ncert xii micro economics

I N T R O D U C T I O N

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INTRODUCTORY MICROECONOMICS2

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1.1 Central Problems of anEconomy

1.2 Production PossibilityCurve and OpportunityCost

1.3 Micro versus MacroEconomics

Welcome to the science of economics. Yes,economics is a social science, like chemistryis a physical science. It is true that there areno test tubes and sophisticated equipmentrequired to study economics, but just asphysical sciences are means to understandhow the real physical world around usworks – our planet, the solar system or theuniverse – in economics, we try to understandhow the economy of a particular region, acountry, or the global economy works. Thereare principles or laws of economics (parallel tolaws of chemistry or physics). With the helpof these principles, we analyse how aneconomy works.

What is economics after all? There is nouniversally accepted, single, definition of it.But we can understand what it is about. Manynon-economists think that it only concernsthe matters of money – how to make or managemoney. Not true. Economics is about makingchoices in the presence of scarcity. The notions,“scarcity” and “choice”, are very important ineconomics. You may not see these words in allchapters to come, but they are in thebackground throughout. Scarcity and choicego together: if things were available in plenty(literally) then there would have been no choiceproblem; you can have anything you want.

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CHAPTER 1

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INTRODUCTION TO ECONOMICS 3

Unfortunately, this may be true only inheaven, not in the real world. Even therichest person on earth would have toface scarcity and make choice. Ifnothing else, time is scarce. Ratan Tata,a leading industrialist of India, between6 p.m. and 8 p.m. in a particularevening, may have to decide whether togo to a musical concert, or just keepworking in his office. Think about thelength of syllabi of various subjects thatyou have to cover before the final exam.We do not need to convince you thattime is scarce. Likewise, food, clothing,housing, clean air, drinkable water etc.are scarce in every country in theworld, except that the degree ofscarcity varies. The point is thatproblems of choice arise because ofscarcity. The study of such “choiceproblems”, at the individual, social,national and international level is whateconomics is about.

1.1 CENTRAL PROBLEMS OF ANECONOMY: WHAT, HOW ANDFOR WHOM

There are many choice problems thatany particular economy attempts tosolve within a given time period. Forexample, during the fiscal year 1998-99,71.3 million tons of wheat wasproduced in India.1 Output of foodgrains in general is not entirelydetermined by external factors like

rainfall etc. It is partly influenced byhow much of land is used to raise foodgrains, by the application of fertilisers,by the supply of power to agriculturalsector etc. And these are consequencesof individual choice as well as policiesby the government. Thus India’s wheatproduction in a given year is, partly,an outcome of choice.

India, as many other countries,does not produce jet planes. But itproduces helicopters, small air-craftsfor training purposes as well as somefighter planes.2 This also reflects achoice problem.3

Not only what goods a nationshould produce is a problem ofchoice, so is how or in which methoda good is to be produced. Usually,there is more than one method toproduce a given commodity. Forexample, agricultural activity is morelabour-intensive in India than indeveloped countries like US, Franceor Germany.

Who is paid how much is also achoice problem from the economy’sviewpoint. There are differences in payor salary across occupations. Forinstance, in the latter half of 1990s thebeginning salary (including allowances)for a Class I government servant wasbetween Rs. 1.5 lakhs to Rs. 2 lakhsper annum. In comparison, on theaverage, a computer programmer in

1 The source is Ministry of Finance, Government of India, Economic Survey 2000-2001, published in 2001.2 These are produced by Hindustan Aeronautics Limited (HAL). We recommend you to visit its website:

www.hal-india.com. It contains pictures and brief descriptions of different aircrafts produced by HAL.3 You may argue that India does not produce jet planes because it does not have the necessary technology.

However, having a technology or not can be seen as a choice problem. Many technologies can be purchasedif we decide to pay for it. But we do not – and should not – buy any available technology even if wecan afford it. We have to weigh the benefits from having a technology against the cost of acquiring it.


India was receiving Rs. 2.58 lakhs perannum in 1999.4

Various economic problems facingan economy can be categorised intothree types. These are the so-called“what”, “how” and “for whom”problems. They arise due to scarcity.

What to be: What goods and servicesare produced and in what quantities?For example, in the fiscal year 1997-98, the Indian economy produced 82.1million tons of cement. Why is it 82.1million tons, not 40 million tons? In thesame year India produced 9.8 millionbicycles.5 What factors determine thesequantities? And so on.6

How to be: How (i.e. by which methods)would the goods and services beproduced? Should garments in Indiabe produced by relatively labour-intensive or machine-intensivemethods? What techniques ofproduction are to be used?

For whom to be: Given that variousgoods and services are available to aneconomy, who gets how much toconsume? This essentially refers to whoearns how much or who has moreassets than others. For example, howmuch a computer engineer consumesis based on his earnings compared to achemical engineer or a high-schoolteacher? This is the “for whom”question. It refers to distribution ofincome and wealth in the society.

In a market-oriented or capitalisteconomy, these fundamental problemsare solved by the “market”. There isa price, which is influenced by theforces of demand and supply. Theseforces guide which goods and howmuch is to be produced andconsumed. For example, alu bhujiais produced in the Indian economybecause the technology of making alubhujia is available, the cost ofproducing and supplying it is not toohigh and there is demand for alubhujia. This illustrates how the “what”problem is solved in a market-orientedeconomy.

Suppose that the oil production inthe world market declines drastically forsome reason. This will increase the priceof diesel and petrol world-wide. A taxicompany in Ludhiana, which wasrunning 10 taxis, will now wish toconvert some of them to CNG(compressed natural gas). In other words,the method of production of taxi servicewill change. This example illustrates howthe “how” problem is solved.

As another example, if there is anincrease in demand for computerhardware and software by businessesand households, this will push up thedemand for services by computerengineers. As a result, their salaries(“prices”) would increase. These

4 See Ed.Frauenheim,“India Inc.”, TechWeek, September 20, 1999 (also see http://www.techweek.com).This salary figure, stated in US dollars, is $6,000. At the 1999 dollar-rupee exchange rate of$1 = Rs. 43, it becomes Rs. 2.58 lakhs.

5 The source is Economic Survey 2000-2001, Ministry of Finance, Govt. of India, 2001.6 These are examples of “goods” or “commodities” that have physical dimensions. “Services” refer to

tasks being performed for someone, e.g., a hair-cut, education, doctor’s advice etc. “What” problemapplies to services as well.


engineers would now have morepurchasing power (money and wealth)and can buy more goods and servicesthan before. This is an example of howthe solution of “for whom” problemchanges over time.

The following chapters examine indetail how these central problems areaddressed in a market-orientedeconomy.

Alternatively, in a centrally plannedeconomic system, which was inpractice in the former Soviet Union andother East European countries till thelate 1980s, these problems areaddressed in a very direct way by thegovernment. See Clip 1-1 for details.7

Clip 1-2 provides an account of thedemerits of a central planning systemrelative to a capitalist system.

CLIP 1-1A Centrally Planned Economy*

In a centrally planned economy, there is a central planning authority, a wing ofthe government. It decides which goods and how much should be consumed andproduced in the economy within a given span of time, say within a year or in fiveyears. These are like targets. They are set according to the overall growth anddevelopment strategy for the economy that is considered desirable by the membersof the planning authority. Once the total production target levels are fixed, theyare then allocated over different factories, which are supposed to deliver the amountsrequired. Realise that production of any particular good (e.g. bicycles) requiresother goods as well (e.g. steel, rubber pedals etc.) In turn, these “other goods”require different other goods as well. Hence it is a massive planning process thattakes into account simultaneous production of thousands of goods. This is howthe “what” problem is attended.With respect to the “how” question, factories are government-owned and the methodof production is chosen by the planning authority. Thus the “how” problem issolved by the government.Properties are government-owned too. It also determines salaries of various skills.Hence the “for whom” problem is solved by the government also. In other words,all three central problems are essentially addressed by the government in a directway – by command so-to-speak. That is why a centrally planned economy is alsocalled a command economy.

7 However, no economy in the world is cent per cent centrally planned or market-oriented. If both theprivate sector (i.e. market forces) and the government play almost equal roles in the functioning of theeconomy, then such an economy is called a mixed economy. Otherwise, if government or public sectoractivities are dominant, we call it a centrally planned economy (e.g. the former Soviet Union). If privatesector activities are dominant, we call it a market-oriented or a capitalist economy (e.g. United Statesand Japan).The Indian economy, until the end of the seventies, was a very much a mixed economy. It is still considereda mixed economy today, but since the 1980s has been gradually moving towards a market-orientedeconomy. It is much less controlled and private firms operate in a much more liberalised environmentnow, than in 1960s or 1970s.

* All Clips are NETs (not for exams and tests).


1.2 PRODUCTION POSSIBILITYCURVE AND OPPORTUNITYCOST

From a general discussion abouteconomics and how an economy works,we now move to a specific issue andlook at it analytically. It sets the tonefor the type of economic analysis tocome in the following chapters.

To begin with, suppose thatMr. Kheti Lal, a farmer in U.P., owns 50acres of land for cultivation. He can growwheat or sugar cane or both. Supposethat the production technologies ofwheat and sugar cane are such that oneacre of land yields 2500 kgs of wheat or80 tons of sugar cane. How doesMr. Kheti Lal decide how much of landhe should use for wheat and how muchfor sugar cane?

A natural way is to first determinethe various combinations of wheat andsugar cane that he can grow, given thetotal land he has and given thetechnologies of producing wheat andsugar cane. Next, he can select aparticular combination, depending onprofitability of raising wheat and sugarcane. We are not interested in the latterissue, but only in how much of wheatand sugar cane are feasible forMr. Kheti Lal to produce.

For example, he uses all his landin growing wheat. Then he canproduce 125 tons of wheat and zerosugar cane. Instead, if he uses all hisland to grow sugar cane, then he getzero wheat and 4,000 tons of sugarcane. There are, obviously, many otherpossibilities. For instance, he can use30 acres of land on wheat and 20 acres

on sugar cane, and, this will give him75 tons of wheat and 1, 600 tons ofsugar cane. The important point to notehere is that, as long as Mr. Kheti Lal usesall his land resource, which is given,having more of one good implies havingless of the other. Interestingly, aneconomy as whole, whether it ismarket-oriented or not, faces a similarsituation.

At any given point of time, thetechnologies available to producevarious goods and services as well asthe resources available to an economy(meaning the size of its workingpopulation, land, buildings, machineryetc.) are all given. Evidently, aneconomy cannot produce an unlimitedamount of any particular good orservice. If all resources are used inproducing a single good say,computers, only a given number ofcomputers can be produced. Startingfrom a given allocation of resources todifferent sectors of an economy, if moreresources go into one particular sector(e.g. the computers), less is availablefor other sectors. In order to decidewhich combination of goods serves theeconomy the best, we have to firstidentify various combinations that canbe available to an economy (likedifferent combinations of wheat andsugar cane Mr. Kheti Lal can grow).This is best illustrated through aconcept called the productionpossibility curve, which will be definedin a moment.

Now consider a hypotheticaleconomy, in which two goods can beproduced: cricket bats and saris.


(Assume that all cricket bats are of thesame quality and so are saris.) Supposethat if all resources of this economy(such as land and total amounts ofskilled and unskilled labour availableto the economy) are used in the sarisector and if they work efficiently,75 lakh saris can be produced (within,say, a year). Assume that the sameresources can produce cricket batsalso. If, instead, all resources areemployed in producing cricket bats,suppose that 5 thousand bats can bemade. These are two productionpossibilities and both are ratherextreme. Most likely there will be otherpossibilities which are “intermediate”.For instance, if the economy isproducing 50 lakh saris, it canproduce, say, 3 thousand cricket bats.

Table 1.1 summarises the variousproduction possibilities that areavailable to the economy. Notsurprisingly, you see that as theproduction of one good increases thatof the other falls. This is because

resources are scarce. As more resourcesgo into one sector and produce more,less is available for other sectors andthey will produce less than before.

Let us now plot these possibilities,namely, (0, 75), (1, 70) etc. and jointhe line segments.8 This gives rise to acurve as shown in fig. 1.1(a). (Ignorepanel (b) for the moment.) It measuresone good along the x-axis and the otheron the y-axis. This is the productionpossibility curve of our hypotheticaleconomy. If we consider an economyin which, more realistically, there arenumerous production possibilities, notjust 6 as in Table 1.1, then we get asmooth curve as shown in fig. 1.1(b).This is how a production possibilitycurve (PPC) is normally exhibited.Formally, it is defined for a “two-good”economy, and, it shows variouscombinations of the two goods thatcan be produced with availabletechnologies and with givenresources, which are fully andefficiently employed. Equivalently, the

Table 1.1 Production Possibilities

Production of Cricket Bats Production of Saris (in thousands) (in lakhs)

Possibility A 0 75

Possibility B 1 70

Possibility C 2 62

Possibility D 3 50

Possibility E 4 30

Possibility F 5 0

8 An introduction to graph plotting and joining points is given in Appendix 1.


PPC shows the maximum amount thatcan be produced of one good, given theamount produced of the other good. A

India) or resources work inefficiently (e.g.machines or plants are kept idle), thenthe economy will operate strictly withinthe PPC, e.g. at point G, (see fig. 1.1(b)). Itshould be clear however that, bydefinition, an economy cannot operate atany point outside of the PPC, such as atpoint H. Moreover, assuming that theeconomy is operating on the curve, wecannot, without further information, saythe exact point of operation. It dependson preferences and tastes of individualsin the economy.

You should realise that, althoughPPC is defined in the context of atwo-good economy, the idea behind itis general and holds for any number ofgoods. It illustrates the maximumproduction capabilities of an economyat a given point of time.

1.2.1 Marginal Opportunity Cost,Increasing Marginal Oppor-tunity Cost and the Shape ofthe PPC

We already know that, along a PPC,more production of one good meanssome sacrifice of the other good. Therate of this sacrifice is called themarginal opportunity cost of theexpanding good. Go back to Table 1.1.Starting from possibility B, if theproduction of cricket bats increases byone unit (to 2), 70 – 62 = 8 lakh sarisneed to be forgone. Hence, at theproduction possibility C, the marginalopportunity cost of cricket bats isequal to 8 lakh saris. Similarly, when3 thousands bats are produced, the

Fig. 1.1 Production Possibility Curve

(b)

9 The concept of “downward sloping” is explained in Appendix 1.

PPC is downward sloping, becausemore production of one good isassociated with less of the other.9

Note that the PPC does not show orsay which point the economy will actuallyoperate on. It only shows the possibilities.The economy may not be even operatingon the curve. For example, if there isunemployment (as true for a country like

(a)


marginal opportunity cost (perthousand bats) is 12 lakh saris, and,so on. Generally, the marginalopportunity cost of a particular goodalong the PPC is defined as the amountsacrificed of the other good per unitincrease in the production of the goodin question.

Note that “marginal” means“additional”, and, it is a very importantnotion in economics. You will seerepeated use of it in later chapters.

Table 1.2 is an expanded versionof Table 1.1 and lists the marginalopportunity cost of cricket bats. Weobserve that, as the production ofcricket bats increases, its marginalopportunity cost increases (from 5 to8, 8 to 12 and so on). These numbersare indicated in column (3). Why doesthe marginal opportunity costincrease? The economic reason is that,as more and more of a good isproduced, factors producing it becomemarginally less and less productive.Hence more and more of the other goodhas to be sacrificed to ensure a unit(given) increase of the former good.

Increasing marginal opportunity costimplies that the PPC is concave to theorigin. If, instead, the marginalopportunity cost were decreasing, youcan check, by constructing an example,that the PPC will look convex. Finally, ifthe marginal opportunity cost wereconstant, the PPC will be a straight line;an important example of this will bestudied in Chapter 8. Typically however,the marginal opportunity cost of aparticular good on the PPC is increasingand therefore the PPC is concave [asshown in fig. 1.1(b)].

1.2.2 Opportunity Cost – A MoreGeneral Concept

The concept of opportunity cost is veryimportant and universal - not specificto PPC. Most generally, the opportunitycost of a given activity is defined asthe value of the next best activity. Asan illustration, suppose that you are adoctor having a private clinic in NewDelhi and your annual earnings are Rs.8 lakhs. There are two other alternativesto having a clinic in New Delhi. Eitheryou can work in a government hospital

Table 1.2 Marginal Opportunity Cost along the PPC

Production of Production of MarginalCricket Saris Opportunity

Bats (in thousands) (in lakhs) Cost of Bats (in saris)

0 75 —

1 70 5

2 62 8

3 50 12

4 30 20

5 0 30


in New Delhi, earning Rs. 4 lakhsannually, or you can open a clinic inyour home town, Mumbai, which wouldhave generated an annual income of Rs.3 lakhs. Then your opportunity cost ofhaving a clinic in New Delhi is Rs. 4lakhs because you forego an income ofRs. 4 lakhs from the second bestalternative of working in a governmenthospital.

In the context of PPC, there are onlytwo goods, and therefore, theopportunity cost of (additionally)producing one has to be defined interms of the only remaining good.

then the economy can produce more ofboth goods. That is, the PPC can shiftto the right, such as from AC to FH infig. 1.2.

It may be noted at this point thatthe following chapters contain manyanalytical constructs or curves (likePPC), which will be derived fromeconomic considerations. It will begood idea for you to go throughAppendix 1 thoroughly now, if youhave not done so already.

1.3 MICRO VERSUS MACROECONOMICS

So far we have discussed in generalwhat economics is about, and analyticalconcepts like PPC and opportunitycost. The discipline of economicsis vast, and, it has many branchesor sub-disciplines. Out of them,there are two core branches,called microeconomics andmacroeconomics. The former refersmostly, but not exclusively, to theanalysis of scarcity and choice problemsfacing a single economic unit such as aproducer or a consumer. Consider anexample of producing a service say,hair-cut. If you own a barber shop, howmany barbers should you hire? Howmany persons should you serve per dayon the average? What price are yougoing to charge for a crew-style haircut?As another example, given yourmonthly pocket money, how many icecreams and chocolates you are goingto buy? These are questions ofindividual choice. Microeconomics dealswith the principles behind such choices.

Fig. 1.2 Shift of the PPC

1.2.3 Shift of the PPC

We now return to our discussion of thePPC. Note that, although a given PPCshows that, if the production of onegood goes up, the (maximum)production of the other must fall, youshould not however think that aneconomy can never produce more of allgoods. Over time, if the technologiesprogress or if the resources available toan economy (such as different types ofequipment, the sizes of unskilledand skilled labour force etc.) grow,


On the other hand, macro economicsdeals with the behaviour of aggregatessuch as real Gross Domestic Product(GDP), employment, inflation etc. Whatdetermines the real GDP or inflation rate

CLIP 1-2

Capitalism Versus Central Planning*

We all know that the Soviet Union – along with its economic system - broke down inthe late 1980s. Even the Chinese economy that used to be centrally planned ismoving vigorously towards a market system today. Why did the central planningsystem fail?

While the ultimate goals of a central planning system are same as that of amarket-oriented economy, i.e., improvement of standard of living of people, themeans of achieving them in the former suffers from two inherent flaws, namely,(a) lack of coordination and (b) lack of individual incentives. A modern economyproduces millions of different kinds of goods and services. Obviously, a centralcoordination of activities in all or most of these sectors is bound to fail becauseof unanticipated events or just human error. And a failure to achieve the targetedlevel of production in one sector will create problems for many other sectors.

Equally or probably more serious is the problem of individual incentives. Sincewhich goods and how much to be produced are already decided by a central bodyand there is no immediate or adequate reward for innovation, there is little incentiveto discover new or better quality products. Also, guranteed life-time employmentin the government-run industries or businesses provided no incentive to worksincerely or efficiently. “Work according to one’s ability” remained only an ideal, asthere was little reward for it.

On the other hand, the market economy provides an opportunity and incentivefor individuals to take risks, which is essential for inventions and to voluntarily“work according to one’s ability”. Individual freedom is respected and rewarded -definitely more so than in a centrally planned system.

The capitalist system has its serious problems too. Fluctuations, i.e., periodicrecessions or depressions, are problems of one kind. Profit-oriented businessesmay disregard the adverse impact of industrial activity on local or globalenvironment. Such problems call for government restrictions, but only in selectiveand discrete ways. They do not imply that direct government control over mosteconomic activities in the economy – as in centrally planned economies – is theright solution.

* We need not mention NET in every clip.

in an economy? What policies canreduce the rate of unemployment in adeveloping country like India? And so on.

This book is designed to cover somebasic principles of microeconomics.


EXERCISES

Section I1.1 What is economics about?

1.2 Name any two central problems facing an economy.

1.3 Define the production possibility curve.

1.4 Define marginal opportunity cost along a PPC.

1.5 What does increasing marginal opportunity cost along a PPCmean?

1.6 Define opportunity cost.

1.7 What is microeconomics?

1.8 What is macroeconomics?

SUMMARY

� Economics is a social science.

� Economics is concerned with the study of individual and social choicein situations of scarcity.

� There are three central problems facing any economy, namely, “what”,“how” and “for whom”.

� The “what” problem refers to which goods and services will be producedin an economy and in what quantities.

� The “how” problem refers to the choice of methods of production of goodsand services.

� The “for whom” problem concerns with the distribution of income andwealth.

� In a capitalist or market-oriented economy, these problems are addressedthrough the operation of markets.

� Normally, the production possibility curve is concave to the origin. It isbecause of increasing marginal opportunity cost.

� A production possibility curve shifts out due to technological progressor increases in the supply of resources available to an economy or both.


Section II1.9 Explain how scarcity and choice go together.

1.10 ‘‘Economics is about making choices in the presence of scarcity.”Explain.

1.11 What are the central problems of an economy and why do theyarise?

1.12 Explain any two central problems facing an economy.

1.13 Explain the central problem of “what” with examples.

1.14 Explain the central problem of “how” with examples.

1.15 Explain the central problem of “for whom” with examples.

1.16 Why does the PPC look concave to the origin?

1.17 An economy produces two goods: T-shirts and cell phones. Thefollowing table summarises its production possibilities.Calculate the marginal opportunity costs of T-shirts at variouscombinations.

T-shirts Cell phones(in millions) (in thousands)

0 90,000

1 80,000

2 68,000

3 52,000

4 34,000

5 10,000

1.18 Draw the production possibility curve for the example ofMr. Kheti Lal in the text.

1.19 Suppose you have to practice question-answers for two subjects:mathematics and social science. You have 8 hours to study.You are very good at answering multiple choice questions inmathematics: 20 questions per hour, while you are not thatgood in answering such questions in social science: 12questions per hour. Derive your production possibility scheduleand plot it. (The two “goods” here are (i) mathematics questionspractised and (ii) social science questions practised.)


1.20 Give two examples of under-utilisation of resources.1.21 “An economy always produces on, but not inside, a PPC.”

Defend or refute.1.22 Define opportunity cost and explain it with the help of an

example.1.23 Suppose that you choose the science stream. You had two

other options: the arts stream (A) or the commerce stream(C). If you would have chosen (A), you would have expected acareer, offering you Rs. 3 lakhs annually. If you would havechosen (B), you would have expected a career, giving you Rs.4 lakhs annually. What is your opportunity cost of choosingthe science stream? (Note: It is only a hypothetical example.)

1.24 “Massive unemployment shifts the PPC to the left.” Defend orrefute.

1.25 Which factors lead to a shift of the PPC?1.26 Give two examples of growth of resources.1.27 Why do technological advance or growth of resources shift

the PPC to the right?1.28 A lot of people die and many factories are destroyed because

of a severe earthquake in a country. How will it affect thecountry’s PPC?

1.29 Distinguish between microeconomics and macroeconomics.

Section III1.30 A country produces two goods: green chilli and sugar. Its

production possibilities are shown in the following table. Plotthe PPC in a graph paper and verify that it is concave to theorigin. What is the pattern in the table that gives rise to theconcave shape of the PPC?

Green Chilli Sugar

Possibility A 100 0

Possibility B 95 1

Possibility C 85 2

Possibility D 70 3

Possibility E 50 4

Possibility F 25 5

CONSUMER BEHAVIOUR AND

DEMAND

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In Chapter 1 it was stated that, in a market-oriented economy, the central problems of“what”, “how” and “for whom” are solvedthrough forces of demand and supply forvarious goods and services. Who demands aparticular good and who supplies it? Thisdepends on the type of good or service inquestion.

Consider a final product such as alubhujia.1 As consumers, households are thedemanders of alu bhujia and companies likeBikanerwala and Leher are the suppliers.Another example is the service of a computerprogrammer. This service is demanded bycompanies or firms. Who are the suppliers ofthis service? The households, because somemembers of some households work ascomputer programmers.

In summary, in case of final goods andservices, households demand them and firmssupply them. In case of services that arerequired for production, households are the

1 Final goods and services include things that are consumedby households, e.g. a piece of bread, a haircut, a bicyclerepair job etc. As opposed to final goods and services,there are “intermediate” goods (or raw materials) thatare “consumed” (i.e. used up) by businesses. Theexamples are steel in a bicycle factory, wheat in a flourmill, and various automobile components in a Maruti carworkshop.

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CHAPTER 2

•2.1 Consumer's Equilibrium

2.2 Meaning andDeterminants of Demand

2.3 Market Demand Curve

2.4 Price Elasticity ofDemand

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CONSUMER CHOICE AND THE DEMAND CURVE 17

suppliers and the firms are thedemanders.

This chapter deals with householdsas consumers and their demand forfinal goods and services. How should aconsumer decide how much of aproduct to buy? What factors do affectthis decision and how?

2.1 CONSUMER’S EQUILIBRIUM:THE BASIS OF THE LAW OFDEMAND

Let us ignore for the moment the word“equilibrium” or the phrase “Law ofDemand”, and focus on the question ofhow much of any particular good aconsumer should demand (or buy) ata given point of time. In order tounderstand this, we first have to learna few concepts.

2.1.1 Utility Concepts

We begin with the notion that aconsumer derives some satisfactionfrom consuming a product; otherwise,she would not demand it at all. This iscaptured by a term called total utility,defined as the total psychologicalsatisfaction a consumer obtains fromconsuming a given amount of aparticular good. Consider for exampleyour consumption of gol guppa - themouth-watering small round-shapedpuffed puris, served with tamarind(imli)– water and fillings.1

Imagine that you are hungry andhave come to your favourite gol guppavendor. Suppose that if you consumeonly one gol guppa you derive 20units of pleasure or utility measuredin some units. Let this (psychological)

unit be called “utils.” Thus, the totalutility from consuming one gol guppais 20 utils. Suppose that you like golguppa so much that eating just oneincreases your appetite for it. Let thesecond unit give an additional utilityof 22 utils. Then, the total utility fromconsuming two gol guppas is 20+22=42 utils. In the same manner we cancalculate total utility from consumingthree, four or five units and so on.

Besides total utility, there isanother important concept calledmarginal utility, defined as the utilityfrom the last unit consumed. Thusthe marginal utility from consumingone gol guppa is 20 and that fromconsuming two gol guppas is 22. Youcan now notice the relationship thattotal utility is the sum of marginalutilities.

Getting on with our story, yourintensity of desire for gol guppa mustfall, after consuming a certain amount,regardless of how much you like golguppa. Suppose that, in your case,such decline in the intensity of desirestarts with the third gol guppa youconsume. Accordingly, let the thirdunit give you utility equal to a numberless than 22, say, 18 utils. That is, themarginal utility and the total utilityobtained from consuming three golguppas are 18 and 42+18=60 utilsrespectively. The next (fourth) unitgives you still less utility, say,14 utils, and so on.

This pattern of marginal utility iscalled the law of diminishingmarginal utility. It states that, afterconsuming a certain amount of a good

1 Incase gol guppa is not known to the children, the teachers can use other popular eatable asexample to explain the concept.


or service, the marginal utility from itdiminishes as more and more isconsumed. If you think about it, thislaw is very natural and should holdfor any product one consumes. In factit is considered as a fundamentalpsychological law. You will see thecritical role of it a little later.

Let us resume our story once again.When you have already consumed quitea few gol guppas – say 8, and you arevery full in your stomach – supposethat the next (9th) unit gives zero utility.Imagine what will happen if you keepgulping more. Suppose that eating the10th unit makes you vomit! This isobviously not a pleasant experience andshould give you negative satisfaction.Accordingly, let the utility associated

with the 10th unit be -7 utils. That is,the marginal utility of ten gol guppas is-7 utils. (If you are crazy and still eatmore, each additional one can only giveyou more negative utility.)

Table 2.1 summarises yourexperience with gol guppa in terms ofmarginal utility and total utility up to10 units of consumption. Columns (2)and (3) present the marginal and totalutility schedules.

2.1.2 How many Gol Guppas willyou consume or buy?

From Table 2.1, it is clear that if youare a rational (not crazy) consumer,you will eat less than 10 gol guppas,since consuming 10 or more gives younegative marginal utility. If gol guppas

Table 2.1 Marginal and Total Utility

Units Consumed of Marginal Utility Total UtilityGol guppa (in utils) (in utils)

0 - 0

1 20 20

2 22 42

3 18 60

4 14 74

5 11 85

6 8 93

7 4 97

8 2 99

9 0 99

10 -7 92


were free, i.e., its price were zero, youwould have consumed 8 or 9 units atwhich your total utility is at itsmaximum. But as long as you paysomething for it, you may not wish toconsume so many. You would like toknow how much utility you could haveobtained if you had spent someamount on other items, e.g., ice cream,chocolate etc. In other words, exactlyhow many gol guppas you will eatwould depend not only on marginaland total utility from consuming golguppas, but also on the price of golguppas, and, how much a rupee isworth to you in terms of other goods.

We now define marginal utility ofone rupee as the extra utility when anadditional rupee is spent on otheravailable goods in general. Supposethat, for you, it is 4 utils and let theprice of gol guppa be Rs. 2 per piece.

Having the information on priceand marginal utility of a rupee, we candetermine how many gol guppas youwill consume. Consider first whetheryou will buy just one gol guppa. Fromconsuming only one, you obtain utilityequal to 20 utils (from Table 2.1). Sincethe marginal utility of a rupee is 4 utils,we can say that, from consumingone gol guppa, you get utility worthRs. 20/4 = Rs. 5. On the other hand,you pay – and thus sacrifice – Rs. 2 forit. Hence you will buy the first unit.Similarly, from the second unit, youget utility worth Rs. 22/4 = Rs. 5.50,while you pay only Rs. 2. Hence youwill buy the second gol guppa also.

We keep on making suchcomparisons for successive units. For

example, the 5th gol guppa is worthhaving it since it gives Rs. 11/4 =Rs. 2.75 worth of utility, which isgreater than the price.

What happens with the 6th golguppa is a bit different. It gives youutility worth Rs. 8/4 = Rs. 2, which isequal to the price. Will you buy it? Theanswer is that you will be “indifferent,”that is, whether or not you buy the 6th

unit does not make any difference.However, it is clear that you will not buy(consume) more than 6. Because, at anylevel of consumption beyond 6, themarginal utility in terms of rupees isless than the price (you can check thisdirectly). Hence we have found theanswer to our query: you will buy 5 or6 gol guppas.

The above comparisons betweenhow much of marginal utility in termsof money you get and the price you payimplies that, at either of these two levelsof consumption, the difference betweenthe total utility in terms of money andyour total expenditure on gol guppas(defined as price × quantity purchased)is maximised. Table 2.2 illustrates this.Its second column gives total utility interms of money, defined as total utilitydivided by the marginal utility of onerupee (equal to 4 utils in this example).Column (3) gives your total expenditureor spending on gol guppas. The lastcolumn gives the difference betweenthese two columns; this is like the netgain to a consumer. We see that thisdifference is maximised (equal toRs. 11.25) when your gol guppaconsumption is either 5 or 6.

Having gone through the example,we can now understand why this


Table 2.2 Difference between Total Utility in Terms of Money and TotalExpenditure

Amount Consumed Total Utility in Total Differenceof gol guppas terms of money (Rs.) Expenditure (Rs.) (Rs.)

0 0 0 0

1 5 2 3

2 10.50 4 6.50

3 15 6 9

4 18.50 8 10.50

5 21.25 10 11.25

6 23.25 12 11.25

7 24.25 14 10.25

8 24.75 16 8.75

9 24.75 18 6.75

10 23 20 3

section is titled “Consumer’sEquilibrium.” The word “equilibrium”,frequently used in economics, means aposition of rest. In this example, youwill rest, stop – or, as economists say,attain consumer’s equilibrium – at 5or 6 gol guppas. Because you do notwant to consume less or more thanthese quantities. In general, we canthen say that consumer’s equilibriumwith respect to the purchase of onegood is attained when the differencebetween total utility in terms of moneyand the total expenditure on it ismaximised.

2.1.3 The General Principle

From the example just worked out, wecan now derive the general principle of

consumer’s equilibrium with respect toany particular good. Recall that one ofour answers is 6 gol guppas. Ignoringthe other answer for the moment, notethat, at this level of consumption, themarginal utility in terms of money (Rs.2) is equal to price (Rs. 2). This is indeedthe principle and we can state this intwo alternative ways. That is, theconsumer’ s equilibrium is attainedwhen

Price Its

Rupeea of Utility Marginal

Producta of Utility Marginal)A(

= Or

Price Its

Producta of Utility Marginal)(B

Rupee.a of Utility Marginal =


In particular, the condition (A) saysthat the marginal utility of a product interms of money be equal to its price.Sometimes, this is loosely stated as“marginal utility is equal to price.”

Now go back to the example onceagain and see that the consumer’sequilibrium is also attained at 5 golguppas, where the principle is notsatisfied. This possibility exists becausegol guppas are not perfectly divisible:they cannot be measured continuouslylike points on a straight line. If, instead,a product is perfectly divisible and thuscan be measured continuously, forexample by weight on a weighing scale,there will be just one level ofconsumption at which the consumer’sequilibrium is achieved, with condition(A) [or (B)] met.

We do implicitly assume from nowon that a product is perfectly divisibleand thus treat (A) or (B) as the conditionof consumer’s equilibrium.2

2.2 MEANING AND DETERMINANTSOF DEMAND

Our analysis of consumer’s equilibriumimplies that the price of a product is animportant factor in determining howmuch of the product a consumer willbe willing to buy within a given timeperiod. It is because, as the productprice changes, the ratio of marginalutility to price changes so that theconsumer’s equilibrium will occur at adifferent level of consumption.

This forms the basis of definingdemand for a particular good by aconsumer: it is the quantity of thegood that she is willing to buy atdifferent prices within a given periodof time.

However, the price of a product isnot the only factor that influences howmuch a consumer should buy of thatproduct. For example, if there is a tastechange, it will change the marginalutilities from a product, and, theconsumer’s equilibrium condition willbe fulfilled at some other level ofconsumption even when there is nochange in price.

Moreover, while our precedinganalysis is confined to one good (e.g.gol guppa), in reality, a consumerbuys many goods. The consumer’sequilibrium analysis with respect tomany goods (which is outside ourscope) suggests two other factors,namely, prices of related goods andincome. This is quite natural. If aperson consumes, for example, teaand coffee, then a change in the priceof tea should affect her consumptionof coffee and vice versa. Also, if incomechanges, different amounts can bebought even when the prices of goodsand services she consumes remainunchanged.

The last three factors justmentioned are called thedeterminants of demand. They arenamely,

2 Nothing essential or important is gained by deviating from this assumption. The only modification isthat, when a good is not perfectly divisible, the condition (A) or (B) holds either exactly or approximately.


The law of demand in tabular formis called a demand schedule. If wegraph a demand schedule, we obtain ademand curve. It typically measuresown price along the y-axis and quantitydemanded on the x-axis. The demandcurve corresponding to the demandschedule in Table 2.3 is shown infig. 2.1. We see that the demand curveis downward sloping. It is because anincrease in the own price lowers the

(a) prices of related goods,(b) income and(c) tastes. 3

The next question is how the ownprice of a product as well as these threefactors affect the quantity demanded ofa particular good.

2.2.1 Own Price: The Law ofDemand

To isolate its effect, hold the otherfactors constant and ask how thequantity demanded of a productchanges as its own price changes. Theanswer is summarised as what is calledthe Law of Demand. It states that otherthings remaining unchanged, as theown price of a commodity increases,the quantity demanded of it by aconsumer falls. “Other things” refer tothe prices of related goods, income andtastes.

Suppose that, for a particular family,within a month, Table 2.3 lists itsquantities demanded of apples atdifferent prices, which are consistent withits consumer’s equilibrium. The leftcolumn lists various prices, while theright column lists the correspondingquantities demanded. It is assumed thatthe prices of related goods, family incomeand tastes are kept fixed at somepre-determined levels.

3 Apart from (a), (b) and (c), there may be other determinants of demand for a good, e.g., future priceexpectation. Consider an essential product, say, edible oil or sugar. Suppose there is a weatherprediction that your village or town will be hit by a severe cyclone in the next three days. You wouldthen anticipate that supply interruptions would occur and prices of these commodities would sky-rocket. If you are a rational consumer, you would buy more of these commodities now (and store them)even if prices, income or tastes do not change.Moreover, taste changes can occur not only because of natural changes in a person’s liking, but also dueto advertising of products.

Table 2.3 A Demand Schedule

Own Price Quantity Demanded(in Rs.) of Apples

12 24

13 17

14 12

15 9

16 7

17 6

quantity demanded. Each point of thedemand curve shows the quantitydemanded that is consistent withconsumer’s equilibrium.

Why is the Demand Curve DownwardSloping?

Isn’t it obvious that the demand curveis downward sloping? That is, as


the own price increases, the quantitydemanded of a product falls.Interestingly, it is not. There is a reasonbehind it, namely, the law ofdiminishing marginal utility. Indeed,the demand curve is essentially themarginal utility curve.4

Consider Table 2.4, which lists themarginal utility from consumingT-shirts. Mark that, for simplicity,diminishing marginal utility sets in withthe very first unit of consumption.Assume further, again for simplicity ofexposition, that the marginal utility ofa rupee is equal to 1 util. Then, ourconsumer’s equilibrium condition (A)can be stated as “Marginal Utility =Price.”

To begin with, suppose that theprice of a T -shirt is Rs. 45. Theconsumer’s equilibrium conditionholds at 7 T-shirts consumed. This can

Fig. 2.1 Demand Curve Correspondingto Table 2.3

4 An intuitive way to see this is that, as a consumer buys more of a good, her marginal utility decreasesand therefore she is willing to pay less per unit. This can be turned around to say that if the price of aproduct falls, a consumer buys more of it.

Table 2.4 Marginal UtilitySchedule and the Demand

Schedule

Quantity of Marginal Utility of T-shirts T-shirts

1 75

2 70

3 65

4 60

5 55

6 50

7 45

be restated as follows. The quantitydemanded of T-shirts is 7 when theprice is Rs. 45. Thus the pair (45, 7)will be on the demand curve. Similarly,suppose that the price of T-shirtsincreases to Rs. 65. The consumer’sequilibrium condition now holds at 3T-shirts consumed, that is, at priceRs. 65, the quantity demanded is 3.Hence the pair (65, 3) will be on thedemand curve too. Likewise, we candetermine that all other points on themarginal utility schedule are points onthe demand schedule. This means thatthe marginal utility curve itself is thedemand curve, and, the demand curveis downward sloping because of the lawof diminishing marginal utility.


2.2.2 Determinants of Demand

Now turn to the remaining factors thataffect the quantity demanded of aparticular product, or, what we havecalled the determinants of demand.

Change in Price of a Related Good

Suppose that Mrs. Das, who lives nextdoor to you, has a weakness for sweets.Burfi and gulab jamun are herfavourites. Suppose that burfis becomemore expensive: from Rs. 5 a piece toRs. 8 a piece. How will this affect Mrs.Das’s demand for gulab jamun? It willincrease. Why, because burfi and gulabjamun are substitutes of each other inconsumption. Consider anotherexample: that of tea and coffee. Thesame should happen to the demand fortea if the price of coffee rises or viceversa, because tea and coffee are alsosubstitutes. We say that good A is asubstitute of good B if an increase inthe price of good B increases thedemand for good A.

On the other hand, consider tea andsugar. Sugar is complementary to tea

in consumption. Thus, if the price of teagoes up, the quantity demanded of teashould fall, which will reduce thedemand for sugar. Another example ofa pair of complementary products ispetrol and cars. If the price of petrol rises,the quantity demanded of cars shouldfall. In other words, good A is said to becomplementary to good B if an increasein the price of good B decreases thedemand for good A.

These examples illustrate crossprice effects: how the demand for oneparticular product is affected by achange in the price of another.Numerical examples of cross priceeffects are given in Tables 2.5 and 2.6.

In Table 2.5, note that as the priceof coffee rises from Rs. 200 to Rs. 250,the quantity demanded of tea increasesfor any given price of tea. For example,given price of coffee = Rs. 200, at teaprice equal to Rs. 170, the quantitydemanded of tea is 11, whereas, givencoffee price = Rs. 250, at the same teaprice (Rs. 170), the quantity demandedof tea is 18. The demand schedules of

Table 2.5 Effect of an Increase in the Price of Coffee on Demand for Tea

Price of Tea Quantity Demanded of Tea Quantity Demanded of Tea(per kg) when Price of Coffee when Price of Coffee

Rs. (per kg) = Rs. 200 (per kg) = Rs. 250

150 20 28

170 11 18

190 5 10

210 2 7

230 1 4


Table 2.6 Effect of an Increase in the Price of Tea on Demand for Sugar

Price of Sugar Quantity Demanded of Quantity Demanded of Sugar(per kg) Sugar when Price of Tea when Price of Tea

Rs. (per kg) = Rs. 170 (per kg)= Rs. 200

5 20 12

8 14 7

11 9 4

14 6 2

17 5 1

tea given in column (2) and (3) ofTable 2.5 are graphed in Figure 2.2.We see that demand curve for teawhen the price of coffee is Rs. 250 liesto the right of that when the price ofcoffee is Rs. 200. Hence, an increase(a decrease) in the price of a substitutegood shifts the demand curve for aproduct to the right (left).

Similarly, in Table 2.6, notice that,as the tea price increases from Rs. 170to Rs. 200, the quantity demanded ofsugar decreases for any given price ofsugar. Figure 2.3 graphs Table 2.6.The demand curve for sugar when teaprice is Rs. 200 lies to the left of thatwhen the sugar price is Rs. 170. Thus,an increase (a decrease) in the priceof a complementary good shiftsthe demand curve for a product to theleft (right).

A Change in Income

Suppose that you only buy peanutsand ice cream from your pocket money.Ice cream is your favourite but it iscostly. You like peanuts much less, but

they are cheap. Suppose that yourpocket money increases. Will you buymore of ice cream, more of peanuts orboth? We bet that you will buy moreice cream. Whether you will buy morepeanuts is not clear. Very likely, you willbuy less of peanuts, not because yourtaste changes but because you canafford more ice cream, which is yourfavourite.

Hence, generally, we can say that,as income increases, a consumer may

Fig. 2.2 Change in demand due to increasein the price of a substitute good


buy more or less of a product. If shebuys more (e.g. ice cream), then we saythat the product in question is a normal

those, for which demand falls asincome rises.

Table 2.7 presents numericalexamples of both normal and inferiorgoods. Observe that, at any given price,as income increases, quantitydemanded of the normal good increases(by comparing columns (2)-(3)) and thatof the inferior good decreases (bycomparing columns (5)-(6)). These aregraphed in figs. 2.4 and 2.5. Theoriginal demand curve for the normalgood, when income is Rs. 300, isindicated by the line NN0 in fig. 2.4.This represents the column pair (1)-(2).The new demand curve, when incomeof Rs. 400, is marked by NN1 thatrepresents the column pair (1)-(3).Hence an increase in income shifts thedemand curve to the right if the goodis normal. For the inferior good,the demand curves are indicatedby FF0 (original) and FF1 (new) in

Fig. 2.3 Change in demand due toincrease in the price of acomplementary good

good. If she buys less (e.g. peanuts),then we say that it is an inferior good.Put differently, normal goods arethose, for which demand increases asincome increases. Inferior goods are

Table 2.7 Normal and Inferior Goods

A Normal Good An Inferior GoodOwn Price (Quantity (Quantity Own Price Quantity Quantity

Demanded: Demanded: Demanded: Demanded:Income = Income = Income = Income =Rs. 300 Rs. 400 Rs. 300 Rs. 400

1 15 19 3 20 15

2 12 16 4 17 12

3 9 13 5 14 9

4 7 11 6 11 6

5 5 9 7 8 3

6 3 7 8 5 0


fig. 2.5. Thus an increase in incomeshifts the demand curve to the left ifthe good is inferior.

In the real world, there are muchfewer examples of inferior goods thannormal goods. Yet there are importantexamples. In India, cereals as a singlecategory of goods (that includes rice,wheat, bajra, jowar etc.) constitute aninferior good. Within this category, theinferior-good characteristic applies tobajra, jowar, maize and related cereals.

A Change in Tastes

Finally, consider a taste change.Suppose you are impressed by anadvertisement in TV, in which yourfavourite actor drinks Coca Cola, and,as a result, your liking for Coca Colaincreases. This will shift your demandcurve for Coca Cola to the right. This isan example of a “favourable” change intastes. An unfavourable change in tastewill imply the opposite. We can then say

Fig. 2.4 Change in demand due toincrease in income (Normal Good)

Fig. 2.5 Change in demand due toincrease in income (Inferior Good)

that a favourable (an unfavourable)change in tastes shifts the demandcurve to the right (left).

A taste change may result from achange in a person’s liking, or, from someother source. If, for instance, for healthreasons, you have to consume more of aproduct although you don’t like it, thisis also considered a taste change.

2.2.3 Change in QuantityDemanded Versus Change/Shift in Demand

We have seen that the quantitydemanded of a product depends onown price and “other” factors likeprices of related goods, income andtastes. The law of demand refers to theeffect of a change in the own price. Agraphical representation of this is thedemand curve, which is downwardsloping. A change in the own pricecauses a movement along a givendemand curve: higher (lower) the price,less (more) is the quantity demanded.


Such a movement is called a changein the quantity demanded.

In contrast, when a change in anyother factor causes a (left or rightward)shift of a demand curve, we call this achange in demand.

The distinction between the twoconcepts is illustrated in fig. 2.6.Fig. 2.6(a) illustrates a change in thequantity demanded. There is a pricechange from P0 to P1. As a result, thereis a movement along the same demandcurve from A to B. The quantitydemanded changes from Q0 to Q1. Incontrast, fig. 2.6(b) shows a change indemand, meaning a shift of a demandcurve from DD0 to DD1 due to a changein the prices of related goods, incomeor tastes.

2.3 MARKET DEMAND CURVE

We have studied consumer’sequilibrium and the determinants ofdemand for a good from the perspectiveof a single individual. How do we getthe demand curve of a product by allindividuals together in an economy,e.g., the economy of a region or acountry? The economy-wide demandcurve for a particular product is calledthe market demand curve. It isobtained by summing up the demandcurves across consumers orhouseholds.

Consider the market for, say, gulabjamun. Suppose that there are threeconsumers in the market: Amar, Akbarand Anthony. If at the price equal toRs. 3 a piece, Amar demands 5, Akbar6 and Anthony 8 per week, then thetotal quantity demanded is 19. Hence

Fig. 2.6 Change in Quantity DemandedVersus Change in Demand

(3, 19) is a point on the market demandcurve. Repeat the same exercise forother possible prices and obtain thecorresponding points. Plot the points,join them and you get the marketdemand curve.

A numerical example is given inTable 2.8. Individual demandschedules are given by column pairs(1)-(2), (1)-(3) and (1)-(4). The column

(a) Change in Quantity Demanded

(b) Change in Demand


pair (1)-(5) gives the market demandschedule. Note that for each row (price),the entry in column (5) is the sum ofcorresponding entries in columns (2),(3) and (4).

These individual demand schedulesand the market demand schedule aregraphed in fig. 2.7. Amar’s, Akbar’s andAnthony’s demand curves arerespectively marked by their names.The right most line is the marketdemand curve. This is obtained byhorizontally summing the individualdemand curves.

What are the determinants of themarket demand curve? They are thedeterminants of the individual demandcurve described earlier plus how manyconsumers buy the product, that is,(a) prices of related goods;(b) income levels across individuals, or

what we can call, the distributionof income;

(c) consumers’ tastes

(d) the number of consumers who buythe product, or what we can call, themarket size.5

2.4 PRICE ELASTICITY OFDEMAND

We have seen how various factors likeown price and income affect the demandfor a commodity. The direction ofchange was our focus - whether thequantity demanded increases ordecreases as price, income or otherfactors change. The concept of elasticitycaptures the magnitude of change orthe degree of responsiveness. Forexample, the price elasticity of demandquantifies the effect of a change in ownprice on the quantity demanded.

Table 2.8 Individual and Market Demand Schedules for Gulab Jamun

Price of Gulab Amar’s Akbar’s Anthony’s MarketJamun in Rs. Demand Demand Demand Demand

1 7 15 13 35

2 6 10 10 26

3 5 6 8 19

4 4 3 7 14

5 3 1 6 10

6 2 0 5 7

5 Many multinational firms today look at the Indian or the Chinese market as very lucrative, because oftheir market sizes, which refer to the huge number of consumers in these countries.


2.4.1 Definition and Formulas

Formally, Elasticity of demand isdefined as

price own the in change %demanded quantity the in change %

demand of elasticity Price )(

−=

= DeC

Since the changes in price andquantity along a demand curve occurin opposite directions, the ratio of %change in quantity demanded and thatin the own price is negative in sign.Hence attaching a negative sign in frontof the ratio makes the sign of eD positive.Some other textbooks define the priceelasticity the same way as above, exceptfor the “minus” sign. But there is noreason to get confused. Strictly speaking,our definition gives the absolute valueof the elasticity, which is, often, referredto as “elasticity”.

Along a given demand curve, let theoriginal price be P0 and the originalquantity be Q0. Suppose that the priceincreases to P1 and the quantitydemanded falls to Q1. Then the %changes in price and quantitydemanded are respectively equal to[(P1–P0)/P0]×100 and [(Q1–Q0)/Q0]×100.Thus (C) can be written as

./)(/)(

)(001

001

PPPQQQ

eD D −−

−=

If we further denote a change in

quantity as Q∆ and a change in price

as P∆ , we can also write

./

Q/Q)(

0

0

PPeE D ∆

∆−=

Consider the following numericalexample. Suppose that in your hometown, rasgoolas were being available atRs. 5.00 per piece and the residents of

Fig. 2.7 Individual and Market Demand Curves


the town were buying 1200 rasgoolasper day. Now they become moreexpensive for some reason, at Rs. 5.50per piece. Fewer people are eatingrasgoolas and many who eat, are eatingless. Suppose that the people in thetown are now buying 960 rasgoolas perday. What is the price elasticity ofdemand?

We have to do some arithmetic. The% change in the price is equal to[(5.50 –5.00)/5.00]×100=10. The %change in quantity is equal to [(960–1200)/1200]×100=–20. Hence, e

D, the

price elasticity, is equal to 20/10 = 2.

Properties

1. A very desirable property of theelasticity formula in measuring thedegree of responsiveness is that itis independent of the choice ofunits. It is because any percentagechange of a variable is independentof units.

2. If two demand curves intersect, attheir point of intersection, theelasticity associated with theflatter demand curve is higher. Thisis exhibited in fig. 2.8. The demandcurves DD and DD� intersect at thepoint C. At this point, P0 is the priceof the product. The claim is that, atprice P0, the elasticity is greateralong the flatter demand curve DD�.Why? Because the original quantitydemanded is the same, equal to D0,along both demand curves, and, ifthere is an increase in price, say toP1, the quantity demanded fallsmore along the flatter demand curve(by amount D2D0 as compared to

D1D0 along DD). This implies that,while the % change in price is thesame along both demand curves,the % change in quantity demandedis greater along DD�. Therefore,price elasticity associated with DD�

is higher.3. Higher the value of the price

elasticity, greater is the degree ofresponsiveness of quantitydemanded to price. In particular, ifeD>1, then the % change in quantitydemanded must exceed the %change in price. We then say thatthe product demand is elastic (e.g.jewellery). If eD<1, the % change inquantity demanded is less than thatof the price, and, we say that theproduct demand is inelastic.Typically, the demand for luxurygoods is elastic and that fornecessary goods (e.g. basic fooditems) is inelastic. Finally, if eD=1, itis said that the demand is unitarilyelastic. In this special case, thedemand curve takes a particular

Fig. 2.8 Elasticity Comparison


shape, called rectangular hyperbolain geometry. It is a curve, whichextends towards the x-axis and y-axisin a uniform manner withouttouching them. Fig. 2.9 exhibits this.

4. There are two other special cases. Ifthe product is absolutely essential,like demand for a rare medicine orsome very bad case of addiction toundesirable products like opium,the demand curve is vertical. In thiscase, the price elasticity is zero, i.e.,the product demand is totally orperfectly inelastic. This is evident,because, along a vertical demandcurve, the quantity demanded istotally insensitive to any change inprice. This case is exhibited infig. 2.10(a). The last special case isthe one, where demand curve ishorizontal and thus the demand isperfectly elastic, i.e., the price

2.4.2 Factors Affecting theMagnitude of Price Elasticity

In general, the magnitude of priceelasticity depends on the followingfactors.

Availability of Close Substitutes: Ifclose substitutes of a product arereadily available, its price elasticity ofdemand is likely to be high, becauseeven a very small increase in price willmake consumers switch to other

Fig. 2.9 Unitarily Elastic Demand

Fig. 2.10 Elasticitiy = 0, ∞

(a) Perfectly Inelastic Demand

(b) Perfectly Elastic Demand

elasticity is equal to infinity.Fig. 2.10(b) shows this. Aneconomic example of this demandcurve will be given in Chapter 4.


products in a big way. Otherwise, in theabsence of close substitutes, theelasticity is likely to be small. Forexample, if it is a staple food item of aparticular region, say, rice in Orissa orWest Bengal, by definition, there are no(very) close substitutes available. It isindispensable. Hence the demand forrice is likely to be inelastic. Moregenerally, the demand for essentialproducts is likely to be inelastic. On theother hand, “luxury” items like eatingin a restaurant, buying a big-sizecolour TV etc. are relatively dispensable.Hence the demand for these items islikely to be relatively elastic.

Proportion of Total ExpenditureSpent on the Product: If the amountspent on a product constitutes a verysmall fraction of the total expenditureon all goods and services you consume,then the price elasticity is likely to besmall. The demand for salt is anexample. On the other hand, if it is ahigh-price item and takes a majorportion of your total expenditure, yourdemand for it is more sensitive to a pricechange; that is, the elasticity of demandis likely to be high.

Habits: Some products which are notessential for some individuals areessential for others. A form ofconsumption such as eating out in five-star restaurants is a luxury for manypeople; therefore, their demand for it isvery elastic. But, for someone who isvery rich, it may be an essentialdemand, because he is alreadyhabituated. Hence his demand for five-

star restaurant food is inelastic.Similarly, for an opium addict, thedemand for opium is very inelastic,whereas for other casual opium takers,the demand is likely to be elastic.

Time Period: All other things remainingthe same, the longer the time period,more elastic is the demand for anyproduct. The consumption of petrol isa prime example. In the 1970s, whenOPEC (Organisation of PetroleumExporting Countries) dramaticallyincreased the price of oil for the first timein history, the whole world wasshocked. Countries could notimmediately find and adopt any otherforms of energy for their needs. In otherwords, substitutes of oil could not beavailable and the demand for oil wasvery inelastic. But over years alternativetypes of energy were developed, and,substitutes became more readilyavailable. The demand for oil is moreelastic today than it was 30 years ago.

Clip 2-1 reports price elasticities forvarious products that have beenestimated by various authors.

2.4.3 Measurement of Elasticity

Finding price elasticity of demandusing its definition as such is called thepercentage method of measuringelasticity. In particular, when the pricechange is very small, a graphicalformula or a geometric method canalso be used to measure elasticity.

Suppose that it is a straight-linedemand curve, as shown in fig. 2.11,having intercepts A and B respectivelyon the price axis and quantity axis


Clip 2-1Price Elasticity Estimates

Price elasticities have been estimated for various products and services and inthe context of different countries. Five examples are reported below, four of whichare for India and one for America.As you see, the price elasticities for food items and clothing are less than one, asthese are essential items. Note that item No. 4 is an example of a service: longdistance phone calls from PCOs. The elasticity for this item is also less than one.It indicates that long-distance telephone calls are not a “luxury” demand anymore;they have become a necessity in a country like India.The item no. 5 shows that the demand for residential land in America is elastic,equal to 1.64.

Product/Service Price Elasticity Estimate Source

1. Cereals & cereal 0.544 Meenakshi and Raysubstitutes (1999)(India)

2. Other foods 0.804 Meenakshi and Ray(India) (1999)

3. Clothing 0.560 Meenakshi and Ray(India) (1999)

4. Long distance 0.580 Das and Srinivasanphone calls (1999)from PublicCall Offices(India)

5. Residential 1.640 Gyourko and VoithLand in (2001)Philadelphia(U.S.A.)

Das, P. and P.V. Srinivasan, “Demand for Telephone Usage in India,”Information Economics and Policy, 11, 1999, pages 177-194. Meenakshi, J. V.and Ranjan Ray, “Regional Differences in India’s Food Expenditure Pattern: AComplete Demand Systems Approach,” Journal of International Development,11, 1999, pages 47-74. Gyourko, J. and R. Voith, “The Price Elasticity of Demandfor Residential Land: Estimation and Some Implications for Urban Reform,”mimeo, Wharton School of Management, 2001.


respectively. Suppose that initially theprice is P0, and the quantity consumedis Q0, that is, the consumer is at point Con the demand curve. Then, for smallprice changes, the price elasticity turnsout to be equal to BC/AC. Thisgraphical formula is called pointelasticity. In other words, pointelasticity, at a certain point along astraight-line demand curve, is equal tothe lower segment divided by the uppersegment of the demand curve at thatpoint.

A proof of it is given in Appendix 2.The point elasticity formula impliesthat, as price increases, the ratio of thelower segment to the upper segmentincreases (as we are looking at pointshigher up on the demand curve) andtherefore the product becomes moreelastic.6,7,8

2.4.2 Total Expenditure and PriceElasticity

The concept of price elasticity does notjust quantify the relationship betweenprice and quantity demanded, it alsoindicates the direction in which the totalexpenditure on a product changes, asthere is a change in price.

Return to the rasgoola exampleand ask the following simple question.Because of the increase in the price of

Fig. 2.11 Point Elasticity along a StraightLine Demand Curve

rasgoolas, does consumer spending ortotal expenditure on rasgoolas increaseor decrease? By definition, the totalexpenditure on a particular good =price × quantity. If we denote totalexpenditure by TE, price by P andquantity by Q, then TE = PQ. Let us nowcalculate TE. Originally, P and Q wererespectively Rs. 5.00 and 1,200; henceTE was equal to Rs. 6,000. At the newprice Rs. 5.50 and quantity = 960, TE= Rs. 5,280. Thus the total expenditurehas fallen. Note also that the elasticityis equal to 2. That is, in the example,the demand for rasgoola is elastic, and,as there is a price increase, the totalexpenditure falls.

6 This is not a general property of price elasticity. It may not hold when the demand curve is not a straightline.

7 At point B the elasticity is zero and at point A it is infinity.8 If it is not a straight-line demand curve, then the point elasticity measure at a point on it is based on

the tangent to the curve at that point. You will find a treatment of this in a higher-level micro economicstextbook.


It turns out that such oppositemovements in the directions of priceand total expenditure changes hold, notjust in this example, but always, whenthe product demand is elastic. Similarly,if the product demand is inelastic, thetotal expenditure always increases asprice increases. Moreover, as a specialcase, if the product demand is unitarilyelastic, then the total expenditure doesnot change with any price change. Youcan relate the last case to fig. 2.9, whichdepicts the unitarily-elastic case. Thatis, the total expenditures at all pointson that demand curve are the same.

There is thus a general relationshipbetween the direction of price changeand the direction of change in totalexpenditure, depending on themagnitude of price elasticity. If theproduct demand is elastic, unitarilyelastic or inelastic, an increase in priceleads respectively to a decrease, nochange or an increase in the totalexpenditure on the product. Table 2.9presents this result in a tabular form.

This result can be provenalgebraically, but it is beyond our

scope. However, it is quite intuitive. Ifthe demand for a product is elastic, itmeans that a small price change invitesa relatively large adjustment in thequantity. Hence the total expendituremust change in the same direction inwhich the quantity changes. Now yousee that, as price increases, quantityfalls and the fall in quantity is associatedwith a fall in the total expenditure. Justthe opposite holds when the productdemand is inelastic. In this case a largeprice change leads only to a relativelysmall adjustment in quantity. Hence thetotal expenditure must change in thesame direction as the price change, i.e.,a price increase leads to an increase intotal expenditure.

So far we have discussed how wecan determine the direction of changein total expenditure, given the directionof change in the price and givenwhether the product is elastic orinelastic. Alternatively, if we know thedirection of change in price and thedirection of change in total expenditure,we can infer whether the productdemand is elastic or inelastic. For

Table 2.9 Price Change and Its Effect on Total Expenditure

Price Change Elasticity Total Expenditure

↑ 1>De ↓

↓ 1>De ↑

↑ 1<De ↑

↓ 1<De ↓

↑ ↓ 1=De No Change


instance, if because of a price increase,the total expenditure increases, thenthe product demand must be inelastic.You can readily verify that from Table2.9.

This link, via price elasticity, betweenchanges in price and total expenditure hasimportant practical implications. Returnonce again to the rasgoola example.Suppose that there is only one (giant)halwai shop in town, who sells rasgoolas.If you are the halwai shop owner and are

thinking about increasing the price ofrasgoola, wouldn’t you want to know if aprice increase would increase or decreaseyour total sales in rupees? From a seller’sperspective, the total value of sales isusually called total revenue and note thattotal revenue is equal to the totalexpenditure by the consumers.9 Hencethe relationships between elasticity, pricechange and total expenditure areimportant from the viewpoint of decisionmaking by a producer or a firm.

9 We will see the use of the term “total revenue” in Chapters 4, 6 and 7.

SUMMARY

� Total utility is equal to the sum of marginal utilities.

� A rational consumer will never consume that much of a product suchthat the marginal utility from it is negative.

� At the consumer’s equilibrium, the difference between total utility interms of money and the total expenditure on a good is maximised.

� Consumer’s equilibrium is attained when the condition that themarginal utility in terms of money is equal to the price is met.

� The law of demand defines demand curve, which is downward sloping.

� The demand curve is downward sloping because of the law ofdiminishing marginal utility.

� The demand curve is essentially same as the downward sloping portionof the marginal utility curve.

� A shift of the demand curve is caused by a change in the prices of relatedgoods, a change in income or a change in tastes.

� An increase in the price of a substitute good causes an increase indemand or a rightward shift of the demand curve, while an increase inthe price of a complementary good causes a decrease in demand or aleftward shift of the demand curve.

� As income increases, the demand for a product increases or decreases,i.e., the demand curve shifts to the right or left, depending on whetherthe good is normal or inferior.


� A favourable taste change increases the demand for a good, i.e.,shifts the demand curve to the right; an unfavourable change doesthe opposite.

� Market demand curve is obtained by horizontally summing upthe individual demand curves.

� The determinants of market demand curve are prices of relatedgoods, distribution of income, tastes and the market size.

� The price elasticity of demand is independent of the choice of units.

� When two demand curves intersect, the elasticity associated withthe flatter demand curve is greater.

� Greater the availability of close substitutes of a product, the higheris the price elasticity of demand for a product.

� Typically, the demand for luxury products is elastic and that fornecessary goods is inelastic.

� Greater is the share of the total budget spent on a particular good,the more elastic is the demand for it.

� Longer the time horizon, the more elastic is the demand for aproduct.

� If the demand curve is vertical (horizontal), the price elasticity iszero (infinity). In case of elasticity equal to one, the demand curveis a rectangular hyperbola.

� Given that the demand is a straight line, the point elasticity isequal to the lower segment divided by upper segment of thedemand curve at that point.

� If demand is elastic (inelastic), an increase in the price of theproduct leads to a decrease (an increase) in the total expenditureon the product.

� In case of a unitarily elastic demand, a change in price leaves thetotal expenditure on the product unchanged.

EXERCISES

Section I2.1 Define total utility.

2.2 Define marginal utility.


2.3 How is total utility derived from marginal utilities?

2.4 State the law of diminishing marginal utility.

2.5 Give the meaning of demand.

2.6 Name two determinants of the demand.

2.7 List the factors that cause changes in demand.

2.8 What is the law of demand?

2.9 What is a demand schedule?

2.10 Give an example of a pair of commodities that are substitutes ofeach other.

2.11 Give an example of a pair of commodities such that one of themis complementary in consumption to the other.

2.12 If the price of good X rises and it leads to an increase in demandfor good Y, how are the two goods related?

2.13 If the price of good X rises and this leads to a decrease in demandfor good Y, how are the two goods related?

2.14 Define price elasticity of demand.

Section II2.15 A person’s total utility schedule is given below. Derive her

marginal utility schedule.

Amount Consumed Total Utility

0 0

1 10

2 25

3 38

4 48

5 55

2.16 A person’s marginal utility schedule is given below. Derive hertotal utility schedule. (Assume that the total utility of consumingzero is zero.)


Amount Consumed Marginal Utility

1 7

2 10

3 8

4 6

5 3

6 0

2.17 What is consumer’s equilibrium.

2.18 State the condition of consumer’s equilibrium.

2.19 Starting from an initial situation of consumer’s equilibrium, supposethat the marginal utility of a rupee increases. Will it increase ordecrease the quantity demanded of the product?

2.20 Ice creams sell for Rs. 30. Lakhmi, who loves ice cream, has alreadyeaten 3. Her marginal utility from eating 3 ice creams is 90. Supposefurther that, for her, the marginal utility of one rupee is 3. Shouldshe eat more ice cream or should she stop?

2.21 Explain the determinants of demand.

2.22 What is meant by cross price effects? Give two numerical examplesto illustrate this.

2.23 What is meant by one good being a substitute of another?

2.24 What is meant by one good being complementary to another?

2.25 Differentiate between substitute and complementary goods.

2.26 How will an increase in the price of coffee affect the demand for tea?

2.27 How will an increase in the price of tea affect the demand for sugar?

2.28 Suppose that good A is a substitute of good B. How will an increasein the price of good B affect the demand curve for good A?

2.29 Suppose that good A complementary to good B in consumption.How will an increase in the price of good B affect the demand curvefor good A?

2.30 Give two examples of normal goods and two examples of inferiorgoods.

2.31 How does an increase in income affect the demand curve for a normalgood?


2.32 How does an increase in income affect the demand curve for aninferior good?

2.33 Define (a) complementary goods, (b) substitute goods, (c) inferiorgood and (d) normal good.

2.34 Distinguish between a change in quantity demanded and achange in demand.

2.35 How is the market demand curve derived from the individualdemand curves?

2.36 There are four consumers of a fruit called Smile. They are Isha,Ifraah, Ila and Ibema. Their demand curves for Smile are givenbelow. Derive the market demand curve.

Price Quantity Quantity Quantity Quantity (Rs.) Demanded by Demanded by Demanded by Demanded by

Isha Ifraah Ila Ibema

1 16 7 15 8

2 11 6 12 6

3 7 5 9 4

4 4 4 6 2

5 2 3 3 0

6 1 2 0 0

2.37 Explain the determinants of the market demand curve.

2.38 Distinguish between individual and market demand curves.

2.39 Originally, a product was selling for Rs. 10 and the quantitydemanded was 1000 units. The product price changes toRs. 14 and as a result the quantity demanded changes to 500units. Calculate the price elasticity.

2.40 Which of the following commodities have inelastic demand? Salt,a particular brand of lipstick, medicine, mobile phone and schooluniform.

2.41 Draw diagrams showing elasticity equal to (a) zero, (b) one and(c) infinity.


2.42 Draw a straight line demand curve. Choose any three points onit and compare the point elasticities at these three points.

2.43 Consider the above straight line demand curve. Compare thepoint elasticities between the points A, B and C.

2.44 The price elasticity is 2. The % change in price is equal to 5.Find the % change in quantity.

2.45 The price elasticity is 0.5. The % change in quantity is 4. Whatis the % change in price?

2.46 As the price of peanut packets increases by 5%, the number ofpeanut packets demanded falls by 8%. What is the elasticity ofdemand for peanut packets?

2.47 As the price of a product decreases by 7%, the total expenditureon it has gone up by 3.5%. What can we say about the elasticityof demand for this product?

2.48 The price of cauliflower goes up by 8% and the total expenditureby a family on cauliflower goes up by 8%. What can we sayabout the elasticity of demand for cauliflower by this family?

2.49 Show the effect of an increase in price on total expendituredepending on the values of price elasticity.

2.50 A dentist was charging Rs. 300 for a standard cleaning job andper month it used to generate total revenue equal to Rs. 30,000.She has since last month increased the price of dental cleaningto Rs. 350. As a result, fewer customers are now coming fordental cleaning, but the total revenue is now Rs. 33,250. Fromthis, what can we conclude about the elasticity of demand forsuch a dental service?


2.51 “If a product price increases, a family’s spending on the producthas to increase.” Defend or refute.

2.52 Determine how the following changes (or shifts) will affect marketdemand curve for a product.(a) A new steel plant comes up in Jharkhand. Many people who

were previously unemployed in the area are now employed.How will this affect the demand curve for colour TVs andBlack and White TVs in the region?

(b) In order to encourage tourism to Goa, the Government ofIndia suggests Indian Airlines to reduce air fare to Goa fromthe four major cities, Chennai, Kolkata, Mumbai and NewDelhi. If the Indian Airlines reduces the air fare to Goa, howwill this affect the market demand curve for air travel to Goa?

(c) There are train and bus services between New Delhi andJaipur. Suppose that the train fare between the two citiescomes down. How will this affect the demand curve for bustravel between the two cities?

Section III2.53 Discuss how the market demand curve is derived from the

individual demand curves and the determinants of marketdemand.

2.54 Explain why consumer’s equilibrium is attained when themarginal utility of a product in terms of money is equal to itsprice.

2.55 Suppose there are three consumers in a particular market:Leander, Andre and Tim. Their demand schedules are given inthe following table.

Price Quantity Demanded Quantity Demanded Quantity Demandedby Leander by Andre by Tim

1 60 55 24

2 50 40 13

3 40 25 5

4 30 10 0

5 20 0 0


(a) Derive the market demand schedule and plot the market demandcurve.

(b) Suppose Andre drops out of the market. Derive the new marketdemand curve.

(c) Suppose Andre stays in the market and another person, Marat, joinsthe market, whose quantity demanded at any given price is half ofthat of Leander. Derive the new market demand curve.

2.56 Why does the demand curve slope downwards?

2.57 Explain the factors affecting the magnitude of price elasticity of demand.

PRODUCTION AND COSTS 45

PRODUCER BEHAVIOUR

AND SUPPLY

� � � ��


In Chapter 2 we studied the consumer’sbehaviour. In Chapters 3 and 4 we will beconcerned with the producer’s behaviour. Inthis chapter in particular, we study importantconcepts associated with production andcosts.

A producer or a firm is in business tomaximise profit.1 By definition, profit earnedby a firm is equal to its total revenues minusthe total costs. As an example, suppose thatyou are in the business of making hammers,and, during a month, you produce and sell500 hammers. They are selling at the price ofRs. 20 each. Then the total revenuesgenerated are equal to price × quantity, thatis, Rs. 20 × 500 = Rs. 10,000.

Producing hammers requires inputs suchas labour, building, equipment and rawmaterials. This is a technological relationship.In turn, inputs have to be paid. The sum totalof payments to all inputs is the total cost ofproduction. Let the total cost of making 500hammers over the month be Rs. 6,500.

Then your profit is equal to Rs. 10,000 –Rs. 6,500 = Rs. 3,500.

1 In this chapter and others, we will use the term “profit”or “profits”. Both are correct uses.

��

CHAPTER 3

•3.1 Production

3.2 Costs•


The above example is illustrative ofsome important linkages. On one hand,the amount produced, or, what is calledoutput, is linked to total revenues inthe product market. On the other hand,output is linked to inputs viatechnology, which is called productionfunction (to be defined in a moment),and, the employment of inputs leads totheir payments. This chain links outputto costs.

output. In section 3.2, we will analysethat between output and payments toinputs. The link between output andrevenues will be examined in Chapter4 (and in Chapter 6 also).

3.1 PRODUCTION3.1.1 Production Function

The most basic concept here is whatis called the production function,defined as a technological relationshipthat tells the maximum outputproducible from various combinationsof inputs.

For instance, a firm employs onlytwo factors or inputs, say, labour(measured in hours) and land (inacres), and, Table 3.1 lists some factorcombinations and the correspondingoutput levels. 1 hour of labour and2 acres of land produce at the most5 units output, 2 hours of labour and4 acres of land produce at the most

Table 3.1 Production Function

Labour Land Output(in hours) (in acres) (in units)

A 0 0 0

B 1 2 5

C 2 4 11

D 3 6 18

E 4 8 24

F 5 10 30

G 6 12 35

H 7 14 40

Fig. 3.1 Linkages

These linkages are depicted infig. 3.1. In Section 3.1, we will studythe relationship between inputs and


11 units of output, and so on. It isnormally assumed that inputs work tothe best of their efficiency. Hence,instead of “maximum” output, we justsay output, e.g., 2 hours of labourcombined with 4 acres of land produce11 units of output.2

Note that the notion of productionfunction is not just confined to twoinputs. There can be other inputs likecapital, raw material etc.3

3.1.2 Returns to an Input

A production function given in thetabular form such as in Table 3.1 doesnot reveal much about the contributionof a single factor towards production.A reasonable way to assess this will beto vary the employment of one inputwhile keeping the employment of otherinputs fixed. Three concepts arise in thisexperiment.

One is total product or totalphysical product, denoted by TPP. Itsimply defines the total output at aparticular level of employment of aninput when the employment of allother inputs is unchanged. The nextone is marginal product or marginalphysical product (MPP). This isdefined as the increase in the totalphysical product per unit increase inthe employment of an input when theemployment of other inputs is given.4

When the employment of an inputchanges, we call it a variable input.

Finally, we define Average Productor Average Physical Product (APP) asthe TPP per unit employment of thevariable input, i.e., APP = TPP/L, whereL is the level of employment of thevariable input.

These are also respectively calledtotal, marginal and average returnsto an input.

A numerical example showing aTPP schedule is given in Table 3.2,where the variable input, L, is calledlabour. If we graph a TPP schedule, weget a total physical product curve.

Table 3.2 A Total PhysicalProduct Schedule

Labour Hours Total Physicalemployed (L) Product (TPP)

0 0

1 10

2 22

3 33

4 43

5 51

6 56

7 56

8 48

9 36

2 Table 3.1 gives only some, not all, possible combinations of inputs and output.3 Also, we can differentiate between unskilled labour and skilled labour.4 These are respectively similar to the concepts of total utility and marginal utility discussed in Chapter 2.


Fig. 3.2 shows the TPP curve for the TPPschedule given in Table 3.2.

Fig. 3.2 The Total Physical Product CurveCorresponding to Table 3.2

the MPP at L = 2, which is 12, is equalto the difference between TPP at L = 2,which is 22, and TPP at L = 1, which is10. The MPP schedule correspondingto the TPP schedule in Table 3.2 is givenin column (2) of Table 3.3. Likewise, theAPP schedule, given in column (3) ofTable 3.3, is obtained through dividingTPP by L in Table 3.2. The graphs of anMPP schedule and an APP schedule arerespectively called the marginalphysical product curve and theaverage physical product curve. Thesegraphs corresponding to Table 3.3 aregiven respectively in figs. 3.3 and 3.4.

Note the following :

1. It is not true that the concepts ofTPP, MPP and APP are applicable to

Table 3.3 Marginal Physical and Average Physical Product Schedules

Labour Marginal AverageHours Physical Physical

employed (L) Product (MPP) Product (APP)

0 — —

1 10 10

2 12 11

3 11 11

4 10 10.75

5 8 10.20

6 5 9.33

7 0 8

8 -8 6

9 -12 4

The marginal physical product,MPP, is derived from the total physicalproduct, TPP, just as marginal utility isobtained from total utility. For instance,


one particular input (e.g. labour)and not to others (e.g. land or

variable input increases. Thisrelationship is verified from TPPand MPP schedules. In Table 3.2,TPP increases up to L = 6; fromTable 3.3, we see that MPP ispositive in this range. In Table 3.2,TPP decreases from L = 8 onwards;in Table 3.3, MPP is negative in thisrange.

4. Although we have derived MPP andAPP from TPP above, in general,given any one of these, we canderive the other two. SupposeMPPs are given to us. Then we canget TPP by adding MPPs (as TPP isthe sum of MPPs). Once we get TPP,we can readily obtain APP byapplying its definition. Similarly, ifthe APPs are known, we get TPPby multiplying APP with the levelof employment. Then MPPs areobtained by applying its definition.

Law of Variable Proportions and Lawof Diminishing Returns

As we will see later in this chapter andin the next, the most importantschedule (curve) from our viewpoint isthe marginal physical product schedule(curve). We notice from fig. 3.3 that theMPP initially increases with an increasein the employment of the input inquestion, then it diminishes and finallyit becomes negative. This pattern of MPPis called the Law of VariableProportions. Put differently, this lawoutlines three stages of production. Instage I, when the level of an input’semployment is sufficiently low, its MPPincreases. In stage II, it decreases butremains positive, and, finally, in stage

Fig. 3.3 The Marginal Physical ProductCurve Corresponding to Table 3.3

Fig. 3.4 The Average Physical ProductCurve Corresponding to Table 3.3

equipment). It is applicable to allinputs, but one at a time.

2. Since MPPs are additions to the TPP,TPP is the sum of MPPs ( just as totalutility is the sum of marginalutilities). For example, in Table 3.2,the TPP at L = 3 is equal to 33. InTable 3.3, the MPPs at L = 1, 2 and3 add up to 33.

3. The MPPs being additions to theTPP also implies that if MPP ispositive, TPP must be increasingand if MPP is negative, TPP mustbe decreasing as the level of the


III, it becomes negative. In our example,stage I holds till L = 2, stage II isoperative between L = 3 and L = 7, and,stage III sets in at L = 8.

Note that in stages I and II, TPPincreases with the employment of thevariable input as MPP in this range ispositive. But in stage III, it decreasessince MPP is negative.

Closely associated with this law isanother important law, called the lawof diminishing marginal product orthe law of diminishing marginalreturns (which is similar to the law ofdiminishing marginal utility). Morebriefly, it goes by the name of the lawof diminishing returns. This saysthat, the employment of other inputsremaining the same, as more of aparticular input is used in production,after a certain level, its marginalphysical product decreases withfurther employment of it.

Fig. 3.5 illustrates these laws moreclearly. Suppose that the input can bemeasured continuously like points ona line, not just in integer units like 1,2, 3 etc. Then the resulting TPP, MPPand APP curves will look smooth. Asmooth MPP curve is drawn in fig. 3.5.We observe that the MPP increasesbetween 0 to A. This region marks stageI. The MPP diminishes but remainspositive between A to B, which marksstage II. From the point B onwards, itis the stage III, wherein the MPP isnegative. Diminishing returns holds instages II and III.

The reason behind the law ofvariable proportions or the law ofdiminishing returns is fundamentally

the same. As the employment of aparticular input gradually increaseswhile all other inputs are keptunchanged, the factor proportionsbecome initially more suitable forproduction, but, after a certain level,the variable factor can work with othergiven inputs only less efficiently, thatis, factor proportions becomeincreasingly unsuitable forproduction.

The significance of these stages ofproduction is that a profit-maximisingfirm will never operate in stage III. It isbecause, by entering stage III, a firmwill have to incur higher costs on onehand (as it is hiring more of the input),and, at the same time, since output isfalling, in the output market, it will getless revenues. This implies that profitswill be less.

It is not obvious at this point, butwe will learn in Chapter 7 that a profit-

Fig. 3.5 Three Stages of Production andDiminishing Returns

maximising firm will not operate instage I either. That leaves out only stageII, in which the marginal returns to an


constant: the output always increaseswhen all inputs are increased.5

The production function outlinedin Table 3.1 contains stages showingall three types of returns to scale. Forexample, from B to D there areincreasing returns to scale. Why? Incombination B, 1 unit of labour and 2units of land produce 5 units ofoutput. Compared to B, thecombination C has double the amountof each input, but output (equal to 11)is more than double of the output atcombination B. Similarly, from C to D,inputs increase by 50% but outputincreases by more than 50% (as 18 ismore than 50% higher than 11).

Likewise, you can calculate that,in the range from D to F, there areconstant returns, and, finally from Fonwards there are decreasing returnsto scale.

3.2 COSTS

We now move on to discuss some costconcepts. As fig. 3.1 suggests, costconcepts are very much related toconcepts associated with the productionfunction. This point will be clearer aswe go along.

3.2.1 Short Run

Fixed and Variable Costs

At a given point of time, a firm facestwo types of costs: fixed costs andvariable costs. Fixed costs are thosethat do not vary with the level ofoutput. (These are also called overhead

input is positive but diminishing. Fromthe viewpoint of the operation of the firm,this is the most relevant stage.

Finally, note that the law ofdiminishing returns implies that theMPP curve is inverse U-shaped. Inturn, this implies that the APP curveis inverse U-shaped also.

3.1.3 Returns to Scale

Suppose that, instead of increasingone input at a time, you increase theemployment of all inputs by the sameproportion (e.g. by 20%). The effectof this change on output is capturedby the notion of returns to scale. Ofcourse, the output is going toincrease. But by how much? Will itincrease (a) by more than 20%,(b) by less than 20% or (c) exactly by20%? The possibilities (a), (b) and (c)respectively illustrate increasingreturns to scale, decreasing ordiminishing returns to scale andconstant returns to scale.

In other words, suppose all inputsare increased by a given proportion.Increasing (respectively decreasing)returns to scale hold when outputincreases more (respectively less) thanproportionately. Constant returns toscale hold when output increasesexactly by the proportion in whichinputs are increased.

You should not make the mistakethat the terms “decreasing”,“diminishing” or “constant” mean thatthe output decreases or remains

5 This holds as long as the MPP of each factor is positive, i.e., the firm is not operating in stage III.


costs.) For example, you operate agarment factory. You pay a fixed rentfor the factory building, fixed insurancepayments for your machinery againstfire etc. These are independent of howmany garments per month youproduce.

There is a time element ininterpreting these costs as fixed. Thatis, even if these costs are fixed at anygiven point of time or within a shorttime period, in a long run horizon, youcan think of renting more or less space,having more or less number ofmachinery depending on yourbusiness outlook for the future. Hencethe rent and insurance costs etc. thatare fixed in the short run can vary inthe long run. In other words, fixed costsare present only in the short run, notin the long run.

Note that these notions of short runand long run do not refer to anyparticular calendar time. They referonly to different periods of planninghorizon by producers in an industry.Hence, they can vary from one industryto another.

Having noted this difference, wereturn to the short run situation.Besides fixed cost, there are variablecosts − those that change with the levelof output, e.g., labour costs and costsof raw materials. If you want toproduce more garments, you have tobuy more cotton and other rawmaterials, hire more workers and soon. Variable costs increase withoutput.

Instead of being termed simply fixedand variable cost, these are formally

called Total Fixed Cost (TFC) andTotal Variable Cost (TVC). Total cost(TC) is then, by definition, total fixedcosts + total variable costs. Table 3.4presents a numerical example. Noticethat TFC, given in column (2), do notchange with output. But TVC, given incolumn (3), does. The columns (2) and(3) against column (1) are respectivelytotal fixed cost and total variable costschedules.

Graphs of these schedules are thetotal fixed cost curve and the totalvariable cost curve respectively.Figure 3.6 depicts these, togetherwith the total cost curve that graphs theTC schedule, given in the last columnof Table 3.4. The TFC curve is horizontalbecause fixed costs do not change withthe output. However, since TVC and TCincrease with the output, these curvesare upward sloping. By definition, thetotal cost curve is the verticalsummation of the total fixed and totalvariable cost curves. Notice that, at thezero level of output, TC = TFC, becauseTVC is zero when output is zero.

Average Costs

If we divide total fixed cost and totalvariable cost by output, we respectivelyget the Average Fixed Cost (AFC) andthe Average Variable Cost (AVC). Thatis, AFC = TFC/Output and AVC = TVC/Output. Similarly, by dividing total costby output, we obtain the Average TotalCost (ATC), i.e., ATC = TC/Output. Notethat, by definition, ATC = AFC + AVC.Average total cost is sometimes looselycalled average cost only. The AFCs, theAVCs and the ATCs corresponding to


Table 3.4 Total Fixed Costs and Total Variable Costs

Output Total Fixed Costs Total Variable Costs Total Costs(Rs.) (Rs.) (Rs.)

0 10 0 10

1 10 8 18

2 10 13 23

3 10 16 26

4 10 20 30

5 10 26 36

6 10 35 45

7 10 47 57

8 10 63 73

9 10 83 93

Fig. 3.6 TFC, TVC and TC Curvescorresponding to Table 3.4

Table 3.4 are given in Table 3.5, andfig. 3.7 graphs them. The AFC curvecontinuously decreases as outputincreases, because the numerator of theratio TFC/Output is constant while thedenominator increases. The AVC and

ATC curves slope downwards initiallyand then upwards, i.e, they areU-shaped. The reason behind thisshape will be discussed later.

Marginal Costs

There is another important costconcept, the marginal cost (MC). Similarto marginal utility or marginal product,this is defined as the increase in totalcost when one extra unit is produced.Thus, it is the (additional) cost ofproducing an extra unit. In the examplegiven in Table 3.4, suppose that thecurrent level of output is 7. The MC ofthis output level is Rs. 12. It is becausethe 7th unit of output costs Rs. 57 –Rs. 45 = Rs. 12. The MC schedulecorresponding to Table 3.4 is given inTable 3.6.


Table 3.5 AFC, AVC and ATC Schedules (Based on Table 3.4)

Output AFC (Rs.) AVC (Rs.) ATC (Rs.)

0 - - -

1 10 8 18

2 5 6.50 11.50

3 3.33 5.33 8.66

4 2.50 5 7.50

5 2 5.20 7.20

6 1.66 5.84 7.50

7 1.43 6.71 8.14

8 1.25 7.875 9.125

9 1.11 9.22 10.33

MCs (just as total utility is the sum ofmarginal utilities). For example, theTVC of producing 2 units is Rs. 13,and, this is the sum of the MC ofproducing one unit (= Rs. 8) and thatof producing two units (= Rs. 5).

Fig. 3.8 graphs the MC schedulegiven in Table 3.6. It is the marginal costcurve.

Assuming that the output isperfectly divisible, a smooth(hypothetical) marginal cost curve isdrawn in fig. 3.9. Recall that the TVCis sum of the marginal costs. Thisimplies a property associated with asmooth marginal cost. That is, the TVCis equal to the area under the marginalcost curve. For example, at output q0,the TVC is equal to the area 0ABq0.This result will be used in Chapter 4.

Fig. 3.7 AFC, AVC and ATC CurvesCorresponding to Table 3.5

Note that, since total costs andtotal variable costs differ only by aconstant term (equal to the total fixedcost), MC can be equivalently definedas the increase in the total variablecost when one extra unit is produced.Moreover, TVC is equal to the sum of


As you see from fig. 3.8 or fig. 3.9,the MC curve is initially decreasing inoutput and then it is increasing, i.e, itis U-shaped. The reason behind the U-shape of the MC curve is the law ofdiminishing returns. As you recall, thislaw says that, as other inputs are kept

Output

Costsin Rs

.

MC

0

5

10

15

20

25

0 1 2 3 4 5 6 7 8 9 10

Fig. 3.8 The MC Curve corresponding toTable 3.6

Table 3.6 Marginal Costs (based on Table 3.4)

Output Marginal Cost (Rs.)

0 -

1 8

2 5

3 3

4 4

5 6

6 9

7 12

8 16

9 20

unchanged, an increase in any giveninput leads first to an increase in itsmarginal physical product, and, then,after certain point, leads to a decreasein its marginal physical product. Let ussuppose that this particular input isthe only variable input, so that the totalpayment to it is equal to the totalvariable cost. Similarly, interpret theother inputs, which are keptunchanged, as the fixed factors, thetotal payment to which is the total fixedcost.

Fig. 3.9 A Smooth Marginal Cost

Let us now turn around thestatement of the law of diminishingreturns and say equivalently that, asmore and more output is produced,initially, the rate of increase in therequirement of the variable input willbe less and less, and, after a certainpoint, it will be more and more. Thisimplies that, initially, the rate of increasein the variable cost − which is same asthe marginal cost − will be less and lessas output increases, and then, it willbe more and more when output


increases further. This explains the U-shape of the MC curve.6

Once we know that the MC curveis U-shaped, it follows that the AVCand the ATC curves are U-shaped also.

There is indeed another relationshipthat holds between AVC, ATC and MCcurves. Consider fig. 3.10, whichdepicts smooth AVC, ATC and MCcurves. Observe that the MC curve cutsthe AVC and ATC curves at theirminimum points. The reason behindthis is mathematical, not economic,and, it can be understood through thefollowing example.7

Consider the game of cricket.Suppose that you are interested incalculating the average score ofbatsmen out as wickets continue to fall.Begin to calculate this after, say, 3wickets are down. The runs scored bythose already out are say 40, 105and 2. The average is (40 + 105 + 2)/3= 49. The game goes on and the fourthwicket falls. You calculate the averageagain and find that it has increasedfrom 49 runs. Has then the fourthbatsman, who got out, scored more orless than 49? The answer is “more.”Why, because otherwise the averagewouldn’t have increased. Similarly, if theaverage had fallen from 49, the fourthbatsman must have scored less than49. This simple deduction means thefollowing.

Think of the runs scored by thefourth batsman out as “marginal” (i.e.

“additional” runs scored by the next“unit” or batsman, when 3 are alreadyout). We are then saying that if theaverage increases (respectivelydecreases), the “marginal” should beabove (respectively below) the average.Now go back to fig. 3.10. The AVCcurve is decreasing in the range ofoutput from 0 to q0. Then it must betrue that, (a) at any output level in thisrange, MC <AVC. Likewise, (b) at anyoutput greater than q0, AVC isincreasing in output; hence MC >AVC.Now, statements (a) and (b) togetherimply that the MC curve must cut theAVC curve at the AVC’s minimum point.

By definition, MC is the addition toboth the TVC and the TC. Hence theabove logic applies to the relationship

6 Indeed, the MC curve is a mirror reflection of the MPP curve.7 This is contained in Richard Manning and Kenneth Henry, The Logic of Markets, The Dunmore Press

Limited, New Zealand, 1983, Chapter 7.

Fig. 3.10 AVC, ATC and MC Curves


between MC curve and ATC curve also.The former cuts the latter at itsminimum point too.

3.2.2 Long Run

Recall that, in the long run, all inputsare variable, because costs that arefixed in the short run can be changedif the planning horizon of theproducer is long enough.Accordingly, there are no TFC or AFCcurves in the long run. There is nodistinction between total costs andtotal variable costs; we simply usethe term “total costs.” Similarly, thereis no distinction between averagetotal costs and average variable costsand we will use the term “long-runaverage cost”, denoted by LAC, whereL stands for long run. The concept ofmarginal cost remains exactly thesame however; we will abbreviate itto LMC.

In what follows, we discuss theshapes of the LAC and LMC curves, thereasons behind their shapes and therelationship between them.

Like the short run average andmarginal cost curves, the LAC and LMCcurves, in general, are U-shaped, and,the LMC curve cuts the LAC at itsminimum point. However, the reasonbehind the U-shape is not the law ofdiminishing returns. Instead, since allinputs are variable, it is the pattern ofthe returns to scale, which determinesthe U-shape of these curves. 8

In particular, increasing returns toscale mean that if output is increasedat a given rate (say 10%), inputs needto be increased only by less thanproportionately (say by 7%). Thisimplies that the average cost must fallas output expands. Similarly,decreasing returns to scale imply thatthe average cost must rise with output.Finally, if returns to scale are constant,the average cost is constant −independent of output. We cansummarise all this as follows:

Increasing returns to scale ⇒ LACdecreases with output

Constant returns to scale ⇒ LACdoes not change with output

Decreasing returns to scale ⇒ LACincreases with output.

Now look at fig. 3.11. It shows aU-shaped LAC curve. This means that,as output is gradually increased

8 The short-run and long-run average or marginal cost curves are not unrelated however. As you willlearn in a higher course in microeconomics, the LAC curve is flatter than short-run average variablecost curves.

Fig. 3.11 The Long-Run Average andMarginal Cost Curves


starting from a small level, there areincreasing returns to scale (in theoutput range 0 to q0) such that LACfalls, then there are constant returns toscale (at q0), and finally decreasingreturns to scale prevail at output levelshigher than q0, such that LAC increaseswith output. In fig. 3.11, increasing,constant and decreasing returns toscale are written in short forms asIRS, CRS and DRS respectively.

Now the question is why do IRSoccur first, followed by CRS andDRS? Starting from a relatively small-scale operation (output), as the scaleof operation increases, a firm wouldbe able to reap the advantages of (a)division of labour and (b) volumediscounts. To cite an example in caseof former, suppose that a firmhas only one manager, whosespeciality is in marketing but who islooking into both marketing andmanufacturing. Now, as the firmincreases its production and hiresanother manager who expertise is inmanufacturing, then each managercan specialise in their expertise and be more efficient. This iscalled division of labour, meaningallocation of tasks according to thespecialisation of workers.9 In case ofvolume discounts, for instance, agarment factory buys 100 tons ofyarn at a certain price. If, instead, it

plans to buy 200 tons of yarn it cannegotiate a better price.

However, as the output level goesbeyond a certain limit, difficulties inmanaging an enterprise crop up.Crowding and congestion occurtypically, which lead to decreasingreturns to scale.

In between IRS and DRS, a firmexperiences constant returns to scale.It is shown at point q0 in fig. 3.11. Moregenerally, CRS may prevail over a rangeof output, rather than at a single levelof output. In this case, the LAC will havea flat portion in the middle.

A couple of remarks are in order:

First, given that initially increasingreturns, then constant returns andfinally decreasing returns to scale occuras output increases, the long runaverage cost is minimised whereconstant returns to scale prevail, suchas at point q0. In some sense, this is thelevel at which production is mostefficient.

Second, the U-shape of the LACcurve implies the U-shape of the LMCcurve. This is different in nature fromthe short run, where the U-shape of themarginal cost curve implies the U-shapeof the average cost curve.

The concepts developed in thischapter will be used very much in thefollowing chapters.

9 The same applies to other kinds of workers and to machinery and land. For instance, at a small scale ofoperation, the firm may have only one room, which is used as a storage as well as office space for itsemployees. Storing merchandise and taking them out generate traffic, which would adversely affect theproductivity of other employees. If, instead, the firm acquires an additional room, one of them can beused as storage only and as a result the productivity of employees will improve.


SUMMARY

� TPP is equal to the sum of MPPs.� There are generally three stages of production. In the initial stage, the

MPP increases with input employment, then it diminishes but remainspositive and finally it becomes negative.

� A profit-maximising firm will never employ an input at such a level thatits MPP is negative.

� The MPP and APP curves are generally inverse U-shaped.� The law of diminishing returns explains why the MPP curve is inverse U-

shaped. In turn, the inverse U-shape of the MPP curve implies a similarshape of the APP curve.

� In the short run, there are fixed costs and variable costs.� In the long run, there are only variable costs.

� The AFC curve is downward sloping.

� The MC, AVC and ATC curves are generally U-shaped.

� The sum of MCs equals the TVC.

� The area under the MC curve is equal to the TVC.

� The law of diminishing returns explains why the MC curve is U-shaped.In turn, the shape of the MC curve implies the similar shape of the AVCand ATC curves.

� The MC curve cuts the AVC curve and the ATC curve at their minimumpoints.

� The long run marginal cost (LMC) curve and the long run average cost(LAC) curve are generally U-shaped.

� The LMC curve cuts the LAC curve at the latter’s minimum point.

� The U-shape of the LAC curve follows from a firm experiencing increasingreturns to scale initially, followed by constant returns to scale and thenby decreasing returns to scale.

� The U-shape of the LAC curve implies the U-shape of the LMC curve.

� In the long run, the sources of increasing returns to scale lie in the divisionof labour and volume discounts.


EXERCISES

Section I3.1 What is a production function?3.2 List any three inputs used in production.3.3 What is meant by total physical product?3.4 What is meant by average physical product?3.5 What is meant by marginal physical product?3.6 How is total physical product derived from the marginal physical

product schedule?3.7 What will you say about the marginal physical product of a

factor when total physical product is falling?3.8 What is the general shape of the MPP curve?3.9 What is the general shape of the APP curve?

3.10 What do returns to scale refer to?3.11 Give the meaning of increasing returns to scale.3.12 Give the meaning of constant returns to scale.3.13 Give the meaning of decreasing returns to scale.3.14 Classify the following into fixed cost and variable cost.

(a) Rent for a shed.(b) Minimum telephone bill.(c) Cost of raw materials.(d) Wages to permanent staff.(e) Interest on capital.(f) Payment for transportation of goods.(g) Telephone charges beyond the minimum.(h) Daily wages.

3.15 How does total fixed cost change when output changes?3.16 How is total variable cost derived from a marginal cost schedule?3.17 How can one obtain total variable cost from a marginal cost

curve?3.18 What is the general shape of the AFC curve?3.19 What is the general shape of the MC curve?3.20 What is the general shape of the AC curve?3.21 What will happen to ATC when MC > ATC?3.22 What does division of labour mean?3.23 What are volume discounts?3.24 Name two factors behind increasing returns to scale in the long

run.


Section II3.25 What is meant by the law of variable proportions?

3.26 Calculate the APPs and the MPPs of a factor from the followingtable on its TPP schedule.

3.27 The following table gives the MPP of a factor. It is also knownthat the TPP at zero level of employment is zero. Determine itsTPP and APP schedules.

Level of Factor Employment TPP

0 0

1 5

2 12

3 20

4 28

5 35

6 40

7 42

Level of Factor Employment MPP

1 20

2 22

3 18

4 16

5 14

6 6

3.28 The following table gives the APP of a factor. It is also knownthat the TPP at zero level of employment is zero. Determine itsTPP and MPP schedules.


3.29 Explain the law of diminishing marginal returns. In other words,why does the marginal product of an input decline with furtheremployment of it?

3.30 How does the total physical product change with the change inthe marginal physical product of an input?

3.31 What is meant by the law of diminishing returns?3.32 Distinguish between fixed and variable costs.3.33 With the help of a suitable diagram, explain the relationship

between TC, TFC and TVC.3.34 Do ATC and AVC curves intersect? Give reasons.3.35 Why is the MC curve in the short run U-shaped?3.36 A firm is producing 20 units. At this level of output, the ATC

and AVC are respectively equal to Rs. 40 and Rs. 37. Find outthe total fixed cost of this firm.

Section III3.37 A firm’s total cost schedule is given in the following table.

Level of Factor Employment APP

1 50

2 48

3 45

4 42

5 39

6 35

Output (in units) Total Cost In (Rs.)

0 40

1 120

2 170

3 180

4 210

5 260

6 340

7 440

8 550


(a) What is the total fixed cost of this firm?(b) Derive the AFC, AVC, ATC and MC schedules.

3.38 Complete the following table if the AFC at 1 unit of productionis Rs. 60.

3.39 A firm’s fixed cost is Rs. 2,000. Compute the TVC, AVC, TC and ATCfrom the following table.

Output TC TVC TFC AVC AFC ATC MC

1 90

2 105

3 115

4 120

5 135

6 160

7 200

8 260

Output (in units) Marginal Cost (in Rs.)

1 2,000

2 1,500

3 1,200

4 1,500

5 2,000

6 2,700

7 3,500


3.40 Suppose that a firm’s total fixed cost is Rs. 100, and the marginalcost schedule of a firm is the following.

Output (in units) Marginal Cost (in Rs.)

1 10

2 20

3 30

4 40

5 50

6 60

7 70

(a) Is the MC curve U-shaped?(b) Derive the AVC schedule. Will the AVC curve be U-shaped?

Discuss why or why not.

3.41 Explain the relationship between ATC, AVC and MC with asuitable illustration.

3.42 Tables A and B below outline two production technologies orproduction functions. There are two factors: unskilled labourand skilled labour. Show that the production function given inTable A satisfies increasing returns to scale and that in Table Bsatisfies decreasing returns to scale.

Table A

Unskilled Labour Skilled Labour Output(in hours) (in hours) (in units)

8 4 2

10 5 3

12 6 4

14 7 5


Table B

Unskilled Labour Skilled Labour Output(in hours) (in hours) (in units)

8 4 6

10 5 7

12 6 8

14 7 9

3.43 “Increasing and decreasing returns to scale respectively implydownward and upward sloping portion of the long run averagecost curve.” Defend or refute.

REVENUES, PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 67

4.1 Total Revenues

4.2 Producer's Equilibrium:The Basis of the SupplyCurve

4.3 Change in QuantitySupplied Versus Changein Supply

4.4 Determinants of SupplyCurves

4.5 Market Supply Curve

4.6 Time Horizon

4.7 Price Elasticity of Supply

Besides the demand forces, the supply forcesconstitute the other crucial component ofmarket mechanism. It is the producers whosupply goods and services to the market. Inthe last chapter we studied conceptsassociated with production and cost, whichare relevant for producers. But we did notlearn about their choice behaviour i.e. whichlevel of output they should produce so as tomaximise their profits. In this chapter wedevelop the revenue concepts, and, togetherwith the cost concepts, we study profitmaximisation. This, in turn, forms the basisof what is called the supply curve.Comparable to the demand curve, the supplycurve shows different quantities producedand sold at different prices.

In the last chapter, we saw that profits areequal to the difference between total revenuesand total costs. We also discussed how totalcosts change with output. In this chapter, wefirst analyse how total revenues, defined asprice × output, change with output. This setsthe stage for analysing profit maximisation orwhat is called producer’s equilibrium. It isan equilibrium notion in the sense that if thefirm selects the level of output at whichprofit is maximised, it would like to “stay” or“rest” at that level of output; there is

��

��

CHAPTER 4

•

•

•

••••


no incentive for it to increase ordecrease output from that level.

4.1 TOTAL REVENUES

Unlike costs, the effect of a change inoutput on the total revenue of a firmdepends on the market structure,which refers to the number of firmsoperating in an industry, the nature ofcompetition between them and thenature of the product. In this chapter,we will consider only one kind of marketstructure, namely, perfect competition,which is of central importance ineconomic analysis. Other types ofmarket structure will be studied inChapter 6.

4.1.1 Perfect Competition

The following six characteristics defineperfect competition or a perfectlycompetitive market.(A) There are a large number of buyers

and sellers (producers).(B) Firms sell a very homogeneous (i.e.

identical) product or service.(C) There is free entry and exit.(D) Perfect knowledge.(E) Uniform price.(F) No transport and selling costs.

It is hard to find markets, whichexactly fit the definition of perfectcompetition. But the markets for goodsand services like wheat, a standard hair

cut or a leather football can be thoughtof as examples of industries, which arevery close to perfectly competitivemarkets. Because, there are typicallymany producers of these items. Eachof these is a standardised item, i.e.,naturally homogeneous. Moreover, it isrelatively easy to enter or get out of thesebusinesses.1

The implication of the product beinghomogeneous or identical is that allfirms have to charge the same pricefor the product. That is because if oneproducer happens to charge a pricehigher than some other, no one will buyfrom the former. Why would anyone paymore for exactly the same item? Hence,all producers who operate in the marketmust charge the same price. Producthomogeneity and the existence of alarge number of firms together implythat each firm is very small comparedto the whole market and no single firmcan influence the market price. That is,each firm is a price taker in perfectcompetition.2 An example may help tobetter understand the price takingbehaviour.

Think of a product like jalebi (asweet). If you operate a halwai(sweetmeat) shop in a big town in whichthere are many such halwai shops,

1 You can of course argue that there may be some differences between wheat produced in Punjab andwheat produced in Australia. But, for most practical purposes, the differences are negligible. Similarly,a standard haircut may differ slightly from one barber to another. But, again, it is essentially the sameeverywhere. The chosen examples are different from, say, the market for TVs, which are differentiated.There are black and white TVs as well as colour TVs. Even in the category of colour TVs, there are 19"TVs and 29" TVs. TVs differ not just in quality but also in style and design.

2 This does not mean that the market price itself cannot change. How it may change will be studied inChapter 5.


and, the market price of jalebi per kg isRs. 70, you will charge Rs. 70 too.Obviously, you will not charge more thanRs. 70 (and lose a lot of, possibly, allcustomers). There is also no reason foryou to sell at any price less, becausebeing small compared to the market,you can “sell” as many jalebi as you likeat the going price in the market. Thusyou will be a price taker.

4.1.2 Total Revenue Curve andPrice Line

Once you understand that each firmis a price taker and can sell as manyunits as it wishes at the market price,it is quite simple to relate total revenue(TR) to output.3 For example, if yousell five kilograms of jalebi, the TR isRs. 70 × 5 = Rs. 350. If you sell six, it is

Rs. 420 and so on. Table 4.1 reportsthe total revenue schedule for thisexample.

4.1.3 Total Revenue Curve andPrice Line

If we graph the total revenue schedule,measuring output along the x-axis andtotal revenue along the y-axis, we obtainthe total revenue curve. This is depictedin fig. 4.1(a). At zero output, TR isobviously zero. Hence the TR curvemust pass through the origin.Moreover, it is a straight line. This isbecause the market price isindependent of how much quantity issold by one firm. Turn to fig. 4.1(b)now. The y-axis measures price, nottotal revenues. Since the market priceis given or “exogenous” to the firm, weobtain a horizontal line. This is calledthe price line. It is also called the“demand curve facing a competitivefirm” in the sense that, from a firm’sperspective, it is able to sell to theconsumers any amount it wishes atthe same price. (The price elasticity ofthis demand curve is infinite.)

There is a relationship between theprice line and the total revenue. Thatis, the total revenue is equal to the areaunder the price line. This is seen infig. 4.2, in which AB is a hypotheticalprice line. Suppose that the firm isproducing the amount q0. Then, TR =price × quantity = OA × Oq0 = OADqo,which is the area under the price line.

Table 4.1 Total Revenue Schedule

Output In Kg. TR (Rs.)

0 01 70

2 140

3 210

4 280

5 350

6 420

7 490

8 560

*Market price jalebi = Rs. 70/kg

3 The feature (C) of perfect competition, namely, free entry and exit, does not have any direct bearing onhow TR changes with respect to output. Its implication will be studied in Chapter 6.


4.1.4 Average Revenue andMarginal Revenue

These are two more “revenue” concepts.Average Revenue (AR) is defined asrevenue per unit of output. It is equalto TR/output. Note that, since TR =price × output, AR is always equal toprice.

Marginal revenue is defined as theincrease in total revenue when oneextra unit is sold, i.e., it is therevenue obtained from one extra orlast unit sold.4 Since a competitivefirm is a price taker, if it sells oneextra unit, the extra revenuegenerated will be equal to whateverthe price is. Thus, for a competitivefirm, MR = price.5

However, the terms of AR and MRwill not be used much in this chapter.But they will be in Chapter 6. Here theyare introduced for the sake ofcompleteness.

4.2 PRODUCER’S EQUILIBRIUM:THE BASIS OF THE SUPPLYCURVE

We are now ready to study producer’sequilibrium. The question is at whatlevel of output will a firm’s profit bemaximised? Unlike the numericalmethod that was used in Chapter 2 tostudy consumer’s equilibrium, we usea graphical method to answer thisquestion. In order to do so, we need tworesults from our study of costs andrevenues:

Fig. 4.1 Total Revenue Curve and thePrice Line corresponding toTable 4.1

Fig. 4.2 Price Line and Total Revenues

(a)

(b)

4 This is similar to the concept of marginal utility or marginal cost.5 This is not true for a firm, which is not perfectly competitive.


1. The total variable cost is equal tothe area under the marginal costcurve.

2. The total revenue is equal to thearea under the price line.

4.2.1 The Profit-MaximisingCondition

Turn now to fig. 4.3. Suppose that acompetitive firm faces the market priceP0, that is, P0A" is the price line. Itsmarginal cost curve is denoted by MC.At which level of output is the firm’sprofit maximised? The answer is q0. Inother words, we are saying that, ingeneral, a competitive firm’s profit ismaximised at the point where the priceline intersects the MC curve, i.e., where(A) P = MC,with P denoting the market price. Thisis the profit maximising condition or thecondition for producer’s equilibrium.6

Why is profit maximised where theprice line intersects the MC curve?Define gross profit equal to TR – TVC.By definition, this is equal to profit plusTFC. However, since TFC is constant,profit is maximised where gross profitis maximised and vice versa. We nowargue that, at the market price P0, thegross profit is maximised at the outputq0, where the price line P0 intersects theMC curve.

We have TR = the area under theprice line = 0P0Aq0, and TVC = the areaunder the MC curve = 0DAq0 . Thusgross profit = 0P0Aq0 – 0DAq0 = DP0A.Now consider any output less than q0,

say q'. By similar calculation, the grossprofit = DP0A'B. Notice that this is lessthan DP0A. Look at next, a level ofoutput greater than q0, say q". The totalrevenue is equal to 0P0A"q" and the totalvariable cost is equal to 0DCq"; thusgross profit = 0P0A"q" – 0DCq" =DP0A – ACA". This is also less thanDP0A. Hence, at any level of outputeither less or greater than q0, the grossprofit is less. This proves that grossprofits, and, hence profits, aremaximised at q0, where P = MC.

Fig. 4.3 Profit Maximisation

4.2.2 Rationale Behind theCondition, P = MCIn Chapter 2 we saw that diminishingmarginal utility is the key behind theconsumer’s equilibrium condition of“marginal utility is equal to price.” In aparallel way, the key reason behindthe producer’s equilibrium condition,P = MC, is that marginal cost beincreasing with output.

To see this, suppose that, startingfrom the level of output at which P=MC,

6 Observe the similarity of this condition with the condition for consumer’s equilibrium in Chapter 2,which stated that marginal utility be equal to price.


the firm decides to produce one unitmore. Given that MC is increasing inoutput, P will be now less than MC.But P and MC are respectively equalto extra revenues earned and extracosts incurred. Hence, extra revenueswill be less than the extra costs,implying that the profits will be less.Similarly, suppose that the firmdecides to produce one unit less thanwhere P = MC. In this case therevenues sacrificed (equal to P) aregreater than savings in costs (equal toMC). Hence, profits will also be less.In summary then, increasing ordecreasing output from where P = MCresults in less profits. Thus, profit ismaximised where P = MC, as long asMC is increasing in output.

The above discussion implies that,if at any given market price there is alevel of output at which P = MC holds

but MC is decreasing, it cannot be theprofit-maximising level of output. Sucha possibility is shown in fig. 4.4. Atprice P1, the price line cuts the MCcurve at two points, q1

a and q1b, but,

unlike at q1b, at q1

a, MC decreases.Therefore, the profit-maximisingoutput is q1

b not q1a .7

The preceding analysis gives riseto an important conclusion: acompetitive firm chooses an outputonly on the rising portion of the MCcurve.

4.2.3 A More General Profit-Maximising Condition

Recall the definition of MR, themarginal revenue, and that P = MR fora competitive firm. Thus we can write(A) as MR = MC. That is, marginalrevenue is equal to marginal cost.Indeed, this is a very general conditionof profit-maximisation − somethingthat holds irrespective of the marketstructure.

Having noted this, we however returnto P = MC as our profit-maximisingcondition for a competitive firm.

4.2.4 Law of Supply and the SupplyCurve

The law of supply states that, otherthings remaining unchanged, anincrease in the price of a product leadsto an increase in the quantity suppliedof it. It is because, higher the price, themore a producer wants to supply.

Fig. 4.4 Profit Maximising Outputs atDifferent Prices

7 Suppose the firm is producing at q1a. If it increases output by one unit, the extra revenue generated is

P1 and the extra cost incurred is equal to MC. But since MC is decreasing, P1 > MC, and thus profit ishigher. You can similarly argue that profit is less also if output is reduced by one unit from q1

a. Hence,profit is not maximised at q1

a.


“Other things” refer to otherdeterminants of supply, which will bediscussed later.

This law, stated in a tabular form,gives rise to the supply schedule, and,the graph of a supply schedule givesthe supply curve. Table 4.2 lists asupply schedule. Figure 4.5 graphs thecorresponding supply curve.

What is the basis of the law ofsupply or the supply curve? Refer backto fig. 4.4. We see that, at price P1, thefirm produces the amount q1

b, at priceP2, it produces q2; and so on. Hence all

price-output combinations are simplythe points on the rising part of the MCcurve. We can think of the output asthe amount supplied to the market(assuming implicitly that the firmdoes not store anything beyond oneperiod). Hence it follows that the risingportion of the MC curve is the supplycurve itself ! 8

4.3 CHANGE IN QUANTITYSUPPLIED VERSUS CHANGE INSUPPLY

The difference between these two termsis similar to the difference between achange in quantity demanded and achange in demand. A change inquantity supplied refers to a movementalong a given supply curve because ofa price change, whereas a change insupply means a shift of the supplycurve due to a change in “other factors.”It is now the time to discuss thesefactors.

4.4 DETERMINANTS OF THESUPPLY CURVE

Since the supply curve is a part of themarginal cost curve, the factors thatshift the marginal cost curve are thedeterminants of supply or the supplycurve. Generally, there are two suchfactors, technological changes andchanges in factor or input prices.

Besides, in India particularly, onmany industrial goods, there are taxesthat are based on the total production

Table 4.2 A Supply Schedule

Price (Rs.) Quantity Supplied

5 0

10 7

15 16

20 28

25 43

Fig. 4.5 The Supply Curve for the SupplySchedule in Table 4.2

8 Strictly speaking, the supply curve is only a portion of the rising part of the MC curve. The reason forthis will be covered in a higher course in micro economics.


cost of output of a firm. These are calledexcise taxes or excise duties. As wewill see, a change in the rate of exciseduty will also shift the supply curve.

There is still another factor that oursimple profit-maximising analysis doesnot capture, namely, changes in theprices of related goods.

In what follows, we consider thesedeterminants of supply. 9

4.4.1 Technological Changes

Science and research laboratoriesaround the world as well as thebusiness firms themselves look for newtechnology or methods that reducecosts of production. Consider forinstance the printing business. In olddays, bringing out a book in print wasa fairly complex process.10 Now a days,with computers, word processing,spread sheet and presentationpackages, all tasks except for printingare done in a computer. Changes arenearly costless to include. Usingprinters to print is also an easy andfairly inexpensive job. The average andmarginal costs facing a commercialpublisher for any given number of

printed pages are much less today thanthey were prior to 1980s. This is anexample of cost-saving technologicalchange. In the real world, there aremany such examples.11

Such a technological advance lowersmarginal cost at any given level ofoutput. Table 4.3 illustrates this.Column (2) lists an old marginal costschedule. Column (3) lists the new oneafter the technological change.12 Noticethat each entry in Column (3) is smallerthan the corresponding entry inColumn (2), meaning that the marginalcost has decreased for any given level ofoutput. The two marginal cost schedulesare plotted in fig. 4.6. As we can see, thenew MC curve lies below or to the right ofthe old one. Since the MC curve isessentially the supply curve, we have theresult that a technological progress shiftsthe supply curve to the right.

4.4.2 Input Price Changes

Changes in raw material prices, wagesto workers etc. can also affect themarginal cost curve and the supplycurve. Suppose you own a haircut

9 There are chance factors like weather changes or health of workers, which can also shift the marginalcost curve. But we ignore them here. The supply curve is also influenced sometimes by price speculations.In times of disasters like earthquake, war, famine and cyclones, prices of essential goods typically rise.Some private producers take advantage of this situation by “hoarding”, that is, withholding supply oftheir product to the market, expecting to sell later at very high prices. We ignore these factors in thischapter.

10 Once manuscripts of books were prepared by authors in long hand, the alphabets in the manuscriptsused to be set in a frame and the frame would be mounted on a letter-press machine. The pictures anddiagrams were etched on metal plates. The whole plate had to be changed if changes were to be madein the pictures or diagrams. The metal plate and the frame were mechanically inked and pressed on topaper to produce a page of the book.

11 There is another kind of technological progress that we do not consider here, namely, development ofnew products.

12 For simplicity, in both cases, the marginal cost always increases with output.


of an increase in input prices is shownin fig. 4.7.

Table 4.3 A Decrease in MarginalCosts due to Technological

Change

Output Old MC New MC(Rs.) (Rs.)

0 7 3

1 8 4

2 12 7

3 14 9

4 17 13

5 22 17

Fig. 4.6 Technological Progress and Shiftof the Supply Curve

saloon, employ 10 barbers and service120 haircut jobs a day now. The hourlymarket wage of barbers increases forsome reason. This will increase thecost of the haircut service that youprovide and shift your marginal costcurve up or to the left. As a result, youwill employ fewer barbers and serviceless number of haircuts.

In general then, an increase (adecrease) in an input price shifts thesupply curve to the left (right). The case

Fig. 4.7 Increase in Input Prices and theShift of the Supply Curve

4.4.3 Changes in the Excise TaxRate

In India, producers of variousindustries in the manufacturing sectorpay excise taxes. As said earlier, theseare taxes levied on the total productioncost of a firm. Hence they add to thetotal variable cost. Therefore, a changein the rate of this tax affects the overallmarginal cost.

Suppose the rate of excise duty ona particular product increases. For anygiven level of output, this wouldincrease the marginal cost and henceshift the MC curve and the supplycurve to the left.

Thus, an increase (a decrease) inthe excise tax shifts the supply curveto the left (right).

4.4.4 Change in the Prices ofRelated Products

Many producers, with their givenamount of resources, manufacture or


grow more than one item. Consider afarmer who has a given amount of land,which he can use to produce wheat orcorn (or both). If the market price ofwheat increases, he will grow less corneven when the price of corn, thetechnology of producing corn and inputprices (e.g. the price of corn seeds)remain the same. It is because growingcorn is less profitable now, comparedto growing wheat. This will shift thesupply curve of corn to the left.

Thus an increase (a decrease) inthe price of a substitute good inproduction shifts the supply curve ofa good to the left (right).

4.5 MARKET SUPPLY CURVE

This is parallel to the market demandcurve. It is derived as the horizontalsummation of individual supply curves.In Chapter 2 the market demandschedule was obtained by numericallyadding up individual demandschedules. Here, the market supplycurve is derived in an equivalent,geometric way (so that you get to knowboth ways).

Assume that there are two firms inan industry, A and B. In fig. 4.8 thecurves SA, SB and SA+B respectivelydenote A’s supply curve, B’s supplycurve and the market supply curve. Forexample, at price P1 the producer Asupplies A1 units and the producer Bsupplies B1 units. The total quantitysupplied to the market is then A1+B1,shown along the SA+B curve against thisprice. Similarly at P2, the total quantitysupplied is A2+B2, where A2 and B2 arequantities supplied by producers(firms) A and B respectively. All otherpoints on the market supply curve arederived in the same manner.

Note that a market supply curve isderived on the assumption of a givennumber of firms (100, 200 or whateverit may be). Hence, apart from any factor,like a technological change or a changein any input price, that shifts theindividual supply curve and therebythe market supply curve, the latteralso shifts when the number offirms changes. An increase(a decrease) in the number of firmsshifts the market supply curve to theright (left).

Fig. 4.8 Individual Supply Curves and the Market Supply Curve


When there is an increase (adecrease) in the number of firms, we saythat there is more (less) competition inthe market. Thus, we can also say thatmore (less) competition shifts themarket supply curve to the right (left).13

4.6 TIME HORIZON

An element of time lies behind thesupply curve being upward sloping.Suppose that you manufacturechewing gum. The market price thathas been prevailing for a long time isone rupee a piece. At this price, youwere producing 1 lakh chewing gumsper month. Now suppose the priceincreases to two rupees a piece. This isgood news for you. As a rationalproducer, you would want to producemore by hiring more workers, morechemical engineers, more equipmentetc. This will mean that your supplycurve is upward sloping.

However, it takes time to hire people,get new machinery etc. Within a veryshort period, you cannot make thesechanges. Your production level in a veryshort period of time is given, irrespectiveof whether the price may have changedto Rs. 2, Rs. 3 or Rs. 1.50. The resultingsupply curve will be a vertical line, asshown in fig. 4.9. Such a short period

is called the market period ineconomics. By definition, it is that shorta period within which firms cannotadjust their output to any change inprice. As a result, the supply curve of afirm or the whole industry is vertical.

In a longer run − i.e. in the shortrun or long run − the supply curve willbe upward sloping, as drawn earlier,because inputs can be changed.

13 As you know, India has been following a path of economic liberalisation, especially since the 1990s.Many foreign firms that couldn’t earlier enter the Indian market in different sectors can and do so now.Thus liberalisation brings forth more competition. The Indian automobile market is a prime example ofthis.Until the seventies, in the passenger car market there were only two companies that were allowed tooperate: Hindustan motors (with Ambassador) and Fiat (with Premier Padmini). In the 1980s cameMaruti, which is owned jointly by the Indian government and Suzuki Motor Corporation of Japan. In the1990s, many foreign companies started to produce and sell such as Daewoo of South Korea (Cielo),Hyundai of South Korea (Santro), Honda of Japan (Honda City) etc. Even Telco, an Indian Company,which earlier produced only trucks and buses, entered into the production of small sized cars (Indica).

Fig. 4.9 Supply Curve in the Market Period

4.7 PRICE ELASTICITY OF SUPPLY4.7.1 Definition and the Percentage

Method of Measurement

Parallel to price elasticity of demand,the price elasticity of supply quantifiesthe responsiveness of quantity suppliedto changes in price. It is defined as(B) Price elasticity of supply = es


price the in change% supplied quantity the in change%

On a given supply curve, let P0 andS0 denote the original price andquantity. If the price rises to P1 andquantity supplied increases to S1, the% changes in price and quantitysupplied are respectively[(P1 – P0 )/P0] × 100 and [(S1 – S0 )/S0] ×100. Hence

,//

/)(/)(

)(0

0

001

001

PP

SSPPPSSS

seC∆∆=−

−=

where ∆ denotes the change.If the supply curve is vertical, then

the price elasticity of supply is,obviously, zero. Otherwise, given thatthe supply curve is positively sloped,the price elasticity is positive.

As a numerical example, supposethat you manufacture one type of ball-point pens. When they were selling atthe price Rs. 8, you produced and sold5,000 pens a month. Now its marketprice has increased to Rs. 10 and youare producing and selling 8,000 pensa month. In this example, P0 = Rs. 8,

S0 = 5,000, P1 = Rs. 10 and S1 = 8,000.

Thus,

,25100]8/)810[(100]0/)01[( PPP

and

.60100]5000/)]50008000[(

100]0/)01[(

=×−

=×− SSS

Hence, .4.225/60Se

Just as in case of price elasticity ofdemand, (a) the price elasticity of supplyis independent of units, and (b), if twosupply curves intersect, the flatter onehas higher price elasticity at the point ofintersection. The reasons are exactlyparallel what they were in case of priceelasticity of demand.

4.7.2 The Geometric Method

Also similar to point elasticity of demand,for very small price changes, the priceelasticity of supply can be measured by aconvenient geometric formula.

Refer to fig. 4.10. It shows threestraight line supply curves. Panel (a)illustrates one, in which the supplycurve, extended towards the x-axis,intersects the x-axis in its negative

Fig. 4.10 Price Elasticity associated with Straight Line Supply Curves

(a) (b) (c)


range at point B. In fig. 4.10(b), thesupply curve intersects the x-axis inits positive range. Finally, in fig. 4.10(c),the point of intersection is the origin;that is, the straight line supply curvepasses through the origin. In all panels,P0 is the original price, 0C is thequantity supplied and A is the pointon the supply curve.

It turns out that the point elasticityis equal to the horizontal segment BCdivided by the quantity supplied 0C,that is, BC/0C. 14 (Ignore for the momentfig. 4.1.(c) in which there is no point B.)

Thus, along the supply curve inpanel (a), the price elasticity is greaterthan one (as BC > 0C). By the sameargument, along the supply curvein panel (b), it is less than one(as BC < 0C).

Finally, in panel (C), you can saythat the point B is same as the origin.Thus BC = 0C implying es=1. Thatis, any straight line supply curvepassing through the origin,irrespective of how steep or flat it is,implies price elasticity of supplyequal to one.

CLIP 4-1Does computerisation reduce employment?

This is a sensitive issue for a populous country like India. The traditional thinkingis that computerisation – or for that matter, any technical improvement that islabour-saving – is or must be bad for employment. If you replace a person with amachine, how could it not reduce employment? This is, however, a narrow point ofview, having two major flaws. First, it has a very short run perspective, and second,it presumes that those who are replaced by computers or machines do not have orare incapable of developing any other skills and hence must remain unemployedfor a long time.Yes, at the time when a machine is replacing a person or many persons, it has anegative effect on employment. But this is hardly the end of the story. A firm is doingit in order to save costs. As the total variable cost curve shifts down, so does themarginal cost curve. This means that the supply curve will shift out and more will beproduced in the new equilibrium. From the whole economy’s perspective, the productionpossibility curve (see Chapter 1) shifts out. Higher output would require moreemployment of workers, both skilled and unskilled. Also, computerisation by itselfcreates demand for new types of jobs. Hence there is little reason to believe thatcomputerisation will reduce employment in the long run. On the other hand, it leadsto a greater productivity of workers and higher wages.The negative effects of computerisation are present only in the short run. Atraditional typist who is replaced by a computer can learn word processing andpossibly land a more paying job. Of course, computerisation or mechanisationmay, for example, take away the job of artisans, who with their own bare hands,make beautiful handicrafts. On the other hand, expansion of the small-scale

14 The proof of this is beyond our scope.


industries due to computerisation will lead to more employment. In the worst case,one type of job is replaced by other type of job: the workers who lose their jobs andcannot change their skills may not get their jobs back, but other category of workerswill now find jobs.In summary, there may be employment costs of computerisation, but only in theshort run. On the other hand, there are major long-run benefits.

SUMMARY

� The total revenue curve facing a competitive firm is a straight line passingthrough the origin.

� The price line facing a competitive firm is horizontal because this firm isa price taker.

� The price line is also interpreted as the demand curve facing a competitivefirm.

� A perfectly competitive firm maximises profits, i.e., attains producer’sequilibrium, when price is equal to the marginal cost.

� In general, a firm’s profit maximising condition is that marginal revenueis equal to marginal cost.

� The profit-maximising condition, price is equal to marginal cost, formsthe basis of the supply curve.

� Increasing marginal cost explains the law of supply or why the supplycurve is upward sloping.

� A firm’s supply curve consists of the rising portion of its marginal costcurve.

� A cost saving technological progress shifts the marginal cost curve downand hence shifts the supply curve to the right.

� An increase in input prices shifts the marginal cost curve up and henceshifts the supply curve to the left.

� An increase in the rate of the excise duty shifts the supply curve to theleft.

� An increase in the price of a substitute good in production shifts thesupply curve of the product in question to the left.

� Market supply curve is obtained by horizontally summing up theindividual supply curves.


EXERCISES

Section I4.1 What is meant by producer’s equilibrium?4.2 What is the relationship between total revenue, price and

quantity sold?4.3 What is the relationship between price and marginal revenue

for a competitive firm?4.4 What is the condition of producer’s equilibrium for a competitive

firm?4.5 What is the condition of profit maximisation for a competitive

firm?4.6 What is the general profit maximising condition of a firm?4.7 What is meant by the Law of Supply?4.8 What is meant by a change in the quantity supplied?4.9 What is meant by a change in supply?

4.10 Due to improvement of technology, the marginal costs ofproduction of televisions have gone down. How will it affectthe supply curve of television?

4.11 What effect does a cost saving technical progress have on thesupply curve?

4.12 What effect does an increase in input price have on the supplycurve?

4.13 What effect does an increase in excise tax rate have on the supplycurve of the product?

� An increase in the number of firms shifts the market supply curve to theright.

� During the market period, the individual and the industry supply curvesare vertical.

� Price elasticity of supply measures the responsiveness of quantitysupplied to a change in its own price.

� A straight line supply curve which intersects the x-axis in its negativerange implies price elasticity of supply greater than one.

� A straight line supply curve which intersects the x-axis in its positiverange implies price elasticity of supply less than one.

� A straight line supply curve passing through the origin implies priceelasticity equal to one, irrespective how steep or flat it is.


4.14 If a farmer grows rice and wheat, how will an increase in theprice of wheat affect the supply curve of rice?

4.15 What is meant by ‘market period’?4.16 How will an increase in the number of firms shift the market

supply curve?4.17 What does price elasticity of supply measure or quantify?4.18 If two supply curves intersect, which one does have higher price

elasticity?4.19 What is the price elasticity associated with a straight line supply

curve passing through the origin?

Section II4.20 Why is the total revenue curve facing a competitive firm a straight

line passing through the origin?4.21 What factors determine the market structure?4.22 What are the features of perfect competition?4.23 What is meant by a product being perfectly homogeneous? What

is its implication for the price charged by producers in themarket?

4.24 Briefly explain why a perfectly competitive firm is price-taker inthe market.

4.25 A perfectly competitive firm faces market price equal to Rs. 15.(a) Derive its total revenue schedule for the range of output

from 0 to 10 units.(b) Suppose the market price increases to Rs. 17. Will the new

TR curve be flatter or steeper?4.26 Complete the following table when each unit of a commodity

can be sold at Rs. 5.

Quantity Sold TR MR AR

1

2

3

4

5

6

7


4.27 A firm’s TR schedule is given in the following table. What is theproduct price facing the firm?

4.28 Why is AR always equal to MR for a competitive firm?4.29 Name three factors that can shift a supply curve.4.30 Give two examples where technological progress leads to a shift

in the supply curve.4.31 How does a change in the price of inputs affect the supply curve

of a commodity and why?4.32 How does an increase in the rate of excise tax shift the supply

curve and why?4.33 How does a cost saving technological progress shift the supply

curve and why?4.34 A new technique of production reduces the marginal cost of

producing stainless steel. How will this affect the supply curveof stainless steel utensils?

4.35 Because of cyclone in a coastal area, the sea level, covers a lot ofrice fields. This reduces the productivity of land. How will itaffect the supply curve of rice of that region?

4.36 Consider the following individual and market supply schedules.

Price Firm A Firm B Firm C Market(in Rs./kg.) (kg.) (kg.) (kg.) (kg.)

1 — 20 45 100

2 37 30 50 —

3 40 — 55 135

4 44 50 — 154

5 48 60 65 —

Output TR (Rs.)

1 7

2 14

3 21

4 28

5 35


(a) Complete the above table on quantities of potatoes suppliedby the firms and the market.

(b) Plot the supply curve of each firm and the market supplycurve in a single diagram. What relationship do you observebetween the individual supply curves and the marketsupply curve?

(c) Calculate the price elasticity of supply of Firm A when pricerises from Rs. 2 to Rs. 3.

4.37 Draw straight line supply curves with (a) unitary price elasticityand (b) zero price elasticity.

4.38 The above diagram shows the supply curve of 3 commodities.Rank their price elasticities.

Section III4.39 Show that the rising portion of the marginal cost curve is the

supply curve of a competitive firm.

PRICE DETERMINATION UNDER PERFECT COMPETITION 85

FORMS OF MARKET AND PRICE

DETERMINATION

� � � ��


The foundations underlying the demand andsupply curves were laid in Chapters 2 and 4respectively. These curves respectively tell ushow much consumers demand and howmuch producers supply at different prices.But they do not tell us what the actual priceof the product will be (in principle) or, in otherwords, what points on the demand or thesupply curve will be actually chosen in themarket place.

This issue is addressed in this chapter bypooling together what we have learnt aboutthe demand and supply. It forms the core ofhow the market system works − in particularhow an economy’s central problem of “what”is solved through the price mechanism. Youwill see that there are not many new conceptsor definitions to be learnt. The emphasis ison applications. A number of examples willbe provided as we proceed.

5.1 MARKET EQUILIBRIUM ANDDETERMINATION OF PRICE ANDQUANTITY

Consider fig. 5.1. It depicts the marketdemand and supply curves of a particularproduct, denoted respectively by DD and SS.The question is: which price will prevail inthe market? Suppose that, initially, the price

��

��

CHAPTER 5

5.1 Market Equilibrium andDetermination of Priceand Quantity

5.2 Demand and SupplyShifts

5.3 Sources of DemandShifts

5.4 Sources of Supply Shifts

5.5 Anatomy of Famines

5.6 Efficiency of the PriceMechanism andCompetitive Markets

5.7 Economic Policy by theGovernment and MarketEquilibrium

•

•

•••

•

•


in the market for that good is P1. At thisprice, the consumers demand thequantity D1 and the producers supplythe quantity Q1. Obviously, there is amismatch. Consumers want morethan what the producers are willingto supply. There is excess demand,equal to AB or Q1D1.

1 Will then theprice stay at P1? No, excess demandwill create competition among thebuyers and push the price up. It willincrease, say, to P2. Excess demand ispresent at this price also. Thus pricewill increase further. Indeed, the pricewill keep increasing as long as thereis an excess demand. This is indicatedby the upward-looking arrow. Finallyit will converge to PO, at which there isno excess demand.

Just the opposite happens ifinitially the price is P3. The quantitydemanded (D3) is less than the quantitysupplied (Q3). There is excess supply,equal to D3Q3 which will createcompetition among the sellers andlower the price. The price will keepfalling as long as there is an excesssupply. It is indicated by the arrow,pointing downwards. Where will theprice finally settle? The answer is againP0, at which there is no excess supply.

The situation of zero excessdemand and zero excess supplydefines market equilibrium.Alternatively, it is defined by theequality between quantity demandedand quantity supplied. In fig. 5.1, it isshown at the point E0. The price P0 is

called the equilibrium price. Recall thatequilibrium means a position of rest.Here, the market “rests” at price P0 inthe sense that there is no pressure onprice to either increase or decrease. Theequilibrium quantity exchanged(between consumers and producers) isequal to Q0.

This is how price and quantity aredetermined in the market.

Fig. 5.1 Market Equilibrium

1 The term “excess demand” here refers to a particular commodity or service. This is different from whatis meant by “excess demand” in macroeconomics.

As a numerical example, considerTable 5.1, which gives the demand andsupply schedules of bananas (in agiven geographical location and withina given time period). The equilibriumprice is Rs. 21, since at this pricequantity demanded matches withquantity supplied. The equilibriumquantity sold/purchased is 6,000dozens. The corresponding demandand supply curves and marketequilibrium are shown in fig. 5.2.


which any positive amount can besupplied is higher than what theconsumers are willing to pay. Putdifferently, costs are too high for anypositive output to be produced.

In India and many other countries,commercial aircraft is such anexample, i.e., it is not produced at all.Of course, an industry, which is notviable in one country, can be viable insome other. For example, commercialaircrafts are produced in America,Russia, Britain and France.2

Table 5.1 An Example of Demand, Supply and Equilibrium

Price of Bananas Quantity Demanded Quantity Suppliedper dozen (in Rs.) (in dozen) (in dozen)

18 10,000 1,000

19 8,000 2,000

20 7,000 4,000

21 6,000 6,000

22 5,000 7,500

23 4,500 8,500

Fig. 5.2 Market Equilibrium Corres-ponding to Table 5.1

It is, however, quite possible that asituation such as in fig. 5.3 occurs: thedemand curve and the supply curve donot intersect with each other at anypositive quantity. What does this mean?This means that the product inquestion will not be produced in theeconomy. The industry is noteconomically “viable”. The price at

2 Computer memory chips, mother boards and copying machines are other examples. These are totallyimported, not produced at all in India.

Fig. 5.3 A Non-Viable Industry


Figs. 5.1 and 5.3 illustrate how the“what” problem of an economy is solvedby market mechanism. Goods andservices for which fig. 5.3 applies are notproduced. Those for which fig. 5.1applies are. Given that a good isproduced, from fig. 5.1 we also know thequantity that will be produced and theprice that will be charged in equilibrium.

5.2 DEMAND AND SUPPLY SHIFTS

For any given product in the real world,price and quantity exchanged changefrom time to time. Some of you musthave shopped for fruits and vegetablesfor your family or for yourself. The samecauliflower, for example, costs less inthe winter than in the summer. Applessell for less in some seasons thanin others. A computer for a givenconfiguration sells in your town for,say, Rs. 30,000. The same computerwill sell for much less, six months after.The analysis of demand and supplycurves and the market equilibriumprovides the framework to explain suchchanges. How? Through shifts in thedemand curve, the supply curve orboth. We already know in Chapters 2and 4 how various factors cause shiftsin these curves. Changes in thosefactors explain price and quantitychanges.

Without going into what causes ashift, we first discuss how a demandor a supply shift will affect price andquantity.

5.2.2 Demand Shifts

Turn to fig. 5.4(a). Let the initialdemand and supply curves be DD

0 and

SS0 respectively. Accordingly, the initial

price and quantity are respectively P0

and Q0. Now let the demand curve shift

to the right, as shown by DD1. We see

immediately that the equilibrium pointshifts from E

0 to E

1. The new price and

quantities are P1 and Q

1 respectively.

Thus both price and quantity increase.It is important to understand theeconomic process that leads to thesechanges.

Starting from the initial situationof no excess demand or supply [at E

0

in fig. 5.4(a)], a rightward shift of thedemand curve moves the consumptionpoint from E

0 along DD

0 to A along DD1.

Fig. 5.4 Demand Shifts

(a)

(b)


This creates an excess demand, equalto Q

0Q'. In turn, it causes price to

increase, and, hence the new pricesettles at a higher level. While there isa change in demand, producershowever operate on the same supplycurve. Hence, there is a change in thequantity supplied, not a change insupply. At a higher price they supplymore quantity. This explains why thenew quantity exchanged is greater.

Likewise, a leftward shift of thedemand curve will lower theequilibrium price and quantity, asshown in fig 5.4(b).

and supply curves are denoted againas DD

0 and SS

0; E

0 is the original

equilibrium point. Suppose the supplycurve shifts to the right to SS

1. The new

equilibrium point is E1. The new price

and quantity are P1 and Q

1. We see that

the price decreases and the quantityincreases. Why? At the original price P0

,an increase in supply causes an excesssupply in the market. This causes theprice to fall and the new price settlesat a level that is less than the originalprice. Since the demand curve remainsthe same, the decrease in price leadsto a downward movement along thedemand curve. More quantity isdemanded and in equilibrium more isproduced.

The effects of a leftward shift ofthe supply curve cause rise in priceand fall in quality as shown inFig. 5.5 (b)

5.2.4 Simultaneous Demand andSupply Shifts

It is possible that both demand andsupply shifts occur simultaneously.Their net impact on price and quantitywill be a combination of 1 and 2 inTable 5.2.

For example, the demand andsupply curves both shift to theright. Then the market pricemay increase or decrease, but thequantity exchanged will increaseunambiguously. The opposite happensif both curves shift to the left.

Similarly, if the demand curveshifts to the right and the supply curveto the left, the market price willunambiguously increase, while the

Fig. 5.5 Supply Shifts

5.2.3 Supply Shifts

Now consider supply shifts, shown infig. 5.5. In panel (a) the original demand

(a)

(b)


quantity exchanged may increase ordecrease. The opposite happens if thedemand curve shifts to the left and thesupply curve to the right.

We return now to demand andsupply shifts one at a time, examinetheir causes, and, by using Table 5.2,their effects of price and quantity.

5.3 SOURCES OF DEMAND SHIFTS

Recall from Chapter 2 that the marketdemand curve can shift because ofchanges in income, prices of relatedgoods, tastes or size of the market. Weanalyse each of these in turn.

5.3.1 A Change in Income

Suppose that there is an increase inaggregate income in an economy. Weknow from Chapter 2 that, as long asa product is normal, the demand curvefor it shifts to the right. Fig. 5.4(a)applies. Both price and quantityincrease. For a decrease in incomefig. 5.4(b) applies. Both market priceand quantity fall. Therefore, for anormal good, an increase (a decrease)in income leads to increases (decreases)in the price and quantity exchanged.

If it is an inferior good, we know thatan increase in income shifts the demandcurve to the left. Fig. 5.4(b) then applies:both price and quantity fall.

Example 5.1 Market for Real Estatein Kerala.

Think of the market for land, flats etc.The 1990s saw a large increase in urbanland price and a vast increase in thenumber of single-houses and apartmentbuildings in Kerala, especially in townslike Cochin, Trichur, Kottayam,Chalakudi and Chavakkad. It was notbecause there was a massiveindustrialisation or an unusualpopulation explosion in these areas.Instead, the reason was that a lot ofKeralites from these areas moved to theMiddle East countries to work andearned substantial income there.3 Theyused that income to buy more and betterhousing at home. This shifted out themarket demand curve for housing inurban Kerala. In some places the landprice almost trippled in two years.4

Example 5.2 Japan in late 1980s andearly 1990s.

In this period, as the Japanese economywas growing strongly, various name

3 Air India even operated special flights from Trivandrum to the Middle East to accommodate theincreased traffic. An estimated 16 lakh Keralites were working in the Middle Eastern countries andthey brought, annually, foreign exchange worth of 700 to 1,000 crores of rupees.

4 This is based on Sonali Mujumdar, “Highrise Hungama,” Touchdown India, undated.

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Table 5.2 Summary of Demand and Supply Shift Effects

1. A rightward (leftward) shift of the demand curve leads to an increase (adecrease) in market price and an increase (a decrease) in the quantityexchanged.

2. A rightward (leftward) shift of the supply curve leads to a decrease (anincrease) in market price and an increase (a decrease) in the quantityexchanged.

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brand products became the outlet forrising income. For example, there wasan increase in demand for Levi’s jeansand Nike shoes. As a result, the pricesand quantities sold of these items inJapan soared.5

5.3.2 A Change in the Price of aRelated Good in Consumption

Take for instance, the market for tea.Suppose the price of coffee rises forsome reason. From our analysis ofdemand shifts in Chapter 2, we knowthat, tea being a substitute of coffee,the demand curve for tea will shift tothe right. Fig. 5.4(a) applies then. Theprice of tea rises and so does thequantity of tea exchanged. Thus, as theprice of a substitute good inconsumption rises, the price of a givenproduct rises and its quantityexchanged increases.

Unlike coffee and tea, sugarconsumption is complementary to tea.Suppose the price of tea goes up. Howdoes it affect the sugar market? FromChapter 2 again, the demand curve forit shifts to the left. Applying fig. 5.4(b),we find that the price of sugar as well

as its quantity will fall. Hence, as theprice of a complementary goodincreases, the price of a given productand its quantity exchanged bothdecrease.

Example 5.3 Prices of Coffee and Teain the World Market in the Late 1990s.

Brazil is a major producer in the worldcoffee market. In 1994, it was hit by twosevere frosts, which damaged more thanhalf of its coffee trees. As a result, theprice of Brazilian coffee in the worldmarket shot up and it remained high inthe next few years. With a lag of twoyears, the price of tea in the world marketalso jumped up (while the production oftea was still growing). This can beinterpreted as a delayed effect of anincrease in the price of coffee on demandfor tea.6

5.3.3 A Change in Tastes

Think about the market for bittergourd.7 Surely it is not a very popularvegetable in your age group. Butimagine that medical research showsthat eating 100 grams of bitter gourdper day prevents pimples on the face.This will definitely generate a

5 See William Baumol and Alan Blinder, Economics: Principles and Policy, 8th Edition, Harcourt CollegePublishers, 2000, page 80. Also see JETRO (Japan External Trade Organization), “The JapaneseConsumer: From Boom to Reality,” 1994, http://www.jetro.go.jp/it/e/pub.

6 In the New York wholesale market, Brazilian coffee sold for $1.43/pound in 1994, compared to66.58 cents in 1993, i.e. it more than doubled. It remained high for the next four years ($1.46, $1.20,$1.67 and $1.22 in 1995, 1996, 1997 and 1998 respectively). During the same time period, thewholesale tea prices, as quoted in the London auction market, were 84.20 cents, 83.15 cents, 74.46cents, 80.36 cents, $1.08 and $1.08 per pound for the years 1993, 1994, 1995, 1996, 1997 and1998. Observe that the tea price went up particularly in 1997 and 1998. However, the world productionof tea in 1997 was 2% higher than that in 1996, and, in 1998, it was 11% higher than it was in 1997.The Data sources are the following. For coffee and tea prices, it is International Monetary Fund,International Financial Statistics Yearbook 2000. For tea production, it is the web site of UK TeaCouncil, namely, http://www.teacouncil.co.uk.

7 This is called karela in Hindi, kalara in Oriya and Pavakkai in Tamil.

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change in your food habits.8 Many ofyou will start to eat more bitter gourdthan before. The market demand curvewill shift out. We can use fig. 5.4(a), anddeduce that price of bitter gourd as wellas the total quantity produced andconsumed of it will increase.

Likewise, a decline in liking for aproduct will cause opposite changes.Thus, a favourable (an unfavourable)change in taste will cause productprice and quantity exchanged toincrease (decrease).

Example 5.4 Market for Air Travel.

Consider air travel. After the terroristattacks in America on September 11,2001, many people became afraid offlying. This can be thought of as anadverse change in tastes due to fear offlying, which would shift the demandcurve for air travel to the left. The priceof air tickets would fall and less numberof people would travel. These things didhappen. Shortly after that day, therewas a major decline in the ticket priceof air travel within America and a largedecrease in the number of passengers.Many airlines had to reduce their scalesof operation drastically.

5.3.4 A Change in Market SizeBy now you should know immediatelyhow this affects price and quantity. Anincrease in population would shift themarket demand curve to the right andresult in a higher price and a higher

quantity, whereas a decrease in thepopulation will do the opposite.

Example 5.5 Land Price Increase inDelhi in 1980s.

Compared to 1970s, there was asubstantial increase in land price inDelhi. It was because of large scalemigration of people from Punjab toDelhi following disturbances in Punjabin the mid 1980s. This can beinterpreted as an increase in marketsize for land in Delhi, which pushedup the land price in Delhi.

Example 5.6 House Price Rise inVancouver, Canada, during 1990-1995.

During this period the price of housesin this city in Canada increasedsubstantially − from nearly 2.2 lakhCanadian dollars, on the average, in1990 to nearly 3.08 lakh Canadiandollars, on the average, in 1995. Thiswas primarily due to the huge migrationof people from Asian countries,especially from Hong Kong. Uncertaintyover the future of Hong Kong after thescheduled hand-over of the city fromBritain to China in 1997 forced manyresidents of Hong Kong to leave forUnited States and Canada. They were,by and large, wealthy. Most of thosewho came to Canada settled inVancouver.9 Their demand for housingwas the main factor behind the houseprice surge there during the period1990-1995.10

8 Recall that a change in taste does not only include a change in taste in one’s mouth; it means achange in demand due to reasons other than price or income changes.

9 Overall, migration from overseas contributed 79% to the net population growth of Vancouver.10 The source of this material is David Ley and Judith Tutchener, “Immigration and Metropolitan House

Prices in Canada,” Research on Immigration and Integration in the Metropolis Working Paper Series,Vancouver Centre of Excellence, March 1999.

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5.4 SOURCES OF SUPPLY SHIFTS

In Chapter 4 we learnt thattechnological progress, changes ininput prices, changes in excise taxes orchanges in the prices of related goodsin production cause shifts in a firm’ssupply curve − and hence shifts in themarket supply curve. Moreover, achange in the number of firms shifts themarket supply curve without affectingthe individual supply curves.

5.4.1 Technological Progress

It shifts the supply curve to the right.Fig. 5.5(a) applies. Thus, technologicalprogress leads to a fall in price and anincrease in quantity exchanged.

Example 5.7 Micro-computer CPUs.

This is a prime example of technologicalprogress. As you might know, the brainof any micro-computer is its CPU, theCentral Processing Unit. About 1.5 squareinches in size only, the CPU is placedinside a computer. Its speed (similar tothe speed of brain) is given in a MHzrating.11 Over the last few decades, theproduction of CPU has seen phenomenaltechnological progress. As a result, wesee the price of a CPU of a given speedgoing down rapidly over time. Indeed, thetechnological progress is so rapid that,after being introduced in the market, aCPU of a given speed becomes almostobsolete in a matter of 6 to 7 years,sometimes less. For instance, in 2000, a550 MHz CPU cost around Rs. 14,000. Ayear later in 2001, it was selling at aroundRs. 9,000.

5.4.2 Change in Input Prices

From Chapter 4 we know that thesupply curve shifts to the right or left,as an input price decreases orincreases. Therefore, in view offigs. 5.5(a) and (b), the product pricedecreases and the quantity rises orthe price increases and the quantityfalls according as an input pricedecreases or increases.

Example 5.8 Personal Computers.

It is a common observation now a daysthat the price of a PC system (thecomputer, the monitor and the printer)of given configurations goes downrapidly over time. It is because thecomponents (i.e. inputs) that go intomaking a PC are becoming increasinglycheaper. The case of CPU was discussedin Example 5.7. Other components ofa computer system are becomingcheaper also. A 15" colour monitor usedto cost around Rs. 8,400 in 2000. In2001, it came down to about Rs. 7,000.

Note carefully that Example 5.7was about a decrease in input pricedue to technological progress, whereasin Example 5.8 the productprice decreases because of decreasein input prices.

Example 5.9 Internet Café Rates inIndia.

These cafes have sprawled in manycities, big and small, all over India.In the year 2000, in Delhi an hourly

11 For example, at the time of writing this book, my desk-top computer had a 550 MHz CPU in it.

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rate for internet “surfing” was no lessthan Rs. 50. In 2002, it came downto an average Rs. 15 in many suchcafes.12 This is because of reductionin input prices. First, the price ofcomputers came down. Second, theinternet access charges to these cafesby ISPs (Internet Service Providers)such as VSNL (Videsh Sanchar NigamLimited), Satyam etc. went down.Third, in connecting to the ISPs,instead of phone lines, cable linescould be used, which are cheaper andthrough which the connection canbe kept uninterrupted for 24 hours aday.

5.4.3 Change in Excise

In Chapter 4, we saw that an increase(decrease) in the excise duty ratesshifts the supply curve to the left(right). From fig. 5.5 then, it followsthat the price of the product willincrease (decrease) and quantitytransacted will decrease (increase),as the excise duty rate increases(decreases).

Example 5.10 Cosmetics andToiletories in 2002.

In the union budget of 2002-2003, thespecial excise duty on cosmetics andtoiletories, 16% earlier, was completelyremoved. As soon as it happened, majorcompanies like Hindustan Livers Ltd.(HLL), Godrej and Proctor and Gamble(P & G) reduced prices in this categoryof products. For example, HLL reducedprices across a variety of brandsincluding Clinic and Sunsilk shampoos,Pond’s skin creams, Pond’s talc andLakme make-up products.

5.4.4 Increase in the Price ofSubstitute Goods inProduction

It was also discussed in Chapter 4 thatan increase in the price of a substitutegood in production shifts the supplycurve of a given product to the left.Applying fig. 5.5 we can then say thatan increase (a decrease) in the priceof a substitute good in productionleads to an increase (a decrease) inprice and a decrease (an increase) inquantity.

5.4.5 Number of Firms

Even when the individual supply curvedoes not shift, the market supply curvecan if the number of suppliers in themarket changes. We already know thatan increase in the number of firms(which can be interpreted as greatercompetition) shifts the market supplycurve to the right. A decrease in thenumber of firms, i.e., less competitiondoes the opposite. Thus, fromfigs. 5.5(a) and (b), price falls andquantity rises or price rises and quantityfalls, as there is more or less competitionin terms of the number of firms.

Example 5.11 Mobile Phone Rates.

Mobile phones came to the four majorcities of India in the mid 1990s. InDelhi, there were initially twocompanies: AirTel and Essar. Thecharges for outgoing and incoming callswere quite high, no less than Rs. 15per minute. By the end of 2002, there

12 This rates were found from the author’s own survey.

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were four companies : Bharati's AirTel,Hutchison's Hutch (which acquiredEssar), MTNL's Dolphin and Tata-Birla-AT & T's Idea. The mobile phone rateshave come down drastically. Incomingcalls in some schemes are even free.

Although the mobile phone markethas only a few number of firms, notmany as in a perfectly competitivemarket, it is the entry of new firms,which is a contributing factor in thedecline of mobile phone charges.

5.4.6 Other Factors

Factors like weather, natural disasterssuch as cyclone, flood etc., which areresults of Nature’s play, can also affectthe supply of a product. For instance,variation in agricultural output in Indiafrom one year to the next is dependentpartly on how good the monsoons are.A specific example of this and its effecton price is given below.

Example 5.12 (In)Famous Onion PriceIncrease in 1998.

In October-November of 1998, theonion price in India increased 6 to 10times from its usual price. Onion beinga very common vegetable, consumed bymost households, it became a verypolitically sensitive issue. The reasonbehind this unprecedented onion pricerise was heavy rains and flooding in theonion growing areas in India, whichcaused a drastic decrease in supply ofonions to the market in that year.

5.5 ANATOMY OF FAMINES: ANAPPLICATION OF THE DEMAND-SUPPLY ANALYSIS

The reach of demand-supply analysisis quite far and deep. Not only itexplains what happens in the marketfor products like coffee, tea orcomputers, it can shed light on verycomplex socio-economic issues. In thissection, we apply it to understand howfamines occur.

A famine is characterised bywidespread death due to starvation andepidemics.13 Epidemics typically resultfrom large scale starvation. Hence,famine can be seen as a massiveincidence of starvation. In turn,starvation is reflected mostly in thestaple food of the region. Therefore,analytically, the question is how a largesection of a region’s population cannotafford to buy the minimum amount ofthe staple food for survival.

The standard view is that it isprimarily a production or “totalavailability” problem. We can definetotal availability of a product as theamount produced plus the amountstored in government and privatewarehouses. For reasons like naturalcalamities and unfavourable weatherover critical months, the totalproduction of the staple food isseverely affected, which drasticallylimits the total availability. As a result,a large portion of a region’s population

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13 In the Bengal Famine of 1943 for example, one of the worst famines of the 20th century, an estimated16 lakh people died.


14 The material on FAD theory and Sen’s own theory is based on Sen, A.K., Poverty and Famines: AnEssay on Entitlement and Deprivation, Oxford University Press, 1981. The demand-supply versionof these theories is the author’s own copyrighted work, based on “Theories of Famine: An Exposition”,mimeo, Indian Statistical Institute, April 2002.

15 It is hoped that some of you will be inspired, decide to study economics further in college andeventually bag Nobel prizes for India.

16 If the price of rice is p3 or higher no one can buy rice; but such a price cannot prevail in equilibrium andhence is irrelevant.

17 We can instead draw a standard upward sloping supply curve. But this will not change the analysis.

does not get the minimum amount forsurvival and there is a large-scalestarvation. Professor Amartya Sen ofIndia, the only Nobel laureate ineconomics in Asia thus far, calls thisthe FAD theory, with FAD standing forfood availability decline.

In what follows, the FAD theory isillustrated in terms of the demand-supply analysis. Professor Sen’s owntheory of famines is different. For thosewho are interested, Appendix 3illustrates his theory in terms ofthe demand-supply analysis.14 See Clip5-1 for a short bio-sketch of AmartyaSen. 15

5.5.1 The FAD Theory

Let the staple food be called rice. Turnto fig. 5.6, which depicts the individualand market demand curves for rice aswell as the market supply curve of rice.Let us say that there are three families,A, B and C, in the market. The panels(a), (b) and (c) graph their demandcurves respectively. The B-type family’sdemand curve lies to right of that of theA-type and the C-type family’s demandcurve lies to right of that of the B-type.We can interpret the A-type as thepoorest, the B-type as the next poorestand the C-type, the “richest”.

Note that when the price of rice isp1, the A-type family cannot afford tobuy any rice at all, but the B-type orthe C-type family can. As shown, thisprice is above the point at which theDDA, curve intersects the price axis.Hence, the A-type family’s quantitydemanded is zero. This is not true forthe B-type or the C-type family. Theformer demands the amount B1, and thelatter the amount C

1. If the market price

is p2 the A- and B-type families cannot

buy rice but the C-type can; its quantitydemanded is C

2. 16 Panel (d) depicts the

market demand curve, DDM as the

horizontal summation of the threeindividual demand curves.

This graph assumes that there isone family of each type. But it is not amajor assumption at all. If there are twoor more families of any given type, themarket demand curve is obtained byhorizontally summing the demandcurves of all families. The resultingcurve will look similar to DD

M.

From the supply side, let the totalavailable amount initially be M

0. It is

drawn vertical to represent that, afterthe harvest, this is the total, potentialamount available for consumption.17

The equilibrium price is then p0. At this

price, all families are able to buy rice.The types A, B and C respectively buy


A0, B

0, and C

0. This situation can be

interpreted as “normal”, one in whichthere is no starvation or famine.

Now suppose that, for some reason,say, because of a bad monsoon, thereis less amount available, equal to M

1.

The equilibrium price is higher, equalto p

1. Notice that at this price, the

poorest cannot afford to buy any rice,but the other types can. We can thinkof this situation as “starvation”:

some people in the lower end of incomecannot just afford to buy enough foodfor survival. If, instead, the totalavailable amount were much lesscompared to the initial situation, e.g,equal to M

2, the price would have risen

to p2 and observe that at this price both

A-type and B-type families would beout of the market. We can interpret thisas a situation of famine or massivestarvation. Whether exactly two types

Fig. 5.6 FAD Theory of Famines

CLIP 5-1

By now Professor Amartya Sen is a household name in India. He was born inSantiniketan in 1933. He studied in Calcutta University and later got his Ph.D.

from Cambridge University in 1959. Since then he has heldfaculty positions in various prestigious institutions at homeand abroad such as Delhi School of Economics, OxfordUniversity, London School of Economics and HarvardUniversity. Currently, at this time of writing, he is theMaster of Trinity College at Cambridge University. He hasreceived more than forty honorary doctorates from majoruniversities around the world, and the Bharat Ratna award,which is the highest civilian award in India.He has published numerous books and articles, and, hisresearch has ranged over many areas of economics,particularly welfare economics, and philosophy.In awarding him the Nobel prize in 1998, the Royal SwedishAcademy of Sciences said that he had made “several keycontributions to the research on fundamental problems in

welfare economics. His contributions range from axiomatic theory of social choice,over definitions of welfare and poverty indices, to empirical studies of famine.”

Amartya Sen


of families are deprived of the staplefood or not is immaterial. This situationgenerally represents that a largenumber of people are under starvation.

This is the FAD theory. In summary,it says that a drastic fall in the totalavailability of food causes massivestarvation and famine. The causal linkis that a large scale decline in foodsupply pushes the market price up tosuch a level that many poor people canno longer afford to buy the minimumamount for survival.

5.6 E F F I C I E N C Y O F T H EPRICE MECHANISM ANDCOMPETITIVE MARKETS

Many examples of demand and supplyshifts have been analysed. You shouldnot think, however, that such shifts areconfined mostly to these examples. Thechosen examples are the very obviousones. In a market economy, these shiftsoccur almost always and in case of allgoods and services, but they occurgradually over time.

At this point, it will be better if youpause for a moment here and reflecthow the forces of demand and supplyand the price mechanism solve the“what” problem in a market-orientedeconomy.

Suppose for some reason, demandfor a product rises. This shifts out themarket demand curve (which is not anobservable physical object). It tends toraise the market price that is observed.The price change acts as a signal toproducers. They increase their quantitysupplied. The new equilibrium price ishigher. The consumers are able to buy

as much as they wish to, and, theproducers are able to sell as much asthey wish to at that price. Theadjustment is complete. You caninterpret the equality between quantitydemanded and quantity supplied as co-ordination between demanders andsuppliers through the pricemechanism. Unlike in a centrallyplanned economy, there is no need fora central authority to directly co-ordinate between the wants of millionsof consumers out there and theproduction capabilities of the economy.Things happen in a systematic way −by an “invisible hand” so-to-speak.This is the “beauty” of the pricemechanism. In fact, it is said that pricemechanism is one of the fundamentaldiscoveries of the modern society.

Like all great discoveries, however,the price mechanism has its owndrawbacks. As argued by Sen andillustrated in Appendix 3, widespreadstarvation can occur even when thereis no decline in the total availability offoodgrains. This is potentially a seriousproblem in a free market economy.There are also other issues relating toequity, preservation of ourenvironment etc. that a free marketsystem cannot handle in efficient ways.It does not however imply that aseverely restricted market system is theright answer.

What are the drawbacks of the freemarket system and what are theircorrective solutions? These are veryimportant questions. But we do notexamine them here. It is a subjectmatter of higher courses in economics.


5.7 ECONOMIC POLICY BY THEGOVERNMENT AND MARKETEQUILIBRIUM

Not only is market equilibrium affectedby the sources of demand and supplyshifts considered earlier, it is influencedby various government policies as well.There are some policies, e.g., differentkinds of taxes and subsidies, thatchange the market price indirectly viashifting the demand and supply curves.Sales taxes and excise taxes arecommon examples.18 These are calledindirect interventions. There areother policies by which prices are fixeddirectly by the government; these aredirect interventions. In what follows,we study direct interventions only.

Price Control

It is thought that if necessary items likesugar, rice, wheat etc. were left to theplay of free market entirely, poor people

would not be able to afford them at themarket-clearing price.19 Hence, for along time, the government has adopteda system of price control through rationshops for such commodities.

In terms of demand and supplycurves, price control means fixing pricebelow the equilibrium price (as theequilibrium price is presumed to be toohigh). This is shown in fig. 5.7(a) anddenoted as P

1. It is called the control

price. Since it is below the equilibriumprice (P

0) the quantity demanded,P

1D

1,

exceeds the quantity supplied, P1S

1,

This means that everyone’s demand, atthe given price, cannot be satisfied. Itimplies the following:1. There has to be some “rationing” −

an upper limit on the amount thatcan be purchased within a giventime period. This explains whyone cannot buy a large quantityat a time from a fair -price orration shop.

18 For example, in Delhi, the sales tax on pastries in the financial year 2001-2002 was 8% and that onbicycles was 5%. In general sales taxes vary across states and range typically from 5 to 15%. Somecommodities are totally exempt from sales taxes.

19 This is similar to the famine theory discussed earlier.

Fig. 5.7 Price Control and Price Support

(a) (b)


20 While the intentions behind price control and price support programmes are well-meant, there isconsiderable debate in economics literature about their efficiency in achieving the objectives, incomparison to other policies that can achieve the same objectives. This is something that will be studiedin specialised courses in economics.World Trade Organisation is an international body like United Nations, having more than 120 membercountries, whose objective is to promote free and fair international trade and commerce in the worldeconomy. It came to existence in 1995 and is headquartered in Geneva, Switzerland. India is afounding member of WTO. China joined WTO in 2001.

2. Since there is a shortage at thecontrol price, there will always besome buyers who are willing to paya higher price than the control priceand obtain the quantity that theydesire. This gives rise to theexistence of black markets.

Support Price

It is interesting that for the growers ofthe same essential products, e.g., forfarmers who raise sugarcane, wheatetc., there have been support price orprice support programmes, meaningprice being fixed above the equilibriumprice. These programmes are meant toinsulate farmers from incomefluctuations resulting from pricevariations in the free market. Supportprice is illustrated in fig. 5.7(b) and isdenoted by P2. Since this price is above

the equilibrium price (P0), opposite tothe price control case, the quantitysupplied (P2S2) exceeds the quantitydemanded (P2D2). There is always somesurplus. Who buys the amount ofsurplus or excess supply, P2S2? It isthe government − by committing to buythe surplus at the pre-announcedsupport price.

It is noteworthy that while pricecontrol programmes are commonlyobserved in developing countries ratherthan in developed countries,agricultural price support programmeshave been common in both groups ofcountries. However, many price supportprogrammes are being phased out nowin both developed and developingcountries, because of theircommitments made to World TradeOrganisation as members.20

SUMMARY

� Excess demand pushes up the market price by causing competition among thebuyers. Excess supply pushes down the market price by causing competitionamong the sellers.

� At the market equilibrium, there is no excess demand or excess supply anddemand and supply curves intersect.

� A non-viable industry is one, in which the demand and supply curves do notintersect at any positive level of output. The supply curve lies above the demandcurve and thus nothing is produced.

� A rightward (leftward) shift of the demand curve leads to an increase (a decrease)in price and quantity transacted.


� A rightward (leftward) shift of the supply curve leads to a decrease (anincrease) in price and an increase (a decrease) in the quantity transacted.

� If both the demand and supply curves shift to the right (left), the effect onprice is ambiguous but the equilibrium quantity exchanged increases(decreases).

� If the demand curve shifts to the right and the supply curve to the left, theprice rises but the effect on quantity exchanged is unclear.

� An increase in the price of a substitute (complementary) good in consumptionleads an increase (a decrease) in price and quantity transacted of a good inquestion.

� An increase in income results in a higher (a lower) price and quantitytransacted according as the good is normal (inferior).

� A favourable (an unfavourable) taste shift leads to a higher (a lower) priceand quantity transacted.

� A cost reducing technological progress leads to a lower price and morequantity being sold.

� An increase in an input price leads to a higher price and less quantity beingsold.

� An increase in the rate of excise duty leads to a higher price and less quantitybeing exchanged of a particular product.

� An increase in the price of a substitute good in production will lead to ahigher price and less amount exchanged of a particular product.

� More competition in an industry leads to a lower price and a higher quantityexchanged.

� According to the FAD theory of famines, as the available quantity of foodgrainsfalls, the price of foodgrains increases, such that families in the lower end ofwealth and income can no longer afford to buy it. This causes starvation.

� The demand-supply equilibrium in a free market can be seen as co-ordinationbetween consumers and producers.

� A price control system includes a rationing scheme since the quantity demandedat the control price exceeds the quantity supplied of it. It also leads to blackmarketing.

� A price support system leads to a surplus of output, which is purchased bythe government.

EXERCISES

Section I5.1 Give the meaning of excess demand for a product.5.2 Give the meaning of excess supply of a product.5.3 Define market equilibrium.5.4 Give the meaning of equilibrium price.


5.5 For a non-viable industry, where does the supply curve lie relative tothe demand curve?

5.6 How does an increase in the price of a substitute good in consumptionaffect the equilibrium price?

5.7 How does an increase in input price affect the equilibrium quantityexchanged in the product market?

5.8 How does a favourable change in taste affect the market price andthe quantity exchanged?

5.9 How does a cost-saving technological progress affect the market priceand the quantity exchanged?

5.10 How does an increase in excise tax rate affect the market price andthe quantity exchanged?

5.11 When will an increase in demand imply an increase in price but nochange in quantity supplied?

5.12 What does the FAD theory of famines say?5.13 What is the relationship between the control price and the equilibrium

price?5.14 What is the relationship between the support price and the

equilibrium price?5.15 Why does a surplus emerge in case of a support price?

Section II5.16 Show the determination of market equilibrium with the help of

demand and supply schedules and a diagram.5.17 What is meant by economic viability of an industry?5.18 What will be impact on market price and the quantity exchanged

when(a) there is a rightward shift in the demand curve?(b) the demand curve perfectly elastic and the supply curve shifts

out ?(c) both the demand and supply curves decrease in the same

proportion?5.19 How does an increase in the income affect the equilibrium price of a

product?5.20 A severe drought results in a drastic fall in the output of wheat.

Analyse how will it affect the market price of wheat.5.21 Suppose the demand for jeans increases. At the same time, because

of an increase in the price of cotton, the supply of jeans decreases.How will it affect the price and quantity sold of jeans?

5.22 “Equilibrium price may or may not change with shifts in both demandand supply curves.” Comment.


5.23 How are decisions taken by consumers and producers in a marketco-ordinated?

5.24 Trace the effect of demand shifts on equilibrium price and quantity.5.25 Given one example each of direct intervention and indirect

intervention in the market mechanism.5.26 What do you understand by (a) control price and (b) support price ?5.27 Show with the help of a diagram how rationing and black marketing

can emerge in a price-control system.5.28 Answer all questions in terms of shifts in or movements along the

demand and supply curves.(a) In 2001, the Supreme Court of India banned smoking in public

places. How is this likely to affect the average price of cigarettesand the quantity sold?

(b) New discoveries of oil reduce the price of petrol and diesel.Consider their effects on the market for new cars.

(c) New environmental regulations require that the drug industryuse a more environment-friendly technology whose runningcosts are higher but which discharges less toxic chemicals thanbefore. How would it affect the price of drugs?

5.29 China is a big manufacturer of telephone instruments. It has recentlybecome a member of WTO, which means that it can sell its productin other member countries like India. Suppose that it does export alarge number of telephone instruments to India.(a) How will it affect the price and quantity sold of telephone

instruments in India?(b) Suppose that the demand for telephone instruments is

relatively elastic. How will it affect India’s total expenditure ontelephone instruments?

5.30 In the union budget for year 2002-2003, the excise duty on tea wasreduced from Rs. 2 per kg. to Rs. 1 per kg (this is a fact). All otherthings remaining unchanged, how will it affect the market price oftea?

5.31 Suppose the price controls on sugar are lifted. How, ceteris paribus,will it affect the price and quantity consumed of sugar?

Section III5.32 Mrs. Ramgopal says that economists say inconsistent things: as price

falls, demand rises, but as demand rises, price rises. Defend or refute.5.33 Describe the FAD theory of famines.

OTHER FORMS OF MARKET STRUCTURE 105

6.1 Perfect Competition inthe Long Run: FreeEntry and Exit

6.2 Monopoly

6.3 MonopolisticCompetition

The notion of market structure wasintroduced in Chapter 4. A perfectlycompetitive market structure is one thathas the following features: (a) there are alarge number of sellers and buyers in themarket, (b) the product is homogeneous and(c) there is free entry and exit of firms inthe long run. In Chapter 4 we saw how (a)and (b) lead to the supply curve, given thatthe objective of a firm is to maximise profits.In Chapter 5 we studied the interactionbetween supply and demand curves, and,learnt how the price/market mechanismworks.

In this chapter we study marketstructures as such. Having already analysedthe implications of (a) and (b) under perfectcompetition, we begin by analysing theimplications of feature (c), i.e., perfectcompetition in the long run.

There are other market structures, whichare not perfectly competitive. They go underthe name of imperfect competition orimperfectly competitive market. There arethree broad forms of imperfectly competitivemarkets: monopoly, monopolisticcompetition and oligopoly. In this chapter,we analyse the first two.

��

CHAPTER 6

••

•


6.1 PERFECT COMPETITION INTHE LONG RUN: FREE ENTRYAND EXIT

Before analysing the implications of freeentry and exit, we discuss a couple ofthings.1. Recall from Chapter 3 that there

are no fixed costs in the long run.Moreover, both the Long runAverage Cost (LAC) and the Longrun Marginal Cost (LMC) curve areU-shaped. The pattern of returns toscale − that is, initially at low levelsof output, a firm would experienceincreasing returns to scale, followedby constant returns to scale anddiminishing returns to scale −implies the U-shape of LAC curve,which, in turn, implies the U-shapeof LMC curve.

2. How does producer’s equilibriumor profit-maximisation happen inthe long run? The answer is that ithappens the same way in principleas in the short run. Profit ismaximised when P = LMC. Theeconomic logic behind it is alsoparallel to that in the short run.We are now ready to examine the

effects of free entry and exit.Suppose that the market price of

the product is P1, and the firms areproducing at the point where theprice line intersects the LMC curve.Moreover, suppose that the price, P1,is high enough such that, at the profit-maximising level of output, firms aremaking positive profits. In economics,a positive profit is sometimes referredto as abnormal profit, in the sensethat the total cost is assumed to

include not just the production costsbut also the opportunity cost of theproducer herself − and hence profitsare equal to the producer’s excessearning over her opportunity cost.(Likewise, negative profits, that is,losses are called abnormal losses.)

In this situation, abnormal profitswill attract many new firms to theindustry. This will shift the marketsupply curve to the right, driving downthe market price and profits. Anotherway to look at it is that there will bemore competition, which will lower priceand profits. How far will this continue?It will happen till there are no abnormalprofits.

Similarly, if, initially, the price is lowenough such that firms are incurringlosses, free exit means that someexisting firms will start to quit theindustry. This will tend to shift themarket supply curve to the left. Theprice will rise. Losses will be less. Theexit process will continue till there areno losses.

It then follows that free entry andexit imply zero profit in equilibrium.Note that profit being zero is equivalentto P = LMC . This is the break-evenprice, the price at which the abnormalprofit is zero. We can then say that freeentry and exit imply that in the long runthe market price will be equal to thebreak-even price.

Together with the profit maximisingcondition P = LMC, the long-runcompetitive equilibrium is thendefined by

P = LMC = LAC.


That is, at the long run equilibrium,firms are in equilibrium (i.e. they aremaximising profits) and there is noentry or exit.

This is illustrated in fig. 6.1.Panel (a) shows that a firm producesthe output qL. At this level of output,both the marginal cost and the averagecost are equal to the price pL. Abnormalprofits are zero, as price equals averagecost. Implicit in this panel is that thereis an equilibrium number of firms, nottoo many or too few, which isconsistent with profits being zero.However, it is not possible to see whatthis number is in this diagram. SeeExercise 6.47 for a numerical solution.

Fig. 6.1(b) depicts the long-runmarket supply curve (with the numberof firms being equal to its equilibriumvalue) and the demand curve. Marketequilibrium occurs at price pL. The totalequilibrium quantity produced andexchanged is QL .

There is an important propertyassociated with a perfectly competitivemarket in the long run equilibrium.

That is, the firm produces at a level(qL),where the LAC is at the minimum,i.e., production occurs at the mostefficient scale. The firm’s scale ofoperation is large enough such thatthe benefits of increasing returns toscale have been realised, but it is notthat large so as to incur the problemsassociated with decreasing returns toscale.

6.2 MONOPOLY

Some of you must have heard thisterm before. “Mono” means “one”,“poly” means “seller” and thus“monopoly” means one seller. This isdefined in the context of a givengeographical location or space. InIndia, before liberalisation in the powersector got underway in the 1990s, thegeneration, transmission anddistribution of electricity were in thehands of State Electricity Boards(SEBs). The SEBs were monopolies inthe respective states.

To take another instance, you hearmany people use the term “xeroxing”

Fig. 6.1 Firm and Market Equilibrium in the Long Run

(a) (b)


CLIP 6.1

Patent Laws

Most developed countries have comprehensive patent laws. During the patentlife the patent holder can sell license to other firms for using its technology(legally). Typically, the license is sold to firms who operate in markets otherthan where the patent holder operates, e.g., in a different country. Theenforcement of patent law is also strict in developed countries. A patent holdercan take to court some other firm, who may be using its technology without alicense, and get a fairly quick decision.

In India, the patent law and its enforcement are rather passive. This is becauseresearch and development, discoveries and inventions have not been a focus ofactivities by firms. Barring a few exceptions, we generally import technology fromabroad.

The most important patent legislation in India is the Indian Patent Act of 1970. Itprovided that any invention of a new product or a process of production, which isuseful and not obvious, is patentable. But it explicitly did not allow product patentsin the drug and food sector. This allowed Indian drug companies to produce drugsinvented in the developed countries and sell them in less developed countries. Cipla,an Indian drug company, is an example. For a long time, Cipla has supplied anti-AIDS drugs, named Combivir, to a country like Ghana.

Recently however, as an obligation of being a member of WTO (World TradeOrganisation), India and other countries had to revamp their patent laws. In India,a major amendment to the Patent Act of 1970 was done in 1999, by which bothproduct and process patents are allowable in the food and drugs sector. In general,patents are being protected more aggressively than before.

To continue our account of Cipla selling Combivir in Ghana, a multinational companynamed Glaxo Smith Kline claimed that it had patents on the generic version of drugCombivir and it filed a patent violation complaint against Cipla in Ghana. After thehearing of arguments by both companies, the government of Ghana in 2000 rejectedCipla’s application to market this drug in Ghana.

There is a fear in India that, because of our being a member of WTO, we are forcedto honour patent protection. As a result, particularly in the drug sector, Indiancompanies will no longer be able to sell many essential drugs at affordable prices.Once multinational companies start to sell them, the drug prices are going to sky-rocket, and many poor people will be denied access to these drugs.

Are patents a good thing for a developing country like India? Should India be amember of WTO? An immediate reaction may be a “no” to both. However, a carefuland rational thinking might suggest just the opposite. We recommend you tovisit WTO’s website, http://www.wto.org and read many articles on these issues.


to mean the use of a photocopyingmachine. Actually, Xerox is anAmerican company, which discoveredthe plain-paper photocopying machinein 1959. It obtained patent on it. (Theconcept of patent will be explainedshortly.) Throughout the 1960s it wasthe only company that manufacturedand sold plain-paper photocopyingmachines.1 This is an example of aprivate monopoly.

A monopoly is the opposite of theperfectly competitive marketstructure: there is just one firm/sellerinstead of many. There is littlecompetition. It is implicit that there areno close substitutes to the monopoly’sproduct or service available in themarket. It is also implicit that there isno free entry (otherwise, more than onefirm can operate in the industry).A monopoly market structure emergesbecause of any of the followingreasons.(a) The government gives license to

only one company for producing aproduct or providing a service in agiven locality or space. Forinstance, till 2002, VSNL (VideshSanchar Nigam Limited) hadmonopoly in India in providinginternational telephony service.

(b) Big private companies − typicallyin developed countries − engage inresearch and come up with new

products or new technology inproducing an existing product. Asa reward for their risk andinvestment in research, they canapply to their government for apatent, which is an of ficialrecognition that they are theoriginators of the new product ortechnology and no one else can usetheir technology without obtaininglicense from them. In other words,monopoly arises because ofgranting patent certificate or whatis called patent rights. The case ofXerox is an example.2

However, patents are not grantedfor ever. They are valid only for acertain number of years (afterwhich other firms can freely copythe technology). This period iscalled patent life. In mostdeveloped countries the patent lifevaries between 15 to 20 years. InAustralia it is 20 years; in theU.S. it is currently 17 years. SeeClip 6-1 on patent laws.

(c) Sometimes, firms retain theirindividual identity but they co-ordinate their outputs and pricingpolicy so as to act as if it is amonopoly. This is called a cartel.The OPEC (Organisation ofPetroleum Exporting Countries) inthe 1970s is an example of a cartelthat led to virtual monopoly in the

1 Plain-paper photocopy machine has been regarded as the most successful commercial product inhistory. Now there are many well-known companies, besides Xerox, in the world market that producephotocopying machines, e.g., Canon, Mita, Panasonic, Ricoh, Royal, Sharp and Toshiba. Many faxmachines also have copying capability.

2 Another example is a drug company called Eli Lilly, which has a patent on a very widely usedantidepressant called Prozac. This patent is supposed to expire in 2003.


world market for oil. See Clip 6-2for a brief history of the OPEC andthe world oil market.3

6.2.1 Total, Average and MarginalRevenues

The objective of a monopolist is tomaximise its total profit, which, bydefinition, equals total revenue minustotal cost. The cost structure facing amonopolist is similar to that of acompetitive firm. We have the sameconcepts, total cost, average cost,marginal cost etc., and their generalshapes are also the same as for acompetitive firm. But the revenuestructure facing the monopolist isquite different.

Recall that a perfectly competitivefirm is very small compared to the

market. It does not have any marketpower and thus it is a price-taker. Noneof this is true for a monopoly since it isthe only producer by definition. It hasmarket power and it is a price-makerso-to-speak. This is the most importantdifference of a monopoly firm from aperfectly competitive firm. It implies thatthe way total revenue changes asoutput changes is different from whathappens to a perfectly competitive firm.In case of the latter, we already knowthat, as output increases, the priceremains unchanged. But a monopolyfirm faces the entire market, hence facesthe market demand curve. Hence, as itincreases or decreases its output itcannot expect that the market priceremains unchanged: price will changeaccording to what consumers are

Clip 6-2 OPEC and The World Oil Market

OPEC had five founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela.It came into existence in 1960. Qatar joined it in 1961, followed by Indonesia andLibya in 1962, United Arab Emirates in 1967, Algeria in 1969 and Nigeria in 1971.In the 1970s when the first oil price shock overtook the world economy, OPECconsisted of the above-mentioned countries. (Currently there are two other countriesin OPEC, namely, Ecuador and Gabon.) The aim of the OPEC countries is to setproduction quotas, so as to manipulate the price of petrol in the world market.Besides the OPEC, there are other countries which are major producers of oil. Forexample, America was and still is, a big producer of oil. But its consumption is evengreater and thus it is an importer of oil. India also produces oil and is an importer.Hence, in the import-export market, OPEC in the 1970s can be interpreted as amonopoly.The oil shortage of 1970s motivated many other countries to explore oil. By mid1980s there were other countries, who were major exporters of oil and who used to beimporters of oil earlier, e.g., Mexico, The Netherlands and Russia.

3 There are other reasons for monopoly or near-monopoly also, e.g., merger and acquisition. In the early1990s, in the tea industry, Brooke Bond and Lipton merged and subsequently they merged withHindustan Lever. It left out Tata, another large tea firm.


willing to pay along the demand curve.The monopolist has to take this intoaccount. Put differently, the marketdemand curve is a constraint facing amonopoly firm. This point must beunderstood very clearly.

Suppose, the market demandschedule is as given in Table 6.1. Sincethe monopolist faces this demandschedule it means that if she wants tosell 4 units for example, she (themonopolist) must charge price equalto Rs. 7. The reason is as follows. Ifshe charges any price higher thanRs. 7, she will be able to sell only lessthan 4 units. Moreover, as long as shewants to sell 4 units, she can sell themall by charging Rs. 7 each − becausealong the market demand curve 4 unitsare demanded at the price equal toRs. 7. Therefore, there is no reason tosell at any price less than Rs. 7.Similarly, it can be argued that if themonopolist wants to produce and sell5 units, the price charged will be Rs. 5,and so on.4

We can then write “Output” or“Quantity” in place of “QuantityDemanded” and present the samedemand schedule with output listedin increasing order, starting withoutput equal to 0 (and correspondingprice equal to Rs. 15). This is done alongthe first two columns in Table 6.2. Thesetwo columns represent the same

demand schedule as in Table 6.1. Now,by multiplying output by price, we getthe Total Revenue (TR), which are givenin column (3). Dividing TR by outputgives average revenue, AR, since, bydefinition, AR = TR/output. This is

Table 6.1 A Demand Schedule

Price Quantity Demanded(in Rs.) (units)

1 7

3 6

5 5

7 4

9 3

11 2

13 1

15 0

shown in column (4). TR being equalto price × output, AR = price × output/output = price, that is, AR is equal toprice.5 Thus the entries in column (4)are same as those in column (2). Alsorecall from Chapter 4 the concept ofMarginal Revenue (MR), defined as theaddition to the total revenue from oneextra unit sold. The last column givesthe MR schedule.

4 Hence, unlike what many, especially non-economists, believe, a monopolist despite having marketpower, cannot not just charge any price at its sweet will. It could have, only if the demand curve weretotally vertical, i.e., there were absolutely no substitutes available. But for most products substitutesare available.

5 This is true except when output is zero. At zero output, TR/output = 0/0, which is not defined.


We note the following properties of thethree revenue concepts.1. MR decreases with the output.

Initially it is positive and after a

4. Since AR = price, if we wish to graphthe AR curve, it is always same asthe demand curve facing the firm.

5. Except for the first unit, at all otherlevels of output, MR < AR. Thisfollows from the relationshipbetween “average” and “marginal”discussed in Chapter 3, that is, if“average” is falling (rising),“marginal” is less (greater) than the“average”.Panels (a) and (b) of fig. 6.2

respectively graph the TR curve, andthe AR and MR curves correspondingto Table 6.2. The TR curve is inverseU-shaped as TR initially increases andthen decreases with output.

certain level of output it becomesnegative.

2. TR increases or decreases as MR ispositive or negative.

3. TR first increases with output andthen it decreases. Therefore, if wegraph TR against output (i.e. theTR curve), it rises initially and thenfalls. This is because MR is initiallypositive and then negative.Moreover, it means that, if outputis measured on a continuousscale, TR reaches maximum whenMR = 0. Thus the shape of the TRcurve facing a monopoly firm isquite different from that facing acompetitive firm.

Fig. 6.2 The TR, AR and MR Curvescorresponding to Table 6.2

(a)

(b)

Table 6.2 TR, AR and MR underMonopoly

Output Price TR AR MR(Rs.) (Rs.) (Rs.) (Rs.)

0 15 0 - -

1 13 13 13 13

2 11 22 11 9

3 9 27 9 5

4 7 28 7 1

5 5 25 5 -3

6 3 18 3 -7

7 1 7 1 -11


The condition (A) is quite intuitive.At very low level output, MR will exceedMC. Since, by definition, these arerespectively equal to additionalrevenue and additional cost, as long asMR > MC, a marginal increase in outputwill fetch additional revenues, whichwill be more than the additional costinvolved in increasing the output. Thusthe firm will obtain more profits if itincreases its output. On the other hand,at a very large level of output, MC willbe very high and MR very low (possiblynegative). This means that, if the firmreduces output, the savings in cost willbe greater than the revenues lost andhence profits will be higher. Therefore,profit is maximum at the level of output,where MR = MC.

6.2.3 Monopoly Versus PerfectCompetition

These are the following general andimportant features of monopoly incomparison to perfect competition.1. In perfect competition profit

maximisation leads to a supplycurve which tells how much a firmproduces at different market pricesthat are given to the firm. Inmonopoly, however, the firmdecides output and price. There isno question of the optimal level ofmonopoly output at different prices.Hence there is no supply curve assuch under monopoly.This does not mean however thatdemand and supply forces do notinteract. They do. Shifts in theDemand Curve (AR) or in the MCcurve do affect a monopolist’soutput and price.

(a)

(b)

Fig. 6.3 depicts a smoothhypothetical TR curve and theassociated AR and MR curves. As youcan notice, TR reaches its maximumwhen MR = 0.

6.2.2Profit-Maximising Rule

A full analysis of a monopoly’sprofit maximisation or producer’sequilibrium is beyond our scope here.But we can state its condition:

(A) MR = MC.That is, a monopolist maximises

profit by selecting the level of output atwhich MR = MC.

This is indeed a very generalcondition of profit maximisation by afirm. (It was noted in Chapter 4 also.)Recall that for a competitive firmMR = P and thus the condition P = MCis a special case of the general conditionMR = MC.

Fig. 6.3 Smooth TR, AR and MR Curves


2. In perfect competition there is amajor difference between short runand long run. Not only are costcurves different (because there areno fixed costs in the long run),there is free entry and exit, whichdrives profits to zero in the longrun. In contrast, in monopoly, bydefinition, there is no entry andexit. Hence, essentially, there is notmuch analytical difference betweenshort run and long run.6

3. Now we come to the most importantbehavioural difference betweenmonopoly and perfect competition.We already know that, for amonopoly, P > MR and it selectsan output level where MR = MC.These two relations imply thatP > MC, that is, while price isequal to marginal cost in perfectcompetition, the price exceedsmarginal cost under monopoly. Itmeans that a monopoly, in a sense,charges “too high a price” for itsproduct. Moreover, the monopolyprice being higher than thecompetitive price, it follows that,along a given demand curve, less issold − and therefore less isproduced − under monopoly thanunder perfect competition. Insummary, we can then say that themonopolist produces less andcharges a higher price, comparedto perfect competition.

The last point summarises what is“wrong” with a monopoly marketstructure. It is the basis of negativesentiments against a monopolist,which arises from time to time andwhich flares up to a slogan that amonopolist exploits the public andhence should be regulated anddiscouraged.

6.2.4 MERITS OF MONOPOLY

But before we rush to this conclusionwe should note some good thingsabout the monopoly too.1. Suppose that initially there are two

firms in an industry and both aresomewhat inefficient. Their MCcurves are at a high level andconsequently they charge a higherprice and produce less than whatthey would if the MC curves wereat a lower level. They realise,however, that if they merge witheach other − and thereby become amonopoly − they can reduce theircosts. For instance, one firm mayhave excellent technical manpowerbut may not have good marketingskills, whereas the other may nothave good technical manpower butpossesses superior marketingknowledge. By merging, theresulting monopoly firm’s MC curvewill be at a lower level and thus itwill be a more efficient firm. This,by itself, will induce the monopoly

6 However, it is quite possible – and likely – that over a long period the monopolist loses its monopolypower. For example, if the monopoly is present, in the first place, by virtue of a patent, the patenteventually expires and other firms use the same technology and there is competition. But the pointis that as long as there is monopoly, there is little analytical difference between short run and longrun in terms of output and price determination.


to charge a price, which is less, andproduce a quantity, which is greaterthan when both firms werecompeting with each other. This isa good thing about monopoly.On the other hand, the resultingmonopoly will be in a position toexercise greater market power andcharge the monopoly price. Wealready know that this is a badthing. Hence, there is a trade-offbetween efficiency and marketpower. If ef ficiency gains aresufficiently strong, then amonopoly serves the society betterand hence is preferable.Many countries including Indiahave the so-called anti-trustlegislations to deal with this issue.The objective of this legislation isto permit mergers, acquisitionsand business practices that havestrong efficiency ef fects andprevent those, which are meant tocreate or enhance market poweraccompanied by little efficiencygains.7

2. Another major benefit fromgranting monopoly is thatmonopoly power and profitsprovide incentives for inventionsand innovations. In reality, theseactivities are very riskypropositions. Often times theymaterialise from individual effortsand persistence. Why would

someone invent a product if he/sheis not allowed to enjoy monopolyprofits for a few years? Asmentioned earlier in the chapter,this is indeed the essence behindgranting patents.

These two points together with theinherent property of the monopolymarket structure that price exceedsmarginal cost imply that economicpolicy toward monopolies is a subtlepractical issue that should be handledwith care rather than be governed bysimplistic − and often populist − viewthat all private monopolies are bad.

6.3 MONOPOLISTIC COMPETITION

This is an interesting market structure,in which both competitive andmonopoly elements are present. Itsfeatures are the following. (a) There area large number of sellers and buyers.(b) There is free entry and exit in thelong run. Moreover, (c) there is productdifferentiation. That is, each firmproduces a brand or variety (of the sameproduct) that is unique, i.e., differentfrom what any other firm produces. Thevarieties produced are very closesubstitutes of one another. Productslike toothpaste, soap and lipstick areprominent examples.8

Features (a) and (b) are competitivefeatures. (a) states that each firm is smallrelative to the market. (b) implies thatfirms earn zero abnormal profits in the

7 In India, the MRTP Act of 1969 is the land-mark anti-trust legislation.8 For example, at the point of writing this book, there are 7 brands of lipstick available in the Indian

market: Avon, Elle, Lakme, Loreal, Maybelline, Revlon and Tips & Toes. There are many more brandsof toothpaste, e.g., Acquafresh, Anchor, Amar, Babool, Cibaca, Close-Up, Colgate, Forhans, Meswak,Neem, Pepsodent, Promise and Vicco Bajradanti.


long run. However, (c) is a monopolyfeature in the following way. Eventhough a firm is small and produces abrand that has many close substitutes,yet it is a unique brand. No one elseproduces exactly the same brand. Inother words, there is only one firmproducing a given brand. In this sense,each firm has some monopoly power.

The last point means that amonopolistically competitive firm alsofaces AR and MR curves for its brandand it maximises profits at the level ofoutput, where MR = MC. Moreover, itcharges a price, which exceedsmarginal cost.

Analytically, all these are analogousto the case of monopoly, except for onequalitative difference. That is, since thereare close substitutes available for anyparticular brand, the demand curvefacing a monopolistically competitivefirm (unlike that facing a monopolyfirm) is very elastic, implying that theAR curve must be quite flat.

There is, however, a major differencebetween monopolistic competition andmonopoly in the long run. Unlike inmonopoly, there is free entry and exit,which implies that abnormal profit isdriven to zero. As we have already seen,this is equivalent to P = LAC, where theletter “L” refers to the long run. Togetherwith the profit maximising conditionMR = LMC we can then compactly writethe long-run equilibrium conditions inmonopolistic competition as

MR = LMC;

P = LAC.

Although the features of monopolisticcompetition are a combination ofperfect competition and monopoly, interms of decision-making, there is oneaspect of it, which is different from bothperfect competition and monopoly.That is, monopolistically competitivefirms typically engage in advertising,i.e., they incur advertising costs orwhat is also called selling costs. It isbecause of the need to maintain aperception in the mind of the potentialconsumers that their respective brandsare different (and more tasteful orclassy), compared to other brands. Thisis persuasive advertisement and itspurpose is to lure away consumers fromother brands. In perfect competition,the product is perfectly homogeneousand hence there is no scope toengage in persuasive advertisement.In monopoly, since there is nocompetition, there is no need toengage in persuasive advertisement.

Realise that such selling costs donot benefit the consumers as a group:they only serve to move consumers onebrand to another. But they involveresources, which can be potentiallyused for production. Therefore, suchcosts are “wasteful” from the viewpointof the society.9

This closes our analyticaldiscussion on market structure. Assaid in the beginning of this chapter,we leave out one important form of animperfectly competitive market,namely, oligopoly. See Clip 6-3 for abrief description of oligopoly.

9 Not all advertising costs are wasteful. There can be informative advertising (e.g. information abouthealth), which is useful for the consumers.


CLIP 6-3

Oligopoly

A market in which there are a few (two or more) number of large firms is calledoligopoly. (The firms in it may be producing a homogeneous product or a differentiatedproduct.) As a special case, if there are only two firms, then it is called a duopolymarket. From an analytical perspective, what distinguishes oligopoly from othermarket structures is strategic interaction among firms. Since there are only a fewnumber of firms, a particular firm, in choosing its output or price, has to take intoaccount what the other firms are choosing and how they may react to its choices.This is a subject matter of a higher course in microeconomics.

SUMMARY

� Imperfectly competitive markets are of three types: monopoly, monopolisticcompetition and oligopoly.

� The long run profit-maximising condition is essentially same as theshort run profit-maximising condition. For a perfectly competitive firm,it is price being equal to the long run marginal cost.

� Free entry and exit imply zero profit, i.e., price is equal to the long runaverage cost. Firms break-even.

� The long run competitive equilibrium is characterised by the conditions:P = LMC = LAC.

� In the long run with free entry and exit, a perfectly competitive firm operatesat the level where the long run average cost is at its minimum.

� A monopoly market structure emerges from licensing, granting of apatent or forming a cartel.

� A monopoly is a price maker.� The market demand curve is a constraint facing a monopoly firm.� For a monopoly firm, TR first increases and then decreases with output.� For a monopoly firm, TR reaches its maximum when MR = 0.� For a monopoly firm, MR typically decreases with an increase in output.� MR = MC is indeed a very general condition for profit maximisation by

any firm.� Unlike in perfect competition, price exceeds marginal cost in monopoly.� In comparison to a perfectly competitive industry, in monopoly a higher

price is charged and less is sold.� Formation of monopoly may lead to more efficiency (in the form of lower

costs).� Patents encourage discovery and invention.


� A monopolistically competitive firm typically faces a very elastic demandcurve for the brand it produces.

� The long run equilibrium in monopolistic competition is characterisedby the conditions, MR = LMC and P = LAC.

� Monopolistically competitive firms engage in advertising costs to lureaway customers from other brands to their own brands.

EXERCISES

Section I6.1 Name the three forms of imperfectly competitive markets.6.2 What is the profit-maximising condition of a competitive firm in

the long run?6.3 What is meant by abnormal profit?6.4 What is meant by abnormal loss?6.5 If the firms are earning abnormal profits, how will the number

of firms in the industry change?6.6 If the firms are making abnormal losses, how will the number of

firms in the industry change?6.7 What is the relationship between marginal cost and average cost

at the long run competitive equilibrium?6.8 State the conditions of long run equilibrium in a perfectly

competitive industry.6.9 What is break-even price?

6.10 What is the relationship between break-even price and marginalcost at the long run competitive equilibrium?

6.11 Which point on the long run average cost curve does acompetitive firm produce in the long run equilibrium?

6.12 How many firms are there in a monopoly market?6.13 What are patent rights?6.14 What is patent life?6.15 What is a cartel?6.16 How does the total revenue change with output when the

marginal revenue is positive?6.17 How does the total revenue change with output when the

marginal revenue is negative?6.18 What is the relationship between the average revenue curve and

the demand curve in a monopoly market?6.19 What is the profit-maximising condition for a monopoly firm?


6.20 What is the shape of the total revenue curve in monopoly?6.21 What is the shape of the average revenue curve in monopoly?6.22 What is the shape of the marginal revenue curve in monopoly?6.23 What is the profit-maximising rule for a monopolist?6.24 What is the relationship between price and marginal cost at the

monopoly equilibrium?6.25 How do the equilibrium monopoly output and price compare

with the equilibrium price and output in perfect competition?6.26 What are anti-trust legislations?6.27 Which feature/features of monopolistic competition is/are

monopolistic in nature?6.28 Which feature/features of monopolistic competition is/are

competitive in nature?6.29 Give two examples of a monopolistically competitive market?6.30 State the conditions of long run equilibrium in a monopolistically

competitive industry.6.31 What is the relationship between price and marginal cost in a

monopolistically competitive market?6.32 What are selling costs?6.33 What are advertising costs?6.34 What is persuasive advertising?

Section II6.35 Explain how in the long run equilibrium with free entry and

exit, firms, under perfect competition, earn zero abnormalprofits.

6.36 Explain why the marginal revenue is less than average revenuefor a monopoly firm.

6.37 Explain how the market demand curve is a constraint facing amonopoly firm.

6.38 Discuss various ways in which a monopoly market structuremay arise.

6.39 Explain how the efficiency may increase if two firms merge.6.40 Explain the motivation behind granting patent rights.6.41 Briefly discuss the features of monopolistic competition.6.42 Why is the demand curve facing a monopolistically competitive

firm likely to be very elastic?6.43 Explain how price exceeds marginal cost in monopoly or in

monopolistic competition.


6.44 Explain how in the long run equilibrium with free entry andexit, firms, under monopolistic competition, earn zero abnormalprofits.

Section III6.45 The demand schedule facing a monopoly is given below. Derive

its TR, AR and MR schedules.

Price (Rs.) Quantity Demanded (units)

0 8

10 7

20 6

30 5

40 4

50 3

60 2

70 0

Output (units) MR (Rs.)

0 —

1 14

2 10

3 7

4 5

5 0

6 –3

7 –5

6.46 The MR schedule of a monopoly firm is given below. Derive the

TR and AR schedules.


6.47 The technology is such that the long-run average cost is

minimised at the firm output equal to 10 and the minimum long-

run average cost is Rs. 15. Suppose that the demand schedule

for the product is given as follows.

Price (Rs.) Aggregate Quantity Demanded

10 1800

12 1440

15 1200

18 1000

20 760

(a) What will be total quantity sold in the market and how many

firms will operate in the long run competitive equilibrium?

(b) Suppose that, because of technological progress, the average

cost curve shifts down such that the minimum average cost

is equal to Rs. 12 and it occurs at output level 8. How many

firms will now operate in the market in the long run?

6.48 Explain why MR = MC is the profit-maximisation principle of a

firm in general.

FACTOR PRICE DETERMINATION

� � � ��

FACTOR PRICE DETERMINATION 123

In Chapter 2 to Chapter 6, we examined theproduct markets: which good or service willbe produced, and if so, how much and whatits price will be. In other words we dealt withthe central problem of “what” facing aneconomy. Households are demanders andfirms are suppliers in product markets.

In this chapter we examine factor or inputmarkets, e.g., different types of labour or skill,capital (i.e. machinery and equipment), landetc. In factor markets, firms are demandersand households are suppliers.

There are similarities and dissimilaritiesbetween product and factor markets.Dissimilarities arise because the demandersand suppliers in a factor market are oppositeof who they are in a product market. Theissues are different also. Instead of theeconomy’s central problem of “what,” thefactor market analysis sheds light on the “forwhom” problem. For example, consider thelabour market. The price of labour service isthe wage rate. We will learn how the wages todifferent types of labour are determined in amarket economy. In general, earnings todifferent individuals in the form of wageincome or income from land etc. determineincome distribution in an economy. Incomedistribution, in turn, determines differences

��

CHAPTER 7

•7.1 Factor Demand

7.2 Total Factor Demand,Factor Supply andEquilibrium

7.3 Trade Unions

•

•


in the purchasing power over goods andservices among individuals orhouseholds. This is how the factormarket implications are linked tocentral problem of “for whom.”

The similarity between factor andproduct markets lies in that there is ademand side and there is a supply sideof a factor. The equality betweendemand and supply of a factordetermines the respective factor price.

7.1 FACTOR DEMAND7.1.1 A Firm’s Problem

At a given point of time, a firm facesdifferent prices for different factors. Forinstance, think of a transport andstorage company. It employs workers,rents warehouse space for storage etc.The prevailing hourly wage rate may beRs. 15. Warehouse facility may beavailable at the rate of Rs. 50 per dayper cubic metre of space. The questionis, given factor prices, how much ofdifferent factors a profit-maximisingfirm should hire?

On one hand, hiring more of factorswill generate more output, which willgenerate more revenues (as long as themarginal revenue is positive). On theother hand, hiring more factors willcost more.

7.1.2 One Variable Factor

To begin with, suppose that theemployment levels of all factors,except one, are fixed, i.e., there is onlyone variable input and the rest arefixed. Let this variable factor be calledlabour, measured in hours of work.(If all workers are supposed to work a

given number of hours per day, thenwe can measure labour as the numberof workers hired.) In other words, weare not differentiating betweendifferent types of workers at themoment. The question is, how manylabour hours (denoted by L) a firmshould employ?

The total cost of fixed factors isfixed by definition. The total cost ofthe variable factor (labour in ourexample) is easy to compute.Suppose that the wage rate is Rs. 20per hour. If the firm hires 4 hours oflabour, the total cost of labour is Rs.20 × 4 = Rs. 80. If 7 hours of labourare hired, the total cost of labour orthe total wage bill is Rs. 20 × 7 = Rs.140, and so on.

The way a firm’s total revenuechanges with employment of a factorcontains two steps: (a) how changesin the employment of the factor affectoutput and (b) how changes in outputaffect total revenue. Realise that wehave already studied (a) in Chapter 3.We also have analysed (b) − for acompetitive firm in Chapter 4 and fora monopoly firm in Chapter 6.What we need to do then is to combinewhat we have already learnt.For simplicity, let us assumethroughout this chapter that the firmunder consideration is a perfectlycompetitive firm.

From Chapter 3, recall in particularthe definitions of Total Physical Product(TPP) and the Marginal PhysicalProduct (MPP). The former refersto different levels of total outputat different levels of employment


second one is the Value of theMarginal Product (VMP), defined as P× MPP. Equivalently, VMP is equal tothe increase in TVP or total revenuesper unit increase in the employmentof the factor. It is because an extra unitemployed of a factor generates extraoutput equal to MPP, which will fetchextra revenues equal to the value of thisextra output.

Consider the TPP schedule and theMPP schedule, as given in Tables 3.2and 3.3 in Chapter 3. In order tocalculate the TVP and the VMP, weneed to know the product price.Suppose that P = Rs. 2. Table 7.1 givesthe TPP schedule, the MPP scheduleas well as the associated TVP and VMPschedules.

of a factor, when the employment ofother factors is unchanged. The latteris the increase in total output perunit increase in the employment of afactor when the employment of allother factors is held constant. FromChapter 3, we also know the shapes ofthe TPP and MPP curves. In particular,the inverse U-shape of the MPP curvefollows from the law of diminishingreturns.

We need two more concepts beforewe are able to answer in principle thequestion of how much of a factor aprofit-maximising competitive firm willemploy. The first is the Total ValueProduct (TVP), defined as P × TPP,where P is the product price. This isindeed same as total revenue. The

Table 7.1 TPP, MPP, TVP and VMP Schedules

Labour Hours TPP MPP TVP = P.TPP VMP = P.MPP(L) (Rs.) (Rs.)

0 0 — 0 —

1 10 10 20 20

2 22 12 44 24

3 33 11 66 22

4 43 10 86 20

5 51 8 102 16

6 56 5 112 10

7 56 0 112 0

8 48 –8 96 –16

9 36 –12 72 – 24

Product Price = Rs. 2


Particularly relevant for us will be theVMP schedule and its properties.A. It is proportional to the MPP schedule

as it is obtained by multiplying theMPP schedule by price, which isconstant. This implies that the lawof diminishing returns, whichgoverns the nature of the MPPschedule, also determines the natureof the VMP schedule. It initiallyincreases with factor employmentand then diminishes.

B. TVP of a particular level of factoremployment is the sum of VMPs upto that level of employment. Forinstance, at L = 3, TVP = 66. This isequal to the sum of VMPs at L = 1(20), at L =2 (24) and at L = 3 (22).Property A implies that the VMP

curve, the graphical representation ofa VMP schedule, will be inverse U-shaped, just as the MPP curve. This isillustrated in fig. 7.1(a). Property Bimplies that, if we draw a smooth VMPcurve, the area under it will be equalto the TVP (i.e. the total revenue). Ageneral, smooth VMP curve is shownin fig. 7.1(b). For instance, at L = L1, theTVP is equal to the area 0ABL1.

So far we have analysed conceptsthat help in understanding how anincrease in the employment of a factoraffects the total revenues of acompetitive firm. Now we discuss howit affects its costs. Suppose that thefactor L costs W per unit, i.e., thehourly wage rate is Rs. W. Fig. 7.2draws the Factor Price Line or the“wage line” in this case. It is a horizontalline since the wage rate is unaffectedby how many labour hours our

competitive firm − by definition, a smallfirm − hires in the labour market. Thepoint to note for us is that the areaunder the factor price line is the totalfactor cost or payment to the factor. If,for instance, the firm hires L1 labourhours, its total wage bill is the area0WCL1.

Fig. 7.1 The VMP Curve

Fig. 7.2 Factor Price Line

(a)

(b)


We are now ready to derive theprinciple that governs how manylabour hours a profit-maximising firmshould hire. Turn to fig. 7.3, whichcombines figs. 7.1(b) and 7.2. Let thefactor price facing the firm (wage rate)be W0. The answer is that the firmshould hire up to that level, where thefactor price line intersects the VMPcurve, i.e. it should hire L0 labourhours. In other words, the generalprinciple of hiring a factor (or profit-maximisation with respect to aparticular factor) is(A) VMP of a Factor = Its Price.

0W0CL0. Thus the gross profit, whichis the difference between TVP and totalfactor cost, is equal to the area W0 AC.1

Now consider any employment level less(such as LA) or more (such as LB) thanL0. We can compute that the profit isless than W0AC. For instance, at L = LA,it is equal to W0 AFD, which is equal toW0 AC – CDF. At L = LB, it is equal toW0 AC– CEG. This proves that profit ismaximised at L = L0.

The law of diminishing returns isthe key. Starting from where the VMPof a factor is equal to its price andthe MPP is diminishing, if the firmhires one extra unit of the factor, theVMP will be less than the factor price.This is same as saying that theadditional revenue generated (equalto VMP) is less than the additionalcost incurred (equal to the factorprice). This implies less profit thanbefore. Similarly, if the firm hires oneless unit than where VMP is equal tothe factor price, the VMP will be higherthan the factor price. As a result, therevenue sacrificed (equal to VMP) byhiring one unit less will be more thanthe savings on the total factor cost(equal to the factor price). Thus profitwill be less.

In summary, under diminishingreturns, any deviation from theprinciple (A) will only generate lessprof it . This proves why prof itis maximised when condition (A)is met.

Fig. 7.3 Factor Employment Decision

This condition is perfectly parallelto the profit-maximising condition fora competitive firm, that is P = MC.Indeed the two conditions are two sidesof the same coin. The rationale behindcondition (A) is also parallel to thatbehind P = MC. At L = L0, TVP or totalrevenue is equal to the area 0ACL0. Thetotal factor cost is equal to the area

1 The adjective “gross” is attached, since fixed costs are not deducted. By definition, profit = grossprofit – fixed cost. However, since the fixed costs are given, gross profit is maximised where profit ismaximised and vice versa.


Factor Demand Curve

Note from the preceding discussion thata firm always chooses a point on theVMP curve, and moreover, never at apoint where diminishing returns do nothold. This means that the downwardportion of the VMP curve is the firm’sdemand curve for the factor.2 It alsomeans that a firm’s demand curve for afactor is downward sloping.

Next we examine the determinantsor the sources of shift of the factordemand curve.

7.1.3 Factor Demand Curve Shifts

Since the factor demand curve is a partof the VMP curve, anything that shiftsthe VMP curve shifts the factordemand curve. We consider thefollowing sources of change.

A Change in Product Price

By definition, VMP = P.MPP. Hence anincrease in the product price, P,increases the VMP at any given level offactor employment. As a consequence,the factor demand curve shifts tothe right (or up). This is illustratedin fig. 7.4.

In general then, we can say that anincrease (a decrease) in the productprice shifts the factor demand curveto the right (left).

From this result, we can see a linkbetween product and factor markets.For instance, consider the industry ofa particular handicraft. On thedemand side, the product is sold in

India and abroad. On the supply side,there are artisans, who, with the helpof raw materials and equipment, makethe handicraft. Suppose that in aninternational exhibition this handicraftattracts a lot of attention. Many peopleand organisations around the worldcome to know about it and they like it.Consequently there is an increase indemand for this handicraft. From thedemand-supply analysis in Chapter 5we know the effect: the price of thishandicraft increases.

Now consider the (factor) marketfor artisans. The increase in the priceof the handicraft will shift their VMPcurve and hence the demand curve forartisans to the right.

The general point here is thatfactor demand is, in a sense, derivedfrom product demand. This iswhy, factor demand is said to be aderived demand.

Fig. 7.4 Product Price Increase andFactor Demand

2 This is parallel to the supply curve of a firm being same as the upward sloping portion of the marginalcost curve.


such that the MPP of a factor increases,then the demand curve for thatfactor shifts to the right.Fig. 7.5(a) shows this effect. Otherwise,if the MPP of a factor decreases due toa technological change, then itsdemand curve shifts to the left.Fig. 7.5(b) illustrates this.

For example, it is widely believed byeconomists that, in recent two/threedecades, the whole world economy hasexperienced technological progress thathas increased the MPP of skilled labour.Whether it has increased the MPP ofunskilled labour is not clear.3

7.1.3 Marginal Productivity Theoryof Distribution

So far we have assumed that the firmemploys only one variable factor ofproduction. In reality, firms employmany, e.g., different types of labour,raw materials, power, various kindsof machines, land etc. What are the(profit maximising) principles thatgovern the simultaneous demand/employment of more than one factor?

They are simply the extensions ofthe condition (A). If, for example, thereare two factors, say X and Y, theirrespective prices are WX and WY, andtheir respective marginal products areMPPX and MPPY, the profit-maximisingprinciples are:

(A') VMPX = P.MPPX = WX,

VMPY = P.MPPY = WY.

Fig. 7.5 Technological Change andFactor Demand

Technological Change

A technological change can alter theMPP of a factor and thereby itsdemand curve, even when theproduct price is unchanged. If it is

3 Another possible source of a shift in the factor demand curve, which we have not discussed and whichis something to be done in a higher course in microeconomics, is the change in the employment ofother factors.

(a) Technological Change increasing theMPP of a Factor

(b) Technological Change lowering the MPPof a Factor


That is, profit is maximised whenthe VMP of each factor is equal to itsprice.

Note that even when there is morethan one variable factor, the definitionof MPP remains valid.

Recall, from Chapter 1, the centralproblem of “for whom” facing aneconomy, which concerns who earnshow much. The conditions (A') imply atheory of this, that is, each factorearns the value of its marginalphysical product. It is called themarginal productivity theory ofdistribution.

This theory implies, for example,that skilled workers normally earnmore than unskilled workers, becausethe (marginal) productivity of skilledworkers is greater than that ofunskilled workers.

To see this more exactly, supposethat factor X is skilled labour, factor Yis unskilled labour, WX is the skilled-labour wage and WY is the unskilled-labour wage rate. Both work in thesame sector, and, let P be the price ofthe good produced in that sector. Thenfrom (A´),

...

Y

X

Y

X

Y

X

MPPMPP

MPPPMPPP

WW

Hence, if MPPX > MPPY, then WX >WY.That is, skilled labour earns more thanunskilled labour.

7.2 TOTAL FACTOR DEMAND,FACTOR SUPPLY ANDEQUILIBRIUM

In principle, factor prices should bedetermined by forces of demand andsupply both, not just by demand forcesthat we have emphasised so far.However, when we do take intoaccount the supply side, the marginalproductivity theory does hold, withappropriate interpretation. In order tosee this and analyse factor marketequilibrium in general, let us returnto the one-factor case.

We have derived a single firm’sdemand for a factor. There are manyfirms in a perfectly competitiveindustry. So, if we sum up the demandfor a factor across various firms, weget the total industry demand curvefor that factor.4 However, some factorsare used in many industries and inthat case, the total demand curve for afactor is the horizontal summation ofindividual (firm) demand curves forthat factor in various industriescombined. In Fig. 7.6(a) and (b), thetotal demand for a factor is shown asthe line DD. 5

We now turn to the supply side.Consider, for example, teaching serviceas a factor of production (in producingeducation). If the salaries of schoolteachers increase, more people thanbefore will be willing to choose school

4 The derivation of total demand for a factor is more complicated than the derivation of market demandcurve for a commodity. This complication arises due to a change in the price of the commodity when allfirms increase or decrease their outputs together. To simplify the discussion, the price of the commodityis implicitly kept constant during this summing up.

5 How DD is derived is parallel to how the product market demand curve is derived from individualdemand curves.


teaching as a career. Hence the supplycurve of this factor service is upwardsloping. This is, however, true in the longrun. In the short run, like over a fewmonths or over a year, the supply ofschool teachers in a particular regionwill be given, because teachers’education, training and certificationetc. take years. This is true for almostany type of (relatively high) skill. Theshort run and long run factor supplycurves, denoted by SS, of a particularskill are shown in panel (a) and panel(b) of fig. 7.6 respectively.

The intersection of demand andsupply curves defines equilibrium inthe factor market − similar to whathappens in a product market. In bothpanels, E denotes the marketequilibrium point. The equilibriumwage is denoted by W0, and N0 denotesthe equilibrium amount of theparticular skilled labour that is hired.

Besides different types of labour,a firm hires land, capital etc. Theseare examples of non-human factors ofproduction. Consider for instance thesupply of land. Here land does not justmean a piece of land per se butincludes room, building floors etc. Inthe short run the land supply is given.In the long run it is likely to change.The earning of land is the rent per unitof space. Higher the rent, more landor space will be supplied by land-owners.6 Hence the long-run supplycurve of land is upward sloping also.

Fig. 7.6 Demand, Supply and MarketEquilibrium of a Particular Skill

Thus the land market equilibrium issimilar to that of a particular skill.Fig. 7.6 applies except that “rent”substitutes the “wage rate” and “land”substitutes “labour.”

A point to note here is that, if weinterpret land narrowly in terms ofarea on ground, the supply of land toa particular industry is upwardsloping (in the long run), but landsupply to the entire economy is given.7

6 In the present context this is the “price” of land in terms of its service as a factor of production. It isdifferent from price of land as an asset.

7 There are exceptions. Countries like Japan and Hong Kong have claimed land from sea.

(a) Short Run

(b) Long Run


Capital is also a factor ofproduction. The term capital ineconomics means different things indifferent contexts. Here it means plants,equipment, machinery etc. It is similarto land in that it is non-human. We saythat capital earns rental. If you own anAmbassador car and use it for taxibusiness, then the hourly or daily rateyou charge is an example of capitalearning rental. It is dissimilar toland in that the total capital stock in aneconomy is “reproducible”, i.e. it canbe increased continuously overtime, whereas the total land space isnon-reproducible. In any event, fig. 7.6applies to the market for a particulartype of capital.

There are two general implicationsof our factor demand-supply analysis.A. An increase in demand for a factor

tends to increase its price (byshifting out its demand curve) andan increase in the supply of a factortends to lower its price (by shiftingout its supply curve). By now thisconclusion must be something veryevident to you. It can be applied tovarious sources of shifts and theireffect on factor price. For instance,if there is an increase in thedemand for a commodity, theproduction of which requires aspecific skill (e.g. computer skills),the wage of this skill (e.g. ofcomputer engineers) will increase.A technological change thatimproves the MPP of a factor willenhance its reward.

B. Whichever factor is underconsideration, at the equilibrium

point, from the demand side, thefactor reward is equal to the valueof its marginal physical product.Thus the marginal productivitytheory holds when the marginalphysical product is evaluated atthe equilibrium quantity of thefactor service that is in use.

7.3 TRADE UNIONS

The demand-supply analysis aboverefers to how the price/marketmechanism works in factormarkets. This is parallel to our demand-supply analysis for commodities inChapter 5. In that chapter we also sawthat the government sometimes directlyintervenes in a market and fixes theprice of a product in the form of controlprice and support price.

In the factor market, there is alsoan important example where a factorprice is not determined by the market.You might have heard of workers’organisation in various sectors of theeconomy called trade unions or labourunions. These unions voice grievancesof workers in a collective way.Sometimes they organise strikes andboycott work for days and weeks. Veryoften they also try to bargain for higherwages than the employers are willingto offer. Sometimes they succeed innegotiating a wage rate, which is higherthan what the equilibrium wage ratewould have been in the labour market.

What effect does this “wage-fixing”by trade unions have on the labourmarket? Turn to fig. 7.7, where Lsdenote the total number of workers.This is the supply curve of labour. The


demand curve for labour is denoted byLD. If there were no trade unions, theintersection of the labour supply andlabour demand curves would havedetermined the market wage rate. In thediagram, W0 would have been marketwage. Now suppose that the tradeunion fixes the wage at W1, which ishigher than W0. As a result, the firmswill demand less labour, which isindicated at the point D1 on the labourdemand curve, or equivalently, at thepoint L1 on the horizontal axis. Whatwe see now is that there isunemployment of labour; L1Ls

measures the number of workers whoare unemployed.

Fig. 7.7 Trade Unions and Unemployment

Thus, unemployment sometimesmay be caused by the presence of tradeunions.

SUMMARY

� A factor service is demanded by firms and supplied by households.

� Factor price is determined by forces of demand and supply of a factor.

� For a competitive firm, the VMP curve of a factor is generally inverseU-shaped. This is because of the law of diminishing returns.

� For a competitive firm, TVP of a factor is equal to the area under its VMPcurve.

� The total factor cost or payment to a factor is the area under the factorprice line.

� For a competitive firm, profit maximisation occurs when each factor ispaid its VMP.

� The demand curve for a factor is essentially the downward sloping portionof its VMP curve.

� An increase in the product price shifts out the demand curve of a factor.In this sense, the demand for a factor is “derived demand.”


� The MPP of a factor and hence its demand curve can shift because oftechnological changes.

� Marginal productivity theory implies that different factors are paiddifferently because of differences in their VMPs.

� Skilled labour is paid more than unskilled labour because the marginalproduct of former is higher than that of the latter.

� The total demand curve for a factor is the horizontal summation ofindividual (firm) demand curves for that factor.

� The supply curve of a factor is upward sloping in the long run, but it maybe vertical in the short run.

� Capital, as a factor of production, is different from land in the sense that,unlike land, it is typically reproducible.

� An increase in the demand for a factor tends to increase its price, while anincrease in the supply of a factor tends to lower its price.

� When a labour union fixes a wage above the market-clearing wage,unemployment results in the labour market. It is because, at a higherwage rate, firms employ less labour, while the supply of labour by workersmay increase or remain unchanged.

EXERCISES

Section I7.1 Who are the demanders in the factor markets?7.2 Who are the suppliers in the factor markets?7.3 To which central problem does the problem of factor pricing relate

to?7.4 How are TVP and TPP of a factor related?7.5 How are VMP and MPP of a factor related?7.6 What is the difference between MPP and VMP of a factor?7.7 How is the TVP of a factor derived from its VMP curve?7.8 What happens to TVP of a factor when its VMP is positive?7.9 What happens to TVP of a factor when its VMP is negative?

7.10 How is the total payment to a factor derived from the factor priceline?

7.11 What is the relationship between the VMP curve and the factordemand curve?

7.12 Name two factors responsible for a shift in the factor demand curve.7.13 What is the relationship between the wage rate that a labour union

typically fixes and the equilibrium wage rate?


Section II7.14 The TVP at the employment level L = 4 is 50 units. That at L = 5

is 65 units. The price of the product is Rs. 3. What is the MPP atL = 5?

7.15 The product price is Rs. 5. The TPP schedule of a factor is givenin the following table. Derive its VMP schedule.

Employment of a Factor TPP (units)

0 0

1 8

2 20

3 32

4 42

5 50

6 56

7 60

8 62

7.16 The total payment to a factor is Rs. 12,000. The price of thefactor is Rs. 40. How many units of that factor are beingemployed?

7.17 Suppose that the product price is Rs. 10 and a factor is paidRs. 70 per unit. The law of diminishing returns holds. At somelevel of employment, MPP = 5. Show that, at this level ofemployment, profit is not being maximised. Should the firmincrease or decrease employment in order to increase itsprofits?

7.18 Explain why a factor demand is called “derived demand.”7.19 What does the marginal productivity theory of distribution say

about the earnings of different factors?7.20 Explain why skilled workers earn more than unskilled workers.7.21 How does an increase in the supply of a factor affect its earning

(price)?7.22 Unfortunately an earthquake hits a town and destroys many

residential flats, which were used for renting. All other things


remaining unchanged, will this affect the demand curve or thesupply curve of residential flats for rent and how? How will itaffect the rental rate per month?

7.23 Suppose that technological advance takes place in such a waythat the MPP of skilled labour increases. How will it affect thewage of skilled labour? Further suppose that the technologyadvance lowers the MPP of unskilled labour. How will it affectthe wage of unskilled labour?

Section III7.24 Explain how profit is maximised when the VMP of a factor is

equal to its price.7.25 Explain why, under perfect competition, the VMP curve for an

input is considered its demand curve.

COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE AND FACTOR MOBILITY 137

In previous chapters we studied howproducers and households interact with eachother in product and factor markets. We canthink of such interaction as “trade” betweenproducers and households, in the sense thateach party has something to offer to theother. Not only producers and consumerswithin a country trade with each other, thecountries themselves, i.e., consumers andproducers across countries, trade/exchangewith each other in goods and services. Thisis called international trade. As an exampleof trade in goods, India exports tea to therest of the world and imports petrol. Manyforeign banks today offer banking servicesin India, which is an example of trade inservices.

In this chapter, our objective is to learnsome fundamentals of international trade.This is very important, because countries, ingeneral, are much more interdependent todaythan they were 30 or 40 years ago.

In the process, we learn a very importantconcept in economics, called comparativeadvantage. Through this concept, we willunderstand that promoting internationaltrade is not a bad thing, and, it is not truethat, if one country gains from it, some othercountry has to lose. On the contrary, we will

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CHAPTER 8

•

8.1 Ricardo's Theory ofComparative Advantageand Benefit from Trade

8.2 Factor EndowmentTheory of InternationalTrade

8.3 Factor Mobility

••


learn that trading with each other is,by and large, a mutually beneficialactivity.

The idea behind comparativeadvantage (to be defined in Section 8.1)and gains from trade can beunderstood through this example.Suppose that you are a very good popsinger and a very good cook. But youare much more productive as a singerthan as a cook. This is in the sensethat if you sing you get Rs. 5,000 perhour, whereas you can hire anexcellent cook at the rate of Rs. 300per hour, i.e., if you cook, you saveRs. 300 per hour. One option for youwill be to pursue a singing career andstill cook for yourself – be “self-sufficient”, so-to-speak. That is, youare capable of doing both and youactually choose to do both. Considernow the alternative option of hiring acook and engaging yourself full timein singing. Which option will youprefer? Surely, the latter. Now thinkabout this example in a different light.The option to do both activities is likechoosing not to do trade between yourservice as a cook and your service asa singer. The latter option is likeimporting the service that you do nothave comparative advantage in (thatis, cooking) and, specialising andexporting the service you havecomparative advantage in (that is,singing).

What applies for an individual inthe above example also applies to acountry. A country, in comparisonto producing all goods it can produceand not trading, is better off by

(a) producing more of the goods whichit can produce relatively cheaply andexporting part of them and (b)producing less – possibly none – of thegoods which it cannot producerelatively cheaply compared to othercountries and importing them. This isthe idea behind comparativeadvantage. Put differently, it impliesthat countries can trade and benefitby exploiting their differences. Insimpler language, it means that youand I are different, I have somethingwhich you want but cannot obtain thateasily, and you have something that Iwant but cannot get that easily;both are better off by trading witheach other.

This principle was firstdemonstrated formally by a famousEnglish economist, named DavidRicardo. In what follows, we firstdiscuss Ricardo’s theory ofcomparative advantage. It is thesimplest and yet a very elegantexposition of how international tradecan be beneficial to a country.Although Ricardo wrote about italmost two hundred years ago (in theearly 19th century), its relevance is felteven today.

As we will see, Ricardo’s theory ofcomparative advantage and trade isbased on differences in technologyacross countries. We also consideranother source (basis) of comparativeadvantage, namely, differences infactor supplies across countries. Thenext two sections study thesealternative sources of comparativeadvantage.


In terms of concepts introduced inChapter 3, the average physicalproduct of labour is the inverse of thelabour coefficient. Thus, labourcoefficient being given means constantaverage physical product of labour orconstant output per worker.1

We are almost ready to definecomparative advantage.

8.1.1 Absolute Advantage andComparative Advantage

Between two countries, one is said tohave absolute advantage in a good ifit can produce that good absolutelymore efficiently than the other country.A country is said to have comparativeadvantage in a good if it can produceit relatively more efficiently or relativelyless inefficiently, compared to theother country.

We now apply these definitions toTable 8.1 and say that India hasabsolute advantage in producing bothgoods, and Australia in none. Because,in the production of either good, labourrequired to produce one unit is lessin India than in Australia. Moreimportantly for us, let us determine who

International trade refers tomovement of goods and services. In thereal world, not only goods and services,but also factors of production movefrom one place to another. The chapterends with a discussion of movementof factors.

8.1 RICARDO’S THEORY OFCOMPARATIVE ADVANTAGEAND BENEFIT FROM TRADE

We will make a number of simplifyingassumptions so as to clearly bring outthe essence of this theory. Assume thatthere are two countries in the world:India (N) and Australia (A). Each canproduce two goods, say, cricket batsand footballs. Perfect competitionprevails in the market for each good.There is one factor of production, say,labour (L). Each country is endowedwith a given supply − or what is calledendowment − of labour, say LN = 100and LA = 120 respectively for India andAustralia. Furthermore, the labourrequired to produce one unit of output,or what is called the labour coefficient,is given in each sector. As a numericalexample, suppose that

• Producing 1 cricket bat in Indiarequires 10 units of labour

• Producing 1 football in Indiarequires 20 units of labour

• Producing 1 cricket bat in Australiarequires 15 units of labour.

• Producing 1 football in Australiarequires 60 units of labour

1 In turn, this means constant marginal physical product of labour.

This is written more compactly inTable 8.1.

Table 8.1 Labour Coefficients

India Australia

Cricket Bats 10 15

Footballs 20 60


has comparative advantage in what.See that, in India, the labour coefficientratio of the football sector to the cricketsector is 20/10 = 2, whereas, inAustralia, the same ratio is 60/15 = 4.Hence, in India, labour is relatively moreproductive or efficient in the footballsector. Therefore, India, hascomparative advantage in producingfootballs. Although Australia is lessefficient in producing both goods, it isrelatively less so in producing cricketbat. Hence Australia has comparativeadvantage in producing cricket bats.

By definition, both countries cannothave comparative advantage inproducing the same good.

8.1.2 Production Possibility Curves

Given the labour coefficients and thelabour endowment in each country, wecan draw the Production PossibilityCurve (PPC) for each country. This willserve as a background to analysinghow international trade affects aneconomy.

Recall from Chapter 1 the conceptof marginal opportunity cost along aPPC. It says how much of one good hasto be sacrificed to ensure a unitincrease in the production of the other.Consider India for instance. Suppose,starting from a given allocation oflabour between the football sector andthe cricket bat sector, the productionof football increases by one unit. FromTable 8.1, this requires additionallabour equal to 20 (since this is labourcoeffcient in producing football). As 20units of labour leave the cricket batssector to produce one extra football, by

how much will the production of cricketbats fall? It is equal to 20 divided bythe labour coefficient in producingcricket bats (that is, 10). This gives20/10 = 2 cricket bats as the marginalopportunity cost of football.

Note that the marginal opportunitycost of football is constant (equal to 2cricket bats) at any initial allocationof resources, because the labourcoefficients are constant. You cansimilarly calculate that cost inAustralia, which is also constant,equal to 60/15 = 4. Thus labourcoefficients being given imply that themarginal opportunity cost of eithergood along the PPC is constant. In turn,from Chapter 1, we know that constantmarginal opportunity cost implies astraight line PPC. Hence the PPC is astraight line in a Ricardian economy.

Fig. 8.1 shows the PPCs of India andAustralia. Recall that India’sendowment of labour is 100, i.e.,LN =100. If all its labour resources areused in producing football, they willproduce 100/20 = 5 footballs. If,instead, they are all used in producingcricket bats, they will produce100/10 = 10. These points arerespectively marked on the football axisand cricket bat axis in fig. 8.1(a). Thestraight line, DE, joining these twopoints is the PPC of India. The PPC ofAustralia, GH, is derived in a similarmanner, which is shown in fig. 8.1(b).

8.1.3 No Trade

In order to see how international trademakes a difference, suppose thatinitially there is no trade between the


two countries. There are four importantpoints to note for the world economy,in which there is no trade.1. Since there is no opportunity to

trade, in each country, theconsumption of a good cannotexceed how much of that good isproduced. In other words, theconsumption possibilities arelimited to the PPC, i.e., the countrycannot consume at any pointoutside its PPC. We can say thatthe PPC is equal to a country’s“consumption possibility curve”. Inour example, it is DE for India andGH for Australia.

2. It will also be useful to know therelative price of one good in termsof the other in each country. Whatdo we mean? Recall that bothgoods are produced in competitivemarkets. From Chapter 6, we knowthat, under perfect competition,free entry and exit imply zero profits.

Thus, in each sector, price will beequal to the average cost. In thiseconomy, the average cost of a goodis equal to the wage rate times thelabour required to produce one unitof the good. For example, let WN bethe wage rate in India. Then theaverage cost of, say, football is Rs.WN × 20. This will be equal to theprice of football, say PF. Similarly, PC

= Rs. WN ×10, where PC is the priceof cricket bats. Thus the relativeprice of football is equal to PF/PC =WN × 20/(WN × 10) = 2. That is, ifyou have a football, sell it in themarket and use the money to buycricket bats, you will get 2 cricketbats. The relative price of cricketbats is the inverse of that offootball, equal to 1/2. In general,the relative price of a good isdefined in terms of some other goodand is equal to the amount of the

Fig. 8.1 The Production Possibility Curves

(a) India (b) Australia


other good that one gets inexchange for one unit of the goodin question. Put differently, it is anexchange ratio between goods. Wethen have the exchange ratio inIndia in the no-trade situationequal to 2 cricket bats for 1 football.You can similarly calculate the

exchange ratio in Australia:4 cricket bats for 1 football.We can call these the domestic

exchange ratios.3. Notice that the relative price of a

good in each country is equal toits marginal opportunity cost (asprice is equal to marginal costunder competitive conditions). InAustral ia for example, therelative price of football is 4cricket bats and the marginalopportunity cost of football isalso 4 cricket bats.

4. Also notice from the exchangeratios that football is relativelycheaper in India, which hascomparative advantage inproducing football, and cricketbats are relatively cheaper inAustralia, which has comparativeadvantage in producing cricketbats. This is intuitive.The stage is ready now to

understand the effect of internationaltrade.

8.1.4 Effect of International Trade

Let India and Australia now open uptrade. Further, let there be “free” trade,i.e., no restrictions like trade taxes orany limits on how much a country can

export or import etc. Also, assumethat there is no transport cost ofmoving goods between the twocountries. (We make these strongassumptions, not because they arecritical for our argument, but becausethey help us to see the effect of tradevery clearly.)

The above assumptions imply thatthe exchange ratios or the relative priceof a good will be the same in the twocountries. It is because, if a good ischeaper in one country than in theother, every one in both countries willbuy the product from the formercountry and this will push its price up.In equilibrium, the exchange ratios willbe the same. We can call this the worldexchange ratio or what is called theworld terms of trade.

Range of World Terms of Trade

The next question is: what will be theequilibrium world terms of trade?Terms of trade, in general, refer to arelative price and we know fromChapter 5 that the equilibrium priceof a good is determined by supply anddemand forces. The supply side of aneconomy is represented by the PPC ofa country. But we do not have anyinformation on the demand side.Hence, we cannot determine the worldterms of trade exactly.

We can, however, find its range: itwill lie in between the domesticexchange ratios. In this example, itmeans that the world relative price offootball will be in between 2 and 4cricket bats. It cannot exceed 4 or fallshort 2. Why? Suppose it exceeds 4, say


football only. Mark that football is thegood, in the production of which Indiahas comparative advantage. By similarargument, Australia specialises incricket bats, in which it hascomparative advantage. Specialisationoccurs as the world terms of trade aredifferent from the domestic exchangeratio. This is shown in fig. 8.2, whichgraphs the same PPCs as in fig. 8.1(shown by the dashed lines). India’sand Australia’s production points infree trade are shown at points D andH respectively.

We can then summarise that in theRicardian world economy, as long asthe world terms of trade differ from thedomestic exchange ratio, a tradingcountry specialises in the good, in theproduction of which it has comparativeadvantage. This is how internationaltrade affects production and resourceallocation in an economy.

Consumption Possibilities

Now we come to the last stage of ourdiscussion. What are the consumptionpossibilities facing the two countriesand how do they benefit from trade? Butbefore we address this question, weshould know what we mean by exportsand imports. Exports of a commodityare equal to its production minus itsconsumption, whereas imports of acommodity are equal to itsconsumption minus its production. Inother words, if a good is exported(imported), then its production exceeds(falls short of) its consumption in thecountry.

1 football for 5 cricket bats. Then, inboth countries, a football fetches morethan it fetches in the no-trade situationand thus both would like to exportfootball. But this is not possible, sincethere is no third country they can bothexport to: by definition, the twocountries comprise the world economy.(When there are more than twocountries, you can group them into the“home” country and “the rest of theworld” and the same argument holds.)You can similarly argue that if the worldterms of trade are 1 football forsomething less than 2 cricket bats, bothcountries would want to import footballand that is not possible. This provesthat the equilibrium world terms oftrade will lie between the domesticexchange ratios. Assume that the worldterms of trade lie strictly in betweenthe two domestic exchange ratios. Asan example, suppose that they areequal to

1 football for 3 cricket bats.

Specialisation

Now think about how much of eachgood will be produced in the twocountries. From the viewpoint of India,the relative price of football is 3 cricketbats, which is greater than its themarginal opportunity cost (equal to 2cricket bats). This will mean that thereare abnormal profits in the footballsector. Hence resources (labour) willmove out of the cricket bat sector tothe football sector. This process willcontinue until there is no productionof cricket bats in India. That is, India“specialises” in football, i.e. produces


In fig. 8.2, since India produces atD, one consumption possibility for heris the point D itself. But there are otherpossibilities. For instance, it can exportone football in exchange for 3 cricketbats (all imported), or 2 footballs inexchange for 6 cricket bats (allimported) and so on. Thesepossibilities give rise to the heavy lineDE', whose slope is 3, equal to therelative price of football in the worldmarket.2 Put differently, theconsumption possibility curve for Indiaat the world terms of trade, equal to 1football for 3 cricket bats, is the heavyline DE'. This situation is surely abetter proposition for India than notrade, which only offered theconsumption possibilities along the PPC

that lies to the left of or “inside” the lineDE'. Alternatively, you can see that forevery possible consumption point in theno-trade situation, e.g., A, except thecorner points on the PPC, there is at leastone point on DE', which guaranteesmore consumption of each good. Hence,free trade must be preferred to no trade.

By similar argument, Australia’sconsumption possibility curve is nowthe heavy line G'H, whose slope is alsoequal to 3, the relative price of footballin the world market. The line G'H liesoutside Australia’s PPC. ThusAustralia also benefits from free trade.

Note that, irrespective of whichconsumption points on DE' and G'H arechosen, India exports footballs andAustralia exports cricket bats. That is,

Fig. 8.2 Free International Trade in the Ricardian Economy

2 The concept of slope of a straight line is explained in Appendix 2.

(a) India (b) Australia


each country exports the good ithas comparative advantage in. Thisis a very general principle ofinternational trade.

The lesson to be learnt from theRicardian theory is that a countrybenefits from international trade byspecialising and exporting theproducts that it has comparativeadvantage in. This is true even whena country is more efficient inproducing all goods in an absolutesense.

8.2 FACTOR ENDOWMENT THEORYOF INTERNATIONAL TRADE

In the Ricardian theory, it is thedifference in technology that formsthe basis of comparative advantageand mutually beneficial trade.Otherwise, if the ratio of labourcoefficients is the same between thetwo countries, then the domesticexchange ratios will be the same; nocountry will have comparativeadvantage in producing any goodand there will be no reason to trade.Even if international trade is openedbetween the two countries, nothingwill change in any country.

However, technology differences arenot only basis for comparativeadvantage and trade. Differences inrelative factor endowment (to be definedin a moment) form another major basisfor comparative advantage. The theory

that brings out this point is called thefactor endowment theory.3

View the world as having twocountries once again, say, India (N) andAmerica (A). They produce two goods:Chairs (C) and Medicine (M). Instead ofone factor of production, suppose thatthere are two, labour and capital. Theyare required in producing each of thesetwo goods. There are constant returnsto scale. Furthermore, the technologyof producing either good is samebetween India and America and theproduction of chairs is relatively labour-intensive and that of medicine isrelatively capital-intensive.4 All marketsare perfectly competitive.

Suppose that the supply of eachfactor in each country is given. We cancall these factor endowments, just likelabour endowment in the Ricardiantheory.

8.2.1 Factor Endowment Difference

Let LN and KN denote the endowmentsof labour and capital in India.Likewise, let LA and KA denote theendowments of labour and capital inAmerica. These are absolute factorendowments. The ratio of absoluteendowments is called the relativefactor endowment. For example,LN/KN is the relative endowment oflabour in India.

Having defined relative endowment,we can always compare it betweencountries. In our example, we say that

3 It was formulated originally by two Swedish economists, Eli Heckscher and Bertil Ohlin, and iscalled the Heckscher-Ohlin theory.

4 It is not that the technology cannot differ between countries. But the idea here is to suppress suchdifference and focus on difference in factor endowments.


India is the relatively labour-abundantcountry and America is the relativelycapital-abundant country, if

.)(A

A

N

N

KL

KL

A 5

Let us assume this, since it isreasonable to suppose that India is arelatively labour-abundant country,compared to America.

8.2.2 Factor Price Difference

What does this difference in relativefactor endowment imply for factorprices? We first define two terms:absolute factor price difference andrelative factor price difference. Ingeneral, we say that there is anabsolute factor price dif ferencebetween two regions or countries if thereward (price) of a factor dif fersbetween the two regions or countriesin absolute terms. For instance, iflabour earns wage equal to Rs. 50 perday in India and Rs. 200 per day inAmerica, we say that there is anabsolute wage difference and the wagerate is less in India than in America.Similarly, there can be an absolutedifference in the rental rate of capitalbetween the two countries.

Given our ranking of the relativeendowment in (A), can we say anythingabout absolute factor price differencesbetween India and America? Theanswer is no, because the ranking (A)does not say anything about absoluteendowment levels. But it can say

something about relative factor pricedifference, where relative factor price isdefined as the ratio of factor rewards.

Suppose that, in America, labourearns wage equal to Rs. 200 and capitalearn rental equal to Rs. 1,000. In India,let the wage rate and the rental tocapital be Rs. 100 and Rs. 900respectively. Thus, the two absolutefactor rewards are less in India. But,relatively speaking, the wage/rentalratio is greater in America. It is 1/5 thereand 1/9 in India. In this case, we saythat relative reward (price) of labour isgreater in America and the relativereward of capital is greater in India.Indeed, our relative factor ranking (A)implies this. How?

Our analysis of factor pricedetermination in Chapter 7 comes intoplay. Let us invoke a result from thatchapter which states that, greater thesupply of a factor, the lower is its reward.In the present context, it implies that,since India (respectively America) isrelatively labour – (respectively capital)–abundant, the wage/rental ratio in Indiawill be less than that in America. Inother words, India is the relatively low-wage country and America is therelatively high-wage country.

8.2.3 Comparative Advantage

We now proceed to analyse how thedifference in the relative factorendowment and the resultingdifference in the relative factor pricedetermine the flow of goods between the

5 For example, let LN = 1, 500, KN = 500, LA=2,000 and KA = 1000. Then LN/KN = 3, LA/KA = 2, and thusLN/KN>LA/KA.


two countries. Ask yourself which goodwill be produced more efficiently (i.e.with lower cost) in the low wage/rentalratio country and in the high wage/rental ratio country. Remember that theproduction technology of chairs (C) islabour-intensive and that of medicines(M) is capital-intensive. The answer isthat the labour-intensive good C will beproduced relatively more efficiently inthe relatively low-wage, labour -abundant country, and, the capital-intensive good (M) will be producedrelatively more efficiently in the relativelyhigh-wage, capital-abundant country.

We can state this in terms ofcomparative advantage. The relativelylabour-abundant, low wage/rentalratio, country (India) will havecomparative advantage in producingthe relatively labour-intensive good.The relatively capital-abundant, highwage/rental ratio country (America)will have comparative advantage inproducing the relatively capital-intensive good.

8.2.4 International Trade

Thus far we have linked relative factorendowment difference and relativefactor price difference to comparativeadvantage. We next link comparativeadvantage to international trade:i.e.,compared to no trade, in free trade,a country will produce more andexport the product, in which it hascomparative advantage.

Joining the two links now, we cansay that the relatively labour-abundant,low wage/rental ratio, country (India)will export the relatively labour-

intensive good (chair) and therelatively capital-abundant, highwage/rental ratio, country (America)will export the relatively capital-intensive good (medicine). This is howthe relative factor endowment differenceand the relative factor price differenceare linked to international trade.

You can reflect back to see that theaforementioned result is quitereasonable. This is the gist of the factorendowment theory. It emphasisesrelative factor endowment differenceas the basis of comparativeadvantage and predicts that a countrywill export those products which usesits relatively abundant factor moreintensively.

Three remarks are in order.1. Unlike the material in previous

chapters and our discussion of theRicardian theory, the factorendowment theory has beenmerely sketched. A specialisedcourse in international economicswill deal with this theory in moredetail.

2. In Chapter 7, we learnt that thedemand for a factor is called aderived demand. This is becausechanges in product markets affectthe demand for a factor. Incontrast, the factor endowmenttheory illustrates how factor marketdifferences influence the productmarket − the pattern of flow of goodsbetween countries. Thus, a generaland an important point to be learntis that, in an economy, factor andproduct markets are very muchinterrelated.


3. Recall the central prediction of thefactor endowment theory. In ourexample, India, the relativelylabour-abundant country, exportsrelatively labour-intensive goodsand America, the relatively capital-abundant country exportsrelatively capital-intensive goods.We can look at this conclusion in adifferent light. India exportingrelatively labour-intensive goodscan be thought of as Indiaexporting the “services” of labour.Likewise, America exportingrelatively capital-intensive goodsmeans that America is exportingcapital services. Put differently,international trade in goods can beseen as international trade in factorservices. This again shows howinterrelated goods and factormarkets are; it is as if factors aremoving internationally, althoughthey are not (in our analysis).

8.3 FACTOR MOBILITY

The very last point made brings us tothe very last topic to be analysed inthis book. That is, factors do movebetween regions and countries. In ourcountry daily labour moves typicallyfrom villages to towns. There arethousands of workers from India whoare working in middle-east countrieslike Kuwait and Yemen.

These are not the only instancesof mobility. Unskilled labour movesfrom Mexico to America. Skilledworkers move typically from countrieslike India and China to Europe andAmerica.

We now ask why factors move theway they do? Here, unlike in the factorendowment theory, the absolute factorprice difference (already defined) playsa role. As an example, we have alreadynoticed that in India daily labourmoves from rural to urban areas. Whyis this so? Because, there is anabsolute factor price difference. Givensuch a difference, a factor moves fromthe low-reward region to a high-rewardregion. Daily labour earns more in anurban area on an average than in arural area on an average. This inducesit to move from rural to urban areas.

However, the absolute factor pricedifference or in this case the rural-urban wage differential, is just animmediate cause of factor/labourmigration, not the underlying cause.This chapter − and the book − endswith an investigation of why a rural-urban wage differential exists.

We can think of this issue in termsof demand and supply of a factor,studied in Chapter 7. Indeed there aredifferences in both demand and supplysides, which explain the rural-urbandifference in daily wage.

First, there are more nucleusfamilies, as opposed to joint families,in urban areas than in rural areas. Inmany urban households, bothhusband and wife work outside thehome. Hence there is a greater demandfor household services like cleaning,cooking etc. Also, construction worksare more prevalent in urban than inrural areas. Both these factors implyhigher demand for daily labour inurban areas, compared to rural areas.


Second, the urban cost of living ishigher than the rural cost of living, sothat families of many daily workersprefer to live in rural areas. Thisimplies that, ceteris paribus, thesupply of daily labour in towns is lessthan in villages.

Both these factors together implythat the urban wage must be higher.We can see this in terms of fig. 8.3.There are two demand curves. The oneto the right, DDB, can be interpretedas the demand curve for daily labourin the urban area and the one to theleft, DDR, can be thought of as that inthe rural area. There are also twosupply curves. The one to the left, SSB,marks the supply curve in the urbanarea and the one to the right, SSR,marks that in the rural area. Theurban labour market equilibrium isshown at the point EB where DDB andSSB intersect. Likewise, the labourmarket equilibrium in the rural areaoccurs at the point ER where the curvesDDR and SSR intersect. As we can seeclearly, the urban wage, WB is greaterthan the rural wage, WR.

Once we establish that there is anabsolute difference in wages, it is easyto predict that labour wants to movefrom a low-wage region to a high-wageregion.

We note that this is true not just forunskilled labour but also for skilledlabour. Skilled workers want to moveout of countries like India and Chinato the U.S. and Europe in order to earnhigher wage for their skill. Similarly,capital, which earns less rental incapital-abundant developed countries,has an incentive to move (throughmultinational firms) to capital-poor,high-rental, developing countries.

We should carefully note howeverthat absolute factor price difference isonly an immediate cause − or anindicator − of factor movement.Regional differences or differencesbetween countries in demand andsupply conditions of factors are theunderlying cause of factormovement.

Fig. 8.3 Urban and Rural Wage for DailyLabour

SUMMARY

� The principle of comparative advantage implies that countries can benefitfrom trade by exploiting their differences.

� In the Ricardian theory, differences in technology form the basis ofcomparative advantage.

� Average physical product a factor is the inverse of its coefficient.


� In the Ricardian economy, constant labour coefficients imply that themarginal opportunity cost of a good, in terms of the other along the PPC,is constant. This in turn implies that the PPC is a straight line.

� In the absence of trade, a country’s PPC is same as its consumptionpossibility curve.

� The world terms of trade lie in between the domestic exchange ratios.� In the Ricardian economy, a country specialises, in free trade, in the good

in which it has comparative advantage, as long as the world terms oftrade are different from the domestic exchange ratio.

� In the Ricardian economy, as long as the world terms of trade are differentfrom the domestic exchange ratio, the consumption possibility curve infree trade lies outside its PPC.

� The Ricardian theory illustrates that a country benefits from internationaltrade by specialising and exporting the products that it has comparativeadvantage in. This is true even when a country is more efficient inproducing all goods in an absolute sense.

� The differences in relative factor endowment also form a basis ofcomparative advantage. This is captured by the factor endowment theory.

� A difference in the relative factor endowment causes a difference in therelative factor price.

� A relatively labour – (capital–) abundant country will have comparativeadvantage in relatively labour – (capital–) intensive goods.

� Factor endowment theory of trade predicts that a country will export theproducts which use its relatively abundant factor more intensively.

� This prediction can also be interpreted as that a country exports theservices of its relatively abundant factor and imports the services of itsrelatively scarce factor.

� Absolute factor price difference is the immediate cause, not the underlyingcause, of factor mobility. In turn, absolute factor price difference arisesbecause of variations in demand and supply factors in respective regions.

� Compared to rural areas, in urban areas, the daily wage rate is higher.This is because of greater demand for daily labour and less supply ofdaily labour in the urban areas.

� The greater demand for daily labour in urban areas stems from higherdemand for household work and construction projects. Higher cost ofliving in urban areas implies less supply of daily labour in these areas, asfamilies of many daily workers prefer to live in rural areas.


EXERCISES

Section I8.1 What is meant by international trade?8.2 Give one example of international trade in services.8.3 What is meant by labour coefficient?8.4 Give the meaning of absolute advantage.8.5 Give the meaning of comparative advantage.8.6 What does the Ricardian theory emphasise as a basis of

comparative advantage?8.7 In the Ricardian theory, which good does a country specialise

in free trade?8.8 In the no-trade situation, what is the relationship between a

country’s PPC and its consumption possibility curve?8.9 In the Ricardian theory, in the free-trade situation, what is the

relationship between a country’s PPC and its consumptionpossibility curve?

8.10 What does the factor endowment theory emphasise as a basisof comparative advantage?

8.11 What is meant by relative factor endowment difference?8.12 What is meant by relative factor price difference?8.13 What is meant by absolute factor price difference?

Section II8.14 Give two examples of international trade in services.8.15 Explain the concept of comparative advantage by using a

suitable example.8.16 Explain that, in a two-country Ricardian world economy, both

countries cannot have comparative advantage in producing thesame good.

8.17 Explain how, in the Ricardian world economy, constant labourcoefficients imply that the PPC is a straight line.

8.18 In an economy, there is one factor of production, labour. Twogoods are produced: sitar and guitar. 5 units of labour isrequired to produce one sitar and 12 units of labour is requiredto produce one guitar. Determine the domestic exchange ratiobetween sitars and guitars in this country.

8.19 The following table gives labour coefficients in the two sectorsin two countries. Determine which country has absoluteadvantage and comparative advantage in which good.


8.20 Refer to the previous question. Suppose technological progressoccurs in Popland. As a result, the labour coefficients are now40 and 30 respectively for the sitar sector and the guitar sector.Determine which country now has absolute and comparativeadvantage in which good.

8.21 A Ricardian economy can produce two goods: tooth brush andshoe brush. The labour coefficients in these two sectors arerespectively 30 and 90. Its labour endowment is equal to 1,800.If the world terms of trade facing this country are 1 tooth brushfor 4 shoe brushes, determine how many tooth brushes andshoe brushes this country will produce in free trade.

8.22 Differentiate (with example) between a capital-intensive goodand a labour-intensive good.

8.23 Explain absolute factor price difference. Why may it arise?8.24 Explain relative factor price difference. Why may it arise?8.25 Name two commodities which are relatively labour-intensive in

production.8.26 Name two commodities which are relatively capital-intensive in

production.8.27 Name two relatively labour-abundant countries.8.28 Name two relatively capital-abundant countries.8.29 The world consists of two countries: Blueland and Yellowland.

There are two factors, labour and land. They produce twogoods, apples and grapes. The production of apples is relativelymore land intensive compared to grapes. Suppose theendowments in the two countries are as given in the followingtable. If both countries engage in free trade with each other,determine which country will export what.

Popland Rockland

Sitar 50 60

Guitar 60 50

Blueland Yellowland

Labour 50 60

Land 70 140

8.30 Give two instances where factors are mobile.8.31 Name two labour-intensive commodities in India.


8.32 Suppose the supply of workers for household services declinesin the economy. How will it affect the urban and rural wage forthese services?

Section III8.33 Explain why a relatively labour-abundant country will export

relatively labour-intensive goods.8.34 Analyse why daily wage is higher in urban areas than in rural

areas.8.35 Suppose that many of our computer professionals migrate to

foreign countries. Ceteris paribus, how will it affect the salaryof computer professionals in India and abroad?