MICRO ECONOMICS BY SUMAN MADAM

INTRODUCTION TO ECONOMICS

WHAT IS ECONOMICS?
Various definitions of economics can be grouped together under four heads:
Wealth definition
Welfare definition
Scarcity definition
Growth definition

Economics as a science of wealth:

Pioneers of the science of economics defined it as a science of wealth.
Adam Smith who is known as father of economics named his famous book on economics as “An
enquiry into the nature and causes of wealth of nations.” Thus according to Adam Smith,
Economics enquires into the causes that determine the wealth of a country and its growth.
According to J B Say Economics is a science which deals with wealth.
According to F A Walker,” Economics is the name of that part of knowledge which relates to
wealth.
Critical Evaluation of the wealth definition:
It ignored immaterial things such as education, health etc outside the definition of wealth and
therefore beyond the bounds of economics wealth.
It ignored many aspects of economics like welfare and social justification.
They also showed a biased attitude by regarding rights to private property or wealth as natural
and moral rights.

Economics as a science of material welfare:

Marshall pointed out that wealth is not an end in itself; but it is only a means to an end; end
being promotion of human welfare. Thus, according to Marshall, wealth is only a secondary
thing; it is man and his ordinary business of life which is the primary object of economic study.
According to Alfred Marshall,” Economics is the study of mankind in the ordinary business of
life. It examines that part of individual and social action which is most closely connected with
the attainment and with the use of the material requisites of well being. Thus, it is one side the
study of wealth and more important side a part of study of the man.
According to A. C. Pigou’” The range of our enquiry becomes restricted to that part of social
welfare that can be brought directly or indirectly into relation with the measuring rod of
money.”
According to Cannan’ “The aim of political Economy is the explanation of the general causes on
which the material welfare of the human being depends.”
Critical Evaluation of the Welfare Definition:

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Economics studies not only material things but also non material things.
Welfare is a subjective thing and varies person to person.
Goods like liquor, opium and cigarettes etc are harmful to health but are studied in economics
as they are scarce in relation to demand for them.

Economics as a science of Scarcity:

Robbins gave a more scientific and correct definition of Economics in his famous book, “Nature
and Significance of Economic Science” which he brought out in 1931.
According to Robbins,” Economics is the science which studies human behavior as a
relationship between ends and scarce means which have alternative uses.”
Critical Evaluation of Scarcity Definition:
1. Robbins defined economics as neutral between ends and declaring economists to be
least bothered about values and welfare.
2. Robbins’ definition of economics does not cover the aspects of economic growth and
economic development.
3. Problem of unemployment is not a problem of scarcity but a problem of abundance of
manpower.
4. It has reduced the scope of economics only to allocation of resources.

Some Recent definitions of Economics:

According to Professor Henry Smith, “Economics is the study of how in a civilized society one
obtains the share of what other people have produced and of how the total product of society
changes and is determined.”
According to Jacob Viner, “Economics is what economists do.”
According to Paul A Samuelson, “Economics is the study of how men and society choose, with
or without the use of money, to employ scarce productive resources which could have
alternative uses, to produce various commodities over time and distribute them for
consumption now and in future amongst various people and groups of society.”

IS ECONOMICS AN ART OR SCIENCE OR BOTH?

Economics is a science but it is different from physical sciences. It is a social science i.e. it is a
science dealing with human beings.
Unlike physical sciences, Economics is based on assumptions. Since our subject matter is human
being whose behavior is very unpredictable, economics assumes man to behave rationally.
However, many a times, a man is not rational but emotional and in such cases economics laws
do not operate. Similarly, there are many factors which affect a phenomenon simultaneously.
But for simplicity sake, we assume other things to remain same which they may not.

SCARCITY

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Scarcity refers to the limitation of supply in relation to demand for a commodity. It refers to the
situation, when wants exceed the available resources. As a result, goods are not readily
available and society does not have enough resources to satisfy all the wants of its people.
Scarcity is pervasive, i.e. each and every economy and individual faces scarcity of resources. A
scare resource is the one, for which the demand at zero price would exceed the available
supply.

POSITIVE AND NORMATIVE ECONOMICS

In economics we study different issues and problem arising out of scarcity of resources.
Economists also try to find solutions to the economic problems. Like, for example, the
economists would suggest ways and means to solve the problem of poverty and unemployment
in the country. When we are studying a problem and its related issues which are subject to
verification, like the extent of poverty and unemployment we are referring to positive
economics. On the other hand, when we are offering suggestions to solve the problem (which
are not subject to verification, like for example the suggestion of reservation in jobs the
problem of poverty) we are referring to normative economics.
The positive statements describe what was, what is and what would be under the given set of
circumstances. All these statements are capable of empirical verification. On the basis of their
empirical verification, we can find out the degree of truth in such statements. These statements
do not pas any value judgment. There is no value judgment or an issue of debate in the
statement that means are scarce in relation to human want. Also, there is no value judgment in
the statement that consumers tend to maximize their satisfaction and the producers tend to
maximize their profits. All these are positive statements. A positive science does not offer any
suggestion about facts. Normative statements describe ‘What ought to be’. Its objective is to
determine the norms or aims. These statements pronounce value judgment. These are opinions
relating to right or wrong of a particular policy matter, and are always a matter of debate.

CENTRAL PROBLEMS OF AN ECONOMY

Economic problem is the problem of choice. The problem of choice has to be faced by every
economy of the world, whether developed or developing. Human beings have wants which are
unlimited. When these wants get satisfied, new wants multiply at a fast rate. The economic
resources to satisfy these unlimited wants are limited.
They are available in limited quantities in relation to the demand. Resources are not only
scarce but they also have alternative uses. All this necessitates a choice between which goods
and services to produce first. The economy comprising of individuals, business firms, and
societies must make this choice.
According to Prof. Robbins, “the economic problem is the problem of choice or the problem of
economizing, i.e., it is the problem of fuller and efficient utilization of the limited resources to
satisfy maximum number of wants. The scarcity of resources creates this situation.

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CAUSES OF CENTRAL PROBLEMS

The three main causes of central problem are:-
Causes of Central Problem

Unlimited Human Limited Economics Alternatives Uses

Wants Resources of Resources

1. Human Wants are Unlimited:- Human beings have wants which are unlimited.
Human wants get satisfied by consuming goods and service, but new wants keep arising.
2. Economic Resources are Limited:- Economic or productive resources can be of
four kinds:-
(a) Natural resources: land, air, minerals, forest, etc.
(b) Human resources: labour
(c) Capital resources: machines, equipments etc.
(d) Entrepreneurial resources: entrepreneurial is a person who combines all the other
resources to produce output and bear risk.
These resources are limited in supply in relation to their demand. Scarcity is the basic
feature of every economy. No economy can be self-sufficient in everything. Scarcity is a
universal phenomenon which continues indefinitely. The scarcity of resources creates
economic problems for every country in the world.
3. Resources have Alternative Uses:- The resources are not only scarce in supply but
they also have alternatives use. For example, land can be used to produce wheat or rice
or build a hospital or a school. A choice between the alternative uses of land has to be
made. This problem of choice leads to economic problems.

KINDS OF CENTRAL PROBLEMS

(1) What to Produce:-
It is a standard knowledge that resources are scarce in relation of human needs. We
cannot produce all goods as much as we wish to produce. Allocation of resources and
the consequent problem of choice require that we decide what to produce and what
not. It involves two-fold decisions:
(a) Firstly, the economy has to decide what goods and services are to be produced.
For instance, which of the consumer goods like sugar, cloth, wheat, ghee, etc.
are to be produced and which of the capital goods like machines, tractors etc.
are to be produced.
(b) When an economy has taken a decision as to what goods or services are to be
produced, then it has to decide about its quantity. How much of consumer goods
and how much of capital goods are to be produced.

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Guiding Principle: Such a combination of goods should be produced which gives maximum
aggregate utility.
(2) How to Produce?
How to produce means how to organize production. This problem is concerned with the
choice of technique of production. Broadly, there are two techniques of production:
(a) Labour Intensive Techniques:- Under this technique, labour is used more than
capital.
(b) Capital Intensive Technique:- Under this technique, capital is used more than
labour.
An economy must decide as to which technique is to be used in a given industry so that
efficient production is obtained.
Guiding Principle: That technique of production should be chosen which gives least cost
combination.
(3) For Whom to Produce
This is the question of how to distribute the product among the various sections of the
society. National product is the total output generated by the firms. The total output
ultimately flows to the households in the form of income, i.e., their wages, rent profits
or interest. There are millions of people in a society. Each one cannot get sufficient
income to satisfy all his wants. This raises the problem of distribution of national
product among different households. In economics, the problem of distribution of
national product is studied under the Theory of Distribution. According to Karl Marx the
distribution of national income should be on the basis of “from each according to one’s
ability; to each according to one’s needs”.
Guiding Principle: National Income should be distributed in such a way that no one can
be made better off without making anyone else worse off.

BRANCHES OF ECONOMICS
Microeconomics:- Adam Smith is considered to be founder of the field of microeconomics.
The term ‘micro’ has been derived from Greek word ‘Mikros’ which means ‘small’.
Microeconomics deals with analysis of behaviour and economic actions of small and individual
units of the economy, like a particulars consumer, a firm or a small group of individual units.
The concept of microeconomics is very important as it supplies the foundation for most of our
understanding of the functioning of an economy.
Microeconomics is that part of economics theory, which studies the behaviour of individual
units of an economy. For example, Individual Income, Individual output, price of a commodity,
etc. Demand and supply are the main tools of Microeconomics.
Macroeconomics:- The term ‘macro’ has been derived from the Greek word ‘macros’ which
means ‘Large’. So, macroeconomics deals with overall performance of the economy. It is
concerned with study of problems of the economy like inflation, unemployment, poverty, etc.

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Macroeconomics is that part of economic theory which studies the behaviour of aggregates of
the economy as a whole. For example, National income, aggregate output, aggregate
consumption, etc. Its main tools are aggregate demand and aggregate supply.

Difference between Microeconomics and Macroeconomics

Microeconomics Macroeconomics

1. It studies individual economics units. 1. It studies aggregate economics units.

2. It deals with determination of price and 2. It deals with determination of general price
output in individual markets. level and national output in the country.
3. The basic parameter of microeconomics is 3. The basic parameter of macroeconomics is
price, that is, consumers and producers take income, that is, economic decision relating to
economic decision on the basis of price. consumption, saving, investment etc., are on
the basis of national Income.
4. It aims at optimal allocation of resources. 4. It aims at determination of aggregate
output, national income, price level and
employment level in the economy.
5. Example:- Individual demand, price of a 5. Example:- Aggregate demand, national
firms, etc. income, etc.

It is difficult to demarcate or differentiate between micro and macro economics. What is macro
from an economy’s point is micro in the context of the world. It is difficult to say which is more
important. Both have their own significance. According to Prof. Samuelson, knowledge of both
is absolutely vital and there is no competition between macro and micro economics. Both are
complementary and should be fully utilized for proper understanding of an economy.

OPPORTUNITY COST
Opportunity cost is defined as the cost of alternative opportunity given up or surrendered. For
example, on a piece of land both wheat and sugarcane can be grown with the same resources.
If wheat is grown then opportunity cost of producing wheat is the quantity of sugarcane given
up.
It is clear that question of opportunity cost arises whenever resources have alternative uses.
These resources are not always physical resources; they may be monetary resources or time.
For example, the opportunity cost of spending in a restaurant, may be a book that you could
have purchased by spending the same amount. Also, opportunity cost of time devoted to
studies, effort or work is the leisure or play that could have been enjoyed. In terms of
production possibility curve, the slope of the curve at every point measures the opportunity
cost of producing more units of good X in terms of good Y given up.

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PRODUCTION POSSIBILITY CURVE

Meaning:- Production possibility set refers to different combinations of two goods that can be
produced from a given amount of resource and a given stock of technological knowledge.
Production possibility Curve (PPC) shows the various alternative combinations of goods and
services that an economy can produce when the resources are all fully and efficiently
employed. PPC shows the obtainable options.
There is a maximum limit to the amount of goods and services which an economy can produce
with the given resources and the sate of technology. The resources can be used to produce
various alternative goods which are called production possibilities and the curve showing
different production possibilities is called production possibility curve.
Assumptions:- Assumptions underlying production possibility curve are:-
(a) Economy produces only two goods, X and Y. (Examples of goods X any Y can be gun and
butter, wheat and sugar cane, cricket bats and tennis rackets or anything else.)
(b) Amount of resource available in an economy are given and fixed.
(c) Resources are not specific, i.e. they can be shifted from the production of one good to
the other good.
(d) Resources are fully employed, i.e., there is no wastage of Resources. Resources are not
lying idle.
(e) State of technology in an economy is given and remains unchanged.
(f) Resources are efficiently employed.
Basic Properties of PPC:-
(i) Production possibility Curve Slopes Downward to the right:- Production
possibility Curve slopes downwards from left to right. It is because in a situation of
fuller utilization of the given resources, production of both the goods cannot be
increased. More of good-X can be produced only with less of good-Y.
(ii) Production possibility Curve is Concave to the Point of Origin:- Any curve
is concave to the origin if it has an increasing slope. PPF has an increasing slope. The
slope of PPF is Marginal Opportunity cost or MRTxy which keeps increasing. But the
question arises why does MOC keep increasing? A simple answer to this question is that
resources can be shifted from the production of one good to the production of other good
but resources are not equally efficient in the production of both the goods. Initially those
resources are transferred which are more efficient in production of good 2 but gradually
even those resources have to be transferred which are more efficient in the production of
good 1. Opportunity cost of producing every additional units of good-X tends to
increase in terms of the loss of production of good-Y.
Example:
Suppose an economy decides to produce only two goods, namely wheat and cloth, with its
available resources and given technology. If all the resources are used for the production of
wheat alone then 100 lakh tones of wheat can be produced. On the contrary, if all the
resources are used for the production of cloth alone then 4,000 bales of cloth can be produced.

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If the economy produces both the goods, then within these limits, various combinations of two
goods can be produced.
The following table show different possibilities of production of wheat and cloth. It is called
Production possibility schedule.
Production possibility schedule
Goods Production Possibilities
A B C D E
Wheat (lakh tones) 100 90 70 40 0
Cloth (‘000 bales) 0 1 2 3 4
The above schedule shows that if production is
carried out under ‘A’ combination, then 100 Inefficient use of
lakh tones of wheat alone will be produced resources Unattainable
without any production of cloth. combination
On the contrary, if production is obtained
under ’E’ combination then 4,000 bales of F

Good Y (Wheat)
cloth alone will be produced without any
production of wheat. Besides these extreme
limits, there are many alternative possibilities G
of production of wheat and cloth.
Representing these various production
possibilities on a graph, we get Production
possibility curve as in figure. The quantity of
cloth is represented on X-axis (horizontal axis) Good X (Cloth)
and wheat on Y-axis (vertical axis). It is the
Production possibility or transformation
Curve. Point F represents unattainable
combinations and point G inside the curve
shows inefficient use of resources.

MARGINAL OPPORTUNITY COST

Production Possibility Curve is also called transformation curve because looking at it, it appears
as if one good is being transformed into another. A movement along PPC implies that more of
good X is produced by sacrificing the production of a certain amount of good Y.
Production Possibility Curve is also called opportunity cost curve because slope of the curve at
each and every point measures opportunity cost of one commodity in terms of alternative
commodity given up. The rate of this sacrifice is called the Marginal Opportunity Cost of the
expanding good. Table- shows how marginal opportunity cost is calculated in a hypothetical
example of two goods X any Y with their production values.
Marginal Opportunity Cost along a PPC
Production of Good X Production of Good Y Marginal Opportunity Cost of good
X (in Good Y) = Y

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X
0 20 -
1 19 1
2 17 2
3 14 3
4 10 4
5 5 5
The table shows that, if the production of good X increases from 1 unit to 2 units, then two
units of good Y (19-17) have to be foregone. Thus, marginal opportunity cost of good X is equal
to 2 units of good Y. In the same way, marginal opportunity cost for the other situations can be
worked out. It is clear from the table that marginal opportunity cost increase from 1 to 2, 2 to 3,
3 to 4 and 4 to 5. It shows the law of increasing marginal opportunity cost. Its economic
meaning is that to produce one more unit of good X, increasing units of good Y have to be
sacrificed.

CHANGE IN PPC:
PPC is based on the assumption, that resources of an economy are fixed. However, in this
changing world, PPC never remains fixed. The productive capacity of an economy is constantly
changing due to increase or decrease in resources. Such changes in resources lead to change in
PPC. The change in PPC indicates either an increase or a decrease in the productive capacity of
the economy.
The change in PPC can be of two types:-
1. Shift in PPC:- PPC will shift when there is change in productive capacity (resources
or technology) with respect to both the goods.
2. Rotation of PPC:- PPC will rotate when there is change in productive capacity
(resources or technology) with respect to only one good.

1. Shift in PPC
The PPC can shift either towards right or towards left, when there is change in
resources or technology with respect to both the goods.

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(a) Rightward Shift in PPC:-

When there is advancement of
technology or/and increase in
availability of resources in
respect to both the goods, then
we can produce more of both
the goods. Accordingly, PPC
will shift to the right.

(b)Leftward Shift in PPC:- PPC

will shift to the left when there
is a technological degradation
and/or decrease in resources
with respect to both the goods.
For example, destruction of
resources in an earthquake will
reduce the productive capacity
and as a result, PPC will shift to
the left.

2. Rotation of PPC:-
(a) Rotation for commodity on the X-axis:- When there is a technological
improvement or an increase in resources for production of the commodity on the X-
axis (say, butter), then PPC will rotate from AB to AC. However, in case of
technological degradation or decrease in resources for production of butter, the PPC
will rotate to the left from AB to AD.
Y

Guns (In units)

Leftward Rotation Rightward Rotation

O D B C

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Butter (In Units)

(b) Rotation for commodity on the Y-axis:- A technological improvement or an

increase in resources for production of commodity on Y-axis (say, guns), will rotate the
PPC from AB to CB. But, any degradation in technology or a decrease in resources for
production of guns, will rotate the PPC to the left from AB to DB as shown in fig.

C Rightward Rotation

A
Guns (In units)
D
Leftward Rotation

O B
Butter (In Units)

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CONSUMER’S EQUILIBRIUM

INTRODUCTION
A consumer is one who buys goods and services for satisfaction of wants. He takes decisions with
regards to the kind of goods to be purchased in order to satisfy his wants. The main objective is to get
maximum satisfaction from spending his income on various goods and services. As the resources are
limited in relation to unlimited wants, a consumer has to follow some principles or laws in order to
attain the highest satisfaction level. The two main approaches to study consumer’s behaviour and
consumer’s equilibrium are.
1. Cardinal Utility Approach (or Marshall’s Utility Analysis or Marginal Utility Analysis)
2. Ordinal Utility Approach (or Indifference Curve Analysis)

CONSUMER’S EQUILIBRIUM WITH UTILITY

APPROACH
1. Utility:- The term utility refers to the want satisfying power of a commodity. It is assumed to
be measured in numbers, like 1,2,3,4, etc. These numbers are called utils or units of utility.
Utility is a subjective concept and differs from person to person, place to place and time to time.
2. Total Utility:- It is the sum total of utility derived from the consumption of all the units of a
commodity.
For example:- If 2 units of a commodity are consumed and 1st units give satisfaction of 10 units
and the 2nd units gives satisfaction of 8 units, then total utility = 10+8 = 18 units.
TU can be calculated as:
TUn = U1 + U2 + U3 + - - - - - - - -+Un
Where TUn = TU from n units
U1, U2,U3 = Utility from 1st, 2nd, 3rd
n = No. Of units consumed
3. Marginal Utility:- It refers to additional utility due to consumption of an additional unit of a
commodity. If 10 units of a commodity yield satisfaction of 100 utils, and 11 units of a
commodity yield satisfaction of 105 utils, then additional utility on account of the consumption
of 11tgh unit of the commodity is 105-100=5 utils. This is called marginal utility. Thus, marginal
utility (MU) is measured as under:
MUnth = TUn – TUn-1

Law of diminishing Marginal Utility:-

Law of diminishing marginal utility (DMU) states that as more and more units of a commodity are
consumed continuously, the utility derived from each successive unit goes on decreasing. Law of DMU

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has universal applicability and applies to all goods and services. It should be noted that it is marginal
utility that keeps falling not the total utility.

Relation between TU and MU:

1. As long as TU increases at a decreasing

rate, MU falls but remains Positive.
2. When TU is maximum, MU is Zero. This is
known as point of satiety or Saturation.
3. When consumption is increased beyond
the saturation point, TU starts falling & MU
becomes negative.

Quantity TU MU
(Units)
0 -
1 8 8-0 = 8
2 14 14-8 = 6
3 18 18-14 = 4
4 20 20-18 = 2
5 20 20-20 = 0
6 18 18-20 = -2

Assumption of Laws of Diminishing Marginal Utility

1. Cardinal measurement of utility: It is assumed that utility can be measured and a
consumer can express his satisfaction in quantitative terms such as 1, 2, 3, etc.
2. Consumption of standard quantity: It is assumed that standard quantity of the
commodity is consumed. For example, we should compare MU of glassfuls of water and not of
spoonfuls.
3. Continuous consumption: It is assumed that consumption is a continuous process. For
example, if one ice-cream is consumed in the morning and another in the evening, then the
second ice-cream may provide equal or higher satisfaction as compared to the first one.
4. No change in Quality: Quality of the commodity consumed is assumed to be uniform. A
second cup of ice-cream with nuts and toppings may give more satisfaction than the first one, if
the first ice-cream was without nuts or toppings.
5. Rational consumer: The consumer is assumed to be rational who measures, calculates and
compares the utilities of different commodities and aims at maximizing total satisfaction.
6. MU of money remains constant: As a consumer spends money on the commodity, he
is left with lesser money to spend on other commodities. In this process, the remaining money

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becomes dearer to the consumer and it increase MU of money for the consumer. But, such an
increase in MU of money is ignored. As MU of a commodity has to be measured in monetary
terms, it is assumed that MU of money remains constant.
7. Fixed Income and prices: It is assumed that income of the consumer and prices of the
goods which the consumer wishes to purchase remain constant.

Consumer’s Equilibrium
Equilibrium means a state of rest or a position of no change. Consumer’s equilibrium refers to a
situation where a consumer gets maximum satisfaction out of his given income and he has no tendency
to make any change in his existing expenditure.

Attainment of Equilibrium in case of single commodity

A consumer purchasing a single commodity will be at equilibrium, when he is buying such a quantity of
that commodity, which gives him maximum satisfaction. The number of units to be consumed of the
given commodity by a consumer depends on 2 factors:
1. Prices of the given commodity (Px);
2. Expected utility (Marginal utility or MUx) from each successive unit.
To determine the equilibrium point, consumer compares the price (or cost) of the given commodity with
its utility (satisfaction or benefit). Being a rational consumer, he will be at equilibrium when utility is
equal to the price paid for the commodity, i.e. when Marginal Utility (MUx) = Price (Px)
For Example:-
Quantity of X Px (In Rupees) MUx (In Rupees)
1 5 8
2 5 6
3 5 5
4 5 4
5 5 3

The table shows that if Px = Rs. 5, then the consumer will buy 3 units of goods X. If the consumer buys
less than 3 units say 2 units then the MU he derives from 2 units is worth Rs. 6 and the price he pays is
Rs. 5. Since his MUx > Px he buys more. In other words, since price is less, he buys more which is the
logical basis of the law of demand.
A consumer will not buy more than 3 units of X. This is because if he buys 4 units of X then the price he
pays (Rs. 5) will be more than the MU he derives which is worth Rs. 4. Hence, in order to maximize utility
a consumer will buy that quantity of the good where the MU of the good is equal to the price that he
has to pay. That is, consumer is in equilibrium (with respect to purchase of one good only) where:
Marginal utility of the good = Price paid
Or MUx = Px
Where,
MUx = Marginal utility of good X
Price / Utility

Px = Price of good X
The consumer’s equilibrium condition is P E MUx = Px
geometrically illustrated in figure at point E, where
MUx = Px. The equilibrium price is given at OP. The
consumer will buy OQ Quantity of X in Order to MUx
maximize his utility. Total gain falls as more is
purchased after equilibrium.
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O Q (Quantity)
Attainment of Equilibrium in case of two commodities/ Law of Equi
Marginal Utility
Statement of the Law:
The law of equi-marginal utility states that, other things being equal, a consumer gets maximum total
utility from spending his given income, when he allocates his expenditure to the purchase of different
goods in such a way that the marginal utilities derived from the last unit of money spent on each item of
expenditure tends to be equal.
In order to get maximum satisfaction out of the funds (money) we have, we carefully weigh the
satisfaction obtained from each rupee that we spend. If we find that a rupee spend in one direction has
greater utility than in another, we shall go non spending money, on the former ( first) commodity, till
the satisfaction derived from the last rupee spent in the two cases is equal. In other words, we
substitute some units of commodity of greater utility for some units of the commodity of less utility. The
results of this substitution will be the MU of the former will fall and that of the latter will rise, till the two
marginal utilities are equalized. That is why this law is called the laws of substitution or equi-marginal
utility.
Symbolically,
MUm = MUx/Px
Where MUm is marginal utility of money; MUx is marginal utility of good X and Px is price of good X. The
law of equi-Marginal utility can be stated in following words:
The consumer will spend his money income on various goods in such a way marginal utility of each good
is proportional to its price.
Symbolically, a consumer is in equilibrium when
MUx/Px= MUy/Py
But equality between MUx/Px and MUy/Py can be attained at many levels. The question is how far
consumer will go on purchasing the goods he wants. It is determined by the size of his money income.
With a given income, one rupee has certain utility for him. This is marginal utility of money to him. thus,
the consumer will be in equilibrium when the following equation holds good:
MUx/Px= MUy/Py = MUm
Law of equi- marginal utility has been has been illustrated in following table. Price of good X(apple) and
good y (orange) are Rs.2 and Rs.3 respectively. Suppose the consumer has Rs. 24 to spend on the two
goods.
A consumer will be in equilibrium when MUx/Px = MUy/Py while spending his given money income on
two goods.
By looking at table below, it is clear that consumer is in equilibrium where he is buying 6 units of X and 4
units of Y and spending total income of Rs.24.
Marginal utility of Good X and Y and Money expenditure
Units MUx MUy MUx/Px Muy/Py
1 20 24 10 8
2 18 21 9 7
3 16 18 8 6
4 14 15 7 5
5 12 9 6 3
6 10 3 5 1
Consumer’s equilibrium is graphically portrayed in figure given below.

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 MICRO ECONOMICS BY SUMAN MADAM

CONSUMER’S EQUILIBRIUM WITH INDIFFERENCE

CURVE APPROACH
Indifference curve method has been evolved to supersede the marginal Utility Analysis. The Indifference
Curve method seeks to derive all rules and laws about consumer’s demand that are derivable from
cardinal utility approach. But Indifference Curve analysis is based on fewer and more realistic
assumptions. It is Ordinal approach. It says utility can’t be quantified but can be ordered in terms of
higher or lower i.e. a consumer can’t tell how much utility he/she derives from a commodity but he/she
can tell whether good A gives him/her greater utility or good B.

Assumptions:
1. Rationality: The consumer tries to maximize his/her satisfaction, given his income and prices of
the goods.
2. Ordinality: Consumer is capable of ordering his/her utility. For example she can say: A is
preferred to B or B is preferred to A or A or B are equally preferred. Indifference Curve analysis
is based on weak ordering form of preference hypothesis. Weak ordering hypothesis implies
that there is a possibility of the consumer being indifferent between two combinations. Strong
ordering means he will always prefer one commodity to other but can’t be indifferent.
3. Diminishing Marginal Rate Of Substitution: MRS is defined as the amount of commodity B that
the consumer is willing to give up to consume an additional unit of good A while leaving total
utility unchanged. It is assumed that the greater is the quantity of good A consumer is having,
the less willing consumer will be to give up B for A. this relationship is known as Law of
Diminishing Marginal Rate of Substitution.
4. Consistency of Choice: If consumer prefers A to B in one time period, she will not prefer B to A
in other time period.
5. Transitivity of Choice: If A is preferred to B and B is preferred to C then A will be preferred to C.
6. Non Satiety or Monotonic preferences: A consumer’s choices are monotonic if and only if
between two bundles, the consumer prefers the bundle which has at least more of one of the
goods and no less of the other goods. IC Analysis assumes consumer preferences to be

16
 MICRO ECONOMICS BY SUMAN MADAM

monotonic as she has not reached her saturation point. Monotonic preferences can also be
defined as a fact that a consumer always prefers more of commodity as compared to less of it.
Meaning of indifference Curve
When a consumer consumes various goods and services, then there are some combinations, which give
him exactly the same total satisfaction. The graphical representation of such combinations is termed as
indifference curve.
Indifference curve refers to the graphical representation of various alternative combinations of the
goods, which provide same level of satisfaction to the consumer.
For example:-
Following are the different combinations of apples and oranges, the two goods that a consumer buys
with his given income.
Different Combinations of Apples and Oranges
Combinations of Apples Oranges
Apple & Oranges
A 1 10
B 2 7 Indifference Set
C 3 5
D 4 4

These combinations (A, B, C, D) offer the consumer the same amount of satisfaction. Consumer’s
preferences are such that:
Satisfaction level from A = satisfaction level from B = Satisfaction level from C, and so on.
Following is the graphical presentation of Indifference curve.

Indifference curve

Indifference Map A family of indifference curves is called an

Indifference Map. It gives a complete
picture of a consumer’s scale of preference
for two goods. The given figure illustrates
an indifference map. In the figure,
indifference map is a set of five indifference
curves I1, I2, I3, I4, I5 each of which is
reflecting a different level of total utility.
Higher indifference curve represents higher
utility.

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 MICRO ECONOMICS BY SUMAN MADAM

Slope of Indifference curve/Marginal Rate of substitution (MRS)

Moving along an IC we find that one good is substituted for the other. The rate at which one more unit
of Good-1(on the X-axis) is substituted for Good-2 (on the Y-axis) is called MRS. The following figure
illustrates the estimation of MRS.
At point A on IC, MRS = Goods-2 = AC Y
 Good-1 CB
Suppose a consumer is initially at point A on IC in Fig.
He wants to move to point B. By doing so he is
having RP or CB more of Good-1. For this he is willing
to give up ST or AC amount of Good-2. For CB units S A
of Good-1 he is willing to give up AC units of Good-2.
So that for a unit more of Good-1 he is willing to give  Good-2 B
up AC÷ CB units of Good-2. This is rate at which he is T C IC
willing to substitute Good-1 for Good-2, when Good-2 
initially he is at point A on IC. Thus, MRS may be Good-1
defined as the rate at which a consumer is willing to
give up Good-2 for a unit more of Good-1. It is
exactly the slope of IC. O R P X
Good-1

Properties of Indifference Curve

1. Indifference Curve is always convex to the origin: An Indifference Curve is convex
to the origin because of diminishing MRS. Therefore, Indifference Curve are convex to the origin.
It must be noted that MRS indicates the slope of Indifference Curve.
2. Indifference Curve Slope downwards:- An Indifference Curve has a negative slope,
i.e. it slope downwards from left to right. It happens because if the consumer decides to have
more units of one good, he will have to reduce the number of units of another good, so that the
level of satisfaction remains unchanged.
3. Indifference Curve can never intersect
each other:- As two Indifference Curve cannot
Y
represent the same level of satisfaction, they
cannot intersect each other. It means, only one
Indifference Curve will pass through a given point
on an Indifference map. In Fig. satisfaction 18from
ood-2

point A and from B on IC1 will be the same.

Similarly, points A and C on IC2 also give the same
 MICRO ECONOMICS BY SUMAN MADAM

B IC2

IC1

O X

4. Higher Indifference Curve represent higher levels of satisfaction:- The level

of satisfaction depicted by the higher Indifference Curve is more as compared to the lower two
Indifference Curve.

Budget Line
As a higher Indifference Curve gives a higher level of satisfaction, a consumer will always wish to reach
at the highest possible Indifference Curve. It is the budget line which is a constraint. To obtain more and
more satisfaction, he has to work under two constraints:
1. He has to pay the prices of two goods.
2. He has limited money income.
Combination which a consumer actually purchases depends upon his money income and prices of the
two commodities. It means, a consumer can purchase only those combinations of goods, which cost less
than or equal to his income.
Budget line is a graphical representation of all possible combinations of two goods which can be
purchased with given incomes and prices, such that the cost of each of these combinations is equal to
the money income of the consumer. It is shown below:

Budget Set
Budget set refers to set of all those bundles which are available to the consumer within his income.
In addition to the three options, these are some more options available to the consumer within his
income, even if entire income is not spent. For example: A consume has an income of Rs.20. He wants to

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 MICRO ECONOMICS BY SUMAN MADAM

spend it on two commodities: X and Y and both are priced at Rs.10 each. Budget set includes all the
bundles with the total income of Rs. 20, i.e. possible bundles are (0,0); (0,1); (0,2); (1,0); (2,0); (1,1).
Algebraic Expression of budget line:-
The budget line can be expressed as an equation:
M = (PA x QA) + (PB x QB)
Where:
M = Money Income
QA = Quantity of apples (A);
QB = Quantity of Bananas (B);
PA = Price of each apple;
PB = Price of each Banana.
All points on the budget line ‘AB’ indicate those bundles, which cost exactly equal to ‘M’
Algebraic Expression for Budget Set: The consumer can buy any bundle (A,B),
Such That: M> (PA x QA) + (PB x QB)
Shifts in Budget Line
Shift in the budget line can take place when there are:
(a) Changes in the price of good X or good Y or both, and
(b) Changes in money income of the consumer QY Figure 1
A
Change in Price:-
(a) Suppose, price of good X falls. Then new
budget line will rotate from point A and shift PX Falls
toward becoming flatter. It is graphically
illustrated in figure 1. The new budget line
AB1 shows that with a fall in price of X,
consumer can buy more of X The slope of the O B B1 Qx
line AB changes. The flatter budget line, AB1,
implies that the relative price of good X is Qy
lesser. Figure 2
A
(b) Figure 2 shows shift in budget line AB when
Px rise. The new budget line AB1 will rotate PX Rises
inwards to AB1 showing that less of good X
will be demanded.

(c) Figure 3 shows shift in budget line AB when

there is fall in Py. The new budget line A1B O B1 B Qx
shows that consumer will buy more of good Y.
AB will rotate upward to A1B. Qy
Figure 3
A1
Change in Income A Py falls
Suppose, money income of the consumer
increases then the new budget line will make
parallel shift towards right. It is shown in the
figure.
20
The new budget line A1B1 is parallel to AB. The
slope of both the budget lines is same, i.e. prices
have not changed. The consumer can buy more of
 MICRO ECONOMICS BY SUMAN MADAM

O B Qx
Qy

A1 When income falls

A When income rises

O B B1 Qx
Consumer’s Equilibrium:-
Consumer is said to be in equilibrium in a situation in which given her income and prices of the goods,
she is buying such a combination of two goods which give her maximum satisfaction. She is then in a
position of balance in regard to the allocation of his money expenditure among various goods.
Following assumptions have been taken to explain equilibrium of the consumer through Indifference
Curve approach:
1. A Consumer tries to maximize his satisfaction.
2. The consumer has a given indifference map exhibiting his scale of preference for various
combinations of good X and Y.
3. He has a fixed amount of money to spend on two goods. He has to spend his total income on two
goods.
4. Prices are given and constant for him. He cannot influence the prices of the goods.
5. Goods are homogeneous and divisible.

Conditions of Consumer Equilibrium:

According to IC Approach a consumer will be in equilibrium when two conditions are satisfied:
1. Budget line should be tangent to Indifference curve i.e. MRSxy=Px/Py When MRSxy is less or greater
than the price ratio between the two goods, it is advantageous for the consumer to substitute one
good for the other.
2. The second order condition must also be fulfilled at the point of equilibrium. At the point of
tangency, Indifference Curve must be convex to the origin. To put it differently, MRSxy must be
falling at the point of equilibrium.
It is shown by following diagram:

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MICRO ECONOMICS BY SUMAN MADAM

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 MICRO ECONOMICS BY SUMAN MADAM

THEORY OF DEMAND
MEANING OF DEMAND
Demand is the quantity of a commodity that a consumer is willing and able to buy, at each
possible price during a given period of time. In other words, demand is wiliness for a
commodity backed by the purchasing power and will to part with that purchasing power. If a
middle class man wishes to have Mercedes Benz, it can be called a desire but not demand.
Demand is that desire which is backed by purchasing power. It is for this reason that in a free
economy, Pedigree is produced for the dogs of the rich but food is not produced for the
children of the poor.
The definition of demand highlights four essential elements of demand:
(i) Quantity of the commodity
(ii) Willingness to buy
(iii) Price of the commodity
(iv) Period of time
Individual demand & Market demand:-
Demand for a commodity may be either with respect to an individual or to the entire market.
1. Individual demand:- Individual demand refers to the quantity of a commodity that a
consumer is willing and able to buy, at each possible price during a given period of time.
2. Market demand:- Market demand refers to the quantity of a commodity that all consumers
are willing and able to buy, at each possible price during a given period of time.

DETERMINANTS OF INDIVIDUAL DEMAND/

INDIVIDUAL DEMAND FUNCTION
When we say X is a function of Y that means Individual demand function shows how demand for a
commodity, by an individual consumer in the market, is related to its various determinants. It is
expressed as under:
Dx = f(Px, Pr, Y, T, E)
It will be read as: Demand for a commodity X (Dx) is a function (f) of price of commodity (Px); price of
other related goods (Pr); Income of consumer (Y); tastes & preferences (T) and expectations (E).
1. Price of Commodity- Ordinarily, quantity demanded of a commodity depends on its
price. Other influencing factors remaining constant or “Other things being equal” (ceteris
paribus), change in the price of a commodity causes a change in its demand also. Ordinarily,
with the rise in the price of a commodity, its demand contracts. Conversely, with the fall in
the price of a commodity, its demand extends.
2. Price of Other Related Goods- Demand for a commodity is also influenced by the
change in the price of other related goods. These are of two types:

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 MICRO ECONOMICS BY SUMAN MADAM

(i) Substitute Goods:- These are the goods Of tea

which can be substituted for each other,
such as tea and coffee, or ball-pen and ink-
pen. They satisfy human wants with equal
ease. In case of such goods, increase in the
price of one causes increase in demand for
the other and decrease in the price of one
causes decrease in the demand for the
other. Increase in the price of coffee, for
example, will increase the demand for tea
– the consumers will shift from the
consumption of coffee to the consumption
of tea. The demand curve of tea shifts
rightward.

(ii) Complementary Goods-

Complementary Goods are those goods
which complete the demand for each
other, and are, therefore, demanded
together. For example:- Pen and Ink, or
mobile and sim. In case of complementary
goods, a fall in the price of one causes
increase in the demand of the other and a
rise in the price of one causes decrease in
the demand for the other. For example: if
price of milk falls, people will make more
of khoya and sweets and demand for sugar D1
will also increase.This is graphically shown
D2
in figure. There is leftward shift in demand
curve from D1 to D2 when the two goods
are complementary. That is, if there is
increase in the price of complementary
good, the demand curve shifts leftward.

Normal good
3. Income of the consumer- Change in
the income of the consumer also Price
influences his demand for different
goods. How a change in the income
will affect the demand for a good D1
depends upon the type of the good. If D
the good is a ‘normal good’ then with O Quantity
the increase in income, consumer buys
more of the good.

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 MICRO ECONOMICS BY SUMAN MADAM

Normal goods are those goods whose demand

rises with the rise in income. On the other hand, Price Inferior good
the demand for inferior goods like coarse grains
tends to decrease with increase in income, and
vice-versa. Inferior goods are those goods whose
demand falls with the rise in income. D
It is shown by figures also. D1
3. Tastes and Preferences- The demand for goods
and services depends on individual’s tastes and O Quantity
preferences. These terms are used in broad sense.
They include fashion, habit, custom, etc. Tastes and
preferences of the consumers are influenced by
advertisement, change in fashion, climate, new
inventions, etc. Other things being equal demand for Price
those goods increases for which consumers develop P
tastes and preferences. Contrary to it, if a consumer
has no taste or preference for a product, its demand
will decrease. A favourable change in tastes & D2 D D1
preferences will cause a rightward shift in demand O Quantity
curve from D to D1. Reverse happens in case of
unfavourable changes i.e. the demand curve will shift
from D to D2.

4. Expectations- If the consumer expects that price in future will rise he will buy more
quantity in present, at the existing price. In this case, the demand curve will shift to the
right. Likewise, if he hopes that price in future will fall, he will buy less quantity in present,
or may even postpone his demand. Here the demand curve will shift to the left.

DETERMINANTS OF MARKET DEMAND/ MARKET

DEMAND FUNCTION
Market demand function shows how market demand for a commodity is related to its various
determinants. It is expressed as under:
Market Dx = f(Px, Pr, Y, T, E, P, S, D)
It will be read as: Market Demand for a commodity X (Market Dx) is a function (f) of price of
commodity (Px); price of other related goods (Pr); Income of consumer (Y); tastes & preferences (T),
expectations (E), Population (P), Season & weather (S) and Distribution of Income (D). Some of the
factors have been explained earlier and some are explained below
1. Size and composition of population- Market demand for a commodity is affected
by size of population in the country. With increase in population, demand for the
commodity rises. However, if the population is decreasing, then the demand will fall.
Composition of population, i.e. ratio of males, females, children and number of old

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 MICRO ECONOMICS BY SUMAN MADAM

people in the population also affects the demand for a commodity. For example, if
number of females exceeds the number of males, then demand for cosmetics, sarees
etc. will increase.
2. Season and Weather- The seasonal and weather conditions also affect the market
demand for commodity. For example, during winters, demand for woolen clothes and
jackets increases, whereas, market demand for raincoat and umbrellas increases during
the rainy season.
3. Distribution of income- If income in the country is equitably distributed, then
market demand for commodities will be more. However, if income distribution is
uneven, i.e. people are either very rich or very poor, then market demand will remain at
lower level. If the large sector of the society will be poor and because of its low income,
market demand will also be low.

DEMAND & QUANTITY DEMANDED

Quantity demanded is a particular amount the buyers are willing and able to buy at a given
price during a given time, other things being equal. For example- at a price of Re. 1 per ice
cream, the consumer buys 5 ice creams. Accordingly, the quantity demanded at Re. 1 per ice
cream is 5 ice creams.
Demand is the quantities that buyers are willing and able to buy at alterative prices during a
given period of time, other things being equal. For example, at a price of Re. 1 per ice cream,
the demand is for 5 ice creams; at Rs. 2, the demand is for 4 ice creams and at Rs. 3, it is for 2
ice creams.

LAW OF DEMAND
The law of demand states that, other things being equal, the demand for a good extends with a
decrease in price and contracts with an increase in price. In other words, there is an inverse
relationship between quantity demanded of a commodity and its price, provided other factors
influencing demand remain unchanged. The term ‘other thing being equal’ implies that income
of the consumer, his tastes and preferences and prices of other related goods remain constant.
Demand Schedule
It is a tabular presentation showing the different quantities of a good that buyers of the good
are willing to buy at different prices during a given period of time.
The following table shows a hypothetical demand schedule for wheat.
Price (Rs. per kg.) Quantity Demanded (kg per month)
20 6
30 5
40 4
50 3

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 MICRO ECONOMICS BY SUMAN MADAM

The demand schedule shows an inverse relationship between price and the quantity
demanded. The consumer is willing to pay 50 rupees per kg. to buy 3 kg. of wheat each month.
If the price reduces to 40 rupees per kg, he would be willing to buy an additional one kg. per
month and so on. This implies that lower the price more will be the demand and vice-versa.
Demand Curve
The Graphical representation of the demand
function is called a demand curve. In the figure,
demand curve for wheat is drawn which shows
different quantities of wheat demanded at different
prices in a month.
The demand curve slopes downward to the right or
is negatively sloped. This law of downward sloping
demand has been empirically tested and verified.
The price is measured along the y-axis and quantity
is measured along the x-axis. The demand curve
shows the quantity demanded by the consumer at
different prices.

Assumptions of the Law of Demand

Law of demand holds goods when “other things remain the same.” It means factors influencing
demand other than price are assumed to be constant. These constitute the assumptions of the
law. It applies to normal goods and not to Giffen goods.
The main assumptions of the law are as follows:-
(i) Tastes and preferences of the consumers remain constant
(ii) There is no change in the income of the consumer.
(iii) Prices of the related goods do not change.
(iv) Consumers do not expect any change in the price of the commodity in the near future.

Reasons for law of demand/ why demand curve slopes downwards/

why does law of demand operate? (Salid )
1. Law of Diminishing Marginal Utility: Law of diminishing marginal utility states
that as we consume more and more units of a commodity; the utility derived from each
successive unit goes on decreasing. So, demand for a commodity depends on its utility.
If the consumer gets more satisfaction, he will pay more. However, if he derives less
utility, then he will buy additional units only at a lower price. It means, a consumer will
buy more and more units of a commodity only when he has to pay less price for each
successive unit. Due to this reasons, law of diminishing marginal utility is the basic
reason for operation of law of demand.
2. Substitution Effect- When the price of a good rises, consumer buys more of
substitute goods and less of the good whose price has risen. This shows inverse
relationship between price and quantity demanded. Substitution effect is defined as
change in the optimal quantity of a good when its price changes and the consumer’s

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 MICRO ECONOMICS BY SUMAN MADAM

income is adjusted so that he/she can just buy the bundle he/she was buying before the
price change.
3. Income effect:- Income effect is the effect on the change in the quantity demanded
when the real income of buyer changes as a result of the changes in the price of
commodity alone. Changes in the price of a commodity cause a change in the real
income of the consumer. Real income is that income which is measured in terms of
goods and services. With fall in price, real income increases. The increased real income
is used to buy more units of the commodity. Thus demand extends with increase in real
income. Conversely, rise in price leads to fall in real income and hence, contraction of
demand.
4. Additional Customers:- When price of a commodity falls, many new consumers,
who were not in a position to buy it earlier due to its high price, starts purchasing it. In
addition to new customers, old consumers of the commodity start demanding more due
to its reduced price. For example, price of ice-cream family pack falls from Rs. 100 to Rs.
50 per pack. Many Consumers who were not in a position to afford the ice-cream earlier
can now buy it with decrease in its price. Moreover, the old customers of ice-cream can
now consume more. As a result, its total demand increases.
5. Different Uses:- The law of demand operates due to the principle of different uses.
Some commodities like milk, electricity, etc. have several uses, some of which are more
important than the others. When price of such a good (say, milk) increases, its use get
restricted to the most important purpose (say drinking) and demand for less important
uses (like cheese, butter, etc.) gets reduced. However, when the price of such a
commodity decreases, the commodity is put to all its use, whether important or not.

Exceptions to the law of demand:-

There are certain cases where the law of demand gets violated. That is, there is a direct
relationship between price and quantity demanded of a good. If price rises, demand also rises
and vice versa. The situations where the law of demand does not hold are:
1. Giffen goods: - These were pointed out by Sir Robert Giffen. Giffen goods are those
inferior goods whose negative income effect is so large that it overtakes positive
substitution effect and hence price effect is negative. In case of giffen goods when price
rises, its quantity demanded rises and when price falls, its quantity demanded falls.
1. Goods of status/ Veblen Goods- According to Veblen, some consumers measure
the utility of a commodity entirely by its price. There are certain goods that are referred
to as ‘Prestige goods” or “goods of status”. Such goods are purchased not because of
their utility but because such goods acts as status symbol. They promote social prestige
of the holder. For example: diamond, gold, antique paintings etc. Higher the price, more
the demand for them. If prices of such goods fall down so that even the poor can buy
them, they would no longer confer any prestige and richer classes may stop buying
them altogether.

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 MICRO ECONOMICS BY SUMAN MADAM

2. Expectations of price rise in future- Consumer’s expectations about price affect

their buying behaviour. If price rises and the buyer expects further rise in price then it
causes increase in the quantity bought. The reverse also holds. For example, Shares.
3. Demonstration effect- Sometimes, a section of society tends to imitate the
consumption pattern of higher income groups or some popular film star. In this case,
the law of demand gets violated because people demand more of that commodity
which the upper class people are buying, even at higher prices.
4. Emergency:- In case of emergencies like war, curfew, drought or famine, the law of
demand does not hold. In such situations, there is general insecurity and fear of
shortage of necessities. Hence, consumers demand more goods even at higher prices.

MOVEMENT ALONG THE DEMAND

CURVE/CHANGE IN QUANTITY DEMANDED
When change in quantity demanded of a commodity is caused by change in its price, it is called
extension or contraction of demand or change in quantity demanded.

Extension of Demand:
Other things being equal, when with a
fall in price, quantity demanded of a
commodity rises; it is called extension of
demand.
Extension of demand is indicated by a
movement along the same demand
curve, as shown in figure. Movement of
the demand curve is downward.

Contraction of Demand
Other things remaining the same, when with
a rise in price, quantity demanded of a
commodity decrease, it is called a
contraction of demand.
Like extension of demand, contraction of
demand is also indicated by a movement
along the same demand curve as shown in
the figure also. Here the movement of
demand curve is upward.

SHIFT IN DEMAND CURVE/ CHANGE IN DEMAND

A shift of the demand curve is caused by changes in factors other than price of the good. The
factors are:

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 MICRO ECONOMICS BY SUMAN MADAM

(a) Consumers’ income

(b) Price of other goods.
(c) Consumer’s tastes and preferences.
A change in any of these factors causes shift of the demand curve. It is also called change in
demand. In a shift, a new demand curve is drawn. A shift of the demand curve can bring about:
(a) Increase in demand, or
(b) Decrease in demand

(a) Increase in Demand: It refers to more

demand of a commodity at a given price.
The causes of increase in demand are:
(i) Increase in the income of the consumers.

Price (Rs.)
(ii) Increase in the price of substitute goods.  
(iii) Falls in the price of complementary goods.
(iv) Consumers’ taste becoming stronger in D1
favour of the goods. D
Increase in demand can be shown with the given Quantity (Units)
demand schedule & figure. In the figure, d is the
original demand curve. An increase in demand is
shown by rightward shift of the demand curve from Price (Rs.) Quantity (Units)
D to D1. An increase in quantity demanded shows 3 90
that at original price of Rs. 3, more units (100 units) 3 100
of the good are demanded. In the original situation
90 units were demanded
(b) Decrease in Demand:-
It refers to less demand of a commodity at the
given. It occurs due to unfavorable changes in factors
other than the price of the good. The causes of
decrease in demand are:
Price (Rs.)

(i) Fall in the income of the consumers.  

(ii) Fall in the price of substitute goods.
(iii) Rise in the price of complementary goods. D
(iv) Consumers’ taste becoming unfavorable towards D1
the good.
Quantity (Units)
Decrease in demand can be shown with the help of a
demand schedule given & the figure.
In the figure, D is the original demand curve. A decrease
is demand is shown by leftward shift of the demand
curve from D to D1. A decrease in demand shows that at Price (Rs.) Quantity (Units)
the original price of Rs. 3, lesser units (80 units) of the 3 90
goods are demanded. In the original situation 90 units 3 80
were demanded.

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 MICRO ECONOMICS BY SUMAN MADAM

ELASTICITY OF DEMAND

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 MICRO ECONOMICS BY SUMAN MADAM

ELASTICITY OF DEMAND
The law of demand states that when the price of a good falls, consumers demand more units of
the good. But how much more? It is important and useful to have magnitude of change in
quantity demanded to a change in price. It is price elasticity of demand. Elasticity of demand
measures the extent to which quantity demanded of a commodity increases or decreases in
response to increase or decrease in any of its quantitative determinants. Thus, by elasticity of
demand, we mean the extent to which the quantity demanded of a commodity changes with
change in its price or income of the consumer or price of related goods.
Elasticity of demand can be calculated as:
Elasticity of demand = ____ Percentage change in demand for X___________
Percentage change in a factor affecting the demand for X
Out of various determinants of demand, there are 3 quantifiable determinants of demand:-
(1) Price of the given commodity;
(2) Price of related goods;
(3) Income of the consumer.
So, we have 3 dimensions of elasticity of demand.
(1) Price elasticity of demand:- Price elasticity of demand refers to the percentage
change in demand for a commodity with respect to percentage change in the price of
the given commodity.
(2) Cross elasticity of demand:- Cross elasticity of demand refers to the percentage
change in demand for a commodity with respect to percentage change in the price of a
related good (Substitute good or complementary good).
(3) Income elasticity of demand:- Income elasticity of demand refers to the
percentage change in demand for a commodity with respect to percentage change in
the income of consumers.

FACTORS AFFECTING PRICE ELASTICITY OF

DEMAND/ WHY DO SOME GOODS HAVE MORE
ELASTICITY THAN OTHERS?
Following factors determine the price elasticity of demand:-
(1) Nature of Commodity:- Ordinarily, necessities like salt, kerosene oil, matchboxes,
textbooks, seasonal vegetable, etc. have less than unitary elastic(inelastic)demand.

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 MICRO ECONOMICS BY SUMAN MADAM

Luxuries, like air conditioner, costly furniture, fashionable garments, etc. have greater
than unitary elastic demand. The reason being that change in their prices has a great
effect on their demand. Comforts like milk, transistor, cooler, fans, etc. have neither
very elastic nor very inelastic demand.
(2) Availability of Substitutes:- Demand for those commodities which have substitutes
(for example, tea has its substitute in coffee, orange juice has its substitute in lime juice)
are relatively more elastic. The reason being that when the price of commodity falls in
relation to its substitute, the consumers will go in for it and so its demand will increase.
Commodities having no substitutes like cigarettes, liquor etc. have inelastic demand.
(3) Different Uses of Commodity:- Commodities that can be put to a variety of uses
have elastic demand. For instance, electricity has multiple uses. It is used for lighting,
room-heating, air-conditioning, cooking, etc. If the tariffs of electricity increase, its use
will be restricted to important purpose like lighting. It will be withdrawn from less
important uses. On the other hand, if a commodity such as paper ahs only a few uses, its
demand is likely to be inelastic.
(4) Postponement of the Use:- Demand will be elastic for those commodities whose
consumption can be postponed. For instance, demand for constructing a house can be
postponed. As a result, demand for bricks, cement, sand, gravel, etc. will be elastic.
Conversely, goods whose demand cannot be postponed, their demand will be inelastic.
(5) Income of Consumer:- People whose income are very high or very low, their
demand will ordinary be inelastic. Because rise or fall in price will have little effect on
their demand. Conversely, middle income groups will have elastic demand.
(6) Habit of Consumer:- Goods to which a person becomes accustomed or habitual will
have inelastic demand like cigarette, coffee, tobacco, etc. It is so, because a person
cannot do without them.
(7) Proportion of Income spent on a Commodity:- Goods on which a consumer
spends a very small proportion of his income, e.g., toothpaste, boot-polish, newspaper
needles, etc. will have an inelastic demand. On the other hand, goods on which the
consumer spends large proportion of his income, e.g., clothes, scooter etc. their
demand will be elastic.

MEASUREMENT OF PRICE ELASTICITY OF

DEMAND
A. Total Expenditure or Total Outlay Method:-
Total Expenditure Method to measure elasticity of demand was evolved by Marshall. Under
this method, to measure elasticity of demand, we find out how much and in what direction
total expenditure changes as a result of change in the price of a commodity. We can
consider three possible situations:

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 MICRO ECONOMICS BY SUMAN MADAM

(i) If rise or fall in price of a commodity makes no change in its total expenditure, then
elasticity of demand is unitary.
(ii) If with fall in price of a commodity, total expenditure increases and with rise in its
price, total expenditure decrease then demand for that commodity is greater than
unitary elastic.
(iii) If with fall in price of a commodity, total expenditure decrease and with rise in its
price total expenditure increase then demand for that commodity is less than
unitary elastic. In this case, total expenditure goes in the same direction as the price
does.
It can be explained with the help of the following table:
Total Expenditure Method
Situation Price of Quantity Total Effect on Total Elasticity of
Commodity (Rs.) (kg.) Expenditure Expenditure Demand
(Rs.)
2 4 8 Same Total Unitary Elastic
A Expenditure Ed = 1
1 8 8
2 4 8 Total Greater than
B Expenditure Unitary
1 10 10 increase Ed > 1
2 3 6 Total Less than
C Expenditure Unitary
1 4 4 decrease Ed < 1

The three situations of the total expenditure

method is shown on the x-axis and price of the C Ed> 1
good on the y-axis. OABC is the total expenditure / B
outlay curve.
(a) Between points O and A, Ed < 1 or inelastic. It Ed = 1
Price

shows that with rise in price, total outlay also

A
rises and vice versa.
(b) Between points A and B, Ed = 1 or unitary
elastic. It shows that with rise or fall in price, Ed < 1
total outlay is constant.
(c) Between point B and C, Ed is > 1 or elastic, O Total Expenditure
showing that with rise in price, total outlay falls
and vice versa.

B. Proportionate or Percentage Method:-

The Second method of measuring elasticity of demand is called Proportionate or Percentage
Method. This method was also suggested by Marshall. Under this method, elasticity of demand is
measured by the ratio of the proportionate (percentage) change in quantity demanded to the
proportionate (percentage) change in price. It is worked out as under.

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 MICRO ECONOMICS BY SUMAN MADAM

Ed = Proportionate change in Quantity Demanded / Proportionate change in Price

Change in Demand x 100
= Initial Demand__________
Change in Price x 100
Initial Price
Q1 – Q Q
= Q___ = Q
P1 – P P
P P
Or Ed = Q ÷ P = Q x _P_ Or Ed = P x Q
Q P Q P Q P
Here, Ed = Price elasticity of demand, Q = Initial Demand;
Q1 = New Demand; P = Initial Price;
P1 = New Price; Q = Change in Demand; P = Change in Price.
The absolute value of the coefficient of elasticity of demand ranges from zero to infinity (0 < eD
< ∞). The five different magnitudes of elasticity of demand are explained below:
1. Perfectly inelastic demand (ED = 0)
When the demand of a commodity does not
change as a result of change in its price, the
demand is said to be perfectly inelastic. The
perfectly inelastic demand curve is a vertical line
parallel to y-axis as shown in figure. As it is clear
from the diagram, price may be Rs.2 or Rs.4 or
Rs.6, but the demand will be constant at 4 units.
In other words, there is no effect of changes in
the price on the quaintly demanded. It exists in
case of essentials like life saving drugs. Perfectly Inelastic Demand Schedule
Price (Rs.) Demand (Units)
2 4
4 4
6 4

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 MICRO ECONOMICS BY SUMAN MADAM

2. Inelastic (or less than unit elastic)

Demand (0 < Ed < 1 )
When a change in price leads to a less than
proportionate change in the demand, the
demand is said to be less elastic or
inelastic.
It is shown in Table, where price falls by Rs.
8, quantity demanded said to be less than
1 unit. The slope of an inelastic demand
curve is more i.e., the demand curve is
steep as shown in figure. It exists in case of
necissities like food, fuel etc.
Inelastic Demand Schedule
It exists Pricein (Rs.)case of Demand (Units)
necessities like food, fuel, etc.10 20
2 21
The inelastic demand curve show that change in quantity demanded is less than change
in price.

3. Unit Elastic Demand (ED = 1 )

When percentage change in demand is
equal to the percentage change in price,
the demand for the commodity is said
to be unitary elastic.
It is shown in table, where when price
falls by Rs. 5, demand increases by 10
Units. The unitary elastic demand curve
is a straight downward sloping line
forming 45° angles with both the axis. It
is also a rectangular hyperbola. It is
drawn in figure also. It exists in case of
normal goods. It exists in case of
necessities like food, fuel, etc.
Unitary Elastic Demand Schedule
Price (Rs.) Demand (Units)
10 20
5 30

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 MICRO ECONOMICS BY SUMAN MADAM

4. Elastic (or more than unit elastic)

Demand (1 < ED < ∞)
When a change in price leads to a more than
proportionate change in demand, the
demand is said to be elastic or more than
unit elastic. It is shown in Table, when price
falls by Rs. 1 demand increases by 20 units.
The coefficient of elasticity of demand is
greater than unity. The demand curve is
downward sloping and flatter as shown in
figure. It exists in case of luxuries. The
change in demand is more than the change
in price.
Elastic Demand Schedule
Price (Rs.) Demand (Units)
10 20
9 40

5. Perfectly Elastic Demand (eD = ∞ )

When the demand for a commodity rises or falls to
any extent without any change in price, the demand
for the commodity is said to be perfectly elastic. It is
shown in Table, where quantity demanded keeps on
changing at the same price of Rs. 4. The coefficient of
price elasticity of demand is infinity. It is shown
graphically in figure. It exists under perfect
competition, which is an ideal and imaginary situation.
Perfectly Elastic Demand Curve is a horizontal line
parallel to the x-axis. It means that at price of Rs.4,
quantity demanded can be 10 or 40.

Perfectly Elastic Demand Schedule

Price (Rs.) Demand (Units)
4 10
4 20
4 40

C. Geometric Method:-

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 MICRO ECONOMICS BY SUMAN MADAM

Geometric Method was suggested

by Prof. Marshall and is used to Upper
measure the elasticity at a point Segment
on the demand curve. When
there are infinitely small changes
in price and demand, then the Lower
‘Geometric Method’ is used. It is N Segment
also known as “Graphic method”
or ‘Point Method’ or ‘Arc
Method’.
Elasticity of demand (Ed) is
different at different points on
the same straight line demand
curve. In order to measure Ed at
any particular point, lower
portion of the curve from that
point is divided by the upper
portion of the curve from the
same point.
Elasticity of demand (Ed) = Lower segment of demand curve (LS)__
Upper segment of demand curve (US)

As seen in figure elasticity at a particular point ‘N’ is calculated as NQ.

NP
Elasticity of demand at point ‘N’ = NQ (Lower segment)
NP (Upper segment)

Similarly elasticity of demand on different points of a straight line demand curve is

shown in fig.
1. Unitary Elastic Demand:- At the midpoint Y
of the demand curve, i.e. at point B, the E  Ed = ∞
lower and upper segments (BD and BE) are
exactly equal. Thus, elasticity at point A  Ed > 1
B = LS = BD = 1
Price (in Rs.)

US BE B  Ed = 1
2. Highly Elastic Demand:- At every point
above the mid-point B but below E, i.e.,
between E and B, the elasticity will be C  Ed <1
greater than one. It happens because lower
segment is greater than the upper D Ed = 0
segment. Quantity (in units)
So, Ed at point A = AD/AE > 1

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 MICRO ECONOMICS BY SUMAN MADAM

3. Less Elastic Demand:- At every point below the mid-point B but above D, i.e., between B
and D, the elasticity will be less than one. It happens because lower segment is less than
the upper segment.
So, Ed at point C = LS = CD < 1
US CE

4. Perfectly Elastic Demand:- At any point on the Y-axis (like point E), elasticity is equal to
infinity because at this point, there is no upper segment of demand curve.
So, Ed at point E = ED = ∞
0
5. Perfectly Inelastic Demand:- At any point on the X-axis (like point D), elasticity is equal
to zero because at this point, there is no lower segment of demand curve. So, Ed at
point D = _0 _ = 0
ED

USES OF PRICE ELASTICITY OF DEMAND:

1. Helpful in Business Decisions: Price elasticity of demand is considered in price
determination. Firms may decide to increase the price of a commodity even without
increase in cost of production but whether it will bring about increase in total revenue
depends on Price elasticity of demand as well as cross elasticity of demand as it will
automatically make its substitute to be comparatively cheaper. Rising price will be
beneficial if Price elasticity of demand is less than one and elasticity of its substitute is much
less elastic.
2. Helpful to Finance Minister: Price elasticity of demand also helps government in
formulating its taxation policies, in granting subsidies to the industry, in determining prices
of public utilities, in determining export and import duties and in determining rate of
devaluation. Whether policy will bring desirable increase in revenue will depend on Price
elasticity of demand.
3. For a Monopolist: Price elasticity helps a monopolist to decide the price in two markets in
such a way that his profit is maximized.
4. Determination of Wages: Elasticity of demand also influences the determination of wages
as well as the prices of other factors of production. If the product is inelastic, wages can be
easily increased on demand of trade union and burden can be shifted on to consumers. But
if good is elastic, wages can’t be increased so easily.

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PRODUCTION FUNCTION

MEANING OF PRODUCTION
In Economics production means to include any activity which aims at satisfaction of human wants. It
converts a commodity or commodities into a different commodity. Production refers to transformation
of inputs into output. For example: To manufacture shoes (output), we need various inputs like leather,
nails, land, labour, capital, services of entrepreneur etc. The want satisfying power of goods or services
is called utility. Hence production can also be defined as creation or addition of utility.
But production cannot mean creation of matter. According to fundamental law of science MAN CAN
NEITHER CREATE NOR DESTROY MATTER.

Methods of Production or creating/adding utility:

1. Form Utility: Changing the form of a good, for ex. Converting wood into furniture.
2. Place utility: Shifting goods from place of less utility to the place of more utility. This utility can
be obtained by: a) Extraction from earth ex. Extracting minerals, b) Transferring goods ex.
shifting wheat from farmers to cities.
3. Time utility: Making goods available when they are normally not available, ex. Safal vegetables.
4. Personal Utility: Making use of personal skills for providing services.

Factors of Production:
It refers to the factor services used in the production or basic services without which production can’t
take place. These factors can be classified into Land, Labor, Capital, Entrepreneur.
While land refers to the natural resources, the human endeavor is classified functionally and
qualitatively into labor, capital and entrepreneur.

PRODUCTION FUNCTION
It expresses the functional relationship between inputs and corresponding output. In other words, it
shows the minimum quantities of various input required to produce a given level of output.
Mathematically,
Q= F (L L1 K O)
Where Q is quantity produced, L L1 K O are land, labor, capital and organization respectively.

TYPES OF PRODUCTION FUNCTION

1. Production Function in the Short Run:-
Short run is a period of time when some factors are fixed and some are variable. Accordingly,
output can be increased only by using more of a variable factor. Often, in the short period K
(production capacity of a firm) is constant and L (labour) is variable. Short period, by definition,

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 MICRO ECONOMICS BY SUMAN MADAM

is too short for a firm to change its production capacity. Accordingly, production can be
increased only by using more of L (labour).
2. Production Function in the Long Run:-
Long period is a period of time when all factors are variable. Accordingly, output can be
increased only by using more of all factors of Production. In the long run, production will
increase when all factors are increased in the same proportion.

CONCEPTS OF PRODUCT
(i) Total Product (TP)
Total product refers to total quantity of goods produced by a firm during a given period of time with
given number of inputs.
TP = AP X Q or ΣMP
For example, if 10 labours produce 60 kg. of rice, then total product is 60 kg.
In the short-run, a firm can expand TP by increasing only the variable factors. However, in the long-run,
TP can be raised by increasing both fixed and variable factors.
Shape of TP Curve:- TP Curve starts from the origin,
increases at an increasing rate, then increases at a
decreasing rate, reaches a maximum and after that it
starts falling. Thus as more units of variable factors
are employed, it will not always increase the TP. It is
illustrated with a TP Schedule in Table and a TP curve.
TP Schedule confirms that in the beginning total
production increases at an increasing rate. TP starts
increasing at a decreasing rate with the employment
of the fourth unit of labour. When seventh unit of
labour is employed, TP becomes stable at 30 units
and with the employment of the eighth unit, it start
declining.

TP Schedule
Unit of Labour (L) Total Physical Product (TP) Shape of TP Curve
0 0
1 4 TP rises at an increasing rate
2 10
3 18
4 24
5 28 TP rises at a decreasing rate
6 30
7 30
8 28 TP falls

(ii) Average Product (AP)

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 MICRO ECONOMICS BY SUMAN MADAM

Average product refers to output per unit of variable input. Average Product is also known
as ‘Average Physical Product (APP)’ or ‘Average Return’
For example, if total product (TP) is 60 kg. of rice, produced by 10 labour (variable input),
then average product will be 60 ÷ 10 = 6 kg.
AP is obtained by dividing TP by units of variable factor.
Average Product (AP) = _____Total Product (TP)_______
Units of Variable factor (n)
AP Schedule
Units of Labour TP AP = TP
(L) L
0 0 0
1 4 4
2 10 5
3 18 6
4 24 6
5 28 5.6
6 30 5
7 30 4.3
8 28 3.5

From the AP Schedule, it is clear that initially AP is zero when no labor is employed, then it
increases till three units of labour are employed, reaches a maximum when four units of labour
are employed and then starts declining.

Shape of AP Curve:- AP curve starts

from the origin, increases at a
decreasing rate, reaches a maximum
and then starts falling. AP curve is
inverted-U shaped. It can be
illustrated with the help of an AP
schedule given in Table and AP Curve
given in fig.

Marginal Product (MP) :-

Marginal Product refers to addition to total product, when one more unit of variable factor
is employed. Marginal Product (MP) is also known as ‘Marginal physical product (MPP)’ or
‘Marginal Return’.
MPn = TPn – TPn – 1
Where:-
MPn = Marginal product of nth unit of variable factor;
TPn = Total product of n units of variable factor;
TPn-1 = Total product of (n-1) units of variable factor;
n = Number of units of variable factor.

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 MICRO ECONOMICS BY SUMAN MADAM

For example, If 10 labours make 60 kg. of rice and 11 labours make 67 kg. of rice, then MP of
11th labour will be:
MP11 = TP 11 – TP10
MP11 = 67 – 60 = 7 kg.
One More way to calculate MP:
MP is the change in TP when one more unit of variable factor is employed. However, when
change in variable factor is greater than one unit, then MP can be calculated as:
MP = _____Change in Total Product___ = TP
Change in units of Variable Factor n

MP Schedule
Units of Labour TP MP = TP
(L) L
0 0 -
1 4 4
2 10 6
3 18 8
4 24 6
5 28 4
6 30 2
7 30 0
8 28 -2

Shape of MP Curve:- The MP Curve

rises initially, reaches a maximum and
then starts falling. When TP is
maximum, MP is Zero. When TP falls,
MP is negative. It can be illustrated
with a MP schedule given in Table and
MP curve given in fig.

RELATIONSHIP BETWEEN AP & MP CURVES

1. As long as MP>AP, AP rises or AP will rise

as long as MP curve lies above it.

2. When AP is maximum, AP=MP or MP

cuts AP curve at its maximum.

3. When MP<AP, AP starts falling or AP will

fall as long as MP curve lies below it.

4. There may be a situation when MP is

Falling but AP is rising only condition is
MP>AP whether falling or rising. It has
43
been shown in the diagram.
 MICRO ECONOMICS BY SUMAN MADAM

RELATIONSHIP BETWEEN TP & MP CURVES

1. As long as TP increases at increasing rate, MP is also increasing
2. When TP increases at a diminishing rate, MP starts diminishing.
3. When TP is maximum, MP = 0.
4. When TP starts decreasing, MP becomes negative.

Important observation about TP and MP:

 Increasing MP means Increase in TP at increasing rate;
 Diminishing MP means increase in TP at diminishing rate;
 Zero MP means TP stops increasing;
 Therefore, it can be concluded that MP is the rate of TP.

LAW OF VARIABLE PROPORTIONS/ RETURNS TO

A FACTOR/ LAW OF DIMINISHING RETURNS
STATEMENT OF THE LAW: This law states that as more and more units of variable factors are employed
on a given quantity of fixed factors, TP first increases at an increasing rate(MP increases) then at a
diminishing rate (MP falls but is positive), reaches its maximum(MP is 0), and finally starts falling (MP
becomes Negative).

Assumptions of Law of Variable Proportions:-

1. It operates in short run, as factor are classified as variable and fixed factor;
2. The law applies to all fixed factors including land;
3. This law applies to the field of production only;
4. The effect of change in output due to change in variable factor can be easily determined;
5. The state of technology is assumed to be constant during the operation of this law;
6. It is assumed that all variable factors are homogeneous.

Three Stages or Phases of Production

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 MICRO ECONOMICS BY SUMAN MADAM

The law of variable proportion can be divided into three distinct stages. These three stages of the short-
run law of production are graphically illustrated by the relationship between TP and MP curves. It is
given in the schedule and figure.
SCHEDULE:

Units of fixed Units of variable TP AP MP Stages

factor input
1 0 0 0 - Stage of Increasing
1 1 2 2 2 Returns
1 2 6 3 4
1 3 12 4 6

1 4 16 4 4 Stage of decreasing
1 5 18 3.6 2 Returns
1 6 18 3 0
1 7 14 2 -4 Stage of negative
1 8 8 1 -6 Returns

Stage I :- Stage of Increasing Returns

It goes from the origin to the point where the Mp curve is
maximum. In this stage, TP curve is increasing at an increasing
rate. MP curve rises and reaches a maximum.
A rational producer will not operate in this stage because the
producer can always expand through stage I. It is a non-
economic range.
Stage: II:- Stage of Diminishing Returns
It is the most important stage out of the three stages. Stage II
Negative
of production ranges from the point where MP curve is Returns
maximum to the point where the MP Curve is zero. MP curve
is positive but declining. TP curve increases at a decreasing
rate and reaches a maximum. A rational producer will always
operate in this state. The law of diminishing returns operates
in stage II.
Stage III:- Stage of Negative Returns
It covers the entire range over which MP curve is negative. In
this stage, TP curve falls. A rational producer will not operate
in this stage, even with free labour, because he could increase
his output by employing less labour. It is a non-economic and
an inefficient stage.

Saturation point is the point where MP is zero or TP is maximum.

Reasons for Increasing Returns:-

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 MICRO ECONOMICS BY SUMAN MADAM

1. Better Utilization of the Fixed Factor: In the first phase, the supply of the fixed factor (say, land)
is too large, whereas variable factor are too few. So, the fixed factor is not fully utilized. When
variable factors are increased and combined with fixed factor, then fixed factor is better utilized
and output increases at an increasing rate.
2. Increased Efficiency of Variable Factor: As more and more units of labour are employed, the
work gets divided according to skills and abilities which leads to specialization and hence
improvement in efficiency. This leads to increasing returns to a factor.

Reasons for Diminishing Returns to a Factor:-

The main reasons for occurrence of diminishing returns to a factor are:-
1. Optimum Combination of Factors:- Among the different combination between variable and
fixed factor, there is one optimum combination, at which total product (TP) is maximum. After
making the optimum use of fixed factor, the marginal returns of variable factor begins of
diminish. For example, if a machinery (fixed factor) is at its optimum use, when 4 labours are
employed, then addition of one more labour will increase TP by very less amount and MP will
start diminishing.
2. Imperfect Substitutes:- Diminishing returns to a factor occurs because fixed and variable factors
are imperfect substitutes of one another. There is a limit to the extent of which one factor of
production can be substituted for another. For example, labour can be substituted in place of
capital or capital can be substituted in place of labour till a particular limit. But, beyond the
optimum limit, they become imperfect substitutes of one another, which lead to diminishing
returns.

Reasons for Negative Returns to a Factor:-

The main reasons for occurrence of negative returns to a factor are:-:-
1. Limitation of Fixed Factor:- The negative returns to a factor apply because some factors of
production are of fixed nature, which cannot be increased with increase in variable factor in the
short run.
2. Poor Coordination between Variable and Fixed Factor:- When variable factor becomes too
excessive in relation to fixed factor, then they obstruct each other. It leads to poor coordination
between variable and fixed factor. As a result, total output falls instead of rising and marginal
product becomes negative.
3. Decrease in Efficiency of Variable Factor:- With continuous increase in variable factor, the
advantages of specialization and division of labour start diminishing. It results in inefficiencies of
variables factor, which is another reason for the negative returns to eventually set in.

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CONCEPTS OF COST

COST FOR AN ACCOUNTANT AND AN ECONOMIST

FOR AN ACCOUNTANT, COST = EXPLICIT COST
FOR AN ECONOMIST, COST= IMPLICIT COST+EXPLICIT COST+NORMAL PROFITS.
EXPLICIT COST: It may be defined as money expenditure which is actually incurred by producer
to hire the factors of production from outside the firm. These costs are shown in the books of
accounts, hence called Accounting Cost.
IMPLICIT COST: It may be defined as the cost of self owned factors of production. For ex.
Imputed rent of owner occupied building , interest of owner’s capital, wages of self owned
entrepreneur. These costs are also called non accounting cost or opportunity cost of owned
factors.
For an accountant, Cost = Explicit Cost
For an Economist, Cost = Explicit + Implicit Cost
ECONOMIC COST= ACCOUNTING COST (EXPLICIT COST)+NON ACCOUNTING COST (IMPLICIT
COST)
ACCOUNTING PROFIT= TOTAL REVENUE- ACCOUNTING COST
ECONOMIC PROFIT=ACCOUNTING PROFIT-NON ACCOUNTING/IMPLICIT COST
NOTE: ACCOUNTING PROFIT IS ALWAYS HIGHER THAN ACCOUNTING COST.

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OTHER IMPORTANT CONCEPTS OF COST

OPPORTUNITY COST: Opportunity cost is opportunity lost. It is the next best alternative
sacrificed by a factor of production in order to avail of a given opportunity. For example, If a
person invests his money in the business, he had to sacrifice the interest he could earn by
keeping that money in the bank. This is opportunity cost.
MONEY COST vs REAL COST: That cost which is capable of being measured in terms of money is
called money cost.
Real cost refers to the cost which is subjective and can’t be measured in terms of money. It
may be defined as all those pains, toils, discomforts, disutility and sacrifices made by a factor of
production to contribute her services in the production process.
PRIVATE COST vs SOCIAL COST: Private cost refers to the cost borne by the organization. It
includes money/explicit cost.
Social cost refers to the cost which is borne by the society and can’t be measured in terms of
money. For example, polluting environment

COST & COST FUNCTION

Cost of producing a commodity is the payment made to the factors of production which are
used in the production of that commodity.

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 MICRO ECONOMICS BY SUMAN MADAM

A Cost function shows the functional relationship between output and cost of production. It
gives the least cost combinations of inputs corresponding to different levels of outputs.
Cost function is given as:
C = f(Q)
Where, C = Cost
Q = Output

SHORT RUN COSTS

1. Total Cost: In short period, total cost comprises of fixed costs and Variable Cost:
TC = TFC + TVC
(TC = Total Cost, TFC = Total Fixed Cost; TVC = Total Variable Cost)
(a) Total Fixed Cost: - Fixed Costs are the sum total of expenditure incurred by the
producer on the purchase or hiring of fixed factors of production. These costs do not
change with the change in volume of output. Whether the output is zero or maximum,
fixed costs remain the same.
These costs are also known as supplementary costs or Indirect Costs. Fixed costs include
expenses like: (i) Rent (ii) Wages of permanent employees, (iii) Licence Fees, etc. Fixed
costs are explained with the help of following table and figure.

Units of Output Fixed costs (Rs.)

0 10
1 10
Cost (Rs.)

2 10
3 10
4 10
5 10
6 10

Output (Units)

(b) Total Variable Costs or Prime Costs:- Variable Costs are those which are incurred
on the use of variable factors. When output changes, these costs also change. As the
output increases, these costs also increase and as the output decreases, these costs also
decrease. When output is zero, these costs are also zero. These costs are called Prime
Costs or Direct Costs. Variable costs include expense like:
(i) Purchases of raw material,
(ii) Wages of casual labour,
(iii) Expenses on motive power or electricity,
(iv) Wear and tear expenses, etc.

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 MICRO ECONOMICS BY SUMAN MADAM

Variable costs are explained with the help of table and figure.

Units of Output Variable costs (Rs.)

0 0
1 10
2 18
3 24
4 28
5 32
6 38

(c) Total Cost: It is defined as the

aggregate of all costs of
producing any given level of
output. TC curve has been shown
in the figure. It is an inverse S-
shaped curve starting from the
level of fixed cost. A change in TC
is entirely due to change in TVC.
TC curve is above the TVC curve
by the amount of TFC. The
vertical distance between TVC
and TC curves is the amount of
TFC.

RELATIONSHIP BETWEEN TFC, TVC

AND TC
The TC curve is inverted-S shaped. This is because of the TVC curve. Since the TFC curve is
horizontal, the difference between the TC and TVC curve is the same at each level of output and
equals TFC. This is explained as follows: TC – TVC = TFC
The TFC curve is parallel to the horizontal axis while the TVC curve is inverted-S shaped.
Thus, the TC curve is the same shape as TVC but begins from the point of TFC rather than the
origin.
The law that explains the shape of TVC and subsequently TC is called the law of
variable proportions.

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 MICRO ECONOMICS BY SUMAN MADAM

2. Average Total Cost (ATC):- Average Cost is the cost per unit of output
produced. It is also called unit cost of production. The per unit cost explain the relationship
between cost and output in a more realistic manner. From total fixed cost (TFC), total
variable cost (TVC) and total cost (TC), we can obtain per unit costs. The kinds of ‘per unit
costs’ are:
1. Average Fixed Cost
2. Average Variable Cost
ATC = AFC + AVC / TC ÷ Q

The AC curve as derived from TC curve is U-shaped. It shows that as the output
increases the value of AC falls continuously till it reaches a minimum point. Beyond this
point, the AC starts rising. The reason behind the U-shape of AC curve is the law of
variable proportion.

Output AFC AVC ATC

(in units) (Rs.) (Rs.) (Rs.)
0 ∞ - -
1 12 6 12 + 6 = 18
2 6 5 6 + 5 = 11
3 4 5 4+5=9
4 3 6 3+6=9
5 2.40 7 2.40 + 7 = 9.40

(a) Average Fixed Cost (AFC)

Average fixed cost refers to the per unit fixed cost of production. It is calculated by
dividing TFC by total output. AFC = TFC ÷ Q
Where: AFC = Average Fixed Cost; TFC = Total Fixed Cost; Q = Quantity of output

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 MICRO ECONOMICS BY SUMAN MADAM

AFC falls with increase in output as TFC remain same at all levels of output. AFC curve is
a rectangular hyperbola, i.e. area under AFC curve remains same at different points.

Output TFC (Rs.) AFC (Rs.)

0 12 12 ÷ 0 = ∞
1 12 12 ÷ 1 = 12
2 12 12 ÷ 2 = 6
3 12 12 ÷ 3 = 4
4 12 12 ÷ 4 = 3
5 12 12 ÷ 5 = 2.40

AFC does not touch any of the axes

As AFC is a rectangular hyperbola, it approaches both the axes. It gets nearer and nearer
to the axes, but never touches them. AFC can never touch the X-axis as TFC can never be
zero. AFC curve can never touch the Y-axis because at zero level of output, TFC is a
positive value and any positive value divided by zero will be an infinite value.

(b) Average Variable Cost (AVC)

Average variable cost refers to the per unit variable cost of production. It is calculated
by dividing TVC by total output.
AVC = TVC ÷ Q
Where: AVC = Average Variable Cost; TVC = Total Variable Cost; Q = Quantity of output
AVC initially falls with increase in output. Once the output rises till optimum level, AVC
starts rising. It can be better understood with the help of Table. AVC initially falls with
increase in output and after reaching its minimum level (Rs. 5), AVC starts rising.
Like AVC, average cost also initially falls with increase in output. Once the output rises
till optimum level, AC starts rising.

Output TVC (Rs.) AVC (Rs.)

0 0 -
1 6 6÷1=6
2 10 10 ÷ 2 = 5
3 15 15 ÷ 3 = 5
4 24 24 ÷ 4 = 6
5 35 35 ÷ 5 = 7

RELATIONSHIP BETWEEN AFC, AVC AND ATC

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 MICRO ECONOMICS BY SUMAN MADAM

a) In the beginning, both AVC and AFC curves fall. Hence, the ATC curve falls as well.
b) Next, the AVC curve starts rising, but the AFC curve is still falling. Hence, the ATC curve
continues to fall. This is because, during this phase, the fall in the AFC curve is greater than
the rise in the AVC curve.
c) As the output rises further, the AVC curve rises sharply. This offsets the fall in the AFC curve.
d) Hence, the ATC curve falls initially and then rises.
e) The gap between AVC and ATC keep on decreasing because gap is AFC which continuously
falls.
f) But AVC and ATC can never touch each other as AFC can never be zero.

Output AFC AVC ATC

(in units) (Rs.) (Rs.) (Rs.)
0 ∞ - -
1 12 6 12 + 6 = 18
2 6 5 6 + 5 = 11
3 4 5 4+5=9
4 3 6 3+6=9
5 2.40 7 2.40 + 7 = 9.40

3. Marginal Cost (MC)

Marginal cost is defined as
addition made to total variable
cost or total cost when one more
unit of output is produced.
Symbolically,
MC =  TVC or  TC
Q Q
Alternatively,
MC = TCn – TCn-1 or
MC = TVCn – TVCn-1

Shape of MC Curve: MC curve, as Units TVC MC

derived from the TVC curve, is U- 0 0 -
shaped. The reason behind its 1 10 10
shape is the law of Variable 2 18 8
Proportion. 3 30 12

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 MICRO ECONOMICS BY SUMAN MADAM

4 45 15

RELATIONSHIP BETWEEN TVC AND MC CURVES

1. MC is the slope of the TVC curve at each

and every point. The value of slope
decline continuously, reaches a

Cost
minimum, and then starts rising.
2. TVC curve is inverse S-shaped which
starts from the origin and MC is U-
shaped.
3. When TVC rises at a diminishing rate, MC
declines. Output
4. When TVC rises at an increasing rate, MC
rises.
5. TVC is equal to the sum of MC.
Graphically TVC is the area under the MC
Cost

curve.

RELATIONSHIP BETWEEN AC AND MC CURVES

Output

1. Both AC and MC are derived from TC by

the formulas:
AC = TC
Q
And, MC = TC
Q
2. Both AC and MC curves are U-shaped,
reflecting the law of Variable Proportion.
3. AC includes both variable cost and fixed
cost since AC = AFC + AVC. But MC is
addition made only to variable cost when
output is increased by one more unit.
4. When AC is falling, then MC is below AC.
5. When AC is rising, then MC is above AC.
6. When AC is neither falling nor rising, then Minimum Minimum
MC is equal to AC. MC AC
7. There is a range over which AC is falling
but MC is rising.
8. MC curve cuts the AC curve at its54
minimum point.
 MICRO ECONOMICS BY SUMAN MADAM

RELATIONSHIP BETWEEN AVC AND MC CURVES

1. Both AVC and MC are derived from TVC by the
formulas,
AVC = TVC
Q
And MC = TC or = TVC
…… since MC is the changes in TVC or TC due
Q Q
to additional unit produced.

2. Both AVC and MC curves are U-shaped

reflecting the law of Variable Proportion.
3. The minimum point of AVC curve will always
occur to the right of the minimum point of MC
curve.
4. When AVC is falling, then MC is below AVC.
5. When AVC is rising, then MC is above AVC.
6. When AVC is neither falling nor rising, then MC
= AVC.
7. There is a range over which AVC is falling and
MC is rising.

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 MICRO ECONOMICS BY SUMAN MADAM

CONCEPTS OF REVENUE

MEANING OF REVENUE
The amount of money that a producer receives in exchange for the sale proceeds is known as
revenue. For example, if a firm gets Rs. 16,000 from sale of 100 chairs, then the amount of Rs.
16,000 is known as revenue.
In the words of Dooley, “The revenue of a firm is its sales receipts or money receipts from the
sales of a product.” It is also called sale proceeds.

TYPES OF REVENUE

1. Total Revenue (TR)

Total Revenue refers to total receipts from the sale of a given quantity of a commodity. It is the
total income of a firm. Total revenue is obtained by multiplying the quantity of the commodity
sold with the price of the commodity.
Total Revenue = Quantity x Price
For example, if a firm sells 10 chairs at a price of Rs. 160 per chair, then the total revenue will
be: 10 chairs x Rs. 160 = Rs. 1,600.
2. Average Revenue (AR)
Average revenue refers to revenue per unit of output sold. It is obtained by dividing the total
revenue by the number of units sold.
Average Revenue = Total Revenue
Quantity
For example, if total revenue from the sales of 10 chairs @ Rs. 160 per chair is Rs. 1,600, then
average revenue will be: 1,600 = Rs. 160
10
NOTE: AR IS THE PRICE OF THE COMMODITY if and only if all units are being sold at the same
price. If producer charges different price for different units of the product then AR will not be
equal to the Price. But in real life we see that most of the times, (except for discriminating
monopoly) a seller charges same price for all the units of a product and hence, AR is equal to
price.

3. Marginal Revenue (MR)

MR is addition made to total revenue when one more unit of output is sold.
Marginal Revenue = Change in Total Revenue ÷ Change in Quantity or
Marginal Revenue = TRn – TRn-1

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 MICRO ECONOMICS BY SUMAN MADAM

RELATIONSHIP BETWEEN TR AND MR

(a) MR is an addition to TR when one more unit of output is sold.
(b) When MR is positive, TR rises.
(c) When MR is zero, TR is Maximum.
(d) When MR is negative, TR falls.
(e) When MR is constant, TR will increase at a constant rate.

RELATIONSHIP BETWEEN AR AND MR

(a) AR and MR both are straight line downward sloping curves.
(b) MR can be zero or negative but AR can’t be.
(c) When AR is constant, AR = MR
(d) When AR falls, MR also fall but MR falls at twice the rate at which AR falls.

FIRM’S REVENUE CURVE IN DIFFERENT MARKETS

(i) Revenue Curves under
Perfectly Competitive Market
or Perfect Competition: Under
perfect competition, a firm is only a price-
taker. It can sell any number of units of
output at the prevailing price. If a firm
tries to sell at a price higher than market
Price = AR = MR = d
price, it will lose its entire customer,
because they are fully aware of market
condition. In other words, no firm under
perfect competition can charge a price
higher than the prevailing market price.
Nor can it afford to charge a price less
than the prevailing market price.

Hence, its marginal revenue is equal to its average revenue (price). It is shown in figure.
The horizontal straight line represents both marginal as well as average revenue and
price. Thus, firm’s AR and MR curves are perfectly elastic under perfect competition.

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 MICRO ECONOMICS BY SUMAN MADAM

TR, AR, MR Schedules under Perfect Competition

No. of Units Sold Price (P) TR = P x Q AR = P MR = TR
(Q) Q
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
(ii)Revenue Curves under Monopoly: Under Maximum TR
monopoly, the average revenue curve and
marginal revenue curve slope downwards
from left to right. It means that if a
monopolist desires to sell more units of
the output, he will have to reduce the
price. On the other hand, if the monopolist
desires to charge high price, he will be able
to sell less units of output. In other words,
there is negative relationship between the
demand for the product of monopolist and
its price.
(iii) Revenue curves under monopolistic
competition: Revenue curves under
monopolistic competition are similar to
monopoly. The main difference between
monopoly and monopolistic competition is
that under monopolistic competition, AR
MR = 0
and MR curves are more elastic. It means
that when a monopoly firm raises the
price, the demand will fall proportionately Revenue Schedules under Monopoly
less for a firm than under monopolistic and Monopolistic Competition
competition. On the other hand, if a firm
under monopolistic competition raises the
price, the proportionate fall in its demand Output AR TR MR
will be more. It is so because in a 1 10 10 10
2 9 18 8
monopolistic competitive market, goods 3 8 24 6
have their substitutes and buyers are 4 7 28 4
equally attracted towards them. If one firm
raises the prices of its products, the buyers
will shift their demand to the substitute
product whose price remains unchanged.
Thus, if a firm raises price, demand for its 58
product will fall and if it lowers the price,
demand for its product will rise.
 MICRO ECONOMICS BY SUMAN MADAM

THEORY OF SUPPLY

MEANING OF SUPPLY
Supply of a commodity means quantity of the commodity which a firm or an industry is willing
to produce at a given price during some particular time. Like demand, supply definition is
complete when it has the following elements:
(i) Quantity of a commodity that the producer is willing to offer for sale;
(ii) Price of the commodity; and
(iii) Time during which the quantity is offered for sale.
For example: Firm A supplies 50 kg. of wheat at price of Rs. 10 per kg. in a month is a statement
of supply.
Like demand, supply also can be either for a single seller (Individual Supply) or for all the seller
(Market Supply).
1. Individual Supply refers to quantity of a commodity that an individual firm is willing
and able to offer for sale at each possible price during a given period of time.
2. Market Supply refers to quantity of a commodity that all the firms are willing and
able to offer for sale at each possible price during a given period of time.

DISTINCTION BETWEEN STOCK AND SUPPLY

In the ordinary language, the terms supply and stock are used in the same sense. In economics,
these terms have different meanings. Stock of a commodity refers to the total quantity of that
commodity which at any given time is available in the market with the seller. Supply refers to
that part of the stock that the seller is prepared to sell at a given price and at a given time.
Supposing, the stock of wheat in the market in the month of March 2000 is 100 tonnes and the
prevailing price is Rs. 500 per quintal. If at this price, seller is prepared to sell 10 tonnes of
wheat, then the supply of wheat will be 10 tonnes only.

DETERMINANTS OF INDIVIDUAL SUPPLY OR

INDIVIDUAL SUPPLY FUNCTION
Supply function is a functional relationship between quantity supplied of a commodity and
factors affecting it. The supply function can be written as:
Sx = f(Px, Pz, T,C,Gp)
Where
Sx = Supply of commodity X
f = function of

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 MICRO ECONOMICS BY SUMAN MADAM

Px = Price of commodity X
Pz = Price of related good, Z
T = Technological changes
C = Cost of production or price of inputs
Gp = Government policy or excise tax rate.

1. Price of the Commodity

At a higher price, producer offers more quantity of the commodity for sale and at a lower price,
less quantity of the commodity is offered for sale.
There is a direct relationship between price and quantity supplied as shown by law of supply.
2. Price of related Good (Z)
Supply of commodity depends upon the prices of its related goods, especially substitute goods.
If the price of commodity remains constant and the price of its substitute good Z increase, the
producers would prefer to produce substitute good Z. As a result, the supply of commodity X
will decrease and that of substitute goods Z will increase. This will shift the supply curve of good
X leftward. Thus, an increase in the price of substitute good will lead to decrease in supply
curve of the other good and vice versa.
3. State Of Technology
If there is a change in the technique of production leading to a fall in the cost of production,
supply of commodity will increase.
For example: New photocopy technique, printing technique, computerized calculations, etc.
Such advancement will lower the Marginal Cost (MC) at each level of output,
Thus, with technological advancement supply curve shifts to the right.
4. Cost of production
A change in the cost of production, i.e., price of factors of production also affects the supply of
a commodity. If wages of labour or price of raw materials increase, then MC of production will
rise. As a result, supply of the good will fall because producers would prefer to produce some
other commodities that can be produced at a lower cost. Thus, an increase in input price or
cost will shift the supply curve to the left and vice versa.
5. Government Policy
Government’s policy also affects the supply of a commodity. If heavy excise taxes are imposed
on a commodity, it will discourage producers and as a result, its supply will decrease. It is
because excise duty is levied on the total production cost of a firm. An increase in excise duty
will raise firm’s total variable cost, which will raise MC curve. Thus, supply curve will also shift t
the left.
Thus, an increase in excise tax will shift the supply curve to the left and vice versa.

SUPPLY & QUANTITY SUPPLIED

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 MICRO ECONOMICS BY SUMAN MADAM

1. Change in Quantity Supplied: Whenever supply for the given commodity

changes due to changes in its own price, then such change in supply is known as
“Change in Quantity Supplied”. For example, if supply of Close-Up changes due to
change in its own price, then such change in supply for Close-up is known as change in
quantity supplied.
2. Change in Supply: Whenever supply for the given commodity change due to
factors other than price, then such change in supply is known as “Change in Supply”. For
example, If supply of Close-Up changes due to change in price of other goods or due to
change in technology or due to change in taxation policy, then such change in supply for
Close-Up is known as change in supply.

SUPPLY SCHEDULE
Supply schedule is a tabular presentation of various quantities of a commodity offered for sale
corresponding to different possible prices. A hypothetical supply schedule is given in the
following table. Table clearly shows that more and more units of the commodity are being
offered for sale as the price of the commodity is increased.
It has two aspects:
(i) Individual Supply Schedule: Individual supply Price Quantity
schedule refers to supply schedule of an individual firm in the (Rs.) (units)
market. It shows supply response of a particular firm in the 1 10
market. 2 20
Individual supply schedule expresses different quantities 3 30
supplied by a firm at different prices. 4 40
(ii) Market Supply Schedule: Market supply schedule 5 50
refers to supply schedule of all the firms in the market
producing/supplying a particular commodity. Sum total of the
firms producing a particular commodity is called ‘Industry’.
Thus, market supply schedule refers to the supply schedule of
the industry as a whole. It shows supply response of all the
firms (producing a particulars commodity) in the market.

SUPPLY CURVE

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 MICRO ECONOMICS BY SUMAN MADAM

Supply Curve refers to a graphical

representation of supply schedule. It shows
the direct relationship between price and
quantity supplied, keeping other factor
constant. Supply curve can be drawn for any
commodity. It is drawn by plotting each
combination of the supply schedule on a
graph. The supply curve slopes upwards
due to positive relationship between price
and quantity supplied. Like supply
schedules, supply curves can also be drawn
both for individual producer and for all the
producers in the market. So, supply curve is of
two types:
(i) Individual Supply Curve: Individual supply curve refers to a graphical
representation of individual supply schedule.
(ii) Market Supply Curve: Market supply curve refers to a graphical representation of
market supply schedule. It is obtained by horizontal summation of individual supply
curves.

LAW OF SUPPLY
Definition: Law of Supply states that as price of the commodity increases, there is more supply
of that commodity in the market and vice-versa, i.e., quantity supplied of a commodity is directly
related to the price of the commodity.
The law states that other things remaining the same, the producers will supply more quantity of
goods at a higher price and less quantity of goods at a lower price.

Assumption of law of Supply

The law of supply is based on the assumption that all factors other than price of the commodity
that affect the supply remain the same. In other words:
1. Price of other goods is constant;
2. There is no change in the state of technology;
3. Prices of factors of production remain the same;
4. There is no change in the taxation policy;
5. Goals of the producer remain the same.

REASONS BEHIND UPWARD SLOPING SUPPLY

CURVE
1. Profit Motive:- The basic aim of producers, while supplying a commodity, is to
secure maximum profits. When price of a commodity increases, without any change in

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 MICRO ECONOMICS BY SUMAN MADAM

costs, it raises their profits. So, producers increase the supply of the commodity by
increasing the production. On the other hand, with fall in prices, supply also decreases as
profit margins decreases at law prices.
2. Law of diminishing marginal productivity: The law states that as more
units of variable factors are employed, the addition made to total production falls, i.e.,
cost of production rises. Thus, more quantity is supplied only at higher prices so as to
cover the rise in cost of production.
3. Changes in Number of Firms: A rise in price induces the prospective
producers to enter into the market to produce the given commodity so as to earn higher
profits. Increase in number of firms raises the market supply. However, as the price starts
falling, some firms which do not expect to earn any profits at a low price either stop the
production or reduce it. It reduces the supply of the given commodity as the number of
firms in the market decreases.
4. Change in Stock:- When the price of a good increases, the seller are ready to
supply more goods from their stocks. However, at a relatively lower price, the producers
do not release big quantities from their stocks. They start increasing their inventories with
a view that price may rise in near future.

EXCEPTIONS TO LAW OF SUPPLY

1. Future Expectations: If seller expects a fall in price in the future, then the law of
supply may not hold true. In this situation, the sellers will be willing to sell more even at
a lower price. However, if they expect the price to rise in the future, they would reduce
the supply of the commodity, in order to supply the commodity later at a high price.
2. Agricultural Goods: The law of supply does not apply to agricultural goods as
their production depends on climatic conditions. If, due to unforeseen changes in
weather, the production of agricultural product is low, then their supply cannot be
increased even at higher prices.
3. Perishable Goods: In case of perishable goods, like vegetables, fruits, etc., sellers
will be ready to sell more even if the price is falling. It happens because sellers cannot
hold such goods for long.
4. Rare Articles: Rare, artistic and precious article are also outside the scope of law of
supply. For example, supply of rare articles like painting of Mona Lisa cannot be
increased, even if their prices are increased.
5. Backward Countries: In economically backward countries, production and
supply cannot be increased with rise in price due to shortage of resources.

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 MICRO ECONOMICS BY SUMAN MADAM

EXTENSION & CONTRACTION OF SUPPLY /

CHANGE IN QUANTITY SUPPLIED / MOVEMENT
ALONG THE SUPPLY CURVE

(i) Extension of Supply:

Other things being equal, when quantity supplied of a
commodity increases due to rise in its price, it is called
extension of supply. It is shown in Table & Figure.
In the table, it is shown that when price is Re 1 the
quantity supplied is of 5 unit. When price rises to Rs. 5,
the supply extends to 5 units. In figure SS is the supply
curve of ice cream. When price of Ice-cream is Re 1,
supply is of 1 ice cream. When price rises to Rs. 5, the
supply extends to 5 units.

Price of Quantity Description

Ice Cream (Rs.) Supplied (Units)
1 1 Rise in Price

5 5 Extension of
Supply

(ii) Contraction of Supply

Other things being equal, when quantity supplied
of a commodity decrease due to fall in its price, it
is called contraction of supply.
In the table it is shown that when price of ice
cream is Rs. 5, the supply is of 5 units of ice
cream. When price falls to Re 1, then the supply
contracts to 1 units of ice cream. In figure SS is
the supply curve of ice cream. When the price is
Rs. 5, supply is 5 units.

Price of Quantity Description

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 MICRO ECONOMICS BY SUMAN MADAM

Ice Cream (Rs.) Supplied (Units)

5 5 Fall in Price

1 1 Contraction of
Supply

INCREASE IN SUPPLY AND DECREASE IN SUPPLY

When supply of a commodity changes due to factors other than its own price, such as change in
expectations, state of technology or goal of the firm then it is called increase or decrease in
supply.
Such changes are represented by forward or rightward and back ward or leftward shifts in
supply curve.
(i) Increase in Supply
Increase in supply is a situation when firms are willing
to supply more of a commodity at its existing price. It
may be due to cheaper availability of inputs or due to
technological improvements causing a reduction in
cost of production, or other such factors. Table and

Price
figure illustrate the situation of increase in supply.
The table shows that initially, 20 units of the
commodity are supplied at the price of Rs. 10 per
unit. Owing to some causes (generally related to
reduction in that cost of production) firms are now
willing to supply 30 units even when the price Quantity
remains to be Rs. 10 per unit.

Price of X (Rs.) Quantity Supplied of X (Units)

10 20
10 30

Causes of Increase in Supply

Increase in supply occurs due to the following reasons:-
(i) Improvement in technology.
(ii) Reduction in the price of factors of production causing fall in cost of production.
(iii) When price of competing good decreases.
(iv) Increase in number of firms in the market.
(v) When the firm expects a fall in the price of the commodity in near future.
(vi) When goal of the firm shifts from profit maximization to sales maximization.

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 MICRO ECONOMICS BY SUMAN MADAM

(ii) Decrease in Supply

Decrease in supply is a situation when firms
are willing to supply lesser quantity of a
commodity at its existing price. It may be due
to increase in the price of inputs or such other
factors. Table and figure illustrate the situation
of decrease in supply.
The table shows that initially, 30 units of the
commodity are supplied at the price of Rs. 10
per unit. Due to some factors (generally
related to increase in the cost of production),
firms are now willing to supply only 20 units
even when price remains to be Rs. 10 per unit.

Decrease in Supply
Price of X (Rs.) Quantity Supplied of X (Units)
10 30
10 20

Causes of Decrease in Supply

Decrease in supply occurs due to the following reasons:
(1) When the technique becomes obsolete resulting in high cost of production.
(2) When factor prices increase causing increase in cost of production.
(3) When prices of competing goods increase.
(4) Decrease in number of firms in the market.
(5) When the firm expects a rise in commodity price in the near future.
(6) Objective of the firm shifts from sales maximization to profit maximization.

DIFFERENCE BETWEEN INCREASE IN SUPPLY AND

EXPANSION OF SUPPLY
Increase in Supply Expansion of Supply
1. It is shift of supply curve. 1. It is movement along a supply curve.
2. In this case there is a rightward shift of 2. In this case there is an upward
supply curve. movement along the supply curve.
3. It is due to favourable changes in factors 3. It is due to rise in the price of the
like: commodity.
(a) Improvement in the technique of

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 MICRO ECONOMICS BY SUMAN MADAM

production.
(b) Decrease in cost of production.
(c) Decrease in price of related goods.
Etc
4. It is defined as rise in supply at the same 4. It is defined as the rise in supply at
price of the good. higher
price of the good.
5. Graphical representation 5. Graphical representation
* already shown above * already shown above

DIFFERENCE BETWEEN DECREASE IN SUPPLY

AND CONTRACTION OF SUPPLY
Decrease in Supply Contraction of Supply
1. It is shift of supply curve. 1. It is movement along a supply curve.
2. In this case there is a leftward shift of 2. In this case there is an downward movement
supply curve. along the supply curve.
3. It is due to: 3. It is due to fall in the price of the
(a) Outdated technology commodity.
(b) Increase in cost of production.
(c) Rise in price of related goods. Etc

4. It is defined as fall in supply at the same 4. It is defined as the rise in supply at lower
price of the good. price of the good.
5. Graphical representation 5. Graphical representation
* already shown above * already shown above

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 MICRO ECONOMICS BY SUMAN MADAM

PRODUCER’S EQUILIBRIUM
MEANING OF PRODUCER’S EQUILIBRIUM
A producer is said to be in equilibrium when he produces that level of output at which his
profits are maximum. Producer’s equilibrium is also known as profit maximization situation.
The primary objective of a producer is to earn maximum profits. Profit is the difference
between total revenue and total cost. Producer is in equilibrium at that level of output
at which he is earning maximum profit. He has no incentive to increase or decrease this level of
output. If he produces less than this, he does not maximize total profits. Similarly, if he
produces beyond this, total profits decline. Thus, the producer is in a ‘state of rest’ only at the
level of output, at which the difference between the total revenue and total cost of production
is maximum, i.e., total profits are maximum.
There are two methods for determination of Producer’s Equilibrium:
1. Total Revenue and Total Cost Approach (TR – TC Approach)
2. Marginal Revenue and Marginal Cost Approach (MR – MC Approach)

TOTAL REVENUE – TOTAL COST APPROACH

A firm attains the stage of equilibrium when it maximizes its profit. Profits of the firm are
defined as the difference between TR and TC. So, a producer will be at equilibrium when he
maximizes this difference.
So, two essential conditions for producer’s equilibrium are:
1. The difference between TR and TC is positively maximized;
2. Total profits fall after that level of output.

Producer’s Equilibrium in case of Perfect Competition

When price remains same at all output levels
(like in case of perfect competition), each
producer takes the price of the product as fixed
by the market. It means price remains same at
all levels of output. Producer aims to produce Maximum Profit
that level of output at which he can earn
maximum profits, i.e. when difference between
TR and TC is the maximum.

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The producer will be at equilibrium at 4 Output Price TR TC Profit Remarks

units of output because at this level, (units) (Rs.) (Rs.) (Rs.) (TR-TC)
(Rs.)
both the conditions of producer’s
equilibrium are satisfied: 0 10 0 5 -5 Profit rises
1. Producer is earning maximum 1 10 10 8 2 With
profit of Rs. 9; 2 10 20 15 5 increase
2. Total profit falls to Rs. 8 after 4 3 10 30 21 9 In output
units of output. 4 10 40 31 9 Producer’s
Equilibrium
5 10 50 42 8 Profit falls
6 10 60 54 6 with
Increase in
output

Producer’s Equilibrium in case of Imperfect Competition

When firms can increase their volume of sales only by decreasing the price, then there is no fixed
price and price has to be reduced to increase the sales. It means price falls with rise in output.
Producer will aim to achieve that output level, at which there are maximum profits, i.e. when
difference between TR and TC is the maximum. It can be better understood with the help of the
following schedule.

Output Price TR TC Profit Remarks

(units) (Rs.) (Rs.) (Rs.) (TR-TC)
(Rs.)
0 10 0 2 -2 Profit rises
1 9 9 5 4 With increase
2 8 16 9 7 In output
3 7 21 11 10
4 6 24 14 10 Producer’s Equilibrium
5 5 25 20 5 Profit falls with
6 4 24 27 -3 Increase in output

Break-even points are those points at which

TR = TC and profit is zero. It is also called Break-even
‘no-profit-no-loss’ point. The producer will points
be at equilibrium at 4 units of output
because at this level, both the conditions of TR
producer’s equilibrium are satisfied:
TR & TC

1. Producer is earning maximum profit

of Rs. 10;
2. Total profit falls to Rs. 5 after 4 units
of output.

Output
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MARGINAL REVENUE – MARGINAL COST

APPROACH (MR-MC APPROACH)
According to MR-MC approach, two essential conditions for producer’s equilibrium are:
1. MC = MR;
2. MC curve should cut the MR curve from below or MC curve must be rising at the point
of equilibrium or slope of MC > Slope of MR.

Producer’s Equilibrium in case of Perfect Competition

When price remains constant, Firms can sell any quantity of output at the price fixed by the
market. Price or AR remains same at all level of output. Also, the revenue from every additional
unit (MR) is equal to AR. It means, AR curve is same as MR curve. Producer aims to produce
that level of output at which MC is equal to MR and MC curve cuts the MR curve from below.

Output Price TR TC MR MC Profit

(units) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (TR-TC)
(Rs.)
1 8 8 6 8 6 2
2 8 16 14 8 8 2
3 8 24 20 8 6 4
4 8 32 28 8 8 4
5 8 40 38 8 10 2

Both AR and MR curves are straight line parallel to the X-axis. MC curve is U-shaped.
Producer’s equilibrium will be determined at OM1 level of output corresponding to point B
because only at point B, the following two conditions are met:
1. MC = MR: At profit maximizing level of output, it is necessary for the firm to operate at
a level where MR is equal to MC. As long as MR>MC, it is not advisable to stop. When
MR<MC, it is not advisable to continue further. Therefore, a point of stability or
equilibrium can only be one where MR=MC. This however, is necessary but not
sufficient condition. There may be two levels where MR=MC but both are not profit
maximizing levels of output. So, there is another sufficient condition which must be
fulfilled at profit maximizing level of output.
2. MC curve cuts the MR curve from below: It is so because a point where MR curve cuts
MC from above, it is a level where profits are minimum and not maximum. It is just at
this level that firm has started to earn profits. It is actually, Break Even Point.

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Although MC = MR is also satisfied at point A, but it is not the point of equilibrium as it satisfies
only the first condition (i.e. MC = MR). So, that producer will be at equilibrium at point B when
both the conditions are satisfied.

Producer’s Equilibrium in Imperfect Competition:-

When there is no fixed price and price falls with rise in output, MR curve slope downwards.
Producer aims to produce that level of output at which MC is equal to MR and MC curve cuts
the MR curve from below:

Output Price TR TC MR MC Profit

(units) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (TR-TC)
(Rs.)
1 8 8 5 8 6 3
2 7 14 8 6 5 6
3 6 18 12 4 4 6
4 5 20 15 2 3 5
5 4 20 19 0 5 1

According to Table both the conditions of equilibrium are satisfied at 3 units of output. MC
is equal to MR and MC is greater than MR when more output is produced after 3 units of
output. So, producer’s Equilibrium will be achieved at 3 units of output.
In Fig. Output is shown on the X-axis and revenue and revenue and cost on the Y-axis.
Producer’s equilibrium will be determined at OM level of output corresponding to point E
because at this, the following tow conditions are met:
1. MC = MR;
2. MC curve cuts the MR curve from below.

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FORMS OF MARKET
CONCEPT OF MARKET
In economics, market is more than a geographical area or a ‘mandi’ where goods are bought
and sold. Market is defined as a complex set of activities by which potential buyers and
potential sellers are brought in close contact for the purchase and sale of a commodity.
A market must have the following features:-
(i) Commodity, i.e., there must be a commodity which is being demanded and sold.
(ii) Buyers and Sellers, i.e., there must be buyer and sellers of the commodity.
(iii) Communication, i.e., there must be communication between buyers and sellers.
(iv) Place of Areas, i.e., there must be a place or area where buyers and sellers interact
with each other.

TYPES OF MARKET STRUCTURE

1. Perfect Competition
Perfect competition is defined as a market structure in which an individual firm cannot
influence the prevailing market price of the product on its own. A good example of
perfect competition is the agriculture market. Otherwise, it is an ideal situation which
rarely exists in the real world. There said to be perfect competition in an industry when
certain conditions are satisfied. These conditions or assumptions are divided into two
group:-
(a) Conditions of pure competition among the producers, plus (from 1, 2 and 3)
(b) Conditions of perfect market for the commodity. (4, 5, 6 and 7)
Features of Perfect Competition:-
The following are the main features of perfect competition:-
1. Large Number of Sellers and Buyers:- The number of firms selling a particular
commodity is so large that any increase or decrease in the supply of one particular
firm hardly influences the total market supply. Accordingly, any individual firm fails
to make any influence on the price of the commodity. Not only is the number of
sellers very large, also the number of buyers is very large. Accordingly, like an
individual firm, an individual buyer is also not able to influence price of the
commodity. It is therefore said that a firm under perfect competition is a price taker.
In other words, it has to sell its products at the prevailing market price.
Implication: The perfectly competitive firm is then a ‘price-taker’ and can sell any
amount of the commodity at the given price.
2. Homogeneous Product:- All sellers sell identical units of a given product. An
important conclusion can be drawn from this feature. It is that buyers will have no

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reason to prefer the product of one seller to the product of another seller. Thus, the
price of the product throughout the market will be the same.
Implication: Since the products are identical, buyers are indifferent between
suppliers.
3. Free Entry and Exit of Firms:- A firm can enter and leave any industry. There is no
legal restriction on the entry or exit.
Implication: The implication of this feature is that given sufficient time, all firms in
the industry will be earning just normal profit.
4. Perfect Knowledge:- Buyers and sellers are fully aware of the price prevailing in the
market. Buyers know it fully well at what price sellers are selling a given product. As
a consequence, only one price prevails in the market.
Implication: The implication of this feature is that any attempt by any firm to charge
a price higher than the prevailing uniform price will fail. The buyers will not pay
higher price because they have perfect knowledge.
5. Perfect Mobility:- Factors of production are perfectly mobile under perfect
competition. Factor will move to that industry which pays the highest remuneration.
Implication: Its implication is that skills can be learnt easily.
6. No Extra Transport Cost:- All goods are produced locally. Transportation costs are
zero.
7. No Selling costs: Selling homogeneous product at the given price rules out the
possibility of advertisement or other sale-promotion expenses. So that there are no
selling costs in perfectly competitive market.

2. Monopoly
‘Monopoly’ is derived from two Greek words: ‘Monos’ means single and ‘polus’ means a
seller. Monopoly refers to a market situation where there is a single seller selling a
product which has no close substitutes. For example, Railways in India.
Features of Monopoly:-
The Various features of Monopoly are:-
1. Single Seller:- Under monopoly, there is a single seller selling the product. As a
result, the monopoly firm and industry is one and the same thing and monopolist
has full control over the supply and price of the product. However, there is large
number of buyers of monopoly product and no single buyer can influence the
market price.
2. No Close substitutes:- The product produced by a monopolist has no close
substitutes. So, the monopoly firm has no fear of competition from new or existing
products. For example, there is no close substitute of electricity services provided by
NDPL. However, the product may have distant substitutes like inverter and
generator.
3. Restrictions on Entry and Exit:- There exist strong barriers to entry of new firms and
exit of existing firms. As a result, a monopoly firm can earn abnormal profits in the
long run. These barriers may be due to legal restrictions like licensing or patent right
or due to restrictions created by firms in the form of cartel.

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4. Price Discrimination:- A monopolist may charge different prices for his product from
different sets of consumers at the same time. It is known as ‘Price Discrimination’.
5. Price Maker:- In case of monopoly, firm and industry are one and the same thing.
So, firm has complete control over the industry output. As a result, monopolist is a
price-maker and fixes its own price. It can influence the market price by changing
the supply of the product.
Causes of Monopoly:-
The Main causes that leads of emergence of monopoly are:-
1. Control of Resources:- Sometimes, a firm gains control of resources that is necessary
for the production of particular commodity. There are no good substitutes for this
resource. New firms cannot enter the market for this commodity and compete.
2. Patent Rights:- Sometimes, one firm may gain exclusive right to the production
process for a good. The alternative production processes are not available. A firm
can apply for patent rights. It entitles it owner exclusive right to a production
process. None else can use their technology without getting licence from them.
3. Economies of Scale:- Sometimes, a firm starts controlling the market when it has
substantial economies of scale. The competitors who desire to enter the market
should have substantial financial standing to be able to sell the good at a price as
low as the price of the existing firm and remain profitable too.
4. Legal Barriers:- Sometimes, monopolies are created by state or bylaw as in case of
water, railways, etc.
5. Cartels:- Cartel is a large number of firms which have explicitly and openly agreed to
work together. Cartels are often international. The most widely recognized and
successful example of a cartel is the Organization of Petroleum Exporting Counties
(OPEC). In this, individual identity of the firm is retained.

3. Monopolistic Competition:-
In real life, it is monopolistic competitive market that generally exists. It is that situation
of the market wherein there are many sellers of the product, but the product of each
seller is a bit different from the products of other sellers.
There are many examples relating to this kind of market. Firms producing different
brands of toothpaste, as Pepsodent, Colgate, Close-up, etc. are operating under
monopolistic competition. This market situation is a combination of monopoly and
competition.
Features of Monopolistic Competition:-
1. Large Number of Firms:- There are large number of sellers selling closely related but not
homogeneous products. Each firm acts independently and has limited share of the
market.
2. Product Differentiation:- The distinct feature of monopolistic competition is product
differentiation. Though the number of firms is large but their products differ from one
another, in colour, shape, brand, quality, durability, etc. These products are close
substitutes. Product differentiation has many examples i.e. in case of soaps, we have
several brands as Lux, Hamam, Godrej, Pears, Palmolive, etc. and in case of tea, Lipton,

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Brooke Bond, Taj Mahal and in case of tooth-paste, Close-up, Colgate, etc. Because of
product differentiation, each firm can decide its price policy independently. So that each
firm has a partial control over price of its product.
3. Freedom of Entry and Exit of Firms:- Firms are free to enter into, or exit from the
industry. But new firms have no absolute freedom of entry into industry. They may have
to face several difficulties. Products of some firms may be legally patented. New firms
cannot produce those products. No rival firm can produce and sell a patented item like
Woodland shoes.
4. Selling Cost:- Each firm has to spend a lot on the advertisement of its products. In order
to sell more units of the product, it gives wide publicity of its product in newspapers,
cinemas, journals, radio, TV, etc. The expenses on advertisement and publicity are called
selling costs.
5. Less Mobility:- There is no perfect mobility of factors, goods and services.
6. Lack of Perfect Knowledge:- Sellers and buyers of products and owners of factors of
production do not have perfect knowledge about the prices of the products and factor
services. It is so because due to product differentiation, it is not possible to compare the
price of different products. Likewise, factors of production are also not fully aware of
the price being paid by different firms for the services of the factors.
7. Non-Price Competition:- Another feature of monopolistic competition is that firms may
compete with one another without changing the price of their products. For example, if
you buy one packet of ‘Surf’, you may get one glass tumbler free with it; and on the
purchase of one packet of ‘Rin’, you may get one stainless steel tea-spoon free. Thus,
firms compete in attracting potential buyers by offering them gifts and other services. In
short, they compete on other than the price front. The consumers develop liking for a
particular product. They would buy that very product even if its price is higher than the
products of other firms.
8. More can be sold only at Lower Price:- Under monopolistic competition, a firm can sell
more of the product only by lowering the price. Accordingly, firm’s demand curve under
monopolistic competition also slopes downwards.

4. Oligopoly
Oligopoly is a market structure in which there are only a few sellers (but more than two)
of the homogeneous or differentiated products. So, oligopoly lies in between
monopolistic competition and monopoly. Oligopoly refers to a market situation in which
there are a few firms selling homogeneous or differentiated products. Oligopoly is,
sometimes, also known as ‘competition among the few’ as there are few seller in the
market and every seller influences and is influenced by the behaviour of other firms.
Example:- (i) Automobiles, steel etc.
Features of Oligopoly:-
(a) Few Dominant Firms:- Oligopolists are often large firms, each producing a significant
portion of total market output. There are only a few rival firms.

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(b) Mutual Interdependence:- Since the market is dominated by a few firms, the price
and output decisions of one firm affects the profitability of the remaining firms in
the market. Mutual interdependence is an incentive to develop alternatives to price
competition in the pursuit of economic profit.
(c) Barriers to Entry:- Barriers to entry limits the threat of competition and facilitates
the ability of firms to earn long-run economic profits.
(d) Homogeneous or Differentiated Products:- The output of an oligopolistic market
may be either homogeneous or differentiated.
(e) Demand Curve:- In an Oligopoly, due to high degree of interdependency amongst
oligopolistic firms, we cannot define the demand curve faced by an oligipolist firm.
Hence, the solution is indeterminate.
(f) Price Rigidity:- In oligopolistic firms, price are administered. Each rival firm reacts
immediately to the changed price, due to which the price remains rigid in the
market.

DEMAND CURVE UNDER PERFECT COMPETITION

In case of perfect competition, there are very
large number of buyers and sellers selling a
homogeneous product at a price fixed by the Demand Curve/ AR Curve
market. Therefore, each firm is a price-taker
and faces a perfectly elastic demand curve. Ed= ∞
In case of perfect competition, MR = AR, since
price is uniform in the market and revenue
from every additional unit (i.e. MR) is equal to
price (i.e. AR) of the product.

DEMAND CURVE UNDER MONOPOLY

A monopoly firms is like an industry as the single seller
Demand Curve/
constitutes the entire market for the product, which has no
close substitutes. So, a monopolist has full freedom and AR Curve
power to fix price for the product. However, demand of the
product is not in the control of monopoly firm. In order to
increase the output to be sold, monopolist will have to reduce
the price. Therefore, monopoly firm faces a downward sloping
demand curve.
MR< AR under Monopoly
A monopoly firm faces a downward sloping demand curve as
more output can be sold by reducing the price. As a result,
revenue generated from every additional unit (known as MR)
is less than price (AR) of the product. Due to this reason, MR is
less than AR.

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DEMAND CURVE UNDER MONOPOLISTIC

COMPETITION
Under monopolistic competition, large number
of firms selling closely related but differentiated
products makes the demand curve downward Demand Curve/
sloping. It implies that a firm can sell more AR Curve
output only by reducing the price of its products.
MR < AR under Monopolistic Competition
Like monopoly, MR is also less than AR under
monopolistic competition due to negatively
sloped demand curve.

COMPARISON BETWEEN PERFECT COMPETITION

AND MONOPOLY
Basis Perfect Competition Monopoly
Meaning It refers to a market situation Monopoly refers to a market
where there are very large situation where there is a single
number of buyers and sellers seller selling a product which has
dealing in a homogenous product no close substitutes.
at a price fixed by the market.
Number of Sellers There is very large number of There is a single seller and the
sellers and no individual seller monopolist has full control over
has control over activities of the supply.
other firms.
Nature of Product The products sold are There are no close substitutes of
homogeneous. So, buyers are the product, so, there is no
willing to pay same price for all competition from new and
products, which lead to uniform existing products.
price in the market.
Entry and Exit Any firm can freely enter or exit There is restriction on entry and
from this kind of market. It leads exit. So, a firm can earn abnormal
to absence of abnormal profits profit in the long run.
and abnormal losses in the long
run.
Price Firm is a price-taker as price is Monopolist is a price maker as
determined by the industry. firm and industry are one and the

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same thing.
Level of Buyers and sellers have perfect Sellers and buyers do not have
Knowledge knowledge about market perfect knowledge.
conditions.
Demand Curve Demand Curve is perfectly elastic Demand Curve slopes downward
as price remains the same at all as more output can be sold only at
levels of output. less price.
Selling Cost No selling costs are incurred as Selling costs are incurred for
buyers and sellers have perfect informative purposes due to lack
knowledge about market of perfect knowledge.
conditions.

COMPARISON BETWEEN PERFECT COMPETITION

AND MONOPOLISTIC COMPETITION
Basis Perfect Competition Monopolistic Competition
Meaning It refers to a market situation It refers to a market situation in
where there are very large which there is large number of
number of buyers and sellers firms selling closely related but
dealing in a homogenous product differentiated products.
at a price fixed by the market.
Nature of Product The products sold are Products are differentiated on the
homogeneous. So, buyers are basis of brand, size, colour, shape
willing to pay same price for all etc. So, a firm is in a position to
products, which leads to uniform influence the price.
price in the market.
Demand Curve Demand Curve is perfectly elastic Demand Curve slopes downward
as price remains the same at all as more output can be sold only at
levels of output. less price.
Price Firm is a price-taker as price is Firm is neither a price taker nor
determined by the industry. price-maker but has partial control
over price due to product
differentiation.
Level of Buyers and sellers have perfect Sellers and buyers do not have
Knowledge knowledge about market perfect knowledge due to product
conditions. differentiation and selling costs
incurred by the sellers.
Selling Cost No selling costs are incurred as Heavy Selling costs are incurred on
buyers and sellers have perfect sales promotion due to lack of
knowledge about market perfect knowledge among buyer
conditions. and seller.

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COMPARISON BETWEEN MONOPOLY AND

MONOPOLISTIC COMPETITION
Basis Monopoly Monopolistic Competition
Meaning It refers to a market situation Monopolistic Competition refers
where there is a single seller to a market situation in which
selling a product which has no there is large number of firms
close substitutes. selling closely related but
differentiated products.
Number of Sellers There is a single seller. So, a There are large number of sellers.
monopolist has full control over So, a firm does not have much
the market. impact on activities of other firms.
Nature of Product There are no close substitutes of Products are differentiated on the
the product. So, there is no basis of brand, size, colour, shape
competition from new and etc. So, a firm is in a position to
existing products. influence the price.
Entry or Exit There is restriction on entry and Although there is freedom of entry
exit. So, a firm can earn abnormal and exit but it is possible only for a
profits in the long run. competitive firm to enter or leave
the industry.
Price Monopolist is a price-maker as Firm is neither a price taker nor
firm and industry are one and the price-maker but has partial control
same thing. over price due to product
differentiation.
Demand Curve Downward sloping demand curve Downward sloping demand curve
is less elastic due to absence of is more elastic due to presence of
close substitutes. close substitutes.
Selling Cost Low selling costs are incurred. Heavy Selling costs are incurred on
sales promotion.

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PRICE DETERMINATION
MEANING OF EQUILIBRIUM & EQUILIBRIUM
PRICE
In economics, the term equilibrium means the state in which there is no tendency on the part
of consumers and producers to change. The two factors determining equilibrium price are
demand and supply.
Equilibrium Price is the price at which the sellers of a good are willing to sell the same quantity
which buyers of that good are willing to buy.
Thus, equilibrium price is the price at which demand and supply are equal to each other. At this
price, there is no incentive to change.

MARKET EQUILIBRIUM UNDER PERFECT

COMPETITION
In the short-run, there are fixed number of firms under perfect competition. Equilibrium price is
determined by the equality between demand and supply. At this price,
Quantity demanded = Quantity supplied
In the very short period, supply is fixed. Thus, demand is more active in determining price. In
the long-run, supply plays a more active role in determining price.
Equilibrium between Demand and Supply: - The forces of demand and supply determine the
price of a commodity. There is a conflict in the aim of producers and consumers. Producers
want to sell the goods at the highest price to maximize profit and consumers want to buy the
goods at the lowest price to maximize satisfaction.
Equilibrium is achieved at a point where quantity demanded is equal to quantity supplied.
This is called market equilibrium. There is neither excess nor shortage of demand and supply in
the market. If at a price the market demand is not equal to market supply there will be either
excess demand or excess supply and the price will have tendency to change until it settles once
again at a point where market demand equals market supply. A demand and supply schedule
and curve will show the determination of equilibrium price.
Market Demand-Supply Schedules
Price Demand Supply Equilibrium
10 10 50 Excess Supply
9 20 40 Excess Supply

8 30 30 Market Equilibrium

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7 40 20 Excess Demand
6 50 10 Excess Demand

In the table, demand and supply of the commodity at different prices are shown. The
equilibrium price is fixed at Rs.8 where the quantity demanded and the quantity supplied are
equal, i.e., equal to 30 units. The following figure shows the market equilibrium.

VIABLE AND NON-VIABLE INDUSTRY

Viable Industry refers to an industry for which supply curve and demand curve intersect each
other in positive axes.
In the Viable Industry, there is some price at which supply and demand happen to coincide.
Supply and demand curves must intersect at some positive point as shown in the given
diagram. In both demand and supply curves intersect each other in the positive range of X-axis
and Y-axis.
Non-viable Industry refers to an industry for which supply curve and demand curve never
intersect each other in the positive axes.
In an Non-viable Industry, supply curve lies above the demand curve as price too high for the
consumers. It happens when the price, at which producers are ready to produce, is so high that
consumers are not willing to buy even a single unit. As a result, the product is not produced.

EFFECTS OF CHANGES IN DEMAND AND SUPPLY

ON EQUILIBRIUM
I. Change in Demand
Equilibrium price and equilibrium quantity will increase with the Increase in demand.
Equilibrium price and equilibrium quantity will decrease with the Decrease in demand. It is so
because with increase in demand there is an increased competition amongst buyers. They get
willing to pay a higher price. This rise in price leads to expansion of supply. Opposite happens
when supply remaining same, demand decreases. It is shown in the figure given below.

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II. Change in Supply

Equilibrium price and equilibrium quantity will decrease with the Increase in supply.
Equilibrium price and equilibrium quantity will increase with the Decrease in supply. It is so
because with increase in supply, demand remaining same there is an increased competition
amongst sellers to dispose off their output. In this competition, they get ready to sell their
output at a lower price. This lower price leads to expansion in demand. Opposite happens when
there is decrease in supply. It is shown in the figure given below.

III. Simultaneous Change in Both Demand and supply

i. Increase in both demand and supply:

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a) If both demand and supply increase

equally, there will be no change in
equilibrium price but equilibrium
quantity will increase as shown in
figure given below. It is so because
the effect of increase in demand and
increase in supply is in opposite
directions and it balances each other.
Equilibrium quantity will increase.

b) If increase in demand is more than

increase in supply, equilibrium price
will increase and equilibrium
quantity will also increase as shown
by figure given below. It is so
because when increase in demand is
more than increase in supply, the
effect of increase in demand
dominates.

c) If increase in supply is more than

increase in demand, equilibrium
price will decrease and equilibrium
quantity will increase as shown by
figure given below. It is so because
when increase in supply is more than
increase in demand, the effect of
increase in supply dominates.

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ii) Decrease in both demand and supply:

a) If both demand and supply decrease

equally, there will be no change in
equilibrium price but equilibrium
quantity will decrease as shown in
figure given below. It is so because
both affect equilibrium price in
opposite directions and hence their
effect gets neutral.

b) If decrease in demand is more than

decrease in supply, equilibrium price
will decrease and equilibrium
quantity will also decrease as shown
in figure given below. It is so because
if decrease in demand is more than
decrease in supply, the effect of
decrease in demand dominates.

c) If decrease in supply is more than D S1

D1
decrease in demand, equilibrium S
price will increase and equilibrium
quantity will decrease as shown in
figure given below. It is so because if
decrease in supply is more than
decrease in demand, the effect of
decrease in supply dominates.

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iii) Demand Decreases and Supply Increase:-

a) When decrease in demand is equal

to increase in supply, equilibrium
quantity remains the same but
equilibrium price falls as shown in
the figure.

b) When decrease in demand is more

than increase in supply, then both
equilibrium quantity and price as
shown in the figure.

c) When decrease in demand is less

than increase in supply, equilibrium
quantity rises but equilibrium price
falls as shown in the figure.

85
 MICRO ECONOMICS BY SUMAN MADAM

iv) Demand Increases and Supply Decreases:-

a) When increase in demand is equal to
decrease in supply, equilibrium
quantity remains the same at OQ,
but equilibrium price rises as shown
in the figure.

b) When increase in demand is more

than decrease in supply, both
equilibrium quantity and price rises
as shown in the figure.

c) When increase in demand is less

than decrease in supply, both
equilibrium quantity falls and price
rises as shown in the figure.

86