furthermore,
it should be noted that a commodity is defined with reference to its particular quality/brand; if
its quality/brand changes, it can be deemed as another commodity.

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Characteristics of Demand:
There are thus three main characteristics of demand in economics.

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

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

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

Determinants of Demand:
The knowledge of the determinants of market demand for a product or service and the nature of
relationship between the demand and its determinants proves very helpful in analyzing and estimating
demand for the product. It may be noted at the very outset that a host of factors determines the demand
for a product or service. In general, following factors determine market demand for a product or service:

1. Price of the product

2. Price of the related goods-substitutes, complements and supplements
3. Level of consumers income
4. Consumers taste and preference
5. Advertisement of the product
6. Consumers’ expectations about future price and supply position
7. Demonstration effect or ‘bend-wagon effect’
8. Consumer-credit facility
9. Population of the country
10. Distribution pattern of national income.

These factors also include factors such as off-season discounts and gifts on purchase of a good,
level of taxation and general social and political environment of the country. However, all these
factors are not equally important. Besides, some of them are not quantifiable. For example,
consumer’s preferences, utility, demonstration effect and expectations, are difficult to measure.
However, both quantifiable and non-quantifiable determinants of demand for a product will be
discussed.

1. Price of the Product

The price of a product is one of the most important determinants of demand in the long run and
the only determinant in the short run. The price and quantity demanded are inversely related to
each other. The law of demand states that the quantity demanded of a good or a product, which
its consumers would like to buy per unit of time, increases when its price falls, and decreases
when its price increases, provided the other factors remain’ same. The assumption ‘other factors
remaining same’ implies that income of the consumers, prices of the substitutes and
complementary goods, consumer’s taste and preference and number of consumers remain
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unchanged. The price-demand relationship assumes a much greater significance in the
oligopolistic market in which outcome of price war between a firm and its rivals determines the
level of success of the firm. The firms have to be fully aware of price elasticity of demand for
their own products and that of rival firm’s goods.

2. Price of the Related Goods or Products

The demand for a good is also affected by the change in the price of its related goods. The
related goods may be the substitutes or complementary goods.
• Substitutes: Two goods are said to. be substitutes of each other if a change in price
of one good affectsthe demand for the other in the same direction. For instance goods X and
Y are considered as substitutes for each other if a rise in the price of X increase demand for
Y, and vice versa. Tea and coffee, hamburgers and hot-dog, alcohol and drugs are some
examples of substitutes in case of consumer goods by definition,the relation between demand
for a product and price of its substitute is of positive nature. When, price of the substitute of
a product (tea) falls (or increase), the demand for the product falls (or increases).
• Complementary Goods: A good is said to be a complement for another when it
complements the use of the other or when the two goods are used together in such a way that
their demand changes (increases or decreases) simultaneously. For example, petrol is a
complement to car and scooter, butter and jam to bread, milk and sugar to tea and coffee,
mattress to cot, etc. Two goods are termed as complementary to each other. If an increase in
the price of one causes a decrease in demand for the other. By definition, there is an inverse
relation between the demand for a good and the price of its complement. For instance, an
increase in the price of petrol causes a decrease in the demand for car and other petrol-run
vehicles and vice versa while other thing’s remaining constant.

3. Consumers Income
Income is the basic determinant of market demand since it determines the purchasing power of
a consumer. Therefore, people with higher current disposable income spend a larger amount on
goods and services than those with lower income. Income-demand relationship is of more varied
nature than that between demand and its other determinants. While other determinants of demand,
e.g., product’s own price and the price of its substitutes, are more significant in the short-run,
income as a determinant of demand is equally important in both short run and long run. Before
proceeding further to discuss income-demand relationships, it will be useful to note that consumer
goods of different nature have different kinds of relationship with consumers having different
levels of income. Hence, the managers need to be fully aware of the kinds of goods they are dealing
with and their relationship with the income of consumers, particularly about the assessment of
both existing and prospective demand for a product.
For the purpose of income-demand analysis, goods and services maybe grouped under four
broad categories, which ate: (a) essential consumer goods, (b) inferior goods, (c) normal goods,
and (d) prestige or luxury goods. To understand all these terms, it is essential to understand the
relationship between income and different kinds of goods.
I. Essential Consumer Goods (ECG): The goods and services of this category are called
‘basic needs’ and are consumed by all persons of a society such as food-grains, salt, vegetable

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oils, matches, cooking fuel, a minimum clothing and housing. Quantity demanded for these
goods increases with increase in consumer’s income but only up to certain limit, even though
the total expenditure may increase in accordance with the quality of goods consumed, other
factors remaining the same. Consumer’s demand for essential goods increases only until a
particular income level. It tends to saturate beyond this level of income.
II. Inferior goods: Inferior goods are those goods whose demand decreases with the
increase in consumer’s income. For example millet is inferior to wheat and rice; coarse, textiles
are inferior to refined ones, kerosene is inferior to cooking gas and travelling by bus is inferior
to travelling by taxi. The relation between income and demand for an inferior good is under the
assumption that other determinants of demand remain the same demand for such goods rises
only up to a certain level of income, and declines as income increases beyond this level.
III. Normal goods: Normal goods are those goods whose demand increases with increase
in the consumer income. For example, clothing’s household furniture and automobiles.
Demand for such goods increases with the increases in consumer income but at different rates
at different levels of income. Demand for normal goods increases rapidly with the increase in
the consumer’s income but slows down with further increase in income. Up to certain level
of income the relation between income and demand for all type of goods is similar. The
difference is of only degree. Therefore, it is important to view the income-demand relations in
the light of the nature of product and the level of consumer’s income.
IV. Prestige and luxury goods: Prestige goods are those goods, which are consumed mostly by
rich section of the society, e.g., precious stones, antiques, rare paintings, luxury cars and such other
items of show-off. Whereas luxury goods include jewellery, costly brands of cosmetics, TV sets,
refrigerators, electrical gadgets and cars. Demand for such goods arises beyond a certain level of
consumer’s income, i.e., consumption enters the area of luxury goods. Producers of such goods,
while assessing the demand for their goods, should consider the income changes in the richer
section of the society and not only the per capita income.

4. Consumer’s Taste and Preference

Consumer’s taste and preference play an important role in determining demand for a product.
Taste and preference depend, generally, on the changing life-style, social customs, religious
values attached to a good habit of the people. Change in these factors changes consumer’s taste
and preferences. As a result, consumers reduce or give up the consumption of some goods and add
new ones to their consumption pattern. For example, following the change in fashion, people
switch their consumption pattern from cheaper, old-fashioned goods to costlier ‘mod’ goods, as
long as price differentials are proportionate with their preferences. Consumers are prepared to
pay higher prices for ‘mod goods’ even if their virtual utility is the same as that of old-fashioned
goods. The manufacturers of goods and services that are subject to frequent change in fashion
and style, can take advantageof this situation in two ways:
1. They can make quick profits by designing new models of their goods and popularizing them
through advertisement, and
2. They can plan production in a better way and can even avoid over-production if they
keep an eye on the changing fashions

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5. Advertisement Expenditure
Advertisement costs are incurred with the objective of increasing the demand for the
goods. This is done in the following ways:
• By informing the potential consumers about the availability of the goods.
• By showing its superiority to the rival goods.
• By influencing consumers choice against the rival goods, and
• By setting fashions and changing tastes.
The impact of such effects shifts the demand curve upward to the right. In other words,
when other factors’remain same, the expenditure on advertisement increases the volume of
sales to the same extent.
The relationship between demand and advertisement cost is based on the following
assumptions:
• Consumers are fairly sensitive and responsive to various modes of advertisement.
The rival firms do not react to the advertisements made by a firm.
The level of demand has not already reached the saturation point. Advertisement beyond
this pointwill make only marginal impact on demand.
Per unit cost of advertisement added to the price does not make the price prohibitive for
consumers, as compared particularly to the price of substitutes.
Others determinants of demand, e.g., income and tastes, etc., are not operating in the reverse
direction. In the absence of these conditions, the advertisement effect on sales may be
unpredictable.

6. Consumers Expectations
Consumers’ expectations regarding the future prices, income and supply position of goods play
an important role in determining the demand for goods and services in the short run. If consumers
expect a rise in the price of a storable good, they would buy more of it at its current price with a
view to avoiding the possibility of price rise future. On the contrary, if consumers expect a fall in
the price of certain goods, they postpone their purchase with a view to take advantage of lower
prices in future, mainly in case of non-essential goods. This behavior of consumers reduces the
current demand for the goods whose prices are expected to decrease in future. Similarly, an
expected increase in income increases the demand for a product. For example, announcement of
dearness allowance, bonus and revision of pay scale induces increase in current purchases.
Besides, if scarcity of certain goods is expected by the consumers on account of reported fall in
future production, strikes on a large scale and diversion of civil supplies towards the military use
causes the current demand for such goods to increase more if their prices show an upward trend.
Consumer demand more for future consumption and profiteers demand more to make money
out of expected scarcity.

7. Demonstration Effect
When new goods or new models of existing ones appear in the market, rich people buy them first.
For instance, when a new model of car appears in the market, rich people would mostly be
the first buyer, LED TV sets and Blu-Ray Drives were first seen in the houses of the rich families
some people buy new goods or new models of goods because they have genuine need for them.
Some others do so because they want to exhibit their affluence. But once new goods come in
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fashion, many households buy them not because they have a genuine need for them but because
their neighbors have bought the same goods. The purchase made by the latter category of the
buyers are made out of such feelings as jealousy, competition, equality in the peer group, social
inferiority and the desire to raise their social status. Purchases made on account of these factors
are the result of what economists call ‘demonstration effect’ or the ‘Band-wagon-effect’. These
effects have a positive effect on demand. On the contrary, when goods become the thing of
common use, some people, mostly rich, decrease or give up the consumption of such goods. This
is known as ‘Snob Effect’. It has a negative effect’on the demand for the related goods.

8. Consumer-Credit Facility
Availability of credit to the consumers from the sellers, banks, relations and friends encourages
the consumers to buy more than what they would buy in the absence of credit availability.
Therefore, the consumers who can borrow more can consume more than those who cannot
borrow. Credit facility affects mostly the demand for durable goods, particularly those, which
require bulk payment at the time of purchase.

9. Population of the Country

The total domestic demand for a good of mass consumption depends also on the size of the
population. Therefore, larger the population larger will be the demand for a product, when price,
per-capita income, taste and preference are given. With an increase or decrease in the size of
population, employment percentage remaining the same, demand for the product will either
increase or decrease.

10. Distribution of National Income

The level of national income is the basic determinant of the market demand for a good. Apart from
this, the distribution pattern of the national income is also an important determinant for demand
of a good. If national income is evenly distributed, market demand for normal goods will be the
largest. If national income is unevenly distributed, i.e., if majority of population belongs to the
lower income groups, market demand for essential goods, including inferior ones, will be the
largest whereas the demand for other kinds of goods will be relatively less.

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TYPES OF DEMAND
The different types of demand are:

i) Direct and Derived Demands

Direct demand refers to demand for goods meant for final consumption; it is the demand for
consumers’ goods like food items, readymade garments and houses. By contrast, derived
demand refers to demand for goods which are needed for further production; it is the demand
for producers’ goods like industrial raw materials, machine tools and equipment.
Thus the demand for an input or what is called a factor of production is a derived demand;
its demand depends on the demand for output where the input enters. In fact, the quantity
of demand for the final output as well as thedegree of substitutability/complementary
between inputs would determine the derived demand for a given input. For example, the
demand for gas in a fertilizer plant depends on the amount of fertilizer to be produced
and substitutability between gas and coal as the basis for fertilizer production. However,
the direct demand for a product is not contingent upon the demand for other products.

ii) Domestic and Industrial Demands

The example of the refrigerator can be restated to distinguish between the demand for domestic
consumption and the demand for industrial use. In case of certain industrial raw materials
which are also used for domestic purpose, this distinction is very meaningful.
For example, coal has both domestic and industrial demand, and the distinction is
important from the standpoint of pricing and distribution of coal.

iii) Autonomous and Induced Demand

When the demand for a product is tied to the purchase of some parent product, its demand is
called induced or derived.
For example, the demand for cement is induced by (derived from) the demand for housing. As
stated above, the demand for all producers’ goods is derived or induced. In addition, even in
the realm of consumers’ goods, we may think of induced demand. Consider the complementary
items like tea and sugar, bread and butter etc. The demand for butter (sugar) may be induced
by the purchase of bread (tea). Autonomous demand, on the other hand, is not derived or
induced. Unless a product is totally independent of the use of other products, it is difficult to
talk about autonomous demand. In the present world of dependence, there is hardly any
autonomous demand. Nobody today consumers just a single commodity; everybody consumes
a bundle of commodities. Even then, all direct demand may be loosely called autonomous.

iv) Perishable and Durable Goods’ Demands

Both consumers’ goods and producers’ goods are further classified into perishable/non-
durable/single-use goods and durable/non-perishable/repeated-use goods. The former refers to
final output like bread or raw material like cement which can be used only once. The latter
refers to items like shirt, car or a machine which can be used repeatedly. In other words, we
can classify goods into several categories: single-use consumer goods, single-use producer
goods, durable-use consumer goods and durable-use producer’s goods. This distinction is

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useful because durable products present more complicated problems of demand analysis than
perishable products. Non- durable items are meant for meeting immediate (current) demand,
but durable items are designed to meet current as well as future demand as they are used over
a period of time. So, when durable items are purchased, they are considered to be an addition
to stock of assets or wealth. Because of continuous use, such assets like furniture or washing
machine, suffer depreciation and thus call for replacement. Thus durable goods demand has
two varieties – replacement of old products and expansion of total stock. Such demands
fluctuate with business conditions, speculation and price expectations. Real wealth effect
influences demand for consumer durables.

v) New and Replacement Demands

This distinction follows readily from the previous one. If the purchase or acquisition of an item
is meant as an addition to stock, it is a new demand. If the purchase of an item is meant for
maintaining the old stock of capital/asset, it is replacement demand. Such replacement
expenditure is to overcome depreciation in the existing stock.
Producers’ goods like machines. The demand for spare parts of a machine is replacement
demand, but the demand for the latest model of a particular machine (say, the latest
generation computer) is anew demand. In course of preventive maintenance and breakdown
maintenance, the engineer and his crew often express their replacement demand, but when a
new process or a new technique or anew product is to be introduced, there is always a new
demand.
You may now argue that replacement demand is induced by the quantity and quality of the
existing stock, whereas the new demand is of an autonomous type. However, such a
distinction is more of degree than of kind. For example, when demonstration effect operates,
a new demand may also be an induced demand. You may buya new VCR, because your
neighbor has recently bought one. Yours is a new purchase, yet it is induced by your neighbor’s
demonstration.

vi) Final and Intermediate Demands

This distinction is again based on the type of goods- final or intermediate. The demand for
semi-finished products, industrial raw materials and similar intermediate goods are all derived
demands, i.e., induced by the demand for final goods. In the context of input-output models,
such distinction is often employed.

vii) Individual and Market Demands

This distinction is often employed by the economist to study the size of the buyers’ demand,
individual as well as collective. A market is visited by different consumers, consumer
differences depending on factors like income, age, sex etc. They all react differently to the
prevailing market price of a commodity. For example, when theprice is very high, a low-
income buyer may not buy anything, though a high income buyer may buy something. In
such a case, we may distinguish between the demand of an individual buyer and that of the
market which is the market which is the aggregate of individuals. You may note that both
individual and market demand schedules(and hence curves, when plotted) obey the law of

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demand. But the purchasing capacity varies between individuals. For example, A is a high
income consumer, B is a middle-income consumer and C is in the low- income group. This
information is useful for personalized service or target-group-planning as a part of sales
strategy formulation.

viii) Total Market and Segmented Market Demands

This distinction is made mostly on the same lines as above. Different individual buyers together
may represent a given market segment; and several market segments together may represent
the total market. For example, the Hindustan Machine Tools may compute the demand for its
watches in the home and foreign markets separately; and then aggregate them together to
estimate the total market demand for its HMT watches. This distinction takes care of different
patterns of buying behavior and consumers’ preferences in different segments of the market.
Such market segments may be defined in terms of criteria like location, age, sex, income,
nationality, and so on.

x) Company and Industry Demands

An industry is the aggregate of firms (companies). Thus the Company’s demand is similar to
an individual demand, whereas the industry’s demand is similar to aggregated total demand.
You may examine this distinction from the standpoint of both output and input.
For example, you may think of the demand for cement produced by the Cement Corporation of
India (i.e., a company’s demand), or the demand for cement produced by all cement
manufacturing units including the CCI (i.e., an industry’s demand). Similarly, there may be
demand for engineers by a single firm or demand for engineers by the industry as a whole,
which is an example of demand for an input. You can appreciate that the determinants of a
company’s demand may not always be the same as those of an industry’s. The inter-firm
differences with regard to technology, product quality, financial position, market (demand)
share, market leadership and competitiveness- all these are possible explanatory factors. In
fact, a clear understanding of the relation between company and industry demands necessitates
an understanding of different market structures.

Demand Function and Demand Curve

Demand function is a comprehensive formulation which specifies the factors that
influence the demand for theproduct. What can be those factors which affect the demand?
For example,
Dx= D (Px, Py, Pz, B, W, A, E, T, U)
Here Dx, stands for demand for item x (say, a car)Px, its own price (of the car)
Py, the price of its substitutes (other brands/models)Pz, the price of its complements (like
petrol)
B, the income (budget) of the purchaser (user/consumer)W, the wealth of the purchaser
A, the advertisement for the product (car)E, the price expectation of the user
T, taste or preferences of userU, all other factors.

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Law of Demand:
What Does Law Of Demand Mean?
A microeconomic law that states that, all other factors being equal, as the price of a good or
service increases,
consumer demand for the good or service will decrease and vice versa.
This law summarizes the effect price changes have on consumer behavior. For example, a
consumer will purchase more pizzas if the price of pizza falls. The opposite is true if the price
of pizza increases.

Assumptions of Law of Demand:

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

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

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

Example of Law of Demand:

If there is a change, in the above and other assumptions, the law may not hold true. For
example, according to the law of demand, other things being equal quantity demanded increases
with a fall in price and diminishes with rise to price. Now let us suppose that price of tea comes
down from R40 per pound to R20 per pound. The demand for tea may not increase, because there
has taken place a change in the taste of consumers or the price of coffee has fallen down as
compared to tea or the purchasing power of the consumers has decreased, etc., etc. From this we
find that demand responds to price inversely only, if other thing remains constant.
Otherwise, the chances are that, the quantity demanded may not increase with a fall in price or
vice-versa. Demand, thus, is a negative relationship between price and quantity. diminishes with
rise to price. Now let us suppose that price of tea comes down from R40 per pound to R20 per pound.
The demand for tea may not increase, because there has taken place a change in the taste of consumers
or the price of coffee has fallen down as compared to tea or the purchasing power of the consumers
has decreased, etc., etc. From this we find that demand responds to price inversely only, if other thing
remains constant.
Otherwise, the chances are that, the quantity demanded may not increase with a fall in price or vice-versa.
Demand, thus, is a negative relationship between price and quantity.

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Limitations/Exceptions of Law of Demand:

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

• 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.

• 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.

• Ignorance of the consumer: If the consumer is ignorant about the rise in price of goods, he may
buy more at a higher price.

• 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.

Demonstration effect or ‘Band-wagon-effect’

When new goods come in fashion, many people buy them not because they have a genuine need for
them but because their neighbors have bought the same goods. The purchase made by the buyers are
made out of such feelings as jealousy, competition, equality in the peer group, social inferiority and the
desire to raise their social status. Purchases made on account of these factors are the result of what
economists call ‘demonstration effect’ or the ‘Band-wagon-effect’. These effects have a positive effect
on demand.

Reasons Behind the law of demand:

Demand Curve is negatively Sloped:
The demand curve generally slopes downward from left to right. It has a negative slope because the two
important variables price and quantity work in opposite direction. As the price of a commodity
decreases, the quantity demanded increases over a specified period of time, and vice versa, other , things
remaining constant.

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

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. The consumer, therefore, will purchase more units of that
commodity only if its price falls. Thus a decrease in price brings about an increase, in demand. The
demand curve, therefore, is downward sloping.

Income effect: Other things being equal, when the price of a commodity decreases, the real income or
the purchasing power of the household increases. The consumer is now in a position to purchase more
commodities with the same income. The demand for a commodity thus increases not from the new
buyers who were earlier unable to purchase at higher price. 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.

(i) 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. Then the households would prefer to purchase meat because it is now
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relatively cheaper. The increase in demand with a fall in the price of meat will move the demand curve
downward from left to right.

(ii)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. The combined result of the income and
substitution effect is that demand extends, ceteris paribus, as the .price falls. The demand curve slopes
downward from left to right.

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

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

(1) Movement along the Demand Curve: A movement refers to a change along a curve. On the demand
curve, a movement denotes a change in both price and quantity demanded from one point to another on
the curve. Therefore, a movement occurs when a change in the quantity demanded is caused only by a
change in price, and vice versa.

Expansion in Demand:

Expansion in demand refers to a rise in the quantity demanded due to a fall in the price of
commodity,other factors remaining constant.

i. It leads to a downward movement along the same demand curve.

ii. It is also known as ‘Extension in Demand’ or ‘Increase in Quantitydemanded’. It can be

better understood from Table and Fig.

.
Price (Rs.) Demand (units)
20 100

15 150

As seen in the given schedule and diagram, the quantity demanded rises from 100 units to 150 units
with a fall in the price from Rs. 20 to Rs. 15, resulting in a downward movement from A to B along the
same demand curve DD.
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Contraction in Demand:

Contraction in demand refers to a fall in the quantity demanded due to a rise in the price of commodity,
other factors remaining constant.

i. It leads to an upward movement along the same demand curve.

ii. It is also known as ‘Decrease in Quantity Demanded’. It can be betterunderstood from
Table and Fig.

Table : Contraction in Demand

Price (Rs.) Demand (units)

20 100

25 70

As seen in the given schedule and diagram, the quantity demanded falls from 100 units to 70 units with
a rise in the price from Rs. 20 to Rs. 25, resulting in an upward movement from A to B along the same
demand curve DD.

(2) Shifts in Demand Curve:

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

For example, if the level of income in community rises, other factors remaining the same, the
demand for the goods increases. Consumers demand more goods at each price per period of me (rise or
Increase in demand). The demand curve shifts upward from he original demand curve indicating that
consumers at each price purchase more units of commodity per unit of time. If there is a fall in the
disposable income of the consumers or rise in the prices of close substitute of a good or decline in
consumer taste or non-availability of good on credit, etc, etc., there is a reduction in demand (fall or
decrease in demand). The fall or decrease in demand shifts the demand curve from the original demand
curve to the left. The lower demand curve shows that consumers are able and willing to buy less of the
good at each price than before.

Schedule:
Pdx ($) Qdx Rise in Qdx Fall in Qdx
12 100 300 50
6 250 500 200
4 500 600 300

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Diagram/Figure:

In this figure, the original demand curve is DD/.

At a price of $12 per unit, consumers purchase 100 units. When price falls to$4 per unit, the quantity
demanded increases to 500 units per unit of time. Let us assume now that level of income increases in a
community.
Now consumers demand 300 units of the commodity at price of $12 per unit and 600 at price of $4
per unit.
As a result, there is an upward shift of the demand curve DD2. In case the community income falls, there
is then decrease in demand at price of $12 per unit. The quantity demanded of a good falls to 50 units. It is
300 units at price of $4 unit per period of time. There is a downward shift of the demand to the left of the
original demand curve.

Movement along a supply curve

The amount of commodity supplied changes with rise and fall of the price while other determinants of supply
remain constant. This change when shown in the graph is known as movement along a supply curve.In simple
words, movement along a supply curve represents the variation in quantity supplied of the commodity with
change in its price and other factors remaining unchanged.
The movement in supply curve can be of two types – extension and contraction. Extension in a supply
curve is caused when there is increase in the price or quantity supplied of the commodity while contraction
is caused due to decrease in the price or quantity supplied of the commodity.

In the above fig. II, let us suppose Rs. 20 is the original price of milk per liter and 20,000 liters is the original
quantity of supply. When the price rises from Rs. 20 to Rs. 30, the amount of quantity supplied rises from
20,000 liters to 30,000 liters, and there is a movement in the supply curve from point B to point C. This
movement is known as extension in supply curve.

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Similarly, when price falls from Rs. 20 to Rs. 10, the amount of quantity supplied falls from 20,000 liters
to 10,000 liters, and there is another movement in the supply curve from point B to point A. This movement
is known as contraction in supply curve.

Shift in supply curve

The amount of commodity that the producers or suppliers are willing to offer at the marketplace can change
even in cases when factors other than price of the commodity change. Such non-price factors can be cost
of factors of production, tax rate, state of technology, natural factors, etc.

When quantity of the commodity supplied changes due to change in non-price factors, the supply curve
does not extend or contract but shifts entirely. For an instance, introduction of improved technology in
industries helps in reducing cost of production and induces production of more units of commodity at same
price. As a result, quantity of commodity supplied increases but price of the commodity remains as it is.

Fig. Shift in supply curve:

Shift in supply curve can also be of two types – rightward shift and leftward shift. Rightward
shift occurs in supply curve when quantity of supplied commodity increases at same price due
to favorable changes in non-price factors of production of commodity. Similarly, leftward shift
occurs when quantity of supplied commodity decreases at the same price.

In the above fig. III, let us suppose that SS is the original supply curve where Q amount of
commodity have been supplied at price P. Due to favorable changes in non-price factors, the
production of the commodity has increased and its supply has been increased by Q2 – Q amount,
at the same price. This has caused the supply curve rightwards and new supply curve S2S2 has
formed.

In the same, due to unfavorable changes in non-price factors of the commodity, the production
and supply has fallen to Q1 amount. Accordingly, the supply curve has shifted leftwards and
new supply curve S1S1 has formed.

Reasons for rightward shift of supply curve

• Improvement in technology
• Decrease in tax
• Decrease in cost of factor of production
• Favorable weather condition
• Seller’s expectation of fall in price in future

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Reasons for leftward shift of supply curve

• Use of old or outdated technology

• Increase in tax
• Increase in cost of factor of production
• Unfavorable weather condition
• Seller’s expectation of rise in price in future

Market Equilibrium:
Market equilibrium is a market state where the supply in the market is equal to the demand in
the market. The equilibrium price is the price of a good or service when the supply of it is equal
to the demand for it in the market. If a market is at equilibrium, the price will not change unless
an external factor changes the supply or demand, which results in a disruption of the
equilibrium.

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Production Function
Production may be defined as a process through which a firm transforms inputs into
output. It is the process of creating goods and services with the help of factors of production or
inputs for satisfaction of human wants. In other words, ‘transformation of inputs into output’
whereby value is added, is broadly called production. Whatever is used in the production of a
commodity is called input. For example, in the production of wheat, the use of land, seed,
fertilizer water, pesticides, tractors, labour etc. are inputs and wheat is output. The relationship
between inputs and output of a commodity depends upon the state of technology because with
the help of advanced technology more can be produced with the help of same inputs or same
output can be produced with the help of less inputs.
Production is an important economic activity which satisfies thewants and needs of
the people. Production function brings out the relationship between inputs used and the resulting
output. A firm is anentity that combines and processes resources in order to produce output
that will satisfy the consumer’s needs. The firm has to decide as to how much to produce and how
much input factors (labour and capital) to employ to produce efficiently. This chapter helps to
understand the set of conditions for efficient production of an organization.

Factors of production include resource inputs used to produce goods and services. Economist
categorise input factors into four major categories such as land, labour, capital and organization.

Land: Land is heterogeneous in nature. The supply of land is fixed andit is a permanent factor
of production but it is productive only with the application of capital and labour.

Labour: The supply of labour is inelastic in nature but it differs in productivity and efficiency
and it can be improved.

Capital: is a man made factor and is mobile but the supply is elastic.

Organization: the organization plans, , supervises, organizes and controls the business activity
and also takes risks.

Concepts related to production function:

(a) Short run and long run Short run refers to a time period in which a firm does not have
sufficient time to increase the scale of output. It can increase only the level of output by increasing the
quantity of a variable factor and making intensive use of the existing fixed factors. On the other hand
long run refers to the time period in which the firms can increase the scale of output by increasing the
quantity of all the factor inputs simultaneously and in the same proportion.
The distinction between fixed and variable factors is relevant only in the short run but this distinction
disappears in the long run.
(b) Fixed factors and variable factors Fixed factors are those factors of production whose quantity can
not be hanged with change in the level of output. For example, the quantity of land, machinery etc. can
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not be hanged during short run. On the other hand, variable factors are those factors of production whose
quantity can easily be hanged with change in the level of output. For example, we can easily change the
quantity of labour to increase or decrease the production.
(c) Level of production and scale of production When any firm increases production by increasing the
quantity of one factor input where as the quantity of other factor inputs keeping constant; it increases the
level of production. But on the other hand, when the firms increases production by increasing the quantity
of all the factors of production simultaneously and in the same proportion, it increases the scale of
production.

Production Function
Production function indicates the maximum amount of commodity ‘X’ to be produced
from various combinations of input factors. It decideson the maximum output to be produced
from a given level of input, and how much minimum input can be used to get the desired level
of output.The production function assumes that the state of technology is fixed. If there is a change
in technology then there would be change in production function.
Q = f (Land, Labour, Capital, Organization) Q = f (L, L, C, O)

In economics, production function refers to the physical relationship between inputs and output
under given technology. In otherwords production function is a mathematical
functional/technical/engineering relationship between inputs and output such that with a given
combination of factor inputs and technology at a given period of time, the maximum possible output can
be produced. Such as land, labour capital and entrepreneurship. If there are two factor inputs: labour (L)
and capital (K), then production function can be written as: Qx = f (L, K) where Qx is the quantity of
output of commodity x, f is the function and L and k are the units of labour and capital respectively. It
says that quantity of output depends on units of labour on capital used in production. Here two points are
worth considering. Firstly, production function must be considered with reference to particular period of
time i.e. short period and long period. Secondly, production function is determined by state of
technology.

(i) Short run production function: A production function that shows the changes in output when
only one factor is changed while other factor remains constant is termed as a short run
production function. In the above example of production funciton, Labour (L) is considered as
the variable factor which can be changed to influence the level of output. The other factor capital
(K) is a fixed factor which can not be changed. The underlying theory to the short run production
function is the “Law of variable proportion or Returns to a factor”. This law will be discussed
later in this chapter. (ii) Long run production function A long run production function studies the
impact on output when all the factors of production can be changed simultaneously and in the
same proportion. So in the long run size of operation of the firm can be expanded or contracted
depending on the fact that the factors of production are increased or decreased.
(ii) Production may be defined as a process through which a firm transforms inputs into output. It
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is the process of creating goods and services with the help of factors of production or inputs for
satisfaction of human wants. In other words, ‘transformation of inputs into output’ whereby
value is added, is broadly called production. Whatever is used in the production of a commodity
is called input. For example, in the production of wheat, the use of land, seed, fertilizer water,
pesticides, tractors, labour etc. are inputs and wheat is output. The relationship between inputs
and output of a commodity depends upon the state of technology because with the help of
advanced technology more can be produced with the help of same inputs or same output can be
produced with the help of less inputs.

(iii) The production manager’s responsibility is that of identifyingthe right combination of inputs
for the decided quantity of output. As a manager ,he has to know the price of the input factors and
the budget allocation of the organization. The major objective of any business organization is
maximizing the output with minimum cost. To achieve the maximum output the firm has to utilize
the input factors efficiently. In the long run, without increasing the fixed factors it is not possible
to achievethe goal. Therefore it is necessary to understand the relationship between the input
and output in any production process in the short and long run.

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Cobb Douglas Production Function:

This is a function that defines the maximum amount of output that can be produced with a given level
of inputs. Let us assume that all input factors of production can be grouped into two categories such
as labour (L) and capital (K).The general equilibrium for the production function is Q = f (K, L)
There are various functional forms available to describe production. In general Cobb-Douglas
production function (Quadratic equation) is widely used
Q = A Kα Lβ

Q = the maximum rate of output for a given rate of capital (K) and labour (L).

Short Run Production Function:

In the short run, some inputs (land, capital) are fixed in quantity. The output depends on
how much of other variable inputs are used. For example if we change the variable input namely
(labour) the production function shows how much output changes when more labour is used.In
the short run producers are faced with the problem that some input factors are fixed. The firms can
make the workers work for longer hours and also can buy more raw materials. In that case, labour and
raw material are considered as variable input factors. But the number of machines and the size of the
building are fixed. Therefore, it has its own constraints in producing more goods.
In the long run all input factors are variable. The producer canappoint more workers, purchase more
machines and use more raw materials. Initially output per worker will increase up to an extent.
Thisis known as the Law of Diminishing Returns or the Law of Variable Proportion. To understand
the law of diminishing returns it is essential to know the basic concepts of production.

Measures of Productivity
Total production (TP): the maximum level of output that can be produced with a given amount of input.
Average Production (AP): output produced per unit of input AP = Q/L

Marginal Production (MP): the change in total output produced by thelast unit of an input

Marginal production of labour = Δ Q / Δ L (i.e. change in the quantityproduced to a given change in the
labour)

Marginal production of capital = Δ Q / Δ K (i.e. change in the quantityproduced to a given change in the
capital)

Production Function:

A production function, like any other function can be expressed and analysed by any one or more
of the three tools namely table, graph and equation. The maximum amounts of output attainable from
various alternative combinations of input factors are given in the table.

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The production function expressed in tabular form is as follows.

Table - Production Schedule

Labour TP AP MP
1 20 20 0
2 54 27 34
3 81 27 27
4 104 26 23
5 125 25 21
6 138 23 13
7 147 21 9
8 152 19 5
9 153 17 1
10 150 15 -3

The firm has a set of fixed variables. As long with that it increasesthe labour force from 1
unit to 10 units. The increase in input factor leadsto increase in the output up to an extent. After that
it start declining. Marginal production increases in the initial period and then it starts declining and
it become negative. The firm should stop increasing labour force if the marginal production is zero-
that is the maximum output that can be derived with the available fixed factors. The 9th labour does
not contribute to any output. In case the firm wants to increase the output beyond 153 units it has to
improve its fixed variable. That means purchaseof new machinery or building is essential. Therefore
the firm understands that the maximum output is 153 units with the given set of input factors.
The graphical representations of the production function are as shown in the following graph.

Graph-Production Curves

The graphical presentations of the values are shown in the graph. The ‘X” axis denotes the
labour and the ‘Y’ axis indicates the total production (TP), average production (AP) and marginal
production (MP). From the given table and graph we can understand all the three curves in the
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graph increased in the beginning and the marginal product (MP) first fell, then the average product
(AP) finally total production (TP). The marginal production curve MP cuts the AP at its highest point.
Totalproduction TP falls when marginal production curve cuts the ‘X’ axis. The law of diminishing
returns states that if increasing quantity of a variable input are combined with fixed, eventually the
marginal product and then average product will decline.

When the production function is expressed as an equation it shall be asfollows:

Q = f (Ld, L, K, M, T )
It can be expressed as Q = f1, f2, f3, f4, f5 > 0

Where:
Q = Output in physical units of good X
Ld = Land units employed in the production of Q
L = Labour units employed in the production of Q K = Capital units employed in the
production of Q
M = Managerial Units employed in the production of QT = Technology employed in the
production of Q
f = Unspecified function
fi = Partial derivative of Q with respect to input.

This equation assumes that output is an increasing function of all inputs.

The Law of Diminishing Returns

In the combination of input factors when one particular factor is increased continuously without
changing other factors the output will increase in a diminishing manner. Let us assume that a person
preparing for an examination continuously prepares without any break. The output or the
understanding and the coverage of the syllabus will be more in the beginning rather than in the later
stages. There is a limit to the extent to which one factor of production can be substituted for another.
The total production increases up to an extent and it gets saturated or there won’tbe any change in
the output due to the addition of the input factor andfurther it leads to negative impact on the output.
That means the marginal production declines up to an extent and it reaches zero and becomes negative.
The point at which the MP becomes zero is the maximum outputof the firm with the given set of input
factors. This law is applicable in all human activities and business activities.

For example with two sewing machines and two tailors, a firm can produce a maximum of 14
pairs of curtains per day. The machines are used only from 9 AM to 5 PM and the machines lie idle from
5 pm onwards. Therefore the firm appoints 2 more tailors for the second shift and the production goes
up to 28 units. Then adding two more labour to assist these people will increase the output to 30
units. When the firm appointstwo more people, then there won’t be any change in their production
because their Marginal productivity is zero. There is no addition in thetotal production. That means
there is no use of appointing two more tailors. Therefore, there is a limit for output from a fixed input
factors but in the long run purchase of one more sewing machine alone will help the firm to increase the
production more than 30 units.

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The Law of Returns to Scale

In the long run the fixed inputs like machinery, building and other factors will change along
with the variable factors like labour, raw material etc. With the equal percentage of increase in input
factors various combinations of returns occur in an organization.

Returns to scale: the change in percentage output resulting from a percentage change in all the factors
of production. They are increasing, constant and diminishing returns to scale.

Increasing returns to scale may arise: if the output of a firm increases more than in proportionate
to an increase in all inputs. For example the input factors are increased by 50% but the output has
doubled (100%).

Constant returns to scale: when all inputs are increased by a certainpercentage the output increases by
the same percentage. For example input factors are increased by 50% then the output has also
increased by50 percentages. Let us assume that a laptop consists of 50 components we call it as a set.
In case the firm purchases 100 sets they can assemble 100 laptops but it is not possible to produce more
than 100 units.

Diminishing returns to scale: when output increases in a smaller proportion than the increase in
inputs it is known as diminishing return to scale. For example 50% increment in input factors lead to
only 20% increment in the output.

From the graph given below we can see the total production (TP) curveand the marginal production
curve (MP) and average production curve (AP). It is classified into three stages; let us understand the
stages in termsof returns to scale.

Stage I: The total production increased at an increasing rate. We refer to this as increasing stage
where the total product, marginal productand average production are increasing.
Stage II: The total production continues to increase but at a diminishing rate until it reaches the
next stage. Marginal product, average product are declining but are positive. The total production is at
the maximum level at the end of the second stage with a zero marginal product.

Stage III: In this third stage total production declines and marginal product becomes negative.
And the average production also started decline. Which implies that the change in input factors
there is a decline in the over all production along with the average and marginal.

In economics, the production function with one variable input is illustrated with the well known law
of variable proportions. (below graph) it showsthe input-output relationship or production function
with one factor variable while other factors of production are kept constant. To understand a
production function with two variable inputs, it is necessary know the concept iso-quant or iso-product
curve.

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ISO-Quants

To understand the production function with two variable inputs,iso-quant curve is used. These
curves show the various combinations oftwo variable inputs resulting in the same level of output. The
shape of an Iso-quant reflects the ease with which a producer can substitute among inputs while
maintaining the same level of output. From the graph we can understand that the iso-quant curve
indicates various combinations of capital and labour usage to produce 100 units of motor pumps. The
pointsa, b or any point in the curve indicates the same quantum of production.If the production
increases to 200 or 300 units definitely the input usagewill also increase therefore the new iso-quant
curve for 200 units (Q1) is shifted upwards. Various iso-quant curves presented in a graph is called as
iso- quant map.

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Iso-cost: different combination of inputs that can be purchased at a given expenditure level.

The above graph explains clearly that the iso quant curve for 100 units of motor consists of ‘n’
number of input combinations to produce the same quantity. For example at ‘a’ to produce 100 units of
motors the firm uses OC amount of capital and OL amount of labour ie., more capital and less labour
force. At ’b’ OC1 amount of capital and OL1 labour force isused to produce the same that means
more labour and less capital.

Optimal input combination: The points of tangency between iso quantand iso cost curves depict
optimal input combination at different activity levels.

Expansion path: Optimal input combinations as the scale of production expand. From the graph it is
clear that the optimum combination is selected based on the tangency point of iso cost (budget line) and
iso- quant ie., a, b respectively. The point ‘a’ indicates that to produce 100 units of motor the best
combination of capital and labour are OC and OM which is within the budget. Over a period of time a
firm will face various optimum levels if we connect all points we derive expansion path of a firm.

Managerial Uses of Production Function:

Production functions are logical and useful. Production analysis can be used as aids in decision
making because they can give guidance to obtain the maximum output from a given set of inputs and
how to obtaina given output from the minimum aggregation of inputs. The complexproduction functions
with large numbers of inputs and outputs are analyzed with the help of computer based programmes.
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COST FUNCTION
A production function tells us how much output a firm can produce with its existing plant and
equipment. The level of output depends on prices and costs. The most desirable rate of output is the one
that maximizes total profit that is the difference between total revenue and total cost.

Entrepreneurs pay for the input factors- Wages for labour, pricefor raw material, rent for
building hired, interest for borrowed money. All these costs are included in the cost of production. The
economist’s concept of cost of production is different from accounting.
The cost function helps us to understand the basic cost concepts and the cost output
relationship in the short and long runs. Having looked at input factors in the previous chapter it is now
possible to see how the lawof diminishing returns affect short run costs.

Cost Determinants
The cost of production of goods and services depends on various input factors used by the
organization and it differs from firm to firm. The major cost determinants are:
1. Level of output: The cost of production varies according to the quantum of output. If the size
of production is large then the cost of production will also be more.
2. Price of input factors: A rise in the cost of input factors will increase the total cost of production.
3. Productivities of factors of production: When the productivity of the input factors is high then
the cost of production will fall.
4. Size of plant: The cost of production will be low in large plants due to mass production with
mechanization.
5. Output stability: The overall cost of production is low when the outputis stable over a period
of time.
6. Lot size: Larger the size of production per batch then the cost of production will come down
because the organizations enjoy economiesof scale.
7. Laws of returns: The cost of production will increase if the law of diminishing returns appliesin the
firm.
8. Levels of capacity utilization: Higher the capacity utilization, lower the cost of production
9. Time period: In the long run cost of production will be stable.
10. Technology: When the organization follows advanced technology in their process then the cost
of production will be low.
11. Experience: over a period of time the experience in production process will help the firm to reduce
cost of production.
12. Process of range of products: Higher the range of products produced, lower the cost of production.
13. Supply chain and logistics: Better the logistics and supply chain, lower the cost of production.
14. Government incentives: If the government provides incentives on input factors then the cost of
production will be low.

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Types of Costs
There are various classifications of costs based on the nature andthe purpose of calculation.
But in economics and for accounting purposethe following are the important cost concepts.
Actual cost/ Outlay cost/ Absolute cost / Accounting cost: The cost or expenditure which a firm incurs for
producing or acquiring a good or service. (Eg. Raw material cost)
Opportunity cost: The revenue which could have been earned by employing that good or service in
some other alternative uses. (Eg. A land owned by the firm does not pay rent. Thus a rent is an income
forgone bynot letting it out)
Sunk cost: Are retrospective (past) costs that have already been incurred and cannot be recovered.
Historical cost: The price paid for a plant originally at the time of purchase.
Replacement cost: The price that would have to be paid currently for acquiring the same plant.
Incremental cost: Is the addition to costs resulting from a change in the nature of level of business
activity. Change in cost caused by a given managerial decision.
Explicit cost: Cost actually paid by the firm. If the factors of productionare hired or rented then it
is an explicit cost.
Implicit cost: If the factors of production are owned by a firm then its cost is implicit cost.
Book cost: Costs which do not involve any cash payments but a provisionis made in the books of
accounts in order to include them in the profit and loss account to take tax advantages.
Social cost: Total cost incurred by the society on account of production ofa good or service.
Transaction cost: The cost associated with the exchange of goods and services.
Controllable cost: Costs which can be controllable by the executives are called as controllable cost.
Shut down cost: Cost incurred if the firm temporarily stops its operation. These can be saved by
continuing business.
Economic costs are related to future. They play a vital role in business decisions as the costs considered
in decision - making are usually future costs. They are similar in nature to that of incremental,
imputed explicitand opportunity costs.

Determinants of Short –Run Cost

Fixed cost: Some inputs are used over a period of time for producing more than one batch of goods.
The costs incurred in these are called fixed cost.For example amount spent on purchase of equipment,
machinery, land and building.

Variable cost: When output has increased the firm spends more on these items. For example the money
spent on labour wages, raw material and electricity usage. Variable costs vary according to the output.
In the longrun all costs become variable.
Total cost: The market value of all resources used to produce a good or service.
Total Fixed cost: Cost of production remains constant whatever the levelof output.
Total Variable cost: Cost of production varies with output.
Average cost: Total cost divided by the level of output.
Average variable cost: Variable cost divided by the level of output.
Average fixed cost: Total fixed cost divided by the level of output.
Marginal cost: Cost of producing an extra unit of output.

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Short Run Cost Output Relationship

Fixed cost curve is a horizontal line which is parallel to the ‘X’ axis. This cost is constant with
respect to output in the short run. Fixed cost does not change with output. It must be paid even if ‘0’
units of output are produced. For example: if you have purchased a building for the business you have
invested capital on building even if there is no production.
Total fixed cost (TFC) consists of various costs incurred on the building, machinery, land, etc..
For example if you have spent Rs. 2 Lakhs and boughtmachinery and building which is used to produce
more than one batch of commodity, then the same cost of Rs. 2 Lakhs is fixed cost for all batches. The
total variable costs vary according to the output. Whenever the output increases the firm has to buy
more raw materials, use more electricity,labour and other sources therefore the TVC curve is upward
sloping. The total cost consists of fixed (TFC) and variable costs (TVC). The TFC ofRs. 2 Lakhs is
included with the variable cost throughout the production schedule so the total cost (TC) is above the
TVC line.

Graph – Total Cost Curves

Graph – Average Cost Curves

The above set of graphs indicates clearly that the average variable cost curve looks like a boat.
Average fixed cost curve declines as output increases and it is a hyperbola to the origin. The Marginal
cost curve slopes like a tick mark which declines up to an extent then it starts increasing along
with the output. Let us see and understand the nature of each andevery curve with an example. The
table and graphs shown below indicates the total costs curves and average cost curves at various output
level.

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Table - Cost Schedule

(Rupees in thousands ‘000)

Outp TC TF TV AF AT A M
ut C C C C V C
C
0 v12 30 - - - - -
00 0
1 180 30 15 30 18 15 6
0 0 00 0 00 00 0
0
2 200 30 17 15 10 85 2
0 0 00 0 00 0 0
0
3 210 30 18 10 70 60 1
0 0 00 0 0 0 0
0
4 225 30 19 75 56 48 1
0 0 50 2.5 7.5 5
0
5 260 30 23 60 52 46 3
0 0 00 0 0 5
0
6 330 30 30 50 55 50 7
0 0 00 0 0 0
0

Graph – Average Cost Curves

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Graph – Total Cost Curves

From the above table and set of graphs we can understand thatcapital is the fixed factor of
production and the total fixed cost will be the same Rs. 300,000. The total variable cost will increase as
more and more goods are produced. So the total variable cost TVC of producing 1 unit is Rs.1500 000,
for 2 units 1700 000 and so on.
Total cost = TFC + TVC for 1 unit TC = 300 + 1500 = 1800.

The marginal cost of producing an extra unit is calculated based on thedifference in total cost.

MCn = TCn – TCn-1

MC2 = TC2 – TC2 -1 = 2000 – 1800 = 200

MC for 5th unit = TC of 5th unit minus TC of 4th unit,in our example 2600 – 2250 = 350.
AVC also is calculated in the same manner TVC / output = 2600 / 5 = 460AFC = TFC / output = 300
/ 5 = 60.

Relationship Between Marginal Cost And Average Cost Curve:

The marginal cost and average cost curves are U shaped because of law of diminishing returns.
The marginal cost curve cuts the average cost curve and average variable cost curves at their lowest
point. Marginal cost curve cuts the average variable cost from below. The AC curve is abovethe
MC curve when AC is falling. The AC curve is below the MC whenAC is increasing. The
intersecting point indicates that AC=MC and thatis the minimum average cost with an optimum
output. (No more outputcan be produced at this average cost without increasing the fixed cost of
production)
Graph – Relationship Between Average Cost And Marginal Cost

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Optimum Output And Minimum Cost

The MC and AC curves are mirror image of the MP and AP curves.

It is presented in the graph below.

All organizations aim for maximum output with minimum cost. To achieve this goal they like
to derive the point where optimum output canbe produced with the given amount of input factors and
with a minimum average cost. In the graph the MP=AP at maximum average production.On the
other hand MC = AC at minimum average variable cost. Therefore this is the optimum output to be
produced to achieve their managerialgoals.

Graph – Optimum Cost And Output

The above set of cost curves explain the cost output relationship in the short period but in the
long run there is no fixed cost because all costs vary over a period of time. Therefore in the long run
the firm will haveonly average cost curve that is called as long run average cost curve (LAC). Let us
see how the average cost curve is derived in the long run. This LAC also slopes like the short period
average cost curve (U shaped) providedthe law of diminishing returns prevails. In case the returns to
scale are increasing or constant then the LAC curve will have a different slope. Itwill be a horizontal
line, which is parallel to the ‘X’ axis.

Cost Output Relationship In The Long Run

In the long run costs fall as output increases due to economies of scale, consequently the average
cost AC of production falls. Some firms experience diseconomies of scale if the average cost begins
to increase.This fall and rise derives a U shaped or boat shaped average cost curve inthe long run
which is denoted as LAC. The minimum point of the curve is said to be the optimum output in the
long run. It is explained graphicallyin the chart given below.

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Graph – Long Run Average Cost Curve

In the long run all factors are variable and the average cost may fall or increase to A, B
respectively but all these costs are above the long runcost average cost. LAC is the lower envelope
of all the short run averagecost curves because it contains them all. At point ‘E’ the SAC1 and SMC1
intersects each other, in case the organization increases its output fromOM to OM1 they have to spend
OC1 amount. In case the organization purchases one more machine (increase in fixed cost) then they
will get anew set of cost curves SAC2, and SMC2. But the new average cost curve reduces the cost
of production from OC1 to OC2.That means they cansave the difference of C1C2 which is nothing
but AB. Therefore in the long run due to business expansion a firm can reduce their cost of production.
During their business life they will meet many combinations of optimum production and minimum
cost in different short periods. In the long run due to law of diminishing returns the long run
average cost curve LACalso slopes like boat shape.

Economies of Scale
Economies of scale exist when long run average costs decline as output is increased.
Diseconomies of scale exist when long run averagecost rises as output is increased. It is graphically
presented in the following graph. The economies of scale occur because of (i) technical economies: the
change in production process due to technology adoption. (ii) Managerial economies (iii) purchasing
economies, (iv) marketing economies and (v) financial economies.
Economies of scale means a fall in average cost of production dueto growth in the size of the industry
within which a firm operates.

Diseconomies of Scale:
Arises due to managerial problems. If the size of the business becomes too large, then it
becomes difficult for management to controlthe organizational activities therefore diseconomies of
scale arise.

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Graph – Economies of Scale and Diseconomies of scale

Factors Causing Economies Of Scale:

There are various factors influencing the economies of scale of an organization. They are
generally classified in to two categories as Internal factors and External factors.

Internal Factors:
1. Labour economies: if the labour force of a firm is specialized in a specific skill then the organization
can achieve economies of scale due to higher labour productivity.
2. Technical economies: with the use of advanced technology theycan produce large quantities
with quality which reduces their cost of production.
3. Managerial economies: the managerial skills of an organizationwill be advantageous to achieve
economies of scale in variousbusiness activities.
4. Marketing economies: use of various marketing strategies will help in achieving economies of
scale.
5. Vertical integration: if there is vertical integration then there willbe efficient use of raw material
due to internal factor flow.
6. Financial economies: the firm’s financial soundness and past record of financial transactions will
help them to get financial facilities easily.
7. Economies of risk spreading: having variety of products and diversification will help them to spread
their risk and reduce losses.
8. Economies of scale in purchase: when the organization purchases raw material in bulk reduces the
transportation cost and maintains uniform quality.
External Factors:
1. Better repair and maintenance facilities: When the machinery and equipments are repaired and
maintained, then the production process never gets affected.
2. Research and Development: research facilities will provide opportunities to introduce new products
and process methods.
3. Training and Development: continuous training and development of skills in the managerial,
production level will achieve economies of scale.
4. Economies of location: the plant location plays a major role in cutting down the cost of materials,
transport and other expenses.
5. Economies of Information Technology: advanced Information technology provides timely accurate
information for better decision making and for better services.
6. Economies of by-products: Organizations can increase the economies of scale by minimizing waste
and can be environmental responsible by using the by- products of the organization.
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Factors Causing Diseconomies of Scale:

1. Labour union: continuous labour problem and dissatisfaction can lead to diseconomies of scale.
2. Poor team work: Poor performance of the team leads to diseconomies of scale.
3. Lack of co-ordination: lack of coordination among the work force has a major role to play in causing
diseconomies of scale.
4. Difficulty in fund raising: difficulties in fund raising reduce the scale of operation.
5. Difficulty in decision making: the managerial inability, delay in decision making is also a factor
that determines the economiesof scale.
6. Scarcity of Resources: raw material availability determines the purchase and price. Therefore there
is a possibility of facing diseconomies in firms.
7. Increased risk: growing risk factors can cause diseconomies of scale in an organization. It is essential
to reduce the same.

Constant Returns to Scale:

In the long run if the returns to scale are constant then the average cost of production will be the
same. For example : Ananda Vikatan magazine, started 100 years ago and it was sold in the market for
25 paise but now it is still sold at a nominal cost of Rs.15. The price increased because raw material cost
and printing and labour costs have also increased but in the long run the price of the commodity has
not increased much.
The constant returns to scale curve is graphically presented below which indicates that the LRAC
is not a boat shaped curve

From the above graph it is clear that in the long run it is possible to derivea LRAC as a straight line
with constant returns to scale.
Economies of scope: producing variety to get cost advantage. In retail business it is commonly used.
Product diversification within the same scale of plant will help them to achieve success.
Lessons For Managers:
• To achieve reasonable return the firm should go for larger plants orexpand their plant for optimum
utilization of available resources.
• Build market share to achieve the scale which in turn reduces thecost of production.
• All business activities of the organization leads to economies of scale directly or indirectly.

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CONSUMER'S EQUILIBRIUM
We buy many goods and services to satisfy our wants. Using up of goods and services to satisfy wants is
called consumption and the economic agent who buys goods and services is called a consumer. When a consumer
buys any good or service, his/her main objective is to get maximum satisfaction from the quantity of the commodities
purchased by spending his/her income at the given market price. How does a consumer maximize his/her satisfaction
from spending his/her income on various goods and services.

MEANING OF CONSUMER’S EQUILIBRIUM

Equilibrium means a state of rest from where there is no tendency to change. A consumer is said to be in
equilibrium when he/she does not intend to change his/ her level of consumption i.e., when he/she derives maximum
satisfaction. Thus, consumer’s equilibrium refers to a situation where the consumer has achieved maximum possible
satisfaction from the quantity of the commodities purchased given his/her income and prices of the commodities in the
market. As the resources are scarce in relation to unlimited wants, a consumer has to follow some principles or laws in
order to attain the highest level of satisfaction. There are two main approaches to study consumer’s equilibrium.
They are as follows:
1. Cardinal utility approach (or Marshall’s utility analysis)
2. Ordinal utility approach (or indifference curve analysis)

CARDINAL UTILITY APPROACH

The theory of consumers behaviour by using utility approach was first given by the noted economist Alfred Marshall.
Before discussing how a consumer attains equilibrium , we need to understand the concept of utility, marginal utility
and total utility.
i) Utility is defined as the power of a commodity to satisfy a human want. Utility of a commodity is the
total amount of psychological satisfaction that a person gets from consumption of a good or service, e.g. a
thirsty person derives satisfaction from drinking a glass of water. So a glass of water has got utility for the
thirsty person. Utility differs from person to person. Utility is subjective and cannot be measured
quantitatively. Yet for the sake of convenience it is measured in ‘utils’. Marshall suggested that the
measurement of utility should also be done in monetary terms by converting ‘util’ into money by using the
following formula Utility in Money = Utility in Util/Utility of a rupee. Utility of rupee can be assumed to be
any number such as 1, 2, 3 ... .
Let utility of a rupee is assumed to be 2 utils. Then 10 utils = 10/ 2 = ` 5.
ii) Marginal Utility (MU): Marginal utility is the addition to the total utility derived from the consumption of an
additional unit of a commodity. It can also be defined as the utility from the last unit of a commodity consumed. Let
us explain the concept of marginal utility with the help of an example. Suppose, a consumer gets total utility of 10
utils from consumption of one orange and 18 utils from two oranges. He gets 8 utils from consumption of second
orange. So, marginal utility of second orange is 8 utils. If total utility derived from three oranges is 24 utils then
marginal utility of three oranges is 6 utils (i.e. 24-18 utils). In this case third orange is the last orange. Thus marginal
utility of 3 oranges is 6 utils.
Marginal utility can be calculated by the following formula:
MUn = TUn – TUn–1
or MU = ∆TU / ∆MU
Where, MUn = Marginal utility of nth unit of the commodity
TUn = Total utility of n units
TUn–1 = Total utility of n–1 units
Xn = Quantity of nth unit of good X
Xn–1 = Quantity or (n–1)th unit of good X
“n” takes the values 1, 2, 3, ... .

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(iii) Total utility: Total utility is the total satisfaction obtained from the consumption of all possible units
of a commodity. For example, if the first orange gives you a satisfaction of 10 utils, second one gives you 8
utils and third one gives you 6 utils, then total utility from three oranges = 10 + 8 + 6 = 24 utils. Total utility
can be obtained by summing up marginal utilities from consumption of different units of a commodity.
Thus, total utility can be calculated as:
TUn = MU1 + MUZ + MU3 + ........ MUn
Or TUn = ∑ MU
where, TUn = Total utility from n units of a given commodity
MU1, MU2, MU3, MUn = Marginal utilities from 1st, 2nd 3rd and nth unit of the commodity.

RELATIONSHIP BETWEEN TOTAL UTILITY AND MARGINAL UTILITY

The relationship between total utility and marginal utility is explained with the help of following table

• MU is the rate of change of TU. It means that Total Utility increases as long as
marginal utility is positive.
• Total Utility is maximum when marginal utility is zero.
• Total utility starts declining when marginal utility becomes negative.
1. MU is the rate of change of TU. It means that Total Utility increases as long as marginal utility is positive. In the
table marginal utility is declining between the range AB but is positive. So total utility is increasing at decreasing rate.
2. Total Utility is maximum when marginal utility is zero. At point B, MU = 0, and the corresponding point on TU is
C where TU is maximum.
3. Total utility starts declining when marginal utility becomes negative (i.e., less than zero.

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LAW OF DIMINISHING MARGINAL UTILITY
It is a matter of common observation that as we get more and more units of a commodity, the intensity of our
desire for that commodity tends to diminish. The law of diminishing marginal utility also explains the same thing. It
states that ‘as more and more units of a commodity are consumed, marginal utility derived from each successive unit
goes on diminishing.’ The law can be explained with the help of an example. Suppose, a thirsty man drinks water. The
first glass of water he drinks will give him maximum satisfaction (utility), say, 20 utils. Second glass of water will
also fetch him utility but not as much as the first one because a part of his thirst is satisfied by drinking the first glass
of water. Suppose he gets 10 utils from the second glass. It is just possible that he may get zero utility from the third
glass because his thirst has now been satisfied. There will be negative utility from the fourth glass of water. Any
rational consumer will not consume additional glass of water when it gives disutility or negative utility.

Assumption of Law of Diminishing Marginal Utility:

The law of diminishing marginal utility operates under certain specific conditions. These are called
assumptions of the law. Some important assumptions of the law are:
1. It is assumed that utility can be measured and a consumer can express his satisfaction in quantitative terms like 1,
2, 3 etc. We have already said that unit of measurement of utility is ‘util’. So utility is cardinal.
2. Quality of the commodity should not undergo any change. Take the above example of glass of water. From the
quality point of view a consumer who drinks a glass of cold water must continue with the same. He or she cannot
change its quality from cold to normal as normal water give different satisfaction.
3. Consumption should not proceed at intervals. It should be a continuous process. Continuing with the above
example, second glass of water, if consumed two hours after the first glass of water was consumed, may give more,
less or equal satisfaction.
4. Consumer should be a rational person. This means that he/she prefers more quantity to less quantity of a good.
5. Time period of consumption should not be too long. Consumer’s tastes, habits, income etc. may change if the time
gap is more.
6. The price of the substitute and complementary goods should not change. If these prices change, it may be difficult
to predict about the utility derived from the commodity in question.

Exceptions to the Law of Diminishing Marginal Utility Some of the important exceptions to the law are following:
(i) A miser is not a good subject for this law. His desire for more wealth may in fact increase with every
successive increase in the accumulation of wealth.
(ii) A collector of rare articles like stamps, coins, paintings etc. may escape this law.
(iii) The law may not apply when it comes to a melody recital or a beautiful scenic view. These are in fact the
only real exceptions of the law and these too do not prove real hurdles to the application of the law. It is easy
to visualize that a miser or stamp collector or a musician may find their marginal utilities increasing instead
of decreasing as postulated by the law. But this tendency shall not last for long having reached a particular
stage; the law must come into operation.

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CONSUMER’S EQUILIBRIUM IN CASE OF A SINGLE COMMODITY:
Consumer’s equilibrium in case of a single commodity can be explained on the basis of the law of diminishing
marginal utility. How does a consumer decide as to how much to buy of a good? It will depend upon two factors.
(a) The price she pays for each unit which is given and
(b) The utility she gets At the time of purchasing a unit of a commodity, a consumer compares the price of the given
commodity with its utility. The consumer will be at equilibrium when marginal utility (in terms of money) equals the
price paid for the commodity say ‘X’ i.e. MUx = PX. (Note that marginal utility in terms of money is obtained by
dividing marginal utility in utils by marginal utility of one rupee).
If MUX > Px, the consumer goes on buying the commodity because she is paying less for each additional amount of
satisfaction. As she buys more, MU falls due to operation of law of diminishing marginal utility. When MU becomes
equal to price, consumer gets maximum satisfaction and now she is at equilibrium.
When MUX < Px, the consumer will have to reduce consumption of the commodity to raise his total satisfaction till
MU becomes equal to price. This is because she is paying more than the additional amount of satisfaction that she is
getting. Consumer’s equilibrium (in case of single commodity) can be explained with the help of table. Suppose, the
consumer wants to buy a good which is priced at Rs.10 per unit. Further, suppose, MU obtained from each successive
unit is determined. Assumed that 1 util = Re. 1.

Consumer’s Equilibrium (in case of a single commodity)

It is clear from the table that the consumer will be at equilibrium when he buys 3 units of the commodity X. He will
increase consumption beyond 2 units as MUx > Px. He will not consume 4 units or more of the commodity X as MUx <
Px.

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CONSUMER’S EQUILIBRIUM IN CASE OF TWO OR MORE COMMODITIES:

The law of diminishing marginal utility applies in case of one commodity only. But in real life a consumer
normally consumes more than one commodity. In such a situation, law of equi-marginal utility helps in optimum
allocation of his income. Law of equi-marginal utility is based on law of diminishing marginal utility. According to
the law of equi-marginal utility a consumer will be in equilibrium when the ratio of marginal utility of a commodity to
its price equals the ratio of marginal utility of other commodity to its price.
Let a consumer buys two goods X and Y. Then at equilibrium
MUx/Px = MUY/PY = MU of last rupee spent on each good, or simply MU of Money. X X MU P = Y Z Y Z MU MUz /
Pz = MU Money – MU Money Similarly if there are three goods X, Y, Z then the condition of equilibrium will be
simply MU Money. Thus, to be in equilibrium
1. Marginal utility of the last rupee of expenditure on each good is the same.
2. Marginal utility of a good falls as more of it is consumed.
To explain the consumer’s equilibrium in case of two goods let us take an example. Suppose a consumer has Rs.24
with him to spend on two goods X and Y. Further, suppose price of each unit of X is Rs. 2 and that of Y is Rs.3 and
his marginal utility schedule is given in table.

Consumer’s Equilibrium (in case of two goods)

.
For obtaining maximum satisfaction from spending his income of Rs.24, the consumer will buy 6 units of X by
spending Rs.12 (` 12 = 2 × 6) and 4 units of Y by spending ` 12 (12 = 2 × 6). This combination of goods brings him
maximum satisfaction (or state of equilibrium) because a rupee worth of MU in case of good X is 5 (MUx/Px = 10/2)
and in case of good Y is also 5
(MUY/PY = 15/3)
(= MU of last rupee spent on each good)
It should be noted that, consumer’s maximum satisfaction is subject to-budget constraints i.e. the amount of money to
be spent by the consumer (Rs. 24 in this example)

Dr. M. Babima, St. Xavier’s Catholic College of Engineering

 68 MS22103 Managerial Economics
Consumer`s Equilibrium in case of Several Commodities
The law of diminishing marginal utility applies in case of one commodity only. But in real life a consumer normally
consumes more than one commodity. In such a situation, law of equi-marginal utility helps in optimum allocation of
his income. Law of equi-marginal utility is based on law of diminishing marginal utility. According to the law of equi-
marginal utility a consumer will be in equilibrium when the ratio of marginal utility of a commodity to its price equals
the ratio of marginal utility of other commodity to its price. Let a consumer buys two goods X and Y. Then at
equilibrium

It is also known as ‘Law of Equi- Marginal Utility.

•
𝑀𝑈1 𝑀𝑈2 𝑀𝑈3
+ + + …….

𝑀𝑈𝑛
⋯⋯ = 𝑀𝑈𝑀

• According to the law of equi- marginal utility a consumer will be in equilibrium when the ratio
of marginal utility of a commodity to its price equals the ratio of marginal utility of other
commodity to its price.
• Similarly if there are three goods X, Y, Z then the condition of equilibrium will be simply MU Money.
Thus, to be in equilibrium
1. Marginal utility of the last rupee of expenditure on each good is the same.
2. Marginal utility of a good falls as more of it is consumed.

What happens when the consumer is not in equilibrium?

Suppose, MUx/Px is greater than MUy/Py. This means that MU from last rupee spent on X is greater than the MU
of the last rupee spent on Y. This induces the consumer to transfer his expenditure from Y to X. As a
consequence, MUx falls and MU rises. The act of transfer of expenditure continues until MUx/Px becomes equal
to MUy/Py.

LIMITATION OF UTILITY ANALYSIS

In the utility analysis, it is assumed that utility is cardinally measurable, i.e., it can be expressed in quantitative term.
However, utility is a feeling of mind and there cannot be a standard measure of what a person feels. So, utility
cannot be expressed in figures.

Dr. M. Babima, St. Xavier’s Catholic College of Engineering

 69 MS22103 Managerial Economics
ORDINAL UTILITY APPROACH (INDIFFERENCE CURVE ANALYSIS)
The utility approach which was based on the assumption that utility is measurable numerically (like 1 util, 2
utils, 3 utils). This is called cardinal utility approach. Prof. J.R. Hicks criticized the utility approach as unrealistic
because satisfaction (utility) is a subjective phenomenon and so it can never be measured precisely. He, therefore,
presented an alternative technique known as indifference curve approach (also called ordinal utility approach). It is
based on the assumption that every consumer has a scale of preference in the form of assigning ranks (like 1st 2nd, 3rd
rank) to different combinations of two goods called bundle and can tell which bundle he likes most.
Concepts related to indifference curve analysis.

(i) Meaning of Indifference Curve: When a consumer consumes various goods and services, then there are some
combinations (bundles) which give him same satisfaction. The graphical representation of such combinations is
termed as indifference curve

An indifference curve is a curve that shows all those combinations (bundles) of two goods which give equal
satisfaction to the consumer. Table 14.4 shows an indifference schedule showing all the combinations of good X and
good Y giving ‘equal satisfaction to the consumer.

Indifference Schedule

Combinations A, B, C and D of good X and Y viz. (1X + 8Y), (2X + 4Y), (3X + 2Y) and (4X + 1Y) give the
consumer equal satisfaction. In other words, consumer is indifferent between these combinations of good X and good
Y. When these combinations are represented graphically, we get an indifference curve as shown in Fig.

(ii) Monotonic Preferences

Consumer’s preferences are called monotonic if and only if between two bundles, consumer prefers the bundle which
has more of at least one of the good and no less of other good as compared to other bundles. For example, between the
bundles (2X + 2Y), (1X + 2Y), (2X + 1Y) and (1X + 1Y), the consumer will prefer only bundle (2X + 2Y) to all the
three bundles, if his preferences are monotonic.

Dr. M. Babima, St. Xavier’s Catholic College of Engineering

 70 MS22103 Managerial Economics
(iii) Indifference Map
An indifference map is a collection of indifference curves that represent different levels of satisfaction. Higher
indifference curves represent higher level of satisfaction because higher indifference curves represent more quantities
of both the goods or same quantity of one good and more quantity of other good.

An indifference map containing three indifference curves IC1, IC2 and IC3, is drawn in Fig. All the bundles on IC2
give more satisfaction to the consumer in comparison to IC1. Similarly, the bundles on IC3 give more satisfaction to
the consumer in comparison to IC1 and IC2. This is a result of monotonic preferences.

(iv) Budget Line

A budget line graphically represents all possible combinations of two goods which a consumer can buy with
his entire income at the prevailing market prices. Anywhere on the budget line consumer is spending his
entire income either on single or both the goods. Suppose, the consumer wants to buy good X and good Y;
price of each unit of X is P and that of Y is P2; Then Accordingly the expenditure on X will be equal to P1X
and the same on Y will be equal to P2Y. Total expenditure on good X and Y will be P1X + P2Y. Let the
money required to buy these goods is denoted as M. So we can write that
P1X + P 2Y = M
This is called the equation for budget line.

In the Fig., AB is the budget line. Point A is located by dividing the entire income over quantity of good Y only.
Similarly point B is located by dividing the entire income over quantity of good X only. At any point on the line AB
other than, A and B, the consumer can buy certain combination of X and Y by using her income.
A budget line changes when either the prices of the goods or income of the consumer or both changes. A budget line
is negatively sloped because to buy more units of a good, consumer must buy less units of other good as consumer’s
income is fixed.
Slope of budget line = Quantity of other good sacrificed/ Quantity of good obtained
= ∆Y/∆X

Dr. M. Babima, St. Xavier’s Catholic College of Engineering

 71 MS22103 Managerial Economics
Suppose, price of good X is Rs.2 and that of good Y is Re.1. So, he has to sacrifice 2 units of good Y to obtain one
unit of good X. In this example,
Slope of budget line = ∆Y/∆X = 2/1
2/1 is nothing but the price ratio between good X and good Y. So the price ratio indicates the slope of budget line.
Thus, Slope of budget line = Px/Py. This is also called market rate of exchange (MRE) because the two goods can be
exchanged at this rate, given their prices in the market.

V) Budget Set Budget set is the set of all possible combinations of two goods which a consumer can afford, given
his income and market prices of the two goods. So, a budget set includes all the bundles of two goods which
consumer can afford even if her entire income is not spent.

VI) Marginal rate of substitution (MRS) Marginal rate of substit ution refers to the rate at which consumer is
willing to give up amount of other good to obtain one extra unit of the good in question without affecting total
satisfaction. So, the rate of substitution of one commodity for another is called marginal rate of substitution. It is
expressed as MRSxy of good X for good Y. Symbolically, MRSxy = Loss of good Y/ Gain of good X = ∆Y/ ∆X
MRSxy can be explained with the help of Fig.

MRSXY = ∆Y/∆X = AC/CB AC/CB is the slope off indifference curve, i.e. slope of indifference curve = MRSXY. As
the consumer gets more and more units of good X, marginal utility of good X goes on falling with every increase in
units of good X. Simultaneously, the consumer is left with lesser units of good Y. So, marginal utility of Y rises.
Therefore, he is willing to give up lesser quantity of good Y for obtaining additional units of good X. Hence MRS
diminishes along an indifference curve when we move from upwards to downward.

PROPERTIES OF INDIFFERENCE CURVES

(i) Indifference Curves are always convex to the origin Indifference curves are always convex to the origin
because of diminishing marginal rate of substitution. As the consumer consumes more and more of one
good, his marginal utility of this good keeps on declining and he is willing to give up less of other good.
Therefore, indifference curves are convex to the origin.
(ii) Indifference Curves slope downwards It implies that as a consumer consumes more of one good, he must
consume less quantity of the other good so that the total utility remains the same.
(iii) Higher Indifference Curves represent Higher level of satisfaction Consider Fig

Bundle A on indifference curve IC1, contains OY1 quantity of good Y and OX, quantity of good X. Bundle B on
indifference curve IC2 has same quantity i.e. OYl of good Y but more quantity i.e. OX2 of good X. Since, the
consumer’s preferences are monotonic, he will prefer bundle B to bundle A. It means, higher indifference curves
represent higher level of satisfaction.

Dr. M. Babima, St. Xavier’s Catholic College of Engineering

 72 MS22103 Managerial Economics
(iv) Indifference Curves can never Intersect To analyze this, let us consider Fig

We have two indifference curves that intersect at point B. The consumer is indifferent between bundles A and B as
they lie on the same indifference curve IC1. Similarly, the consumer is indifferent between bundles C and B as they lie
on the same indifference curve IC2. This implies that bundles A and C give the consumer the same level of
satisfaction. However, this is not possible as higher indifference curve represents higher level of satisfaction

ASSUMPTIONS OF INDIFFERENCE CURVES :

Indifference curve analysis is based upon the following assumptions:

(i) It is assumed that the consumer has fixed amount of money whole of which is to be spent on two goods,
given the market prices of goods.
(ii) It is assumed that the consumer has not reached the point of satiety. He always prefers more of both the
commodities.
(iii) Consumer can rank his preferences on the basis of the satisfaction from each bundle of goods.
(iv) It is assumed that marginal rate of substitution is diminishing.
(v) Consumer is a rational person i.e. he always aims to maximize his satisfaction.

CONSUMER’S EQUILIBRIUM BY INDIFFERENCE CURVE ANALYSIS:

As stated earlier, consumer’s equilibrium refers to a situation when he gets maximum satisfaction and he feels no need
to change his position, subject to his income and market prices of two goods. Condition of Consumer’s Equilibrium
According to indifference curve approach, a consumer will be at equilibrium when:
(i) Budget line is tangent to the indifference curve. i.e. slope of budget line = slope of indifference curve Or,
MRSXY = Px/PY
Suppose, two goods consumed are X and Y. Further suppose the consumer wants to increase consumption of good
X in place of good Y. MRS is the rate/at which consumer is willing to sacrifice amount of Y to get one more unit
of X. Market rate of exchange (MRE) is the rate at which consumer has to sacrifice amount of Y to get one more
unit of X.

When MRS>MRE, it implies that in order to obtain one unit of X, the consumer is willing to sacrifice more units of Y
than the market allows. This will lead to increase in consumption of X but decrease in consumption of Y. MRS starts
falling. He continues to consume more of X till MRS becomes equal to MRE.

Dr. M. Babima, St. Xavier’s Catholic College of Engineering

 73 MS22103 Managerial Economics

Given the indifference map and the budget line, the consumer is at equilibrium at point E. The consumer obtains
maximum satisfaction when, he consumes bundle E containing OXl quantity of good X and OY1 quantity of good Y.
At E point budget line is tangent to the indifference curve IC2, i.e. MRS = MRE= Px/PY Note that the consumer can
buy bundles C and D because they also lie on his budget line but these bundles lie on lower indifference curve which
represents lower level of satisfaction. He will like to consume bundle G lying on indifference curve IC3 which
represents highest level of satisfaction but it is beyond his budget. So the consumer's equilibrium bundle is X 1, Y1 at
point E where the budget line is tangent to indifference curve.

Dr. M. Babima, St. Xavier’s Catholic College of Engineering