Unit 1

Unit 1. Introduction1.1 Concept of microeconomics

Microeconomics is the study of the individual parts of the economy. It is that part of the economic analysis, which is concerned with the behavior of individual units: consumers, households, and firms. It examines how consumers choose between goods, how workers choose between jobs, and how a business firm decides what to produce and what production methods to use.

Microeconomics, often called the price theory, is mainly concerned with the equilibrium in the particular markets ( markets for potato, onion, cloths, cars and so on), assuming that there is equilibrium of the market system as a whole. This implies that microeconomics is concerned with the demand and supply of particular goods and services, and resources.The word micro refers to small. Thus under microeconomics, we separate a particular economic activity from the rest and study it individually. In doing so, we suppose that the behavior of the particular activity under consideration is not affected by the behavior of the other economic activities.

While studying microeconomics, we assume the existence of full employment in the economy. Full employment is the situation in which total job seekers just equal total job vacancies i.e. it is a situation where those able and willing to work at the prevailing wage rate could get the job or employment.

Given the assumption of full employment, microeconomics proceeds to know how a consumer and a producer attain equilibrium, and how the resources of the economy are allocated. For example, in order to study market demand of a commodity, it is assumed that the price and output of related goods are constant. The assumption of other things remain same, or ceteris paribus is the main assumption of microeconomics. Under the ceteris paribus assumption, microeconomic analysis is often called the partial equilibrium.

Thus, microeconomics has the following basic features:

* It concerned with individual parts of the economy.

* It studies economy in disaggregate manner.* Its concern is about individual firms and consumers.

* It presupposes the existence of full employment in the whole economy.

* It analyses economic phenomena under the ceteris paribus assumption and hence it is a method of partial equilibrium analysis.

* Its objective is to analyze the process by which scarce resources are allocated among alternative uses.

1.2 Types of MicroeconomicsMicroeconomics can be divided into three principle types- microstatics, comparative microstatics and microdynamics.

I. Microstatics:

It is a notion (concept) having no motion or change. So, microstatics is concerned with the analysis of economic variables such as price, demand, supply etc. in a given period of time. Microeconomics is concerned mainly with the equilibrium position in a particular market. Thus, microstatics deal with the relationship between different micro economic variables at a given period under condition of equilibrium. Microstatics assume that equilibrium position is given and no change occurs in it. Given this assumption, microstatics tries to specify the relationships between micro variables in the system. It deals with the condition which the system must satisfy for all equilibrium exists.

It assumes that there is no disturbance in the equilibrium and analysis situation such as the equality between demand and supply, marginal revenue and marginal cost, factor supply, and factor demand and so on at given period of time. Take the case of price of a commodity at a market, determined by the equality between demand and supply at a given time. Her microstatics assume that there is no change in demand and supply function and the price determined by the interaction of two prevails in the market. Figure 1.1 is an illustration of static equilibrium between demand and supply.The above figure shows a simple microeconomic model of a static equilibrium. This model contains three variables. They are quantity of commodity supplied which is denoted by line SS; quantity of commodity demanded which is shown by line DD; and price of commodity P which is determined by the interaction between DD and SS. The above model also contains three relationships among the three variables. Under the given condition, the equilibrium price P has been determined by the equality between demand and supply. Microstatics analyze this condition- the condition of equilibrium between demand and supply at a particular point of time. It does not deal with the process by which the forces of demand and supply have reached the equilibrium position. It simply studies the variables-demand, supply, and price as they are. It ignores passage of time and the process of change in the above model. It only indicates the position of the model in the given period. It does not tell us what the position would be in any other period.Thus, the model analyzed by the microstatics is that to a static equilibrium.

II Comparative microstatics:To make comparison, we need at least two comparable items or things. In the comparative microstatics, we make comparison between two equilibrium situations. Thus, comparative microstatics make a comparative analysis of equilibrium position of micro variables at different points of time. Microstatics deals with equilibrium position at a given point of time assuming the micro variables remain constant. But with the course of time, the micro variables changes which disturb the original equilibrium position. After certain adjustment, a new equilibrium is re-established between micro variables. Comparative microstatics make a comparison between the equilibrium positions- the original and the new one.Thus, comparative microstatics deal with the comparison of two or more successive equilibrium situation in a system or model. More precisely, comparative microstatics is concerned with a comparative study of different equilibrium at different points of time. However, it does not deal with the transitional period involved in the movement from one equilibrium position to other. It merely compares the initial equilibrium state with the final equilibrium state. Consider figure 1.2 for an illustration of a comparative microstatics.

In figure 1.2, simple microeconomic model of the comparative microstatics is presented. The original equilibrium point is E where the demand curve DD and the supply curve SS intersect with each other. Any change in the micro variables such as income, tastes of the buyer, price of alternatives goods, inputs prices and others would disturb the equilibrium position. Suppose such a change have shifted the demand curve in the figure to D1D1 and a new equilibrium has been established at point E1. Comparative microstatics enables us to trace the direction and magnitude of the change in the micro variables that has shifted the demand curve. In figure 1.2, changes in the micro variables have raised the equilibrium price from 0P to 0P1 and the equilibrium quantity from Q to Q1. A new equilibrium point has resulted due to an upward shift in the demand curve, given the supply. Comparative microstatics also enables us to analyze a shift in both the demand and supply curves giving rise a new equilibrium point. However, the result would be the same i.e. either a rise or fall in the equilibrium price or quantity.Thus, comparative microstatics compares the equilibrium positions- point E and E in above example in figure 1.2- as they are. It does not still deal with the process by which the forces of demand and supply have reached the new equilibrium position. It simply compares the micro variables- demand, supply and price in our example- as they are at different points of time. It still ignores the passage of time involved in reaching the new equilibrium position E after a departure from the old equilibrium position E. It is interested only in the equilibrium values of the micro variables involved in the analysis implying an instantaneous adjustment to disturbances to equilibrium. It tells nothing about the transition from one equilibrium point to another and jumps straight away from on equilibrium to another.III Microdynamics:Comparative microstatics is useful in explaining the situation when a new equilibrium succeed the old one. This model is incapable of tracing the path followed by the system over time in moving from the old equilibrium to the new one. It simply comapares the two equilibrium positions as given and jumps from the old equilibrium to the new . it tells us nothing about how we move from one position to another.

However, the world is dynamic one where changes take place every now and then. Therefore, positions of disequilibrium are more common than those of equilibrium. This is because change in the prices and outputs are in constant motion in an economy today. Frequent changes in tastes and technology are the principle causes. Micro variables such as demand, supply and prices change quite frequently in market. Therefore, we are interested in learning how equilibrium prices and quantities come to settle down in a market despite there being such disturbances in the real world. Microdynamics help us do so. It explains not only the original and new equilibrium situations but also the time taken by the system to reach a new equilibrium after getting disrobed from its initial equilibrium position. It also tells us how prices and quantities are still determined when the system is still under process to adjustment.Thus microdynamics analyses the process by which the system moves from one equilibrium to another. It explains the happenings on the way to a transition from one equilibrium to another. It is concerned mainly with the states of disequilibrium rather than equilibrium and, thus takes time into consideration. It studies systems or models involving time and explains how the present value of a micro variable bears a relationship with the past or future value of a micro variable. The microdynamics has been explained in figure 1.3.

In above figure, the system is initially in equilibrium at point E where Q and P are equilibrium quantity and price respectively. Suppose demand shift to DD due to change in micro variables which raises price to P1. Producers expect this price to prevail for at least one year. Hence, in year 1, Q1 is produced. But the demand curve DD shows that Q1 can be sold only at P2 price. Therefore, P2 becomes the price for year 1. In year 2, producers will base their output on price P2 and produce Q2. But the new demand curve shows that Q2 amount can be sold at price P4. This induces them to produce Q3 in year 3. But it can be sold at lower price and so on. This process continues until the new equilibrium point establish. At new equilibrium, again, demand and supply are equal and new price P0 and quantity Q0 is determined.

Thus microdynamics does not only compares the equilibrium situations but also the process how a system reaches a new equilibrium position from an old one.1.3 Dependence of microeconomics on macroeconomics:Actually micro and macro-economics are interdependent. Microeconomics depends upon the macroeconomic variables to some extent. For example the determination of rate of interests or profit of a firm depend on the aggregate economy. If the level of national income has decreased, it decreases the aggregate demand which also affects demand for a firms product. It reduces the profits of the firm. Similarly a fall in general price level also affects the profit earned by firm. This situation occurs when the economy is passing through recession.

Another classical example of how macroeconomics affects microeconomics is the national income. If the national income of a country is low, the per capita GNP is low which limits purchasing power of the consumers. This limits the profits of the firms. Thus a change in macroeconomic variables affect microeconomic variables.It follows from the above discussion that microeconomics and macroeconomics are not independent from each other in general. Though the two branches of economic study different subjects, they are interdependent. In fact, it is only a combination of the micro and macroeconomics that provides an adequate solution to an economic question.1.4 Importance and Limitations of Microeconomics:Microeconomics or the price theory is of paramount importance theoretically as well practically in many respects. Its theoretical importance lies on the fact that microeconomic explanations and predictions are based on the theoretical foundations. We may list the uses of microeconomics under following headings.

1. Understanding an economy: Micro economic theory helps in understanding the mechanism of a free market economy. It helps in understanding how commodity prices are determined by competition among the producers. It helps in understanding how the various enterprises of an economy function. It is microeconomics that makes it possible to understand how the million of consumers and sellers behave in an economy.

2. Use in designing economic policies: Microeconomics is an instrument of the government when it designs an economic policy for the country. Microeconomics helps in formulating a policy that is best suited for promoting productive efficiency in the country. Microeconomic tools are useful in designing price policies, taxation policies and others in an economy dominated by public sector. It is also useful in designing price of public utilities in an economy.

3. Allocation of Resources: The theoretical importance of microeconomics lies in the fact that it helps in efficient allocation of resources. We know that productive resources are scares in supply but production needs are numerous. Particularly, developing and least developed countries are characterized by low availability of resources and multiple development projects. As such microeconomics helps in sorting out the most urgent project and thereby allocating the resources accordingly.4. Distribution of Goods and Services: The market mechanism dealt in by microeconomics helps in understanding how goods and services in an economy are distributed among consumers. This in turn helps in understanding the condition of economic welfare. Economic welfare depends on maximization of social welfare. The amount of goods and services consumed by the society in totally determines its welfare. Microeconomics helps in understanding the amount of goods and services consumed in a society, hence state of its welfare.

5. Making business decisions: The most important use of microeconomics is that it helps business executives in making production decision. As it provides an analytical tool for examining the market mechanism, business firms decide their production and pricing policies based on this analysis. The knowledge about the working of an economy and the prevailing market situation helps firms to make their pricing policy on goods produced by them and the prices of the factors of production.

6. Useful in making sectoral decisions: Microeconomics provides a practical tool to the government in making decisions related to the various sectors of an economy. An economy is consisted of several sectors such as industry, tourism, trade and others. An understanding of each of these sectors is imperative before an appropriate policy is designed for them. Microeconomics provides an useful tool to the government while doing so.Thus microeconomics is of great use in several ways. It provides an analytical tool in understanding the working of individual units in an economy and the micro variables therein. It is useful in understanding how a particular price comes to settle in a market, how some goods are abundant in supply while others are still scarce, and why some factors receive high remuneration than others. Nevertheless, microeconomics suffers from one fundamental limitation. Microeconomics fails to explain the working of the entire economy taken together. The individual conclusions drawn by microeconomics may not be true in aggregate. For example, a particular firm in an industry might have decided to lay off some workers but the economy as a whole may still be in shortage of workers. Similarly, sugar price in the economy may still be high even if a firm has reduced it price. However, the limitation of microeconomics does not omit the use of the price theory at all it is still useful in analyzing individual units in an economy. Microeconomics provides a better tool in understanding the economy in totally.1.5 Distinction between Microeconomics and Macroeconomics: a] Micro economics:- Micro economics is the study of the individual parts of the economy. It is that part of the economic analysis, which is concerned with the behavior of individual units such as a consumer, a household, and a firm. It examines how consumers choose between goods, how workers choose between jobs, and how a business firm decides what to produce and what production methods to use.

In same way microeconomics concerns with price determination process of consumer goods and of factor of production. Therefore microeconomics, often called the price theory, is mainly concerned with the equilibrium in the particular markets (market for consumer goods and factors of production), assuming that there is equilibrium of the market system as whole. This implies that microeconomics is concerned with the demand and supply of particular goods and of factor of production.

b] Macro economics: - It is the study of the behavior of the economy as a whole. Thus, it is concerned with aggregate demand and aggregate supply. Here, aggregate demand refers to the total amount of spending in the economy. It generally includes total consumption demand, total investment demand, government spending and net exports (demand of domestic goods and services by foreigners). Aggregate supply refers to the total national output of the economy.

Macroeconomics concerns with the determination of national income and employment level thus it is also called income theory. With national income and employment level it also concern with the amount of money circulation, rate of inflation, investment level etc.

Difference between micro and macro economicsMicro economicsMacro economics

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It concerns with individual economic units such as a consumer, a house hold a firm

It is also called price theory.

It assumes that there is always full employment in an economy.It concerns with the optimum allocation of resources.

Its principal variables are relative prices, individual demand and supply, output of individual firms and industries and so on.It concern with economy as whole such as national income, national output, total employment etc.

It is also called income theory.

It assumes that under full employment equilibrium is possible in an economy.

It concerns with the optimum utilization of resources.

Its principal variables are national income, level of employment, inflation, money supply and their growth rates overtime.

Unit-2 Consumer Behavior2.1 Meaning of utility

Consumer spent their income on goods according to their taste or desire or preference for them. They buy goods because they satisfy their wants. This want satisfying power of goods is known as utility in economics. Utility is the satisfaction that a consumer derives from a commodity. The basic idea that the theory of utility analysis tries to convey is that a consumer buys a certain commodity or service because of its utility that satisfy wants. Every economic good has the power to satisfy a particular want of consumer- whatever its nature may be. Utility is an economic concept that resides in the mind of the consumer. The consumer knows it by introspection. The concept of utility is ethically neutral and the commodity need not be useful in the ordinary sense of the world. Thus, alcohol and cigarettes still satisfy drunkards and smokers and therefore possess utility although they are harmful to health. Whatever the case may be, the consumer must be able to compare the utility derived from different commodities.Economists employ two basic approaches: cardinalist approach and ordinalist approach to compare utility derived from commodities. Neoclassical economists believed that utility can be measured cardinally in units and the unit of measurement is called utis. Ordinalists on the other hand maintain that utility is a psychological concept and it is immeasurable, theoretically and conceptually as well as practically.

2.2 The cardinal utility analysisThe cardinal utility analysis is based on the assumption of measurability of utility. Neoclassical economists like Marshall and Pigou popularized the idea. According to them the utility derived by the consumer from the consumption of certain goods or servies can be measured in concrete terms and the measurement can be given by assigning definite numbers such as 1,2,3,4 etc. Besides measurability, the cardinal utility approach is based on the following assumptions:

I. Rational behavior of the consumer.II Independent utilities.III Constant marginal utility of money.IV Diminishing marginal utility.Limitations of cardinal utility analysis

I Measurement of Utility in number is not possibleII Utilities are not Independent.III Marginal Utility of money is not constant.2.3 Ordinal utility analysis (Indifference curve approach)The ordinal utility analysis rejects the idea of measurability of utility. Utility cannot be measured in absolute terms and it is difficult to say by how much the utility of one commodity is more than that of the other. Therefore, the ordinalists have developed an alternative approach to the utility analysis. This approach is known as the indifference curve technique.

Under this technique, it is not necessary to measure the amount of utility derived from the consumption of goods and services. It just suffices to rank the various combinations of goods in order of their preference. This technique assumes that the consumer make choice of a particular combination of goods based on their preference for them. If a consumer is in between two combinations of goods, he is indifference between them for while. Finally, makes choice of a particular combination that he likes the best.

The indifference curve technique was first invented by F.Y. Edgeworth and put into use by Vilfredo Pareto. J.R. Hicks and R.G.D. Allen brought it into extensive use.2.3.1 Indifference curve and indifference map:An indifference curve is the locus of all those combinations of different goods, which yield the same utility (the level of satisfaction) to the consumer. Therefore, the consumer is indifferent to purchase the particular combinations he selects. Each points on the indifference curve gives the same total utility as any other points on it. Therefore the consumer is indifferent between the various combinations of the two goods.Construction of an indifference curve can be illustrated with the help of an example as follows. Suppose a consumer is considering buying apples and oranges. We suppose that the consumer is able to rank the various combinations of the two fruits based on their importance to him. We also suppose that the consumer ranks those combinations on the basis of the satisfaction he derives from them. He has several combination of apples and oranges before him such as 300 apples and 60 oranges or 240 apples and 70 oranges etc. This is shown in table below.

Indifference schedule Combinations Apples Oranges

A 300 60

B 240 70

C 200 80

D 170 90

E 150 100

F 140 110

The above table is known as the indifference schedule, which shows alternative combination to the consumer. Thus, the consumer gets as total satisfaction from 300 apples and 60 oranges as from 140 apples and 110 oranges as well as from any other combinations of apples and oranges. From the information is table, we can now construct an indifference curve which is done in figure below.

In above figure, apples and oranges are measured along the vertical axis, and horizontal axis X respectively. The consumer will get equal satisfaction at point A with 300 apples and 60 oranges and at point B with 240 apples and 70 oranges. Similarly, combinations C and D would yield him the same level of satisfaction. If we join points A, B, C, and D, we get a downward sloping curve, which shows that the consumer is indifferent between the various combinations of the two goods. This curve is known as the indifference curve (IC). All the combinations of apples and oranges along the curve IC yield the same total utility to the consumer.We can draw more than one indifference curve showing combinations of two goods representing higher and lower level of satisfaction. Each indifference curve shows combination of two goods, e.g. apple and orange, which give equal satisfaction to the consumer. They yield the same total utility to the consumer. Any curve which lies to the right of another curve representing higher level of satisfaction and the one to the left of another represents lower level of satisfaction. Similarly, those combinations on higher indifference curve are preferred to those on the lower one. When we say that a consumer is indifferent, he is moving along any one of the several ICs. Preference on the other hand, means movement to a new IC and that yields either higher or lower level of satisfaction. A set of indifference curve can be shown graphically and it is called an indifference map.

An indifference MapThe indifference curves I, II, III, IV and V in above figure are the different indifference curves showing the different level of combination of apples and oranges. Thus combination of apples and oranges along IC curve-II gives a higher satisfaction to the consumer than those along IC curve-I. Similarly, the combinations along IC-III would give a higher level of satisfaction than those of IC-II and so on.

The consumer is indifferent between different combinations of apples and oranges along IC-II but the satisfaction at those points of combination are higher than those along IC-I. So is the case along IC-III, IC-IV, and IC-V. On the other hand IC-IV yields a lower level of satisfaction than on IC-V and so on.

2.3.2 Marginal rate of substitution (MRS)When the consumer moves from one point to another along an indifference curve, he is substituting one combination of the two commodities with another combination. That is why when our consumer moved from point A to B along IC in above figure. He in fact gave up combination A (300 apples + 60 oranges) for combination B (240 apples + 70 oranges). What our consumer actually did was that he substituted 60 apples for 10 oranges i.e. he gave up 60 apples in order to get 10 more units of oranges. The rate at which the consumer trades of apples for oranges is called marginal rate of substituting.

Marginal rate of substituting shows the rate at which one commodity is substituted for another. It shows the rate at which the consumer is willing to substitute one commodity for another. The slope of the indifference curve confirms this. If we denote our earlier two commodities, apple and orange, by X and Y then marginal then marginal rate of substitution (MRS) between X and Y can be defined as the amount of Y a consumer is willing to give up ( Y) so as to obtain one more unit of X (X).

Thus, MRSXY= Y/X

The concept of marginal rate of substitution is parallel to the concept of diminishing marginal utility.

Marginal Rate of SubstitutionThe above figure, shows an indifference curve IC sloping downward to the right. Y-axis represents units of apple and X that of oranges. Points A, B and C are the different combinations of the two goods. Indifference curve IC shows the combinations of apples and oranges, which provide same level of satisfaction to the consumer.In above figure, slope of the IC shows the trades the consumer would make between the two goods. Thus when the consumer moves from point A to B he gives up 2 apples to get one additional unit of orange. In other words, two units of apple are given up in exchange for 1 unit of orange. This is to say that MRS is approximately 2. That is:

MRSXY= Y/X= -2/1= -2

We can say that MRS between points A and B is -2 and the consumer is willing to give up two apples in order to get one more orange. Here MRSXY is negative implying that to get the same level of satisfaction, reduction of one good must be accompanied by additional of the other.Marginal rate of substation varies along the IC curve. At point A in above figure, the consumer has enough apples and is more willing to trade them for oranges. However, at C the consumer is willing to give up only one unit of apple for one extra unit of orange. We can, therefore draw an important conclusion about the consumers behavior that as more and more of a good, say apple is substituted for another good, say orange, the marginal rate of substitution diminishes. This is called the principle of diminishing marginal rate of substitution.

The principle of diminishing marginal rate of substitution is illustrated in above figure, as we move along the IC curve from A to C. When the consumer moves from point A to B, he gives up 2 apples to get one more orange. The MRS here is 2. When he moves from point B to C, he gives up only one apple to get one additional orange. Here MRS has declined to 1, indicating that the consumer now is less interested in giving up apples for oranges.

2.3.3 Properties of indifference curves:There are some important properties of indifference curve. These are as follows.

1. Negatively slopped:Indifference curves are negatively sloped. This indicates that when the consumer wants to have more of a commodity, the quantity of the other commodity decreases so that he remains on the same level of satisfaction. That is, if a consumer consumes more of X then the must be prepared to consume less of Y so that he remains on the same level of satisfaction. This is possible only when the indifference curves are negatively sloping downward. A negative slope of IC is also important for the principle of diminishing marginal rate of substitution to hold true.

2. Non-intersecting:Indifference curves do not intersect or touch with each other. If they intersect, the consumers preference would not be consistent or transitive. We have assumed that if a consumer prefers A to B and B to C, he also prefers A to C. This assumption would not remain valid if two indifference curves intersect. An intersection of two indifference curves would imply that the consumer gets two different levels of satisfaction along the same IC, which is absurd. Let us see it with figure:

Intersecting Indifference CurvesIn above figure, IC1 and IC2 intersect at point A, which represents a combination of both apple and oranges. On IC1 combination A and C yield the same level of satisfaction. Similarly, combination A and B on IC2 yield same level of satisfaction. Combination B on IC2 contains more of both apples and oranges than C. As A and B lie on the same IC2, yielding same level of satisfaction, they are equally preferred. Similarly, combination A and C are also equally preferred as they yield the same level of satisfaction being on IC1. Thus, it follows that B is equal to A and A is equal to C. Now according to the transitivity assumption, B is equal to C and they are equally preferred.

But this is absurd and contradictory because B contains more of both apples and oranges and is preferred to C (more is preferred to less). To avoid such a contradiction and absurd conclusion, indifference curves do not intersect with each other.3. Convexity:Indifference curves are more convex to the origin. This implies that as the consumer goes on consuming more and more of the commodity on the horizontal axis (say X) and less and less of the one on the vertical axis (say Y), MRS of X for Y must be falling. This is necessary for the principle of diminishing rate of substitution of hold true. If the indifference curve were a straight line MRS of the two commodities would be same (constant). And if it were concave to the origin MRS of X for Y would rather be increasing. Both the case would be against the principle of diminishing marginal rate of substitution. Therefore, the indifference curve must be convex to the origin.

In above figure, MRS of X for Y is increasing which is against the principle of diminishing MRS. This is absurd.

A Straight-line Indifference curve

In above figure, MRS of X for Y is constant. This too is against the principle of diminishing MRS and is therefore absurd.

A Convex Indifference curveThe above figure shows a normal indifference curve that is convex to the origin. As we move along the IC towards southwest, the MRS of X for Y goes on falling. The same unit of X is substituted for lesser and lesser units of Y. Therefore, the indifference curves are generally convex to the origin.

4. Higher satisfaction on higher IC:Every IC lying to the right represents higher level of satisfaction than that of the preceding one. Moreover, combinations on higher ICs are preferred to those on lower ones.

5. IC enables comparison of combinations:Indifference curve pass through each point in the commodity space. This enables the consumer to compare any combinations of the goods in question, so that he is indifferent between the several combinations.

2.3.4 Budget line or the budget constraint:

Another important element in the analysis of consumer behavior is the budget line, which is also referred to as the budget constraint. Given the indifference map and consumers preference, the actual purchases he would make depend on the income of the consumer and prices of two commodities. The budget line sets a limit on the combination of the two goods that a consumer can buy. That is why it is referred to as budget constraint.

Let us suppose that a consumer is considering purchasing two commodities X and Y with a fixed income of Rs. 300. We further suppose that the price of X per unit is Rs.20 and that of Y is Rs 10 per unit. In this case, the consumer can choose any one of the various combinations given in table below.

Alternative consumption combination with a given incomeNumber of goods XNumber of goods YCombinations

0 30A

5 20 B

10 10C

15 0D

Given that the consumers income is limited to Rs.300, he can choose any one of the combinations in table. The above combinations could be altered but by no means should the total expenditure exceed Rs. 300. The above table can be translated into figure that gives us the budget line of the consumer

Budget lineBeing limited with the fixed income of Rs 300, the consumer can choose any combinations of Y and X such as in figure above. Suppose the consumer chooses combination B. Here, he would be spending Rs. 200 (20 10) on good Y and Rs. 100 (5 20) on good X. If he chooses combination A, he would be buying only good Y and no X. similarly, if he chooses combination D, he would be spending all his money on X and buy no quantity of good Y.If we join combinations A, B, C, and D with a straight line, we get a budget line such as AD in above figure. This line acts as a constraint on the quantity of goods purchased by the consumer. It shows that the consumer cannot choose a combination that lies above the budget line AD. He can make a choice along the line AD or towards its left but not to the right. Thus, the budget line is the boundary within which the consumer is made confined while making his choices.

The budget line can be written algebraically as follows:

Px.X+ Py.Y= M------------------------------(1)

Where, Px and PY denotes the prices goods X and Y respectively and M stands for money income. The above budget line equation (1) implies that, given the money income of the consumer and prices of two goods, every combination lying on the budget line will cost the same amount of money and can therefore be purchased with the given income. The budget line can be defined as a set of combinations of two goods that can be purchased if whole of income is spent on them and its slope is equal to the negative of the price ratio.Solving the equation(1) for Y we have the following alternative form of the budget equation.

Y=-X-------------------------------(2)

Here, the slope of the budget line is - and M/Py is the vertical intercept of the budget line equation. Thus, it proves that the slope of budget line BL represents the ratio of the prices of two goods and the negative sign shows the budget line has negative slope. It falls from left to right.2.3.5 Equilibrium of the consumer:We are in position to explain with the help of indifference curves how a consumer reaches equilibrium position. A consumer is said to be in equilibrium when he is buying such a combination of goods as leaves him with no tendency to rearrange his purchases of goods. He is then in a position of balance in regard to the allocation of his money expenditure among various goods. Regarding the equilibrium, the consumer is assumed rational in the sense that he aims at maximizing his satisfaction. Besides, we shall make the following assumptions to explain the equilibrium of the consumer:

(i) The consumer has given indifference map exhibiting his scale of preference for various combinations to two goods, X and Y.

(ii) He has fixed amount of money to spend on two goods. He has to spend whole of his given money on the two goods.

(iii) Prices of the goods are given and constant for him. He cannot influence the prices of the goods by buying more or less of them.

(iv) Goods are homogeneous and divisible.

To show the equilibrium of the consumer, consumers indifference map and his budget line are brought together. As explained above, the indifference map exhibits the consumers scale of preference between the various possible combinations of two goods. While the budget line shows the various combinations which he can afford to buy with his given money income and given prices of two goods. Consider a figure below, in which we depict consumers indifference map together with the budget line BL. Goods X is measured on X-axis and good Y is measured on Y-axis. With the given money to be spent and given prices of the two goods, the consumer can buy any combination of the goods, which lies on the budget line BL. Every combination on the budget line BL costs him the same amount of money. In order to maximize his satisfaction the consumer will try to reach the highest possible indifference curve which he could with a given expenditure of money and given prices of the two goods. Budget restrain forces the consumer to remain on the given budget line, that is, to choose a combination from among only those which lie on the given budget line.

It will be seen from the above figure that the various combinations of the two goods lying on the budget line BL and which therefore he can afford to buy do not lie on same indifference curve; they lie on different indifference curves. The consumer will choose that combination on the budget line BL that lies on the highest possible indifference curve. The highest indifference curve to which the consumer can reach is the indifference curve to which budget line BL is tangent. Any other possible combination of the two goods either would lie on the lower indifference curve and thus yield less satisfaction or would be unattainable. In above figure, the budget line BL is tangent at point Q on the IC3. Since the indifference curve is convex to origin, all other points on budget line BL, above or below the point Q, would lie on the lower indifference curves. Take point R which also lie on the budget line and which the consumer can afford to buy. The combination R represent same cost as the combination of Q but the combination R lies on the lower indifference curve IC1. Likewise, point S, T and H also lie on lower indifference curve, therefore, provides less satisfaction than Q. It is therefore concluded that with the given money expenditure and the given prices of the goods as shown by BL the consumer will obtain maximum possible satisfaction and will be in equilibrium position at point Q. Here, the consumer purchases OM amount of X goods and ON amount of Y.At the tangency point Q, the slope of the budget line BL and indifference curve IC3 are equal. Slope of indifference curve shows the marginal rate of substitution of X for Y (MRSXY), while the slope of the budget line indicates the ratio between the prices of two goods Px/Py . Thus, at the equilibrium point Q,MRSXY=

EMBED Equation.3 =. It is the condition of equilibrium of consumer in indifference curve approach.2.3.6 Income effect:

We now turn to see the effect of a change in income of a consumer with prices remaining constant. When there is a increase in the income of the consumer with the prices of the two commodities remaining the same, the budget line shift outward, parallel to the old budget line. In this case the purchasing power of the consumer gets enhanced. He will move to a higher indifference curve along a new budget line obtaining higher level of satisfaction at a new equilibrium pont.

Income effectThe above figure shows the series of budget line representing different levels of consumer income. Initially, the consumer was in equilibrium at point A along IC1 with the budget line NM. As his income increased, the budget line shifted to N1M1 and the consumer jumped to the higher indifference curve IC2 where he is in equilibrium in point B and so on. Each equilibrium point is where the budget line is tangent to the indifference curve. In each new equilibrium points, the consumer purchases more of both X and Y goods.

If we join each points of equilibrium, we get the income consumption curve (ICC). The income consumption curve shows the manner in which the consumer reacts to changing income when the prices of the goods are constant.In general, the ICC slopes upward to the right as in the figure above indicating that more of the two goods are purchased with a rise in income of the consumer. In other words, the income effect is positive when more goods are purchased with the rise in income. Such goods are called normal goods in economics.

On the other hand, if the quantity of goods purchased decreases with the successive increase in income, the good is called an inferior good in economics. In this case, when there is a rise in the consumers income the quantity purchased will rise initially.

But after a certain point, the amount purchased of its starts falling with successive rise in income. This would give rise to an income consumption curve that would first move upward to the right hand side and then upward to the left hand side.

The above figure shows that good X is an inferior good. Initially, the consumer is in equilibrium at point A. But as the budget line shifts toN1M1 consequent upon a rise in income, less of X is purchased. Point B is left to the point A indicating that less of X is purchased with a rise in income. Point C lies still left to point B indicating that the purchase of good X decreases further with a rise in income.

2.3.7 Price effect:In price effect, we see the effect of a change in the prices of the commodities keeping constant the income and tastes of the consumer. Suppose the price of X falls, while the consumers income and price of Y remains the same. In this case, the budget line will swing outward as shown in figure below.

Originally, the consumer was in equilibrium at point A along the budget line NM. If the consumer were to spend his whole income on the purchase of X alone, he could purchase OM. Suppose now the price pf X falls. This would mean that the consumers income in terms of X has increased meaning he can now buy more of X. A movement has showed this in the lower foot of the budget line towards right to NM1. Now if the consumer is to spend his whole income on only X, he can buy OM1 of it. He would move to a higher indifference curve IC2 and would be in equilibrium position would be C. With each fall in the price of X, the consumer moves to a new equilibrium position on a higher indifference curve.

If we now a line joining the equilibrium points A, B and C in the figure, we get a line slopping upward to the right. This line is known as the price consumption curve (PCC). The PCC shows the way in which the quantity of X the consumer buys changes with a change in its price.

The slope of the price consumption curve (PCC) is positive for normal goods. If one goods is Giffen, then the slope of price consumption curve is negative which is shown in thefigure below.

2.3.8 Substitution effect:We now turn to the substitution effect, see the result of a change in the relative prices of goods, while keeping the consumers income, and tastes constant. When the relative price of goods change, the consumers money income is rearranged in such a way that he is neither better of nor worse off than before. There is no change in the consumers income, but he has to rearrange his purchases in accordance with the new relative prices. When there is a fall in the price of good, say X, consumers real income increases. He can now more of X. he can buy more not because his money income has increased, but simply because the price of X has fallen. Therefore, the rise in the consumers real income because of fall in the price of commodity X has to be compensated to cancel out the gain in his real income.This compensation would put the consumer at the same level of satisfaction as he was before. This is known as the substitution effect.In figure below, the consumer is initially in equilibrium at point Q on IC1. Here he is purchasing 0Y1 of good Y and 0X1 of good X and his budget is limited to NM. Suppose price of X falls. The budget line will shift to NM1. With the fall in price of X, the real income or purchasing power of the consumer has increased. To find out the substitution effect, the rise in purchasing power of the consumer because of the fall in the price of X must be wiped out so that he is on the same indifference curve. For this a hypothetical budget line AB parallel to NM1 has been drawn in figure below so that it touches IC1 at point R. This would mean that NA has reduced the consumers income in term of good Y or M1B in term of good X to keep him on the same IC. NA or M1B is sufficient to cancel out the rise in real income that occurred as result of the fall in the price X.

Now AB is the new budget line facing the consumer. With the new budget, X has become relatively cheaper and Y relatively dearer. The consumer would buy more of X and less of Y i.e. he substitutes X for Y. Thus in above figure, the consumer is in equilibrium at point R, the consumer is in equilibrium along the same indifference curve IC1 indicating that he is neither better off nor worse off than before. The movement from point Q to R on IC1 is, therefore, the substitution effect. The relative prices of X and Y have changed but the consumer is equality well off as before.2.3.9 Decomposing price effect into income effect and substitution effect:When the price of good X falls, other things remaining the same, consumer would move to a new equilibrium position at a higher indifference curve and would buy more of good X at the lower price unless it is Giffen good. Thus, the consumer, who is initially in equilibrium at lower indifference curve, moves at another point on higher indifference curve. The movement from lower indifference curve to higher indifference curve due to fall in price of good X is called price effect. It is now highly important to understand that this price effect is the net result of two distinct forces-substitution effect and income effect. In other words, price effect can be split into two different parts, one being the substitution effect and the other income effect.

In this decomposition, we adjust the income of the consumer to offset the change in satisfaction and bring the consumer back to his original indifference curve, that is, his initial level of satisfaction, which he was obtaining before the change in price occurred. For instance, when the price of a commodity falls and consumer moves to a new equilibrium position at a higher indifference curve his satisfaction increases. To offset this gain in satisfaction resulting from a fall in price of the good we must take away from the consumer enough income to force him to come back to his original indifference curve. This required reduction in income to cancel out the gain in satisfaction by reduction in price of a good is called compensating variation in income. This is so called because it compensates for the gain in satisfaction resulting from a price reduction of the commodity. How the price effect is decomposed into substitution effect and income effect is illustrated in figure below.

Price effect Split up into Substitution and income effect.When the price of good X falls and as a result budget line shifts to PL2 the real income of the consumer rises, i.e., he can buy more of both the goods with his given money income. That is, price reduction enlarges consumers opportunity set of the two goods. With the new budget line PL2 he is in equilibrium at point R on higher indifference curve IC2 and thus gains in satisfaction as a result of fall in price of good X. Now, if his money income were reduced by the compensating variation in income so that he is forced to come back to the indifference curve IC1 as before, he would buy more of X since X has now become relatively cheaper than before. In figure above because of the fall in price of X, budget line switches to PL2. Now with the reduction in income by compensating variation, budget line shift to AB which has been drawn parallel to PL2 so that it just touches the indifference curve IC1 where he was before the fall in price of X. since the budget line AB has got the same slope as PL2, it represents the changed relative prices with X relatively cheaper than before. Now, X being relatively cheaper than before, the consumer in order to maximize his satisfaction in the new price-income situation substitute X for Y. Thus, when the consumers money income is reduced by the compensating variation in income (which is equal to PA in term of Y or L2B in term of X), the consumer moves along the same indifference curve IC1, and substitutes X for Y. With the price line AB, he is in equilibrium at S on indifference curve IC1 and is buying MK more of X in place of Y. This movement from Q to S on the same indifference curve IC1 represents the substitution effect since it occurs due to the change in relative prices alone, real income remaining constant. If the amount of money income, which was taken away from him, is now given back to him, he would move from S on indifference curve IC1 to R on higher indifference curve IC2. This movement from S on a lower indifference curve to R on a higher indifference curve is the result of income effect. Thus, the movement from Q to R due to price effect can be regarded as having been taken place into two steps: first from Q to S because of substitution effect and second from S to R because of income effect. In is thus manifest that price effect is the combined result of a substitution effect and an income effect.In above figure, the various effects on the purchases of good X are:

Price effect = MN

Substitution effect =MK

Income effect = KN

And MN = MK + KN

Or Price effect = Substitution effect + Income effect.

From the above analysis, it is thus clear that price effect is the sum of income and substitution effects. 2.3.10 Derivation of demand curve with the help of Indifference curve approach:The indifference curve technique can be used to derive the consumer demand curve for a good. For this, we need the price consumption curve (PCC). Using the price effect, we can construct a persons demand curve for a product.

We begin by assuming that we want to derive a persons demand curve for good X. All that we need to demonstrate is a variation in the quantity demanded of X with changes in price of X. For this, we draw figure and show how an individual demand curve can be derived.

Vertical axis on the upper part of the above figure shows the quantity of good Y and horizontal axis shows the quantity of good X purchased with successive fall in the price of X. As the price of X falls, the budget lines turn successively to the right direction and the consumer moves to a higher indifference curve. As we join the different points of equilibrium (A, B, C) on the upper part of figure, we get the price consumption curve (PCC). On the lower part of figure, we plot each point of intersection between the price and quantities of good X purchased with successive fall in price of X. These points are Q, R and S. we then join the points with a straight line sloping down ward to the right. The line DD then stands for the individual demand curve indicating an inverse relationship between price of X and the quantities demanded of it. As can be seen, quantity demanded of X rises successively from Q1 to Q3 with a fall in price of X from P1 to P3. Unit 3: Demand Function3.1 Concept of demand:

Not every wants and desire on the part of a consumer, though they are countless, can be termed as a demand. Demand in economics, refers to that amount of a commodity or service which an individual buyer or a household is willing to purchase at a given price during a given period. Only that desire or want which is backed-up by the capacity to pay for and the willingness to buy is termed as demand in economics. Desire or want becomes effective only when the consumer has the means to buy a particular commodity or service is the amount that would be bought by consumers at a given price and during a given period.* Demand is not a need or a desire. Demand is the amount of a commodity for which a consumer is able and willingness to purchase.

* Demand has no meaning unless it is stated with price and time duration.

Demand is a multivariate variable. Many variables affect the demand. The relationship between demand of a commodity and the variables, which affect the demand, can be expressed in form of an equation. This is called a demand function. in other words, demand function is an equation which shows the mathematical or functional relationship between the quantity demanded of a good and the values of the various determinants of demand. Following is a demand function stated in a general form.

Qx = f ( Px, T, Ps1 Ps2 Ps. Psn, Pc1 Pc2 Pcn,Y, B, PeX )Where, Qx = Quantity demanded of commodity X

PX = Price of commodity X

T = Tastes of consumer

Ps1 Ps2 Psn= the prices of substitute goods

Pc1 Pc2 Pcn= the prices of complimentary goods Y = consumers income

B = distribution of income

Pex= expected price of X in future.

The above equation reads that quantity demanded (Qx) of the commodity at any given time is a function of the price of the good itself (Px), tastes of the consumer (T), the price of substitute goods (Ps1 Ps2Psn), the prices of complimentary goods (Pc1 Pc2.Pcn), consumers income (Y), income distribution (B) and expected price of the good (Pex) at the some future time. The variables in the above equation can be substituted with figures and examine what happens to total demand when any one of the variable changes.

Very often, the above stated demand function is replaced by a simple demand function Qx = f (Px). This implies that quantity demanded (Qx) is function of price (Px) of the same commodity (X). Qx = f (Px), f0, b1, the normal good is luxury otherwise it is a necessary. Nevertheless, elasticity of income for a good is likely to vary with variation in the level of consumers income. This is so because a good considered a luxury at low levels of income may become necessity at intermediate levels of income and an inferior at high levels of income.

Calculation of income elasticity with a numerical example has been shown in table below.

Income elasticity of demandIncome (Y) (Rs In 1000)Quantity Demanded(Q) eyd Types of Goods

850--

121002Luxury

161501.5Luxury

201800.8Necessity

242000.56Necessity

28190-0.30Inferior

32180-0.37Inferior

The above table shows calculation of income elasticity using the formula defined above. Thus, when income increases from Rs. 8,000 to Rs. 12,000 quantity demanded rises from 50 to 100 units. Using the formula,

eyd ====2

As eyd >1, the good is considered a luxury. Finally, when the consumers income rises to Rs. 28000, the quantity demanded of the good falls to 190 units from the earlier demand 200 units. It thus becomes an inferior food from being a luxury at the first instance.

The concept of income elasticity is helpful in that it helps in classifying goods into necessities and luxuries based on the changes in their demand to change income. When income elasticity is less than one and the quantity demanded remains the same despite a rise in income, the good in question in a necessary. On the other hand, the good in question is a luxury if income elasticity is greater than one.

[III] Cross elasticity of demand:Some times two goods are so closely related that a change in the price of any one of them brings about a change in the demand for the other good as well. Such goods are either substitutes (tea and coffee) or complements (tea and sugar). Cross price elasticity of demand measures the responsiveness of demand for one such good to a change in the price of another good. If we consider the two goods as X and Y and let ecp stand for cross elasticity, then the cross elasticity of demand is measured by the following formula:

ecp = ==

Given the above formula, we can find out whether a good is a substitute or a compliment. In other words, if good Y is a substitute for good X, the demand for X will rise when the price of Y rises. In this case, cross elasticity will be positive indicating that the two goods are substitutes.

If on the other hand, good Y is a complement for good X, the demand for X will fall when the price of Y rises. In this case, cross elasticity will be negative indicating that the two goods are compliments.

Cross price elasticity of substitutes Before Change After change

We want to see whether X and Y are substitutes or complimentary goods using the cross elasticity formula.Thus, ecp= = =0.5

This shows that when price of coffee rises from Rs.4 to Rs. 6 per cup, ( there is no change in the price of tea i.e. Rs. 2) the demand for tea increases to 5 cups from 4 cups per hour. This results in a cross price elasticity ( epc) of 0.5, indicating that the two goods are substitutes.

Cross price elasticity of compliments

Using the same formula again, we want to know whether X and Z are substitutes or compliments. Thus,

epc= ==-0.25

When the price of milk increases from Rs.1 to Rs.2 per cup, the demand for tea falls to 3 cups from 4 cups an hour. This results in a negative cross price elasticity (epc= -0.25) indicating that the two goods are compliments to each other.

Therefore, it can safely be concluded that if the cross elasticity is positive the goods are substitutes and if it is negative the two goods are compliments.

( Measurement of Price elasticity of demand:

The most frequently used methods in the measurement of price elasticity of demand are the Percentage method, total outlay method, point method and arc method

1. Percentage method: In this method, price elasticity of demand is measured dividing percentage change in quantity demanded by percentage change in price. For this following formula is used.

epd = =

Here, if the value of epd>1 then the demand is said to be elastic. If the value of epd slope of MR or MC must cut MR from below.Assuming that MR curve is horizontal ( in case of perfect competition), the profit maximization condition is shown below in a diagram.

Fig.7.2, Equilibrium of firm, Marginal ApproachIn the diagram, MC= MR at E and E. but profit is maximum at E not at E. Why? At Y1 level of output (Point E), MC = MR, when output increases from Y1, MR remains higher than MC up to Y2 (point E). This implies that producing more units adds more to revenue (MR) than to cost MC and profit can be increased by producing more than Y1.

At E, MC= MR and output is Y2. This is the profit maximizing output, because when output is greater than Y2, MC> MR. This implies that when output exceeds Y2, addition to cost exceeds addition to revenue and hence profit declines.

Therefore, profit is maximum with Y2 units of output where MR= MC.

What is the difference between points E and E? At point E, slope of MC is less than slope of MR i.e. MC curve intersects MR from above when MC = MR (at E). At point E, slope of MC > slope of MR, i.e. MC curve intersect MR from below.7.3. Short-run equilibrium of industry and firms under perfect competition. (How price and output is determined under perfect competition in short-run).In the short-run, entry of new firm or exit of existing firm (except in the case of shutdown where P/AR/MR = AVC) is not permissible. This implies that number of firms in the industry is fixed in the short-run.

The market is determined by the interaction between the consumers short-run demand and industrys short-run supply. As firms are price taker under perfect competition, existing firms accept the market price and conduct their activities. Firms that are efficient (firm than can reduce or lower their AC) may earn super normal profit and inefficient firm (having higher AC) may incur loss. In addition, some firms may just earn normal profit (P=AC). All these three conditions are possible in the short run as shown in the following figure.

Fig.7.3, Short-run equilibrium of firms under perfect competitionAt left corner, industrys equilibrium in the short-run is shown. Market price (P) is determined by the interaction between market supply and demand curves (point E).

As firms are price taker under perfect competition, their demand curve is perfectly elastic (horizontal). For equilibrium, MC curve should intersect MR curve (or firms demand curve) from below. At point e, in all three panels, MC=MR, and MC intersects MR from below. So, point e denotes the equilibrium of all three firms in the short-run. For firm A, Firm B and firm C the equilibrium points eA, eB and eC are shown respectively.At equilibrium, firm A is producing QA units of outputs and selling at the given market price, P. As P>AC, firm A is earning abnormal profit (Shaded are in firm A). At equilibrium, firm B is just earning normal profit because the market price (P) is just equal to AC of firm B. But firm C is incurring loss because its AC exceeds the market price at equilibrium point eC where it is producing QC units of output. Though the firm C is incurring loss, it will continue its operation till its AVC lies below the market price (P>AVC). If P< AVC, then it is the shutdown point.The above discussion shows that Price and quantity is determined by the interaction between consumers demand and industrys supply. The total industrys supply is equal with the total sum of the supplies of all firms consisting in industry. The amounts of supply of individual firms depend up on their cost condition.7.4 Long-run equilibrium of industry and firms under perfect competition.

1. Excess Profit case:In the short-run, the firm may earn either abnormal (excess) profits (P>AC), only normal profits (P= AC) or even losses (PAC, so that the firm is earning excess profits. As entry and exit both are free in the long run, new firms will enter into the industry due to the excess profit earned by the existing firms. Entry of new firms leads to increase the total market supply so that market supply curve shift to the right (from S1S1 to S2S2) determines new market price P2, which is lower than the previous market price (P1>P2).When equilibrium market price becomes P2, the firms demand curve also shifts down ward to P2= MR2=MC2=AR. On the otherhand, entry of new firms into the industry leads to increase resource demand, which ultimately leads to shift AC curve upward (from LAC to LAC). Entry of new firms in the long run continues until the firms demand curve become tangent to the LAC ( at point P). The tangency condition guarantees the normal profit situation during long run.

2. The case of short run lossesIn the short run, the firms make incur losses. But in the long run firm can leave the industry if there is only loss. When loss-incurring firms leave the industry (in the long run), there arrive two situations.

First, when inefficient firms (incurring loss) leave the industry. It leads to reduce the total market supply. The reduction market supply leads to shifts market supply curve to the left so that equilibrium price will increase. Increase in equilibrium market price finally leads to shit firms demand curve up so that existing firms losses will be eliminated.

Second, exiting of the loss-incurring firms reduces the use of resources. The reduction in resource demand leads to lower the input price so that AC also reduces. Reduction in AC is reflected in terms of down wards shift of the AC, which again helps to eliminate the loss.

YIn panel (a), industrys equilibrium is shown, which determines the market price P1. At this price (P1), some firms in the industry are incurring losses (P1 AC at equilibrium output level so that the firm is earning profit equal to PCBA. In middle figure, P=AC at equilibrium so that there is only normal profit. In the figure of right corner, P< AC, at the equilibrium, so that the firm is incurring losses. All these three situations may exist during short run.7.5.3 Long run equilibrium of the monopolist firm:In long run, the monopolist can rearrange his production techniques and production plant. A monopolist will remain in the business if he can make a profit in long run. The monopolist will not stay in business if there is loss in long run. But in the short run, there may be profits or losses. With entry blocked, the monopolist may earn even super normal profits (which is not possible in the case of perfect competition) in the long run. However, for the monopolist, it is not necessary to reach an optimal scale (minimum LAC). What is certain for a monopolist in the long run is that is the point of interaction between MR and LMC gives its equilibrium. At the point where MR=LMC, the SAC becomes tangent to the LAC as shown below in the diagram,.In the diagram, MR=LMC at point E, which determines both equilibrium price (P) and output (Q). Here the equilibrium price (P) is greater than Average cost (C). This implies that the monopolist is earning super profit in the long run equilibrium given by the are ABPC.

Capacity utilization of the existing plant and the size of the plant depend on the market demand (the nature of the AR or market demand curve and hence the nature of the MR), depending on the market conditions, the monopolist may operate (in long run):

(a) On the falling part of LAC

(b) On the raising part of LAC (beyond the minimum LAC)

(c) On the minimum point of LAC (Optimal utilization of Plant)

In the panel (a), the monopolist equilibrium is on the raising part of the LAC. This implies that the monopolist is operating in a large market. Compared with the monopolist operating with excess capacity, over utilized plant of the monopolist indicates that it is producing more and selling, relatively, at a lower price.In panel (b), the monopolist equilibrium is on the minimum LAC. In this case, the plant is optimally utilized (minimum LAC). In all the cases, the monopolist is making super normal profits because there is no fear of potential entry of new firms (competitors).

7.6 Comparison between perfect competition and Monopoly:We can list some similarities and difference between perfect competition and monopoly as follows.

Characteristics Perfect competitionMonopoly

1. Goal1. Profit maximization1. profit maximization

2. Nature of product2. Homogeneous2. Unique

3. Number of firms3. Many so that a firm is the price taker3.Single so that the firm is the price maker

4. Entry and exit4. Free so that there is always normal profit in long run.4. Complete barrier so that there may be super normal profit even in the long run.

5. Cost functions5. AC and MC are U shaped ( because of the law of variable proportion)5. AC and MC are U shaped ( because of the law of variable proportion)

6. Equilibrium condition6. MC=MR, and the point of equilibrium, MC is increasing ( slope of MC > slope of MR)6. MC=MR, and the point of equilibrium, MC is increasing ( slope of MC > slope of MR)

7. demand curve7. Perfectly elastic ( horizontal) so that at equilibrium P=MR=AR=MC7. Inelastic (downward sloping) so that P>MR> (P>MC) at equilibrium.

8. Price 8. In long run, P=LAC=MC implying that competitive price is always at the minimum level8. In long run price may or may not be equal to LAC but it is always greater than MC implying that monopoly price is always higher than the competitive price.

9. Capacity utilization9. Full utilization of capacity i.e. equilibrium is at the minimum of LAC in Long run.9. Presence of excess capacity i.e. equilibrium may not be necessarily at the minimum of LAC.

7.7 Price discriminating monopolyIf a monopoly firm has a strong market power, then it often divides the markets into different sub markets and charges different price in each market. The act of selling the same product at different prices to different buyers is called price discrimination. Quantity discount, price differentials between wholesalers and retailers and the similar cases are not cases of price discrimination.

Price discrimination refers to price differences that are not related to cost differentials. Examples of price discrimination are movie show for student and common people, issues of both paperback and hard cover edition of the same book, lower rates of electricity to business than to household use. In all cases, the same product is sold to different customers (market) at different prices.

7.7.1 Necessary condition for price discriminationThe goal of monopoly firm is to maximize its profits (revenue) by charging different prices to different groups of customers. The act of price discrimination will not be possible unless the following three conditions are fulfilled.

1. The firm must have some monopoly power:This condition is equivalent to saying that the firm must be able to set its price. In the case of perfect competition, firms are price taker. Thus, under perfect competition, price discrimination is not possible. If a competitive firm charges higher price, it can not sell its product because the customer can buy the same product from other firms at cheaper market prices.

2. Markets must be separated in such a way that no reselling can take place:If resale is possible, then price discrimination does not work. For example, students must not be able to resale a half-priced cinema ticket to others. At act of reselling reduces the monopoly power of the monopolist.

3. Price elasticity of demand in each market must be different:If price elasticities are different markets, then the firm will charge higher price in the market where demand is less elastic and lower price where demand is more elastic. If elasticities are not different, price discrimination is not possible.

7.7.2 Equilibrium of the price discriminating firmTotal output under discriminating monopoly is determined where MC=MR from all segmented markets. Suppose MRA and MRB are two marginal revenues from two separate markets A and B respectively. Then the price discriminating firm will be in equilibrium when MRA=MC, and MRB=MC

This implies that, for equilibrium,

(1) MR= MRA=MRB and

(2) MC=MRA=MRB=MRFollowing diagram illustrates the equilibrium of price discriminating firm having two separate markets.

In panel (a), equilibrium of the monopoly firm is shown. At point E, MR=MC, and Q is the profit maximizing output (assuming that slope of MC> Slope of MR at E).

The firm has two markets: A and B where demand is more elastic in market B (edB>eAd). So the firm allocates its output in these markets such that MRA=MRB=MR. By doing so, the firm allocates QA in market A, and QB in market B such that Q= QA +QB.

From the diagram, it is evident that PA>PB because, edA Slope of MR at the equilibrium point.

The firm chooses that level of output where MR = MC and sets prices based on its demand curve to sell that level of output. The short run equilibrium of monopolistically competitive firm is shown in the following diagram. In the short run profit may be positive (panel a), negative (panel b), or zero (panel c). If price is less than the short-run variable cost, the firm will be shut down.

In short run number of firms in the production group is constant. So some firm may earn abnormal profits in the case of panel (a), some may earn only normal profit panel (b), and some may incur loss panel (c). In the above diagram, firms are in equilibrium at point E producing equilibrium output level (Q) where MC= MR. The profit and loss condition depends on the cost component of the production. Efficient firm may earn profit while inefficient firm may incur loss due to high cost.

Diagrammatically, the equilibrium of monopolistically competitive firm resembles that of a monopoly. However, monopolistically competitive firm faces more elastic demand curve than monopoly and firms demand curve does not represent the market demand curve. Due to the product differentiation, we cannot derive the market demand curve and the market supply curve of the monopolistically competitive firm. It is because of the problem of adding the differentiated products having different demand elasticities. Each monopolistically competitive firm has some market power and can set their own price with some flexibility. Therefore, under monopolistically competitive market there is no unique market price. Instead, there is a cluster of equilibrium prices of closely substitutable products. Thus, monopolistic competition only the equilibrium of a representative firm is shown instead of market equilibrium.7.6.3 Long run equilibrium under monopolistic competition:In monopolistically competitive market, there is free entry into and exit from the production group. So if some firms earned abnormal profits in the short run, new firms enter into the production group in the long run. The entry of new firms shifts each firms demand curve down making it more elastic. At the same time, cost will change due to product differential (pricing policy, selling activities and product itself). Due to downward shits in firms demand curve (reduction in market share due to new entry) and increase in the production cost, the short run abnormal profits are eliminated.In the case of short run loss, loss-incurring firms will go out from the product group so that existing firm will just earn normal profit.

Thus, due to the unrestricted entry and exit, monopolistically competitive firms will earn just zero economic profits in the long run as shown in the following diagram.

In the diagram, panel (a) shows the short run economic profits. So, in the long run entry takes place. An increase in the number of firms reduces the market share of each firm resulting into downward shift of the demand curve of each firm. To counter the reduced market share and increased elasticity of demand, each firm spends more on product differentiation and selling activities. This extra expenditures lead to shift average cost upward. In order to maximize profit, each firm chooses to operate along the LAC. All adjustments ultimately result into zero economic profit of each firm in the long run. Firms are in the equilibrium where LMC=MR, where the firms demand curve (AR) is tangent to LAC. At the point of tangency, there will be neither economic profit nor losses with optimal output level (Q).

7.6.4 Comparison between monopolistic and perfect competition:* Common element between perfect competition and the monopolistic competition is the large number of firms with the provision of free entry and exist. With homogeneous product, perfectly competitive firm faces elastic demand curve with given market price. With product differentiation, monopolistically competitive firms faces downward sloping demand curve implying that it has some power of setting its own prices within a limited range. To high price ultimately compels the consumer to change their preference toward the cheaper product, so that total sales will decline drastically.

* Monopolistic competition differs from the competitive market in the following respect:

(i) In perfect competitive market, there is optimal utilization of plant because firms attain equilibrium at the minimum point of LAC in long run. But in monopolistic competition, there remains unutilized excess capacity because in long run firm is in equilibrium at the falling part of LAC. It happens due to downward slope of AR curve and free entry to group.(ii) In perfect competition, resources are allocated optimally but in monopolistic competition, resources are allocated inefficiently.

7.8 Oligopoly:Oligopoly is a form of market structure in which a few sellers sell differentiated or homogeneous products. How few are the seller is not easy to define numerically in the oligopolistic market structure. The economists are not specified about a definite number of seller for the market to be oligopolistic in its form. It may be two, three, four, five or more. In fact, the number of sellers depends on the size of the market. If there are only two sellers then the market structure is called duopoly.

The products traded by the oligopolist may be differentiated or homogeneous. Accordingly, the market may be characterized by heterogeneous oligopoly or homogeneous (pure) oligopoly. In automobile industry, Maruti Zen, Hyundais Santro, Daewoos Matis and Tatas Indica, etc., are the outstanding examples of differentiated oligopoly. Similarly, cooking gas of different companies is the example of homogeneous oligopoly.7.8.1. Characteristics of Oligopoly:The basic characteristics of oligopolistic market structure are following:

1. Intensive Competition: The characteristic fewness of their number brings oligopolist in intensive competition with one another. Let us compare oligopoly with other market structures. Under perfect competition, competition is non-existent because the number of sellers is so large that no sellers are strong enough to make any impact on market condition. Under monopoly, there is a single seller and, therefore there is absolutely no competition. Under monopolistic competition, number of sellers is so large that degree of competition is considerably reduced. But, under oligopoly, the number of seller is so small that any move by one seller immediately affects the rival seller. As a result, each firm keeps a close watch on the activities of the rival firms and prepares itself with a number of aggressive and defensive marketing strategies. To an oligopolist, business is a life of constant struggle as market conditions necessitate making moves and counter-moves. This kind of competition is not found in other kinds of market. Oligopoly is the highest form of competition.2. Interdependence of business decisions: The nature and degree of competition among the oligopolist make them interdependent in respect of decision-making. The reason for interdependence between the oligopolists is that a major policy change made by one of the firms affects the rival firms seriously and immediately, and forces them to make counter move to protect their interest. Therefore, each oligopolist, while making a change in his price, advertisement, product characteristics, etc. takes it for granted that his actions will cause reaction by the rival firms. Thus, interdependence is the source of action and reaction, moves and counter-moves by the competing firms.

3. Barrier to entry: An oligopolistic market structure is also characterized, in the long run, by strong barriers to entry of new firms to the industry. If entry is free, new firms attracted by the super-normal profits, if it exists, enter the industry and the market eventually becomes competitive. Usually barriers to entry do exist in an oligopolistic market. Some common barriers to entry are economies of scale, absolute cost advantages to old firms, price-cutting, control over important inputs, patent rights and licensing, preventive price and existence of excess capacity. Such factors prevent the entry of new firms and preserve the oligopoly.

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Fig.1.3 Microdynamics

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Fig. 7.14: Long run equilibrium of a firm under monopolistic competition.

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