managerial economics

Managerial Economics

Copyright 2013 by Universal Training Solutions Pvt. Ltd., Pune, Maharashtra (uts)This book contains the course content for Managerial Economics.

First Edition 2013

Printed & Published byutsBavdhan, Pune - 411021

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Index

Content ........................................................................ II

List of Figures .......................................................... VII

List of Tables .......................................................... VIII

Abbreviations ............................................................IX

Case Study .............................................................. 115

Bibliography ............................................................ 119

Self Assessment Answers ........................................ 122

Book at a Glance

I

II

Contents

Chapter I ....................................................................................................................................................... 1Basics of Economics ..................................................................................................................................... 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Introduction .............................................................................................................................................. 21.2 Meaning and Definition of Economics .................................................................................................... 21.3 Economics Basics .................................................................................................................................... 21.4 Macroeconomics and Microeconomics ................................................................................................... 21.5 The Two Basic Concepts of Economics................................................................................................... 2 1.5.1 Production Possibility Frontier (PPF) ...................................................................................... 2 1.5.2 Opportunity Cost ...................................................................................................................... 41.6 Market Economy ...................................................................................................................................... 41.7 Command Economy ................................................................................................................................. 41.8 Choice as an Economic Problem ............................................................................................................. 51.9 Central Problems of an Economy ............................................................................................................ 51.10 Market Mechanism ................................................................................................................................ 51.11 Positive Economics and Normative Economics .................................................................................... 51.12 Inductive Method and Deductive Method of Economic Analysis ......................................................... 6Summary ....................................................................................................................................................... 8References ..................................................................................................................................................... 8Recommended Reading ............................................................................................................................... 8Self Assessment ............................................................................................................................................. 9

Chapter II ....................................................................................................................................................11Demand, Supply and Product Management ............................................................................................11Aim ...............................................................................................................................................................11Objectives .....................................................................................................................................................11Learning outcome .........................................................................................................................................112.1 Introduction ............................................................................................................................................ 122.2 Concept of Demand ............................................................................................................................... 122.3 Demand Schedule and Concept ............................................................................................................. 12 2.3.1 Market Demand Curve ........................................................................................................... 12 2.3.2 Law of Demand ..................................................................................................................... 132.4 Price Elasticity of Demand .................................................................................................................... 13 2.4.1 Types of Demand ................................................................................................................... 132.5 Factors Affecting Demand ..................................................................................................................... 142.6 Concept of Supply .................................................................................................................................. 14 2.6.1 Supply Schedule and Concept ............................................................................................... 14 2.6.2 Market Supply Curve ............................................................................................................. 15 2.6.3 Law of Supply ........................................................................................................................ 16 2.6.4 Price Elasticity of Supply ...................................................................................................... 16 2.6.5 Types of Supply ..................................................................................................................... 16 2.6.6 Factors Affecting Supply ....................................................................................................... 172.7 Equilibrium in Demand and Supply ...................................................................................................... 172.8 Equilibrium as per the Change in Demand and Supply ......................................................................... 182.9 Tax Impact on Price or Quantity of Goods ............................................................................................ 212.10 Perfect Competition ............................................................................................................................. 212.11 Economic Factors Related to Industry with Perfect Competition ........................................................ 22 2.11.1 Marginal Revenue ................................................................................................................ 222.12 Perfect Competition in Short Run ........................................................................................................ 232.13 Perfect Competition in Long Run ........................................................................................................ 24 2.13.1 Economic Profit and Losses ................................................................................................ 24

III

2.13.2 Zero Economic Profit in Long Run ..................................................................................... 242.14 Monopoly Market ................................................................................................................................ 242.15 Characteristics of Monopoly Firm ....................................................................................................... 242.16 Factors of Monopoly Power ................................................................................................................. 242.17 Monopoly and Market Demand ........................................................................................................... 252.18 Marginal Decision Rule in Monopoly Market ..................................................................................... 252.19 Oligopoly Market ................................................................................................................................. 262.20 Concentration in Oligopoly .................................................................................................................. 262.21 Game Theory and Oligopoly Behaviour .............................................................................................. 27Summary ..................................................................................................................................................... 29References ................................................................................................................................................... 29Recommended Reading ............................................................................................................................. 29Self Assessment ........................................................................................................................................... 30

Chapter III .................................................................................................................................................. 32Analysis of Consumer Choice, Production Analysis and Cost Concept ................................................ 32Aim .............................................................................................................................................................. 32Objectives .................................................................................................................................................... 32Learning outcome ........................................................................................................................................ 323.1 Introduction ............................................................................................................................................ 333.2 Utility Theory ......................................................................................................................................... 33 3.2.1 Total Utility (TU) ................................................................................................................... 33 3.2.2 Marginal Utility (MU) ........................................................................................................... 33 3.2.3 Budget Constrain ................................................................................................................... 353.3 Production Analysis ............................................................................................................................... 363.4 Short Run Production Function ............................................................................................................. 36 3.4.1 Total, Marginal and Average Product..................................................................................... 363.5 Cost Concept .......................................................................................................................................... 38 3.5.1 Total Cost and Marginal Cost ................................................................................................ 38 3.5.2 Average Total Cost ................................................................................................................. 393.6 Relationship between Marginal Cost, Average Fixed Cost, Average Variable Cost and

Average Total Cost in Short Run ........................................................................................................... 393.7 Cost Concept in Long Run ..................................................................................................................... 403.8 Economy of Scale, Diseconomy of Scale and Constant Return to Scale .............................................. 40Summary ..................................................................................................................................................... 42References ................................................................................................................................................... 42Recommended Reading ............................................................................................................................. 42Self Assessment ........................................................................................................................................... 43

Chapter IV .................................................................................................................................................. 45The Nature of Factor Demands ................................................................................................................ 45Aim .............................................................................................................................................................. 45Objectives .................................................................................................................................................... 45Learning outcome ........................................................................................................................................ 454.1 Introduction ............................................................................................................................................ 464.2 Income and Wealth ................................................................................................................................. 46 4.2.1 Income ................................................................................................................................... 46 4.2.2 Wealth .................................................................................................................................... 474.3 Input Pricing by Marginal Productivity ................................................................................................. 474.4 The Nature of Factor Demands .............................................................................................................. 47 4.4.1 Factors Demands and Derivation ........................................................................................... 47 4.4.2 Factors Demands are Interdependent ..................................................................................... 484.5 Distribution Theory and Marginal Revenue Product ............................................................................. 484.6 The Demand for Factors of Production.................................................................................................. 49 4.6.1 Rule for Choosing the Optimal Combination of Inputs ......................................................... 49

IV

4.6.2 Least-Cost Rule ...................................................................................................................... 49 4.6.3 Marginal Revenue Product and the Demand for Factors ....................................................... 49 4.6.4 Substitution Rule .................................................................................................................... 504.7 Supply of Factors of Production ............................................................................................................ 504.8 Determination of Factor Prices by Supply and Demand ....................................................................... 514.9 The Distribution of National Income ..................................................................................................... 534.10 Marginal-Productivity Theory with Many Inputs ................................................................................ 54Summary ..................................................................................................................................................... 55References ................................................................................................................................................... 55Recommended Reading ............................................................................................................................. 55Self Assessment ........................................................................................................................................... 56

Chapter V .................................................................................................................................................... 58The Markets for Labor, Capital and Land .............................................................................................. 58Aim .............................................................................................................................................................. 58Objectives .................................................................................................................................................... 58Learning outcome ........................................................................................................................................ 585.1 The Labor Market ................................................................................................................................... 595.2 Fundamentals of Wage Determination ................................................................................................... 59 5.2.1 The General Wage Level ........................................................................................................ 59 5.2.2 Demand for Labor .................................................................................................................. 59 5.2.3 International Comparisons ..................................................................................................... 605.3 The Supply of Labor .............................................................................................................................. 60 5.3.1 Hours Worked ......................................................................................................................... 60 5.3.2 Labor-force Participation ....................................................................................................... 60 5.3.3 Immigration ........................................................................................................................... 605.4 Wage Differentials ................................................................................................................................... 61 5.4.1 Differences in Jobs: Compensating Wage Differentials ......................................................... 61 5.4.2 Differences in People: Labor Quality ..................................................................................... 61 5.4.3 Differences in People: The Rents of Unique Individuals .................................................. 61 5.4.4 Segmented Market and Noncompeting Groups ..................................................................... 615.5 Economics of Labor Union .................................................................................................................... 62 5.5.1 Effect of Unions on Wages and Employment ........................................................................ 625.6 Discrimination by Race and Gender ...................................................................................................... 625.7 Techniques to Determine Extent of Discrimination ............................................................................... 635.8 Reducing Labor Market Discrimination ................................................................................................ 635.9 Land and Rent ........................................................................................................................................ 635.10 Capital and Interest ............................................................................................................................... 635.11 Rate of Return on Capital Goods.......................................................................................................... 645.12 Financial Assets and Tangible Assets .................................................................................................... 64 5.12.1 Financial Assets and Interest Rates ...................................................................................... 64 5.12.2 Real and Nominal Interest Rates .......................................................................................... 645.13 Present Values of Asset ......................................................................................................................... 65 5.13.1 Present Value for Perpetuities ............................................................................................... 65 5.13.2 General Formula for Present Value ....................................................................................... 655.14 Profits ................................................................................................................................................... 66 5.14.1 Profits as Rewards for Innovation ........................................................................................ 66 5.14.2 Uncertainty and Profit .......................................................................................................... 66 5.14.3 Profits and Market Structure ................................................................................................ 665.15 The Theory of Capital and Interest ...................................................................................................... 66 5.15.1 Applications of Classical Capital Theory ............................................................................. 67Summary ..................................................................................................................................................... 68References ................................................................................................................................................... 68Recommended Reading ............................................................................................................................. 68Self Assessment ........................................................................................................................................... 69

V

Chapter VI .................................................................................................................................................. 71International Trade ................................................................................................................................... 71Aim .............................................................................................................................................................. 71Objectives .................................................................................................................................................... 71Learning outcome ........................................................................................................................................ 716.1 Introduction ............................................................................................................................................ 726.2 Factors Determining Gains from Trade ................................................................................................. 73 6.2.1 Relative Differences in Cost Ratio ........................................................................................ 73 6.2.2 Reciprocal Demand ................................................................................................................ 736.3 The Sources of International Trade in Goods and Services ................................................................... 736.4 Comparative Advantage among Nations ............................................................................................... 73 6.4.1 Ricardos Analysis of Comparative Advantage ..................................................................... 74 6.4.2 Autarky Equilibrium .............................................................................................................. 746.5 Economic Gains from Trade ................................................................................................................. 756.6 Extensions to Many Commodities and Countries .................................................................................. 76 6.6.1 Triangular and Multilateral Trade .......................................................................................... 766.7 Protectionism ......................................................................................................................................... 77 6.7.1 Trade Barriers ........................................................................................................................ 77 6.7.2 Tariffs ..................................................................................................................................... 77 6.7.3 Quotas .................................................................................................................................... 786.8 Difference between Tariffs and Quotas .................................................................................................. 786.9 Unsound Grounds of Tariff .................................................................................................................... 796.10 Potentially Valid Arguments for Protection ......................................................................................... 79 6.10.1 The Terms of Trade or Optimal Tariff Argument ................................................................. 79 6.10.2 Infant Industries ................................................................................................................... 80 6.10.3 Tariffs and Unemployment .................................................................................................. 80 6.10.4 Protection against Dumping ................................................................................................. 806.11 Negotiating Free Trade ......................................................................................................................... 80 6.11.1 Multilateral Agreements ....................................................................................................... 80 6.11.2 World Trade Organisation (WTO) ....................................................................................... 81Summary ..................................................................................................................................................... 82References ................................................................................................................................................... 82Recommended Reading ............................................................................................................................. 82Self Assessment ........................................................................................................................................... 83

Chapter VII ................................................................................................................................................ 85Government, Taxation and Expenditure ................................................................................................. 85Aim .............................................................................................................................................................. 85Objectives .................................................................................................................................................... 85Learning outcome ........................................................................................................................................ 857.1 Types of Economy ................................................................................................................................. 867.2 The Role of Government in the Economy .............................................................................................. 867.3 Tools of Government Policy ................................................................................................................... 877.4 Importance of Size of Government ........................................................................................................ 877.5 The Functions of Government ............................................................................................................... 887.6 Public Choice Theory ............................................................................................................................. 887.7 Government Expenditure ....................................................................................................................... 89 7.7.1 Nature of Government Expenditure ....................................................................................... 89 7.7.2 Objectives of Government Expenditure Classification .......................................................... 897.8 Economic Aspects of Taxation................................................................................................................ 907.9 Taxes Levied by Central Government .................................................................................................... 91 7.9.1 Direct Taxes ............................................................................................................................ 91 7.9.2 Indirect Taxes ......................................................................................................................... 927.10 Taxes Levied by State Governments and Local Bodies ....................................................................... 937.11 Tax Incidence ........................................................................................................................................ 94

VI

7.12 Nature and Relevance of Regulation .................................................................................................... 947.13 Government Intervention on Public Interest ........................................................................................ 957.14 Instruments for Regulation ................................................................................................................... 96 7.14.1 Price Cap Regulation ........................................................................................................... 96 7.14.2 Revenue Cap Regulation ..................................................................................................... 96 7.14.3 Rate of Return Regulation ................................................................................................... 96 7.14.4 Benchmarking ...................................................................................................................... 977.15 Effects of Regulation............................................................................................................................ 977.16 Decline of Economic Regulation ......................................................................................................... 977.17 Deregulation ......................................................................................................................................... 987.18 Antitrust Policies .................................................................................................................................. 98 7.18.1 Antitrust Policy in US .......................................................................................................... 98 7.18.2 Indian Scenario .................................................................................................................... 997.19 Mergers: Law and Practice ................................................................................................................... 99 7.19.1 Merger or Amalgamation ..................................................................................................... 99 7.19.2 Acquisitions and Takeovers ................................................................................................ 100 7.19.3 Advantages of Mergers & Acquisitions.............................................................................. 1007.20 Efficiency of Competition Laws ........................................................................................................ 101Summary ................................................................................................................................................... 102References ................................................................................................................................................. 102Recommended Reading ........................................................................................................................... 102Self Assessment ........................................................................................................................................ 103

Chapter VIII ............................................................................................................................................. 105Natural Resource Management .............................................................................................................. 105Aim ............................................................................................................................................................ 105Objectives .................................................................................................................................................. 105Learning outcome ...................................................................................................................................... 1058.1 Introduction .......................................................................................................................................... 1068.2 Population and Resource Limitation .................................................................................................... 1068.3 Pollution, Environment and Development ........................................................................................... 1068.4 Natural Resource Economics ............................................................................................................... 1078.5 Conservation and Allocation of Natural Resources ............................................................................. 1088.6 Natural Resource Management ............................................................................................................ 1088.7 Environmental Economics ................................................................................................................... 1088.8 Externalities ......................................................................................................................................... 1098.9 Market Inefficiency .............................................................................................................................. 1098.10 Correcting Externalities ......................................................................................................................110 8.10.1 Coase Theorem ...................................................................................................................110 8.10.2 Cap and Trade .....................................................................................................................110 8.10.3 Individual Transferable Quotas (ITQs) ...............................................................................110 8.10.4 Economic Incentives and Disincentives (India) ..................................................................1108.11 Globalisation and Environment ...........................................................................................................111Summary ....................................................................................................................................................112References ..................................................................................................................................................112Recommended Reading ............................................................................................................................112Self Assessment ..........................................................................................................................................113

VII

List of Figures

Fig. 1.1 Production possibility frontier .......................................................................................................... 3Fig. 1.2 Production possibility frontier shifts outward .................................................................................. 4Fig. 1.3 Derivation of Eagle curve for a normal good ................................................................................... 7Fig. 2.1 Market demand curve ..................................................................................................................... 13Fig. 2.3 Market supply curve ....................................................................................................................... 16Fig. 2.4 Equilibrium in demand and supply ................................................................................................. 17Fig. 2.5 Decrease in demand curve .............................................................................................................. 18Fig. 2.6 Increase in supply curve ................................................................................................................. 18Fig. 2.7 Decrease in supply .......................................................................................................................... 19Fig. 2.8 Price ceiling .................................................................................................................................... 20Fig. 2.9 Price floor ....................................................................................................................................... 20Fig. 2.10 Firms demand and industry equilibrium curve ............................................................................ 22Fig. 2.11 Marginal revenue and demand curve ............................................................................................ 23Fig. 2.12 Profit maximisation ...................................................................................................................... 23Fig. 2.13 Perfect competition vs. monopoly ................................................................................................ 25Fig. 2.14 Marginal decision rule in monopoly market ................................................................................. 26Fig. 2.15 Prisnors dilemma rule in organisation ......................................................................................... 28Fig. 3.1 Total utility ...................................................................................................................................... 35Fig. 3.2 Relation between marginal utility and demand curve .................................................................... 35Fig. 3.3 Total production curve .................................................................................................................... 37Fig. 3.4 Relationship between TP, MP and AP ............................................................................................ 38Fig. 3.5 Relationship between MC, AFC, AVC and ATC ........................................................................... 39Fig. 3.6 Short run and long run average total curve ..................................................................................... 40Fig. 4.1 Factors demands are derived .......................................................................................................... 48Fig. 4.2 Demand for inputs derived through marginal revenue products .................................................... 50Fig. 4.3 Supply curve for factors of production ........................................................................................... 51Fig. 4.4 Factor supply and derived demand interact to determine factor prices and income distribution ... 52Fig. 4.5 The markets for surgeons and fast food workers ............................................................................ 52Fig. 4.6 Marginal product principles determine factor distribution of income ............................................ 53Fig. 5.1 Demand for labor reflects marginal productivity ........................................................................... 59Fig. 5.2 As wages rise, workers may work fewer hours ............................................................................... 60Fig. 6.1 Production possibilities of wheat and cloth .................................................................................... 75Fig. 6.2 With many commodities, there is a spectrum of advantages .......................................................... 76Fig. 6.3 Triangular trades ............................................................................................................................. 76Fig. 6.4 The impact of protectionist policies ............................................................................................... 78Fig. 6.5 U.S. tariff rates, 18202005 ............................................................................................................ 81Fig. 7.1 The size of government-growth curve ............................................................................................ 87Fig. 7.2 Classification of Government Expenditure ..................................................................................... 89Fig. 8.1 Economic view of environment .................................................................................................... 109

VIII

List of Tables

Table 2.1 Demand schedule and concept ..................................................................................................... 12Table 2.2 Market demand curve ................................................................................................................... 12Table 2.3 Types of demand .......................................................................................................................... 13Table 2.4 Factors affecting demand ............................................................................................................. 14Table 2.5 Supply schedule ........................................................................................................................... 14Table 2.6 Market supply curve ..................................................................................................................... 15Table 2.7 Types of supply ............................................................................................................................ 16Table 2.8 Factors affecting supply ............................................................................................................... 17Table 2.9 Equilibrium in demand and supply .............................................................................................. 17Table 2.10 Demand and supply .................................................................................................................... 19Table 2.11 Tax impact on price or quantity of goods ................................................................................... 21Table 3.1 Utility of goods ............................................................................................................................ 33Table 3.2 Marginal utility ............................................................................................................................. 34Table 6.1 Differences between domestic trade and international trade ....................................................... 72Table 8.1 Increasing trend in the resource usage, buildups and the effects on environment ...................... 107

IX

Abbreviations

AFC - Average Fixed CostAPL - Average Product of LaborATC - Average Total CostCCI - Competition Commission of IndiaCRS - Constant Returns to ScaleDTAA - Double Tax Avoidance AgreementGATT - General Agreement on Trade and TariffsGDP - Gross Domestic ProductITQ - Individual Transferable Quotas LRAC - Long Run Average CostMRTP Act - Monopolies and Restrictive Trade Practices Act, 1969MP - Marginal ProductPEoD - Price Elasticity of Demand PEoS - Price Elasticity of SupplyPPF - Production Possibility FrontierTFC - Total Fixed CostTP - Total ProductTVC - Total Variable Cost

Chapter I

Basics of Economics

Aim

The aim of this chapter is to:

define the basic concepts of economics

explain scarce resources in terms of individual and nation

explicate the concepts of macroeconomics and microeconomics

Objectives

The objectives of the chapter are to:

elucidate the concept of scarce resources

define PPF (Production Possibility Frontier) and opportunity cost

explain market economy and command economy

Learning outcome

At the end of this chapter, you will be able to:

understand the application of economics in real life scenario

recognise the advantages of command economy

identify market economy

1

1.1 IntroductionThe motive behind studying economics could be anything like, to make money, understand and be adept at the concepts of economics for in-general usage, or may be due to curiosity to know how technological revolutions and economic reforms give a new direction to our society.

1.2 Meaning and Definition of EconomicsEconomics may appear as study of complicated tables, charts, statistics and numbers, but more specifically, it is the study of optimum utilisation of scarce resources and constitutes the rational human behavior in the attempt to fulfil needs and wants.

With limited resources at hand, a common man, on a daily basis, has to make certain choices in tune with his budget to fulfil wants and needs. Economists are interested in the choices that person makes, and inquire into why, for instance, one might choose to spend ones money on a new DVD player instead of replacing the old TV. Economics, also called Dismal Science, is an in-depth study of certain aspects of society.

1.3 Economics BasicsScarcity is the concept between our limited resource and unlimited want and it is different for both individual and for country. Scarce resource for an individual is money, time and skill and for a country it is capital, labour force and technology.

All the resources are limited in comparison to all our wants and needs. So individuals and nation must take the decision on what goods and services they can afford. For example, if one chooses to buy an Air Conditioner, as opposed to four air coolers, that means one is in favour of high quality of technology rather than going for large quantity of cheap air coolers.

Each individual and nation will have different set of values and due to different level of scarce resources; their decision on utilisation of those resources is also different. Furthermore, because of scarcity, people and an economy must decide on how to allocate resources. In other words, we can say that Economics is a study that deals with the decision and allocation of the resources.

1.4 Macroeconomics and MicroeconomicsThere are two main categories of economics:MacroeconomicsIt is concerned with total output of a nation and the way that nation allocates its limited resources of land, labour and capital in an efficient way.

MicroeconomicsIt is more specific in its approach and is concerned with individuals and firms within the economy. By analysing human tendency and behavior, microeconomics shows how individuals respond to changes in price when there is change in demand and supply.

1.5 The Two Basic Concepts of EconomicsThe two basic concepts of economics are as follows:

Production Possibility Frontier (PPF) Opportunity Cost

1.5.1 Production Possibility Frontier (PPF)Under the category of macroeconomics, it represents the point at which an economy is producing goods and services more efficiently, therefore allocating resources in the best way possible. One can clearly understand the concept of PPF with the help of following figure.


2

Product B: Cotton

Prod

uct A

: Win

e

Production PossibilityFrontier PPF

C

B

X

YA

Fig. 1.1 Production possibility frontier(Source:http://www.investopedia.com/terms/p/productionpossibilityfrontier.asp)

Imagine one economy that produces only wine and cotton. According to PPF, points A, B and C all appearing on the curve, represents most efficient use of resources by the economy.Point X represents the most inefficient use of resources, while point Y represents the goal that an economy cannot attain with the present levels of resources.From the chart, we can see that if an economy produces more wine, it must give up some resources used for cotton production. If the economy starts producing more cotton (represented by points B and C), it would have to divert from wine production.If the economy moves from point B to C, wine output significantly reduces with small increase in cotton production.Every nation must find out the ways for optimum allocation of resources so that they can achieve the PPF. If the demand for wine is more than the cost of increasing its output is proportional to the cost of decreasing cotton production.

In another scenarioIf there is change in technology, while the level of land, labour and capital remains same then the time required in production of cotton and wine will decrease.Point X shows the most inefficient way of utilisation of resources. When PPF shifts outward, as shown in the figure below, then we know that there is a growth in economy.

When it shifts inwards, it indicates that the economy is shrinking as a result of decline in efficient allocation of resources.

3

Product B: Cotton

Prod

uct A

: Win

e

Production PossibilityFrontier PPF

Shifts Outward

C

B

X

AY

Fig. 1.2 Production possibility frontier shifts outward(Source:http://www.investopedia.com/university/economics/economics2.asp)

An economy producing on the PPF curve is more theoretical than practical. In reality, an economy constantly struggles to reach an optimal production capacity. As scarcity compels an economy to give up one choice for another, the slope of the PPF will always be negative. Hence, if the production of A increases then for B it will decrease or vice versa.

1.5.2 Opportunity CostOpportunity cost is the value of what is given up in order to have something else. It is unique for each individual and determined by his or her needs, wants, time and resources (income). It is an important part of PPF because a country will decide how to best allocate its resources according to its opportunity cost.

For example, assume that an individual has a choice between two telephone services. If he or she were to buy the most expensive service, that individual may have to reduce the number of times he or she goes to the movies each month. Giving up these opportunities to go to the movies may be a cost that is too high for this person, leading him or her to choose the less expensive service.

Opportunity cost is different for each individual and nation. Thus, what is valued more than something else will vary among people and countries when decisions are made about how to allocate resources.

1.6 Market EconomyMarket Economy is a type of economic system in which the trading and exchange of goods and services and information takes place in a free market, and hence it is also called as free market economy. Free market is based on law of supply and demand and prices of goods and services. Producers decide which goods are to be produced in what quantity, depending on consumer demand.

For example, for years 2004-07, there was a huge rush in IT sector because of demand for IT professionals. There was phenomenal growth in various IT sector with many IT education firms flourishing to cater the needs. This shows how the demand factor influenced the economy. In the year 2009, there was a sharp decline in growth of various industries, which resulted in recession in all sectors. Eventually, the demand for IT professional also declined. For this reason, market economy is also called as Demand Driven Economy.

1.7 Command EconomyAn economy which is controlled by the government is called Command Economy. Here, the decisions what, when, how and from whom to produce, and so on, are taken by the centralised authority.Some of the advantages of command economy are:

In a command economy, government can utilise land, labour and capital to fulfil its economic and political


4

agendas. So the private players are reluctant to invest in command economy.For example, cholera is a widespread common disease in continents like Africa and Asia. Some of the worlds major pharmaceutical industries like Pfizer and Novartis are not ready to invest in research of Cholera, because people of Africa and Asia are not in a position to pay full price of drugs. In a command economy, the state can take the initiative for R&D for the treatment.

1.8 Choice as an Economic ProblemHuman wants are unlimited but the means or resources to satisfy these wants are limited or scarce. Resources are not only scarce but they have alternative uses. This gives rise to the problem of choice in economics. For example, iron can be used for making tanks, it can be used for making trains, it can also be used for building houses. It is because of the various alternative uses of the resources that we have to decide about the best allocation of resources. Thus, economics develops principles for making the best use of available resources. (If our wants are limited or the resources are unlimited, or if the resources have no alternative uses, then there would have been no economic problem at all).

1.9 Central Problems of an EconomyHuman wants are unlimited but the means or resources to satisfy these wants are limited or scarce. Resources are not only scarce but they have alternative uses. This gives rise to the central problems of an economy. These are:

What to produce and in what quantities? This involves the allocation of scarce resources in relation to the composition of total output in the economy.How to Produce? Whether to use labour intensive or capital intensive techniques of production For Whom to Produce? This involves the distribution of national income among the members of the society. How efficiently are the Resources being utilised? This is the problem of economic efficiency or welfare maximisation where there has to be no wastage or misuse of resources.Problem of Full Employment: An economy must try to achieve full employment not only of labour but of all its resources.Problem of Growth: An economy must make sure that it keeps expanding or developing so that it maintains conditions of stability.

1.10 Market MechanismThe market mechanism, works through supply and demand in a free market economy. It acts as the principal organising force for economic efficiency. It solves all the central problems of an economy by efficiently allocating scarce resources among alternative uses.

It determines what to produce and how much to produce according to the criterion of maximum profit. It allocates the different factors of production among their various uses according to the criterion of maximising their incomes.It brings about an equitable distribution of income by causing resources to be allocated in the right directions. It works to ration out the existing supplies of goods and services, utilises the economys resources fully and provides the means for economic growth.

1.11 Positive Economics and Normative EconomicsPositive economics is concerned with what is whereas Normative economics is concerned with what ought to be. Positive economics describe economic behaviours without any value judgment while normative economics evaluate them with moral judgment. Positive economics is objective while normative economics is subjective. The statement, Price rise as demand increase is related to positive economics, whereas the statement, Rising prices is a social evil is related to normative economics.

5

1.12 Inductive Method and Deductive Method of Economic AnalysisDeductive method involves reasoning or inference from the general to the particular or from the universal to the individual. Deduction involves four steps:

Selecting the problems Formulating the assumptions Formulating the hypothesis through the process of logical reasoning whereby inferences are drawn and Verifying the hypothesis.

Inductive method involves reasoning from particulars to the general or from the individual to the universal. This method derives economic generalisations on the basis of experiments and observations. In this method detailed data are collected on certain economic phenomenon and effort is then made to arrive at certain generalisations which follow from the observations collected. (The Engels Law and the Malthusian Theory of Population have been derived from inductive reasoning).

Giffen goods: Giffen goods may be any inferior commodity much cheaper than its superior substitutes, consumed mostly by the poor households as an essential consumer good. If price of such goods increases, its demand increases instead of decreasing because in case of a Giffen good the income effect of a price rise is greater than its substitution effect. Thus, the law of demand does not apply in case of Giffen goods. This phenomenon is known as Giffen paradox.

Consumer Surplus: The difference between the price a consumer is willing to pay and the price which he actually pays is consumers gain which is referred to as consumers surplus. The concept of consumers surplus may also be explained in terms of utility. Since, Marshall assumes constant MU of money, what a consumer is willing to pay for a commodity indicates his expected utility and what he actually pays measures the actual cost in terms of utility of money. The difference between the utility gained and the utility lost in acquiring the commodity is consumers satisfaction which Marshall calls the consumers surplus.

Income-Consumption Curve (ICC): The income-consumption curve may be defined as the locus of points representing various equilibrium quantities of two commodities consumed by a consumer at different levels of income, all other things remaining the same.

Price-Effect: The price-effect may be defined as the total change in the quantity consumed of a commodity due to a change in its price. Price effect is composed of two effects:

Income-Effect: The income-effect arises due to change in real income caused by the change in price of the goods consumed by the consumer.Substitution-Effect: The substitution effect arises due to the consumers inherent tendency to substitute cheaper goods for the relatively expensive ones.

Inferior goods: Inferior goods are those goods whose demand decrease as the income of the consumer increases. That is, the income-effect on inferior goods is negative.

The Engel Curve: The Engel curve shows the relationship between consumers income and his money expenditure on a particular good. The shape of the Engel curve depends on the shape of the income-consumption curve (ICC).

As shown in the following figure we can derive the Engel curve from the ICC.


6

M1

M1

M2

M2

M4

M4

X1

X1

X2

X2

X3

X3

X4

X4

Quantity of X

Quantity of X

Engle curve

Quantity of Y

Total Income

ICCE4E3E2E1

M3

M3

Derivation of Eagle curve for a Normal Good

Fig. 1.3 Derivation of Eagle curve for a normal good(Source:http://www.investopedia.com/university/economics/economics2.asp)

7

SummaryEconomics, also called Dismal Science, is an in-depth study of certain aspects of society. Macroeconomics is concerned with total output of a nation and the way that nation allocates its limited resources of land, labour and capital in an efficient way.Microeconomics is more specific in its approach and is concerned with individuals and firms within the economy. Two basic concepts of economics are Production Possibility Frontier and Opportunity Cost. Opportunity cost is the value of what is given up in order to have something else. It is unique for each individual and determined by his or her needs, wants, time and resources (income).Market Economy is a type of economic system in which the trading and exchange of goods and services and information takes place in a free market, and hence it is also called as free market economy.An economy which is controlled by the government is called Command Economy. Human wants are unlimited but the means or resources to satisfy these wants are limited or scarce. Resources are not only scarce but they have alternative uses.The market mechanism, works through supply and demand in a free market economy. It acts as the principal organising force for economic efficiency.Positive economics is concerned with what is whereas Normative economics is concerned with what ought to be.Deductive method involves reasoning or inference from the general to the particular or from the universal to the individual.

ReferencesRittenberg, L. and Tregarthen, T., 2008. Principles of Microeconomics. Samuelson, P. A., 2002. Economics, Massachusetts Institute of Technology. Tata McGraw-Hill Publishing Co.Ltd.David, A. D.,2004. Introduction to Microeconomics E201, [Pdf] Available at: [Accessed 14 August 2012].Frank, A. C., 2004. Microeconomics Principles and Analysis, [Pdf] Available at: [Accessed 14 August 2012].2010. Introduction to Microeconomics 101 [Video online] Available at: [Accessed 14 August 2012].About.com., 2011. What is Microeconomics? [Video online] Available at:[Accessed 14 August 2012].

Recommended ReadingBernanke, B., 2009. Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.Dr. Mithani, D. M., 2008. International Economics, Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd.Mankiv, N. G., Economic: Principles and Applications, Cengage Learning Products, Canada, Nelson Education Pvt. Ltd.


8

Self Assessment

Economics, also called ________ , is an in-depth study of certain aspects of society.1. dismal sciencea. dismal economics b. economyc. physiological studyd.

___________ is concerned with total output of a nation and the way that nation allocates its limited resources 2. of land, labour and capital in an efficient way stock of resources for future course action.

Microeconomicsa. Macroeconomicsb. Market economyc. Opportunity costd.

What are the important concepts of an economic system?3. Production possibility frontier and opportunity cost a. Distribution of goods and servicesb. Production of goods and servicesc. Quantity of goods and services producedd.

__________is a type of economic system in which the trading and exchange of goods and services and information 4. takes place in a free market

Command economy a. Product economyb. Demand economyc. Market economy.d.

Which of the following statements is true?5. Command economy is a free economy.a. In command economy, government can utilise land, labour and capital to fulfill its political and economic b. agenda.Command economy is based on trading and exchange of goods and services. c. Command economy is a demand driven economy.d.

_________ is the value of what is given up in order to have something else.6. Opportunity costa. Economy costb. Market costc. Product costd.

9

Which of the following statement is true?7. When PPF shifts outward, then we know that there is a decline in economy.a. As scarcity compels an economy to give up one choice for another, the slope of the PPF will always be b. positive.An economy producing on the PPF curve is more practical than theoretical.c. Under the category of macroeconomics, PPF represents the point at which an economy is producing goods d. and services more efficiently.

Which of the following is not scarce resource for individual?8. Money a. Timeb. Skillc. Capitald.

Which of the following is not a scarce resource for a country?9. Capitala. Technology b. Labour force c. Timed.

________ are those goods whose demand decrease as the income of the consumer increases.10. The Angel Curvea. Price Effectb. Inferior goodsc. Income Consumption Curved.


10

Chapter II

Demand, Supply and Product Management

Aim

The aim of this chapter is to:

define the concept of demand and supply

explain the price elasticity of demand and price elasticity of supply

explicate the impact of tax on price and quantity of goods

Objectives

The objectives of this chapter are to:

explain the concept and change in demand and supply on equilibrium price and quantity

elucidate various factors affecting demand and supply

explain the role of the government in setting price

Learning outcome

At the end of this chapter, you will be able to:

understand the application of economics in real life scenario

identify the tax impact on price or quantity of goods

compare the concepts of price elasticity demand and price elasticity supply

11

2.1 IntroductionIn a market economy, individual consumers make plans of consumption and individual firms make plans of production, based on changes in market prices. Economists use the term invisible hand to describe the frequent exchanges in the market because everyone (no matter consumer or producer) takes the market price as a signal on trade and makes exchanges with private property rights.

The price system works in market economy only if there is a free choice within the market. The following explains how the market price is determined by the interaction of producer (supply) and consumer (demand).

2.2 Concept of DemandIn economics, demand consists of some of the major concepts like:

Demand is relative to the concept of price. It refers to both, the ability to pay and the willingness to buy, by the consumer.For example, Toyota is planning its production strategy it wants to know the demand for cars in India. After a survey, they found out that there are almost 250 million Indians willing to have a car. But that doesnt mean that the demand for their car is 250 million. People can purchase the car as per their capability and their income.Demand is a flow concept, which means that the change in price will lead to change in demand for goods. Demands are quantitative expressions of preferences and it is useless to speak demand without referring to price and time.

2.3 Demand Schedule and ConceptA demand schedule for cars in India at different prices is shown below. Here, the demand is totally based upon price of the car.

Price (Rs) Demands (Units)2,50,000 503,50,000 405,50,000 307,00,000 20

Table 2.1 Demand schedule and concept

2.3.1 Market Demand CurveThe Market demand curve is obtained by plotting the graph of sum of the individual demand curve of a particular good in the market, at the same price, within a time period. This technique is also called as Horizontal Summation.

Price(per unit)

Quantity DemandedTom Mary Market (i.e. Tom + Mary)

30 2 1 320 4 3 715 6 5 1112 8 7 1510 10 9 19

Table 2.2 Market demand curve


12

Demand Curve for Tom Demand Curve for Mary Market Demand Curve

30

20

10

02 4 6 8 10

30

20

10

01 3 5 7 9

30

20

10

05 10 15 20

Fig. 2.1 Market demand curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

The slope implies that price and quantity are inversely related.

2.3.2 Law of DemandIn economics, the relationship between price and quantity is called as Law of Demand. If price of any goods or services increases then the demand for that will decrease and vice versa. Though, Giffen goods are an exception where Law of Demand doesnt work. A Giffen good is one which people consume more of as price rises. In such situation, cheaper close substitutes are not available. Because of the lack of substitutes, the income effect dominates, leading people to buy more of the good, even as its price rises.

Some types of premium goods, for example. Expensive French wines, BMW cars are sometimes claimed to be Giffen goods. It is said that, decrease in the price of such high status goods can reduce its demand, as they are no longer perceived to be exclusive or of high status.

2.4 Price Elasticity of DemandIt measures the rate of quantity demanded due to price change. The formula for PEoD (Price Elasticity of Demand) isPEoD = (% Change in Quantity Demanded)/ (% Change in Price)% Change in Quantity Demand = [QDemand (New) QDemand(Old)] / QDemand(Old)% Change in Price = [Price (New) Price (Old)] / Price (Old)

2.4.1 Types of DemandThe given table describes the various types of demand:

Types of demand DescriptionElastic Demand Here the price elasticity of demand is more than 1Inelastic Demand Here the change in demand is less in comparison to change in

price that means price elasticity of demand is less than 1Unit Elastic Demand Here change in demand and price, both are equalPerfectly Elastic Demand Here the value for price elasticity of demand is infinityPerfectly Inelastic Demand Here demand doesnt change with change in time

Table 2.3 Types of demand

13

2.5 Factors Affecting DemandFactors which affect demand of goods are mentioned below:

Factors Description with ExamplesPrice of substitute product

Consumers switch towards the substitute product when there is a price reduction in the regular product they use.

For example, previously there was a difference in price and usage of mobile phone and land line. The main objective behind phone is communication but mobile phone is also useful for other multipurpose activities. So, the demand for land line phone came down in comparison to mobile phone.

Income of consumer This is one of the most important aspects which affect the demand for goods in market. Increase in income of a consumer lead to increase in demand for normal goods.

Preference of consumer It refers to the subjective choice of a consumer. The demand of a product may be affected by knowledge, friends, education and culture.

Weather fluctuation The demand for different product varies as per the seasons. For example demand of AC is more during the time of summer but in off seasons the price is less as compared to summer.

Table 2.4 Factors affecting demand

2.6 Concept of SupplySupply consists of some of the major concepts like:

It refers to both, the ability to sell (produce) and the willingness to sell by the producer(s). Supply implies an effective supply.Supply can be shown by a supply schedule, which illustrates the maximum quantity supplied at different prices.Supply is also a flow concept. Time is an important factor affecting the condition of supply.

2.6.1 Supply Schedule and ConceptA supply schedule, as shown below, gives the numerical data regarding price of goods and total unit producers are ready to produce and sell at that price.

Price (Rs. 000) Units (in 000)230 100220 90210 80200 70

Table 2.5 Supply schedule

Supply curve shows the relationship of above mentioned data.


14

Quantity Supplied (Units)

Supply Curve

X

Y

230

220

210

200

050 60 70 80 90 100

Pric

e (R

upee

s)

Fig. 2.2 Supply curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

2.6.2 Market Supply CurveIt refers to supply of goods by all producers or firms in the market, within a time period. The example below gives a supply schedule in a market consisting of only 2 firms, B & N.

Price(per unit)

Quantity Supplied

B N Market(i.e. B + N)10 2 3 518 4 5 928 6 8 1440 8 10 1850 10 11 21

Table 2.6 Market supply curve

Like the market demand curve, the market supply curve is obtained by summing up the individual supply curves in the market. The technique is also known as Horizontal Summation.

15

2 4 6 8 10

Supply curve for B Supply curve for N Market Supply Curve

3 5 7 9 11 5 10 15 20

50

30

10

0

50

30

10

0

50

30

10

0

Fig. 2.3 Market supply curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

2.6.3 Law of SupplyThe direct relationship between price and quantity supplied is called Law of Supply. In other words, if the price is high then supply is also high or vice versa.

2.6.4 Price Elasticity of SupplyPrice elasticity of supply measures the rate of response to quantity demand due to price change. It is denoted as:

PEoS (Price Elasticity of Supply).

PEoS = (% Change in Quantity Supplied)/ (% Change in Price)

% Change in Quantity Supplied = [QSupply(New) QSupply(Old)] / QSupply(Old)

2.6.5 Types of SupplyStudy the table below to learn types of supply

Types of supply Description

Elastic Supply Here the Price Elasticity of Supply is more than 1 but less than infinity. Change in supply is more than proportionate to change in the price of goods.

Inelastic SupplyWhen the Price Elasticity of Supply is in between 0 and 1, supply is inelastic in nature. It means change in supply will be less than proportionate to change in the price of goods.

Unit Elastic Supply When the coefficient is equal to one, supply is called unit elastic.

Perfectly Elastic Supply

When Price Elasticity of Supply is equal to infinity, it is called as perfectly Elastic Supply.

Perfectly Inelastic Supply

When Price Elasticity of Supply is equal to zero, it is called as perfectly Inelastic Supply.

Table 2.7 Types of supply


16

2.6.6 Factors Affecting SupplyFactors which affect supply of goods are mentioned in the following table.

Factors Description with Examples

Input cost Price of input cost like labour, machines, etc. have a greater impact on supply side. For example, if the input cost is more for any organisation then the supply of product is reduced.

Technology Technology enhances the production of goods. If advanced and efficient technology is used in any organisati=on, then supply of the product will more.

Weather Weather usually affects the agricultural goods and also products like AC, water heaters, etc.

Table 2.8 Factors affecting supply

2.7 Equilibrium in Demand and SupplyEquilibrium is a price where there is no surplus and deficit of goods. That means total demand and total supply in market is equal. One can understand the concept easily with the help of following example.

Price Demand Supply Surplus/Deficit5.0 5000 7000 20004.5 6000 8000 20004.0 7000 9000 20003.5 8000 8000 Nil3.0 9000 7000 -20002.5 10000 8000 -20002.0 11000 8000 -3000

Table 2.9 Equilibrium in demand and supply

From the above table we can see that, there is only one point i.e., 3.5 where both demand and supply is equal. As per the table 2.9 the graph is mentioned below.

Quantity

3.5

X

E

Y

8000

Equilibrium Point

Supply curve

Demand Curve

Pric

e

Fig. 2.4 Equilibrium in demand and supply(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

17

2.8 Equilibrium as per the Change in Demand and SupplyThere are four possible conditions for equilibrium:

Increase in Demand Decrease in Demand Increase in Supply Decrease in Supply

The demand curve move towards right due to increase in demand. It will have an impact on current equilibrium. New equilibrium for increased demand will have the higher price.

For example, there is a demand for 200 motor bikes, each costing Rs.30,000. Due to increase in population, the demand for motorbikes increases from 200 to 500. This increased demand changed equilibrium price level from Rs. 30,000 to Rs. 50,000.

Quantity

Increased Demand

Pric

e

2000

30,000

50,000

YS

X

E1

E0 D2

D1

500

Fig. 2.5 Decrease in demand curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

Increase in supplyThe supply curve will shift rightward with increase in supply. This will lead to increase in quantity demand and increase in price, as shown

Quantity

Increase in Supply

Pric

e

0

YS2

S1

XD

Fig. 2.6 Increase in supply curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)


18

Decrease in supplyThe supply curve will shift leftward with decrease in supply. This will lead to decrease in quantity demand and increase in price, as shown.

Quantity

Decrease in Supply

Pric

e

0

YS2

S1

XD

Fig. 2.7 Decrease in supply(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

Table 2.10 shows the changes in price and quantity when there is a change in demand and supply.

Change in Supply Change in Demand Change in Price Change in QuantityIncreases Decreases , or no changeDecreases Increases , or no changeIncreases Increases , or no changeDecreases Decreases , or no change

Table 2.10 Demand and supply(Source: The McGraw-Hill Companies, Inc.)

In most of the markets, prices are free to rise or fall as per the demand from consumers. Sometimes it happens that the price in market is either too high or too low.At this point, the Government plays a crucial and applies some legal limits on how high or how low may price go, as high price may be unfair to the buyer and low price may be unfair to the seller.Two basic concepts, called Price Ceiling and Price Floor are used for high and low price, respectively. If the price of a product is unfairly high, the government can set a price ceiling, or legal maximum price a seller may charge for a product. Similarly, if the price of a product is unfairly low, the government can set a price floor or minimum fixed price that sellers can charge.In price ceiling, the consumers can afford some essential goods or services that they could not afford at the equilibrium price as it was too high before, which can create shortage of goods.

19

Quantity

Shortage

Price Ceiling

Pric

e

2.50

2

YS

0 X

D

QS QO Qd

Fig. 2.8 Price ceiling(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

The main goal of price floor is to provide a sufficient income to a certain group of resource suppliers or producers, so that people from all classes and group can afford the goods or services which will create surplus of goods.

Surplus

Price Floor

2.50

3

YS

0 X

D

QSQOQd

Fig. 2.9 Price floor(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)


20

2.9 Tax Impact on Price or Quantity of GoodsTable shows the tax impact on goods in various situations.

Various Demand and Supply

Tax paid by Description Graph

Perfectly Elastic Demand

Supplier The entire tax is absorbed by supplier as demand is perfectly elastic in nature. The supplier cannot increase the price of the good because any hike in price will reduce demand to Zero.

D

Tax

P

Q0

S1

S2

Perfectly Inelastic Demand

Buyer The entire tax portion is absorbed by buyer. In this case, demand remains constant irrespective of price of goods.

D

Tax

P

Q0

S1

S2

Perfectly Elastic Supply

Buyer The entire tax portion is absorbed by buyer. Suppliers are ready to sell at a specific price and any tax burden on them will lead supply to Zero.

STax

P

Q0

D1

D2

Perfectly Inelastic Supply

Supplier The suppliers are ready to supply goods irrespective of price. They will pay for entire tax portion.

S

Tax

P

Q0

D1

D2

Table 2.11 Tax impact on price or quantity of goods

2.10 Perfect CompetitionPerfect competition is a model of market based on the assumption that a large number of firms are producing the identical goods and services, which is consumed by large number of buyers.

21

The main behavior of a perfectly competitive market is based on the following two factors;Quantity of good to be produced by a firm Price to be charged for the goods

One of the new concepts called Price Takers is very commonly used in perfect competition market. In other words, we can say that perfect competition is the world of price takers. Individual or firms who must take the market price as given are called as Price Takers. In a perfectly competitive environment, the seller is so small in caparison to market that it cannot affect the market price; hence it simply takes the price as given. The price of any commodity depends entirely upon the supply and demand, and each firm and consumer is a price taker.

Price-taking consumer assumes that he or she can purchase any quantity at the market price, without affecting the price. Price-taking firm assumes that it can sell whatever quantity it wishes at the market price, without affecting the price.

2.11 Economic Factors Related to Industry with Perfect CompetitionFollowing factors must be satisfied for perfect competition:

All firms should produce and sell an identical product The industry is characterised by freedom of entry and exit The firms have relatively small market share

All above requirements are rarely found in any one industry. As a result, perfect competition is difficult to find in reality. Most products have some degree of differentiation, like in case of mineral water; the difference can vary in methodology of purification. Thats why the price of Himalaya Mineral Water is twice than any other mineral water like Aquafina. In the figure, we can see that in equilibrium, the price remains unaffected with variation in output that the firm find feasible to produce. If the perfectly competitive firm tries to change the price that is higher than the equilibrium price, then the consumer will move to the near substitute product and the firm would lose its existing customer.

S

D

0

d10

10

Industries2,000 100Quantity Quantity

MarketSupply

MarketDemand

Pric

e (R

s.)

Pric

e (R

s.)

Single firm

Fig. 2.10 Firms demand and industry equilibrium curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

2.11.1 Marginal RevenueTo elaborate the concept of Marginal Revenue, suppose 100 units of a product are purchased by buyers, each costing Rs 10, totalling the price to Rs 1,000. Now say, the firm sells another unit of product so the total count of product becomes 101 and the price becomes 1,010. Then the firms marginal revenue becomes;


22

Marginal Revenue = Change in Total Revenue / Change in QuantityOr

MR = TR / QTotal Revenue = Price X Quantity

Where,MR - Marginal RevenueTR - Change in Total RevenueQ - Change in QuantityBy the above equation, the Marginal Revenue of the product is, MR = [(1, 1010 1,000) / (101 - 100)] = 10, i.e. Rs 10.

Thus, we can say that price equals to the marginal revenue (P = MR). So the marginal revenue curve is same as the demand curve because price is equal to marginal revenue.

Price (Rs.)

Quantity

d1 MR

1 2 3 4

Fig. 2.11 Marginal revenue and demand curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

2.12 Perfect Competition in Short RunIn short run, a perfectly competitive firm will continue its quantity of output, till the point its marginal revenue equals marginal cost. Thus, the firm will stop producing or increasing its production when such a point is reached.

The profit maximising rule says,Marginal Revenue (MR) = Marginal Cost (MC)

As per the Fig. 2.12, the firm is in equilibrium at E, but at F there is a possibility for the firm to earn profit equivalent to the shaded half, i.e. PQ amount.

Profi

t & C

ost

F E

MC

0 P Q

MR

Quantity

Fig. 2.12 Profit maximisation(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

23

2.13 Perfect Competition in Long RunIn long run, a firm is free to adjust all its input. New firms can enter any market and existing firms can leave their market. We shall see in this section that the model of perfect competition predicts that, at a long-run equilibrium, production takes place at the lowest possible cost per unit and that all economic profits and losses are eliminated.

2.13.1 Economic Profit and LossesEconomic profits and losses play a crucial role in the model of perfect competition. The existence of economic profits in a particular industry attracts new firms to the industry in the long run. As new firms enter, the supply curve shifts to the right, price falls, and profits falls too. Firms continue to enter the industry until economic profits fall to zero.

If firms in an industry are experiencing economic losses, some will leave

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