Lecture : 1 and 2

Economics,
Scarcity,
Choice,
Specialization and Exchange,
Marginal Analysis and Decisions,
Microeconomics and Macroeconomics,
The Common Fallacies in Economics,
Positive Economics and Normative Economics,
Positive and Negative relationship,
Dependent and independent variables,
The rules for constructing graphs,
Slope,
The key problems of an Economics Organization,
Different Economic Systems,
Opportunity Costs,
The Production Possibilities Frontier.

13-Jun-15 1
 Economics,
People are concerned with improving their standard of living; they are worried
about inflation and unemployment; they may be distributed by the poverty of the
less fortunate. People are confronted with difficult personal choice: when to by a
home, whether to change jobs, whether to attend college. People are often
confused by the economic claims and counterclaims of opposing political parties.
People can find help in dealing with these questions and concerns in the study of
Economics. The word “Economics” comes from the word “Household
Management”. Adam Smith wrote a book name “ An Enquiry into the Nature and
Causes of Wealth of Nations” in 1776. He separated Economics as a separate
branch from the word household management. So, Adam Smith is a Father of
Economics.

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 According to Adam Smith, “An Enquiry into the Nature and Causes of
Wealth of Nations”.
According to the French economist John Baptist Say, “Economics is the
science which treats of wealth”.
According to the American economist F. A. Walker, “Economics is the body
of knowledge which relates to wealth”.
According to the Marshall, “Economics is the study of mankind in the
ordinary business of life”.
According to Robbins, “ Economics is the science which studies human
behaviour as a relationship between ends and scarce means which have
alternative uses”.

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 From the above definitions we may summarize as
follows : “ Economics is the branch of social science
which concerned with the proper uses and allocation
of limited resources for the achievement and
maintenance of development and growth with
stability”. Alternatively we may define, “ Economics is
the study of how people choose to use their limited
resources, i.e., land, labour and capital goods like
trucks and machinery and buildings to produce,
exchange and consume goods and services.

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Scarcity
Scarcity : Scarcity is the distinguishing characteristic of an economic
good. That an economic good is scarce does not mean that it is rare,
but only that is not freely available for taking. To obtain such a good,
one must either produce it or offer other economic goods in
exchange. An item is a scarce good if the amount available, i.e.,
offered to users, is less than the amount people want if it would be
given away free of charge. A free good is one where the amount
available is greater than the amount people want at a zero price.

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Choice
Choice and scarcity go together. Individuals, businesses, and societies
must choose among alternatives. An individual must choose between
a job and a college education, between savings and consumption,
between a movie and eating out. Businesses must decide where to
purchase supplies, which products to offer on the market, how much
labour to hire, whether to build new plants. Nations must choose
between more defenses or more spending for social-welfare
programs; they must decide whether to grant tax reductions to
business or to individuals.

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Specialization and Exchange
Specialization : Economics studies how participants in the economy, i.e., people,
businesses, and countries, specialize in tasks to which they are particularly suited.
The physician specializes in medicine, the lawyer in law, the computer scientist in
data processing, the economics professor in teaching economics.

Exchange : Exchange complements specialization. Without exchange,

specialization would be of no benefit because individuals could not trade the
goods in which they specialize for those that other individuals produce.

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Marginal Analysis and Decisions
Scarcity forces people to make choice and economics studies how these choices
are made. The most important tool used by economists to study economic
decision making is Marginal Analysis. Marginal analysis aids decision making by
examining the consequences of making relatively small changes from the current
state of affairs. Decisions are made at the margin when a decision maker
considers what the extra or marginal costs and benefits of an increase or
decrease in a particular activity will be. If the marginal benefits outweigh the
marginal costs, the extra activity is undertaken.

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Microeconomics and Macroeconomics

Microeconomics studies the economic decision making of firms and

individuals in a market setting; it is the study of the economy in the
small.

Macroeconomics is the study of the economy in the large. Rather

than dealing with individual markets and individual consumers and
producers, macroeconomics deals with the economy as a whole.

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 The Common Fallacies in Economics
• If statements appear to be logical and to be based upon facts, and they will
probably be accepted by the average reader without much hesitation. Yet close
examination of these statements reveals that they exemplify three logical fallacies
that plague economic thinking. These fallacies are the false-cause fallacy, the fallacy
of composition and the ceteris paribus fallacy.
• The False-Cause Fallacy : The false-cause fallacy is the assumption that because two
events occur together one event has caused the other. A statistical correlation
between two variables does not prove that one has caused the other or that the
variables have anything whatsoever to do with one another.
• The Fallacy of Composition : The fallacy of composition is the assumption that what
is true for each part taken separately is also true for the whole or that what is true
for the whole is true for each part considered separately.
• The Ceteris Paribus Fallacy : The ceteris paribus fallacy occurs when the effects of
changes in one set of variables are incorrectly attributed to another set of variables.
Ceteris paribus is a Latin term meaning, “Other things being equal”. If the
relationship between two variables is to be established the effects of other factors
that are changing as well must not be allowed to confuse the relationship.

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 Positive Economics and Normative Economics

Positive economics is concerned with those statements which relate to the actual
observations of economic phenomena in the real world.
Normative economics is concerned with what ought to be in the economy. It
involves value judgments and individual’s likings and disliking; consciously or
unconsciously; creep in.
Examples : Any economist will predict that if the government imposes a tax on a
good, the prices of that good will rise. Say, if the government was to impose a tax on
patrol or octane, the prices of those goods would rise, which the example of
positive economics is. Government try to establishes income tax systems that take
relatively more from the rich than from the poor, recommendations to subsidize the
high price of gasoline to avoid a large burden on the poor and recommendations to
cut taxes on the rich to achieve faster economic growth. In each instance the
economist looks at a particular goal that he favours on the basis of personal
preferences.

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Positive and Negative relationship
A positive or direct relationship exists between two variables if
an increase in the value of on variable is associated with an
increase in the value of the other variable, i.e. change will be in
same direction. A negative or inverse relationship exists
between two variables if an increase in the value of one
variable is associated with a reduction in the value of other
variable, i.e., change will be in opposite direction.

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Dependent and independent variables

A change in the value of an independent variable will cause the

dependent variable to change in value. In the function, is referred to
as the argument of function, and is called the value of the function.
We shall also alternatively refer to as the independent variable and
as the dependent variable.

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 The rules for constructing graphs
At first we consider a following schedule :
Combinations Minutes of Typing ( X axis) Number of Pages Typed ]
( Y axis)

0 0 0
A 5 1

B 10 2
C 15 3
D 20 4

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 Four steps are required to graph
these data or any data. These
steps have been carried out in the
above figure.

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 • A vertical axis and a horizontal axis are drawn perpendicularly on
graph paper, meeting at a point called the origin. The origin is labeled
0; the vertical axis is labeled; the horizontal axis is labeled.

• Minutes of typing are marked off along the horizontal axis in equally
spaced increments of 5 minutes, and the horizontal axis is labeled
“Minutes of Typing.”

• The number of pages typed is marked off in equally spaced

increments of 1 page along the vertical axis, and the vertical axis is
labeled “Number of Pages Typed.”

• Each pair of numbers in the following table is plotted at the

intersection of the vertical line that corresponds to that value of and
the horizontal line that corresponds to that value of. Point A shows
that 5 minutes of typing produces 1 page. Point B shows those 10
minutes of typing produces 2 pages, and so on. Point A, B, C, and D
completely describe the data in the above table.

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Slope
The relationship between two variables is represented by a curve’s slope. The
slope reflects the response of one variable to changes in another.

Let (delta) stand for the change in the value of and (delta) stand for the change in
the value of. So,

Y
Slope 
X

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The key problems of an Economics Organization

The economic problem is how to allocate scarce resources among competing

ends. Three questions must be answered : What products will be produced ? How
will they be produced?, For whom will they be produced?

What ? : Should society devote its limited resources to producing civilian or

military goods, luxuries or necessaries goods, goods for immediate consumption
or goods that increase the wealth of society, i.e., capital goods ? Should small or
large cars be produced, or should buses and subways be produced instead of cars
? Should the military concentrate on strategic or conventional forces ?

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 How ? : Once the decision is made on what to produce, society must
determine what combinations of the factors of production will be used. Will
coal, petroleum, or nuclear power be used to produce electricity ? Will
bulldozers or workers with shovels dig dams ? Should automobile tires be
made from natural or synthetic rubber? Should Coca Cola be sweetened
with sugar or corn syrup ? Should tried-and-true methods of production be
replaced by new technology?
For Whom ? : Will society’s output be divided fairly equally or will claims to
society’s output be unequal ? Will differences in wealth be allowed to pass
from one generation to the next ? What role will government play in
determining for whom ? Should government intercede to change the way
the economy is distributing its output ?

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Different Economic Systems
What are the different ways that a society can answer the questions of what, how and for whom ? Different societies are
organized through alternative economic systems, and economics studies the various mechanisms that a society can use to
allocate its scare resources. We generally distinguish two fundamentally different ways of organizing an economy. At one
extreme, government makes most economic decisions, with those on top of the hierarchy giving economic commands to
those further down the leader. At the other extreme, decisions are made in markets, where individuals or enterprises
voluntarily agree to exchange goods and services, usually through payments of money. Let’s explain each of these forms:

In the United States and most democratic countries, most economic questions are solved by the markets. Hence their
economic systems are called market economies.

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 A Market Economy is one in which individuals and private firms make the
major decisions about production and consumption. A system of prices, of
markets, of profits and looses, of incentives and rewards determines what,
how and for whom. Firms produce the commodities that yield the highest
profits, i.e. the what, by the techniques of production that are least costly,
i.e., the how. Consumption is determined by individuals’ decisions about
how to spend the wages and property incomes generated by their labour
and property ownership, i.e., for whom. The extreme case of a market
economy, in which the government keeps its hands off economic decisions,
is called a laissez-faire economy.

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 By contrast, a Command Economy is one in which the government makes
all important decisions about production and distribution. In a command
economy, such as the one which operated in the Soviet Union during most
of the century, the government owns most of the means of production, i.e.,
land and capital; it also owns and directs the operations of enterprises in
most industries; it is the employer of most workers and tells them how to
do their jobs; and it decides how the output of the society is to be divided
among different goods and services. In short, in a command economy, the
government answers the major economic questions through its ownership
of resources and its power to enforce decisions.

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 No contemporary society falls completely into either of these
polar categories. Rather, all societies are Mixed Economies,
with elements of market and command.

Today most decisions in the United States are made in the

marketplace. But the government plays an important role in
overseeing the functioning of the market; government pass
laws that regulate economic life, produce educational and
police services, and control pollution. Most societies today
operate Mixed Economies.

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Opportunity Costs
A sacrificed opportunity is called an opportunity cost by economists
because the economic cost of any choice is that which must be
sacrificed in order to make that choice. The opportunity cost of a
particular action is the loss of the next best alternative.

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 The Production Possibilities Frontier

The production possibilities frontier (PPF) is a useful

analytical tool for illustrating the concepts of scarcity,
choice, and opportunity costs. The production P
possibilities frontier (PPF) shows the combinations of

Wheat
goods that can be produced when the factors of
production are utilized to their full potential. The
production-possibilities curve reveals the economic
choices open to society. Our hypothetical economy is
capable of producing output combination A but
unable to produce output combination B because
which is the outside of the boundary of the PP/
0 P

Tanks

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 Lecture : 3 and 4
The Law of Increasing Cost,
The Law of Diminishing Returns,
Efficiency,
Economic Growth,
Money Prices and Relative Prices,
Principle of substitution,
Invisible Hand,
The circular flow of economic activity,
Rates of interest,
Real and nominal rates of interest,
Market,
Different types of market.

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Law of Increasing Cost and Law of Diminishing Returns

• The law of increasing costs states that as more of a particular

commodity is produced, its opportunity cost per unit increase.

• The law of diminishing returns states that increasing the amount of

one input in equal increments, holding all other inputs constant,
eventually brings about ever-smaller increase in output.

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Efficiency and Economic Growth

Efficiency results when no resources are unemployed and when no

resources are misallocated.

Economic growth occurs when the production-possibilities frontier

expands outward and to the right. One source of economic growth is
the expansion of capital.

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Money Prices and Relative Prices
A money price is a price expressed in monetary units, such as, dollars,
taka, francs etc.

A relative price is a price expressed in terms of other commodities.

The money price of a commodity can rise while its relative price falls.
The money price can fall while its relative price rises. Money prices
and relative prices need not move together.

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Principle of substitution and Invisible Hand

The principle of substitution states that practically no good is irreplaceable in

meeting demand, i.e., the amount of good people is prepared to buy. Users
are able to substitute one product for another to satisfy demand.

A concept introduce by Adam Smith in 1776 to describe the paradox of a

laissez-faire market economy. The invisible hand doctrine holds that, with each
participant pursuing his or her own private interest, a market system
nevertheless works to the benefit of all as though a benevolent invisible hand
were directing the whole process.

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The circular flow of economic activity and rates of
interest.
The circular flow diagram summarizes the flow of goods and services
from producers to households and the flows of the factors of
production from households to business firms.

Interest is the price of credit, usually a percentage of the amount

borrowed.

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Real and nominal rates of interest.
The nominal rate of interest is the rate of interest expressed in terms
of today’s dollars.

The real rate of interest equals the nominal rate of interest minus the
annual rate of inflation.

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Market, Different types of market
A market is an established arrangement by which
buyers and sellers come together to exchange
particular goods or services.

Normally two types of market are available of an

economy, i.e., perfect competition and imperfect
competition. Imperfect competition are classified
as; pure monopoly, discriminating monopoly,
monopolistic competition, oligopoly, duopoly etc.

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 Lecture : 5 and 6
Demand,
Law of demand,
Demand function,
Demand equation,
Demand schedule,
Draw a demand curve,
Why the demand curve is downward sloping ?
Determinants of demand,
Change in demand curve and movement along a demand
curve.

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 Demand

Economics is based upon the principle of unlimited wants. The list

of goods consumers “want” is quite different from the list of goods
they demand. The demand for a good or service is the relationship
between the amount of good or service consumers are prepared
to buy at a given price and time.
Prepared to buy means:
• Willingness to pay
• Ability to pay
• Purchasing power of that commodity.

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Demand Law
The law of demand states that there is a negative or inverse relationship between
the price of a good and quantity demanded, holding other factors are constant.
Thus if prices are lowered, quantity demanded increases, if other factors are held
constant.

For example, if the price of tea rises, more people will drink coffee, or heavy
drinkers may not back one or two cups a day and instead buy a soft drink.

The universal and natural tendency is for people who consume or use the goods
to substitute other goods or services when the price of a good goes up.

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Demand function, Demand equation
In mathematical notation, the demand function is –
Qd= f(P), other things are constant.

The demand equation is –

Qd = a – bP
Where,
Qd = Quantity demanded
a = Intercept
b = Slope
P = Price
To draw a schedule we need a specific demand equation. The equation is -
Qd = 15 – 2P

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Demand schedule
If we the different values of independent variables in a equation then
we get the different values of dependent variables, which we put a
table this is called the schedule.

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The demand schedule is
Combinations Price Quantity
demanded
A 5 5

B 4 7

C 3 9

D 2 11

E 1 13
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Draw a demand curve
If we plot the table in the graph
Price
then we get the demand curve.
The combinations “A” means 5
units of price and 5 units of D/
quantity demanded, and so on.
We add through to the point A, B,
C, D, and E, then we get DD/
demand curve.

D
0
Quantity demanded

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Conclusion
Along with the demand curve DD/ the price and quantity demanded
are negatively related, so the demand curve is downward sloping.

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Why the demand curve is downward sloping ?

There are some reasons, why the demand curve is downward sloping, these are –

The Law of Diminishing Marginal Utility : The law of diminishing marginal utility states that as more of a
good or service is consumed during any given time period, its marginal utility declines, holding the
consumption of every thing else constant

Substitution effect: When the price of a good rises, people will substitutes other similar goods for it. For
example, as the price of beef rises, someone will eat more chicken.

Income effect: When a price of good goes up, people find themselves poorer than they were before.
The reduction of price is like an increase income, the people normally leads to larger demands for all
goods and services, including the one whose price has fallen. For example, if gasoline prices double, real
income falls, so people will naturally curb to cut their consumption of gasoline and other goods.

13-Jun-15 42
Determinants of demand or shift in the demand
curve
A demand curve assumes that all these other factors are held constant and shows what would happen to the quantity demanded if only the
price were to change. In the real world, these other conditions are constantly changing, therefore, it is crucial to understand how changes in
factors other than price affect the demand for a good. The non price factors that can affect the demand for a good include:

Average Income : As people’s incomes rise, individuals tend to buy more of almost everything, even if prices don’t change. For an example of
automobile, as incomes rise, people increase car purchases.

Population: A growth in population, increases car purchases.

Prices of related goods: Lower gasoline prices raise the demand for cars.

Tastes: Having a new car becomes a status of symbol.

Special influences: Special influences include availability of alternative forms of transportation, safety of automobiles, expectations of future
price increases etc.

The result of all these changes was a rightward shift in the demand curve for cars. An increase in the automobiles is illustrated in the following
figure :

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 Price
D D/

D/
D
0
Quantity demanded

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Change in demand curve and movement along a demand
curve
Price

A A/

0
Quantity demanded

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 Lecture : 7 an 8
Supply,
Law of supply,
Supply function,
Supply equation,
Supply schedule,
Draw a supply curve,
Determinants of supply,
Equilibrium,
Equilibrium of Demand and Supply,
Changes in equilibrium.

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 Supply and Law of Supply
Supply : Supply means the amount offered for sale at a given
price and time.

Law of supply : Law of supply means the supply has

functional relationship with price. Other things remaining the
same, as the price of a commodity rises, supply is extended
and as the price falls, supply is contracted. The quantity
offered for sale varies directly with price, i. e, the higher the
price the larger is the supply and lower the price the smaller
is the supply. So we can say,

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 Supply Function and Supply Equation
Supply Function : Supply has a functional relationship with
price. So we can say,
Qs= f(p), Other thins are remaining the same.

Supply Equation : A hypothetical supply equation is –

Qs= - c + dp
A numerical supply equation is -
Qs= - 5 + 2p

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 Supply Schedule
Supply schedule represents the relation between prices and quantities
that people are willing to produce and sell.

Suppose the following is the supply schedule of apples.

Combinations Price(per dozen) Tk. Quantity supplied (in dozen)
A 7 9
B 6 7
C 5 5
D 4 3
E 3 1

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 It will be seen that when price is as high as Tk. 7 per dozen,
as many as 9 dozen apples are offered for sale. As the
price falls, the amount supplied decreases. When the price
is as low as Tk. 3 only 1 dozen apples are offered for sale.
This means that as price falls quantity of supply is
contracted, and as price rises the quantity of supply is
extended. This is the law of supply.

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 Draw a supply curve
The supply schedule given above can be represented in the form of
supply curve. The following curve represent the supply curve of apple. In
this diagram, quantities supplied are measured along X axis, and prices
along Y axis, SS is the supply curve. When the price of apple is 7 Tk. per
dozen, the producer wish to supply 9 dozens of apple per week, which
represent the point A. As the price falls to 6 Tk. per dozen, the producer
wish to supply 7 dozens of apple per week, which represent the point B.
Finally, when the price is 3 Tk. Per dozen, the producer wish to supply 3
dozens of apple per week, which represent the point E. We add through
to the point A, B, C, D, and E, we get a supply curve named SS´.

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 Price
The following curve represent
the supply curve.

Conclusion : Along with A S´

7
the supply curve SS´, the 6 B
price and quantity 5 C

supplied are positively 4

D
related, so the supply 3 E
curve is upward sloping. S

0
1 3 5 7 9
Quantity supplied

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 Determinants of Supply or factors that causes the supply
curve to shift
Just as factors other than the price of the good can change the
relationship between price and quantity supplied, non-price factors
can change the relationship between price and quantity supplied,
causing the supply curve to shift. The non-price factors are :
The price of other goods : Increase in price of corn shifts supply curve
of wheat to left.
The price of relevant resources : Decrease in wage rate of autoworkers
shifts supply curve of autos to right.
Technology : Higher corn yields due to genetic engineering shift supply
curve of corn to right.
The number of sellers : New sellers entering profitable field shift
supply curve of product to right.
Expectations : Expectation of a much higher price of oil next year
shifts supply curve of oil today to left.

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 Equilibrium of demand and supply
The term ‘ equilibrium’ has often to be used in economic analysis. Equilibrium means a
state of balance between to forces. When forces acting in opposite directions are exactly
equal, the object on which they are acting is said to be in a state of equilibrium.
Types of equilibrium :

Stable equilibrium : Stable equilibrium value is an equilibrium value that if changed by a

small amount, calls into action forces that will tend to reproduce the old value.

Unstable equilibrium : Unstable equilibrium value is an equilibrium value, change in which

calls forth forces which tend to move the system farther and farther away from the
equilibrium value.

Neutral equilibrium : Neutral equilibrium value is an equilibrium value is an equilibrium

value that does not know any such forces.

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 Equilibrium of demand and supply

Equilibrium means the state of balance between two

forces. The market equilibrium means the state of
balance between demand and supply. The market
equilibrium comes at that price and quantity where the
forces of demand and supply are in balance. At the
equilibrium price, the amount that buyer want to buy is
just equal to the amount that sellers want to sell. The
reason we call this an equilibrium is that, when the forces
of demand and supply are in balance, there is no reason
for price to rise or fall, as long as other things remain
unchanged.

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 Analysis : Numerical and Graphical
Numerical Analysis : The following table shows the numerical
analysis of equilibrium of demand and supply.
Combinations Possible Quantity Quantity State Pressure
Price Demanded Supplied of Market on Price

A 5 5 13 Surplus Downward
B 4 7 11 Surplus Downward
C 3 9 9 Equilibrium Neutral
D 2 11 7 Shortage Upward
E 1 13 5 Shortage Upward

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 Graphical Analysis : From the above table we may
analyze the equilibrium of demand and supply. When
price is 4 units the quantity demanded is 7 units and
quantity supplied is 11 units, 4 units or LM units of
surplus in the market and pressure on price is
downward. When price is 2 units the quantity
demanded is 11 units and quantity supplied is 7
units, 4 units or HR units of shortage in the market
and pressure on price is upward. When price is 3
units the quantity demanded is 9 units and quantity
supplied is 9 units, and state of market is equilibrium
and pressure on price is neutral.

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The figure shows the
equilibrium of demand Price

and supply.
Conclusion : At point E and D S
L M
only E, the quantity 4
demanded and quantity
supplied are balance, so
consumer riches in 3 E

equilibrium and get

equilibrium price is 3 units 2 H R
and quantity is 9 units. D
S

0 7 9 11
Quantity

13-Jun-15 58
 Lecture : 9 an 10
Price elasticity of demand,
Calculate price elasticity of demand with extreme
cases, or Calculate price elasticity of demand on a
linear demand curve,
Calculate point elasticity of demand,
Relationship between price elasticity of demand
and revenue,
Cross – Price elasticity of demand,
Income elasticity of demand.

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 Price elasticity of demand
The downward sloping demand curve shows the
other things remaining the same when the quantity
demanded (Q ) increases then price (P) decreases
but we need a measure of how much the quantity
demanded responds to its price change. Price
elasticity of demand is a measure of this
responsiveness. The price elasticity of demand is a
measure of the responsiveness of quantity
demanded to a change in price.

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 The measure of responsiveness of quantity
demanded to price changes must therefore be
the relative or percentage change in price or
quantity demanded. The price elasticity of
demand is the percentage change in quantity
demanded divided by the percentage change in
price. Symbolically we may write

Ed = %Qor, Ed = Q or,
/ Q Ed = Q P

%P P / P P Q

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 Calculate price elasticity of demand with extreme cases, or
Calculate price elasticity of demand on a linear demand curve
Introduction : The price elasticity of demand coefficient can range from
a value of zero to a value that is infinitely large, but economists typically
divide elasticity coefficients into three broad categories,
When Ed > 1 means that a 1 percent change in price calls forth more
than a 1 percent change in quantity demanded, the good has price-
elastic demand. Example : luxury goods.
When Ed < 1 means that a 1 percent change in price evokes less than a 1
percent change in quantity demanded, the good has price inelastic
demand. Example : necessary goods.
When Ed = 1 means that the percentage change in quantity demanded
is exactly the same as the percentage change in price, the good has unit
elastic demand. Example : competitive goods.

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 Calculation of Price Elasticity of Demand :
Numerical and Graphical

To illustrate the calculation of elasticities we need a schedule. From the

schedule we put in the diagram then show the different elasticities.

Combinations Quantity(Q) Price(P) ΔQ ΔP

A 1 8 - -
B 10 6 9 (-) 2
C 20 4 10 (-) 2
D 30 2 10 (-) 2

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 Price Price

8 A 6
6 B B
4 C

0 1 10 0 10 20
Quantity Demanded Quantity Demanded

4 C

2
D

0 20 30
Quantity Demanded

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 Figure A, B and C illustrate the three cases of
elasticities, i.e., elastic demand, unitary elastic
demand and inelastic demand. In figure A, price
changes from 8 to 6 and quantity demanded
changes from 1 to 10 and we calculate the price
elasticity of demand from point A to B.
Here,
P = 6; Q = 10; ΔQ = 9; and ΔP = (-)2

We know, Ed = so, Ed =
or Ed = 2.70 Q P 9 6
 
P Q 2 10

13-Jun-15 65
 Lecture : 11 an 12
Theory of Utility – Cardinal and Ordinal Approach,
Cardinal Approach - Relationship Between Total and
Marginal Utility, The Law of Diminishing Marginal Utility,
Consumer Surplus.

Ordinal Approach - Definition and Characteristics of

Indifference Curve, Definition of Budget Line, Consumer
Equilibrium Analysis.
Concept of utility: The demand for a commodity depends
on consumer behavior. People tend to choose those goods
and services they value most highly. Sometimes price are
often fail to reflect the usefulness of goods. Goods like
water and salt, without which human beings would perish,
have low relative prices while goods that have little practical
value, such as diamonds, gold, and high fashion, have
relative prices. People’s preferences for goods and services
are based on their perception of how the goods or services
add to their utility. Utility is the satisfaction that people
enjoy from consuming goods and services.
Cardinalist approach and Ordinalist approach : There
are two basic approaches to the problem of
comparison of utilities, the cardinalist approach and
ordinalist approach.

The cardinalist school postulated that utility can be

measured. Under certainty some economists have
suggested that utility can be measured in monetary
units, by the amount of money the consumer is willing
to sacrifice for another unit of a commodity. Others
suggested the measurement of utility in subjective
units, called utils.
The ordinalist school postulated that utility is not
measurable, but is an ordinal magnitude. The
consumer need not know in specific units the utility
of various commodity to make his choice. It suffices
for him to be able to rank the various baskets of
goods according to the satisfaction that each bundle
gives him. He must be able to determine his order of
preference among the different bundles of goods.
Assume basket A ( x , x ) has higher utility than
basket B ( x , x ), then u (A)> u(B).
Total utility : The total utility is the sum of individual
consumption of goods or services. The total utility of
a basket of goods depends on the quantities of
individual commodities. If there are ‘n’ commodities
in the bundle with quantities x , x ,x ,------ x , then
total utility, TU = f ( x , x , x ,----, x ), and also say
that total utility is the additive of individual utility,
then,
TU = u (x ) + u (x ) + u (x ) + ----- + u (x ).
• Marginal utility: Marginal utility can be defined as the change in the total utility
resulting from a one- unit change in the consumption of a commodity per unit of
time. For example, when you eat an additional unit of apple, you will get some
additional unit of apple, you will get some additional satisfaction or utility. The
increment to this utility is called marginal utility. So the marginal utility
(symbolically) is

TU
MU 
Q
The Law of Diminishing Marginal Utility

• Statement of the Law : Satisfaction of human wants follows some very important laws and one
of them is the Law of Diminishing Marginal Utility. The law refers to the common experience of
every consumer. Suppose a person starts eating pieces of bread one after / often another. The
first bread gives him great pleasure. By the time of the starts taking second, third and so on give
him leis satisfaction than first. The additional satisfaction will go decreasing with every successive
bread till to drops down to zero, and if the consumer is forced to take more, the satisfaction may
become negative. Finally the Law of Diminishing Marginal Utility states that as more of a good or
service is consumed during any given time period, its marginal utility declines, holding the
consumption of everything else constant.
• Assumptions:

• Consumers are rational

• Time is fixed
• Taste and habits are unchanged
• Goods are homogeneous
• Numerical Analysis: We can illustrate the Law of
Diminishing Marginal Utility numerically as in the
following table.
Quantity of Good Total Utility Marginal Utility
Consumed (Q) (TU) (MU)
1 20 -----
2 38 18
3 53 15
4 64 11
5 70 6
6 70 0
7 62 -8
8 46 -16
• Table shows in column (2) that total utility (TU) enjoyed increases as
consumption (Q) grows, but it increases at a decreasing rate. Column (3)
shows the marginal utility which measures as the extra utility gained when
one extra unit of the good is consumed. When the consumer consumes 2
unit of goods, then he gets 38 units of total utility and 18 units of marginal
utility, here call these units is utils. Consumer goes on taking bread, the
extra satisfaction that he gets by the consumption of each successive bread
goes on decreasing till it goes down to zero at the 6 units of goods are
consumed and then it becomes negative, i.e.,7and 8 units of goods are
consumed. The total utility, however, goes on increasing until the
consumption of good is 5 unit but it is worth nothing that it increases at a
diminishing rate. It will seen from the table that the total utility of a
quantity of a commodity is maximum, i.e, 70 units, when the marginal
utility is zero, at 6 units of goods are consumed.
• Diagrammatic Representation: The following diagram illustrates the Law of
Diminishing Marginal Utility as applied to the consumption of bread. Units of breads
are measured on the horizontal axis, i.e, X axis, units of utility are measured on the
vertical axis, i.e, Y axis. Utility of the first bread is represented by the rectangle
standing on a portion of the axis of X. Similarly, the utility of each successive unit
consumed is represented by the rectangles as shown in the diagram. These
rectangles become smaller and smaller, as consumption of units proceeds. The 6
units of bread has no utility. The 7 units and 8 units have negative utilities, as shown
by the rectangles below the axis of X. An another curve MU has been drawn which
slopes downward from left to right, which is diminishing marginal utility curve. It
shows that as the quantity of the commodity with the consumer increases, Its
marginal utility decreases. When he has 0M1 quantity, the marginal utility is M1Q
and when the quantity increases to 0M2, the marginal utility decreases to M2 R and
so on. When the quantity increase to 0M7, the marginal utility drops to zero and it
becomes negative when the consumer comes to have 0M8 quantity.
 Y
20

18
The
following 15

figures 11
illustrate
the law of 06
1 2 3 4 5 6 7 8
diminishing O X
marginal
utility
Y

Q
R

S
T

0 M1 M2 M3 M4 M5 M6 M7 M7 X

MU
Limitations of the Law:
- Suitable units
- Suitable time
- Change in consumer tastes
- Fashion.
Consumer Surplus :The paradox of value emphasizes
that the recorded money value of a good may be very
misleading as an indicator of the total economic value
of that good. The measured economic value of the air
we breath is zero, yet air’s contribution to welfare is
immeasurably large. The gap between the total utility
of a good and its total market value is called consumer
surplus. The surplus arises because we ‘receive more
than we pay for’ as a result of the Law of Diminishing
Marginal Utility. Consumer surplus is the excess of the
total consumer benefit that a good provides ever what
the consumers actually have to pay.
 Price and MU
The Y
following 9
figure
illustrates 8

the
7
concept of
consumer 6
surplus
5
4
3
2 E
1
0.5 1 2 3 4 5 6 7 8 9
O Quantity of Water X
 Here, an individual consumes water, which has a
price of $ 1 per gallon. This is shown by the
horizontal rust line at $1 in the following figure.
The consumer considers how many gallon jugs to
buy at that price. The first gallon is highly
valuable, slaking extreme thirst, and the
consumer is willing to pay $9 for it. But this first
gallon costs only the market price of $1, so the
consumer has gained a surplus of $8.
Consider the second gallon, this is worth of $8 to
the consumer, but again costs only $1, so the
surplus is $7, and so on. The consumer
equilibrium comes at point E, where 8 gallons of
water are bought at a price of $1 each. Consumer
has paid only $8, the total value of the water is $
44. This is obtained by adding up each of the
marginal utility column ($9 + $8-- +$2) = $44. Thus
the consumer has gained a surplus of ($44 - $8) =
$36 over the amount paid.
Economists use consumer surplus when they are
performing a cost benefit analysis, which attempts to
determine the costs and benefits of a government
program. Generally, an economist would recommend
that a free road should be built if its total consumer
surplus exceeds its costs. Similar analysis have been
used for environmental questions such as whether to
preserve wilderness areas for recreation or whether
to require new pollution- abatement equipment.
 Definition of indifference Curve : The law of diminishing
marginal utility does explain the law of demand but its claim to
realism is limited. It requires that people be able to measure
the utility they obtain by consuming various quantities of
goods and services. Because of skepticism about the
measurement of utility, economists were forced to find an
alternative approach to understanding consumer behavior. The
culmination of this search is indifference curve theory. This
theory does not require that consumers be able to measure
utility in any specific units of measurement but does assumes
that consumers are able to rank their preferences for
combinations of goods.

13-Jun-15 85
 On the basis of a consumers scale of preferences,
we can draw indifference curves. Other things
remaining the same, an indifference curve
represents satisfaction of a consumer from two
commodities. It is drawn on the assumption that
for all possible points on an indifference curve,
the total satisfaction remains the same, hence,
consumer is indifferent as to the combinations
lying on an indifference curve. To draw the
indifference curve, consider the following table :

13-Jun-15 86
 Combinations Apples Mangoes Marginal Rate of
Substitution

A 1 7 ------

B 2 4 1:3

C 3 2 1:2

D 4 1 1:1

13-Jun-15 87
 A consumer who wants to buy apples and mangoes,
he knows it well that one combination of apples and
mangoes give him as much satisfaction as another
combination of less apples and more mangoes or
another combination of more apples and less
mangoes give him the same satisfaction, so consumer
is indifferent between the combinations. Now we
draw the indifference curve from the indifference
schedule.

13-Jun-15 88
 In the following
figure, the Quantity of Mangoes
horizontal axis
measures the
quantity of I
apples 7 a(7,1)
consumed and
vertical axis
measures the 4 b(4,2)
quantity of
mangoes
2 c (2,3)
consumed by
d( 1,4)
the individual.
1
I
1 2 3 4
0
Quantity of Apples

13-Jun-15 89
 On the figure, at point a, 7 units of mangoes and 1 unit
apples are consumed. At point a, the consumer is willing to
give up 3 unit of mangoes for more 1 unit of apples. This
trade-off would move the consumer to point b, where 4
units of mangoes and 2 units of apples are consumed. At
point b, the consumer is no longer willing to give up 3
units of mangoes to acquire 1 more unit of apple. The
consumer is now willing to give up only 2 unit of mangoes
to acquire more 1 unit of apple. This trade-off would put
the consumer at point c, consuming 2 units of mangoes
and 3 units of apples. Finally to acquire 1 more unit of
apples the consumer is willing now to give up only 1 unit
of mango, moving the consumer to point d.

13-Jun-15 90
 The consumer is indifferent between points, a, b, c, and d
feels equally well off at any of these points. A curve II can be
drawn from the point add a to d, which is called indifference
curve.

An indifference curve is the locus of points particular

combinations or bundles of goods which yield the same
utility or satisfaction to the consumer, so consumer is
indifferent as to the particular combination he consumes. An
indifference curve is downward-sloping because as long as
both goods yield satisfaction, more is better than less. The
only way for the consumer’s satisfaction to stay the same
when more of one good is consumed is to consume less of
the other good.

13-Jun-15 91
 Marginal Rate of Substitution : The marginal rate of
substitution is how much of one good a person is just willing to
give up to acquire one unit of another. Thus the marginal rate
of substitution is just a fancy name for an acceptable trade-off
between two goods for a person’s valuation of an additional
unit of one good in terms of the other.

The marginal rate substitution is that as more of one good

(Apple - A) is consumed, the amount of other good (Mango - B)
that the consumer is willing to sacrifice for one more units of
(Apple - A) declines. The slope of the tangent at any point on
the indifference curve measures the marginal rate of
substitution of mango - B for apple -A.

13-Jun-15 92
 Properties of Indifference curve: Indifference curves
have the following properties :
• They are bowed out toward the origin, which reflects the
law of diminishing marginal rate of substitution;
• The consumer is better off when he or she moves to a
higher indifference curve;
• Indifference curves that show preferences between two
goods from which consumers derive benefits are
downward- sloping;
• Indifference curves cannot intersect each other, because
an intersection would indicate that the consumer is
simultaneously worse off and better off.
• Indifference curves do not move as a result of market
circumstances.

13-Jun-15 93
 Indifference Map : There is an infinite number of indifference
curves for each consumer. There are three indifference curves
for a particular consumer are shown in the following figure.
The higher the indifference curve, the greater the well-being
of the consumer. An indifference map shows all the
indifference curves which rank the preferences of consumer.
Combinations of goods lying on a higher indifference curve
yield higher level of satisfaction and are preferred
combinations of goods on a lower indifference curve yield a
lower satisfaction. The indifference map shows that
commodity bundle “f” is preferred to bundle “e” because the
former is on a higher indifference curve. Indifference curve I3
represents a higher level of satisfaction than I2 represents a
higher level than I1. The level of satisfaction along each
indifference curve is constant.

13-Jun-15 94
 There are Quantity of Mangoes

three
indifference
curves for a
particular
consumer
are shown in f

the following d
e

figure.
I3
I2
I1
O
Quantity of Apples

13-Jun-15 95
 Budget Line : A consumer’s position on an indifference
curve is determined by the consumer’s budget. A rational
consumer will, therefore, try to reach the highest
possible indifference curve in order to obtain the highest
possible level of satisfaction by his limited income. Our
consumer will be governed by the amount of the money
or income he has to spend on goods, and prices of the
goods in the market. Let us begin with a simple example,
consider a consumer who has a weekly income of $ 100
that is used to purchase only two goods, i.e., food and
clothing. The price of a unit of food (Pf) is $ 10 and the
price of a unit of clothing (Pc ) is $ 5.

13-Jun-15 96
 The following table illustrate the various combinations
of food and clothing that the consumer can purchase
under these conditions.

Combinations Units of Clothing per Units of Food per

Week Week
A 20 0

B 10 5

C 0 10

13-Jun-15 97
 Combinations A shows that an income of $100 permits
the consumer to buy 20 units of clothing at price of $5,
with nothing left over for food purchases. Combinations C
shows the other extreme, when the consumer’s entire
income goes to buy 10 units of food at price of $10, with
nothing left over for clothing. The combination B shows
that an income of $100 permits the consumer to buy 10
units of clothing at price of $5 and 5 units of food at price
of $10. Above schedule put in the graph we get the
budget line, MN.

13-Jun-15 98
 Consumption of
The budget line is all Clothing per week
the combinations of
goods the consumer
is able to buy given
a certain income set
20 A(20,0)
prices. The budget
M
line shows the
choices of consumer
goods available to 10 B(10,5)
the consumer.

N C(0,10)
0 5 10
Consumption of
food per week

13-Jun-15 99
 Consumer Equilibrium

Introduction / Main Idea :The consumer is said to be

in equilibrium when he obtains the maximum
possible satisfaction from his purchases, given the
prices in the market and the amount of money he
has for making purchases.

13-Jun-15 100
 Assumptions: In order to explain how a consumer reaches
equilibrium position, we shall make the following assumptions:
• Our consumer has an indifference map showing his scale of
preferences for various combinations of two goods, i.e., apples and
mangoes. This scale of preferences remains the same throughout
the analysis;
• He has a given and constant amount of money to spend on the
goods and if he does not spend it one good, he must spend it on the
other;
• Prices of the goods in the market are given and constant;
• Each of the good is homogeneous and divisible; and
• The consumer acts rationally, i.e., he tries to maximize his
satisfaction.

13-Jun-15 101
 Diagrammatic Analysis : Our consumer has an indifference
map, shown in the following diagram. Suppose, the budget line
facing the consumer is AM, given a certain amount of money
he has to spend on apples and mangoes and the prices of
apples and mangoes in the market. Any point not lying on this
budget line cannot be possible equilibrium points, because his
situation will not allow him to move the budget line. The
consumer is able to locate any where on the budget line, but
the rational consumer will select that consumption that falls on
the highest attainable indifference curve.

13-Jun-15 102
 Apples

H P

K IC3
IC2
R IC1
0 Mangoes
M

13-Jun-15 103
 The consumer is in equilibrium at point P, where he will be buying OR units
of mangoes and OH units of apples. At point P, the consumer will maximize
his satisfaction and be in equilibrium at that point where budget line
touches or is tangent to an indifference curve. Such a point in our diagram
is P which lies on indifference curve IC2 . This is the highest indifference
curve to which he can go, given the money and the prices of the goods in
the market. Any combination other than P on the given budget line can be
shown to give less satisfaction to the consumer, for all other points on the
budget line must lie on indifference curves of a lower order than that on
which P lies. If consumer chooses a combination of mangoes and apples
represented by N, he will be on a lower indifference curve IC1, and will thus
be getting less satisfaction than when he chooses the point P and is on a
higher indifference curve IC2 and same in point K. Finally we can say,
consumer equilibrium occur at only point P on the highest attainable
indifference curve where the marginal rate of substitution is equals the
price ratio.

13-Jun-15 104
 Conditions of Equilibrium : Two conditions must be satisfied for a
consumer to attain an equilibrium; such as
i) At equilibrium point, the budget line should be tangent to an
indifference curve or MRS of one commodity for another should be
equal to their relative prices, i.e.,
Price of mangoes
MRS of mangoes for apples =
Price of apples
which is called first-order condition or necessary condition.
ii) At the point of equilibrium, an indifference curve must be
convex to the origin, i.e., at or near the point of equilibrium the MRS
of mangoes for apples is decreasing, which is called second-order
condition or sufficient condition.

13-Jun-15 105
 Lecture : 13 and 14
Theory of Production : Definition of
Production, Factors of Production, Land
and Capital, Production Function, The Law
of Variable Returns or Proportion or Three
Stages of production, Short – run and long
– run, Returns to scale.

13-Jun-15 106
 Definition of Production : Production is sometimes defined as the creation
of utility or the creation of want- satisfying goods and services. It is not
correct definition. To produce a thing which has utility but not value is not
production in the economic sense. One may spread the cult of yoga and
promote the physical and spiritual well-being of one’s friends - a thing of
great utility but unless one makes it one’s profession, his activity will not
come under production.

Production, therefore, should be defined, not as creation of utility, but

creation of value.

Utilities are created in three forms, i.e., Form of utility; Time utility; and
Place utility. Production essentially means transformation of one set of
goods into another. A good may be transformed by being physically
changed (form utility), being transported to the place of use (place utility)
and being kept in store till required (time utility).

13-Jun-15 107
 Factors of Production : Productive resources required
to produce a given product are called factors of
production. Generally factors of production as a
group or class of original productive resources. The
term ‘factors’ is used for a class of productive
elements the individual members of which are known
as units or inputs of the factor. The factors of
production have been traditionally classified as Land,
Labour, Capital and Organization. Now we shall briefly
deal with them one by one.

13-Jun-15 108
 Land: The term ‘land’ has been given a special
meaning in economics. It does not mean soil as in the
ordinary speech, but it is used in a much wider sense.
In the words of Marshall, land means the materials
and the forces which nature gives freely for man’s aid,
in land and water, in air and light and heat. Land
stands for all natural resources which yield an income
or which have exchange value. It represents those
natural resources which are useful and scarce,
actually or potentially.

13-Jun-15 109
 Peculiarities of Land :
In contrast of the other factors of production, land presents
certain well-marked peculiarities, such as,
• Land is nature’s gift to man;
• Land is fixed in quantity. It is said that land has no supply price,
i.e., price of land prevailing in the market cannot affect its
supply, the price may high or low, its supply remains the same;
• Land is permanent;
• Land provides infinite variation of degree of fertility and
situation so that no two prices of land are exactly alike. This
peculiarity explains the concept of margin of cultivation.

13-Jun-15 110
 Labour : In the ordinary speech, the term ‘labour’
means a mass of unskilled labour. But in economics it
is used in a wider sense. Any work, whether manual
or mental, which is undertaken for a monetary
consideration, is called labour in economics. In
Marshall’s words, “ Any exertion of mind or body
undergone partly or wholly with a view to some good
other than the pleasure derived directly from the
work, is called labour.”

13-Jun-15 111
 Peculiarities of Labour :
Labour is not only a means of production but also an end of
production. There are certain characteristics which distinguish
labour from the rest of the factors of production:
• Labour is inseparable from the labourer himself;
• Labour has to sell his labour in person;
• Labour does not last. It is perishable;
• There can be no rapid adjustment of the supply of labour to
demand for it, because supply cannot be increased quickly, nor
can it be reduced.

13-Jun-15 112
 Capital : Capital refers to that part of a man’s wealth which is used in
producing further wealth or which yields an income. The term
‘capital’ is generally used in economics for capital goods, e.g., plant
and machinery, tools and accessories, stocks of raw materials, goods
in process and fuel.

Importance of Capital :
Capital plays a vital role in the modern productive system.
Production without capital is hard for us even to imagine. Capital
occupies a central position in the process of economic development.
Capital formation is the very core of economic development. Capital
formation is the creation of employment opportunities in the
country.

13-Jun-15 113
 Enterprise : The fourth factor of production is enterprise which
is supplied by the entrepreneur.
Role of entrepreneur :
The role that the entrepreneur plays consists in co-ordinating
and correlating the other factors of production. He starts the
work, organizes and supervises it. He undertakes to
remunerate all the factors of production. Thus he takes the
final responsibility of the business. The entrepreneur is the
innovator. It may mean the introduction of a new method of
production or an improvement in the old method.

13-Jun-15 114
 Is land capital :
Land is not regarded as capital because

i) Land is a free gift of nature but capital is man-

made;
ii) Capital is perishable, whereas land is permanent;
iii) The amount of capital can be increased but the
quantity of land is fixed and limited; and
iv) Income from capital is uniform whereas rent of
land varies.

13-Jun-15 115
 Production function : Production function may be defined as the functional
relationship between physical inputs, i.e., factors of production and
physical outputs, i.e., the quantity of goods produced. It shows the
maximum amount of output that can be produced from a given set of
inputs in the existing state of technology. In real life, a manufacturer wants
to know how much of the various factors or inputs, viz., land (i.e., natural
resources), labour and capital will be required to produce a unit or given
quantity of a commodity during a given period of time. Production function
is concerned with physical aspects of production, it is more a concern of an
engineer or technician than of an economist. Only a technician can say
what specific quantity of a good can be produced by the use of the various
productive resources and their combinations. Production function can be
expressed as under :
X = f (a, b ,c, d, -----)
Here, X is the output of a commodity per unit of time and a, b, c, d, ------
are the various productive resources which into the making of the quantity
of the commodity, f is function.

13-Jun-15 116
 Total, Average and Marginal Product : We begin by
computing the total product, which designates the
total amount of output produced in physical units,
such as; bushels of wheat or number of telephone
calls produced. The average product, which is equals
total output divided by total units of inputs. The
marginal product of an input is the extra unit of that
input while other inputs are held constant.

13-Jun-15 117
 The Law of Diminishing Returns
Introduction : There are three laws of returns known to economists,
i.e., the laws of diminishing, increasing and constant return. As we
shall explain below, these three laws are only three aspects of one
law, viz., the Law of Variable Proportions.
Statement of the law : The law of diminishing returns was supposed
to have a special application to agriculture. It is the practical
experience of every farmer that “successive applications of labour
and capital to a given area of land must ultimately, other things
remaining the same, yield a less than proportionate increase in
produce.” According to Marshall, “An increase in capital and labour
applied in the cultivation of land causes in general less than
proportionate increase in the amount of produce raised, unless it
happens to coincide with an improvement in the arts of agriculture.”

13-Jun-15 118
 Assumptions: To analyze the Law of
Diminishing Returns we assume the following
assumptions;

i) The state of technology remains

unaltered;
ii) Various inputs employed in
production are constant.

13-Jun-15 119
 No. of Total Returns Marginal Average
Analysis of Workers Returns Returns
the law of 1 80 ------ 80
diminishing 2 170 90 85
returns, we 3 270 100 90
need to a
schedule.
4 368 98 92
The
following is
the given 5 430 62 86
below : 6 480 50 80
7 504 24 72

8 504 0 63
9 495 -9 55
10 440 - 55 44

13-Jun-15 120
 From the table, it appears that there are three
different aspects of the Law of Diminishing Returns.
These are –

Law of Total Diminishing Return : Column two shows

the total return, the returns begin to diminish from the
9th worker. Every successive worker employed does
make some addition to the total output. But the 8th
adds nothing and 9th and 10th are a positive nuisance.
As worker cannot be had gratis, no prudent farmer will
employ more than seven workers in the conditions
represented by this table.

13-Jun-15 121
 • Law of Diminishing Marginal Return : Column 3 represent the marginal
return. Marginal return goes on increasing up to 3rd worker and goes on
falling from 3rd man onwards till it drops down to zero at the 8th man. The
9th and 10th men are merely a cause of obstruction to the others and are
responsible in making the marginal return negative. It can be seen that the
total output is at its maximum when marginal output is zero.
• Law of Diminishing Average Return : Column 4 represent the average
return. The average return reaches the maximum at the 4th worker, i.e., one
step later than the marginal return reaches the maximum. Then the
marginal return falls more sharply. The two equalize somewhere between
the 4th and 5th, i.e., when the 5th worker works part-time. But we do not
employ men in fractions in real life. Therefore, it is not always possible to
equalize the marginal and the average returns. It is also clear that it is
possible for the average output to increase while the marginal output falls
and the marginal return negative but average return always positive.

13-Jun-15 122
 Diagrammatic Representation: The law can be
diagrammatically represented as in the following figure.
There are three stages of production. The total production
goes on increasing till it reaches maximum where the third
stage starts. The marginal return reaches the maximum the
earliest and starts diminishing the first stages. The average
return starts diminishing where the second stage begins. No
sensible entrepreneur will operate in the third stage where the
marginal product is zero, unless, of course, the variable factor
is free. Economically, the second stage is the significant region
where the average product is greater than the marginal
product which is still positive. It can be seen that the total
output curve is steepest where the marginal output is the
largest.

13-Jun-15 123
 Product

Second
Stage Third TP
First Stage Stage

AP
0
No. of Workers
MP

13-Jun-15 124
 Economic Implications :
In the first stage, as more and more labour is used, the average
product of labour increases which reflects the increasing efficiency of
labour. In this stage, the total product increases also for this unit of land
which shows that the efficiency of land too is increasing. Hence, this
stage shows that both land and labour are being efficiently utilized.
In the second stage, the average and marginal product is decreasing.
But since the total output goes on increasing, the marginal product is
positive. This stage shows the decreasing efficiency of labour. But the
efficiency of land continues to increase because the total return
continues to increase.
In the third stage, the average product decreases still further. Also,
the marginal product becomes negative and the total product is
decreasing. Hence, in this stage, both labour and land have been used
inefficiently.

13-Jun-15 125
 Limitations of Law :
i) Improved methods of cultivation;
ii) New soil;
iii) Insufficient capital.

Conclusion : The combination of land and labour attained maximum

efficiency of labour at the boundary line between stage one and stage
two and maximum efficiency of land at the boundary line between
stage two and stage three. Stages one and three are ruled out. Stage
one is ruled out because throughout this stage average product of both
land and labour are still increasing and stage three is ruled out because
the average product of both factors is decreasing. Finally, stage two
represents higher efficiency of land-labour ratio than that of the other
two stages.

13-Jun-15 126
 Short-run and long-run : We define the short-run as a period in
which firms can adjust production by changing variable factors,
such as; materials and labour but cannot change foxed factors,
such as; capital. The long-run is a period sufficiently long so that all
factors including capital can be adjusted.

Returns to scale: The returns to scale reflects the responsiveness

of total product when all the inputs are increased proportionately.
Three important cases should be distinguished:
Constant returns to scale : Constant returns to scale denote a case
where a change in all inputs leads to a proportional change in
output. For example, if labour, land, capital and other inputs are
doubled, then under constant returns to scale output would also
double.

13-Jun-15 127
 Increasing returns to scale : Increasing returns to scale arise when
an increase in all inputs lead to a more than proportional increase in
the level of output. For example, an engineer planning a small-scale
chemical plant would generally find that increasing the inputs of
labour, capital and materials by 10 percent will increase the total
output by more than 10 percent.

Decreasing returns to scale : Decreasing returns to scale occur when

a balanced increase of all inputs leads to a less than proportional
increase in total output. One case has occurred in electricity
generation, where firms found that when pants grew too large, risks
of plant failure grew too large. Many productive activities involving
natural resources such as growing wine grapes or providing clean
drinking water to a city, show decreasing returns to scale.

13-Jun-15 128
 Factor Intensity : In comparing methods of production, it
is common to describe some as capital-intensive and
others as labour- intensive. When a relatively little
labour, it is capital-intensive. When there is heavy use of
labour and little use of capital, the production method is
labour-intensive. The following table illustrates the factor
intensity.

13-Jun-15 129
 Technique Capital Labour Rental Wage Capital Labour Total
Input Input Rate Per Rate Cost Cost Cost
Machine $/ $/week $/week $/
$/week week week

A 4 4 320 300 1280 1200 2480

B 2 6 320 300 640 1800 2440

13-Jun-15 130
 We can say that technique A is more capital- intensive
than technique B. In technique A, the ratio of capital
to labour is 1 to 1, i.e., 4 units of capital to 4 units of
labour. In technique B, the ratio of capital to labour is
1 to 3, i.e., 2 units of capital to 6 units of labour. Thus
the first production method is more capital-intensive
than the second. Conversely, the second production
method is more labour-intensive than the first.

13-Jun-15 131
Application
The production equation for Global Electronics is Q = 2 K1/2L1/2.
Assume that the capital stock is fixed at 9 units, i.e., k = 9, and the
price of output is $6, i.e., p = $6 per unit and wage rate is $2, i.e., w =
$2 per unit.
i) Determine the optimal or profit maximizing rate of labour to hired;
ii) What labour rate is optimal if the wage rate increased to $2 to $3
per unit ?

13-Jun-15 132
 Lecture : 15 and 16
Theory of Cost : Different
costs, Definition of
Relationship Between
Different Costs and Cost
Curves, Producer’s
Equilibrium.

13-Jun-15 133
 Definition of cost : The cost of production of an individual firm
operating in a market has an important influence on the
market supply of a commodity. It is very necessary to have a
clear idea about the concept of cost of production and then
proceed to study the cost curves. The firm’s cost are the
expenses producing the goods or services sold during the
period.

Fixed costs : Fixed costs are those costs that do not vary with
output. The fixed costs are rent for factory or office space,
contractual payments for equipment, interest payments on
debts, and so forth. These must be paid even if the firm
produce no output, and they will not change if output changes.

13-Jun-15 134
 Variable Cost : Variable costs are those costs that do vary
output. The variable costs are raw materials used in the
making of the commodity as well as the costs of causal or
daily labour employed. The are incurred only when the
factory is at work. In the long-run, all costs are variable.
Thus in the long-run, fixed costs are zero.

Opportunity Cost : The opportunity cost of production of

a given commodity is the next best alternative sacrificed
in order to obtain that commodity. So, opportunity cost is
a sacrifice cost.

13-Jun-15 135
 Economic Cost : By economic costs is meant those payments which must be
received by resource owners in order to ensure that they will continue to
supply them in the process of production. This definition is based on the
fact that resources are scarce and they have alternative uses.

Implicit Costs : Implicit costs are costs of self-owned and self-employed

resources, such as; salary of the proprietor or return on the entrepreneur’s
own investment. These costs are frequently ignored in calculating the
expenses of production.

Explicit Costs : An explicit cost or an accounting cost is incurred when an

actual payment is made. Explicit costs are the paid-out costs, i.e., payments
made for productive resources purchased or hired by the firm. They consist
of the salaries and wages paid to the employees, prices of raw and semi-
finished material, overhead costs and payments into depreciation and
sinking fund accounts.

13-Jun-15 136
 Total Costs : Total costs equal to fixed costs plus
variable costs. Total cost represents the lowest total
dollar expense needed to produce each level of
output.

Average Costs : Average costs equal to total costs

divided by number of quantity.

Marginal costs: Marginal cost is the extra cost

associated with producing one more unit of output.

13-Jun-15 137
 Economic Profits : Economic profits are the excess of revenue
over total opportunity costs.

Accounting Profits : Accounting profits equal company

revenues minus accounting costs or explicit cost.

Normal Profit : A normal profit is the return that the time and
capital of the entrepreneur would earn in the best alternative
employment and is earned when total revenues equal total
opportunity cost. Economic profit is earned when total
revenues exceed total opportunity cots.

13-Jun-15 138
Now we can illustrate the concept of all costs in the
following table :
Quantity Total Total Total Average Average Marginal Average Average
(Q) Fixed Variable Cost Total Cost Cost Cost Fixed Variable
Cost Cost (TC) (ATC) (AC) (MC) Cost Cost
(TFC) (TVC) (AFC) (AVC)
1 30 10 40 40 40 --- 30 10

2 30 18 48 24 24 8 15 9

3 30 24 54 18 18 6 10 8

4 30 32 62 15.50 15.50 8 7.50 8

5 30 50 80 16 16 18 6 10

6 30 72 102 17 17 22 5 12

13-Jun-15 139
 This is the family of cost schedule for a hypothetical business
enterprise operating in the short-run with total fixed cost of 30
units in column – 2. Fixed cost does not vary with the level of
output. Total variable cost rises with the level of output which
is shown in the column – 3. Total cost is the sum of total fixed
cost and total variable cost which is shown in the column – 4.
Average cost or average total cost is the total cost divided by
the number of quantity or it is the sum of average fixed cost
and average variable cost which is shown in the column – 5
and 6. Marginal cost is the increase in the total cost due to
increase in the output by one unit which is shown in the
column – 7.

13-Jun-15 140
 Average variable cost is the total variable cost divided
by the number units produced which is shown in the
column – 9. Average fixed cost is the total fixed cost
divided by number of units produced which is shown
in the column – 8. The following equations show the
relationship among the various measures :
TC = TFC + TVC
TC
MC 
Q
TC TFC TVC
  TC
ATC
Q = AFC
Q + AVC
Q AC 
Q

13-Jun-15 141
 Relationship between different cost curves in the
short – run

Cost curves shows the relationship between the level

of output and the cost of producing that output.
Output is on the horizontal axis and cost is on the
vertical axis. Cost curves show what happens to costs
of production as the level of output changes. In the
above table, eight different cost measures are
provided. Together, they make up the family of costs :

13-Jun-15 142
 Total Variable Cost (TVC) : Total variable cost the cost that varies with the
level of output.
Total fixed Cost (TFC) : Total fixed cost the cost that does not vary with the
level of output.
Total Cost (TC) : Total cost is the total of the variable and fixed costs of
producing each level of output.
Average Cost (AC) : Average Cost is the total cost divided by the quantity or
output.
Marginal Cost (MC) : Marginal Cost is the addition to total cost of
producing one more unit of output.
Average Variable Cost (AVC) : Average Variable Cost is the total variable
cost divided by the quantity or output.
Average fixed Cost (AFC) : Average fixed Cost is the total fixed cost divided
by the quantity or output.
Average Total Cost (ATC) : Average Total Cost is the sum of average
variable and average fixed cost.

13-Jun-15 143
 These curves are plotted in the following diagram. In panel (a),
variable cost changes with output, fixed cost does not vary with
output. Total cost is the sum of variable cost and fixed cost. In panel
(b), marginal cost is the change in total cost that results from
producing one more unit of output. Average variable cost is the total
variable cost divided by the number units produced. Average fixed
cost is the total fixed cost divided by the number of units produced
and declines throughout. Average total cost is the sum of average
variable cost and average fixed cost. The marginal cost curve will
intersect the average variable cost curve and the average total cost
curve at their respective minimum values. When marginal cost
equals average variable cost will be at its lowest value. When
marginal cost equals average total cost , average total cost will be at
its lowest value.

13-Jun-15 144
 Cost Cost

TC

MC

ATC

AVC

TVC

TFC

0 0 AFC

Output Output

13-Jun-15 145
 Why the LRAC curve is U – shaped ?

Recall that in the long – run all costs are variable;

therefore, there is no distinction between long – run
variable and total costs – there is only long – run
average cost. The long – run average cost curve shows
the minimum average cost for each level of output
when all factor inputs are variable and when factor
prices are fixed. The long – run average cost curve is
U-shaped because, first, economies of scale, then
constant returns to scale, and finally diseconomies of
scale as output expands.

13-Jun-15 146
 Economies of Scale : The declining portion of the long – run
average cost (LRAC) curve is due to economies of scale that
arise out of the indivisibility of the inputs of labour and
physical capital goods or equipment. Economies of scale can
occur because of the greater productivity of specialization in
any of a variety of areas, including technological equipment,
marketing, research and development, and management. As
the output of an enterprise increases will all inputs variable
average costs will decline because of the economies of scale
associated with increased specialization of labour,
management, plant, and equipment. Economies of scale are
present when equal percentage changes in the use of inputs
lead to larger percentage changes in output.

13-Jun-15 147
 Constant Returns to Scale : Economies of scale will
become exhausted at some point when expanding
output no longer increases productivity. The evidence
suggests that for a large range of outputs there will be
constant returns to scale, where the average costs of
production remain constant. Constant returns to scale
are present when a given percent change in all inputs
result in the same percent change in output.

13-Jun-15 148
 Cost

Economies of Constant Return to Diseconomies of

Scale Scale Scale
0
Quantity of Output

• C

13-Jun-15 149
 Diseconomies of Scale : As the enterprise continues to expand
its output, eventually all the economies of large – scale
production will be exploited and long – run average cost will
begin to rise. The rise in long – run average costs as the capital
stock of the enterprise expands due to diseconomies of scale.
Diseconomies of scale are present when an equal percentage
change in inputs leads to a smaller percentage change in
output.

The long – run average cost curve is the envelope of the short
– run average total cost curves. The long – run average cost
curve is U – shaped. The declining portion shows economies of
scale. The rising portion shows diseconomies of constant
returns to scale.

13-Jun-15 150
 Application : Managerial decision making is facilitated by
information that shows the cost of each rate of output.
Consider a production process that combines variable amounts
of labour with a fixed capital stock, say, 10 machines. In this
process, the rate of production is changed by varying rate of
labour input. Assume that the firm can vary the labour input
freely at a cost of $100 per unit of labour per period.
Therefore, the expenditure for labour is the variable cost.
Again, assume that the variable cost equation is -
Find :
i) Total Fixed Cost; ii) Total Cost Equation;
TVC  10Q  0.9Q 2  0.04Q 3
iii) The rate of output that results in minimum average
variable cost.

13-Jun-15 151
 Lecture : 17 and 18
Market Analysis : Market, Different
types of Market, Perfect Competition,
Characteristics of Perfect Competition,
Short run Equilibrium of Perfect
Competition or price output
determination of perfect competition.

13-Jun-15 152
Market, Different types of market
A market is an established arrangement by which
buyers and sellers come together to exchange
particular goods or services.

Normally two types of market are available of an

economy, i.e., perfect competition and imperfect
competition. Imperfect competition are classified
as; pure monopoly, discriminating monopoly,
monopolistic competition, oligopoly, duopoly etc.

13-Jun-15 153
 Perfect Competition : Adam Smith said that the “
invisible hand” would lead people pursuing their own
interests to serve the interest of society through the
process of competition. A market is said to be perfect
when all the potential sellers and buyers are promptly
aware of the prices at which transactions take place
and all the offers made by other sellers and buyers,
and when any buyer can purchase from any seller and
conversely. Under such a condition, the price of a
commodity will tend to be the same all over the
market.

13-Jun-15 154
 Characteristics of Perfect Competition : The perfect
competition is based on the following characteristics :
• Large number of buyers and sellers;
• Homogeneous product;
• Perfect knowledge about prices;
• Freedom of entry and exit from the industry;
• The goal of firms is profit maximization;
• No government regulation;
• Perfect mobility of factors of production;
• Absence of transport costs.

13-Jun-15 155
 Short-run equilibrium of perfect competition : Short-run has been
defined as a period of time sufficient to allow the firm to adjust its
output by increasing or decreasing the amount of variable factors of
production, but during which fixed factors of production cannot be
altered. Thus in the short-run the size and kind of plant cannot be
changed, nor can new firms enter the industry.

Short-run equilibrium conditions of perfect competitive firm :

There are two conditions of firm’s short-run equilibrium under the
perfect competition:
• Marginal Cost (MC) = Marginal Revenue (MR) = Price (p)
• MC curve must cut MR curve from below; i.e., the slope of MC> the
slope of MR

13-Jun-15 156
 Assumptions : In explaining the equilibrium of a firm
under perfect competition in the short-run, we
assume that all firms are working under identical cost
conditions, i.e., average cost and marginal cost curve
are identical. We also assume that the factors of
production used by the different firms are
homogeneous and are available at given and constant
prices.

13-Jun-15 157
 Analysis : The twin conditions of equilibrium ensure
that profits have been maximized or losses minimized,
but they do not tell about the firm’s absolute profit or
loss position. In this connection there are four
possibilities.
• When the firm makes super normal profits;
• When it makes only normal profits;
• When it incurs losses, but still does not shut-down;
and
• Shut-down position.
Let us take them one by one.

13-Jun-15 158
 When the firm makes super normal profits :The following figure
illustrate the super normal profits in the short-run of perfect
competitive firm. In the following figure, we show the average and
marginal cost curves of the firm together with its demand curve. We
said that demand curve is also the average revenue curve and the
marginal revenue curve of the firm in a perfectly competitive
market. The marginal cost curve cuts the short-run average total cost
(SATC) at its minimum point. So, the firm is in equilibrium at the level
of output defined by the intersection of the MC and MR. At point e,
the MC curve intersect the MR curve and the firm’s output is 0X. The
second condition for equilibrium requires that the MC be rising at
the point of its intersection with the MR curve. This means that the
MC must cut the MR curve from below, i.e., the slope of the MC
must be steeper than the slope of the MR curve.

13-Jun-15 159
 Revenue, Cost, Price
SMC

SATC

e
P MR = P
A B

0 X Output

13-Jun-15 160
 Thus, at point e, both conditions for equilibrium are
satisfied. So, at point e, the per unit cost is BX, per
unit revenue or price is eX or OP, per unit profit equal
to per unit revenue minus per unit cost, i.e., per unit
profit = (eX – BX ) = eB, total profit equal to per unit
profit multiply by total output, i.e., total profit = eB *
OX = eB * AB, which is the area of ABeP, and it is also
the super normal profit of perfect competition.

13-Jun-15 161
 When it makes only normal profits : Thus, at point e,
both conditions for equilibrium are satisfied. So, at
point e, the per unit cost is eX, per unit revenue or
price is eX or OP, per unit profit equal to per unit
revenue minus per unit cost, i.e., per unit profit = (eX
– eX ) = 0, total profit equal to per unit profit multiply
by total output, i.e., total profit = 0 * OX = 0, which is
the normal profit of perfect competition.

13-Jun-15 162
 Revenue, Cost, Price
SMC

SATC

e
P MR = P

0 X Output

13-Jun-15 163
 When it incurs losses, but still does not shut-down :
Thus, at point e, both conditions for equilibrium are
satisfied. So, at point e, the per unit cost is BX, per
unit revenue or price is eX or OP, per unit loss equal
to per unit cost minus per unit revenue, i.e., per unit
loss = (BX - eX ) = eB, total loss equal to per unit loss
multiply by total output, i.e., total loss = eB * OX = eB
* AB, which is the area of ABeP, and it is also the total
loss of perfect competition.

13-Jun-15 164
 Revenue, Cost, Price
SMC SATC

A B
e
P MR = P

0 X Output

13-Jun-15 165
 Shut-down position : The firm will continue to
produce only if it covers its variable costs, other wise
it will shut down, since by discontinuing its operations
the firm is better off, it minimizes its losses the point
at which the firm covers its variable costs is called the
closing down point. In the following figure SAVC
means the short – run average variable cost. At point
e is the closing down point and price is OP or eX, if
the price is falls below the OP or eX, the firm does not
cover its variable cost and is better off if it closes
down. The firm will continue if and only if P = SAVC,
otherwise shut – down.

13-Jun-15 166
 Revenue, Cost, Price
SMC SATC

SAVC
A B
e
P MR = P

0 X Output

13-Jun-15 167
 Application : A new pizza place, Fredrico’s opens in
New York City. The average price of a medium pizza in
New York City is $10 and because of the large number
of pizza sellers, this price will not be affected by the
new entrant in the market. The owner of Fredrico’s
estimates the monthly total costs including a normal
profit will be – TC = 1,000 + 2Q + 0.01Q2
To maximize total profit, how many pizzas should be
produced each month ? In the short – run how much
economic profit will the business earn in each month
?

13-Jun-15 168
 Lecture : 19 and 20
Short run Equilibrium of
Monopoly

13-Jun-15 169
 Monopoly : Perfect competition exists when firms take the
market price as given, each competitive firm is a price taker. A
firm that has monopoly power has the ability to control the
prices of its products. Such a firm is called a price searcher. The
greater the monopoly power, the greater the control over
price. The monopoly is that market form in which a single
producer or seller controls the entire market. There are no
substitute for his product. He controls the whole supply of
commodity and he can fix the price of commodity. He is the
firm and also the industry, so, it is a one firm in the industry.

13-Jun-15 170
 Characteristics of Monopoly : Literally, the monopoly means
‘single seller’. The pure monopoly is one particular type of
price searching firm. A pure monopoly exists :
• When there is one seller in the market for some good or
service that has no close substitutes;
• When the seller has considerable control over price; and
• When barriers to entry protect the seller from competition.

Pure monopoly is hard to find for several reasons. First,

substitutes of some kind exist for almost all product; second,
modern enterprises tend to be multiproduct firms.

13-Jun-15 171
 Sources of monopoly power : Economists generally
find the source of monopoly to lie in barriers to entry.
Barriers to entry are legal, or technical conditions that
make it impossible or prohibitively costly, for a new
firm to enter a given market. The following five types
of entry barriers have historically been associated
with the presence of monopoly.

13-Jun-15 172
 Economies of scale : The average costs of one large firm may
be much lower than the average costs of many smaller firms.
When new firms cannot compete effectively with a large firm,
it is difficult for new firms to enter the market. Large
established firms are protected by economies of scale that bar
the entry of new firms. A natural monopoly occurs when
economies of scale are so large that there is room for only one
firm in the industry. Competition is either unworkable or highly
inefficient. Examples of natural monopolies are the local public
utilities that deliver telephone services, gas services, water
services and electricity.

13-Jun-15 173
 Patents : American patent laws allow an inventor the exclusive
right to use the inventor for a period of 17 years. During that
period, the patent prohibits others from using the invention,
the patent holder is protected from competition. The IBM
corporation’s patents on tabulating equipment, xerox’s patents
on copying equipment, the United Shoe Machinery company’s
patents on shoemaking machinery and Smith Kline’s patent on
the drug Tag - met are examples of this type of entry barrier.
The Bell System monopoly was built on the basis of patents in
the 19th century.

13-Jun-15 174
 Exclusive ownership of raw materials : Established companies may be
protected from the entry of new firms by their control of raw materials. The
International Nickel Company of Canada owns virtually all the world’s nickel
reserves; so percent of the world’s known diamond mines are under the
control of the De Beers Company of South Africa. American Metal Climax
Corporation controls most of the world’s supply of molybdenum.

Public Franchises : State, local and federal governments grant to individuals

or organizations exclusive franchises to be the sole operator in a particular
business. Competitors are legally prohibited from entering the market. The
U.S. post office is a classic example of a public franchise. Along toll ways,
the state grants exclusive franchises to operate restaurants and service
stations; duty-free shops in airports and at international borders are also
franchise operations.

13-Jun-15 175
 Licensing : Entry into an industry or profession may
be regulated by government agencies and by
autonomous professional organizations. The
American Medical Association licenses medical
schools and allocates hospital staff privileges to
physicians. The Federal Communications Commission
licenses radio and television stations and controls
entry into the broadcasting industry. Most countries
license airlines and thus limit entry into the industry.

13-Jun-15 176
 Price-output Determination Under Monopoly in the
Short-run

Introduction : Price-output analysis in the case of

monopoly is done an analysis of the equilibrium of
the firm and industry under monopoly. Since in a
monopoly, a single firm constitutes the whole
industry, there is no need for a separate analysis of
the equilibrium of the firm and of the industry, as is
done in case of perfect competition.

13-Jun-15 177
 Main Idea : In the discussion of perfect competition, we saw that the
demand curve or the average revenue curve faced by a perfectly
competitive firm is perfectly elastic and is represented by a horizontal
straight line parallel to the x-axis. This is so because a producer under
perfect competition cannot affect price by his own individual action. He has
to accept the ruling market price as given and constant and at this price, he
can sell any quantity of the commodity. But this is not true in the case of a
monopoly. / A firm under monopoly faces a downward sloping demand
curve or average revenue curve (AR). Therefore, if the monopolist lowers
the price of his product, the quantity demanded increases, and if he raises
the price, the quantity demanded decreases. In other words, if the
monopolist wants to sell a larger output, he has to reduce the price of his
product. In that way, it is not only the price of the additional units that falls
but the price of his total output goes down /. Since his output affects the
price at which he can sell, price is not a given factor for him as it is for the
man producing under perfect competition.

13-Jun-15 178
 In perfect competition, since the average revenue curve is
perfectly elastic and a horizontal straight line to the x-axis, the
marginal revenue is always equal to the average revenue, i.e.,
the marginal revenue curve coincides with the average
revenue curve. But unlike this, in a monopoly, since average
revenue falls as more units of output are produced and sold,
the marginal revenue is always less than the average revenue.
In other words, under monopoly the marginal revenue curve
lies below the average revenue curve. In monopoly firm, price
and output are determined at that point where marginal
revenue curve equal marginal cost.

13-Jun-15 179
 Assumptions :
• Single producer;
• Huge number of buyers;
• Average revenue curve downward sloping;
• Marginal revenue curve also downward sloping and it lies
below the average revenue curve.

13-Jun-15 180
 Analysis : The aim of the monopolist, like every other
producer, is to maximize his total money profits. Therefore, he
will produce up to a point and charge a price which gives him
the maximum money profits. In other words, he will be in
equilibrium at that price-output level at which his profits are
the maximum. He will go on producing so long as additional
units of production add more to cost than to revenue. In other
words, he will be in equilibrium position at that level of output
at which marginal revenue equals marginal cost. That is, he will
continue producing so long as marginal revenue exceeds the
marginal cost. At the point where marginal revenue is equal
marginal cost, the profits will be maximized and here he stops.
If the production is carried beyond this point profits will start
decreasing.

13-Jun-15 181
 Price, Revenue and Cost

MC
AC

P B
T L

AR
M MR
o
Output

13-Jun-15 182
 The price-output equilibrium of the monopolist can be easily
understood from the following figure. AR is the demand curve or
average revenue curve facing the monopolist. MR is the marginal
revenue curve which lies below the average renuere AR. AC is the
average cost curve and MC is the marginal cost curve. It can be seen
from the figure that up to OM output, marginal revenue is greater
than marginal cost but beyond OM the marginal revenue is less than
marginal cost. Therefore, the monopolist will be in equilibrium at the
output OM, where marginal revenue is equal to marginal cost and
profits are the greatest. The price at which output OM is sold in the
market can be known from looking at demand or average revenue
curve AR. It can be seen from the figure that corresponding to
equilibrium output OM, the price on the demand or average revenue
curve is MB or OP.

13-Jun-15 183
 Thus, it is clear that, monopolist firm will be in equilibrium at point E,
where the marginal cost equals the marginal revenue and equilibrium
output and price will be OM and OP respectively. Average cost is ML, so per
unit profit will be (MP - ML) = BL. Now, the total profits = profit per unit ×
total output sold
BL × OM = BL × TL = area of PTLB

Total revenue = Price × output sold = OP × OM = area of OMBP

Total cost = average cost × output sold = ML × OM = area of OMLT
Total profit = Total revenue – Total cost = OMBP – OMLT = TLBP
Thus, the total profit is the area of TLBP which is greater than normal profit
and also called super normal profit. So, at equilibrium output OM and price
OP, the monopolist earns super normal profit.

13-Jun-15 184
Discriminating Monopoly
Meaning of Price Discrimination : We know that the
monopolist charges only one price from all the purchasers of
this commodity. This is generally not the case. The monopolist
can and some monopolists do, charge different prices for the
same commodity from different markets or belong to what are
called non-competing groups. This is known as price
discrimination or discriminating monopoly. In other words, it is
defined as charging different price for the same product, or
same price for the differentiated product. The product may be
differentiated by time, appearance or place, so that the
purchasers are not able to shift to the low-price commodity.

13-Jun-15 185
 Types of price discrimination : Price discriminating
monopoly may be a) personal, b) local, and c) according to
trade or use. It is personal when different prices are
charged from different persons. It is local when the price
varies according to locality. Discrimination is according to
use when different prices are charged according to the
uses to which the commodity is put, e. g, electric current
is usually sold cheaper for industrial uses than for
domestic purposes. Sometimes the monopolist introduces
product differentiation by means of special labels and
charges different prices for the differentiated products.

13-Jun-15 186
 Degrees of price discrimination : Normally, we see in the market, there are
three degrees of discrimination as under :
1) Price discrimination of the first degree in which the monopolist charges a
different price for each unit of the commodity sold. He charges the
maximum that each buyer is able and willing to pay, him no consumer’s
surplus. Obviously, this involves maximum exploitation of the buyers. This is
known as perfect price discrimination.
2) Instead of setting price for each buyer as in the first degree
discrimination, in the second degree, the buyers are divided into groups
and from each group a different price is charged, which is the lowest
demand price for that group. Thus, all units with a demand price greater
than, say x, are sold at x price, all units with demand price greater than y
but less than x are sold at y, and so on. Such a price discrimination is
possible. The demand for each individual buyer is perfectly inelastic.

13-Jun-15 187
 3) In the third degree discrimination the monopolist splits the
entire market into a few sub-markets and charges a different
price in each sub-market.

Conditions of Price Discrimination : The essence of price

discrimination is that the monopolist can charge different
customers different prices although there is no fundamental
difference between the goods offered to the different
customers. Let us study the conditions:
a) Under which price discrimination is possible, and
b) When price discrimination is profitable.

13-Jun-15 188
 a) When price discrimination is possible : As already mentioned, a
monopolist can practice price discrimination by dividing his market into
sub-markets and charging different prices in each sub-market. This is
possible only if the monopolist can keep these sub-markets absolutely
separate. For the monopolist to keep his sub-markets separate to
successfully practice price discrimination is possible under the following
conditions:
1. When consumers have certain preferences: Certain consumers,
especially belonging to the upper class, usually have the irrational feeling
that they are paying higher prices for a good because it is of a better
quality, although actually it may be of the same quality. In a market
situation we observe, various brands of a certain article which in fact are
almost alike may be sold as different qualities under names and labels
which induce rich and snobbish buyers to divide themselves from the poor
buyers and in this way the market in split up and the monopolist can sell
what is substantially the same thing at different prices.

13-Jun-15 189
 2. Nature of the good: When the nature of the good is
such as makes it possible for the monopolist to charge
different prices. This happens particularly when the good
in question is a direct service. While goods like combs and
hairpins can be resold by those who are charged lower
prices to those required to pay higher prices, it is not
possible to resell haircuts or beauty treatment effected in
a beauty parlous, so that different price can be changed
from different persons. We often find that surgeons
charge different fees from rich and poor patients for
performing similar surgical operations.

13-Jun-15 190
 3. When consumers are separated by distance or tariff barriers :
The monopolist can charge different prices for different goods
separated by distance. A good may be sold in one ton for tk. 1 and in
another for tk. 2 and so long as the cost of transport exceeds the
difference in prices, resale will not be profitable. Similarly, the
monopolist can charge higher prices in a country levying import duty
on his commodity and lower prices elsewhere where no such duties
are levied. Because of import duty it is obviously not profitable to
import the commodity from countries where it is sold cheaper.
4. Government regulations : Sometimes, the price discrimination
occurs when the government rules and regulation permit. For
instance, according to rules, electricity rates are fixed at lower level
for industrial purposes and higher for domestic uses. Similarly,
railways charge by law higher fare from first class passengers than
from the second or third class passengers.

13-Jun-15 191
 5. Ignorance and lethargy : Monopolists also take
advantage of the ignorance of the customers or of their
disinclination to take the trouble of comparing prices. In this
way, they can charge higher prices from some customer than
from others. They also sometimes cash on the impatience of
the buyers, e.g., charging higher price for the 1st edition of a
book.
6. Same service for different purpose : When a monopolist,
while rendering the same service, is able to cater for different
needs of his customers, it is possible for him to charge
discriminating prices. For example, railways charge different
rates for carrying coal, silk and fruit even though the same
train carries them all.

13-Jun-15 192
 7. Special orders : A monopolist can easily charge
discriminating prices when goods are being supplied
to special orders. In such a case, there is no question
for the buyers to compare prices.
8. Imperfect competition: Price discrimination can
be practiced only under imperfect competition. When
there is a imperfect competition, taking the form of
monopoly, the seller is in a position to fox the price.
The degree of price discrimination will depend on the
degree of imperfection of the market.

13-Jun-15 193
 b) When price discrimination is profitable: Price
discrimination is profitable only if elasticity of
demand in one market is different from elasticity of
demand in the other. Then the monopolist can go on
dividing and sub-dividing his market till no two buyers
with different elasticities are put in the same group,
or till in each market the elasticity of demand is the
same. The monopolist will find it profitable to charge
more in the market where elasticity is low and low
price where it is high.

13-Jun-15 194
 Price-output equilibrium in discriminating monopoly :
We shall now see how a monopolist decides the output to
be produced under price discrimination and how he sets
different prices for a commodity.
First of all, the monopolist divides his total market into
sub-markets. The monopolist can divide his total market
into several sub-markets but we shall explain the case of
two sub-markets only. Price discrimination by the
monopolist has been illustrated in figure (a), (b), and (c).
In these figures, we see that the monopolist has divided
his total market into two sub-markets A and B on the basis
of elasticity of demand for the product in these two
markets.

13-Jun-15 195
 Elasticity of demand is greater in market B than in
market A. In market A, AR is the average revenue
curve and MR is the corresponding marginal
revenue curve. Similarly, AR and MR are the
average revenue and marginal revenue curves
respectively in market B. CMR is the combined
marginal revenue curve. CMR has been obtained
by the lateral summation of MR and MR , MC is
the marginal cost curve of the total output of the
product.

13-Jun-15 196
 The discrimination monopolist has now to decide what level of
output he should produce like every other producer, he aims at
maximizing his profits. As elsewhere, his profits will be
maximum, and, hence he will be in equilibrium position, at the
output at which MR = MC, and MC curve cuts the MR curve
from below. It is evident from figure (c), that equilibrium of the
discriminating monopolist is established at the output OM at
which MC cuts CMR .Now the output OM has therefore to be
distributed between the two markets in such a way that
marginal revenue in each is equal to ME which is the marginal
cost, being on the MC curve.

13-Jun-15 197
 Price, Revenue, Cost
Price, Revenue, Cost

Market – A Market - B
P1

P2
E1
E2
AR2
MR1 AR1 MR2
M1 M2
0 0
Output Output

13-Jun-15 198
 Price, Revenue, Cost

Market - C

MC

P E

CMR

M
0 Output

13-Jun-15 199
 Therefore, price discriminating monopolist will sell output OM1
in market A, because only at this output marginal revenue MR1
in market A is equal to ME (M1E1 = ME). The price charged in
the market for output OM1, P1 being on the average revenue
(AR1) or demand curve which is equal to M1P1. The output
OM2 will be sold in market B as only at this output, marginal
revenue in market B, that is MR2 is equal to ME (M2E2 = ME).
Price charged in market B for output OM2 is equal to M2P2
which is lower than the M1P1 which is charged in market A.
Thus, in market B in which elasticity of demand is greater, the
price charged is lower than that in market A, where the
elasticity of demand is less.

13-Jun-15 200
 Hence, for the discriminating monopolist to be in
equilibrium the following two conditions must be
satisfied:
i) Marginal cost of total output is equal to combined
marginal revenue.
ii) Marginal revenue in market A is equal to marginal
revenue in market B is equal to marginal cost.

13-Jun-15 201
 Finally, we can conclude that it is possible to establish the fact
that total output under discrimination will be greater or less
that under simple monopoly according as the more elastic of
the demand curves in the separate markets is more or less
concave than the less elastic demand curve; and the total
output will be the same if the demand curve is straight lines or
in any other case in which the concavities are equal. This holds
good, however, if marginal cost under simple monopoly and
discriminating monopoly is the same. But it marginal cost is
falling, the increase in output in a discriminating monopoly will
be accentuated and if the marginal cost is rising then the
decrease in the output will be accentuated.

13-Jun-15 202
 Application : A monopolist’s demand equation is given by
Q = 50 – 0.50P, where P is selling price (in thousand of
dollars) per ton and Q tons of product are sold. Suppose
that fixed cost is 50 thousand and each ton costs are $40
thousand to produce. Find the corresponding maximum
profit and selling price per ton. We also assume that
monopoly acts are price discriminating monopoly and his
demand equation divided by two segments, i.e., Q1 = 32 –
0.40P1 and Q2 = 18 – 0.10P2 where Q1 + Q2 = Q and P1 + P2
= P; Show that the profit of price discriminating monopoly
is greater than the profit of monopoly.

13-Jun-15 203
 Lecture : 21 and 22
Price Output Determination
under Price Discriminating
Monopoly.

13-Jun-15 204
 Monopoly : Perfect competition exists when firms take the
market price as given, each competitive firm is a price taker. A
firm that has monopoly power has the ability to control the
prices of its products. Such a firm is called a price searcher. The
greater the monopoly power, the greater the control over
price. The monopoly is that market form in which a single
producer or seller controls the entire market. There are no
substitute for his product. He controls the whole supply of
commodity and he can fix the price of commodity. He is the
firm and also the industry, so, it is a one firm in the industry.

13-Jun-15 205
 Characteristics of Monopoly : Literally, the monopoly means
‘single seller’. The pure monopoly is one particular type of
price searching firm. A pure monopoly exists :
• When there is one seller in the market for some good or
service that has no close substitutes;
• When the seller has considerable control over price; and
• When barriers to entry protect the seller from competition.

Pure monopoly is hard to find for several reasons. First,

substitutes of some kind exist for almost all product; second,
modern enterprises tend to be multiproduct firms.

13-Jun-15 206
 Sources of monopoly power : Economists generally
find the source of monopoly to lie in barriers to entry.
Barriers to entry are legal, or technical conditions that
make it impossible or prohibitively costly, for a new
firm to enter a given market. The following five types
of entry barriers have historically been associated
with the presence of monopoly.

13-Jun-15 207
 Economies of scale : The average costs of one large firm may
be much lower than the average costs of many smaller firms.
When new firms cannot compete effectively with a large firm,
it is difficult for new firms to enter the market. Large
established firms are protected by economies of scale that bar
the entry of new firms. A natural monopoly occurs when
economies of scale are so large that there is room for only one
firm in the industry. Competition is either unworkable or highly
inefficient. Examples of natural monopolies are the local public
utilities that deliver telephone services, gas services, water
services and electricity.

13-Jun-15 208
 Patents : American patent laws allow an inventor the exclusive
right to use the inventor for a period of 17 years. During that
period, the patent prohibits others from using the invention,
the patent holder is protected from competition. The IBM
corporation’s patents on tabulating equipment, xerox’s patents
on copying equipment, the United Shoe Machinery company’s
patents on shoemaking machinery and Smith Kline’s patent on
the drug Tag - met are examples of this type of entry barrier.
The Bell System monopoly was built on the basis of patents in
the 19th century.

13-Jun-15 209
 Exclusive ownership of raw materials : Established companies may be
protected from the entry of new firms by their control of raw materials. The
International Nickel Company of Canada owns virtually all the world’s nickel
reserves; so percent of the world’s known diamond mines are under the
control of the De Beers Company of South Africa. American Metal Climax
Corporation controls most of the world’s supply of molybdenum.

Public Franchises : State, local and federal governments grant to individuals

or organizations exclusive franchises to be the sole operator in a particular
business. Competitors are legally prohibited from entering the market. The
U.S. post office is a classic example of a public franchise. Along toll ways,
the state grants exclusive franchises to operate restaurants and service
stations; duty-free shops in airports and at international borders are also
franchise operations.

13-Jun-15 210
 Licensing : Entry into an industry or profession may
be regulated by government agencies and by
autonomous professional organizations. The
American Medical Association licenses medical
schools and allocates hospital staff privileges to
physicians. The Federal Communications Commission
licenses radio and television stations and controls
entry into the broadcasting industry. Most countries
license airlines and thus limit entry into the industry.

13-Jun-15 211
 Price-output Determination Under Monopoly in the
Short-run

Introduction : Price-output analysis in the case of

monopoly is done an analysis of the equilibrium of
the firm and industry under monopoly. Since in a
monopoly, a single firm constitutes the whole
industry, there is no need for a separate analysis of
the equilibrium of the firm and of the industry, as is
done in case of perfect competition.

13-Jun-15 212
 Main Idea : In the discussion of perfect competition, we saw that the
demand curve or the average revenue curve faced by a perfectly
competitive firm is perfectly elastic and is represented by a horizontal
straight line parallel to the x-axis. This is so because a producer under
perfect competition cannot affect price by his own individual action. He has
to accept the ruling market price as given and constant and at this price, he
can sell any quantity of the commodity. But this is not true in the case of a
monopoly. / A firm under monopoly faces a downward sloping demand
curve or average revenue curve (AR). Therefore, if the monopolist lowers
the price of his product, the quantity demanded increases, and if he raises
the price, the quantity demanded decreases. In other words, if the
monopolist wants to sell a larger output, he has to reduce the price of his
product. In that way, it is not only the price of the additional units that falls
but the price of his total output goes down /. Since his output affects the
price at which he can sell, price is not a given factor for him as it is for the
man producing under perfect competition.

13-Jun-15 213
 In perfect competition, since the average revenue curve is
perfectly elastic and a horizontal straight line to the x-axis, the
marginal revenue is always equal to the average revenue, i.e.,
the marginal revenue curve coincides with the average
revenue curve. But unlike this, in a monopoly, since average
revenue falls as more units of output are produced and sold,
the marginal revenue is always less than the average revenue.
In other words, under monopoly the marginal revenue curve
lies below the average revenue curve. In monopoly firm, price
and output are determined at that point where marginal
revenue curve equal marginal cost.

13-Jun-15 214
 Assumptions :
• Single producer;
• Huge number of buyers;
• Average revenue curve downward sloping;
• Marginal revenue curve also downward sloping and it lies
below the average revenue curve.

13-Jun-15 215
 Analysis : The aim of the monopolist, like every other
producer, is to maximize his total money profits. Therefore, he
will produce up to a point and charge a price which gives him
the maximum money profits. In other words, he will be in
equilibrium at that price-output level at which his profits are
the maximum. He will go on producing so long as additional
units of production add more to cost than to revenue. In other
words, he will be in equilibrium position at that level of output
at which marginal revenue equals marginal cost. That is, he will
continue producing so long as marginal revenue exceeds the
marginal cost. At the point where marginal revenue is equal
marginal cost, the profits will be maximized and here he stops.
If the production is carried beyond this point profits will start
decreasing.

13-Jun-15 216
 Price, Revenue and Cost

MC
AC

P B
T L

AR
M MR
o
Output

13-Jun-15 217
 The price-output equilibrium of the monopolist can be easily
understood from the following figure. AR is the demand curve or
average revenue curve facing the monopolist. MR is the marginal
revenue curve which lies below the average renuere AR. AC is the
average cost curve and MC is the marginal cost curve. It can be seen
from the figure that up to OM output, marginal revenue is greater
than marginal cost but beyond OM the marginal revenue is less than
marginal cost. Therefore, the monopolist will be in equilibrium at the
output OM, where marginal revenue is equal to marginal cost and
profits are the greatest. The price at which output OM is sold in the
market can be known from looking at demand or average revenue
curve AR. It can be seen from the figure that corresponding to
equilibrium output OM, the price on the demand or average revenue
curve is MB or OP.

13-Jun-15 218
 Thus, it is clear that, monopolist firm will be in equilibrium at point E,
where the marginal cost equals the marginal revenue and equilibrium
output and price will be OM and OP respectively. Average cost is ML, so per
unit profit will be (MP - ML) = BL. Now, the total profits = profit per unit ×
total output sold
BL × OM = BL × TL = area of PTLB

Total revenue = Price × output sold = OP × OM = area of OMBP

Total cost = average cost × output sold = ML × OM = area of OMLT
Total profit = Total revenue – Total cost = OMBP – OMLT = TLBP
Thus, the total profit is the area of TLBP which is greater than normal profit
and also called super normal profit. So, at equilibrium output OM and price
OP, the monopolist earns super normal profit.

13-Jun-15 219
Discriminating Monopoly
Meaning of Price Discrimination : We know that the
monopolist charges only one price from all the purchasers of
this commodity. This is generally not the case. The monopolist
can and some monopolists do, charge different prices for the
same commodity from different markets or belong to what are
called non-competing groups. This is known as price
discrimination or discriminating monopoly. In other words, it is
defined as charging different price for the same product, or
same price for the differentiated product. The product may be
differentiated by time, appearance or place, so that the
purchasers are not able to shift to the low-price commodity.

13-Jun-15 220
 Types of price discrimination : Price discriminating
monopoly may be a) personal, b) local, and c) according to
trade or use. It is personal when different prices are
charged from different persons. It is local when the price
varies according to locality. Discrimination is according to
use when different prices are charged according to the
uses to which the commodity is put, e. g, electric current
is usually sold cheaper for industrial uses than for
domestic purposes. Sometimes the monopolist introduces
product differentiation by means of special labels and
charges different prices for the differentiated products.

13-Jun-15 221
 Degrees of price discrimination : Normally, we see in the market, there are
three degrees of discrimination as under :
1) Price discrimination of the first degree in which the monopolist charges a
different price for each unit of the commodity sold. He charges the
maximum that each buyer is able and willing to pay, him no consumer’s
surplus. Obviously, this involves maximum exploitation of the buyers. This is
known as perfect price discrimination.
2) Instead of setting price for each buyer as in the first degree
discrimination, in the second degree, the buyers are divided into groups
and from each group a different price is charged, which is the lowest
demand price for that group. Thus, all units with a demand price greater
than, say x, are sold at x price, all units with demand price greater than y
but less than x are sold at y, and so on. Such a price discrimination is
possible. The demand for each individual buyer is perfectly inelastic.

13-Jun-15 222
 3) In the third degree discrimination the monopolist splits the
entire market into a few sub-markets and charges a different
price in each sub-market.

Conditions of Price Discrimination : The essence of price

discrimination is that the monopolist can charge different
customers different prices although there is no fundamental
difference between the goods offered to the different
customers. Let us study the conditions:
a) Under which price discrimination is possible, and
b) When price discrimination is profitable.

13-Jun-15 223
 a) When price discrimination is possible : As already mentioned, a
monopolist can practice price discrimination by dividing his market into
sub-markets and charging different prices in each sub-market. This is
possible only if the monopolist can keep these sub-markets absolutely
separate. For the monopolist to keep his sub-markets separate to
successfully practice price discrimination is possible under the following
conditions:
1. When consumers have certain preferences: Certain consumers,
especially belonging to the upper class, usually have the irrational feeling
that they are paying higher prices for a good because it is of a better
quality, although actually it may be of the same quality. In a market
situation we observe, various brands of a certain article which in fact are
almost alike may be sold as different qualities under names and labels
which induce rich and snobbish buyers to divide themselves from the poor
buyers and in this way the market in split up and the monopolist can sell
what is substantially the same thing at different prices.

13-Jun-15 224
 2. Nature of the good: When the nature of the good is
such as makes it possible for the monopolist to charge
different prices. This happens particularly when the good
in question is a direct service. While goods like combs and
hairpins can be resold by those who are charged lower
prices to those required to pay higher prices, it is not
possible to resell haircuts or beauty treatment effected in
a beauty parlous, so that different price can be changed
from different persons. We often find that surgeons
charge different fees from rich and poor patients for
performing similar surgical operations.

13-Jun-15 225
 3. When consumers are separated by distance or tariff barriers :
The monopolist can charge different prices for different goods
separated by distance. A good may be sold in one ton for tk. 1 and in
another for tk. 2 and so long as the cost of transport exceeds the
difference in prices, resale will not be profitable. Similarly, the
monopolist can charge higher prices in a country levying import duty
on his commodity and lower prices elsewhere where no such duties
are levied. Because of import duty it is obviously not profitable to
import the commodity from countries where it is sold cheaper.
4. Government regulations : Sometimes, the price discrimination
occurs when the government rules and regulation permit. For
instance, according to rules, electricity rates are fixed at lower level
for industrial purposes and higher for domestic uses. Similarly,
railways charge by law higher fare from first class passengers than
from the second or third class passengers.

13-Jun-15 226
 5. Ignorance and lethargy : Monopolists also take
advantage of the ignorance of the customers or of their
disinclination to take the trouble of comparing prices. In this
way, they can charge higher prices from some customer than
from others. They also sometimes cash on the impatience of
the buyers, e.g., charging higher price for the 1st edition of a
book.
6. Same service for different purpose : When a monopolist,
while rendering the same service, is able to cater for different
needs of his customers, it is possible for him to charge
discriminating prices. For example, railways charge different
rates for carrying coal, silk and fruit even though the same
train carries them all.

13-Jun-15 227
 7. Special orders : A monopolist can easily charge
discriminating prices when goods are being supplied
to special orders. In such a case, there is no question
for the buyers to compare prices.
8. Imperfect competition: Price discrimination can
be practiced only under imperfect competition. When
there is a imperfect competition, taking the form of
monopoly, the seller is in a position to fox the price.
The degree of price discrimination will depend on the
degree of imperfection of the market.

13-Jun-15 228
 b) When price discrimination is profitable: Price
discrimination is profitable only if elasticity of
demand in one market is different from elasticity of
demand in the other. Then the monopolist can go on
dividing and sub-dividing his market till no two buyers
with different elasticities are put in the same group,
or till in each market the elasticity of demand is the
same. The monopolist will find it profitable to charge
more in the market where elasticity is low and low
price where it is high.

13-Jun-15 229
 Price-output equilibrium in discriminating monopoly :
We shall now see how a monopolist decides the output to
be produced under price discrimination and how he sets
different prices for a commodity.
First of all, the monopolist divides his total market into
sub-markets. The monopolist can divide his total market
into several sub-markets but we shall explain the case of
two sub-markets only. Price discrimination by the
monopolist has been illustrated in figure (a), (b), and (c).
In these figures, we see that the monopolist has divided
his total market into two sub-markets A and B on the basis
of elasticity of demand for the product in these two
markets.

13-Jun-15 230
 Elasticity of demand is greater in market B than in
market A. In market A, AR is the average revenue
curve and MR is the corresponding marginal
revenue curve. Similarly, AR and MR are the
average revenue and marginal revenue curves
respectively in market B. CMR is the combined
marginal revenue curve. CMR has been obtained
by the lateral summation of MR and MR , MC is
the marginal cost curve of the total output of the
product.

13-Jun-15 231
 The discrimination monopolist has now to decide what level of
output he should produce like every other producer, he aims at
maximizing his profits. As elsewhere, his profits will be
maximum, and, hence he will be in equilibrium position, at the
output at which MR = MC, and MC curve cuts the MR curve
from below. It is evident from figure (c), that equilibrium of the
discriminating monopolist is established at the output OM at
which MC cuts CMR .Now the output OM has therefore to be
distributed between the two markets in such a way that
marginal revenue in each is equal to ME which is the marginal
cost, being on the MC curve.

13-Jun-15 232
 Price, Revenue, Cost
Price, Revenue, Cost

Market – A Market - B
P1

P2
E1
E2
AR2
MR1 AR1 MR2
M1 M2
0 0
Output Output

13-Jun-15 233
 Price, Revenue, Cost

Market - C

MC

P E

CMR

M
0 Output

13-Jun-15 234
 Therefore, price discriminating monopolist will sell output OM1
in market A, because only at this output marginal revenue MR1
in market A is equal to ME (M1E1 = ME). The price charged in
the market for output OM1, P1 being on the average revenue
(AR1) or demand curve which is equal to M1P1. The output
OM2 will be sold in market B as only at this output, marginal
revenue in market B, that is MR2 is equal to ME (M2E2 = ME).
Price charged in market B for output OM2 is equal to M2P2
which is lower than the M1P1 which is charged in market A.
Thus, in market B in which elasticity of demand is greater, the
price charged is lower than that in market A, where the
elasticity of demand is less.

13-Jun-15 235
 Hence, for the discriminating monopolist to be in
equilibrium the following two conditions must be
satisfied:
i) Marginal cost of total output is equal to combined
marginal revenue.
ii) Marginal revenue in market A is equal to marginal
revenue in market B is equal to marginal cost.

13-Jun-15 236
 Finally, we can conclude that it is possible to establish the fact
that total output under discrimination will be greater or less
that under simple monopoly according as the more elastic of
the demand curves in the separate markets is more or less
concave than the less elastic demand curve; and the total
output will be the same if the demand curve is straight lines or
in any other case in which the concavities are equal. This holds
good, however, if marginal cost under simple monopoly and
discriminating monopoly is the same. But it marginal cost is
falling, the increase in output in a discriminating monopoly will
be accentuated and if the marginal cost is rising then the
decrease in the output will be accentuated.

13-Jun-15 237
 Application : A monopolist’s demand equation is given by
Q = 50 – 0.50P, where P is selling price (in thousand of
dollars) per ton and Q tons of product are sold. Suppose
that fixed cost is 50 thousand and each ton costs are $40
thousand to produce. Find the corresponding maximum
profit and selling price per ton. We also assume that
monopoly acts are price discriminating monopoly and his
demand equation divided by two segments, i.e., Q1 = 32 –
0.40P1 and Q2 = 18 – 0.10P2 where Q1 + Q2 = Q and P1 + P2
= P; Show that the profit of price discriminating monopoly
is greater than the profit of monopoly.

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