GDP, and Say’s Law

Aggregate supply
YS = f(L, K) in the classical model where L is determined in the labor market
while K is exogenous

The aggregate supply YS is defined as the amount of finished goods and services firms
in a country will want to sell under given conditions. In the classical model the aggregate
supply is determined by production function, YS = f[L, K).

The amount of capital in the classical model is an exogenous variable; it is not determined
within the model but assumed to be given. Although we typically assume that K is constant
- which is reasonable in the short run - it need not be constant. K may increase over time,
but we must know K at any point in time.

The amount of labor, however, is an endogenous variable that is determined in the labor
market. This means that YS is determined entirely by the labor market in the classical
model. The following chart illustrates.

 refers to the predictionor estimation of a future situation under given constraints.

 Stuff Forecasting is the process of estimation in unknown situations and
Prediction.
 Demand forecasting is the activity of estimating the quantity of a product
orservice that consumers will purchase.
 Forecasting customer demand for products and services is a proactive process
of determining what products are needed where, when, and in what quantities.
Consequently, demand forecasting is a customer–focused activity.
 Demand forecasting is also the foundation of a company’s entire logistics
process. It supports other planning activities such as capacity planning, inventory
planning, and even overall business planning.
  
Types of forecasting:-
there are following types of forecasting which are below:-
Fig. 10.3: Determination of aggregate supply.

Aggregate demand and Say’s Law

YD = Ys in the classical model (Say’s law)

The aggregate demand YD is defined as the quantity of nationally produced finished
goods and services that consumers, government and the rest of the world want to buy
under given conditions. One of the key elements of the classical model is Say’s Law.
According to Say’s Law the aggregate demand is always equal to the aggregate supply:  YD =
YS.
Say’s Law is sometimes stated as "supply creates its own demand". The motivation for this
statement is something like this. If production (Y) increases by one billion, the national
income will also increase by one billion. This means that individuals will have exactly one
more billion for spending - just enough to buy the increase in production. Thus, YD will
also increase by one billion. An increase in the supply of one billion has created an increased
in the demand by the same amount.

In the classical model, observed GDP Y will be equal to the aggregate

supply: Y = YS. GDP is determined entirely by the firms and there is no need to model
aggregate demand. It is always the case that Yd = Y = Ys = f(L, K).

How not to justify Say’s Law

At first, Say’s Law may seem "obvious". However, it is not - actually, it is highly
controversial. The reason it may seem obvious is that you have probably learned from
microeconomics that in equilibrium, demand is equal to supply. If you are outside
equilibrium, prices will adjust and you will be taken back to equilibrium.

This is not the motivation behind Say’s Law which is not an equilibrium condition. In the
classical model, YD and YS are real variables that do not depend on the price
level. This may strike you as odd. YS depends only directly on L and K and indirectly on
the real wage. If the price level increases in the classical model, the wage level will increase
by the same amount leaving the real wage unchanged. As for aggregate demand, if the price
level and the wage level both increase (by the same amount), there is really no change for
the consumers. If all prices double while you income doubles, there is no need to adjust you
demand.

The justification for Say’s Law is not as an equilibrium condition through price adjustments.
No price adjustment in the world will equilibrate aggregate demand and aggregate supply in
the classical model. Instead, the justification is based on income effects rather than on price
effects: higher supply == higher income == higher demand.

The reason why Say’s law is so controversial is the following. Suppose that consumers and
investors fear that the economy will slow down. They might then decide to save a substantial
part of their income and aggregate demand may not be equal to aggregate supply. This is
really the starting point for Keynesian economics which we will meet in the next chapter.

Factors affecting demand

28 November 2019 by Tejvan Pettinger

The demand for a good depends on several factors, such as price of the good,
perceived quality, advertising, income, confidence of consumers and changes in
taste and fashion.
We can look at either an individual demand curve or the total demand in the
economy.

 The individual demand curve illustrates the price people are willing to pay
for a particular quantity of a good.
 The market demand curve will be the sum of all individual demand curves.
It shows the quantity of a good consumers plan to buy at different prices.
1. Change in price
A change in price causes a movement along the Demand Curve.
For example, if there is an increase in price from $12 to £16 then there will be a
fall in demand from 80 to 60.

How important is price?

Some goods are more affected by price than others.

 If petrol increases in price, because it is a necessity, there is only a small

fall in demand (we say it is inelastic demand).
 If Volvic water increases in price, there will be a significant fall in demand
because people buy cheaper substitutes (demand is elastic)
Shifts in the demand curve

This occurs when, even at the same price, consumers are willing to buy a higher
(or lower) quantity of goods. This will occur if there is a shift in the conditions of
demand.
Even at the same price of $12, more is demanded.

Factors which can shift the demand curve

A shift to the right in the demand curve can occur for a number of reasons:

1. Income. An increase in disposable income enabling consumers to be able

to afford more goods. Higher income could occur for a variety of reasons,
such as higher wages and lower taxes.
2. Credit facilities. If it is easier and cheaper to borrow, this may encourage
consumers to buy expensive items on credit, for example, cars and.
3. Quality. An increase in the quality of the good e.g. better quality digital
cameras encourages people to buy one.
4. Advertising can increase brand loyalty to goods and increase demand.
For example, higher spending on advertising by Coca Cola has increased
global sales.
 5. Substitutes. An increase in the price of substitutes, e.g. if the price of
Samsung mobile phones increases, this will increase the demand for
Apple iPhones – a major substitute for the Samsung.
6. Complements. A fall in the price of complements will increase demand.
E.g. a lower price of Play Station 2 will increase the demand for compatible
Play Station games.
7. Weather: In cold weather, there will be increased demand for fuel and
warm weather clothes.
8. Expectations of future price increases. A commodity like gold may be
bought due to speculative reasons; if you think it might go up in the future,
you will buy now.
 Fall in demand
A fall in demand could occur due to lower disposable income or decline in the
popularity of the good.

Evaluation
 For some luxury goods, income will be an important determinant of
demand. e.g. if your income increased you would buy more restaurant
meals, but probably not more salt.
 Advertising is important for goods in which branding is important, e.g. soft
drinks but not for bananas.
Other types of demand
 Effective demand: This occurs when a consumers desire to buy a good
can be backed up by his ability to afford it.
 Derived demand: This occurs when a good or factor of production such as
labour is demanded for another reason
 A Giffen good is a good where an increase in price of a basic item leads to
an increase in demand, because very poor people cannot afford any other
luxury goods.
 An ostentatious good, is a good where an increase in price leads to an
increase in demand because people believe it is now better.
 Composite demand – A good which is demanded for multiple different
uses
 Joint demand – goods bought together e.g. printer and printer ink.
Related pages

Factors affecting demand

The demand for a good depends on several factors, such as price of the good,
perceived quality, advertising, income, confidence of consumers and changes in
taste and fashion.
We can look at either an individual demand curve or the total demand in the
economy.

 The individual demand curve illustrates the price people are willing to pay
for a particular quantity of a good.
 The market demand curve will be the sum of all individual demand curves.
It shows the quantity of a good consumers plan to buy at different prices.
1. Change in price
A change in price causes a movement along the Demand Curve.
For example, if there is an increase in price from $12 to £16 then there will be a
fall in demand from 80 to 60.

How important is price?

Some goods are more affected by price than others.

 If petrol increases in price, because it is a necessity, there is only a small

fall in demand (we say it is inelastic demand).
 If Volvic water increases in price, there will be a significant fall in demand
because people buy cheaper substitutes (demand is elastic)
Shifts in the demand curve

This occurs when, even at the same price, consumers are willing to buy a higher
(or lower) quantity of goods. This will occur if there is a shift in the conditions of
demand.
Factors which can shift the demand curve

A shift to the right in the demand curve can occur for a number of reasons:

1. Income. An increase in disposable income enabling consumers to be able

to afford more goods. Higher income could occur for a variety of reasons,
such as higher wages and lower taxes.
2. Credit facilities. If it is easier and cheaper to borrow, this may encourage
consumers to buy expensive items on credit, for example, cars and.
3. Quality. An increase in the quality of the good e.g. better quality digital
cameras encourages people to buy one.
4. Advertising can increase brand loyalty to goods and increase demand.
For example, higher spending on advertising by Coca Cola has increased
global sales.
5. Substitutes. An increase in the price of substitutes, e.g. if the price of
Samsung mobile phones increases, this will increase the demand for
Apple iPhones – a major substitute for the Samsung.
 6. Complements. A fall in the price of complements will increase demand.
E.g. a lower price of Play Station 2 will increase the demand for compatible
Play Station games.
7. Weather: In cold weather, there will be increased demand for fuel and
warm weather clothes.
8. Expectations of future price increases. A commodity like gold may be
bought due to speculative reasons; if you think it might go up in the future,
you will buy now.
 Fall in demand

A fall in demand could occur due to lower disposable income or decline in the
popularity of the good.

Evaluation
  For some luxury goods, income will be an important determinant of
demand. e.g. if your income increased you would buy more restaurant
meals, but probably not more salt.
 Advertising is important for goods in which branding is important, e.g. soft
drinks but not for bananas.
Other types of demand
 Effective demand: This occurs when a consumers desire to buy a good
can be backed up by his ability to afford it.
 Derived demand: This occurs when a good or factor of production such as
labour is demanded for another reason
 A Giffen good is a good where an increase in price of a basic item leads to
an increase in demand, because very poor people cannot afford any other
luxury goods.
 An ostentatious good, is a good where an increase in price leads to an
increase in demand because people believe it is now better.
 Composite demand – A good which is demanded for multiple different
uses
 Joint demand – goods bought together e.g. printer and printer ink.
Related pages

Monetarist Theory of Inflation

28 August 2017 by Tejvan Pettinger

Monetarists argue that if the Money Supply rises faster than the rate of growth of
national income, then there will be inflation.

If the money supply increases in line with real output then there will be no
inflation.

M.Friedman stated:

“Inflation is always and everywhere a monetary phenomenon in the

sense that it is and can be produced only by a more rapid increase
in the quantity of money than in output.

Friedman (1970) The Counter-Revolution in Monetary Theory.

Quantity Theory of Money

Fischer Version MV=PT,

 M = Money Supply
 V= Velocity of circulation
 P= Price Level and
 T = Transactions.
T is difficult to measure so it is often substituted for Y = National Income

MV = PY where Y =national output

The above equation must hold the value of expenditure on goods and services
must equal the value of output.

Explanation of why money supply leads to inflation

Monetarists believe that in the short-term velocity (V) is fixed This is because the
rate at which money circulates is determined by institutional factors, e.g. how
often workers are paid does not change very much. Milton Friedman admitted it
might vary a little but not very much so it can be treated as fixed

Monetarists also believe output Y is fixed. They state it may vary in the short run
but not in the long run (because LRAS is inelastic and determined by supply-side
factors.)

Therefore an increase in the Money Supply will lead to an increase in inflation

Example 1
 If the total money supply is initially £1000 and the velocity of circulation is
5.
 The level of output (Y) is 5000 units.
 £1000×5 = P (5000)
 Therefore P = 1
 If the money supply now doubles the equation =
 2000×5 =P×5000
 Therefore P = 2
Example 2
  If the output is 1,000 units, and there is a money supply of £10,000. The
average price of good will be £10.
 In year 2, if the output stays at 1,000 units, but money supply increases to
15,000. Consumers have more money to buy the same amount of goods.
Therefore, firms put up prices to reflect this increase in money supply.
Ceteris paribus, average prices will rise from £10 to £15.
Other points
 Milton Friedman predicted an increase in the money supply would take
about 9-12 months to lead to higher output.
 Friedman placed great emphasis on the role of price expectations. If there
are expectations of higher inflation, it becomes self-fulfilling – workers
demand higher wages to meet rising living costs. Firms put up prices to
meet rising costs. Strict monetarist policies would help reduce
expectations.
 After another year output will return to its initial equilibrium causing prices
to rise to accommodate the rise in money supply
 Cambridge Version of quantity theory states P= f(M)
 Monetarism became more popular in the 1970s due to rising inflation.
(partly caused by rising oil prices).
 In the early 1980s, the UK and US adopted monetarist policies with mixed
results.
Friedman’s k-percent rule

 Milton Friedman argued that the money supply should rise by a fixed k-
percent each year. This rate of increase should depend on institutional
factors and be determined independently of policymakers.
 Friedman believed this rule would avoid the extremes of deflation (Falling
money supply, e.g. Great Depression) and inflation due to rising money
supply.
 It would give business strong expectations of what would happen to money
supply and inflation.
 Monetarist inflation in the AD and AS model
 Following a rise in the Money Supply, consumers have more money and
therefore spend more money on goods; this shifts AD to the right. AD1 to
AD 2.
 Firms respond by increasing output along SRAS. Real output increases
from Y1 to Y2.
 National output now exceeds the equilibrium level of output. Therefore
there is an inflationary gap.
 Firms need to hire more workers, so wages rise leading to an increase in
costs and hence prices. Initially, workers agree to work more hours
because they see an increase in nominal wages.
 As prices rise money can buy less, therefore, there is a movement to the
left along the new AD
 Also, workers realise the increase in nominal wage is not a real wage
increase. Therefore, workers also demand higher nominal wages to
 produce more output and to compensate them for rising prices, therefore
SRAS shifts to the left.
 The economy has returned to the equilibrium level of output (Y1), but at a
higher price level (P3).
 Therefore the rise in the Money Supply cause a rise in AD, But because
the LRAS is inelastic there is no increase in real output, but inflation rises.
It is a form of demand-pull inflation.
Monetarist view of Phillips curve

Mo
netarists believe in the long-run there is no trade-off between inflation and
unemployment. Increase in the money supply only causes an increase in nominal
GDP, but not real GDP.
Criticisms of monetarism
 The link between the money supply and inflation is often very weak in
practice.
 The velocity of circulation (V) is not stable but can vary significantly due to
confidence, changes in the use of credit cards, decline in use of cash. e.t.c
 Targetting arbitrary money supply targets can cause a severe recession
and high unemployment. For example, UK targetted money supply growth
in the early 1980s, but this caused the recession of 1981 with many
economists arguing it was deeper than necessary.
  The large increase in the monetary base following the 2009 recession did
not cause any inflationary pressures.
 Why not target inflation directly? If you want to control inflation, it makes
more sense to target inflation directly rather than through the intermediary
of the money supply.
  Monetarists say that income can vary in the short run, but the short run
could be a long time and therefore make monetary policy ineffective,
Keynesians argue that the LRAS is not necessarily inelastic they argue
that the economy can be below full capacity for a long time.
Related

Market equilibrium
5 December 2019 by Tejvan Pettinger

 Definition of market equilibrium – A situation where for a particular good

supply = demand. When the market is in equilibrium, there is no tendency
for prices to change. We say the market-clearing price has been achieved.
 A market occurs where buyers and sellers meet to exchange money for
goods.
 The price mechanism refers to how supply and demand interact to set the
market price and amount of goods sold.
 At most prices, planned demand does not equal planned supply. This is a
state of disequilibrium because there is either a shortage or surplus and
firms have an incentive to change the price.
Market equilibrium

Market equilibrium can be shown using supply and demand diagrams

In the diagram below, the equilibrium price is P1. The equilibrium quantity is Q1.
If price is below the equilibrium

 In the above diagram, price (P2) is below the equilibrium. At this price,
demand would be greater than the supply. Therefore there is a shortage of
(Q2 – Q1)
 If there is a shortage, firms will put up prices and supply more. As price
rises, there will be a movement along the demand curve and less will be
demanded.
 Therefore the price will rise to P1 until there is no shortage and supply =
demand.
If price is above the equilibrium

 If price was at P2, this is above the equilibrium of P1. At the price of P2,
then supply (Q2) would be greater than demand (Q1) and therefore there
is too much supply. There is a surplus. (Q2-Q1)
 Therefore firms would reduce price and supply less. This would encourage
more demand and therefore the surplus will be eliminated. The new market
equilibrium will be at Q3 and P1.
Movements to a new equilibrium

1. Increase in demand
If there was an increase in income the demand curve would shift to the right (D1
to D2). Initially, there would be a shortage of the good. Therefore the price and
quantity supplied will increase leading to a new equilibrium at Q2, P2.

2. Increase in supply
An increase in supply would lead to a lower price and more quantity sold.

Related posts

Production Possibility Frontier

12 November 2018 by Tejvan Pettinger

A production possibility frontier shows how much an economy can produce given
existing resources.
A production possibility can show the different choices that an economy faces.

For example, when an economy produces on the PPF curve, increasing the
output of goods will have an opportunity cost of fewer services.

Diagram of Production Possibility Frontier

 Moving from Point A to B will lead to an increase in services (21-27). But,

the opportunity cost is that output of goods falls from 22 to 18.
 At point D, the economy is inefficient. At point D, we can increase both
goods and services without any opportunity cost.
  Pareto efficiency is any point on the PPF curve. On the PPF curve, it is
impossible to increase one choice, without causing less production of the
other.
Economic Growth

If there is an increase in land, labour or capital or an increase in the productivity

of these factors, then the PPF curve can shift outwards enabling a better trade-
off.

Graph showing increase in PPF.

Note: there is a link between macroeconomics and the long-run aggregate supply
curve. If the PPF curve shifts to the right, then it is similar effect to the LRAS
shifting to the right
Production possibility frontier and investment
One choice an economy faces is between capital goods (investment) and
consumer goods.

 If more resources are devoted to capital goods (e.g. building new factories)
then in the short-term, consumption will go down.
 However, if the investment is successful, then in the long-run, productive
capacity will increase and the PPF curve will shift to the right
Increase in capital goods has an opportunity cost of fewer consumer goods, but
in long-term can enable economic growth.

Similarly, a decline in investment can enable more consumer goods in the short-
term but can lead to lower rates of economic growth.
PPF and recession

A recession can be shown by output falling below the production possibility

frontier (from A to B).

 A = full employment
 B = unemployed resources
PPF and choices for government

Any government faces a trade-off in how to use scarce resources and tax
revenue. If the government increases spending on the military, then the
opportunity cost will be less spending on another public service, such as health
care.

Different PPF Curves

This shows a trade-off between working and hours spent in leisure.

Related

Opportunity Cost Definition

Definition – Opportunity cost is the next best alternative foregone.
 If we spend that £20 on a textbook, the opportunity cost is the restaurant
meal we cannot afford to pay.
  If you decide to spend two hours studying on a Friday night. The
opportunity cost is that you cannot have those two hours for leisure.

Importance of opportunity cost

The fundamental problem of economics is the issue of scarcity. Therefore we are

concerned with the optimal use and distribution of these scarce resources.
Wherever there is scarcity we are forced to make choices. If we have £20, we
can spend it on an economic textbook, or we can enjoy a meal in a restaurant.
Therefore, many choices involve an opportunity cost – having to make choices
between the two.
Production possibility frontier and opportunity cost

A production possibility frontier shows the maximum combination of factors that

can be produced.

 Moving from Point A to B will lead to an increase in services (21-27). But,

the opportunity cost is that output of goods falls from 22 to 18.
 Therefore, the opportunity cost of increasing consumption of services is
the 4 goods foregone.
At point D, the economy is inefficient. We can increase both goods and services
without any opportunity cost.
Positive Externalities
28 October 2019 by Tejvan Pettinger

Definition of Positive Externality: This occurs when the consumption or

production of a good causes a benefit to a third party. For example:
 When you consume education you get a private benefit. But there are also
benefits to the rest of society. E.g you are able to educate other people
and therefore they benefit as a result of your education. (positive
consumption externality)
 A farmer who grows apple trees provides a benefit to a beekeeper. The
beekeeper gets a good source of nectar to help make more honey.
(positive production externality)
 If you walk to work, it will reduce congestion and pollution; this will benefit
everyone else in the city.
Social Benefit
 With positive externalities, the benefit to society is greater than your
personal benefit.
 Therefore with a positive externality the Social Benefit > Private Benefit
 Remember Social Benefit = private benefit + external benefit.
Diagram of Positive Externality (consumption)

 In this case, the social marginal benefit of consumption is greater than the
private marginal benefit. For example, if you take a train, it reduces
congestion for other travellers.
 In a free market, consumption will be at Q1 because demand = supply
(private benefit = private cost )
 However, this is socially inefficient because at Q1, social marginal cost <
social marginal benefit. Therefore there is under-consumption of the
positive externality.
 Social efficiency would occur at Q2 where social cost = social benefit
For example, in a free market without government intervention, there would be
an under-consumption of education and public transport.
Positive externality (production)

 This occurs when a third party benefits from the production of a good. For
example, building a train station may provide shelter for the homeless
when it is raining.
 If a company develops new technology, such as a database programme,
this new technology can be implemented by other firms who will gain a
similar boost to productivity.
 Tim Berners Lee who developed the World Wide Web, made it freely
available, creating a very large positive externality.
Diagram of positive externality in production

 Because there are positive externalities in production, the social marginal

cost of production is less than the private marginal cost of production.
 In a free market, a firm will ignore benefits to third parties and will produce
at Q1 (free market outcome)
 However, the socially efficient level will be at Q2 (where social marginal
cost = social marginal benefit)
More examples of positive externalities

 Getting a vaccination provides a benefit to other people in society because

you do not spread infectious diseases.
 A decision to stop smoking causes benefits to other people in society who
longer suffer passive smoking.
 Switching from conventional farming to organic farming helps the
environment as there are fewer chemicals in the environment.
 Picking up litter makes the environment nicer for everyone.
Dealing with positive externalities

Positive externalities lead to under-consumption and market failure. Government

policies to increase demand for goods with positive externalities include

1. Rules and regulations – minimum school leaving age

2. Increasing supply – the government building of council housing to increase
the stock of good quality housing.
3. Subsidy to reduce price and encourage consumption, e.g. government
subsidy for rural train services.
Diagram to show the effect of subsidy on good with positive externalities

A subsidy of P0-P2 shifts supply curve to the right (S2) and the new quantity
demand will be Q2 (where SMB=SMC)

In this case, the subsidy has overcome the market failure. Though government
intervention itself could be subject to government failure.

 More detail at: Subsidy on positive externality

Which diagram to draw?
Either (production or consumption externality) is acceptable to show the principle
of positive externalities. Generally, I advise using the positive externalities of
consumption. To simply economics for some students (who often get confused
by these diagrams), I will only teach one positive externality diagram.
(consumption)

Related
Negative Externalities
24 July 2019 by Tejvan Pettinger

 Negative externalities occur when the consumption or production of a good

causes a harmful effect to a third party.
Examples of negative externalities
 Loud music. If you play loud music at night, your neighbour may not be
able to sleep.
 Pollution. If you produce chemicals and cause pollution as a side effect,
then local fishermen will not be able to catch fish. This loss of income will
be the negative externality.
 Congestion. If you drive a car, it creates air pollution and contributes to
congestion. These are both external costs imposed on other people who
live in the city.
 Building a new road. If you build a new road, the external cost is the loss
of a beautiful landscape which people can no longer enjoy.
The externalities of driving a car to work

 The personal cost of driving are buying car, petrol, your time
 The negative externalities are – pollution to other people, possible accident
to other other people, and time other people sit in traffic jams
Social cost
 Social cost is the total cost to society; it includes both private and external
costs.
 With a negative externality the Social Cost > Private Cost
Negative production  externality
 When producing a good causes a harmful effect to a third party. Therefore
the social cost is greater than the private cost.
Examples of negative production externalities
 Burning coal for energy creates pollution.
  Producing conventional vegetables with pesticides causes carcinogens to
get into the environment.
 Producing beef in South America involves cutting down Amazon rainforest,
which has an impact on global climate and local environment

 Because of the external costs the social marginal cost is greater than the
private marginal cost.
 In a free market, producers ignore the external costs to others. Therefore
output will be at Q1 (where Demand = Supply).
 This is socially inefficient because at Q1 – SMC> SMB
 Social efficiency occurs at Q2 where Social marginal cost = Social
marginal benefit
The red triangle is the area of deadweight welfare loss. It indicates the area of
overconsumption (where SMC is greater than PMC)

Negative externality of consumption

This occurs when consuming a good causes a harmful effect to a third party. In
this case, the social benefit is less than the private benefit.
Examples of negative externalities of consumption
 Consuming alcohol leads to an increase in drunkenness, increased risk of
car accidents and social disorder.
 Consuming loud music late at night keeps your neighbours awake.
 Consuming cigarettes causes passive smoking to others in the vacinity.
Diagram of negative externality in consumption

 In a free market, we get Q1 output. But at this output, the social marginal
cost is greater than the social marginal benefit.
 The red triangle is the area of dead-weight welfare loss.
 Social efficiency occurs at a lower output (Q2) – where social marginal
benefit = social marginal cost.
Implications of negative externalities

If goods or services have negative externalities, then we will get market failure.
This is because individuals fail to take into account the costs to other people.

To achieve a more socially efficient outcome, the government could try to tax the
good with negative externalities. This means that consumers pay close to the full
social cost.

See: Tax on negative externalities

Economists on negative externalities

Arthur Pigou 1920 introduced the concept of externalities in The Economics of

Welfare. Pigou used the example of alcohol having external costs, such as
creating more demand for police and health care.
In 1975 William Baumol and W. Oates provided a comprehensive review of the
literature on externalities in Theory of Environmental Policy. In particular, they
applied economic concepts of externalities to the emerging issue of
environmental costs. For example, in 1975, they mentioned some of the
environmental costs which were considered to be pressing.
a. Disposal of toxic wastes,

b. Sulfur dioxide, particulates, and other contaminants of the

atmosphere,

c. Various degradable and nondegradable wastes that pollute the

world’s waterways,

d. Pesticides, which, through various routes, become imbedded in

food products,

e. Deterioration of neighborhoods into slums,

f. Congestion along urban highways, g. High noise levels in

metropolitan areas

Merit and Demerit Goods

28 November 2019 by Tejvan Pettinger
Definition of Merit Good
A merit good has two characteristics:

1. People do not realise the true personal benefit. For example, people
underestimate the benefit of education or getting a vaccination.
2. Usually, these goods also have a positive externality.
Therefore in a free market, there will be under consumption of merit goods.

Examples of Merit Goods

 Health Care – people underestimate the benefits of getting a vaccination. If

people do get a vaccination, then there will be a personal benefit in
protecting against diseases. Also, there will be external benefits to the rest
of society because it will help reduce the prevalence of disease in the rest
of society.
 Museums – the educational benefit of museums may be unappreciated.
 Eating fruit and vegetables – A diet of raw fruit gives health benefits to the
consumers but we may prefer unhealthy food.
 Education – People may undervalue the benefits of studying, and decide to
leave school early or not get good grades.
Demerit Good
A demerit good has two characteristics:
 1. A good which harms the consumer. For example, people don’t realise or
ignore the costs of doing something e.g. smoking, drugs.
2. Usually, these goods also have negative externalities. If you smoke you
harm yourself, but also the smoke negatively affects other people.
Therefore in a free market, there will be overconsumption of these goods.

Examples of Demerit Goods include:

 Smoking – People underestimate health costs or risks of getting addicted.

 Drinking – Health costs to drinkers. Costs to society include more
expenditure on health care and policing.
 Taking drugs – Health costs to drug users – people underestimate risks of
getting addicted. External costs of more crime.
 Driking sugary softdrinks – which damage teeth and cause obesity.
More on demerit goods
Value judgement on merit goods

Merit and demerit goods involve making a value judgement that something is
good or bad for you. Classification is not always straightforward. For example:

Cannabis
 Cannabis is widely considered a demerit good – it contributes to lung
cancer and can lead to psychological problems, such as paranoia.
 However, supporters of cannabis might argue cannabis is a harmless drug
which can help people deal with physical pain and enjoy life more.
Contraception
 Supporters of family planning may argue contraception is a merit good
because contraception can help prevent the personal costs of unwanted
pregnancy.
 However, the Catholic church views contraception as a sin and may argue
it is actually a demerit good because contraception encourages sexual
promiscuity and undermines family values.

Definition of Public Good

A public good has two characteristics:

1. Non-rivalry: This means that when a good is consumed, it doesn’t reduce

the amount available for others.
 – E.g. benefiting from a street light doesn’t reduce the light available for
others but eating an apple would.
2. Non-excludability: This occurs when it is not possible to provide a good
without it being possible for others to enjoy. For example, if you erect a
dam to stop flooding – you protect everyone in the area (whether they
contributed to flooding defences or not.
A public good is often (though not always) under-provided in a free market
because its characteristics of non-rivalry and non-excludability mean there is an
incentive not to pay. In a free market, firms may not provide the good as they
have difficulty charging people for their use.

Free rider problem

The problem with public goods is that they have a free-rider problem. This means
that it is not possible to prevent anyone from enjoying a good, once it has been
provided. Therefore there is no incentive for people to pay for the good because
they can consume it without paying for it.
 However, this will lead to there being no good being provided.
 Therefore there will be social inefficiency.
 Therefore there will be a need for the govt to provide it directly out of
general taxation.
Examples of Public Goods

Bo
th a public bridge and street lighting exhibit characteristics of a public good.

 National defence. If you protect the country from invasion, it benefits

everyone in the country.
 Street lighting. If you provide light at night, you can’t stop anyone
consuming the good. Walking under a street light doesn’t reduce the
amount of light for others.
 Police service. If you provide law and order, everyone in the community
will benefit from improved security and reduced crime.
 Flood defences – Protecting the coastline against flooding provides
benefits for the whole community.
 The internet. Once websites are provided, everyone can see the website
for free, without reducing the amount available to others. (assuming an
individual can access for free, which is not always the case)
Quasi-Public Goods

These are goods which have an element of non-excludability and non-rivalry.

Roads are a good example. Once provided most people can use them, for
example, those who have a driving licence. However, when you use a road, the
amount others can benefit is reduced to some extent, because there will be
increased congestion.

Market provision of public goods

Although classical economic theory suggests public goods will not be provided by
a free market, there are cases when groups of individuals can come together to
voluntarily provide public goods.

Behavioural economics suggests that individuals can have motivations other than

just money. People may volunteer to contribute to local flood defences out of a
sense of civic pride, peer pressure or genuine altruism. Therefore, in the real
world, enough people may contribute to paying for a public good, even if – from a
narrow self-interest point of view – it may be rational to avoid paying.
Examples of market provision of public goods include:
 Local communities providing private policing
 Local communities raising money to pay for a local school, new garden or
new statue.
Difference between public spending and public goods
One possible area of confusion. We talk about public spending. This is spending
done by the government. E.g. UK public spending
However, not all government (public) spending is on ‘public goods’, e.g. the
government will also spend on other goods and services, .e.g. – merit goods, like
education and healthcare.
Related

Definition of government failure:

This occurs when government intervention in the economy causes an inefficient
allocation of resources and a decline in economic welfare.

Often government failure arises from an attempt to solve market failure but
creates a different set of problems.
Reasons for government failure

 Lack of incentives: In the public sector, there is limited or no profit

motive. Because workers and managers lack incentives to improve
services and cut costs it can lead to inefficiency. For example, the public
sector may be more prone to over-staffing. The government may be
reluctant to make people redundant because of the political costs
associated with unemployment.
 Poor information, politicians may have poor information about the type of
service to provide. Politicians may not be experts in their department but
concentrate on their political ideology.
 Political interference Decisions made for short-term political gain – rather
than sound economics, e.g. keep on unproductive workers. e.g. politicians
may take the short-term view rather than considering the long-term effects
 No consistency. Change of government often leads to change of
approach and new political initiatives
 Moral hazard. The government may offer a guarantee to all bank deposits
to protect the financial system, but this could encourage banks to take
risks – because they know they can be bailed out by the government.
  Regulatory capture – When government agencies become too friendly
with business/groups they are trying to regulate
 Unintended consequences. Policies to reduce relative poverty ‘means-
tested benefits’ can create ‘welfare dependency.’ For those on means-
tested benefits, moving from benefits to work could lead to very little extra
income because of lost benefits and higher taxes. Benefits can then solve
one problem of relative poverty but create new problems of higher
spending and lower levels of labour market participation.
 Special interest groups. In the US, many types of business have special
tax credits for their industry; this makes it difficult to reform the tax system,
and leads to horizontal inequality – business with same income can be
treated differently. In the Europe, farmers receive substantial financial
support from the EU, making it difficult to reform CAP. Once people are
used to receiving subsidies it can be politically difficult for the government
to take it away.
Examples of government failure

Concorde Photo By Eduard Marmet –

 White elephant projects. Concorde supersonic airliner was a joint venture

between British and French government. It was seen as a prestigious
 venture, so even when studies suggested it was uneconomic, politicians
didn’t want to back-track but kept putting in public money. Developing
Concorde cost the British and French governments £1.1 billion (about £11
billion in 2003 prices) before it even went into service—nearly ten times
what was budgeted. (Economist)
 Tax leads to fly-tipping. A tax on rubbish is a policy to overcome market
failure. To try and include the external cost of rubbish in the price.
However, a tax on rubbish can lead to illegal dumping of rubbish on the
roads. This creates a different problem of fly-tipping.
 Common Agricultural Policy. The CAP was intended to solve market
failure in agriculture and protect farmers incomes, but the EU didn’t take
into account minimum prices would lead to over-supply; there were also
unintended consequences of trade wars and environmental problems from
farmers trying to supply as much as they could. See: CAP.
 Prohibition strengthened the mafia. When the government banned
alcohol in the US, it caused the mafia to supply alcohol, leading to a rise in
organised crime.
Overcoming government failure

There are various things the government can try and do to overcome government
failure

 Give performance targets/profit incentives

 Competitive tendering – where public sector bodies face competition from
the private sector for the right to run a public service.
 Employing outside private sector consultants to make decisions about how
to cut costs.
 Delegating certain decisions to non-political bodies. For example, setting
interest rates was given to the Bank of England as politicians often set
interest rates for political reasons.
 See also: How to overcome government failure
Evaluation of government failure
It should be remembered many public services are not subject to the same profit
goals. It is difficult to give a profit motive in health or education because the goal
is not profit but the quality of service.

Also, although government failure is a real issue, it is often much less than the
problems arising from market failure. Just because government intervention may
be inefficient, doesn’t mean we should try to tackle problems of pollution e.t.c.

Related
Market Failure
28 November 2019 by Tejvan Pettinger

Definition of Market Failure – This occurs when there is an inefficient allocation

of resources in a free market. Market failure can occur due to a variety of
reasons, such as monopoly (higher prices and less output), negative externalities
(over-consumed and costs to third party) and public goods (usually not provided
in a free market)
Types of market failure
1. Positive externalities – Goods/services which give benefit to a third party,
e.g. less congestion from cycling.
2. Negative externalities – Goods/services which impose a cost on a third
party, e.g. cancer from passive smoking.
3. Merit goods – People underestimate the benefit of good, e.g. education. It
may also have positive externalities
4. Demerit goods – People underestimate the costs of a good, e.g. smoking.
It may also have negative externalities.
5. Public Goods – Goods which are non-rival and non-excludable – e.g.
police, national defence. Public goods are often not provided in a free
market.
6. Monopoly Power – when a firm controls the market (with high market
share) and can set higher prices.
7. Inequality – unfair distribution of resources in free market, e.g. some
experiencing poverty and homelessness
8. Factor Immobility – E.g. geographical / occupational immobility. For
example, when there are pockets of high unemployment, but it is difficult
for the unemployed to move and get a job.
9. Agriculture – Agriculture is often subject to market failure – due to volatile
prices, fluctuating weather and externalities.
10. Information failure – where there is a lack of information to make an
informed choice.
11. Principal-agent problem – Two agents with different objectives and
information asymmetries. For example, adverse selection where a buyer
has less information than the seller.
12. Moral hazard. When individuals have incentive to change their behaviour
when others take the risk. For example, when banks are insured by the
government, bankers take risky decisions which can cause bank losses.
 13. Macroeconomic instability – When an economy enters into prolonged
recession and high unemployment – or inflationary boom which is
unstable.

A way to remember several types of market failure

Key Terms in Market Failure
 Externalities:  These occur when a third party is affected by the decisions
and actions of others.
  Social benefit:  the total benefit to society =
Private Marginal Benefit (PMB) + External Marginal  Benefit (XMB)
 Social Cost: is the total cost to society =
Private Marginal Cost (PMC) + External Marginal Cost (XMC
 Social Efficiency: This occurs when resources are utilised in the most
efficient way. This will occur at an output where social marginal cost (SMC)
= Social Marginal Benefit. (SMB)
Overcoming Market Failure

Diagram shows output in free-market equilibrium and how a tax can shift output
to socially efficient level
 Tax on Negative Externalities – e.g. Petrol tax
 Carbon Tax e.g. tax on CO2 emissions
 Subsidy on positive externalities – why the government may subsidies
public transport
  Laws and regulations – Simple and effective ways to regulate demerit
goods, like a ban on smoking advertising.
 Buffer stocks – aim to stabilise prices
 Government failure – why government intervention may not always
improve the situation
Market failure and behavioural economics

Behavioural economics examines how individuals often act in a non-rational

manner – contrary to the expectation of conventional economic models. These
types of ‘irrational behaviour’ can lead to a type of market failure where people
make poor choices. For example.

 Irrational exuberance – people getting carried away by good news leading

to boom and bust.

Economic objectives of firms

15 July 2019 by Tejvan Pettinger

The main objectives of firms are:

1. Profit maximisation
2. Sales maximisation
3. Increased market share/market dominance
4. Social/environmental concerns
5. Profit satisficing
6. Co-operatives
Sometimes there is an overlap of objectives. For example, seeking to increase
market share, may lead to lower profits in the short-term, but enable profit
maximisation in the long run.
Profit maximisation

Usually, in economics, we assume firms are concerned with maximising profit.

Higher profit means:

 Higher dividends for shareholders.

 More profit can be used to finance research and development.
 Higher profit makes the firm less vulnerable to takeover.
 Higher profit enables higher salaries for workers
See more on: Profit maximisation
Alternative aims of firms

However, in the real world, firms may pursue other objectives apart from profit
maximisation.
1. Profit Satisficing

 In many firms, there is a separation of ownership and control. Those who

own the company (shareholders) often do not get involved in the day to
day running of the company.
 This is a problem because although the owners may want to maximise
profits, the managers have much less incentive to maximise profits
because they do not get the same rewards, (share dividends)
 Therefore managers may create a minimum level of profit to keep the
shareholders happy, but then maximise other objectives, such as enjoying
work, getting on with other workers. (e.g. not sacking them) This is the
problem of separation between owners and managers.
 This ‘principal-agent‘ problem can be overcome, to some extent, by giving
managers share options and performance related pay although in some
industries it is difficult to measure performance.
 More on profit-satisficing.
2. Sales maximisation
Firms often seek to increase their market share – even if it means less profit.
This could occur for various reasons:

 Increased market share increases monopoly power and may enable the
firm to put up prices and make more profit in the long run.
 Managers prefer to work for bigger companies as it leads to greater
prestige and higher salaries.
  Increasing market share may force rivals out of business. E.g. the growth
of supermarkets have lead to the demise of many local shops. Some firms
may actually engage in predatory pricing which involves making a loss to
force a rival out of business.
3. Growth maximisation
This is similar to sales maximisation and may involve mergers and takeovers.
With this objective, the firm may be willing to make lower levels of profit in order
to increase in size and gain more market share. More market share increases its
monopoly power and ability to be a price setter.

4. Long run profit maximisation

In some cases, firms may sacrifice profits in the short term to increase profits in
the long run. For example, by investing heavily in new capacity, firms may make
a loss in the short run but enable higher profits in the future.

5. Social/environmental concerns
A firm may incur extra expense to choose products which don’t harm the
environment or products not tested on animals. Alternatively, firms may be
concerned about local community / charitable concerns.

 Some firms may adopt social/environmental concerns as part of their

branding. This can ultimately help profitability as the brand becomes more
attractive to consumers.
 Some firms may adopt social/environmental concerns on principal alone –
even if it does little to improve sales/brand image.
6. Co-operatives
Co-operatives may have completely different objectives to a typical PLC. A co-
operative is run to maximise the welfare of all stakeholders – especially workers.
Any profit the co-operative makes will be shared amongst all members.
Diagram showing different objectives of firms

 Q1 = Profit maximisation (MR=MC)

 Q2 = Revenue Maximisation (MR=0)
 Q3 = Marginal cost pricing (P=MC) – allocative efficiency
 Q4 = Sales maximisation – maximum sales while still making normal profit
(AR=ATC)

Types of Costs
15 June 2019 by Tejvan Pettinger

A list and definition of different types of economic costs.

Fixed Costs (FC) The costs which don’t vary with changing output. Fixed
costs might include the cost of building a factory, insurance and legal bills. Even
if your output changes or you don’t produce anything, your fixed costs stay the
same. In the above example, fixed costs are always £1,000.
Variable Costs (VC) Costs which depend on the output produced. For example,
if you produce more cars, you have to use more raw materials such as metal.
This is a variable cost.
Semi-Variable Cost. Labour might be a semi-variable cost. If you produce more
cars, you need to employ more workers; this is a variable cost. However, even if
you didn’t produce any cars, you may still need some workers to look after an
empty factory.
Total Costs (TC)  = Fixed + Variable Costs
Marginal Costs – Marginal cost is the cost of producing an extra unit. If the total
cost of 3 units is 1550, and the total cost of 4 units is 1900. The marginal cost of
the 4th unit is 350.
Opportunity Cost – Opportunity cost is the next best alternative foregone. If you
invest £1million in developing a cure for pancreatic cancer, the opportunity cost is
that you can’t use that money to invest in developing a cure for skin cancer.
Economic Cost. Economic cost includes both the actual direct costs (accounting
costs) plus the opportunity cost. For example, if you take time off work to a
training scheme. You may lose a weeks pay of £350, plus also have to pay the
direct cost of £200. Thus the total economic cost = £550.
Accounting Costs – this is the monetary outlay for producing a certain good.
Accounting costs will include your variable and fixed costs you have to pay.
Sunk Costs. These are costs that have been incurred and cannot be recouped.
If you left the industry, you could not reclaim sunk costs. For example, if you
spend money on advertising to enter an industry, you can never claim these
costs back. If you buy a machine, you might be able to sell if you leave the
industry. See: Sunk cost fallacy
Avoidable Costs. Costs that can be avoided. If you stop producing cars, you
don’t have to pay for extra raw materials and electricity. Sometimes known as an
escapable cost.
Explicit costs – these are costs that a firm directly pays for and can be seen on
the accounting sheet. Explicit costs can be variable or fixed, just a clear amount.
Implicit costs – these are opportunity costs, which do not necessarily appear on
its balance sheet but affect the firm. For example, if a firm used its assets, like a
printing press to print leaflets for a charity, it means that it loses out on revenue
from producing commercial leaflets.
Market Failure

 Social Costs. This is the total cost to society. It will include the private
costs plus also the external cost (cost incurred by a third party). May also
be referred to as ‘True costs’
 External Costs. This is the cost imposed on a third party. For example, if
you smoke, some people may suffer from passive smoking. That is the
external cost.
 Private Costs. The costs you pay. e.g. the private cost of a packet of
cigarettes is £6.10
 Social Marginal Cost. The total cost to society of producing one extra
unit. Social Marginal Cost (SMC) = Private marginal cost (PMC) + External
marginal Cost (XMC)
Diagram of Costs
For full diagrams of costs see: Diagrams of cost curves
Average Cost Curves

 ATC (Average Total Cost) = Total Cost / quantity

 AVC (Average Variable Cost) = Variable cost / quantity
 MC = Marginal cost.
 AFC (Average Fixed Cost) = Fixed cost / quantity
Total costs
 Tot
al cost (TC) = Variable cost (VC) + fixed costs (FC)

Economic Efficiency
28 June 2019 by Tejvan Pettinger

Definition of efficiency

Efficiency is concerned with the optimal production and distribution of scarce

resources.
Different types of efficiency

 Productive – producing for the lowest cost.

 Allocative – distributing resources according to consumer preference
P=MC
 Dynamic – Efficiency over time.
 X-efficiency – incentives to cut costs.
 Efficiency of scale – taking advantage of economies of scale.
 Social efficiency – taking into account external costs/benefits.
1. Productive efficiency

This occurs when the maximum number of goods and services are produced with
a given amount of inputs. This will occur on the production possibility frontier. On
the curve, it is impossible to produce more goods without producing fewer
services. Productive efficiency will also occur at the lowest point on the firm’s
average costs curve. (Q1)

See: Productive Efficiency
2. Allocative efficiency

This occurs when goods and services are distributed according to consumer
preferences. An economy could be productively efficient but produce goods
people don’t need this would be allocative inefficient.

Allocative efficiency occurs when the price of the good = the MC of production.
This occurs at an output of 80, where price £11 = MC.

At an output of 40, The price of £15 is much greater than MC of £6 – there is

underconsumption.

See: Allocative Efficiency
3. X inefficiency
This occurs when firms do not have incentives to cut costs, for example, a
monopoly which makes supernormal profits may have little incentive to get rid of
surplus labour.
If a firm’s average costs are higher than potential – then we are x-inefficient.
See: X Inefficiency
4. Efficiency of scale

This occurs when the firms produce on the lowest point of its long-run average
cost (Q2) and therefore benefits fully from economies of scale
5. Dynamic efficiency
This refers to efficiency over time, for example, a Ford factory in 2010 may be
very efficient for the time period, but by 2017, it could have lost this relative
advantage and by comparison, would now be inefficient. Dynamic efficiency
involves the introduction of new technology and working practices to reduce
costs over time.

 Dynamic efficiency
 Static efficiency – efficiency at a particular point in time.
6. Social efficiency
This occurs when externalities are taken into consideration and occurs at an
output where the social cost of production (SMC) = the social benefit (SMB)
Social efficiency occurs at an output of 16 – where SMB = SMC

See: Social efficiency
7. Technical efficiency
This requires the optimum combination of factor inputs to produce a good: it is
related to productive efficiency.

See: Technical efficiency
8. Pareto efficiency

A situation where resources are distributed in the most efficient way. It is defined
as a situation where it is not possible to make one party better off without making
another party worse off.

See: Pareto efficiency
9. Distributive efficiency
Concerned with allocating goods and services according to who needs them
most. Therefore, requires an equitable distribution.
Imperfections in the Labour Market
28 November 2017 by Tejvan Pettinger

In the real world, labour markets are rarely perfectly competitive. This is because
workers or firms usually have the power to set and influence wages and therefore
wages may be set to levels different than anticipated by Marginal Revenue
Product (MRP) theory.
Imperfections in the labour market cause wages to differ from a competitive
equilibrium.

Different Imperfections in the Labour Market

1. Monopsony
2. Trade unions
3. Discrimination
4. Difficult to measure productivity
5. Firms, not profit maximisers
6. Geographical immobiliities
7. Occupational immobilities
8. Poor information
1. Monopsony

Monopsony occurs when there is just one buyer of labour in a market. This gives
the firm market power in employing workers. The monopsony can set (lower)
wages and limit the quantity of workers.
  The marginal cost of employing one more worker will be higher than the
average cost because to employ one extra worker the firm has to increase
the wages of all workers.
 To maximise the level of profit the firm employs Q2 of workers where MC =
MRP
 Therefore the firm only has to pay a wage of W2. This is less than the
competitive wage.
Even if there is more than one employer, firms may still have the ability to set
wages and have a degree of monopsony power. For workers, there are
significant costs and difficulties in moving between employers. This means that if
wages are low, it is costly to give up the job and work for a firm with slightly
higher wages.

2. Trades Unions

Under certain conditions, Trades unions can bargain for wages above the
competitive equilibrium
This can be achieved by restricting the supply of labour (e.g. closed shops) or
threatening to go on strike.

Trades Unions can cause higher wages, however, in competitive markets, this
can have the effect of causing unemployment of Q1 – Q2

However, Trades Unions can be beneficial if:

 They operate in an industry with a Monopsonistic employer

 They help to increased productivity by bringing in new working practices
 Demand for labour is inelastic
 Efficiency wage theories – when higher wages lead to higher productivity.
3. Discrimination

Firms may not be rational but pay some workers different wages on the grounds
of age, race, or gender. See: discrimination in labour markets.
4. Difficult to measure productivity

The theory of MRP assumes firms can measure the MPP of a worker however in
practice this is difficult because in many jobs, especially in the service sector
productivity cannot be measured precisely
e.g. how do we measure the productivity of nurses and teachers?
Therefore wages may be set due to different reasons other than MRP

5. Firms may be non-profit maximisers

If demand for a product falls, MRP theory suggests wages are likely to fall.
However, firms may be reluctant to cut wages or make people redundant
therefore they may keep paying high wages despite this.

6. Wages will vary due to geographical differences

In the north (e.g. Sunderland), wages tend to be lower because there are less
demand, higher unemployment and more elastic supply curve of labour. In the
South, wages tend to be higher for the opposite reason – firms are more
profitable and are willing to pay higher wages.

In theory, workers from the north could move to the south to take advantage of
better employment opportunities. However, there are likely to be geographical
immobilities – e.g. it is difficult for workers to move. Geographical immobilities
can include

 Workers have attachments to their local communities – friends, children at

local schools.
 Difficult to find housing in the south.
  Poor information about jobs elsewhere
7. Occupational immobilities

Even at periods of full employment (strong economic growth) workers can be

unemployed due to occupational immobilities. This involves having inadequate
skills for the labour market. In a fast-changing economy, some workers can be
left behind when old industries close down and their former skills are not
transferable to new jobs. For example, manual workers from manufacturing may
struggle in a high tech service sector based economy. This can lead to structural
unemployment.
8. Poor information

Workers or firms may suffer from poor information. E.g. workers may be unaware
of better-paid jobs elsewhere. Poor information is one factor that enables firms to
have monopsony power.

Monopsony
28 November 2019 by Tejvan Pettinger

Definition of Monopsony

 A monopsony occurs when a firm has market power in employing factors

of production (e.g. labour).
 A monopsony means there is one buyer and many sellers.
 It often refers to a monopsony employer – who has market power in hiring
workers.
 This is a similar concept to monopoly where there is one seller and many
buyers.
Monopsony in Labour Markets

An example of a monopsony occurs when there is one major employer and many
workers seeking to gain employment.

If there is only one main employer of labour, then they have market power in
setting wages and choosing how many workers to employ.
Examples of monopsony in labour markets

 Coal mine owner in town where coal mining is the primary source of
employment.
 The government in the employment of civil servants, nurses, police and
army officers.
Diagram of monopsony

 In a competitive labour market, the equilibrium will be where D=S at Q1,

W1.
 However, a monopsony can pay lower wages (W2) and employ fewer
workers (Q2)
Profit Maximisation for a Monopsony
 The marginal cost of employing one more worker will be higher than the
average cost – because to employ one extra worker the firm has to
increase the wages of all workers.
  To maximise the level of profit, the firm employs Q2 of workers where the
marginal cost of labour equals the marginal revenue product MRP = D
 In a competitive labour market, the firm would be a wage taker. If they tried
to pay only W2, workers would go to other firms willing to pay a higher
wage.
Minimum wage in a monopsony

In a monopsony, a minimum wage can increase wages without causing

unemployment.

 A monopsony pays a wage of W2 and employs Q2.

 If a minimum wage was placed equal to W1, it would increase employment
to Q1.
 A minimum wage of W3 would keep employment at Q2.
Monopsony in the real world
Even if a firm is not a pure monopsony, it may have a degree of monopsony
power, due to geographical and occupational immobilities, which make it difficult
for workers to switch jobs and find alternative employment.

For example, there are several employers who might employ supermarket
checkout workers. However, in practice, it is difficult for workers to switch jobs to
take advantage of slightly higher wages in other supermarkets. There is a lack of
information and barriers to moving jobs. Therefore, although there are several
buyers of labour, in practice the big supermarkets have a degree of monopsony
power in employing workers.

Monopsony and the gig economy

The gig economy refers to recent trends towards self-employment and very
flexible labour practises. In practice, workers in the gig economy can easily face
a monopsony employer. For example, Uber drivers have little control over rates
of pay and have to meet strict criteria from Uber. In theory, they could work
elsewhere but in practise it is difficult to replicate that job.

Problems of monopsony in labour markets

 Monopsony can lead to lower wages for workers. This increases inequality
in society.
 Workers are paid less than their marginal revenue product.
 Firms with monopsony power often have a degree of monopoly selling
power. This enables them to make high profits at the expense of
consumers and workers.
 Firms with monopsony power may also care less about working conditions
because workers don’t have many alternatives to the main firm.
Monopsony in product markets

In several industries, there is one buyer and several sellers.

 Supermarkets have monopsony power in buying food from farmers. If

farmers don’t sell to the big supermarkets, there are few alternatives. This
has led to farmer protests about the price of milk.
 Amazon.com is one of the biggest purchases of books. If publishers don’t
sell to Amazon at a discounted price, they will miss out on selling to the
biggest distributor of books.
Monopolistic Competition –
definition, diagram and examples
27 February 2019 by Tejvan Pettinger

Definition: Monopolistic competition is a market structure which combines elements of

monopoly and competitive markets. Essentially a monopolistic competitive market is one with
freedom of entry and exit, but firms can differentiate their products. Therefore, they have an
inelastic demand curve and so they can set prices. However, because there is freedom of entry,
supernormal profits will encourage more firms to enter the market leading to normal profits in
the long term.
A monopolistic competitive industry has the following features:

 Many firms.
 Freedom of entry and exit.
 Firms produce differentiated products.
 Firms have price inelastic demand; they are price makers because the good is highly
differentiated
 Firms make normal profits in the long run but could make supernormal profits in the short term
 Firms are allocatively and productively inefficient.
Diagram monopolistic competition short run

In the
short run, the diagram for monopolistic competition is the same as for a monopoly.
The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading to
supernormal profit
Monopolistic competition long run

De
mand curve shifts to the left due to new firms entering the market.
In the long-run, supernormal profit encourages new firms to enter. This reduces demand for
existing firms and leads to normal profit. I

Efficiency of firms in monopolistic competition

 Allocative inefficient. The above diagrams show a price set above marginal cost
 Productive inefficiency. The above diagram shows a firm not producing on the lowest point of
AC curve
 Dynamic efficiency. This is possible as firms have profit to invest in research and development.
 X-efficiency. This is possible as the firm does face competitive pressures to cut cost and provide
better products.
Examples of monopolistic competition
 Restaurants – restaurants compete on quality of food as much as price. Product differentiation
is a key element of the business. There are relatively low barriers to entry in setting up a new
restaurant.
  Hairdressers. A service which will give firms a reputation for the quality of their hair-cutting.
 Clothing. Designer label clothes are about the brand and product differentiation
 TV programmes – globalisation has increased the diversity of tv programmes from networks
around the world. Consumers can choose between domestic channels but also imports from
other countries and new services, such as Netflix.
Limitations of the model of monopolistic competition

 Some firms will be better at brand differentiation and therefore, in the real world, they will be
able to make supernormal profit.
 New firms will not be seen as a close substitute.
 There is considerable overlap with oligopoly – except the model of monopolistic competition
assumes no barriers to entry. In the real world, there are likely to be at least some barriers to
entry
 If a firm has strong brand loyalty and product differentiation – this itself becomes a barrier to
entry. A new firm can’t easily capture the brand loyalty.
 Many industries, we may describe as monopolistically competitive are very profitable, so the
assumption of normal profits is too simplistic.
Key difference with monopoly
In monopolistic competition there are no barriers to entry. Therefore in long run, the market will
be competitive, with firms making normal profit.

Key difference with perfect competition

In Monopolistic competition, firms do produce differentiated products, therefore, they are not
price takers (perfectly elastic demand). They have inelastic demand.

New trade theory and monopolistic competition

New trade theory places importance on the model of monopolistic competition for explaining
trends in trade patterns. New trade theory suggests that a key element of product development is
the drive for product differentiation – creating strong brands and new features for products.
Therefore, specialisation doesn’t need to be based on traditional theories of comparative
advantage, but we can have countries both importing and exporting the same good. For example,
we import Italian fashion labels and export British fashion labels. To consumers, the importance
is the choice of goods.

Readers Question: if all firms in a monopolistic competitive industry were to merge would that
firm produce as many different brands or just one brand?
Interesting question. I think it is an open-ended question with many different possibilities. One
approach is to think how firms in different industries may behave if they did merge. Bearing in
mind the model of monopolistic competition doesn’t always stand up to scrutiny too well in the
real world.

If the firms merged together, there is no certainty how they would behave.

In some industries, it makes sense to have many differentiated brands creating an illusion of
competition and providing a barrier to entry.

How many soap powders are there? About 35. But, most of these brands are owned by two
companies, Unilever and Proctor and Gamble. Having brand proliferation means it is harder for a
new firm to enter the market. This is because a new firm would have to compete against 30
established brands as opposed to 2. There is less chance of getting a good market share with so
many brands. Therefore the new firm would have an incentive to keep different brands to deter
competitors.

However, if you have merge different brands there may be economies of scale. You can devote
more resources and investment to improving that particular product and maximising its
efficiency. This might be appropriate for an industry like computer software or computers. There
used to be many different brands of computers until the pc came to dominate.

Are the different brands catering to different sectors of the market. If you take the restaurant
business, there is a big difference between Chinese and Indian. If 2 restaurants merge, they
would be better off retaining distinct business. It would make no sense to have a restaurant which
offered a mixture of Chinese/Indian – consumers would trust it less.

If you fear the arrival of a powerful company, it might be good to consolidate your brands. For
example, there are many small search engines, but they would be better off combining forces to
compete against the mighty Google.

Related
 Oligopoly
 Monopoly
 UK Mergers
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Oligopoly
28 August 2019 by Tejvan Pettinger

Definition of oligopoly
An oligopoly is an industry dominated by a few large firms. For example, an
industry with a five-firm concentration ratio of greater than 50% is considered a
monopoly.

Examples of oligopolies

Car industry – economies of scale have cause mergers so big multinationals

dominate the market. The biggest car firms include Toyota, Hyundai, Ford,
General Motors, VW.

 Petrol retail – see below.

 Pharmaceutical industry
 Coffee shop retail – Starbucks, Costa Coffee, Cafe Nero
 Newspapers – In UK market share dominated by tabloids Daily Mail, The
Sun, The Mirror, The Star, Daily Express.
  Book retail – In UK market share is dominated by Waterstones, Amazon
and smaller firms like Blackwells.
The main features of oligopoly

 An industry which is dominated by a few firms.

The UK definition of an oligopoly is a five-firm concentration ratio of more than

50% (this means the five biggest firms have more than 50% of the total market
share) The above industry (UK petrol) is an example of an oligopoly. See
also: Concentration ratios
 Interdependence of firms – companies will be affected by how other
firms set price and output.
 Barriers to entry. In an oligopoly, there must be some barriers to entry to
enable firms to gain a significant market share. These barriers to entry may
include brand loyalty or economies of scale. However, barriers to entry
are less than monopoly.
 Differentiated products. In an oligopoly, firms often compete on non-price
competition. This makes advertising and the quality of the product are
often important.
 Oligopoly is the most common market structure
How firms compete in oligopoly

There are different possible ways that firms in oligopoly will compete and behave
this will depend upon:

 The objectives of the firms; e.g. profit maximisation or sales maximisation?

 The degree of contestability; i.e. barriers to entry.
 Government regulation.
There are different possible outcomes for oligopoly:

1. Stable prices (e.g. through kinked demand curve) – firms concentrate on

non-price competition.
2. Price wars (competitive oligopoly)
3. Collusion- leading to higher prices.
The kinked demand curve model

This model suggests that prices will be fairly stable and there is little incentive for
firms to change prices. Therefore, firms compete using non-price competition
methods.
  This assumes that firms seek to maximise profits.
 If they increase the price, then they will lose a large share of the market
because they become uncompetitive compared to other firms. Therefore
demand is elastic for price increases.
 If firms cut price then they would gain a big increase in market share.
However, it is unlikely that firms will allow this. Therefore other firms follow
suit and cut-price as well. Therefore demand will only increase by a small
amount. Therefore demand is inelastic for a price cut.
 Therefore this suggests that prices will be rigid in oligopoly
The diagram above suggests that a change in marginal cost still leads to the
same price, because of the kinked demand curve.  Profit maximisation occurs
where MR = MC at Q1.

Evaluation of kinked demand curve

 In the real world, prices do change.
 Firms may not seek to maximise profits,  but prefer to increase market
share and so be willing to cut prices, even with inelastic demand.
 Some firms may have very strong brand loyalty and be able to increase the
price without demand being very price elastic.
  The model doesn’t suggest how prices were arrived at in the first place.
Price wars

Firms in oligopoly may still be very competitive on price, especially if they are
seeking to increase market share. In some circumstances, we can see
oligopolies where firms are seeking to cut prices and increase competitiveness.

A feature of many oligopolies is selective price wars. For example, supermarkets

often compete on the price of some goods (bread/special offers) but set high
prices for other goods, such as luxury cake.

Collusion

 Another possibility for firms in oligopoly is for them to collude on price and
set profit maximising levels of output. This maximises profit for the
industry.

In the above example, the industry was initially competitive (Qc and Pc).
However, if firms collude, they can agree to restrict industry supply to Q2, and
increase the price to P2. This enables the industry to become more profitable. At
Qc, firms made normal profit. But, if they can stick to their quotas and keep the
price at P2, they make supernormal profit.

 Collusion is illegal, but tacit collusion may be hard to spot.

 For collusion to be effective, there need to be barriers to entry.
 A cartel is a formal collusive agreement. For example, OPEC is a cartel
seeking to control the price of oil.
See: Collusion
Collusion and game theory

Game theory is looking at the decisions of firms based on the uncertainty of how
other firms will react. It illustrates the concept of interdependence. For example, if
a firm agrees to collude and set low output – it relies on the other firm sticking to
the collusive agreement. If the firm restricts output (sets the High price), and then
the other firm betrays its agreement (setting low price). The firm will be worse off.

This shows different options. If the market is non-collusive, firms make £3m
each. If they collude, they make £8m. But, there is an incentive for firms to
exceed quota and increase output.

Collusion and game theory is more complex if we add in the possibility of firms
being fined by a government regulator.

Collusion is illegal and firms can be fined. Usually, the first firm who confesses to
the regulator is protected from prosecution, so there is always an incentive to be
the first to confess.
Oligopoly Diagram
28 November 2019 by Tejvan Pettinger

There are different diagrams that you can use to explain 0ligopoly markets.

It is important to bear in mind, there are different possible ways that firms in
Oligopoly can behave.

1. Kinked Demand Curve Diagram

In the kinked demand curve model, the firm maximises profits at Q1, P1 where
MR=MC. Thus a change in MC, may not change the market price. It suggests
prices will be quite stable.

The kinked demand curve makes certain assumptions

 Firms are profit maximisers.

 If one firm increases the price, other firms won’t follow suit. Therefore, for a
price increase, demand is price elastic.
 If one firm cuts price, other firms will follow suit because they don’t want to
lose market share. Therefore, for a price cut, demand is price inelastic.
 This is how we get the ‘kinked demand curve
However, the kinked demand curve has limitations
  It doesn’t explain how the price was arrived at in the first place.
 Firms may engage in price competition.
Collusive Oligopoly
If firms in oligopoly collude and form a cartel, then they will try and fix the price at
the level which maximises profits for the industry. They will then set quotas to
keep output at the profit maximising level.

The price and output in oligopoly will reflect the price and output of a monopoly.
The Quantity Qm will be split between the firms in the cartel.
Economies of scale for Oligopolies

Oligopolies may benefit from economies of scale. This enables lower average
costs with increased output. FIrms in oligopoly producing at Q1 achieve lower
prices of AC1.

Efficiency of firms in oligopoly

 Larger firms can benefit from economies of scale – lower average costs –
which might outweigh other inefficiencies.
 Allocative efficiency? Not clear but firms operating under kinked demand
curve may end up setting price higher than marginal cost. Also, firms able
to successfully collude will set prices higher than MC. If oligopolies are
competitive then prices will be lower and more allocative efficient.
 Dynamic efficiency? Firms in an oligopoly have profits they can use for
investment in new products. Also, competitive pressures encourage them
to innovate.
Pricing strategies
2 September 2018 by Tejvan Pettinger

A look at different pricing strategies a firm may use to try and increase
profitability, market share and gain greater brand loyalty.

Types of pricing strategies

General strategies
1. Profit maximisation. One strategy is to ignore market share and try to work
out the price for profit maximisation. In theory, this occurs at a price where
MR=MC. In practice, it can be difficult to work this out precisely.
2. Sales maximisation. Aiming to maximise sales whilst making normal profit.
This involves selling at a price equal to average cost.
3. Gaining Market Share. Some firms may have a target to increase market
share, this could involve setting prices as low as they can afford, leading to
a price war. A similar concept to sales maximisation.
See: Objectives of firms
Pricing strategies to attract customers / increase profit
 Premium pricing. This occurs when a firm makes a good more expensive
to try and give the impression that it is better quality, e.g. ‘premium
unleaded fuel’, fashion labels.
 Loss Leaders This involves setting a low price on some products to entice
customers into the shop where hopefully they will also buy other goods as
well. However, it is illegal to sell goods below cost, so firms could be
investigated by OFT.
 Price Discrimination. This involves charging a different price to different
groups of consumers to take advantage of different elasticities of demand.
There are different types of price discrimination from first degree to third
degree.
 Reference Pricing. This involves setting an artificially high price to be able
to later offer discounts on previously advertised price.
 Price Matching. The purpose behind price matching is making a promise
to match any price cuts by your competitors. The argument is that this
discourages your competitors from cutting price. This is because they
know there is little point in cutting prices because you will respond straight
away. Very clear price matching stances can thus avoid price wars and
give the impression of being very competitive. For example, Tesco is
offering £10 voucher to customers who can prove their shopping basket
would have been cheaper at other supermarkets.
 Retail price mechanism RPM – when manufacturers set minimum prices
for retailers, e.g. net book agreement.
 Psychological pricing. Setting price at important psychological levels to
trigger purchase, e.g. selling good at £9.99 to make it appear cheaper.
Some firms use reverse psychology and charge exact prices, e.g. clothes
for £40 to indicate quality rather than cheapness.
 Premium decoy pricing. Where a firm sets the price of one good
deliberately high to encourage demand for a lower price. e.g. a car
company may bring out a top of the range sports car, which is very
expensive to make the general brand more attractive.
 Pay what you want. A situation where consumers are left free to decide
how much to pay, e.g. restaurants cafe where there is no cost – only
tipping. When music companies release a new recording and ask for
donations.
 Bundle pricing. When a firm gives special offers, e.g. buy 3 for the price
of 2 – very common for book sales e.t.c.
 Price skimming. When a firm releases a new product, it initially sets a
high price to take advantage of those consumers with inelastic demand.
 Over time, the price is reduced to attract those customers with more price
elastic demand.
 Penetration pricing. When a firm sets a low price to help establish market
share and get established. For example, a new printing company may offer
very low price for its printers to get established. Then it gets to make profits
on selling ink and over time increase the price. Or satellite tv company
offering introductory offer for a few months.
 Optional pricing. When a firm tries to receive a higher price by selling
extras. For example, if you buy a DVD, you can get sold insurance or
additional features.
 Dynamic pricing. When prices are regularly updated in response to
shifting market conditions. For example, if an airline receives high demand
for certain flights, it will increase the price to help fill up other departure
times and maximise revenue from the flight.
Pricing strategies to cement market share/market position
 Limit pricing. This occurs when a monopoly set price lower than profit
maximisation to discourage entry. This enables the firm to make
supernormal profit, but the price is still low enough to deter new firms to
enter the market.
 Predatory pricing. Selling price below cost to try and force rival out of
business. Predatory pricing is illegal. Predatory pricing can be made easier
through cross Subsidisation. This occurs when a big multinational may use
profits in one area to subsidise a price war in another. The cross
subsidisation enables a firm to sell a product very competitively (or even at
a loss) to try and force the rival firms out of business.
Pricing strategies to help determine the price
 Average cost pricing. When a firm sets the price equal to average cost plus
a certain profit margin.
 Market-based pricing. When firms set a price depending on supply and
demand. For example, if football clubs, used market-based pricing, clubs
like Manchester United would probably increase the ticket price – because,
at the moment, all tickets are sold out – suggesting price is below the
equilibrium.
 Markup pricing. This involves setting a price equal to marginal cost of
production + x. (where x = the profit margin a firm wants to make on each
sale)
 Profit maximisation. Setting price and quantity so MR=MC
Importance of Elasticity

If demand for your products is highly elastic, cutting prices should lead to an
increase in revenue. Increasing prices will lead to a fall in revenue.If demand is
price inelastic, then you can increase your profits by increasing your price.

This is the logic behind price discrimination. Firms charge a higher price to that
market segment where demand is more price inelastic, but a lower price to where
demand is more price elastic.
What will determine the most effective pricing strategy?

The optimal pricing strategy will depend on the type of firm. For example, if you
are considered to having a premium brand – cutting price could be perceived as
disastrous as you lose your brand image, and fail to increase sales. For these
products, it might be better to maintain premium pricing and optional pricing. For
normal goods, with firms looking to increase market share and gain more market
dominance, it is more important to offer competitive prices, through strategies
such as penetration pricing and even loss leaders.

Related

Perfect competition
28 May 2019 by Tejvan Pettinger

Perfect competition is a market structure where many firms offer a homogeneous

product. Because there is freedom of entry and exit and perfect information, firms
will make normal profits and prices will be kept low by competitive pressures.

Features of perfect competition

1. Many firms.
2. Freedom of entry and exit; this will require low sunk costs.
3. All firms produce an identical or homogeneous product.
4. All firms are price takers, therefore the firm’s demand curve is perfectly
elastic.
5. There is perfect information and knowledge.
Diagram for perfect competition

 The industry price is determined by the interaction of Supply and Demand,

leading to a price of Pe.
 The individual firm will maximise output where MR = MC at Q1
 In the long run firms will make normal profits.
What happens if supernormal profits are made?
If supernormal profits are made new firms will be attracted into the industry
causing prices to fall. If firms are making a loss then firms will leave the industry
causing price to rise

The features of perfect competition are very rare in the real world. However
perfect competition is as important economic model to compare other models. It
is often argued that competitive markets have many benefits which stem from
this theoretical model.

Changes in long run equilibrium

1. The effect of an increase in demand for the industry.

If there is an increase in demand there will be an increase in price Therefore the
demand curve and hence AR will shift upwards. This will cause firms to make
supernormal profits.

This will attract new firms into the market causing price to fall back to the
equilibrium of Pe

2. An increase in firms costs

 The AC curve will increase therefore AR< AC
 Firms will now start making a loss and therefore firms will go out of
business. This will cause supply to fall causing prices to increase.
Efficiency of perfect competition

 Firms will be allocatively efficient P=MC

 Firms will be productively efficient. Lowest point on AC curve.
 Firms have to remain efficient otherwise they will go out of business. (X-
efficiency)
 Firms are unlikely to be dynamically efficient because they have no profits
to invest in research and development.
 If there are high fixed costs, firms will not benefit from efficiencies of scale.
 see more: efficiency of perfect competition
Examples of perfect competition
In the real world, it is hard to find examples of industries which fit all the criteria of
‘perfect knowledge’ and ‘perfect information’. However, some industries are
close.

1. Foreign exchange markets. Here currency is all homogeneous. Also,

traders will have access to many different buyers and sellers. There will be
good information about relative prices. When buying currency it is easy to
compare prices
2. Agricultural markets. In some cases, there are several farmers selling
identical products to the market, and many buyers. At the market, it is easy
to compare prices. Therefore, agricultural markets often get close to
perfect competition.
3. Internet related industries. The internet has made many markets closer
to perfect competition because the internet has made it very easy to
compare prices, quickly and efficiently (perfect information). Also, the
internet has made barriers to entry lower. For example, selling a popular
good on the internet through a service like e-bay is close to perfect
competition. It is easy to compare the prices of books and buy from the
cheapest. The internet has enabled the price of many books to fall in price
so that firms selling books on the internet are only making normal profits.

Types of market structure

28 November 2019 by Tejvan Pettinger
1. Perfect competition – Many firms, freedom of entry, homogeneous product,
normal profit.
2. Monopoly – One firm dominates the market, barriers to entry, possibly
supernormal profit.
1. Monopoly diagram
3. Oligopoly – An industry dominated by a few firms, e.g. 5 firm concentration
ratio of > 50%. Interdependence of firms
1. Oligopoly diagram
2. Collusive behaviour – firms seek to form an agreement to increase
prices.
3. Kinked demand curve model – when prices are stable and firms
compete on non-price competition.
4. Monopolistic competition – Freedom of entry and exit, but firms have
differentiated products. Likelihood of normal profits in the long term.
5. Contestable markets – An industry with freedom of entry and exit, low sunk
costs. The theory of contestability suggests the number of firms is not so
important, but the threat of competition.
6. Duopoly – where two firms dominate the market. For example, Pepsi and
Coca Cola. Android vs Apple. A duopoly falls between a monopoly and
oligopoly.
Related pages

Price Discrimination
28 July 2019 by Tejvan Pettinger

Definition – Price discrimination involves charging a different price to different

groups of people for the same good. For example – student discounts, off peak
fares cheaper than peak fares.

Cut-price fuel
on Tuesdays and Thursdays is a form of price discrimination.

Different Types of Price Discrimination

1. First Degree Price Discrimination
This involves charging consumers the maximum price that they are willing to pay.
There will be no consumer surplus.

2. Second Degree Price Discrimination

This involves charging different prices depending upon the choices of consumer.
For example quantity, time period, collecting coupons
  After 10 minutes phone calls become cheaper.
 Electricity is more expensive for the first number of units. For a higher
quantity of electricity consumed the marginal cost is lower.
 Loyalty cards reward frequent buyers with discounts on future products.
 If you collect coupons from a newspaper you can get a discount.
2nd-degree price discrimination is sometimes known as ‘indirect price
discrimination’ because the firm allows consumers to choose which price they will
pay. Some choices are offered cheaper because they impose costs on
consumers (e.g. collecting coupons, buying in bulk or unsocial hours.

3. Third Degree Price Discrimination – ‘Group price discrimination’

This involves charging different prices to different groups of people. For example:

 Student discounts,
 Senior citizen railcard
 Peak travel/ off-peak travel
 Cheaper prices by the time of the day (e.g. happy hour’s in pubs – usually
earlier on in evening where demand is lower.
More on third-degree price discrimination
3rd degree price-discrimination is sometimes known as direct price
discrimination. Because a firm directly sets different prices depending on distinct
groups of consumers (e.g. age)
Product versioning
One way firms practise price discrimination is to offer slightly different products
as a way to discriminate between consumers ability to pay. For example:

 Priority boarding tickets. Same flight but for a premium, you get a shorter
queue.
 Organic coffee / fair trade coffee
 Extra legroom on aeroplanes
 First-class/second class
This is a form of indirect segmentation. By offering slightly different choices, the
firm is able to separate consumers who are willing to pay higher prices.

Conditions necessary for price discrimination

1. Firm is a price maker. The firm must operate in imperfect competition; it

must be a price maker with a downwardly sloping demand curve.
2. Separate markets. The firm must be able to separate markets and
prevent resale. E.g. stopping an adults using a child’s ticket. Prevent
business travellers from buying discount tickets.
 3. Different elasticities of demand. Different consumer groups must have
elasticities of demand. E.g. students with low income will be more price
elastic and sensitive to price. Business travellers will have more inelastic
demand.
4. Low admin costs. It must be relatively cheap to separate markets and
implement price discrimination.
Simple diagram for Price Discrimination

Without price
discrimination, the firm charges one price £7 * 100 = £700 revenue
WIth price discrimination, the firm can charge two different prices:

 £10 * 35 = £350
 £4 * 120 = £480
Total revenue = £830. Therefore, the firm makes more revenue under price
discrimination.
Profit maximisation under Price Discrimination

To maximise profits a firm sets output and price where MR=MC. If there are two
sub markets with different elasticities of demand. The firm will increase profits by
setting different prices depending upon the slope of the demand curve.

 Therefore for a group, such as adults, PED is inelastic – the price will be
higher
 For groups like students, prices will be lower because their demand is
elastic
Diagram of Price Discrimination
Profit is maximised where MR=MC. WIthout price discrimination, there would just
be one price set for the whole market (A+B). There would be a price of P3.

 However, price discrimination allows the firm to set different prices for
segment A (inelastic demand) and segment B (elastic demand)
 Because demand is price inelastic, segment (A) will have a higher profit
maximising price (P1)
 In segment (B) demand is price elastic, so the profit maximising price is
lower.
Advantages of price discrimination

1. Firms will be able to increase revenue. Price discrimination will enable

some firms to stay in business who otherwise would have made a loss. For
example price discrimination is important for train companies who offer
different prices for peak and off-peak. Without price discrimination, they
may go out of business or be unable to provide off-peak services.
2. Increased investment. These increased revenues can be used for
research and development which benefit consumers
3. Lower prices for some. Some consumers will benefit from lower fares.
For example, old people benefit from lower train companies; old people are
more likely to be poor. Also, customers willing to spend time in researching
‘special offers’ and travelling at awkward times will be rewarded with lower
prices.
4. Manages demand. Airlines can use price discrimination to encourage
people to travel at unpopular times (early in the morning) This helps avoid
over-crowding and helps to spread out demand.
Disadvantages of Price Discrimination

1. Higher prices for some. Under price discrimination, some consumers will
end up paying higher prices (e.g. people who have to travel at busy times).
These higher prices are likely to be allocatively inefficient because P > MC.
2. Decline in consumer surplus. Price discrimination enables a transfer of
money from consumers to firms – contributing to increased inequality.
3. Potentially unfair. Those who pay higher prices may not be the poorest.
For example, adults paying full price could be unemployed, senior citizens
can be very well off.
4. Administration costs. There will be administration costs in separating the
markets, which could lead to higher prices.
5. Predatory pricing. Profits from price discrimination could be used to
finance predatory pricing.
Importance of marginal cost in price discrimination

In markets where the marginal cost of an extra passenger is very low, the firm
has an incentive to use price discrimination to sell all the tickets. This is why
sometimes prices for airlines can be very low just before their date. Once the
company is due to fly the MC of an extra passenger will be very low. Therefore
this justifies selling the remaining tickets at a low price.
Examples of price discrimination

1. Student discounts on trains

2. Discounts for buying train tickets in advance
3. Discounts for travelling at off-peak time
4. Lower unit cost price for buying high quantity.
5. Phone deals which give 100 texts free.
6. Initially, units of electricity are set at one tariff, but for higher quantity, price
is lower.
Does price discrimination help the consumer?

Benefits and disadvantages of price discrimination

Benefits of Price Discrimination
28 February 2019 by Tejvan Pettinger

Readers Question: Can price discrimination be of benefit to consumers?

Price Discrimination involves charging a different price to different groups of
consumers for the same good. Price discrimination can provide benefits to
consumers, such as potentially lower prices, rewards for choosing less popular
services and helps the firm stay profitable and in business. The advantages of
price discrimination will be appreciated more by some groups of consumers.
Benefits of Price Discrimination

In
the above diagram, there is no single price which enables the firm to make
normal profit and stay in business. They would need price discrimination to
increase profits.
1. Allows an unprofitable business to avoid going bankrupt. In some
cases, it may be possible that there is no one price that would enable a
firm to make normal profits. (i.e. average costs would always be higher
than demand curve) However, price discrimination may enable the firm to
turn a loss into a small profit. This means that a business activity can keep
going, rather than closing down. This is obviously beneficial for consumers
because it increases their choice of goods and services. An example might
be train services. Without price discrimination (off-peak, peak) train
companies would make a bigger loss and may be discontinued.
2. Some groups benefit from cheaper prices. Price discrimination means
that firms have an incentive to cut prices for groups of consumers who are
sensitive to prices (elastic demand). For example, firms often offer a 10%
 reduction to students. Students typically have lower income so their
demand is more elastic. This means they benefit from lower prices. These
groups are often poorer than the average consumer. The downside is that
some consumers will face higher prices.
3. Avoid Congestion. Price discrimination is one way to manage demand. If
there were no price discrimination rush hour trains would be more
overcrowded. Price discrimination gives an incentive for some people to go
later in the day. This means that those who have to travel at rush hour
benefit from less congestion.
4. Low-income consumers may be able to benefit from cheaper prices.
One form of indirect price discrimination is to offer lower prices to
consumers who collect coupons. This imposes a cost on consumers (time
to collect). So if consumers are time-rich and money poor, they can take
advantage of lower prices.
5. Investment. Price discrimination helps a firm to become more profitable.
This may enable the firm to invest in increased capacity. For example, an
airline which maximises profits from price discrimination can invest in
updating its aircraft to the latest technology.

Related
Advantages and problems of
privatisation
12 May 2019 by Tejvan Pettinger

A look at the arguments for and against privatisation.

Privatisation involves selling state-owned assets to the private sector. It is argued

the private sector tends to run a business more efficiently because of the profit
motive. However, critics argue private firms can exploit their monopoly power and
ignore wider social costs. Privatisation is often achieved through listing the new
private company on the stock market. In the 1980s and 1990s, the UK privatised
many previously state-owned industries such as BP, BT, British Airways,
electricity companies, gas companies and rail network.

Arguments for and against privatisation

Potential benefits of privatisation

1. Improved efficiency
The main argument for privatisation is that private companies have a profit
incentive to cut costs and be more efficient. If you work for a government run
industry managers do not usually share in any profits. However, a private firm is
interested in making a profit, and so it is more likely to cut costs and be efficient.
Since privatisation, companies such as BT, and British Airways have shown
degrees of improved efficiency and higher profitability.

2. Lack of political interference

It is argued governments make poor economic managers. They are motivated by
political pressures rather than sound economic and business sense. For
example, a state enterprise may employ surplus workers which is inefficient. The
government may be reluctant to get rid of the workers because of the negative
publicity involved in job losses. Therefore, state-owned enterprises often employ
too many workers increasing inefficiency.

3. Short term view

A government many think only in terms of the next election. Therefore, they may
be unwilling to invest in infrastructure improvements which will benefit the firm in
the long term because they are more concerned about projects that give a
benefit before the election. It is easier to cut public sector investment than
frontline services like healthcare.

4. Shareholders
It is argued that a private firm has pressure from shareholders to perform
efficiently. If the firm is inefficient then the firm could be subject to a takeover. A
state-owned firm doesn’t have this pressure and so it is easier for them to be
inefficient.

5. Increased competition
Often privatisation of state-owned monopolies occurs alongside deregulation –
i.e. policies to allow more firms to enter the industry and increase the
competitiveness of the market. It is this increase in competition that can be the
greatest spur to improvements in efficiency. For example, there is now more
competition in telecoms and distribution of gas and electricity.

 However, privatisation doesn’t necessarily increase competition; it

depends on the nature of the market. E.g. there is no competition in tap
water because it is a natural monopoly. There is also very little competition
within the rail industry.
6. Government will raise revenue from the sale
Selling state-owned assets to the private sector raised significant sums for the
UK government in the 1980s. However, this is a one-off benefit. It also means we
lose out on future dividends from the profits of public companies.

Disadvantages of privatisation

1. Natural monopoly

A natural monopoly occurs when the most efficient number of firms in an industry
is one. For example, tap water has very significant fixed costs. Therefore there is
no scope for having competition amongst several firms. Therefore, in this case,
privatisation would just create a private monopoly which might seek to set higher
prices which exploit consumers. Therefore it is better to have a public monopoly
rather than a private monopoly which can exploit the consumer.
2. Public interest
There are many industries which perform an important public service, e.g., health
care, education and public transport. In these industries, the profit motive
shouldn’t be the primary objective of firms and the industry. For example, in the
case of health care, it is feared privatising health care would mean a greater
priority is given to profit rather than patient care. Also, in an industry like health
care, arguably we don’t need a profit motive to improve standards. When doctors
treat patients, they are unlikely to try harder if they get a bonus.

3. Government loses out on potential dividends.

Many of the privatised companies in the UK are quite profitable. This means the
government misses out on their dividends, instead going to wealthy
shareholders.

4. Problem of regulating private monopolies.

Privatisation creates private monopolies, such as the water companies and rail
companies. These need regulating to prevent abuse of monopoly power.
Therefore, there is still need for government regulation, similar to under state
ownership.

5. Fragmentation of industries
In the UK, rail privatisation led to breaking up the rail network into infrastructure
and train operating companies. This led to areas where it was unclear who had
responsibility. For example, the Hatfield rail crash was blamed on no one taking
responsibility for safety. Different rail companies has increased the complexity of
rail tickets.

6. Short-termism of firms
As well as the government being motivated by short term pressures, this is
something private firms may do as well. To please shareholders they may seek
to increase short term profits and avoid investing in long term projects. For
example, the UK is suffering from a lack of investment in new energy sources;
the privatised companies are trying to make use of existing plants rather than
invest in new ones.

Evaluation of privatisation

 It depends on the industry in question. An industry like telecoms is a typical

industry where the incentive of profit can help increase efficiency.
However, if you apply it to industries like health care or public transport the
profit motive is less important.
 It depends on the quality of regulation. Do regulators make the privatised
firms meet certain standards of service and keep prices low?
 Is the market contestable and competitive? Creating a private monopoly
may harm consumer interests, but if the market is highly competitive, there
is greater scope for efficiency savings.
 Can you create incentives in a nationalised firm? For example,
performance related pay could replace the profit incentive.
A fixed exchange rate is when a country ties the value of its currency to some
other widely-used commodity or currency. The dollar is used for most
transactions in international trade. Today, most fixed exchange rates are pegged
to the U.S. dollar. Countries also fix their currencies to that of their most frequent
trading partners.

Brief History and Definition

In the past, currencies were fixed to an ounce of gold. In the 1944 Bretton Woods
Agreement, countries agreed to peg all currencies to the U.S. dollar. The United
States agreed to redeem all dollars for gold. In 1971, President Nixon took the
dollar off of the gold standard to end the recession. Nixon's action ended the 100-
year history of the gold standard. Still, many countries kept their
currencies pegged to the dollar, because the dollar is the world's reserve
currency.

A fixed exchange rate tells you that you can always exchange your money in one
currency for the same amount of another currency. It allows you to determine
how much of one currency you can trade for another. For example, if you go to
Saudi Arabia, you always know a dollar will buy you 3.75 Saudi riyals,
since the dollar's exchange rate in riyals is fixed. Saudi Arabia did that because
its primary export, oil, is priced in U.S. dollars. All oil contracts and most
commodities contracts around the world are written and executed in dollars.

Advantages
A fixed exchange rate provides currency stability. Investors always know what
the currency is worth. That makes the country's businesses attractive to foreign
direct investors. They don't have to protect themselves from wild swings in the
currency's value. They are hedging their currency risk.

A country can avoid inflation if it fixes its currency to a popular one like the U.S.
dollar or euro. It benefits from the strength of that country's economy. As the
United States or European Union grows, its currency does as well. Without that
fixed exchange rate, the smaller country's currency will slide. As a result, the
imports from the large economy become more expensive. That imports inflation,
as well as goods. 
For example, the U.S. dollar's value is 3.75 Saudi riyals. If the dollar strengthens
20% against the euro, the value of the riyal, which is fixed to the dollar, has also
risen 20% against the euro. To purchase French pastries, the Saudis pay less
than they did before the dollar strengthened. For this reason, the Saudis didn't
need to limit supply as oil prices fell to $50 a barrel in 2014. The value of
money is what it purchases for you. If most of your country's imports are to a
single country, then a fixed exchange rate in that currency will stabilize prices.

One country that is loosening its fixed exchange rate is China. It ties the value of
its currency, the yuan, to a basket of currencies that includes the dollar. In
August 2015, it allowed the fixed rate to vary according to the prior day's closing
rate. It keeps the yuan in a tight 2% trading range around that value. 

China has to manually adjust the exchange rate of the yuan to the dollar. This is
advantageous to China, but not for the U.S. That's why the U.S. government has
pressured the Chinese government to let the yuan rise in value. That action
would effectively make U.S. exports cheaper in China, while
Chinese exports would be more expensive in the U.S. In other words, it's an
attempt by the U.S. to lower its trade deficit with China.

Disadvantages
A fixed exchange rate can be expensive to maintain. A country must have
enough foreign exchange reserves to manage its currency's value. 

A fixed exchange rate can make a country's currency a target for speculators.
They can short the currency, artificially driving its value down. That forces the
country's central bank to convert its foreign exchange, so it can prop up its
currency's value. If it doesn't have enough foreign currency on hand, it will have
to raise interest rates. That will cause a recession.

That happened to the British pound in 1992. The pound was pegged to

Germany's mark, but Britain had higher inflation than Germany, and the already-
high interest rates in the UK left its central bank with little wiggle room to adjust
for inflation differences. George Soros kept shorting the pound until the U.K.
central bank gave in and allowed the pound to float. In 2015, it happened when
Switzerland had to release the Swiss franc from its fix to the euro, which had
plummeted in value.

Examples
There are several ways countries maintain a fixed exchange rate. The purest
form is when its currency is pegged to a set value against a single currency.
Alternatively, many countries fix a set value to a basket of currencies, instead of
just one currency. Other countries peg it to either a single currency or to a basket
of currencies, but then allow it to fluctuate within a range of the pegged currency.
Here are examples of each type.

Currencies fixed at a set value to a single currency: These are the nations

that promise to always give the same amount in their currency for each unit of
currency to which it is fixed. The list is based on a report released in April 2019
by the International Monetary Fund.1

Country Currency Peg (on 11/19/19) Equals one:

Aruba Florin 1.79 U.S. dollar
Bahamas Dollar 1.00 U.S. dollar
Bahrain Dinar 0.38 U.S. dollar
Barbados Dollar 2.00 U.S. dollar
Bosnia and Herzegovina Mark 1.96 Euro
Bhutan Ngultrum 1.00 Indian rupee
Brunei Dollar 1.00 Singapore dollar
Bulgaria Lev 1.96 Euro
Comoros Franc 491.97 Euro
Curacao and Sint Maarten Ang 1.79 U.S. dollar
Denmark Krone 7.47 Euro
Dijibouti Franc 177.78 U.S. dollar
Eritrea Nakfa 15.00 U.S. dollar
Hong Kong Dollar 7.83 U.S. dollar
Iraq Dinar 1,192.11 U.S. dollar
Jordan Dinar 0.71 U.S. dollar
Lebanon Pound 1,507.50 U.S. dollar
Lesotho Loti 1.00 S.A. rand
Namibia Dollar 1.00 S.A. rand
Nepal Rupee 1.61 Indian rupee
Oman Rial 0.38 U.S. dollar
Country Currency Peg (on 11/19/19) Equals one:
Qatar Riyal 3.64 U.S. dollar
Sao Tome and Principe Dobra 24.56 Euro
Saudi Arabia Riyal 3.75 U.S. dollar
Turkmenistan New Manat 3.50 U.S. dollar
UAE Dirham 3.67 U.S. dollar

3.2 Freely floating exchange rates

Definitions:

 Exchange rate – value of a currency expressed in terms of another currency. (In other
words: price of the currency in terms of another currency).
 Floating exchange rates (system) – when the exchange rate of a currency is
determined by the supply and demand for that currency.
 Appreciation (of a currency) – occurs when a currency increases in value
against another currency, i.e. it can buy more of another currency.
 Depreciation (of a currency) – occurs when a currency loses value against another
currency, i.e. it can buy less of another currency.
Determination of Freely Floating Exchange Rates

The diagram above for floating exchange rates shows that the value of the US Dollar ($) is at e1
where Supply (S) = Demand (D) for USD. At that exchange rate (e1), the equilibrium quantity of
US Dollars is Q1. It is important to note that on the Y axis the value of $ is expressed in terms of
how many Euros you can buy with $1 (There are variations of this diagram, hence, always
consult your teacher about which one is the most appropriate). The higher the value of the US
Dollar, the more Euros you will be able to purchase with 1 USD. The lower the value of the USD
– the less Euros $1 will be able to buy.

For people doing the IB Higher Level Economics course, you need to know some maths
connected to floating exchange rates:

Say, you are given that 1 GBP = 1.25 EUR. You have to know how to express the value of 1 EUR
in terms of GBP. How? If 1 GBP = 1.25 EUR, then 1 EUR = 1/1.25 GBP –> 1 EUR = 0.80 GBP

Changes in Floating Exchange Rates

2 diagrams showing an appreciation in the floating exchange rates:
 Diagram 1

Diagram 2

2 diagrams showing a depreciation in the floating exchanges rates:

 Diagram 3

Diagram 4

For your IB Economics course you need to know the following factors affecting supply/ demand
of currencies and hence, their floating exchanges rates:

 Foreign demand for a country’s export:

o Foreign demand for a country’s export increases. To buy larger quantities of that
export foreigners must have more of that country’s currency. So, the demand for
the exporting country’s currency increases and hence, its currency appreciates.
(Diagram 1)
o If the demand for a country’s export decreases, the demand for that country’s
currency will fall and therefore, the currency will depreciate. (Diagram 3)
 Domestic demand for foreign imports:
o Demand for a foreign import increases. To buy more of that import people need
to get more of that country’s currency. To acquire that currency, they must sell
 their own currency. Supply of domestic currency increases and hence, it
depreciates. (Diagram 4)
o If the demand for a foreign import decreases, the domestic currency will
appreciate because less of the foreign currency will be needed and so the supply
of the domestic currency will decrease. (Diagram 2)
 Relative interest rates:

Interest rates in country A are higher than interest rates in country B -> people of
country B want to keep their money in country’s A banks, hence they require more of

country’s A 3.2 Freely floating exchange rates

Definitions:

 Exchange rate – value of a currency expressed in terms of another currency. (In other
words: price of the currency in terms of another currency).
 Floating exchange rates (system) – when the exchange rate of a currency is
determined by the supply and demand for that currency.
 Appreciation (of a currency) – occurs when a currency increases in value
against another currency, i.e. it can buy more of another currency.
 Depreciation (of a currency) – occurs when a currency loses value against another
currency, i.e. it can buy less of another currency.

Determination of Freely Floating Exchange Rates

The diagram above for floating exchange rates shows that the value of the US Dollar ($) is at e1
where Supply (S) = Demand (D) for USD. At that exchange rate (e1), the equilibrium quantity of
US Dollars is Q1. It is important to note that on the Y axis the value of $ is expressed in terms of
how many Euros you can buy with $1 (There are variations of this diagram, hence, always
consult your teacher about which one is the most appropriate). The higher the value of the US
Dollar, the more Euros you will be able to purchase with 1 USD. The lower the value of the USD
– the less Euros $1 will be able to buy.

For people doing the IB Higher Level Economics course, you need to know some maths
connected to floating exchange rates:

Say, you are given that 1 GBP = 1.25 EUR. You have to know how to express the value of 1 EUR
in terms of GBP. How? If 1 GBP = 1.25 EUR, then 1 EUR = 1/1.25 GBP –> 1 EUR = 0.80 GBP

Changes in Floating Exchange Rates

2 diagrams showing an appreciation in the floating exchange rates:

Diagram 1

Diagram 2

2 diagrams showing a depreciation in the floating exchanges rates:

 Diagram 3

Diagram 4

For your IB Economics course you need to know the following factors affecting supply/ demand
of currencies and hence, their floating exchanges rates:

 Foreign demand for a country’s export:

o Foreign demand for a country’s export increases. To buy larger quantities of that
export foreigners must have more of that country’s currency. So, the demand for
the exporting country’s currency increases and hence, its currency appreciates.
(Diagram 1)
o If the demand for a country’s export decreases, the demand for that country’s
currency will fall and therefore, the currency will depreciate. (Diagram 3)
 Domestic demand for foreign imports:
o Demand for a foreign import increases. To buy more of that import people need
to get more of that country’s currency. To acquire that currency, they must sell
 their own currency. Supply of domestic currency increases and hence, it
depreciates. (Diagram 4)
o If the demand for a foreign import decreases, the domestic currency will
appreciate because less of the foreign currency will be needed and so the supply
of the domestic currency will decrease. (Diagram 2)
 Relative interest rates:
o Interest rates in country A are higher than interest rates in country B -> people of
country B want to keep their money in country’s A banks, hence they require
more of country’s A currency. Demand for country’s A currency increases and it
appreciates. (Diagram 1) Also, people living in country A might supply less
currency to earn a higher interest in their domestic banks, hence the supply of
the currency decreases and it appreciates. (Diagram 2)
o Interest rates in country A are lower than interest rates in country B -> people in
country A want to keep their money in country’s B banks offering higher interest
so they start purchasing more of their currency by selling more of their own.
Supply of country A currency increases and it depreciates. (Diagram 4) Also,
foreigners might decide to keep more of their money in country’s B banks and so
demand less of country’s A currency. Demand falls and country’s A currency
depreciates. (Diagram 3)
 Relative inflation rates – the inflation of the country does not directly affect the
exchange rate. However, relative inflation rate (compared to other countries’ inflation)
does.
o Say the inflation rate in the US is 5% and the inflation rate in Germany is 2%.
Because goods and services are becoming more expensive in the US quicker
than in Germany people might choose to buy goods/services from Germany.
This action requires to have euros and to get euros you need to sell USD, hence,
the supply of USD increases and the US Dollar depreciates. (Diagram 4) Or it
could be the case that US exports are becoming less competitive when
compared to Germany’s (because their price is increasing faster) so people might
start demanding less of US exports and more of Germany’s. Therefore,
demanding less US Dollars -> demand for USD decreases and the currency
depreciates. (Diagram 3)
o If the inflation in the US is lower than in Germany the story reverses. People will
demand more US exports, so the demand for the currency will grow (Diagram 1),
leading to currency’s appreciation. Also, people might supply less of USD as they
might be needing less euros because the imports became too expensive
(Diagram 2), leading to appreciation of the US Dollar.
 Investment from overseas in a country’s firms (foreign direct investment and
portfolio investment):
o For foreigners to invest in a country (FDI and portfolio investment) they must
acquire that country’s currency. Hence, they will increase the demand for that
currency and it will appreciate (Diagram 1). It is also possible that they will
decrease supply, because some investors might already be holding USD which
they were planning to sell but decide not to (Diagram 2).
 o Important to note that this works both ways: foreign investors might decide to
pull the money out (sell the factories or their shares) and then exchange that
country’s currency for another one. Leading to increasing supply (and possibly
falling demand) and currency’s depreciation (Diagrams 3 and 4).
 Speculation (“hot money” flows): same as relative interest rates as speculators usually
chase higher interest rates.

o currency. Demand for country’s A currency increases and it appreciates.

(Diagram 1) Also, people living in country A might supply less currency to earn a
higher interest in their domestic banks, hence the supply of the currency
decreases and it appreciates. (Diagram 2)
o Interest rates in country A are lower than interest rates in country B -> people in
country A want to keep their money in country’s B banks offering higher interest
so they start purchasing more of their currency by selling more of their own.
Supply of country A currency increases and it depreciates. (Diagram 4) Also,
foreigners might decide to keep more of their money in country’s B banks and so
demand less of country’s A currency. Demand falls and country’s A currency
depreciates. (Diagram 3)
 Relative inflation rates – the inflation of the country does not directly affect the
exchange rate. However, relative inflation rate (compared to other countries’ inflation)
does.
o Say the inflation rate in the US is 5% and the inflation rate in Germany is 2%.
Because goods and services are becoming more expensive in the US quicker
than in Germany people might choose to buy goods/services from Germany.
This action requires to have euros and to get euros you need to sell USD, hence,
the supply of USD increases and the US Dollar depreciates. (Diagram 4) Or it
could be the case that US exports are becoming less competitive when
compared to Germany’s (because their price is increasing faster) so people might
start demanding less of US exports and more of Germany’s. Therefore,
demanding less US Dollars -> demand for USD decreases and the currency
depreciates. (Diagram 3)
o If the inflation in the US is lower than in Germany the story reverses. People will
demand more US exports, so the demand for the currency will grow (Diagram 1),
leading to currency’s appreciation. Also, people might supply less of USD as they
might be needing less euros because the imports became too expensive
(Diagram 2), leading to appreciation of the US Dollar.
 Investment from overseas in a country’s firms (foreign direct investment and
portfolio investment):
o For foreigners to invest in a country (FDI and portfolio investment) they must
acquire that country’s currency. Hence, they will increase the demand for that
currency and it will appreciate (Diagram 1). It is also possible that they will
decrease supply, because some investors might already be holding USD which
they were planning to sell but decide not to (Diagram 2).
o Important to note that this works both ways: foreign investors might decide to
pull the money out (sell the factories or their shares) and then exchange that
 country’s currency for another one. Leading to increasing supply (and possibly
falling demand) and currency’s depreciation (Diagrams 3 and 4).
 Speculation (“hot money” flows): same as relative interest rates as speculators usually
chase higher interest rates.

Exchange rate change effects

You need to know how a change in the value of a currency will affect:

Exchange rate change effect on inflation rate

As with everything in economics – IT DEPENDS. Especially on what the country in consideration
exports and imports.

Currency appreciation

 Exports – less competitive internationally because their price seems higher to

foreigners. This might lower aggregate demand and decrease inflation (Keynesian
model) if the economy was at its potential or the bottleneck. Otherwise, changes in
exports arising from changes in exchange rate will not affect inflation much.
 Imports – they now seem cheaper due to appreciation of the currency. That means
every firm which uses imports in their production process as inputs will face lower costs
of production. Hence, the price level in the economy should fall (AS shifts down) and
inflation decrease as a result of appreciation in the exchange rate. However, when
evaluating you could mention that producers might keep the same prices and just
increase their profits.

Currency depreciation

 Exports – become more competitive internationally. Therefore, as demand for exports

grows, AD increases and might push the economy to the bottleneck or its potential
resulting in increasing inflation rate. Goods/services which have low PEDs (price
elasticity of demand) will not be likely to affect the AD by much (e.g. oil).
 Imports – seem more expensive and therefore, producers might face growing
production costs. A lot of industries use oil as an input in their production process. If the
country considered is a net oil importer it will be very likely to face increases in inflation
rate due to depreciating exchange rate (AS shifts up).
Exchange rate change effect on employment and economic growth
To find the effect of changing exchange rates on employment and economic growth we need to
do a similar analysis as we did with the effect on inflation.

Currency appreciation

 Exports – less competitive, lower demand for them, producers might have to cut
production, hence, increasing unemployment and lower economic growth (or even
possibly falling GDP). If the country is exporting oil (or other low PED goods/services) the
effect will be much smaller.
 Imports – seem cheaper, so if they are used as inputs, producers face lower production
costs and that might encourage to increase the quantities produced. Therefore,
increasing employment and economic growth (GDP grows) as AD shifts to the right.
However, because imports seem cheaper, people might substitute away from domestic
goods to imported ones and that would lead to falling employment and lower GDP.

Currency depreciation

 Exports – more competitive internationally. As quantity demanded grows, producers

hire more workers and increase production -> employment grows and GDP increases.
The size of this effect might depend on the price elasticities of exports.
 Imports – seem more expensive. Possible higher production costs -> lower production
quantities -> workers being fired and GDP falls. However, people might substitute from
imports which now seem more expensive to domestically produced goods. As AD shifts
to the right (because C component increases and M component decreases) producers
increase quantities produced, hire workers and GDP grows.

Exchange rate change effect on current account balance

The effect of changes in the exchange rate on the current account balance depends on the
same thing: on goods and services that the considered country exports/imports. To be precise –
on the PEDs of the country’s exports and imports.

How Are Exchange Rates

Determined?
The Foreign exchange market is far more complicated as compared to stock or bond markets.
Predicting the foreign exchange rate includes predicting the performance of entire
economies. There are a multitude of factors which come into play when exchange rates are
being determined. This article lists down and explains some of the important factors which
have a major influence on the exchange rates.

Pricing In The Future Expectations

Foreign Exchange markets are also financial markets. The price reflected in any financial market
does not reflect the price of today. Rather, it reflects the expectations about the future based on the
information that we have on hand today. Therefore, the foremost and important determinant of
Forex rates between any two countries is expectations about the future.

The term “expectations about the future” sounds like a vague and generic term. The next question
arises, “expectations about what?” The remainder of this article will explain the various factors that
influence the exchange rates.

Comparison of Monetary Policy

Exchange rates are basically a comparison between the policies of two countries. It is essential to
understand that exchange rates are not absolute rather they are relative. The following factors are
considered amidst many others while comparing the monetary policies of any two countries.

 Inflation: Exchange rate is basically a ratio between the expected number of units of one
currency and the expected number of units of other currency in the market. Inflation
increases the number of currency units. Therefore, if one currency is facing inflation at the
rate of 6% whereas the other is only facing inflation at the rate of 2%, then the ratio between
the two is bound to change. Hence, inflation rates are a major factor while determining
exchange rates. However, the official inflation rates often do not tell the true picture.
Therefore, participants of the market use their own estimates of inflation rate and come up
with their own valuations for currency pairs.
 Interest Rates: When investors hold a certain currency, they get a yield in terms of the
interest rate that is applicable on that currency. Therefore if investors were to hold a
currency with a 6% yield as opposed to a 3% yield, they would end up profiting more!
Therefore, the interest rate yields are also priced into the Forex rates that are quoted in the
market. The currency valuations are extremely subjective to interest rate changes. A small
change in this rate brings about a big reaction from the market participants.

Therefore, Central Banks become extremely important participants in the Forex market since they
control the monetary policy which is one of the biggest determinants of the value of the currency.

Comparison of Fiscal Policy

While monetary policy is controlled by the Central Bank of the country, the fiscal policy is controlled
by the government. This too has important implications because it signals the forthcoming changes
in the monetary policy.

 Public Debt: A large amount of public debt means that the government of a country will
have to make huge interest payments. Investors will analyze whether these payments can be
collected from the tax i.e. from existing money supply. If not, then this signals that the
 country will monetize its debt i.e. print more currency and pay off the debt. Since a huge
public debt today is a signal of problems coming up in the future, the Forex market prices
this too in the value that is quoted.

However, it needs to be understood that once again there is a relative comparison between
the public debts of the two countries in question. Absolute amounts may not matter as
much!

 Budget Deficit: Another major factor which influences the Forex rates is the budget deficit.
This is because a budget deficit is a precursor to public debt. Governments spend more
money than they have and as a result run up a budget deficit. This deficit then has to be
financed by debt. The problems pertaining to public debt and how it impacts the Forex rate
have already been discussed in the above point.

Political Stability

Political stability of the country in question is also of prime importance for Forex rates. This is
because modern monetary system is a system of Fiat money. This means that money is nothing
except the promise of the government. Therefore, if there is a danger to the government, there is a
danger that the promise itself may be worthless once a new government takes over. It is possible
that the new government may want to issue a new currency of its own! Therefore, whenever a
country faces a geopolitical turmoil, its currency usually takes a beating in the Forex markets.

Speculation and Market Sentiment

Lastly, the Forex market is extremely speculative in nature. This is because Forex provides the
leverage for investors to amplify their trade several times using borrowed money and then invest in
the markets. Therefore, sentiments take over the Forex market more than they take over other
asset markets because of the availability of easy money.

Hence, just like all other markets, Forex markets are prone to irrational exuberance and they too can
distort exchange rates in the short term creating long term investment opportunities.

Many other factors like the price of commodities such as gold and oil also play a vital role in
the determination of Forex rates. However, that will be discussed in a later article in this module.

17.18 Nash Equilibrium

A Nash equilibrium is used to predict the outcome of a game. By a game, we mean the interaction of

a few individuals, called players. Each player chooses an action and receives a payoff that depends

on the actions chosen by everyone in the game.

A Nash equilibrium is an action for each player that satisfies two conditions:

1. The action yields the highest payoff for that player given her predictions about the other

players’ actions.

2. The player’s predictions of others’ actions are correct.

Thus a Nash equilibrium has two dimensions. Players make decisions that are in their own self-

interest, and players make accurate predictions about the actions of others.

Consider the games in Table 17.6 "Prisoners’ Dilemma", Table 17.7 "Dictator Game", Table 17.8

"Ultimatum Game", and Table 17.9 "Coordination Game". The numbers in the tables give the payoff

to each player from the actions that can be taken, with the payoff of the row player listed first.

Table 17.6 Prisoners’ Dilemma

Left Right

Up 5, 5 0, 10

Down 10, 0 2, 2

Table 17.7 Dictator Game

100
Number of Dollars (x)
− x, x

Table 17.8 Ultimatum Game

Accept Reject

100
Number of Dollars (x) 0, 0
− x, x

Table 17.9 Coordination Game

 Left Right

Up 5, 5 0, 1

Down 1, 0 4, 4

 Prisoners’ dilemma. The row player chooses between the action labeled “Up” and the one

labeled “Down.” The column player chooses between the action labeled “Left” and the one

labeled “Right.” For example, if row chooses “Up” and column chooses “Right,” then the row

player has a payoff of 0, and the column player has a payoff of 10. If the row player predicts

that the column player will choose “Left,” then the row player should choose “Down” (that is,

down for the row player is her best response to left by the column player). From the column

player’s perspective, if he predicts that the row player will choose “Up,” then the column

player should choose “Right.” The Nash equilibrium occurs when the row player chooses

“Down” and the column player chooses “Right.” Our two conditions for a Nash equilibrium of

making optimal choices and predictions being right both hold.

 Social dilemma. This is a version of the prisoners’ dilemma in which there are a large

number of players, all of whom face the same payoffs.

 Dictator game. The row player is called the dictator. She is given $100 and is asked to

choose how many dollars (x) to give to the column player. Then the game ends. Because the

column player does not move in this game, the dictator game is simple to analyze: if the

dictator is interested in maximizing her payoff, she should offer nothing (x = 0).

 Ultimatum game. This is like the dictator game except there is a second stage. In the first

stage, the row player is given $100 and told to choose how much to give to the column player.

In the second stage, the column player accepts or rejects the offer. If the column player

rejects the offer, neither player receives any money. The best choice of the row player is then

to offer a penny (the smallest amount of money there is). The best choice of the column

player is to accept. This is the Nash equilibrium.

 Coordination game. The coordination game has two Nash equilibria. If the column player

plays “Left,” then the row player plays “Up”; if the row player plays “Up,” then the column
 player plays “Left.” This is an equilibrium. But “Down/Right” is also a Nash equilibrium.

Both players prefer “Up/Left,” but it is possible to get stuck in a bad equilibrium.

Key Insights

 A Nash equilibrium is used to predict the outcome of games.

 In real life, payoffs may be more complicated than these games suggest. Players may be

motivated by fairness or spite.

17.12 Production Possibilities Frontier

The production possibilities frontier shows the combinations of goods and services that an economy

can produce if it is efficiently using every available input. A key component in understanding the

production possibilities frontier is the term efficiently. If an economy is using its inputs in an

efficient way, then it is not possible to produce more of one good without producing less of another.

Figure 17.10 "The Production Possibilities Frontier" shows the production possibilities frontier for an

economy producing web pages and meals. It is downward sloping: to produce more web pages, the

production of meals must decrease. Combinations of web pages and meals given by points inside the

production possibilities frontier are possible for the economy to produce but are not efficient: at

points inside the production possibilities frontier, it is possible for the economy to produce more of

both goods. Points outside the production possibilities frontier are not feasible given the current

levels of inputs in the economy and current technology.

The negative slope of the production possibilities frontier reflects opportunity cost. The opportunity

cost of producing more meals is that fewer web pages can be created. Likewise, the opportunity cost

of creating more web pages means that fewer meals can be produced.
The production possibilities frontier shifts over time. If an economy accumulates more physical

capital or has a larger workforce, then it will be able to produce more of all the goods in an economy.

Further, it will be able to produce new goods. Another factor shifting the production possibilities

frontier outward over time is technology. As an economy creates new ideas (or receives them from

other countries) on how to produce goods more cheaply, then it can produce more goods.

Key Insights

 The production possibilities frontier shows the combinations of goods and services that

can be produced efficiently in an economy at a point in time.

 The production possibilities frontier is downward sloping: producing more of one good

requires producing less of others. The production of a good has an opportunity cost.
 As time passes, the production possibilities frontier shifts outward due to the

accumulation of inputs and technological progress.

Figure 17.10 The Production Possibilities Frontier

The Main Uses of This Tool

17.11 Efficiency and Deadweight Loss

The outcome of a competitive market has a very important property. In equilibrium, all gains from

trade are realized. This means that there is no additional surplus to obtain from further trades

between buyers and sellers. In this situation, we say that the allocation of goods and services in the

economy is efficient. However, markets sometimes fail to operate properly and not all gains from

trade are exhausted. In this case, some buyer surplus, seller surplus, or both are lost. Economists call

this a deadweight loss.

The deadweight loss from a monopoly is illustrated in Figure 17.8 "Deadweight Loss". The

monopolist produces a quantity such that marginal revenue equals marginal cost. The price is

determined by the demand curve at this quantity. A monopoly makes a profit equal to total revenue

minus total cost. When the total output is less than socially optimal, there is a deadweight loss, which

is indicated by the red area in Figure 17.8 "Deadweight Loss".

Deadweight loss arises in other situations, such as when there are quantity or price restrictions. It

also arises when taxes or subsidies are imposed in a market. Tax incidence is the way in which the

burden of a tax falls on buyers and sellers—that is, who suffers most of the deadweight loss. In

general, the incidence of a tax depends on the elasticities of supply and demand.

A tax creates a difference between the price paid by the buyer and the price received by the seller

(Figure 17.9 "Tax Burdens"). The burden of the tax and the deadweight loss are defined relative to

the tax-free competitive equilibrium. The tax burden borne by the buyer is the difference between the

price paid under the tax and the price paid in the competitive equilibrium. Similarly, the burden of
the seller is the difference between the price in the competitive equilibrium and the price received

under the equilibrium with taxes. The burden borne by the buyer is higher—all else being the same—

if demand is less elastic. The burden borne by the seller is higher—all else being the same—if supply

is less elastic.

The deadweight loss from the tax measures the sum of the buyer’s lost surplus and the seller’s lost

surplus in the equilibrium with the tax. The total amount of the deadweight loss therefore also

depends on the elasticities of demand and supply. The smaller these elasticities, the closer the

equilibrium quantity traded with a tax will be to the equilibrium quantity traded without a tax, and

the smaller is the deadweight loss.

Key Insights

 In a competitive market, all the gains from trade are realized.

 If sellers have market power, some gains from trade are lost because the quantity traded

is below the competitive level.

 Other market distortions, such as taxes, subsidies, price floors, or price ceilings, similarly

cause the amount to be traded to differ from the competitive level and cause deadweight
loss.

Figure 17.8 Deadweight Loss

Figure 17.9 Tax Burdens
The Main Uses of This Tool

17.10 Buyer Surplus and Seller Surplus

If you buy a good, then you obtain buyer surplus. If you did not expect to obtain any surplus, then

you would not choose to buy the good.

 Suppose you buy a single unit of the good. Your surplus is the difference between your

valuation of the good and the price you pay. This is a measure of how much you gain from the

exchange.

 If you purchase many units of a good, then your surplus is the sum of the surplus you get

from each unit. To calculate the surplus from each unit, you subtract the price paid from your

marginal valuation of that unit.

If you sell a good, then you obtain seller surplus. If you did not expect to obtain any surplus, you

would not sell the good.

 Suppose you sell a single unit of a good. Your surplus is equal to the difference between the

price you receive from selling the good and your valuation of the good. This valuation may be

a measure of how much you enjoy the good or what you think you could sell it for in some

other market.

 If you sell many units of a good, then the surplus you receive is the sum of the surplus for

each unit you sell. To calculate the surplus from selling each unit, you take the difference

between the price you get for each unit sold and your marginal valuation of that extra unit.
Buyer surplus and seller surplus are created by trade in a competitive market (Figure 17.6 "A

Competitive Market"). The equilibrium price and the equilibrium quantity are determined by the

intersection of the supply and demand curves. The area below the demand curve and above the price

is the buyer surplus; the area above the supply curve and below the price is the seller surplus. The

sum of the buyer surplus and the seller surplus is called total surplus or the gains from trade.

Buyer surplus and seller surplus can also arise from individual bargaining (Figure 17.7 "Individual

Bargaining"). When a single unit is traded (the case of unit demand and unit supply), the total

surplus is the difference between the buyer’s valuation and the seller’s valuation. Bargaining

determines how they share the gains from trade. The quantity of trades, indicated on the horizontal

axis, is either zero or one. The valuations of the buyer and the seller are shown on the vertical axis. In

this case, the valuation of the buyer ($3,000) exceeds the valuation of the seller ($2,000), indicating

that there are gains from trade equal to $1,000. How these gains are shared between the buyer and

seller depends on the price they agree on. In part (a) of Figure 17.7 "Individual Bargaining", the

buyer gets most of the surplus; in part (b) of Figure 17.7 "Individual Bargaining", the seller gets most

of the surplus.

Key Insights

 Buyer surplus and seller surplus are created by trade.

 Buyer surplus is the difference between the marginal value of a good and the price paid.
 Seller surplus is the difference between the price received and the marginal value of a

good.

Figure 17.6 A Competitive Market

Figure 17.7 Individual Bargaining
The Main Uses of This Tool

Transactions motive. The transactions motive for demanding money

arises from the fact that most transactions involve an exchange of money.
Because it is necessary to have money available for transactions, money
will be demanded. The total number of transactions made in an economy
tends to increase over time as income rises. Hence, as income or GDP rises,
the transactions demand for money also rises.

Precautionary motive. People often demand money as a precaution against

an uncertain future. Unexpected expenses, such as medical or car repair
bills, often require immediate payment. The need to have money available in
such situations is referred to as the precautionary motive for demanding
money.

Speculative motive. Money, like other stores of value, is an asset. The

demand for an asset depends on both its rate of return and its opportunity
cost. Typically, money holdings provide no rate of return and often
depreciate in value due to inflation. The opportunity cost of holding money
is the interest rate that can be earned by lending or investing one's money
holdings. The speculative motive for demanding money arises in
situations where holding money is perceived to be less risky than the
alternative of lending the money or investing it in some other asset.

For example, if a stock market crash seemed imminent, the speculative

motive for demanding money would come into play; those expecting the
market to crash would sell their stocks and hold the proceeds as money.
The presence of a speculative motive for demanding money is also affected
by expectations of future interest rates and inflation. If interest rates are
expected to rise, the opportunity cost of holding money will become
greater, which in turn diminishes the speculative motive for demanding
money. Similarly, expectations of higher inflation presage a greater
depreciation in the purchasing power of money and therefore lessen the
speculative motive for demanding money. 

Monetarist Theory of Inflation

28 August 2017 by Tejvan Pettinger

Monetarists argue that if the Money Supply rises faster than the rate of growth of
national income, then there will be inflation.

If the money supply increases in line with real output then there will be no
inflation.

M.Friedman stated:

“Inflation is always and everywhere a monetary phenomenon in the

sense that it is and can be produced only by a more rapid increase
in the quantity of money than in output.

Friedman (1970) The Counter-Revolution in Monetary Theory.

Quantity Theory of Money

Fischer Version MV=PT,

 M = Money Supply
 V= Velocity of circulation
 P= Price Level and
 T = Transactions.
T is difficult to measure so it is often substituted for Y = National Income

MV = PY where Y =national output

The above equation must hold the value of expenditure on goods and services
must equal the value of output.

Explanation of why money supply leads to inflation

Monetarists believe that in the short-term velocity (V) is fixed This is because the
rate at which money circulates is determined by institutional factors, e.g. how
often workers are paid does not change very much. Milton Friedman admitted it
might vary a little but not very much so it can be treated as fixed

Monetarists also believe output Y is fixed. They state it may vary in the short run
but not in the long run (because LRAS is inelastic and determined by supply-side
factors.)

Therefore an increase in the Money Supply will lead to an increase in inflation

Example 1
 If the total money supply is initially £1000 and the velocity of circulation is
5.
 The level of output (Y) is 5000 units.
 £1000×5 = P (5000)
 Therefore P = 1
 If the money supply now doubles the equation =
 2000×5 =P×5000
 Therefore P = 2
Example 2

 If the output is 1,000 units, and there is a money

supply of £10,000. The average price of good will be £10.
 In year 2, if the output stays at 1,000 units, but money supply increases to
15,000. Consumers have more money to buy the same amount of goods.
Therefore, firms put up prices to reflect this increase in money supply.
Ceteris paribus, average prices will rise from £10 to £15.
Other points
 Milton Friedman predicted an increase in the money supply would take
about 9-12 months to lead to higher output.
 Friedman placed great emphasis on the role of price expectations. If there
are expectations of higher inflation, it becomes self-fulfilling – workers
 demand higher wages to meet rising living costs. Firms put up prices to
meet rising costs. Strict monetarist policies would help reduce
expectations.
 After another year output will return to its initial equilibrium causing prices
to rise to accommodate the rise in money supply
 Cambridge Version of quantity theory states P= f(M)
 Monetarism became more popular in the 1970s due to rising inflation.
(partly caused by rising oil prices).
 In the early 1980s, the UK and US adopted monetarist policies with mixed
results.
Friedman’s k-percent rule

 Milton Friedman argued that the money supply should rise by a fixed k-
percent each year. This rate of increase should depend on institutional
factors and be determined independently of policymakers.
 Friedman believed this rule would avoid the extremes of deflation (Falling
money supply, e.g. Great Depression) and inflation due to rising money
supply.
 It would give business strong expectations of what would happen to money
supply and inflation.
 Monetarist inflation in the AD and AS model
 Following a rise in the Money Supply, consumers have more money and
therefore spend more money on goods; this shifts AD to the right. AD1 to
AD 2.
 Firms respond by increasing output along SRAS. Real output increases
from Y1 to Y2.
 National output now exceeds the equilibrium level of output. Therefore
there is an inflationary gap.
 Firms need to hire more workers, so wages rise leading to an increase in
costs and hence prices. Initially, workers agree to work more hours
because they see an increase in nominal wages.
 As prices rise money can buy less, therefore, there is a movement to the
left along the new AD
 Also, workers realise the increase in nominal wage is not a real wage
increase. Therefore, workers also demand higher nominal wages to
 produce more output and to compensate them for rising prices, therefore
SRAS shifts to the left.
 The economy has returned to the equilibrium level of output (Y1), but at a
higher price level (P3).
 Therefore the rise in the Money Supply cause a rise in AD, But because
the LRAS is inelastic there is no increase in real output, but inflation rises.
It is a form of demand-pull inflation.
Monetarist view of Phillips curve

Mo
netarists believe in the long-run there is no trade-off between inflation and
unemployment. Increase in the money supply only causes an increase in nominal
GDP, but not real GDP.
Criticisms of monetarism
 The link between the money supply and inflation is often very weak in
practice.
 The velocity of circulation (V) is not stable but can vary significantly due to
confidence, changes in the use of credit cards, decline in use of cash. e.t.c
 Targetting arbitrary money supply targets can cause a severe recession
and high unemployment. For example, UK targetted money supply growth
in the early 1980s, but this caused the recession of 1981 with many
economists arguing it was deeper than necessary.
  The large increase in the monetary base following the 2009 recession did
not cause any inflationary pressures.
 Why not target inflation directly? If you want to control inflation, it makes
more sense to target inflation directly rather than through the intermediary
of the money supply.
  Monetarists say that income can vary in the short run, but the short run
could be a long time and therefore make monetary policy ineffective,
Keynesians argue that the LRAS is not necessarily inelastic they argue
that the economy can be below full capacity for a long time.

Monetarist Theory of Inflation

28 August 2017 by Tejvan Pettinger

Monetarists argue that if the Money Supply rises faster than the rate of growth of
national income, then there will be inflation.

If the money supply increases in line with real output then there will be no
inflation.

M.Friedman stated:

“Inflation is always and everywhere a monetary phenomenon in the

sense that it is and can be produced only by a more rapid increase
in the quantity of money than in output.

Friedman (1970) The Counter-Revolution in Monetary Theory.

Quantity Theory of Money

Fischer Version MV=PT,

 M = Money Supply
 V= Velocity of circulation
 P= Price Level and
 T = Transactions.
T is difficult to measure so it is often substituted for Y = National Income

MV = PY where Y =national output

The above equation must hold the value of expenditure on goods and services
must equal the value of output.

Explanation of why money supply leads to inflation

Monetarists believe that in the short-term velocity (V) is fixed This is because the
rate at which money circulates is determined by institutional factors, e.g. how
often workers are paid does not change very much. Milton Friedman admitted it
might vary a little but not very much so it can be treated as fixed

Monetarists also believe output Y is fixed. They state it may vary in the short run
but not in the long run (because LRAS is inelastic and determined by supply-side
factors.)

Therefore an increase in the Money Supply will lead to an increase in inflation

Example 1
 If the total money supply is initially £1000 and the velocity of circulation is
5.
 The level of output (Y) is 5000 units.
 £1000×5 = P (5000)
 Therefore P = 1
 If the money supply now doubles the equation =
 2000×5 =P×5000
 Therefore P = 2
Example 2

 If the output is 1,000 units, and there is a money supply of £10,000. The
average price of good will be £10.
 In year 2, if the output stays at 1,000 units, but money supply increases to
15,000. Consumers have more money to buy the same amount of goods.
Therefore, firms put up prices to reflect this increase in money supply.
Ceteris paribus, average prices will rise from £10 to £15.
Other points
 Milton Friedman predicted an increase in the money supply would take
about 9-12 months to lead to higher output.
 Friedman placed great emphasis on the role of price expectations. If there
are expectations of higher inflation, it becomes self-fulfilling – workers
 demand higher wages to meet rising living costs. Firms put up prices to
meet rising costs. Strict monetarist policies would help reduce
expectations.
 After another year output will return to its initial equilibrium causing prices
to rise to accommodate the rise in money supply
 Cambridge Version of quantity theory states P= f(M)
 Monetarism became more popular in the 1970s due to rising inflation.
(partly caused by rising oil prices).
 In the early 1980s, the UK and US adopted monetarist policies with mixed
results.
Friedman’s k-percent rule

 Milton Friedman argued that the money supply should rise by a fixed k-
percent each year. This rate of increase should depend on institutional
factors and be determined independently of policymakers.
 Friedman believed this rule would avoid the extremes of deflation (Falling
money supply, e.g. Great Depression) and inflation due to rising money
supply.
 It would give business strong expectations of what would happen to money
supply and inflation.
 Monetarist inflation in the AD and AS model
 Following a rise in the Money Supply, consumers have more money and
therefore spend more money on goods; this shifts AD to the right. AD1 to
AD 2.
 Firms respond by increasing output along SRAS. Real output increases
from Y1 to Y2.
 National output now exceeds the equilibrium level of output. Therefore
there is an inflationary gap.
 Firms need to hire more workers, so wages rise leading to an increase in
costs and hence prices. Initially, workers agree to work more hours
because they see an increase in nominal wages.
 As prices rise money can buy less, therefore, there is a movement to the
left along the new AD
 Also, workers realise the increase in nominal wage is not a real wage
increase. Therefore, workers also demand higher nominal wages to
 produce more output and to compensate them for rising prices, therefore
SRAS shifts to the left.
 The economy has returned to the equilibrium level of output (Y1), but at a
higher price level (P3).
 Therefore the rise in the Money Supply cause a rise in AD, But because
the LRAS is inelastic there is no increase in real output, but inflation rises.
It is a form of demand-pull inflation.
Monetarist view of Phillips curve

Mo
netarists believe in the long-run there is no trade-off between inflation and
unemployment. Increase in the money supply only causes an increase in nominal
GDP, but not real GDP.
Criticisms of monetarism
 The link between the money supply and inflation is often very weak in
practice.
 The velocity of circulation (V) is not stable but can vary significantly due to
confidence, changes in the use of credit cards, decline in use of cash. e.t.c
 Targetting arbitrary money supply targets can cause a severe recession
and high unemployment. For example, UK targetted money supply growth
in the early 1980s, but this caused the recession of 1981 with many
economists arguing it was deeper than necessary.
  The large increase in the monetary base following the 2009 recession did
not cause any inflationary pressures.
 Why not target inflation directly? If you want to control inflation, it makes
more sense to target inflation directly rather than through the intermediary
of the money supply.
  Monetarists say that income can vary in the short run, but the short run
could be a long time and therefore make monetary policy ineffective,
Keynesians argue that the LRAS is not necessarily inelastic they argue
that the economy can be below full capacity for a long time.

Exchange rates
28 June 2017 by Tejvan Pettinger

 The exchange rate is the rate at which one currency trades against
another on the foreign exchange market
 If the present exchange rate is £1=$1.42, this means that to go to America
you would get $142 for £100. Similarly, if an American came to the UK, he
would have to pay $142 to get £100. Although in real life, the dealer would
make a profit.
 Currencies are being continuously traded on the foreign exchange
markets, with the prices constantly changing as dealers adjust to changes
in supply and demand
 Currencies will also undergo long-term changes depending on the state of
the comparative countries. E.G. in the 1920s the £ was worth $4.50
Value of the Pound to Dollar 2006-2016. In mid-2008, there was a sharp
depreciation in the value of the Pound because the UK was hit very hard by the
credit crunch.  The Pound also dropped after the Brexit vote in June 2016
because markets were less optimistic about the long-term fortunes of the UK
economy outside the EU.

 Definitions
 Exchange rate index  This gives a measure of a currency against a trade-
weighted basket of currencies. It is expressed as an index, where the
value of the index will be 100 in the base year. The weight given to each
currency depends upon the proportion of transactions done with the
country. For example, in the Sterling exchange rate index, the highest
weighting will be given to the Euro and then the dollar.
 Real Exchange Rate. This is the exchange rate after being adjusted for
the effects of inflation, it, therefore, more accurately reflects the purchasing
power of a currency.
 Floating exchange rate – When the value of the currency is determined
by market forces – supply and demand for currency
  Fixed exchange rate – where the government seeks to keep the value of
a currency at a certain level compared to other currencies. See: Fixed
Exchange Rates
Determination of exchange rates using supply and demand diagram

In this example, a rise in demand for Pound Sterling has led to an increase in the
value of the £ to $
from £1 = $1.50 to £1 = $1.70

Factors influencing exchange rates

 Interest rates  – higher interest rates encourage hot money flows and
demand for currency. This causes an appreciation.
 Economic growth – higher economic growth will tend to cause an
appreciation in the currency, this is because markets expect higher interest
rates – when growth is rapid.
 Inflation – higher inflation makes exports less competitive and reduces
demand for currency. This causes a depreciation.
 Confidence in the economy/currency.
  Current account deficit/surplus. A large current account deficit is more
likely to cause a depreciation in the value of the currency because money
is leaving the economy to buy imports.
 See more detail at Factors influencing exchange rates
Appreciation of exchange rate

If the Pound Sterling appreciates in value, the effects will include:

 UK exports more expensive abroad – leading to lower demand.

 Imports into the UK will be cheaper, increasing demand for imports
 An appreciation will tend to reduce inflation,
 Lower economic growth – due to reduced demand for exports.
 Worsening of the current account deficit (because imports are cheaper
and quantity of imports rises, but exports are more expensive and quantity
falls)
 Strong Pound = Imports Cheaper, Exports Dearer. SPICED
 More detail: Effects of appreciation
Depreciation / Devaluation

If the Pound devalues then we will see:

 UK exports become more competitive, increasing demand for exports

 Imports become more expensive, leading to lower demand for imports
 A depreciation will tend to increase economic growth but also cause
inflation.
 Does a devaluation help an economy?
Evaluation of exchange rates

Elasticity of demand. If there is a depreciation in the exchange rate, exports are

cheaper, but the amount quantity increases depend on the elasticity of demand.
If demand is price inelastic, then a depreciation will have a limited impact in
increasing demand and improving economic growth. If demand for exports is
elastic, then there will be a big boost to exports.
Time Lag. In the short term, demand for exports is often inelastic but becomes
more price elastic over time.
Reasons for depreciation/appreciation. Often it is most successful economies
who see appreciation. The currency appreciates because there is more demand
for their exports. Therefore, in this case, a depreciation won’t cause a fall in
economic growth – only limit the growth rate. If the currency appreciates due to
speculation, during a period of weak economic growth, then the negative effect
on growth may be more pronounced.
A2 Economics – Keynes 45˚ line
Leave a reply

Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this
graph useful to explain it. A popular multi-choice question and usually in one part of an essay.
Make sure that you are aware of the following;

Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD
crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:

2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
This entry was posted in Fiscal Policy, Interest Rates and
tagged Keynesian Policy on March 1A2 Economics – Keynes 45˚ line
Leave a reply

Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this
graph useful to explain it. A popular multi-choice question and usually in one part of an essay.
Make sure that you are aware of the following;
Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD
crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:

2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
This entry was posted in Fiscal Policy, Interest Rates and
tagged Keynesian Policy on March 1A2 Economics – Keynes 45˚ line
Leave a reply

Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this
graph useful to explain it. A popular multi-choice question and usually in one part of an essay.
Make sure that you are aware of the following;
Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD
crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:

2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
This entry was posted in Fiscal Policy, Interest Rates and
tagged Keynesian Policy on March 1A2 Economics – Keynes 45˚ line
Leave a reply

Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this
graph useful to explain it. A popular multi-choice question and usually in one part of an essay.
Make sure that you are aware of the following;
Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD
crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:

2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
This entry was posted in Fiscal Policy, Interest Rates and
tagged Keynesian Policy on March 1A2 Economics – Keynes 45˚ line
Leave a reply

Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this
graph useful to explain it. A popular multi-choice question and usually in one part of an essay.
Make sure that you are aware of the following;
Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD
crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:

2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
This entry was posted in Fiscal Policy, Interest Rates and
tagged Keynesian Policy on March 1A2 Economics – Keynes 45˚ line
Leave a reply

Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this
graph useful to explain it. A popular multi-choice question and usually in one part of an essay.
Make sure that you are aware of the following;
Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD
crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:

2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
This entry was posted in Fiscal Policy, Interest Rates and
tagged Keynesian Policy on March 1A2 Economics – Keynes 45˚ line
Leave a reply

Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this
graph useful to explain it. A popular multi-choice question and usually in one part of an essay.
Make sure that you are aware of the following;
Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD
crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:

2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
This entry was posted in Fiscal Policy, Interest Rates and tagged Keynesian Policy on March 1v

The Liquidity Trap

This is a situation where monetary policy becomes ineffective. Cutting the rate of interest is
supposed to be the escape route from economic recession: boosting the money supply,
increasing demand and thus reducing unemployment. But John Maynard Keynes argued that
sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms
could become so risk averse that they preferred the liquidity of cash to offering credit or using
the credit that is on offer. In such circumstances, the economy would be trapped in recession,
despite the best efforts of monetary policy makers.
The graph below shows a liquidity trap. Increases or decreases in the supply of money at an
interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have
reached the floor.

All increases in money supply are simply taken upin idle balances. Since interest rates do not
alter, the level of expenditure in the economy is not affected. Consequently, monetary policy
under these circumstances is futile.

Final thought
Today the threat of deflation seems to have passed us by but the world was looking at a major
global slowdown and it was not a matter of how much things were slowing, but it was how
much they were going backwards. The most disconcerting fact was that all the easing of
interest rates by central banks didn’t really change that outlook. Besides, with the severe threat
of deflation there was a need to preserve the firepower in case the economy needed more
stimulating. Like when an individual is besieged by many attackers while holding limited
ammunition, each shot is used sparingly. But with little ammunition left what was next?
This entry was posted in Deflation on May 29, 2017.

\
Consumption Function cake
Leave a reply

Many thanks to A2 student Lara Hodgson for this superb cake that the class enjoyed this morning. Remember
that the standard Keynesian consumption function is written as follows:

C = a + c (Yd) – where:

   C = total consumer spending

    a = is autonomous spending
    c (Yd) = the propensity to spend out of disposable income

Autonomous spending (a) is consumption which does not depend on the level of income. For example people
can fund some of their spending by using their savings or by borrowing money from banks and other lenders.
A change in autonomous spending would in fact cause a shift in the consumption function leading to a change
in consumer demand at all levels of income. The key to understanding how a rise in disposable income affects
household spending is to understand the concept of the marginal propensity to consume (mpc). The marginal
propensity to consume is the change in consumer spending arising from a change in disposable income. The
higher the mpc the steeper the gradient of the consumption function line. As you can imagine the consumption
of cake was fairly rapid.
This entry was posted in Eco Comedy, Macro and tagged Cake, Consumption, Keynes on March 23, 2017.

Irish Economist Jokes for St Patrick’s Day

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 Being St Patrick’s Day I thought it appropriate to look at some
humour.

“Why was the Irish economist afraid of swimming? He was conscious of the liquidity trap.”

“How do you confuse an Irishman when trying to maximise his utility when purchasing two products? Put two
shovels against the wall and tell him to take his pick.”

“What do you call it when an Irish economist has an idea? Moral Hazard”

“An Irishman said he saw a ghost. The Irish economist said it was just the invisible hand.”

“What’s the difference between Iceland’s economy and Ireland’s? One letter and six months”

“We all know what pareto optimal allocation means… What about Irish optimal allocation — when all persons
are equally well off, and one person really gets it bad, worse off, while all the rest are much better off…”

“An Irish economist walks into a pizzeria to order a pizza. When the pizza is done, he goes up to the counter
get it. There a clerk asks him: “Should I cut it into six pieces or eight pieces?” The Irish economist replies:
“I’m feeling rather hungry right now. You’d better cut it into eight pieces.” (see the “Father Ted” version
above)
 “Why would Father Jack not make a good economist? There
would always be massive inflation as his only policy would be to increase liquidity.”
A2 Economics – Labour Market – MRPL
Leave a reply

Marginal Revenue Product refers to the amount of revenue generated by an additional worker.
This is a theory of wages where workers are paid the value of their marginal revenue product to
the firm and is based on the assumption of a perfectly competitive labour market. Therefore an
employer will hire workers up to the point where the value of the marginal product of labour
equals the wage that is being paid. The demand curve for labour can therefore be represented
by the value of the marginal product curve – see graph below and a revision mindmap.
Adapted from: AS and A Level Economics Revision by Susan Grant

Keynes v Monetarist – Powerpoint download

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Currently covering Keynes vs Monetarist in the A2 course. Here is a powerpoint on the theory that I use for
revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint
includes explanations of:

– C+I+G+(X-M)
– 45˚line
– Circular Flow and the Multiplier
– Diagrammatic Representation of Multiplier and Accelerator
– Quantity Theory of Money
– Demand for Money – Liquidity Preference
– Defaltionary and Inflationary Gap
– Extreme Monetarist and Extreme Keynesian
– Summary Table of “Keynesian and Monetarist”
– Essay Questions with suggested answers.

Hope it is of use – 45˚line shown. Click the link below to download the file.
Keynes v Monetarist Keynote

This entry was posted in Fiscal Policy, Interest Rates and tagged Accelerator, Bonds, Keynes, Monetary

Policy, Multiplier on March 19, 2020.

Economics of Coronavirus – mindmap

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Three different shocks that are prevalent
Supply shock – will become more visible in the coming weeks as importers from China maybe unable to
source adequate supply given widespread shutdowns across Chinese manufacturing.This loss of intermediate
goods for production of final products cause a decline in revenue and consumer well-being. A good example of
supply shocks were the oil crisis years of 1973 (oil prices up 400%) and 1979 (oil prices up 200%).
Demand shock – is already affecting consumer demand as travel slows, people avoid large gatherings, and
consumers reduce discretionary spending. Already many sports fixtures have been cancelled which in turn hits
revenue streams. With the uncertainty about job security demand in the consumer market will drop – cars,
electronics, iPhones etc. Also tourism and airline industries are also exposed to the fall in demand.
Financial shock – although the supply and demand shocks will eventually subside, the global financial system
is likely to have a longer-lasting impact. Long-term growth is the willingness of borrowers and lenders to
invest and these decisions are influenced by: increased uncertainty regarding the global supply chain; a loss of
confidence in the economy to withstand another attack; and a loss of confidence regarding the infrastructure
for dealing with this and future crises.
Policy options
Monetary policy is limited to what it can do with interest rates so low. Even with lower interest rates this does
not tackle the problem of coronavirus – cheaper access to money won’t suddenly improve the supply chain or
mean that consumers will start to spend more of their income. The RBNZ (NZ Central Bank) could instruct
trading banks to be more tolerant of economic conditions.
Fiscal policy will be a much more powerful weapon – the government can help households by expanding the
social safety net – extending unemployment benefit. Also the guaranteeing of employment should layoffs
occur. Tourism and airline industries are being hit particularly hard. Although more of a monetary
phenomenon the ‘Helicopter Drop’ could a policy tool of the government. A lot of governments already have
introduced ‘shock therapy’ and unleashed significant stimulus measures:

 Hong Kong – giving away cash to population – equivalent NZ$2,120.

  China – infrastructure projects and subsidising business to pay workers.
 Japan – trillions of Yen to subsidising workers. Small firms get 0% interest on loans.
 Italy – fiscal expansion and a debt moratorium including mortgages
 US – congress nearing stimulus package
 NZ – stimulus package industry based

What is the Gini Coefficient? The Gini Coefficient is derived from the same information used
to create a Lorenz Curve. The co-efficient indicates the gap between two percentages: the
percentage of population, and the percentage of income received by each percentage of the
population. In order to calculate this you divide the area between the Lorenz Curve and the 45°
line by the total area below the 45° line eg.
Area between the Lorenz Curve and the 45° line
Total area below the 45° line

What is the Gini Coefficient? The Gini Coefficient is

The resulting number ranges between:

0 = perfect equality where say, 1% of the population = 1% of income, and
1 = maximum inequality where all the income of the economy is acquired by a single recipient.

The straight line (45° line) shows absolute equality of income. That is, 10% of the households
earn 10% of income, 50% of households earn 50% of income.

This entry was posted in Inequality and tagged Coronavirus, Gini Coefficient, Lorenz Curve on May 14, 2020.
AS Revision – Indirect Tax
Leave a reply

The AS multiple-choice paper is coming up and here is this graphic to explain indirect taxes – a popular
question. An indirect tax will have the following effects on the market:

• The supply curve shifts vertically upwards(effectively a shift to the left) by the amount of the tax(gf) per unit.
The price increases but not by the full amount of the tax. This is because of the slopes of the demand and
supply curves.
• The consumer surplus is reduced from acp to agb. The portion gbhp of the old consumer surplus is
transferred to government in the form of tax.
• The producer surplus is reduced from pce to fde. The portion phdf of the old producer surplus is transferred
to the government in the form of tax.
• The market is no longer able to reach equilibrium, and there is a loss of allocative efficiency resulting in the
deadweight lost shown by the area bcd. This represents a loss of both consumer surplus bhc and the producer
surplus hcd that is removed from the market. The deadweight loss also represents a loss of welfare to an
individual or group where that loss is not offset by a welfare gain to some other individual or group.

This entry was posted in Exam revision, Fiscal Policy, Micro, Supply & Demand and tagged Indirect
Tax on November 10, 2019.

AS & A2 Revision – How PED varies along a demand curve

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Been doing some more revision sessions on CIE AS economics and went through how the elasticity of demand
varies along a demand curve. Notice in Case A that the fall in price from Pa to Pb causes the the total revenue
to increase therefore it is elastic – the blue area (-) is less than the orange area (+). In Case B the opposite
applies – as the price decreases from Pa to Pb the total revenue decreases therefore it is inelastic – the blue area
(-) is greater than the orange area (+). In Case C the drop in price causes the same proportionate change in
quantity demanded, therefore there is no change in total revenue – it is unitary elasticity.

Remember where MR = 0 – PED = 1 on the demand curve (AR curve). A particularly popular question at A2
level is ‘where on the demand curve will a profit maximising firm produce at?’. As MC = MR above zero the
imperfect firm always produces on the elastic part of the demand curve.

This entry was posted in Micro, Supply & Demand and tagged Elasticity, Total Revenue on August 26,
With the A2 Essay paper tomorrow I thought something on the kinked demand curve might be
useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm
perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate
the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with
any degree of certainty, it has got to estimate how consumers will react to price changes.
In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to
alter the price. It knows that the degree of its price change will depend upon whether or not the
other firms in the market will follow its lead. The graph shows the the two extremes for the
demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever
reason, produces at output Q1 and price P1, determined by point X on the graph. The firm
perceives that demand will be relatively elastic in response to an increase in price, because
they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining
customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease
in price by cutting their prices by an equivalent amount; the firm therefore expects demand to
be relatively inelastic in response to a price fall, since it cannot hope to lure many customers
away from their rivals. In other words, the oligopolist’s initial position is at the junction of the
two demand curves of different relative elasticity, each reflecting a different assumption about
how the rivals are expected to react to a change in price. If the firm’s expectations are correct,
sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the
price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the
two marginal revenue curves associated with the relatively elastic and inelastic demand curves.
Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to
change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is
between an upper limit of MC2 and a lower limit of MC1.
Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an
oligopolist chooses to be a point X in the first place. Research casts doubt on whether
oligopolists respond to price changes in the manner assumed. Oligopolistic markets often
display evidence of price leadership, which provides an alternative explanation of orderly price
behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it
may be advantageous to follow the firm which takes the first steps in raising the price. If all
firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model downlo

Going over monetary policy with my A2 class and have modified a mind map done by Susan
Grant from a CIE Economics Revision Guide. Useful for those who are sitting the June AS and A2
Economics papers.
This entry was posted in Interest Rates, Teaching visuals and tagged AS Level Re

Going over monetary policy with my A2 class and have modified a mind map done by Susan
Grant from a CIE Economics Revision Guide. Useful for those who are sitting the June AS and A2
Economics papers.
This entry was posted in Interest Rates, Teaching visuals and tagged AS Level Revv

A2 Revision – Imperfect Competition AR, MR

and TR curves
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You should note the following from the graphs:
• to sell an additional unit of a commodity, the monopolist must reduce the price of all units
sold. This therefore means the AR curves falls.
• as the price on all units must be lowered to sell the higher output, MR is lower than the price
of the marginal unit(AR)
• TR at first increases with output but as price is reduced to sell more goods and services,
eventually falls.
• where MR = 0 TR is at a maximum.
A2 Revision – Cost Curves
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Firms, according to the analysis we use predict their behaviour, are very interested in their marginal cost. Since
the term marginal means additional or incremental, marginal costs refer to those costs that result from a one-
unit change in the production rate. We find marginal cost by subtracting the total cost of producing all but the
last unit from the total cost of producing all units, including the last one. Marginal costs can be measured,
therefore, by using the formula:

Marginal Cost = Change in Total Cost ÷ Change in Total Output

Average Fixed Costs (AFC) : they continue to fall throughout the output range. The gap between ATC and
AVC = AFC
Average Variable Costs (AVC) : the form it takes is U-shaped: first it falls; then it starts to rise. It is certainly
possible to have other shapes of the AVC.
Average Total Costs or Average Costs (ATC or AC) : similar shape to the average variable cost. However,
it falls even more dramatically in the beginning and rises more slowly after it has reached a minimum point. It
falls and then rises because average total costs is the summation of the AFC and the AVC curve. Thus, when
AFC plus AVC are both falling, it is only logical that ATC would fall, too. At some point, however, AVC
starts to increase while AFC continues to fall. Once the increase in the AVC outweighs the decrease in the
AFC curve, the ATC curve will start to increase and will develop its familiar U-shape. Where MC = ATC this
is the lowest point on the ATC curve and is therefore the cheapest production for the firm. This is called the
technical optimum.
Marginal Cost (MC) : it cuts ATC and AVC at their lowest points. The firm will supply where the price is
greater than or equal to MC. Thus the individual firm’s supply curve consists of the firm’s MC curve, but only
the portion above AVC. The reason for this is that where P=AVC the firm will shut down operations because
they are barely covering avoidable costs.

This entry was posted in Exam revision and tagged Cost Curves on May 20, 2016.
A2 Economics – Evaluation Skills for essay writing
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Here are ten strategies for improving your evaluation skills in data response and essay questions written by
Geoff Riley of Tutor2u.

1. Make good use of your final paragraph – avoid repetition of points already made
2. Look for key stem words in the question – build your evaluation around this
3. Put an economic event, a trend, a policy into a wider context
4. Be familiar with different schools of thought e.g. free market versus government intervention
5. Be aware that a singular economic event never happens in isolation especially in a world where economies
are so closely inter-connected.
6. Question the reliability of the data you have been given
7. Draw on your wider knowledge to provide supporting evidence and examples
8. Consider both short term and longer term consequences (they are not always the same)
9. Consider both positive and negative consequences
10. Think about what might happen to your arguments if you drop the “ceteris paribus” assumption

Very worthwhile with the essay paper on Wednesday.

  

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Economics as a Science of Wealth/Classical View:

 
Definition of Economics By Adam Smith:
 
There is no one definition of Economics which has a general acceptance. The formal roots of the scientific
framework of economics can be traced back to classical economists. The pioneers of the science of economics
defined economics as the science of wealth.
 
Adam Smith (1723 -1790), the founder of economics, described it as a body of knowledge which relates to wealth.
Accordingly to him if a nation has larger amount of wealth, it can help in achieving its betterment. He defined
economics as:
 
“The study of nature and causes of generating of wealth of a nation”.
 
Adam Smith in his famous book, “An Enquiry into the Nature and Causes of the Wealth of Nations” emphasized the
production and expansion of wealth as the subject matter of economics.
 
Ricardo, another British classical economist shifted the emphasis from production of wealth to the distribution of
wealth in the study of economics.
 
J.B. Say, a French classical economist, described economics as:
 
“The science which treats of wealth”.
 
J.S. Mill in the middle of 19th century looked upon economics is as:
 
"Practical science of production and distribution of wealth”.
 
According to Malthus:
 
“Man is motivated by self Interest only. The desire to collect wealth never leaves him till he goes into the grave”.
 
The main points of the definitions of economics given by the above classical economists are that:
 
(i) Economics is the study of wealth only. It deals with consumption, production, exchange and distribution aspects of
wealth.
 
(ii) Only those commodities which are scarce are Included In wealth. Non-material goods such as air, services etc.,
are excluded from the category of wealth.
 
Criticism on the Classical Definition of Economics:
 
The definitions given by Adam Smith and other classical economists were severely criticized by social reformers and
men of letters of that time Ruskin and Carlyle. They dubbed economics as a ‘dismal science’ and a 'science of
getting rich'. The main criticisms on these definitions are as under:
 
(i) Too much importance to wealth: The definitions of economics give primary importance to wealth and
secondary importance to man. The fact is that the study of man is more importance than the study of wealth.
 
(ii) Narrow meaning of wealth: The word ‘wealth’ in the classical economist’s definitions of economics means only
material goods such as chair, book, pen, etc. These do not include services of doctors, nurses, soldiers etc. In
modern economics, the word ‘wealth’ includes material as well as non-material goods.
 
(iii) Concept of economic man: According to wealth definitions, man works only for his self-interest Social interest
is ignored. Dr. Marshall and his followers were of the view that economics does not study a selfish man but a
common man.
 
(iv) No mention of man’s welfare: The 'Wealth' definitions ignore the importance of man’s welfare. Wealth is not be
all and the end all of all human activities.
 
(v) It does not study means: The definitions of economics lay emphasis on the earning of wealth as an end in
itself. They ignore the means which are scare for the earning of wealth.
 
(vi) Defective logic: The definitions economics given by classical economists were unduly criticized by the literacy
 writers of that time. The fact is that what Adam Smith wrote in his book ‘Wealth of Nations' (1776)  still holds well.
The central argument of the book that market economy enables every individual to contribute his maximum to the
production of wealth of nation still not only holds good but is also being practiced and advocated throughout the
capitalistic world. Since the word 'wealth' did not have clear meaning, therefore the definition  economics became
controversial. It was regarded unscientific and narrow. At the end of 19th century, Dr. Alfred Marshall gave his own
definition of economics and therein he laid emphasis on man and his welfare.
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Home » Laws of Returns » Law of Variable Proportions

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Law of Variable Proportions/Law of Non Proportional Returns/Law

of Diminishing Returns:
 
(Short Run Analysis of Production):
 
Definition:
 
There were three laws of returns mentioned in the history of economic thought up till Alfred Marshall's time. These laws
were the laws of increasing returns, diminishing returns and constant returns. Dr. Marshall was of the view that the law of
diminishing returns applies to agriculture and the law of increasing returns to industry. Much time was wasted in
discussion of this issue. However, it was later on recognized that there are not three laws of production. It is only one law
of production which has three phases, increasing, diminishing and negative production. This general law of production
was named as the Law of Variable Proportions or the Law of Non-Proportional Returns.
 
The Law of Variable Proportions which is the new name of the famous law of Diminishing Returns  has been defined
by Stigler in the following words:
 
"As equal increments of one input are added, the inputs of other productive services being held constant, beyond a
certain point, the resulting increments of produce will decrease i.e., the marginal product will diminish".
 
According to Samuelson:
 
"An increase in some inputs relative to other fixed inputs will in a given state of technology cause output to increase, but
after a point, the extra output resulting from the same addition of extra inputs will become less".
  
Assumptions:
 
The law of variable proportions also called the law of diminishing returns holds good under the following assumptions:
                       
(i) Short run. The law assumes short run situation. The time is too short for a firm to change the quantity of fixed factors.
All the, resources apart from this one variable, are held unchanged in quantity and quality.
 
(ii) Constant technology. The law assumes that the technique of production remains unchanged during production.
 
(iii) Homogeneous factors. Each factor unit in assumed to he identical in amount and quality.
 
Explanation and Example:
 
The law of variable proportions is, now explained with the help of table and graph.
 
Schedule:
 
Fixed Inputs Variable Total Marginal      Product                (MP Average
(Land Capital) Resource Produce (TP Quintals) Product (AP
(labor) Quintals) Quintals)
30 1 10 10  Increasing marginal 10
30 2 25 15 return 12.5

 
30 3 37 12 Diminishing marginal 12.3
30 4 47 10 returns 11.8
30 5 55 8 11.0
30 6 60 5
30 7 63 3
10.0
9.0
 

30 8 63 0 Negative marginal 7.9

returns
30 9 62 -1 6.8
 
In the table above, it is assumed that a farmer has only 30 acres of land for cultivation. The investment on it in the form of tubewells, machinery etc.,
(capital) is also fixed. Thus land and capital with the farmer is fixed and labor is the variable resource.
 
As the farmer increases units of labor from one to two to the amount of other fixed resources (land and capital), the marginal as well as average
product increases. The total product also increase at an increasing rate from 10 to 25 quintals. It is the stage of increasing returns.
 
The stage of increasing returns with the employment of more labor does not last long. It is shown in the table that with the employment of 3rd labor at
the farm, the marginal product and the average product (AP) both fall but marginal product (MP) falls more speedily than the average product AP). The
fall in MP and AP continues as more men are put on the farm.
 
The decrease, however, remains positive up to the 7th labor employed. On the employment of 7th worker, the total production remains constant at 63
quintals. The marginal product is zero. if more men are employed the marginal product becomes negative. It is the stage of negative returns. We here
find the behavior of marginal product (MP). it shows three stages. In the first stage, it increases, in the 2nd it continues to fall and in the 3rd stage it
becomes negative.                  
 
Three Stages of the Law:
 
There are three phases or stages of production, as determined by the law of variable proportions:
 
(i) Increasing returns.
 
(ii) Diminishing returns.
 
(iii) Negative returns.
 
Diagram/Graph:
 
These stages can be explained with the help of graph below:
 

 
(i) Stage of Increasing Returns. The first stage of the law of variable proportions is generally called the stage of
increasing returns. In this stage as a variable resource (labor) is added to fixed inputs of other resources, the total
product increases up to a point at an increasing rate as is shown in figure 11.1.
 
The total product from the origin to the point K on the slope of the total product curve increases at an increasing rate.
From point K onward, during the stage II, the total product no doubt goes on rising but its slope is declining. This means
that from point K onward, the total product increases at a diminishing rate. In the first stage, marginal product curve of a
variable factor rises in a part and then falls. The average product curve rises throughout .and remains below the MP
curve. 
                        
Causes of Initial Increasing Returns:
 
The phase of increasing returns starts when the quantity of a fixed factor is abundant relative to the quantity of the
variable factor. As more and more units of the variable factor are added to the constant quantity of the fixed factor, it is
more intensively and effectively used. This causes the production to increase at a rapid rate. Another reason of
increasing returns is that the fixed factor initially taken is indivisible. As more units of the variable factor are employed to
work on it, output increases greatly due to fuller and effective utilization of the variable factor.
 
(ii) Stage of Diminishing Returns. This is the most important stage in the production function. In stage 2, the total
production continues to increase at a diminishing rate until it reaches its maximum point (H) where the 2nd stage ends. In
this stage both the
marginal product (MP) and average product of the variable factor are diminishing but are positive.  
 
Causes of Diminishing Returns:
 
The 2nd phase of the law occurs when the fixed factor becomes inadequate relative to the quantity of the variable factor.
As more and more units of a variable factor are employed, the marginal and average product decline. Another reason of
diminishing returns in the production function is that the fixed indivisible factor is being worked too hard. It is being used
in non-optima! proportion with the variable factor, Mrs. J. Robinson still goes deeper and says that the diminishing returns
occur because the factors of production are imperfect substitutes of one another.
 
Importance:
 
(iii) Stage of Negative Returns. In the 3rd stage, the total production declines. The TP, curve slopes downward (From
point H onward). The MP curve falls to zero at point L 2 and then is negative. It goes below the X axis with the increase in
the use of variable factor (labor).
 
Causes of Negative Returns:
 
The 3rd phases of the law starts when the number of a variable, factor becomes, too excessive relative, to the fixed
factors, A producer cannot operate in this stage because total production declines with the employment of additional
labor.
 
A rational
producer will always seek to produce in stage 2 where MP and AP of the variable factor are diminishing. At
which particular point, the producer will decide to produce depends upon the price of the factor he has to pay. The
producer will employ the variable factor (say labor) up to the point where the marginal product of the labor equals the
given wage rate in the labor market.
 
The law of variable proportions has vast general applicability. Briefly:
 
(i) It is helpful in understanding clearly the process of production. It explains the input output relations. We can find out
by-how much the total product will increase as a result of an increase in the inputs.
 
(ii) The law tells us that the tendency of diminishing returns is found in all sectors of the economy which may be
agriculture or industry.
 
(iii) The law tells us that any increase in the units of variable factor will lead to increase in the total product at a
diminishing rate. The elasticity of the substitution of the variable factor for the fixed factor is not infinite.
 
From the law of variable proportions, it may not be understood that there is no hope for raising the standard of living of
mankind. The fact, however, is that we can suspend the operation of diminishing returns by continually improving the
technique of production through the progress in science and technology.     

Relevant Articles:
Consumer’s Equilibrium
The consumer is in equilibrium when he maximizes his utility, given
his income and the market prices.
– Anna Koutsoyiannis
Every consumer aims at getting maximum satisfaction out of his given expenditure. A
consumer is said to have attained equilibrium when he spends given income or budget
in such a way as to yield optimum satisfaction, given the prices of two goods and the
consumer’s preference.
In simple words, a consumer is said to be in equilibrium when he is getting maximum
satisfaction out of his limited income.

A consumer may find out his equilibrium condition with the help of indifference curve
analysis.

Assumptions
Consumer’s equilibrium through indifference curve analysis is based on the following
assumptions.

1. The consumer is rational and seeks to maximize his satisfaction through the purchase
of goods.
2. The consumer consumes only two goods (X and Y).
3. The goods are homogenous and perfectly divisible.
4. Prices of the goods and income of the consumer are constant.
5. The indifference map for goods X and Y are given. The indifference map is based on the
consumer’s preferences for the goods.
6. The preference or habit of the consumer does not change throughout the analysis.
7. The income of consumer is given and constant.
Conditions of Consumer’s Equilibrium
The following are the conditions of consumer’s equilibrium
1. Budget line should be tangent to the indifference curve
2. At the point of equilibrium, slope of the budget line = slope of the indifference curve
3. Indifference curve should be convex to the point of origin.
1. Budget line should be tangent to the indifference curve
Consumer’s equilibrium is based on the assumption that the income of a consumer is
constant and that he spends his entire income on purchasing two goods whose prices
are given.
A budget line is a graphical representation of various combinations of two goods that a
consumer can afford at specified prices of the products at particular income level. A
budget line can be drawn on the basis of expenditure plan.

The table given below is an example of expenditure plan and the graph that follows is its
presentation on graph.
Table: Expenditure plan

Given: Budget of the consumer is Rs 10, Price of good X is Rs 1 each and Price of good Y is Rs 2 each

Combination Units of good Y Units of good X

A 5 0

C 4.5 1

E 3 4

D 1.5 7

B 0 10

Figure: Interplay of budget line and indifference curves

In the given diagram, we can see IC1, IC2 and IC3 are three different indifference curves
and AB is a budget line. A consumer can only consume such combinations of goods
which lie upon the budget line at a given income level and constant price of goods X and
Y.
Since, we have,
level of income = Rs 10
price of good X = Rs 1
price of good Y = Rs 2
a consumer can only purchase goods in combination which satisfies the given equation
“I = PX X QX + PY X QY” or “10 = 1 X QX+ 2 X QY”
At point A, 0 X 1 + 5 X 2 = 10
At point C, 4.5 X 2 + 1 X 1 = 10
At point E, 3 X 2 + 4 X 1 = 10
At point D, 1.5 X 2 + 7 X 1 = 10
At point B, 0 X 2 + 10 X 1 = 10
Thus, all these points lie on the budget line AB.

By the property of indifference curves, we know,

utility in IC3 > utility in IC2 > utility in IC1
A consumer can have any combination of goods that lie on the budget line except for
the combinations A and B because in either case he would only have X or Y.

The consumer can purchase combinations C or D but these will not yield him maximum
satisfaction as they lie on lower indifference curve. On the other hand, he cannot get any
combination on IC3 as it is away from the budget line.
Thus, the consumer will be in equilibrium (achieve maximum satisfaction at any given
level of income) where the budget line is tangent to the indifference curve, i.e. at point E
on IC2.

Cite this article as: Shraddha Bajracharya, "Consumer’s Equilibrium: Interplay of Budget Line and
Indifference Curve," in Businesstopia, January 12,
2018, https://www.businesstopia.net/economics/micro/consumers-equilibrium.

2. At the point of equilibrium, the slope on indifference curve = slope of

the budget line.
At any given point on the budget line,

For example, at point E, the slope of budget line = intercept on y-axis / intercept on x-
axis
or, slope of budget line at point E = 3/6 = 1/2

The slope is 1/2 throughout the budget line.

From condition 1, we have known that consumer’s equilibrium exist at the point on
indifference curve where budget line is tangent to the curve.

Thus, at equilibrium point, slope of budget line is equal to slope of the indifference
curve.

3. Indifference curve should be convex to the point of origin

The other condition of equilibrium is that at the point of equilibrium, indifference curve
should be convex to the origin. It means that marginal substitution rate between X and Y
(MRSXY) should be diminishing. If indifference curve is concave and not convex to the
origin, then it will not be the point of equilibrium.
In the above figure, AB is a budget line tangent to IC curve at point E.
At point E, marginal rate of substitution is increasing instead of diminishing. It means,
by moving left or right of point E, a consumer can obtain higher amount of either good X
or good Y. Thus point E is not an equilibrium point.

A consumer will therefore be in equilibrium when at the point of tangency of

indifference curve and the budget line, the indifference curve is convex to the origin.

As shown in the above figure, a consumer is in equilibrium at point E1 where budget line
AB is tangent to the indifference curve IC1 which is convex to the origin.

Marginal Rate of Technical Substitution

Marginal rate of technical substitution (MRTS) may be defined as the rate at which the
producer is willing to substitute one factor input for the other without changing the level
of production.
In other words, MRTS can be understood as the indicator of rate at which one factor
input (labor) can be substituted for the other input (capital) in the production process
while keeping the level of output unchanged or constant.

If we denote labor by ‘L’ and capital by ‘K’, then MRTS of labor for capital can be
expressed as
Table 1: marginal rate of technical substitution (MRTS)

Combination Capital (C) Labor (L) MRTSL,K Output

A 12 1   100

B 8 2 4:1 100

C 5 3 3:1 100

D 3 4 2:1 100

E 2 5 1:1 100

In the above table, there are five different combinations of labor and capital, all of which
yield the same level of output.
We can see in combination A that 12 units of capital and 1 unit of labor have jointly
produced 100 units of output. When the producer moves to combination B, he gave up 4
units of capital in order to add 1 unit of labor input while keeping the production level
unchanged. Hence, MRTS of labor for capital is 4 in this case.
Likewise, if we compare the combinations B and C, the consumer gave up 3 input units
of capital in order to add 1 unit of labor. Therefore, MRTS in this case is 3.

In the same way, the MRTS is 2 and 1 between the combinations C and D, and D and E,
respectively.

Principle of Marginal Rate of Technical Substitution

Marginal rate of technical substitution is based on the principle that the rate by which a
producer substitutes input of a factor for another decreases more and more with every
successive substitution.
If we assume labor (L) and capital (K) to be the two inputs of a production process, the
principle of MRTS states that the value of MRTSL,K decreases with subsequent
substitution of labor for capital. And, this diminishing rate of MRTS is also apparent
from the table 1 given above.
Initially, when the producer moved from combination A to combination B, the rate of
MRTS was calculated to be 4. When the producer moved to combination C, the rate of
MRTS fell and became 3. In the same way, with each successive addition of constant
unit of labor, the MRTS were calculated to be 3, then 2 and finally, 1.

Clearly, the marginal rate of technical substitution has diminished more and more as the
producer kept on substituting input of labor for capital.
Figure 1: marginal rate of technical substitution

Causes of Diminishing Marginal Rate of Technical Substitution

Marginal rate of technical substitution is diminishing due to following reasons.
Imperfect substitutability of the factors
Two factors cannot substitute each other perfectly because they have their own uses in
the production process.

Besides, if the factors could perfectly substitute each other, increase or decrease in
either of the factors won’t bring any changes in the marginal rate of technical
substitution.
Inadequacy of the factor
Substituting one factor for the other continuously causes scarcity of the factor being
replaced. As a result, the factor being tradeoff won’t be able to make as much
contribution as it should have for the efficient production.

Therefore, although the producer had sacrificed more units of capital input in the
beginning, the rate of substitution fell with additional substitutions.

Marginal Rate of Technical Substitution

Marginal rate of technical substitution (MRTS) may be defined as the rate at which the
producer is willing to substitute one factor input for the other without changing the level
of production.
In other words, MRTS can be understood as the indicator of rate at which one factor
input (labor) can be substituted for the other input (capital) in the production process
while keeping the level of output unchanged or constant.

If we denote labor by ‘L’ and capital by ‘K’, then MRTS of labor for capital can be
expressed as
Table 1: marginal rate of technical substitution (MRTS)

Combination Capital (C) Labor (L) MRTSL,K Output

A 12 1   100

B 8 2 4:1 100

C 5 3 3:1 100

D 3 4 2:1 100

E 2 5 1:1 100

In the above table, there are five different combinations of labor and capital, all of which
yield the same level of output.
We can see in combination A that 12 units of capital and 1 unit of labor have jointly
produced 100 units of output. When the producer moves to combination B, he gave up 4
units of capital in order to add 1 unit of labor input while keeping the production level
unchanged. Hence, MRTS of labor for capital is 4 in this case.
Likewise, if we compare the combinations B and C, the consumer gave up 3 input units
of capital in order to add 1 unit of labor. Therefore, MRTS in this case is 3.

In the same way, the MRTS is 2 and 1 between the combinations C and D, and D and E,
respectively.

Principle of Marginal Rate of Technical Substitution

Marginal rate of technical substitution is based on the principle that the rate by which a
producer substitutes input of a factor for another decreases more and more with every
successive substitution.

If we assume labor (L) and capital (K) to be the two inputs of a production process, the
principle of MRTS states that the value of MRTSL,K decreases with subsequent
substitution of labor for capital. And, this diminishing rate of MRTS is also apparent
from the table 1 given above.
Initially, when the producer moved from combination A to combination B, the rate of
MRTS was calculated to be 4. When the producer moved to combination C, the rate of
MRTS fell and became 3. In the same way, with each successive addition of constant
unit of labor, the MRTS were calculated to be 3, then 2 and finally, 1.

Clearly, the marginal rate of technical substitution has diminished more and more as the
producer kept on substituting input of labor for capital.
Figure 1: marginal rate of technical substitution

Causes of Diminishing Marginal Rate of Technical Substitution

Marginal rate of technical substitution is diminishing due to following reasons.
Imperfect substitutability of the factors
Two factors cannot substitute each other perfectly because they have their own uses in
the production process.
Besides, if the factors could perfectly substitute each other, increase or decrease in
either of the factors won’t bring any changes in the marginal rate of technical
substitution.
Inadequacy of the factor
Substituting one factor for the other continuously causes scarcity of the factor being
replaced. As a result, the factor being tradeoff won’t be able to make as much
contribution as it should have for the efficient production.

Therefore, although the producer had sacrificed more units of capital input in the beginning, the
rate of substitution fell with additional substitutions

What is a demand curve?

The graphical representation of the relationship between the demand of the commodity
and price of the commodity, at any given time, is known as the demand curve.
A demand curve can also be defined as the graphical representation of a demand
schedule. A demand schedule is a tabular statement which represents the various
quantity of the commodity that the consumers are ready to buy at every different price,
at any given time.

In a graph, the price of the commodity is represented in the vertical axis (Y-axis) and the
quantity demanded is represented on the horizontal axis (X-axis). A commodity’s price
and its demand share inverse relationship. This means, higher the price of the
commodity, lesser will be its demand and lower the price, higher will be the demand.
Therefore, in a graph, demand curve makes a downward slope.

In the following figures, fig. I is an example of demand schedule and fig. II is its
graphical illustration (demand curve).

Fig. I: Demand schedule

Price of soda per bottle (in Rs.) Quantity (bottles) demanded per day (*1000)

10 40
 20 30

20

40 10

Fig. II: Demand curve

Movement along a demand curve

The amount of quantity demanded by the consumer changes with the rise and fall in the
price of the commodity if other determinants of demand remain constant. This
alternation in demand, when shown in the graph, is known as movement along a
demand curve.

Movement along a demand curve can also be understood as the variation in quantity
demanded of the commodity with the change in its price, ceteris paribus.
There can be two types of movement in a demand curve – extension and contraction.

Extension in a demand curve is caused when the demand for a commodity rises due to
fall in price. And, contraction in demand curve is caused when the demand for a
commodity falls due to rise in price.
In the above fig. II, let us suppose Rs. 30 is the original price of the soda per bottle and
20,000 units are the original quantity of demand. When the price falls from Rs. 30 to Rs.
20, the amount of quantity demanded rises from 20,000 units to 30,000 units. With this
change in demand, there is a movement in the demand curve from point B to point C
which is known as an extension of the demand curve.

Similarly, when the price of the soda increases from Rs. 30 to Rs. 40, the demand for the
soda falls from 20,000 units to 10,000 units. This time, there is a movement in the
demand curve from point B to point A, and this movement is known as a contraction in
the demand curve.

Shift in demand curve

The amount of commodity demanded by the consumers may change due to the effect
of non-price factors as well. Non-price factors which influence demand for the
commodity may be consumers’ income, the price of related goods, advertisement,
climate and weather, the expectation of rise or fall in price in future, etc.

When the amount of commodity demanded changed due to non-price factors, there is
no extension or contraction in the curve but the formation of the entirely new demand
curve. As a result, demand curve shifts from its original position.

For an example, the demand for cold drinks in the market may increase substantially
even at same price due to hot weather.
Fig. III: Shift in demand curve
The shift in demand curve is also of two types – rightward shift and leftward shift.

When the demand for a commodity increases at the same price due to favorable
changes in non-price factors, the initial demand curve shifts towards the right, and there
is a rightward shift in the demand curve. Similarly, when the demand for a commodity
fails at same price due to unfavorable changes in non-price factors, the initial demand
curve shifts towards left, and there is a leftward shift in the demand curve.
In the given fig. III, let us suppose, DD is the initial demand curve where P is the original
price and Q is the original quantity of demand of a commodity. Due to favorable
changes in non-price factors, the demand for the commodity in the market has
increased from Q to Q2 amount at the same price. Thus, the demand curve has shifted
rightwards and new demand curve D2D2 has formed.
Similarly, due to unfavorable changes in non-price factors, the demand for the
commodity has fallen from Q to Q1 amount. Thus, a new demand curve D1D1 has formed
at the left side of the initial curve.

Reasons for rightward shift of curve

 Increase in consumers’ income
 Increase in price of its substitute goods
 Decrease in price of its complementary goods
 Favorable change in taste and preference
  Expectation of rise in price of the commodity in future
 Increase in population

Reasons for leftward shift of curve

 Decrease in consumers’ income
 Decrease in price of its substitute goods
 Increase in price of its complementary goods
 Unfavorable changes in taste and preference
 Expectation of fall in price of the commodity in future
 Decrease in population

Utility is the ability of a good to satisfy a want.

– Prof. Hobson
In microeconomics, utility is a controversial topic. It is generally used to describe the
degree of satisfaction an individual receives from consuming a commodity. It can be
understood as the power of a commodity to satisfy the wants of consumers.
The satisfaction can be expected or real. And if the commodity fulfills or is expected to
fulfill the need of the consumer, the commodity is said to have utility.

For an example: A hungry person buys a burger expecting that the burger will curb his
appetite. This means that the burger has utility.

All economists would agree that the person has gained utility by consuming the burger.
But when it comes to measuring the utility, different economists have different views.

Many economists state that utility can be measured numerically while there are many
others who argue that utility is a subjective phenomenon, and thus can’t be expressed
quantitatively.
This difference in opinion regarding measurement of utility has developed the concept
of cardinal and ordinal utility.
Cardinal utility
According to classical economists utility is a quantitative concept and that it can be
measured in terms of a number. Hence they developed the concept of measuring utility
through cardinal approach.

According to this concept, utility can be expressed in the same way that weight and
height are expressed. However, the economists lacked a proper unit for utility. So they
derived a psychological unit called ‘Util’. Util is not a standard unit because it varies
from person to person, place to place and time to time.
For an example, if a person assigns 20 utils to a burger and 10 utils to a sandwich, we
can understand that the burger has double the capacity to satisfy that man’s wants.

Since util is not a standard unit for measuring utility, many economists, including Alfred
Marshall suggested measurement of utility in terms of money that consumers are
willing to pay for a commodity.

If each rupee is equal to 1 util, a burger worth Rs 20 has 20 utils and a sandwich worth
Rs 10 has 10 utils. Thus, whoever consumes burger will yield utility of 20 utils and those
who consume sandwich will yield utility of 10 utils.

Ordinal utility
Opposing to the concept of classical economists, modern economists claimed that
absolute measurement of utility is not possible.
According to these economists, utility is subjective phenomenon, i.e. influenced by
personal feelings, preference and opinions, and thus unquantifiable. However, they
stated that utility can be clearly expressed in terms of rank.

For an instance, if a person prefers fruit juice to soda, it means fruit juice has more
utility than soda. In this case, fruit juice can be placed in the first position and soda in
the second, in terms of utility.
Income elasticity of demand is the measure of degree of change in quantity demanded
for a commodity in response to the change in income of the consumers demanding the
commodity.
In simple words, it can be defined as the change in demand as a result of change in
income of the consumers. Often referred to as just ‘income elasticity’, it is denoted by
Ey.

Consumer’s income is one of the major factors that determine demand of a product.

Unlike price of the product, consumer’s income share direct relationship with the
demand for the product. This implies that higher the income, more will be the demand,
and lower the income, fewer will be the demand of the commodity.

Methods of Measuring Income Elasticity of Demand

Basically, there are three methods by which we can measure income elasticity of
demand. These methods are
i. Percentage method
ii. Point method

iii. Arc method

Percentage Method
Percentage method is one of the commonly used approaches of measuring income
elasticity of demand, under which income elasticity is measured in terms of rate of
percentage change in quantity demanded of the commodity to percentage change in
income of the consumers who demand that commodity.

According to this method, income elasticity can be mathematically expressed as

Where,
ΔQ = change in quantity demanded = Q2 – Q1

Q1 = initial quantity demanded

Q2 = new quantity demanded

ΔY = change in income of the consumers = Y2 – Y1

Y1 = initial income of the consumers

Y2 = new income of the consumers

Cite this article as: Shraddha Bajracharya, "Measuring Income Elasticity of Demand: Percentage, Point
and Arc Methods," in Businesstopia, January 7,
2018, https://www.businesstopia.net/economics/micro/measuring-income-elasticity-demand-percentage-
point-and-arc-methods.

For example: The demand of quantity when the income of the consumer was Rs 3000
was 30 units. When his income increased by Rs 2000, the quantity of commodity
demanded by him became 50 units. Here, income elasticity of demand can be
calculated as
Since Ey = 1, this is an example of unitary income elasticity of demand where
percentage change in income of consumer is equal to percentage change in demand of
the commodity.

Point Method
Point method is one of the geometric methods of measuring income elasticity of
demand at any given point on the income demand curve.
Income demand curve is an upward sloping curve in case of normal goods and a
downward sloping curve in case of inferior goods.

However, the method of calculating income elasticity depends upon the nature of the
income demand curve. These methods are described below.

Price elasticity on a linear income demand curve

Figure: income demand curve
From percentage method, we have known that

ΔBAC and ΔAEQ1 are similar triangles in account of AAA property. Thus, ratios of the
sides of both the triangles are equal.
This implies,

Now, substituting equation (iii) in equation (ii),

Price elasticity on a non-linear income demand curve
If the income demand curve is of a non-linear nature, then income elasticity can be
calculated by drawing a tangent at the point where income elasticity is to be known.
Then income elasticity can be simply calculated by applying the equation (iv) given
above.
In the figure given above, we can see DD is a non-linear demand curve and P is the point
whose income elasticity is to be calculated. Thus, a tangent MN is drawn through the
point P to X-axis. Then income elasticity is simply calculated as
Arc Method
Arc method is also a geometric method of measuring income elasticity of demand
between any two points on an income demand curve. While ‘point method’ is used to
calculate income elasticity at any given point on an income demand curve, this method
is used to measure income elasticity over a certain range or between two points on the
curve.

In the figure, we can see that AB is an arc on the income demand curve DD, and C is the
mid-point of AB. Here, income elasticity of demand at point C is calculated by following
ways.

At first, average of income as well as quantity demanded is measured.

Then income elasticity is calculated by applying the formula

Where,

ΔQ = change in quantity demanded = Q2 – Q1

Q1 = initial quantity demanded

Q2 = new quantity demanded

ΔY = change in income of consumer = Y2 – Y1

Y1 = initial income of consumer

Y2 = new income of consumer

What do you mean by supply?

The economy is composed of two forces – the producers (who produce goods and
services) and the consumers (who buy the products available in the market).
Supply is a fundamental concept of economics which can be defined as the total
amount of a particular good or service which is available to the consumers at the
existing market. It is the quantity of goods that the producers are able to or willing to
offer for sale at given price. In simple words, supply is the amount of specific goods
available at a specific price at a specific time.

Determinants of Supply
There are a number of factors and circumstances which can influence a producer’s
willingness to supply the commodity in the market. These factors are

Price of the commodity

Any producers’ primary motive is to maximize profit or increase revenue. That is why
producers tend to supply more products in the market when the price of the product
rises, with all other factors being constant. In the same way, producers tend to supply
fewer products in cases when the price falls and other factors remain constant.

Price of the related goods

Related goods refer to the goods which are used as input for the production of the
commodity.
The price of such goods is one of the major determinants of supply of the commodity. It
is directly proportional with the price of production of any commodity, i.e. when the
price of related good rise up, the production cost of the commodity also rises and when
the price of related goods fall, production cost also falls.
Producers tend to withdraw their investment from commodities which cost more to
produce, directly affecting the supply of the commodity in the market.

Price of the factors of production

The factor of production refers to the input that is required for producing a product in an
economical way. Generally, land, labor, capital and entrepreneurship are considered as
the factors of production.
Producers have to pay a certain amount in terms of rent, wage and interest in the return
of using factors of production. When these prices rise up, producers may want to divert
their investment (resources, time and money) in the production of other commodities.
As a result, the supply of the product in the market decreases.

Goal of producers
The primary objective of every firm is to earn revenue and maximize profit. However,
there may be circumstances when firms focus on earning prestige rather than profit.

Companies who prioritize prestige to profit may sometimes increase the supply of the
commodity in the market even in times when they earn very little or no profit at all, just
to stand out in the market.

State of technology
Technology is one of the major components of firms and industries these days.
Advancement in technology has a great impact on the production rate. It increases the
production rate efficiently, and with an increase in the amount of products produced,
there will be an increase in the supply of the commodity in the market.
Miscellaneous factors
Under this heading, we can include factors such as means of transportation and
communication, natural factors, taxation policy, expectations, agreement among the
producers, etc. All these factors have potential to influence the ability or willingness of
producers to offer the product in the market.

What is supply function?

The functional relationship between the quantity of commodities supplied and various
determinants are known as supply function. It is the mathematical expression of the
relationship between supply and factors that affect the ability and willingness of the
producer to offer the product. The relationship may exist between two or more number
of variables.

Mathematically, a supply function can be expressed as

Qs = f(P; Prg) where,
Qs = Quantity of commodity supplied
P = Price of the good

Prg = Price of related good

Types of Supply Function

Individual Supply Function

The algebraic expression of an individual supply schedule is called individual supply
function. An individual supply schedule is a tabular statement representing the various
amounts of a commodity that a single producer is willing to sell at a different price,
during a given period of time.

Individual supply schedule

Price of milk per liter (in Rs.) Quantity supplied per day in liters (*1000)

10 10

12 13

14 20

16 25

Mathematically, a supply function can be represented as

Sx = f(Px, Po, Pf, St, T, G) where,

Sx = Supply of the commodity x
Px = Price of the commodity x
Prg = Price of related goods
Pf = Price of factors of production
St = State of technology
T = Taxation policy

G = Goals of the firm

Market Supply Function
Market supply function is the algebraic expression of the market supply schedule.
Market supply schedule can be defined as the tabular statement which represents
various amounts of a commodity that the entire producers in the whole economy are
willing to supply at the optimal price, at any given time.

Market supply schedule

Individual supply per day Market supply per day

Price of the product X per unit (in Rs.) A B C

100 750 500 450 1700

200 800 650 500 1950

300 900 750 650 2300

400 1000 900 700 2600

Market supply function can also be defined as the summation of individual supply
functions within a specific market.

Mathematically, a market supply function can be represented as

Sx = f(Px, Po, Pf, St, T, G, N, F, M) where,

Sx = Market supply of the commodity x
Px = Price of the commodity x
Prg = Price of related goods
Pf = Price of factors of production
St = State of technology
T = Taxation policy

G = Goals of the market

N = Number of firms
F = Future expectation regarding price of the commodity x

M = Means of transportation and communication

What do you mean by supply?

The economy is composed of two forces – the producers (who produce goods and
services) and the consumers (who buy the products available in the market).
Supply is a fundamental concept of economics which can be defined as the total
amount of a particular good or service which is available to the consumers at the
existing market. It is the quantity of goods that the producers are able to or willing to
offer for sale at given price. In simple words, supply is the amount of specific goods
available at a specific price at a specific time.

Determinants of Supply
There are a number of factors and circumstances which can influence a producer’s
willingness to supply the commodity in the market. These factors are

Price of the commodity

Any producers’ primary motive is to maximize profit or increase revenue. That is why
producers tend to supply more products in the market when the price of the product
rises, with all other factors being constant. In the same way, producers tend to supply
fewer products in cases when the price falls and other factors remain constant.

Price of the related goods

Related goods refer to the goods which are used as input for the production of the
commodity.
The price of such goods is one of the major determinants of supply of the commodity. It
is directly proportional with the price of production of any commodity, i.e. when the
price of related good rise up, the production cost of the commodity also rises and when
the price of related goods fall, production cost also falls.
Producers tend to withdraw their investment from commodities which cost more to
produce, directly affecting the supply of the commodity in the market.
Price of the factors of production
The factor of production refers to the input that is required for producing a product in an
economical way. Generally, land, labor, capital and entrepreneurship are considered as
the factors of production.
Producers have to pay a certain amount in terms of rent, wage and interest in the return
of using factors of production. When these prices rise up, producers may want to divert
their investment (resources, time and money) in the production of other commodities.
As a result, the supply of the product in the market decreases.

Goal of producers
The primary objective of every firm is to earn revenue and maximize profit. However,
there may be circumstances when firms focus on earning prestige rather than profit.

Companies who prioritize prestige to profit may sometimes increase the supply of the
commodity in the market even in times when they earn very little or no profit at all, just
to stand out in the market.

State of technology
Technology is one of the major components of firms and industries these days.
Advancement in technology has a great impact on the production rate. It increases the
production rate efficiently, and with an increase in the amount of products produced,
there will be an increase in the supply of the commodity in the market.
Miscellaneous factors
Under this heading, we can include factors such as means of transportation and
communication, natural factors, taxation policy, expectations, agreement among the
producers, etc. All these factors have potential to influence the ability or willingness of
producers to offer the product in the market.

What is supply function?

The functional relationship between the quantity of commodities supplied and various
determinants are known as supply function. It is the mathematical expression of the
relationship between supply and factors that affect the ability and willingness of the
producer to offer the product. The relationship may exist between two or more number
of variables.

Mathematically, a supply function can be expressed as

Qs = f(P; Prg) where,
Qs = Quantity of commodity supplied
P = Price of the good

Cite this article as: Palistha Maharjan, "Concept of Supply Function and Its Types," in Businesstopia,
January 8, 2018, https://www.businesstopia.net/economics/micro/supply-function.

Prg = Price of related good

Types of Supply Function

Individual Supply Function

The algebraic expression of an individual supply schedule is called individual supply
function. An individual supply schedule is a tabular statement representing the various
amounts of a commodity that a single producer is willing to sell at a different price,
during a given period of time.

Individual supply schedule

Price of milk per liter (in Rs.) Quantity supplied per day in liters (*1000)

10 10

12 13

14 20

16 25

Mathematically, a supply function can be represented as

Sx = f(Px, Po, Pf, St, T, G) where,

Sx = Supply of the commodity x
Px = Price of the commodity x
Prg = Price of related goods
Pf = Price of factors of production
St = State of technology
T = Taxation policy

G = Goals of the firm

Market Supply Function

Market supply function is the algebraic expression of the market supply schedule.
Market supply schedule can be defined as the tabular statement which represents
various amounts of a commodity that the entire producers in the whole economy are
willing to supply at the optimal price, at any given time.

Market supply schedule

Individual supply per day Market supply per day

Price of the product X per unit (in Rs.) A B C

100 750 500 450 1700

200 800 650 500 1950

300 900 750 650 2300

400 1000 900 700 2600

Market supply function can also be defined as the summation of individual supply
functions within a specific market.

Mathematically, a market supply function can be represented as

Sx = f(Px, Po, Pf, St, T, G, N, F, M) where,

Sx = Market supply of the commodity x
Px = Price of the commodity x
Prg = Price of related goods
Pf = Price of factors of production
St = State of technology
T = Taxation policy

G = Goals of the market

N = Number of firms

F = Future expectation regarding price of the commodity x

M = Means of transportation and communication

What do you mean by supply?

The economy is composed of two forces – the producers (who produce goods and
services) and the consumers (who buy the products available in the market).
Supply is a fundamental concept of economics which can be defined as the total
amount of a particular good or service which is available to the consumers at the
existing market. It is the quantity of goods that the producers are able to or willing to
offer for sale at given price. In simple words, supply is the amount of specific goods
available at a specific price at a specific time.

Determinants of Supply
There are a number of factors and circumstances which can influence a producer’s
willingness to supply the commodity in the market. These factors are

Price of the commodity

Any producers’ primary motive is to maximize profit or increase revenue. That is why
producers tend to supply more products in the market when the price of the product
rises, with all other factors being constant. In the same way, producers tend to supply
fewer products in cases when the price falls and other factors remain constant.
Price of the related goods
Related goods refer to the goods which are used as input for the production of the
commodity.
The price of such goods is one of the major determinants of supply of the commodity. It
is directly proportional with the price of production of any commodity, i.e. when the
price of related good rise up, the production cost of the commodity also rises and when
the price of related goods fall, production cost also falls.
Producers tend to withdraw their investment from commodities which cost more to
produce, directly affecting the supply of the commodity in the market.

Price of the factors of production

The factor of production refers to the input that is required for producing a product in an
economical way. Generally, land, labor, capital and entrepreneurship are considered as
the factors of production.
Producers have to pay a certain amount in terms of rent, wage and interest in the return
of using factors of production. When these prices rise up, producers may want to divert
their investment (resources, time and money) in the production of other commodities.
As a result, the supply of the product in the market decreases.

Goal of producers
The primary objective of every firm is to earn revenue and maximize profit. However,
there may be circumstances when firms focus on earning prestige rather than profit.

Companies who prioritize prestige to profit may sometimes increase the supply of the
commodity in the market even in times when they earn very little or no profit at all, just
to stand out in the market.

State of technology
Technology is one of the major components of firms and industries these days.
Advancement in technology has a great impact on the production rate. It increases the
production rate efficiently, and with an increase in the amount of products produced,
there will be an increase in the supply of the commodity in the market.
Miscellaneous factors
Under this heading, we can include factors such as means of transportation and
communication, natural factors, taxation policy, expectations, agreement among the
producers, etc. All these factors have potential to influence the ability or willingness of
producers to offer the product in the market.

What is supply function?

The functional relationship between the quantity of commodities supplied and various
determinants are known as supply function. It is the mathematical expression of the
relationship between supply and factors that affect the ability and willingness of the
producer to offer the product. The relationship may exist between two or more number
of variables.

Mathematically, a supply function can be expressed as

Qs = f(P; Prg) where,
Qs = Quantity of commodity supplied
P = Price of the good

Prg = Price of related good

Types of Supply Function

Individual Supply Function

The algebraic expression of an individual supply schedule is called individual supply
function. An individual supply schedule is a tabular statement representing the various
amounts of a commodity that a single producer is willing to sell at a different price,
during a given period of time.

Individual supply schedule

Price of milk per liter (in Rs.) Quantity supplied per day in liters (*1000)
 10 10

12 13

14 20

16 25

Mathematically, a supply function can be represented as

Sx = f(Px, Po, Pf, St, T, G) where,

Sx = Supply of the commodity x
Px = Price of the commodity x
Prg = Price of related goods
Pf = Price of factors of production
St = State of technology
T = Taxation policy

G = Goals of the firm

Market Supply Function

Market supply function is the algebraic expression of the market supply schedule.
Market supply schedule can be defined as the tabular statement which represents
various amounts of a commodity that the entire producers in the whole economy are
willing to supply at the optimal price, at any given time.

Market supply schedule

Individual supply per day Market supply per day

Price of the product X per unit (in Rs.) A B C

100 750 500 450 1700

200 800 650 500 1950

 300 900 750 650 2300

400 1000 900 700 2600

Market supply function can also be defined as the summation of individual supply
functions within a specific market.

Mathematically, a market supply function can be represented as

Sx = f(Px, Po, Pf, St, T, G, N, F, M) where,

Sx = Market supply of the commodity x
Px = Price of the commodity x
Prg = Price of related goods
Pf = Price of factors of production
St = State of technology
T = Taxation policy

G = Goals of the market

N = Number of firms

F = Future expectation regarding price of the commodity x

M = Means of transportation and communication

What do you mean by supply?

The economy is composed of two forces – the producers (who produce goods and
services) and the consumers (who buy the products available in the market).
Supply is a fundamental concept of economics which can be defined as the total
amount of a particular good or service which is available to the consumers at the
existing market. It is the quantity of goods that the producers are able to or willing to
offer for sale at given price. In simple words, supply is the amount of specific goods
available at a specific price at a specific time.
Determinants of Supply
There are a number of factors and circumstances which can influence a producer’s
willingness to supply the commodity in the market. These factors are

Price of the commodity

Any producers’ primary motive is to maximize profit or increase revenue. That is why
producers tend to supply more products in the market when the price of the product
rises, with all other factors being constant. In the same way, producers tend to supply
fewer products in cases when the price falls and other factors remain constant.

Price of the related goods

Related goods refer to the goods which are used as input for the production of the
commodity.
The price of such goods is one of the major determinants of supply of the commodity. It
is directly proportional with the price of production of any commodity, i.e. when the
price of related good rise up, the production cost of the commodity also rises and when
the price of related goods fall, production cost also falls.
Producers tend to withdraw their investment from commodities which cost more to
produce, directly affecting the supply of the commodity in the market.

Price of the factors of production

The factor of production refers to the input that is required for producing a product in an
economical way. Generally, land, labor, capital and entrepreneurship are considered as
the factors of production.
Producers have to pay a certain amount in terms of rent, wage and interest in the return
of using factors of production. When these prices rise up, producers may want to divert
their investment (resources, time and money) in the production of other commodities.
As a result, the supply of the product in the market decreases.

Goal of producers
The primary objective of every firm is to earn revenue and maximize profit. However,
there may be circumstances when firms focus on earning prestige rather than profit.
Companies who prioritize prestige to profit may sometimes increase the supply of the
commodity in the market even in times when they earn very little or no profit at all, just
to stand out in the market.

State of technology
Technology is one of the major components of firms and industries these days.
Advancement in technology has a great impact on the production rate. It increases the
production rate efficiently, and with an increase in the amount of products produced,
there will be an increase in the supply of the commodity in the market.
Miscellaneous factors
Under this heading, we can include factors such as means of transportation and
communication, natural factors, taxation policy, expectations, agreement among the
producers, etc. All these factors have potential to influence the ability or willingness of
producers to offer the product in the market.

What is supply function?

The functional relationship between the quantity of commodities supplied and various
determinants are known as supply function. It is the mathematical expression of the
relationship between supply and factors that affect the ability and willingness of the
producer to offer the product. The relationship may exist between two or more number
of variables.

Mathematically, a supply function can be expressed as

Qs = f(P; Prg) where,
Qs = Quantity of commodity supplied
P = Price of the good

Individual Supply Function

The algebraic expression of an individual supply schedule is called individual supply
function. An individual supply schedule is a tabular statement representing the various
amounts of a commodity that a single producer is willing to sell at a different price,
during a given period of time.

Individual supply schedule

Price of milk per liter (in Rs.) Quantity supplied per day in liters (*1000)

10 10

12 13

14 20

16 25

Mathematically, a supply function can be represented as

Sx = f(Px, Po, Pf, St, T, G) where,

Sx = Supply of the commodity x
Px = Price of the commodity x
Prg = Price of related goods
Pf = Price of factors of production
St = State of technology
T = Taxation policy

G = Goals of the firm

Market Supply Function

Market supply function is the algebraic expression of the market supply schedule.
Market supply schedule can be defined as the tabular statement which represents
various amounts of a commodity that the entire producers in the whole economy are
willing to supply at the optimal price, at any given time.
 Market supply schedule

Individual supply per day Market supply per day

Price of the product X per unit (in Rs.) A B C

100 750 500 450 1700

200 800 650 500 1950

300 900 750 650 2300

400 1000 900 700 2600

Market supply function can also be defined as the summation of individual supply
functions within a specific market.

Mathematically, a market supply function can be represented as

Sx = f(Px, Po, Pf, St, T, G, N, F, M) where,

Sx = Market supply of the commodity x
Px = Price of the commodity x
Prg = Price of related goods
Pf = Price of factors of production
St = State of technology
T = Taxation policy

G = Goals of the market

N = Number of firms

F = Future expectation regarding price of the commodity x

M = Means of transportation and communication

Isocost Line
The combination of factor-inputs with which a firm produces output depends upon the
quantity of output that the firm wants to produce. Besides, the combination of factor-
inputs also depends upon the amount of money that the firm wants to spend and prices
of the factor-inputs.
An isocost line is a graphical representation of various combinations of two factors
(labor and capital) which the firm can afford or purchase with a given amount of money
or total outlay. It is an important tool for determining what combination of factor-inputs
the firm will choose for production process.

Suppose a producer has Rs. 200 and he wants to spend his entire outlay on two factors
– labor and capital. Further suppose that the price of Labor is Rs. 4 per unit and the
price of capital is Rs 5 per unit. If the firm spends its whole outlay of Rs 200 on labor
only, he can buy 50 units of labor. And, if the firm spends its entire outlay on capital only,
then he can buy 40 units of capital.

Mathematically, an isocost line can be expressed as

C=wL+rK
Where,
C = cost of production
w = price of labor or wages
L = units of labor
r = price of capital or interest rate
K =units of capital
A firm can purchase only such combinations of factor-inputs which satisfy the given
equation. For example, a producer can purchase combinations like ’25 units labor + 20
units capital’, ‘30 units labor + 16 units capital’ or ’12.5 units labor + 30 units capital’
because all of them fulfill the equation at given prices and outlay.
This concept is clearly explained by the figure given below.

Figure: isocost line

What is price elasticity of supply?
In Economics, elasticity is defined as the degree of change in demand and supply of
consumers and producers with respect to the change in income or price of the
commodity.
Particularly, price elasticity of supply is a measure of the degree of change in the
supplied amount of commodity in response to the change in the commodity’s price. In
simple words, it can be defined as the rate of change in supply in response to a price
change. It is denoted as PES or Es.
Mathematically, price elasticity of supply is expressed as

Degrees or Types of Price Elasticity of Supply

The degree of elasticity of supply can be of five types. They are described below in brief
with figure.
Relatively elastic supply
When percentage change in quantity supplied is greater than percentage change in
price, the condition is known as relatively elastic supply. This situation when plotted in
graph makes an upward slope which intersects positive Y-axis.
Fig. i: relatively elastic supply curve
In figure i, we can see that ratio of change in quantity supplied is greater than the ratio
of change in price. As a result, when we put their values in the above mathematical
expression, we get PES>1.

Elasticity tends to be greater than 1 in case of products which are not necessary to
sustain our lives. Luxury goods such as expensive smart phone, gold, etc. show this
kind of price elasticity.

Relatively inelastic supply

When the percentage change in quantity supplied is lesser than percentage change in
price, the condition is known as relatively inelastic supply. This situation when plotted in
graph makes highly inclined upward slope which intersects positive X-axis.

Fig. ii: relatively inelastic supply curve

In the above figure, it is clearly shown that ratio of change in price is greater than ratio
of change in quantity, whose value when substituted in the given expression, we get
PES<1.

Such kind of price elasticity can be observed in goods which are necessary in our day to
day lives. Clothes, foods, etc. are good examples of these kinds of goods.

Unitary elastic supply

When percentage change in quantity supplied is exactly equal to percentage change in
price, the situation is known as unitary elastic supply. This situation is graph is
represented by an upward slope which intersects the origin.

Fig. iii: unitary elastic supply

In the above figure, the ratio of change in quantity supplied is equal to the ratio of
change in price. Consequently, when the value of these variables are substituted in the
given expression, we get PES=1. This behavior between price and quantity supplied of
commodity is also known as lock-step movement.
Infinite/perfectly elastic supply
When a slight or minimal change in price causes infinite change in quantity supplied, it
is said to be infinite or perfectly elastic supply. In a graph, such situation is represented
by a straight line which is parallel to X-axis.

Fig. iv: perfectly elastic supply curve

In the above figure, we can see that quantity supplied has varied significantly even at the
same price level. This kind of price elasticity is expected to occur in highly luxurious
goods. However, perfectness of anything, including perfectly inelastic supply is
considered to be rare or impractical in economy.

Zero /perfectly inelastic supply

When quantity supplied remains unchanged with change in price, it is said to be zero or
perfectly inelastic supply. Such situation in graph is represented by a straight line which
is parallel to Y-axis.
Fig. v: perfectly inelastic supply
In figure v, we can see that the amount of commodity supplied has remained unchanged
even when the price has greatly changed. This type of price elasticity is expected to be
observed in highly essential goods such as medicines. However, as mentioned earlier,
perfectness of anything in economy is rare or impractical.

A supply curve is a graphical representation of the relationship between the amount of a

commodity that a producer or supplier is willing to offer and the price of the commodity,
at any given time. In other words, a supply curve can also be defined as the graphical
representation of a supply schedule.
In a graph, the price of the commodity is shown on the vertical axis (Y-axis) and the
quantity supplied is shown on the horizontal axis (X-axis) of the graph. It is an upward
slope, which means higher the price, higher will be the quantity supplied, and lower the
price, lesser will be the quantity supplied.

Given below are two figures –I and II. Figure I is an example of supply schedule and
figure II is its graphical illustration.

Fig. I: Individual supply schedule

Price of milk per liter (in Rs.) Quantity supplied per day in liters (*1000)

10 10
 20 20

30 30

40 40

Fig. II: Supply curve

Movement along a supply curve

The amount of commodity supplied changes with rise and fall of the price while other
determinants of supply remain constant. This change, when shown in the graph, is
known as movement along a supply curve.
In simple words, movement along a supply curve represents the variation in quantity
supplied of the commodity with a change in its price and other factors remaining
unchanged.

The movement in supply curve can be of two types – extension and contraction.
Extension in a supply curve is caused when there is an increase in the price or quantity
supplied of the commodity while contraction is caused due to a decrease in the price or
quantity supplied of the commodity.
In the above fig. II, let us suppose Rs. 20 is the original price of milk per liter and 20,000
liters is the original quantity of supply. When the price rises from Rs. 20 to Rs. 30, the
amount of quantity supplied rises from 20,000 liters to 30,000 liters, and there is a
movement in the supply curve from point B to point C. This movement is known as an
extension of the supply curve.
Similarly, when the price falls from Rs. 20 to Rs. 10, the amount of quantity supplied
falls from 20,000 liters to 10,000 liters, and there is another movement in the supply
curve from point B to point A. This movement is known as a contraction of the supply
curve.

Shift in supply curve

The amount of commodity that the producers or suppliers are willing to offer at the
marketplace can change even in cases when factors other than the price of the
commodity change. Such non-price factors can be the cost of factors of production, tax
rate, state of technology, natural factors, etc.

When the quantity of the commodity supplied changes due to change in non-price
factors, the supply curve does not extend or contract but shifts entirely. For an instance,
the introduction of improved technology in industries helps in reducing the cost of
production and induces production of more units of a commodity at the same price. As
a result, the quantity of commodity supplied increases but the price of the commodity
remains as it is.
Fig. III: Shift in supply curve

The shift in supply curve can also be of two types – rightward shift and leftward shift.
The rightward shift occurs in supply curve when the quantity of supplied commodity
increases at same price due to favorable changes in non-price factors of production of
the commodity. Similarly, a leftward shift occurs when the quantity of supplied
commodity decreases at the same price.
In the above fig. III, let us suppose that SS is the original supply curve where Q amount
of commodity has been supplied at price P. Due to favorable changes in non-price
factors, the production of the commodity has increased and its supply has been
increased by Q2 – Q amount, at the same price. This has caused the supply curve
rightwards and new supply curve S2S2 has formed.
In the same, due to unfavorable changes in non-price factors of the commodity, the
production and supply have fallen to Q1 amount. Accordingly, the supply curve has
shifted leftwards and new supply curve S1S1 has formed.

Reasons for rightward shift of supply curve

 Improvement in technology
 Decrease in tax
 Decrease in cost of factor of production
 Favorable weather condition
 Seller’s expectation of fall in price in future

Reasons for leftward shift of supply curve

 Use of old or outdated technology
 Increase in tax
 Increase in cost of factor of production
 Unfavorable weather condition
Microeconomics refers to the study of individualistic economic behavior at the time of
making economic decisions. It studies an individual consumer, producer, manager or a
firm, price of a particular commodity or a household.

Scopes of Microeconomics
The scope or the subject matter of microeconomics is concerned with:

Commodity pricing
The price of an individual commodity is determined by the market forces of demand
and supply. Microeconomics is concerned with demand analysis i.e. individual
consumer behavior, and supply analysis i.e. individual producer behavior.

Factor pricing theory

Microeconomics helps in determining the factor prices for land, labor, capital, and
entrepreneurship in the form of rent, wage, interest, and profit respectively. Land, labor,
capital, and entrepreneurship are the factors that contribute to the production process.

Theory of economic welfare

Welfare economics in microeconomics is concerned with solving the problems in
improvement and attaining economic efficiency to maximize public welfare. It attempts
to gain efficiency in production, consumption/distribution to attain overall efficiency and
provides answers for ‘What to produce?’, ‘When to produce?’, ‘How to produce?’, and
‘For whom it is to be produced?’

Significance of Microeconomics in Business Decision

Making
Microeconomics plays a vital role in assisting the business firms and business decision
makers. Some of the major functions of microeconomics in business decision making
are listed below:
Optimum utilization of resources
The study of microeconomics helps the decision makers to analyze and determine how
the productive resources are allocated for various goods and services. It also helps in
solving the producers’ dilemma of what to produce, how much to produce and for whom
to produce.
Demand analysis
With the help of microeconomic analysis, business firms can forecast their level of
demand within the certain time interval. The demand for a commodity fluctuates
depending upon various factors affecting it. Thus, business firms and decision makers
can determine the level of demand for the commodity.
Cost analysis
Microeconomic theories explain various conditions of cost like fixed cost, variable cost,
average cost, and marginal cost. Along with this, it also provides an analysis of the
short run and long run costs that help the business decision makers determine the cost
of production and other related costs, so they can implement policies to cut down cost
and increase their level of profit.

Free Market Economy

Microeconomics explains the operating of a free market economy where, an individual
producer has the freedom to take economic decisions like what to produce, how to
produce, or for whom to produce. Allocation of resources is determined by price or
market mechanism i.e. interaction between demand and supply

Production decision optimization

Microeconomics deals with different production techniques that help to find out the
optimal production decision which helps the decision makers to determine the factors
needed in order to produce a certain product or a range of products.

Pricing policy
Microeconomic analysis provides business managers with a thorough knowledge of
theories of production and pricing in order to ensure optimum profit for the firm in the
long run.
Determination of Relative Prices of Products & Factors of
production
Microeconomics helps in analyzing market mechanisms i.e. determinants of demand
and supply which are responsible for the determining prices of commodities in the
market. Along with this, it provides an insight on theories relating to prices of a factor of
rent, wage, interest, and profit.
Basis of Managerial Economics
Microeconomics used for the study of a business unit, but not the economy as a whole
is known as managerial economics. The various tools used in microeconomics like cost
and price determination, at an individual level becomes the foundation of managerial
economics.

Basis of Welfare Economics

Microeconomics is not only concerned with analyzing economic condition but also with
the maximization of social welfare. It studies how given resources are utilized to gain
maximum benefit under various market conditions like monopoly, oligopoly, etc.
Analysis of production efficiency, consumption efficiency, and overall economic
efficiency are conducted on the basis of microeconomics.
Formulation of Public Economic Policies
Microeconomics tools are useful for introducing policies relating to tax, tariff, debt,
subsidy, etc. it helps the governmental bodies to fixate on the tax rate, types of tax, and
the amount of tax to be charged to buyers and sellers.

Helpful in Foreign Trade

Microeconomics is useful in explaining and determining the rate of foreign exchange
between currencies, fixing international trade and tariff rules, defining the cause of
disequilibrium in the balance of payment (BOP), and formulating policies to minimize it.

https://www.businesstopia.net/economics/micro/concept-externalities.

In economics, an externality is a term used to describe the cost or benefit incurred by

the third party who did not choose to receive that cost or benefit. It is the consequence
of economic activities endured by an unrelated third party due to lack of control over the
factors that create the cost or benefit.
An externality can be positive or negative.
Positive externality
Positive externality or benefit is an involuntary gain in the welfare of one party due to
activities of another party. The party causing benefit does not receive any financial
compensation.

Given below are few examples of positive externalities which will clarify the concept of
positive externality.

Example 1: A farmer who farms fruit does not only produce fruits for selling but also
helps bee farmers around the area. The bees can collect ample amount of nectar to
prepare honey and increases the benefit of bee farmers for which bee farmers won’t be
charged any money.
At the same time, bees help in pollination at a fruit farm. Fruit farmers do not need to
pay any kind of compensation to the bee farmers for this benefit.
Example 2: You go to college and university, and pay for education for personal benefit.
However, your knowledge is helpful not only to you but also to other members of the
society.

Also, when you join any company, the employers of that place would not need to spend
time and money to train you, causing the company notable benefit.

Negative externality
Contrary to positive externality, negative externality or cost is an involuntary loss in the
welfare of one party due to activities of another party. The party which causes loss does
not need to pay compensation to the one suffering from it.

Few examples of negative externality are given below that will help you further
understand about negative externality.

Example 1: Chemical manufacturing industries degrade the natural state of water

resources by mixing sewage into them. The consequence of water pollution is faced not
only by the industry causing it but by all the people living in and around that
environment.
People may even suffer from airborne diseases. But the expenses that incur to people
for treating their health won’t be paid by the industries.

Example 2: People who use the automobile for transportation contribute to air pollution
as well as congestion. Other people who do not own an automobile are also affected by
these problems.
Cite this article as: Palistha Maharjan, "Concept of Externalities," in Businesstopia

All producers must tag a reasonable price on their commodity in order to convince
consumers to choose and use their products.
On the other hand, producers look forward to receiving a certain minimal amount in
return for their goods and services, without which they won’t be able to generate profit.

Producers set a certain amount of price for their goods and services, depending upon
different inputs that are used during the production procedure. However, sometimes,
consumers may be willing to pay price greater than that set by the producers due to the
various market condition.

This difference between the minimum price that the producers are willing to supply or
sell their commodity at and the actual price they receive from consumers in exchange
of the commodity is known as producer surplus or producer welfare. The difference
amount or surplus is an additional benefit that the producers gain through selling their
products.

For instance, let us suppose, ABC is a firm which produces rain boots. After careful
evaluation of the cost of production and desired profit, the firm decided to sell its
product at dollar 40 per pair. The firm produced 1000 pairs and distributed in the
market. However, due to the availability of limited amount of boots, consumers became
ready to pay dollar 50 for a pair.
If the firm had sold all 1000 pairs of rain boots for dollar 40 per pair, it would have
earned revenue of dollar 40,000. But, since the firm was able to sell each pair for dollar
50, it gained total revenue of dollar 50,000, generating producer surplus of dollar 10,000.
Figure: graphical representation of producer surplus
Graphically, producer surplus is the area above the supply curve and below the
equilibrium market price.

In the given figure, DD is a linear demand curve, SS is a linear supply curve and O is the
point of equilibrium where Q amount of commodity is supplied at price P. Thus, in the
above figure, the area of ΔNOP gives producer surplus.

All producers must tag a reasonable price on their commodity in order to convince
consumers to choose and use their products.
On the other hand, producers look forward to receiving a certain minimal amount in
return for their goods and services, without which they won’t be able to generate profit.

Producers set a certain amount of price for their goods and services, depending upon
different inputs that are used during the production procedure. However, sometimes,
consumers may be willing to pay price greater than that set by the producers due to the
various market condition.

This difference between the minimum price that the producers are willing to supply or
sell their commodity at and the actual price they receive from consumers in exchange
of the commodity is known as producer surplus or producer welfare. The difference
amount or surplus is an additional benefit that the producers gain through selling their
products.

For instance, let us suppose, ABC is a firm which produces rain boots. After careful
evaluation of the cost of production and desired profit, the firm decided to sell its
product at dollar 40 per pair. The firm produced 1000 pairs and distributed in the
market. However, due to the availability of limited amount of boots, consumers became
ready to pay dollar 50 for a pair.
If the firm had sold all 1000 pairs of rain boots for dollar 40 per pair, it would have
earned revenue of dollar 40,000. But, since the firm was able to sell each pair for dollar
50, it gained total revenue of dollar 50,000, generating producer surplus of dollar 10,000.
Figure: graphical representation of producer surplus

Graphically, producer surplus is the area above the supply curve and below the
equilibrium market price.

In the given figure, DD is a linear demand curve, SS is a linear supply curve and O is the
point of equilibrium where Q amount of commodity is supplied at price P. Thus, in the
above figure, the area of ΔNOP gives producer surplus.

In economics, deadweight loss (excess burden) is a term used to describe the loss
caused to the society due to market inefficiencies.

It occurs when equilibrium for goods and services is not attained. In other words, it
occurs when supply curve of a commodity does not intersect the demand curve at the
free market equilibrium point.

In a graph, the deadweight loss is represented by the area between supply curve and
demand curve, bound by initial quantity demanded and new quantity demanded.
Figure: graphical representation of price ceiling and deadweight loss

In the above graph, SS is a supply curve and DD is a demand curve. They intersect at
free market equilibrium point E where the Q1 amount of commodity is supplied at price
P1.

Let us suppose P2 is the price ceiling of the commodity. As price ceiling is lesser than
the equilibrium price, consumers’ demand for the commodity increases. However,
producers are not willing to offer goods at such low price and therefore cut off their
supply, making Q2 the new supplied in the market.
Thus, the area in the graph bounded by supply curve, demand curve, initial quantity
supplied (Q1) and final quantity supplied (Q2) gives the measure of deadweight loss.

Causes of deadweight loss

Government’s intervening activities such as price ceiling, price flooring and taxation are
the major reasons for the deadweight loss. These activities cause inefficient allocation
of resources in the market creating an imbalance between supply and demand of the
commodity.
Price ceiling
A price ceiling is a measure of price control imposed by the government on particular
commodities in order to prevent consumers from being charged high prices.
As mentioned above, price ceiling creates a deadweight loss if it is set below the
equilibrium price. It is because fall in price increases demand of consumers and
decreases supply from producers simultaneously, creating an imbalance in the free
market equilibrium.

Price floor
Likewise, the price floor is another measure of price control on how low a price can be
charged for a commodity.

When a price floor is set above the free market equilibrium price, there is an excessive
supply of the commodity but significantly low demand. The goods and services will no
longer be sold in quantities they would have otherwise and the imbalance in demand
and supply results in a deadweight loss.

Taxes
Imposing taxes on goods and services increases the price of the commodity which is
followed by a decrease in demand for that commodity.
Once again, commodity fails to make as many sales as it would have made without
taxes and cause imbalances in the free market equilibrium.

Cross elasticity of demand is a measure of degree of change in demand of a

commodity due to change in price of another commodity.

Cross elasticity of demand can also be understood as the proportionate change in

quantity demanded of commodity ‘X’ due to proportionate change in price of
commodity ‘Y’. Cross elasticity of demand is denoted by Exy and is mathematically
represented as
Cross elasticity of demand is one of the major tools that businessmen (producers) take
help from in order to make correct business decisions. Described below are its few
applications in business sector.

Determining nature of relationship between any two goods

We have already understood that cross elasticity of demand is the rate of change of
demand for one commodity in response to change in price of another commodity.
Cross elasticity of demand can only be measured between any two goods at a time, and
the outcome is the representation of the relationship shared by those two goods.

Cross elasticity is greater than zero when rise in price of commodity X causes rise in
demand of commodity Y. Such type of response can be observed in substitute goods
such as Coke and Pepsi.
In the same way, cross elasticity is equal to zero when rise in price of commodity X
does not cause any effect on the demand of commodity Y. This type of response can be
seen in goods that are not related to each other such as sugar and shoe.
And, cross elasticity is lesser than zero when rise in price of commodity Y causes fall in
demand of commodity X. Such type of response can be seen in complementary goods
such as tea and sugar.

Forecasting change of demand

Cross elasticity can be used by a businessman (producer) to predict the future demand
of his product in case when he has the idea of probable future price of substitute or
complementary goods.
Let us suppose that there’s a company which manufactures Limes (cold drink) and
there is another cold drink in the market called Oranges. The cross elasticity of demand
between Limes and Oranges is +1.5.

Let us also suppose that the manufacturer of Limes received the information that the
price of Oranges is about to fall by 10% in the upcoming month.
From the above information, the manufacturer of Limes can predict by how much the
demand of its product will fall as a result of fall in price of Oranges, and thus will be able
to make necessary decisions to keep up its revenue.

Classification of market
Cross elasticity of demand is also helpful in classifying the type of market.
Higher the value of cross elasticity of demand between the products, greater will be the
competition in the market, and lower the value of cross elasticity, the market will be less
competitive. In the same way, if cross elasticity is zero or almost zero, there is
monopoly or zero competition in the market.

Pricing policy
Price of one product can directly affect the price of another if they are related to each
other. That is why large firms which produce more than one product must evaluate
cross price elasticity between each of their products in order to efficiently price them.

For an example: Le t us suppose Oral-D is company which produces toothpaste as well

as toothbrush (complementary goods). The rise in price of any one of these products
causes fall in demand of that product as well as the other. Therefore, the company must
be careful while deciding whether or not to increase the price of any product.

Determination of boundaries between industries

Concept of cross elasticity helps producers determining boundaries of their industries.
Complementary goods belong to different industries. Thus, the negative value of cross
elasticity of demand indicates that the products are from different industries.
Cite this article as: Shraddha Bajracharya, "Use of Cross Elasticity of Demand in Business Decision
Making," in Businesstopia, January 10, 2018, https://www.businesstopia.net/economics/micro/use-cross-
elasticity-demand-business-decision-making.

In the same way, substitute goods belong to same industry. Thus, positive value of
cross elasticity of demand indicates that the products are from same industry.

What are other people reading?

The law of supply states that, other things remaining the same, the quantity supplied of
a commodity is directly or positively related to its price. In other words, when there is a
rise in the price of a commodity the quantity supplied of it in the market increases and
when there is a fall in the price of a commodity, its quantity supplied decreases, other
things remaining the same. Thus, the supply curve of a commodity slopes upward from
left to right.
Law of Supply Assumptions
The term “other things remaining the same” refers to the following assumptions in the
law of supply:

1. No change in the state of technology.

2. No change in the price of factors of production.
3. No change in the number of firms in the market.
4. No change in the goals of the firm.
5. No change in the seller’s expectations regarding future prices.
6. No change in the tax and subsidy policy of the products.
7. No change in the price of other goods.
The law of supply can be explained with the help of supply schedule and supply curve
as explained below.

Supply Schedule
Supply Schedule is a tabular presentation of various combinations of price and quantity
supplied by the seller or producer during a period of time. We can show the supply
schedule through the following imaginary table.
The given schedule shows positive relationship between price and quantity supplied of
a commodity. In the beginning, when the price is Rs.10 per kg, quantity supplied by the
seller is 1kg. As the price increases from Rs.10 per kg to Rs.20 per kg and then to Rs.30
per kg, the quantity supplied by the seller also increases from 1 kg to 2 kg and then to 3
kg respectively.
Further rise in price to Rs.40 and then to Rs.50 per kg results in increase in quantity
supplied by the seller to 4kg and then to 5kg. Thus, the above schedule shows that there
is positive relationship in between price and quantity supplied of a commodity.

Supply curve
The supply curve is a graphical representation of a supply schedule. By plotting various
combinations of price and quantity supplied of the table, we can derive an upward
sloping demand curve as shown in the figure below:
In the given figure, price and quantity supplied are measured along the Y-axis and the X-
axis respectively. By plotting various combinations of price and quantity supplied we
derived points A, B, C, D, E curve and joining these points we find an upward sloping
i.e. SS1. The positive slope of the supply curve SS1 establishes the law of supply and
shows the positive relationship in between price and quantity supplied.
Exceptions and Limitations of the Law of Supply
Auction Sale
The law of supply states that quantity supplied increases with increase in price and vice-
versa. But this law doesn’t hold true in case of auction sale. An auction sale takes place
at that time when the seller is in financial crisis and needs money at any cost.

Price expectation of seller

If the seller expects that the price of commodity is going to fall in near future, he will try
to sell more even if the price level is very low. On the other hand, if the seller expects
further rise in price of the commodity he will not sell more even if the price level is high.
It is against the law of supply.
Stock clearance sale
When a seller wants to clear its old stock in order to store new goods, he may sell large
quantity of goods at heavily discounted price. It is also against the law of supply.

Fear of being out of fashion

As we know that quantity supplied of a commodity is affected by fashion, taste and
preferences of the consumer, technology and time. If the seller thinks that the goods are
going to be outdated in the near future, he sells more at a lower price which is also
against the law of supply.

Perishable goods
Those goods which have very short life-time and they become useless after that are all
perishable goods. Those goods must be made available in the market at its right time
whatever be its price. So the seller becomes ready to sell his goods at any offered price.
It is also against the law of supply.
 

The law of supply states that, other things remaining the same, the quantity supplied of
a commodity is directly or positively related to its price. In other words, when there is a
rise in the price of a commodity the quantity supplied of it in the market increases and
when there is a fall in the price of a commodity, its quantity supplied decreases, other
things remaining the same. Thus, the supply curve of a commodity slopes upward from
left to right.
Law of Supply Assumptions
The term “other things remaining the same” refers to the following assumptions in the
law of supply:
 1. No change in the state of technology.
2. No change in the price of factors of production.
3. No change in the number of firms in the market.
4. No change in the goals of the firm.
5. No change in the seller’s expectations regarding future prices.
6. No change in the tax and subsidy policy of the products.
7. No change in the price of other goods.
The law of supply can be explained with the help of supply schedule and supply curve
as explained below.

Supply Schedule
Supply Schedule is a tabular presentation of various combinations of price and quantity
supplied by the seller or producer during a period of time. We can show the supply
schedule through the following imaginary table.

The given schedule shows positive relationship between price and quantity supplied of
a commodity. In the beginning, when the price is Rs.10 per kg, quantity supplied by the
seller is 1kg. As the price increases from Rs.10 per kg to Rs.20 per kg and then to Rs.30
per kg, the quantity supplied by the seller also increases from 1 kg to 2 kg and then to 3
kg respectively.
Further rise in price to Rs.40 and then to Rs.50 per kg results in increase in quantity
supplied by the seller to 4kg and then to 5kg. Thus, the above schedule shows that there
is positive relationship in between price and quantity supplied of a commodity.

Supply curve
The supply curve is a graphical representation of a supply schedule. By plotting various
combinations of price and quantity supplied of the table, we can derive an upward
sloping demand curve as shown in the figure below:
In the given figure, price and quantity supplied are measured along the Y-axis and the X-
axis respectively. By plotting various combinations of price and quantity supplied we
derived points A, B, C, D, E curve and joining these points we find an upward sloping
i.e. SS1. The positive slope of the supply curve SS1 establishes the law of supply and
shows the positive relationship in between price and quantity supplied.
Exceptions and Limitations of the Law of Supply
Auction Sale
The law of supply states that quantity supplied increases with increase in price and vice-
versa. But this law doesn’t hold true in case of auction sale. An auction sale takes place
at that time when the seller is in financial crisis and needs money at any cost.

Price expectation of seller

If the seller expects that the price of commodity is going to fall in near future, he will try
to sell more even if the price level is very low. On the other hand, if the seller expects
further rise in price of the commodity he will not sell more even if the price level is high.
It is against the law of supply.
Stock clearance sale
When a seller wants to clear its old stock in order to store new goods, he may sell large
quantity of goods at heavily discounted price. It is also against the law of supply.

Fear of being out of fashion

As we know that quantity supplied of a commodity is affected by fashion, taste and
preferences of the consumer, technology and time. If the seller thinks that the goods are
going to be outdated in the near future, he sells more at a lower price which is also
against the law of supply.

Perishable goods
Those goods which have very short life-time and they become useless after that are all
perishable goods. Those goods must be made available in the market at its right time
whatever be its price. So the seller becomes ready to sell his goods at any offered price.
It is also against the law of supply.
[Related Reading: Law of Demand]
Law of supply from businesstopia

Meaning
The term ‘isoquant’ is composed of two terms ‘iso’ and ‘quant’. Iso is a Greek word
which means equal and quant is a Latin word which means quantity. Therefore, these
words together refer to equal quantity or equal product.
An isoquant curve is the representation of a set of locus of different combinations of
two inputs (labor and capital) which yield the same level of output. It is also known as or
equal product curve or producer’s indifference curve.
It is a firm’s counterpart of the consumer’s indifference curve. Thus, an isoquant may
also be defined as the graphical representation of different combinations of two inputs
which give same level of output to the producer. Since all the combinations lying in an
isoquant curve yield the same level of production, a producer is indifferent between the
combinations.

Few Definitions of Isoquant Curve

The isoproduct curves show the different combinations of two
resources with which a firm can produce equal amount of product.
– Bilas
Isoproduct curve shows the different input combinations that will
produce a given output.
– Samuelson
An isoquant curve may be defined as a curve showing the possible
combinations of two variable factors that can be used to produce the
same total product.
– Peterson
An isoquant is a curve showing all possible combinations of inputs
physically capable of producing a given level of output.
– Ferguson

Example of Isoquant Schedule and Isoquant Curve

Table 1: isoquant schedule
 Combinations Labor (L) Capital (K) Output (units)

A 1 12 100

B 2 8 100

C 3 5 100

D 4 3 100

E 5 2 100

The given isoquant schedule represents various combinations of inputs (labor and
capital).

From the table, we can see combination A consists of 1 unit of labor and 12 units of
capital which together produce 100 units of output. In combination B, when 1 unit of
labor was added in place of 4 units of capital, the production process still produced 100
units of output. In the same way, other combinations C (3L + 5K), D (4L + 3K) and E (5L
+ 2K) made the same level of output, i.e. 100 units.
Figure 1: graphical representation of isoquant schedule (isoquant curve)
Assumptions of Isoquant Curve
The concept of isoquant is based on the following assumptions.
1. Only two inputs (labor and capital) are employed to produce a good.
2. There is technical possibility of substituting one input for another. It implies that the
production function is of variable proportion type.
3. Labor and capital are divisible.
4. The producer must be rational, i.e. trying to maximize his profit.
5. State of technology is given and unchanged.
6. Marginal rate of technical substitution diminishes in production process.

Marginal Rate of Technical Substitution

Marginal rate of technical substitution (MRTS) indicates the rate at which one factor
(labor) can be substituted for the other input (capital) in the production process of a
commodity without changing the level of output or production. The marginal rate of
technical substitution of labor for capital (MRTSL,K) can be defined as the units of capital
which can be replaced by one unit of labor, keeping constant the level of output.
Mathematically, it is represented as

Table 2: marginal rate of technical substitution (MRTS)

Combination Capital (K) Labor (L) MRTSL,K Output

A 12 1 100

B 8 2 4:1 100
 C 5 3 3:1 100

D 3 4 2:1 100

E 2 5 1:1 100

Given table 2 represents various combinations of inputs, all of which yield the same
level of output, i.e. 100 units, to the producer.

Comparing combination A with B, we see that 4 units of capital is replaced by 1 unit of

labor, without altering the output. Therefore, 4:1 is the marginal rate of technical
substitution in this case.
Similarly, if we compare combination B with C, we can find that the MRTS for this case
is 3:1. Likewise, MRTS between C and D, and D and E is 2:1 and 1:1, respectively.

Figure 2: marginal rate of technical substitution

Figure 2 is a graphical representation of MRTS. In the figure, MRTS between any two
points is given by the slope between those points.

For example, MRTS between the points A and B can be found as

Cite this article as: Shraddha Bajracharya, "Isoquants: Meaning, Assumptions and Properties,"
in Businesstopia, January 8, 2018, https://www.businesstopia.net/economics/micro/isoquants-meaning-
assumptions-and-properties.

In the same way, MRTS at any particular point on the isoquant curve can be calculated
by finding the slope of the line that is tangent to that point on the curve.

Properties of Isoquant Curve

The isoquant curve has almost the same properties as are possessed by the
indifference curve of the theory of consumer behavior. They are explained below.

Isoquant is convex to the origin

The isoquant is convex to the origin because the marginal rate of technical substitution
(MRTS) between the inputs is diminishing. As shown in the tabular example of MRTS,
the ratio by which the input units of capital is substituted by labor units diminishes with
more and more substitution of labor for capital. Thus, the isoquant curve is convex to
the origin.

If the isoquant curve had been concave to the origin, it would imply that the MRTS
increases as more and more of labor is substituted for capital. And this would be
against the assumption that the isoquant curve is based on.
Isoquant is negatively sloped
The isoquant curve is neither upward sloping nor horizontal but always slopes
downward from left to right. It is because the producer will have to give up some of the
input units of capital to increase the input of labor when keeping the production amount
unchanged.
Increasing input units of either of the factors without deducing the input of the other
factor will result in increased production and it is beyond the principle of isoquant curve.
In the figure, when OK1 units of capital were employed, OL1 units of labor were employed
too. When the input units of labor was increased to OL2, the input units of capital was
reduced to OK2.
Therefore, the curve is downward sloping from to right. And slope of any downward
sloping curve is always negative.

Higher isoquant represents higher production

The isoquant which is in higher stage has higher units of labor and capital
combinations. Greater combination of labor and capital makes large scale of
production. So, higher the isoquant curve, greater will be the production level.
In the figure, we can see that there are two isoquant curves (Iq1 and Iq2). We can also
see that the combination A lies on Iq1 and combination B lies on Iq2.
Combination A consists of OL1 units of labor and OK1 units of capital which is visibly
lesser than the OL2 units of labor and OK2 units of capital at point B. So we can say that
production level at Iq2 is higher than the production level at Iq1.
Two isoquants never intersect each other
Each isoquant curve is a representation of particular level of production. The level of
production or output of a production process is same throughout the curve.
In the above figure, Iq1 and Iq2 are two isoquant curves and R is the point where both the
curves intersect.
According to the principle of isoquant curve, production level at point S = production
level at point R = production level at point T

Also, production level at point P = production level at point R = production level at point
Q

But, production level at point S and point T ≠ production level at point P and point Q

Therefore, two isoquant curves cannot intersect. Yet, two isoquant curves need not be
parallel to each other.

The parallelism of isoquant curves depend upon the MRTS. The isoquant curves can be
parallel only when the MRTS of both the curves are equal.

Meaning
The term ‘isoquant’ is composed of two terms ‘iso’ and ‘quant’. Iso is a Greek word
which means equal and quant is a Latin word which means quantity. Therefore, these
words together refer to equal quantity or equal product.
An isoquant curve is the representation of a set of locus of different combinations of
two inputs (labor and capital) which yield the same level of output. It is also known as or
equal product curve or producer’s indifference curve.
It is a firm’s counterpart of the consumer’s indifference curve. Thus, an isoquant may
also be defined as the graphical representation of different combinations of two inputs
which give same level of output to the producer. Since all the combinations lying in an
isoquant curve yield the same level of production, a producer is indifferent between the
combinations.

Few Definitions of Isoquant Curve

The isoproduct curves show the different combinations of two
resources with which a firm can produce equal amount of product.
– Bilas
Isoproduct curve shows the different input combinations that will
produce a given output.
– Samuelson
An isoquant curve may be defined as a curve showing the possible
combinations of two variable factors that can be used to produce the
same total product.
– Peterson
An isoquant is a curve showing all possible combinations of inputs
physically capable of producing a given level of output.
– Ferguson

Example of Isoquant Schedule and Isoquant Curve

Table 1: isoquant schedule
 Combinations Labor (L) Capital (K) Output (units)

A 1 12 100

B 2 8 100

C 3 5 100

D 4 3 100

E 5 2 100

The given isoquant schedule represents various combinations of inputs (labor and
capital).

From the table, we can see combination A consists of 1 unit of labor and 12 units of
capital which together produce 100 units of output. In combination B, when 1 unit of
labor was added in place of 4 units of capital, the production process still produced 100
units of output. In the same way, other combinations C (3L + 5K), D (4L + 3K) and E (5L
+ 2K) made the same level of output, i.e. 100 units.
Figure 1: graphical representation of isoquant schedule (isoquant curve)
Assumptions of Isoquant Curve
The concept of isoquant is based on the following assumptions.
1. Only two inputs (labor and capital) are employed to produce a good.
2. There is technical possibility of substituting one input for another. It implies that the
production function is of variable proportion type.
3. Labor and capital are divisible.
4. The producer must be rational, i.e. trying to maximize his profit.
5. State of technology is given and unchanged.
6. Marginal rate of technical substitution diminishes in production process.

Marginal Rate of Technical Substitution

Marginal rate of technical substitution (MRTS) indicates the rate at which one factor
(labor) can be substituted for the other input (capital) in the production process of a
commodity without changing the level of output or production. The marginal rate of
technical substitution of labor for capital (MRTSL,K) can be defined as the units of capital
which can be replaced by one unit of labor, keeping constant the level of output.
Mathematically, it is represented as

Table 2: marginal rate of technical substitution (MRTS)

Combination Capital (K) Labor (L) MRTSL,K Output

A 12 1 100

B 8 2 4:1 100
 C 5 3 3:1 100

D 3 4 2:1 100

E 2 5 1:1 100

Given table 2 represents various combinations of inputs, all of which yield the same
level of output, i.e. 100 units, to the producer.

Comparing combination A with B, we see that 4 units of capital is replaced by 1 unit of

labor, without altering the output. Therefore, 4:1 is the marginal rate of technical
substitution in this case.
Similarly, if we compare combination B with C, we can find that the MRTS for this case
is 3:1. Likewise, MRTS between C and D, and D and E is 2:1 and 1:1, respectively.

Figure 2: marginal rate of technical substitution

Figure 2 is a graphical representation of MRTS. In the figure, MRTS between any two
points is given by the slope between those points.

For example, MRTS between the points A and B can be found as

Cite this article as: Shraddha Bajracharya, "Isoquants: Meaning, Assumptions and Properties,"
in Businesstopia, January 8, 2018, https://www.businesstopia.net/economics/micro/isoquants-meaning-
assumptions-and-properties.

In the same way, MRTS at any particular point on the isoquant curve can be calculated
by finding the slope of the line that is tangent to that point on the curve.

Properties of Isoquant Curve

The isoquant curve has almost the same properties as are possessed by the
indifference curve of the theory of consumer behavior. They are explained below.

Isoquant is convex to the origin

The isoquant is convex to the origin because the marginal rate of technical substitution
(MRTS) between the inputs is diminishing. As shown in the tabular example of MRTS,
the ratio by which the input units of capital is substituted by labor units diminishes with
more and more substitution of labor for capital. Thus, the isoquant curve is convex to
the origin.

If the isoquant curve had been concave to the origin, it would imply that the MRTS
increases as more and more of labor is substituted for capital. And this would be
against the assumption that the isoquant curve is based on.
Isoquant is negatively sloped
The isoquant curve is neither upward sloping nor horizontal but always slopes
downward from left to right. It is because the producer will have to give up some of the
input units of capital to increase the input of labor when keeping the production amount
unchanged.
Increasing input units of either of the factors without deducing the input of the other
factor will result in increased production and it is beyond the principle of isoquant curve.
In the figure, when OK1 units of capital were employed, OL1 units of labor were employed
too. When the input units of labor was increased to OL2, the input units of capital was
reduced to OK2.
Therefore, the curve is downward sloping from to right. And slope of any downward
sloping curve is always negative.

Higher isoquant represents higher production

The isoquant which is in higher stage has higher units of labor and capital
combinations. Greater combination of labor and capital makes large scale of
production. So, higher the isoquant curve, greater will be the production level.
In the figure, we can see that there are two isoquant curves (Iq1 and Iq2). We can also
see that the combination A lies on Iq1 and combination B lies on Iq2.
Combination A consists of OL1 units of labor and OK1 units of capital which is visibly
lesser than the OL2 units of labor and OK2 units of capital at point B. So we can say that
production level at Iq2 is higher than the production level at Iq1.
Two isoquants never intersect each other
Each isoquant curve is a representation of particular level of production. The level of
production or output of a production process is same throughout the curve.

Each isoquant curve is a representation of particular level of production. The level of

production or output of a production process is same throughout the curve.
In the above figure, Iq1 and Iq2 are two isoquant curves and R is the point where both the
curves intersect.
According to the principle of isoquant curve, production level at point S = production
level at point R = production level at point T

Also, production level at point P = production level at point R = production level at point
Q

But, production level at point S and point T ≠ production level at point P and point Q

Therefore, two isoquant curves cannot intersect. Yet, two isoquant curves need not be
parallel to each other.

The parallelism of isoquant curves depend upon the MRTS. The isoquant curves can be
parallel only when the MRTS of both the curves are equal.
Monetary policy adopted by the government affects the LM curve, whereas, the fiscal
policy affects the IS curve. Expansionary monetary policy shifts the LM curve to the
right, lowers interest rates and stimulates aggregate output. Contractionary monetary
policy has an inverse effect on the curve.
On the other hand, Fiscal policy causes a shift in the IS curve, where an expansionary
policy shifts the curve to the right, stimulates aggregate demand by increasing
government expenditures and reducing tax rates.

The effect of the changes in the policies on interest rates and aggregate income/output
has been discussed further.

Concept of Demand
Demand refers to the quantity of a commodity or a service that people are willing to buy
at a certain price during a certain time interval. It can be termed as a desire with the
‘willingness’ and ‘ability’ to pay for a commodity.
An increase in the price of the commodity decrease the demand for that commodity,
while the decrease in price increases its demand. The phenomena is termed as law of
demand.

Concept of Demand Function

Demand function is an algebraic expression that shows the functional relationship
between the demand for a commodity and its various determinants affecting it. This
includes income and price along with other determining factors.

Here, the demand for the commodity is the dependent variable, while its determinants
are the independent variables.
Determinants of Demand
Price of the given commodity
Other things remaining constant, the rise in price of the commodity, the demand for the
commodity contracts, and with the fall in price, its demand increases.
Price of related goods
Demand for the given commodity is affected by price of the related goods, which is
called cross price demand.
Income of the individual consumer
Change in consumer’s level of income also influences their demand for different
commodities. Normally, the demand for certain goods increase with the increasing level
of income and vice versa.

Tastes and preferences

The taste and preferences of individuals also determine the demand made for certain
goods and services. Factors such as climate, fashion, advertisement, innovation, etc.
affect the taste and preference of the consumers.
Expectation of change in price in the future
If the price of the commodity is expected to rise in the future, the consumer will be
willing to purchase more of the commodity at the existing price. However, if the future
price is expected to fall, the demand for that commodity decreases at present.

Size and composition of population

The market demand for a commodity increases with the increase in the size and
composition of the total population. For instance, with the increase in total population
size, there is an increase in the number of buyers. Likewise, with an increase in the male
composition of the population, the demand for goods meant for male increases.

Season and weather

The market demand for a certain commodity is also affected by the current weather
conditions. For instance, the demand for cold beverages increase during summer
season.
Distribution of income
In case of equal distribution of income in the economy, the market demand for a
commodity remains less. With an increase in the unequal distribution of income, the
demand for certain goods increase as most people will have the ability to buy certain
goods and commodities, especially luxury goods.

Types of Demand Function

Based on whether the demand function is in relation to an individual consumer or to all
consumers in the market, the demand function cab be categorized as

 Individual Demand Function

 Market Demand Function
Individual Demand Function
Individual demand function refers to the functional relationship between demand made
by an individual consumer and the factors affecting the individual demand. It shows
how demand made by an individual in the market is related to its determinants.

Mathematically, individual demand function can be expressed as,

Dx= f (Px, Pr, Y, T, F)

Where,
Dx= Demand for commodity x;

Cite this article as: Shraddha Bajracharya, "Concept of Demand Function and its Types,"
in Businesstopia, January 9, 2018, https://www.businesstopia.net/economics/macro/concept-demand-
function-types.

Px= Price of the given commodity x;

Pr= Price of related goods;

Y= Income of the individual consumer;

T= Tastes and preferences;

F= Expectation of change in price in the future.

Market Demand Function
Market demand function refers to the functional relationship between market demand
and the factors affecting market demand. Market demand is affected by all the factors
that affect an individual demand. In addition to this, it is also affected by size and
composition of population, season and weather conditions, and distribution of income.
Mathematically, market demand function can be expressed as,

Dx= f (Px, Pr, Y, T, F, Po, S, D)

Where,

Dx= Demand for commodity x;

Px= Price of the given commodity x;

Pr= Price of related goods;

Y= Income of the individual consumer;

T= Tastes and preferences;

F= Expectation of change in price in the future;

Po= Size and composition of population;

S= Season and weather;

D= Distribution of income.

Income elasticity of demand is the degree of responsiveness of quantity demanded of a

commodity due to change in consumer’s income, other things remaining constant. In
other words, it measures by how much the quantity demanded changes with respect ot
the change in income.
The income elasticity of demand is defined as the percentage change in quantity
demanded due to certain percent change in consumer’s income.
Expression of Income Elasticity of Demand
 

Where, EY = Elasticity of demand

q = Original quantity demanded
∆q = Change in quantity demanded

y = Original consumer’s income

∆y= Change in consumer’s income

Example to Explain Income Elasticity of Demand

Suppose that the initial income of a person is Rs.2000 and quantity demanded for the commodity
by him is 20 units. When his income increases to Rs.3000, quantity demanded by him also
increases to 40 units. Find out the income elasticity of demand.
Solution:

Here, q = 100 units

∆q = (40-20) units = 20 units

y = Rs.2000

∆y =Rs. (3000-2000) =Rs.1000

Now,
Hence, an increase of Rs.1000 in income i.e. 1% in income leads to a rise of 2% in
quantity demanded.

Types of Income Elasticity of demand

1. Positive income elasticity of demand (EY>0)
If there is direct relationship between income of the consumer and demand for the
commodity, then income elasticity will be positive. That is, if the quantity demanded for
a commodity increases with the rise in income of the consumer and vice versa, it is said
to be positive income elasticity of demand. For example: as the income of consumer
increases, they consume more of superior (luxurious) goods. On the contrary, as the
income of consumer decreases, they consume less of luxurious goods.
Cite this article as: Shraddha Bajracharya, "Income Elasticity of Demand: Definition and Types with
Examples," in Businesstopia, January 11, 2018, https://www.businesstopia.net/economics/micro/income-
elasticity-demand.

Positive income elasticity can be further classified into three types:

 Income elasticity greater than unity (EY > 1)

If the percentage change in quantity demanded for a commodity is greater than
percentage change in income of the consumer, it is said to be income greater than
unity. For example: When the consumer’s income rises by 3% and the demand rises by
7%, it is the case of income elasticity greater than unity.
In the given figure, quantity demanded and consumer’s income is measured along X-
axis and Y-axis respectively. The small rise in income from OY to OY1 has caused
greater rise in the quantity demanded from OQ to OQ1 and vice versa. Thus, the demand
curve DD shows income elasticity greater than unity.
 Income elasticity equal to unity (EY = 1)
If the percentage change in quantity demanded for a commodity is equal to percentage
change in income of the consumer, it is said to be income elasticity equal to unity. For
example: When the consumer’s income rises by 5% and the demand rises by 5%, it is the
case of income elasticity equal to unity.
In the given figure, quantity demanded and consumer’s income is measured along X-
axis and Y-axis respectively. The small rise in income from OY to OY1 has caused equal
rise in the quantity demanded from OQ to OQ1 and vice versa. Thus, the demand
curve DD shows income elasticity equal to unity.
 Income elasticity less than unity (EY < 1)
If the percentage change in quantity demanded for a commodity is less than percentage
change in income of the consumer, it is said to be income greater than unity. For
example: When the consumer’s income rises by 5% and the demand rises by 3%, it is the
case of income elasticity less than unity.

In the given figure, quantity demanded and consumer’s income is measured along X-
axis and Y-axis respectively. The greater rise in income from OY to OY1 has caused
small rise in the quantity demanded from OQ to OQ1 and vice versa. Thus, the demand
curve DD shows income elasticity less than unity.
2. Negative income elasticity of demand ( EY<0)
If there is inverse relationship between income of the consumer and demand for the
commodity, then income elasticity will be negative. That is, if the quantity demanded for
a commodity decreases with the rise in income of the consumer and vice versa, it is
said to be negative income elasticity of demand. For example:
As the income of consumer increases, they either stop or consume less of inferior
goods.
In the given figure, quantity demanded and consumer’s income is measured along X-
axis and Y-axis respectively. When the consumer’s income rises from OY to OY1 the
quantity demanded of inferior goods falls from OQ to OQ1 and vice versa. Thus, the
demand curve DD shows negative income elasticity of demand.
3. Zero income elasticity of demand ( EY=0)
If the quantity demanded for a commodity remains constant with any rise or fall in
income of the consumer and, it is said to be zero income elasticity of demand. For
example: In case of basic necessary goods such as salt, kerosene, electricity, etc. there
is zero income elasticity of demand.
In the given figure, quantity demanded and consumer’s income is measured along X-
axis and Y-axis respectively. The consumer’s income may fall to OY1 or rise
to OY2 from OY, the quantity demanded remains the same at OQ. Thus, the demand
curve DD, which is vertical straight line parallel to Y-axis shows zero income elasticity of
demand.

The law of diminishing marginal utility was first propounded by 19th century German
economist H.H. Gossen which explains the behavior of the consumers and the basic
tendency of human nature. Hence, this law is also known as Gossen’s First Law. This
was further modified by Marshall.
According to Marshall,

The additional benefit a person derives from a given increase of his

stock of anything diminishes with the growth of the stock that he
already has.
According to Paul A. Samuelson,

As the amount consumed of a good increases, the marginal utility of

the good leads to decrease.
As per the definitions, we can conclude that, if the consumer consumes goods
continuously, the utility obtained from every successive unit goes on diminishing. If the
consumer is consuming the goods continuously, firstly he reaches the point of
maximum satisfaction which is known as level of satiety. If he continues to consume
the goods again, the utility obtained from that particular goods goes in negative aspect
or he gets inutility.

[Related Reading: Concept of Utility: Cardinal and Ordinal Utility]

Law Of Diminishing Marginal Utility Assumptions
1. The consumer who is consuming the goods should be logical and knowledgeable to
consume every unit of goods.
2. The goods which are to be consumed should be equal in size and shape.
3. Consumer should consume the goods without time gap.
4. The consumer’s income, preference, taste and fashion should not be changed while
consuming the goods.
5. To hold the law good, utility should be measured in countable units or cardinal numbers.
The utility obtained from those goods is measured in ‘utils’ unit.
6. As we know that money is the measuring rod of utility, being so, marginal utility of
money should remain constant during consumption of the goods.

Example to Demonstrate Law of Diminishing Marginal Utility

This law can be illustrated with the help of a table shown below:

The table shows that when a consumer consumes 1st unit of orange he derives the
marginal utility equal to 6utils. As the consumer consumes 2nd and 3rd units of orange,
the marginal utility is declined from 4utils to 2utils respectively.
When he consumes 4th unit of orange the marginal utility becomes zero, which is called
the point of satiety. Similarly, from the consumption of 5th and 6th units of orange, the
marginal utility becomes negative, i.e., he gets disutility instead of utility from these
units of consumption.
Thus, the table shows that a consumer consumes more and more units of a commodity
at a certain period of time, the marginal utility declines, becomes zero and even
negative.
This law can be further explained with the help of a diagram:

In the figure, X-axis represents units of orange and Y-axis represents utility. MU is the
marginal utility curve which slopes downward from left to right. It means that as a
consumer consumes more and more units of a commodity, the marginal utility he
derives from the additional unit of consumption goes on declining, becomes zero(at
point D) and even negative(at point E and F.)
[Related Reading: Principle of Marginal Rate of Substitution]
Exceptions Where Law of Diminishing Marginal Utility Doesn’t
Apply
Dissimilar units
This law is applicable for homogenous unit only, i.e. only if all units of a commodity
consumed are similar in length, breadth, shape and size. If there is a change in such
factors, the utility obtained from it can be increased. For example: If the 2 nd orange is
much larger than the 1st one, it will yield more satisfaction than the 1st.
Unreasonable quantity
The quantity of the commodity a consumer consumes should be reasonable. If the units
of consumption are too small, then every successive unit of consumption may give
higher utility to the consumer. For example: If a person is given water by a spoon when
he is very thirsty, each additional spoonful will give him more satisfaction.
Not a suitable time period
There should not be very long gap between the consumption of different units of the
commodity. If there is time lag between the consumption of different units, then this law
may not hold good. For example: If a man has lunch at 10 a.m. and dinner at 8 p.m. and
eats nothing in between, the dinner will possibly yield even more satisfaction than the
lunch, i.e. his marginal utility will not diminish.

Rare collection
This law does not apply for rare collections such as old coins, stamps and so on
because the longer and larger the number he collects, the greater will be the utility.
Cite this article as: Shraddha Bajracharya, "Law of Diminishing Marginal Utility: Assumptions and
Exceptions," in Businesstopia, January 11, 2018, https://www.businesstopia.net/economics/micro/law-
diminishing-marginal-utility.

Change in taste and fashion of the consumer

The law of diminishing marginal utility will be applicable only if the consumer is not
supposed to change taste and fashion of the commodity whatever he/she was using
previously.

Abnormal person
The law of diminishing marginal utility is applicable for normal person only. Abnormal
persons such as drunkards and druggist are not associated with the law.
Change in income of the consumer
To hold the law good, there should not be any change in the income of the consumer. If
the income of the consumer increases, he will consume more and more units of a
commodity which he prefers. As a result, utility can be increased rather than decreased.

Habitual goods
The law will not be applicable for habitual goods such as consumption of cigarettes,
consumption of drugs, alcohol, etc.

Durable and valuable goods

The law is not applicable in case of durable goods as well as valuable goods such as
buildings, vehicles, gems, gold, etc.
Law of diminishi

Changes in monetary policy variables lead to shift in LM curve. The LM curve is affected
by the changes in exogenous variables or by the behavioral shift in the demand for
money. The two main factors that affect the LM curve include change in demand for
money and change in supply of money. The effect of these factors have been explained
below:

\\What is price ceiling?

Price ceiling is a measure of price control imposed by the government on particular
commodities in order to prevent consumers from being charged high prices.
Price ceiling can also be understood as a legal maximum price set by the government
on particular goods and services to make those commodities attainable to all
consumers.

Effect of price ceiling

Price ceiling is practiced in an attempt to help consumers in purchasing necessary
commodities which government believes to have become unattainable for consumers
due to high price. However, price ceiling in a long run can cause adverse effect on
market and create huge market inefficiencies. Some effects of price ceiling are

Shortage
If price ceiling is set above the existing market price, there is no direct effect. But, if
price ceiling is set below the existing market price, the market undergoes problem of
shortage.

When price ceiling is set below the market price, producers will begin to slow or stop
their production process causing less supply of commodity in the market. On the other
hand, demand of the consumers for such commodity increases with the fall in price.
And with this imbalance between supply and demand of the commodity, shortage is
created in the market.

Government rationing and queuing

When there is extreme shortage in the market, government begins rationing distribution
to restrict the demand of the consumers. As a result, consumers won’t be able to utilize
as much goods as they need.

Government rationing also results in consumers needing to stay in queue for great deal
of times, and this can be troublesome to elderly, disabled and other people who cannot
afford to stay in line for a long time.
Black market
Shortage of commodities encourages black market. Sellers begin trading commodities
to relatives and friends, and they start charging other people prices multiple times
higher than that of price ceiling.

Degradation of quality
Producers won’t be able to generate desirable profit when government set price ceiling.
During such condition, many producers may use raw materials of comparatively lesser
quality in order to maintain same or almost same revenue as before.

What is price floor?

Like price ceiling, price floor is also a measure of price control imposed by the
government. But this is a control or limit on how low a price can be charged for any
commodity.

It is legal minimum price set by the government on particular goods and services in
order to prevent producers from being paid very less price.
Price ceiling as well as price floor are both intended to protect certain groups, and these
protection is only possible at the price of others. Price floor is typically proposed to
ensure good income of people involved in farming, agriculture and low-skilled jobs.

Effect of price floor

Government enforce price floor to oblige consumer to pay certain minimum amount to
the producers.

Government set price floor when it believes that the producers are receiving unfair
amount. Price floor is enforced with an only intention of assisting producers. However,
price floor has some adverse effects on the market. These effects are
Supply surplus
If price floor is less than market equilibrium price then it has no impact on the economy.
But if price floor is set above market equilibrium price, immediate supply surplus can be
observed.

At higher market price, producers increase their supply. In contrast, consumers’ demand
for the commodity will decrease, and supply surplus is generated.

Cite this article as: Palistha Maharjan, "Effects of Price Ceiling and Price Floor," in Businesstopia,
January 6, 2018, https://www.businesstopia.net/economics/micro/effects-price-ceiling-and-price-floor.

Government intervention
When price floor is continued for a long time, supply surplus is generated in a huge
amount.
In case of producer surplus, producers would have reduced the price to increase
consumers’ demands and clear off the stock. But since it is illegal to do so, producers
cannot do anything. So, government has to intervene and buy the surplus inventories.
Government may sell these inventories in situation when there is scarcity of those
commodities, or it can also distribute to the poor people and public entities.
 Minimum wage and unemployment
If minimum wage is set below the market price, no effect is seen. But if minimum wage
is set above market price, employers may distribute more work among few workers and
terminate rest of the workers in order to not to pay more wage to more workers. Setting
price floor will obviously help few workers in getting higher wage. But at the same time,
other workers will also have to lose their jobs, creating unemployment.

Per Capita Income of a country usually refers to the average earning of an individual in a
particular year. In order to determine the per capita income of a country, the national
income of the country is divided by the population of the country in that particular year.
Thus,

Per Capita Income= National Income of a country/ Total population of the country

The per capita income of a country helps in determining the standard of living of the
countries and also serves as an index to determine economic development of different
countries.

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Indifference Curve Analysis:

Assumptions, Indifference
Schedule and the Meaning of
Marginal Rate of Substitution
Updated on March 24, 2020

Sundaram Ponnusamy 
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Introduction
Indifference curve analysis is basically an attempt to improve cardinal utility analysis (principle
of marginal utility). The cardinal utility approach, though very useful in studying elementary
consumer behavior, is criticized for its unrealistic assumptions vehemently. In particular,
economists such as Edgeworth, Hicks, Allen and Slutsky opposed utility as a measurable entity.
According to them, utility is a subjective phenomenon and can never be measured on an absolute
scale. The disbelief on the measurement of utility forced them to explore an alternative approach
to study consumer behavior. The exploration led them to come up with the ordinal utility
approach or indifference curve analysis. Because of this reason, aforementioned economists are
known as ordinalists. As per indifference curve analysis, utility is not a measurable entity.
However, consumers can rank their preferences.
Indifference Curve Analysis Vs. Marginal Utility Approach
Let us look at a simple example. Suppose there are two commodities, namely apple and orange.
The consumer has $10. If he spends entire money on buying apple, it means that apple gives him
more satisfaction than orange. Thus, in indifference curve analysis, we conclude that the
consumer prefers apple to orange. In other words, he ranks apple first and orange second.
However, in cardinal or marginal utility approach, the utility derived from apple is measured (for
example, 10 utils). Similarly, the utility derived from orange is measured (for example, 5 utils).
Now the consumer compares both and prefers the commodity that gives higher amount of utility.
Indifference curve analysis strictly says that utility is not a measurable entity. What we do here is
that we observe what the consumer prefers and conclude that the preferred commodity (apple in
our example) gives him more satisfaction. We never try to answer ‘how much satisfaction
(utility)’ in indifference curve analysis.
Assumptions
Theories of economics cannot survive without assumptions and indifference curve analysis is no
different. The following are the assumptions of indifference curve analysis:
Rationality
The theory of indifference curve studies consumer behavior. In order to derive a plausible
conclusion, the consumer under consideration must be a rational human being. For example,
there are two commodities called ‘A’ and ‘B’. Now the consumer must be able to say which
commodity he prefers. The answer must be a definite. For instance – ‘I prefer A to B’ or ‘I prefer
B to A’ or ‘I prefer both equally’. Technically, this assumption is known as completeness or
trichotomy assumption.
Consistency
Another important assumption is consistency. It means that the consumer must be consistent in
his preferences. For example, let us consider three different commodities called ‘A’, ‘B’ and ‘C’.
If the consumer prefers A to B and B to C, obviously, he must prefer A to C. In this case, he
must not be in a position to prefer C to A since this decision becomes self-contradictory.
Symbolically,
If A > B, and B > c, then A > C.
More Goods to Less
The indifference curve analysis assumes that consumer always prefers more goods to less.
Suppose there are two bundles of commodities – ‘A’ and ‘B’. If bundle A has more goods than
bundle B, then the consumer prefers bundle A to B.
Substitutes and Complements
In indifference curve analysis, there exist substitutes and complements for the goods preferred by
the consumer. However, in marginal utility approach, we assume that goods under consideration
do not have substitutes and complements.
Income and Market Prices
Finally, the consumer’s income and prices of commodities are fixed. In other words, with given
income and market prices, the consumer tries to maximize utility.

Indifference Schedule
An indifference schedule is a list of various combinations of commodities that give equal
satisfaction or utility to consumers. For simplicity, we have considered only two commodities,
‘X’ and ‘Y’, in our Table 1. Table 1 shows various combinations of X and Y; however, all these
combinations give equal satisfaction (k) to the consumer.

Table 1: Indifference Schedule

 Combinations X (Oranges) Y (Apples) Satisfaction

A 2 15 k

B 5 9 k

C 7 6 k

D 17 2 k

You can construct an indifference curve from an indifference schedule in the same way you
construct a demand curve from a demand schedule.

On the graph, the locus of all combinations of commodities (X and Y in our example) forms an
indifference curve (figure 1). Movement along the indifference curve gives various combinations
of commodities (X and Y); however, yields same level of satisfaction. An indifference curve is
also known as iso utility curve (“iso” means same). A set of indifference curves is known as an
indifference map.
Marginal Rate of Substitution
Marginal rate of substitution is an eminent concept in the indifference curve analysis. Marginal
rate of substitution tells you the amount of one commodity the consumer is willing to give up for
an additional unit of another commodity. In our example (table 1), we have considered
commodity X and Y. Hence, the marginal rate of substitution of X for Y (MRSxy) is the
maximum amount of Y the consumer is willing to give up for an additional unit of X. However,
the consumer remains on the same indifference curve.
In other words, the marginal rate of substitution explains the tradeoff between two goods.
Diminishing marginal rate of substitution
From table 1 and figure 1, we can easily explain the concept of diminishing marginal rate of
substitution. In our example, we substitute commodity X for commodity Y. Hence, the change in
Y is negative (i.e., -ΔY) since Y decreases.
Thus, the equation is
MRSxy = -ΔY/ΔX and
MRSyx = -ΔX/ΔY
However, convention is to ignore the minus sign; hence,
MRSxy = ΔY/ΔX
In figure 1, X denotes oranges and Y denotes apples. Points A, B, C and D indicate various
combinations of oranges and apples.
In this example, we have the following marginal rate of substitution:
MRSx for y between A and B: AA1/A1B = 6/3 = 2.0
MRSx for y between B and C: BB1/B1C = 3/2 = 1.5
MRSx for y between C and D: CC1/C1D = 4/10 = 0.4
Thus, MRSx for y diminishes for every additional units of X. This is the principle of diminishing
marginal rate of substitution.
 14

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The Law of Equi-Marginal

Utility or Gossen's Second Law
Updated on December 23, 2016

Sundaram Ponnusamy 
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Introduction
The fundamental problem in an economy is that there are unlimited human wants. However,
there are no adequate resources to satisfy all human wants. Hence, a rational individual tries to
optimize the available scarce resources in order to attain maximum satisfaction. An individual’s
attempt to optimize the available scare resources is known as consumer’s behavior. The law of
equi-marginal utility explains such consumer’s behavior when the consumer has limited
resources and unlimited wants. Because of this reason, the law of equi-marginal utility is further
referred to as the law of maximum satisfaction, the principle of income allocation, the law of
economy in expenditure or the law of substitution.
What does the law say?
Suppose that a person possesses $200 (limited resources). However, his wants are unlimited. The
law explains how the person allocates the $200 among his or her various wants in order to
maximize the satisfaction. The point at which the consumer’s satisfaction is maximum with the
given resources is known as consumer’s equilibrium. Hence, we can say that the law explains
how the consumer’s equilibrium is attained. The law is basically a cardinal utility approach.
Concept of Equi-marginal Utility
Now let us see how an individual maximizes his or her satisfaction with the help of equi-
marginal utility. The law says that in order to attain maximum satisfaction, an individual
allocates the resources in such a way that he or she derives equal marginal utility from all things
on which the resources are spent. For instance, you have $100 and you spend the money to buy
10 different things. What the law says is that you spend money on each thing in such a way that
all the 10 things provide you with the same amount of marginal utility. According to the law of
equi-marginal this is the way to attain maximum satisfaction.

Assumptions of the Law of Equi-Marginal Utility

The following explicit assumptions are necessary for the law of equi-marginal utility to hold
good:
1. Consumer’s income is given (limited resources).
2. The law operates based on the law of diminishing marginal utility.
3. The consumer is a rational economic individual. This means that the consumer wants to gain
maximum satisfaction with limited resources.
4. The marginal utility of money is constant.
5. Another important assumption is that the utility of each commodity is measurable in cardinal
numbers (1, 2, 3 and so on).
6. The prices of the commodities are constant.
7. There prevails perfect competition in the market.

Explanation of the Law of Equi-Marginal Utility

Let us look at a simple illustration to understand the law of equi-marginal utility. Suppose there
are two commodities X and Y. The consumer’s income is $8. The price of a unit of commodity
X is $1. The price of a unit of commodity Y is $1.
Assume that the consumer spends all his $8 to purchase commodity X. Since the price of a unit
of commodity X is $1, he can buy 8 units. Table1 shows the marginal utility derived from each
unit of commodity X. since the law is based on the concept of diminishing marginal utility, the
marginal utility derived from the subsequent unit diminishes.

Table 1
 Units of Commodity X Marginal Utility of X

1st unit (1st dollar) 20

2nd unit (2nd dollar) 18

3rd unit (3rd dollar) 16

4th unit (4th dollar) 14

5th unit (5th dollar) 12

6th unit (6th dollar) 10

7th unit (7th dollar) 8

8th unit (8th dollar) 6

Consider that the consumer spends all his $8 to purchase commodity Y. Since the price of a unit
of commodity Y is $1, he can buy 8 units. Table2 shows the marginal utility derived from each
unit of commodity Y. since the law is based on the concept of diminishing marginal utility, the
marginal utility derived from the subsequent unit diminishes.

Table 2
Units of Commodity Y Marginal Utility of Y

1st unit (1st dollar) 16

2nd unit (2nd dollar) 14

3rd unit (3rd dollar) 12

4th unit (4th dollar) 10

5th unit (5th dollar) 8

6th unit (6th dollar) 6

7th unit (7th dollar) 4

8th unit (8th dollar) 2

 Units of Commodity Y Marginal Utility of Y

Now the consumer plans to allocate his $8 between commodity X and Y. Let us see how much
money he spends on each commodity. Table 3 shows how the consumer spends his income on
both the commodities.

Table 3
Units of Commodities
Marginal Utility of X Marginal Utility of Y
(X and Y)

1 20 (1st dollar) 16 (3rd dollar)

2 18 (2nd dollar) 14 (5th dollar)

3 16 (4th dollar) 12 (7th dollar)

4 14 (6th dollar) 10

5 12 (8th dollar) 8

6 10 6

7 8 4

8 6 2

Since the first unit of commodity X gives the highest utility (20 utils), he spends the first dollar
on X. Second dollar also goes to commodity X as it gives 18 utils (the second highest). Both the
first unit of commodity Y and the third unit of commodity X give the same amount of utility.
However, the consumer prefers to buy commodity Y because has already spent two dollars on
commodity X. Similarly, the fourth dollar is spent on X, fifth dollar on Y, sixth dollar on X,
seventh dollar on Y and eighth dollar on X.
In this manner, the consumer consumes 5 units of commodity X and 3 units of commodity Y. In
other words, 5 units of commodity X and 3 units of commodity Y leave him with the same
amount of marginal utility. Therefore, according to the law of equi-marginal utility, the
consumer is at equilibrium at this point. Furthermore, this is point at which the consumer
experiences maximum satisfaction. Let us calculate the total utility of commodities consumed to
understand this.
Total utility = TUX + Y = TUX + TUY = (20 + 18 + 16 + 14 + 12) + (16 + 14 + 12) = 122
Any other combinations of commodities would have left the customer with less total utility. This
is a simple hypothetical illustration to explain how consumer’s equilibrium is attained with the
concept of equi-marginal utility.

Graphical Illustration

Figure 1 details the above explanation graphically. In figure 1, X-axis measures units of money
spent on commodity X and Y, or units of commodities (X and Y) consumed. Y-axis measures
marginal utility derived from each unit of commodity X and Y.
Condition for Equilibrium
The law states that the consumer is said to be at equilibrium, when the following condition is
met:
(MUX/PX) = (MUY/PY) or
(MUx/MUY) = (Px/PY)
In our example, the consumer reaches equilibrium when he consumes the fifth unit of
commodity X and third unit of commodity Y ((12/1) = (12/1)).

Limitations of the Law of Equi-Marginal Utility

 Though the law of equi-marginal utility appears to be very convincing, the following arguments
are advanced against it:
Firstly, the utility derived from commodities is not measurable in cardinal numbers.
Secondly, the marginal utility of money cannot be constant. As the money you possess depletes,
the marginal utility of money increases.
Thirdly, even a rational economic individual does not allocate his or her income according to the
law. Usually, people tend to spend in a certain rough fashion. Therefore, the applicability of the
law is doubtful.
Finally, the law assumes that commodities and their marginal utilities are independent. However,
in real life, we see many substitutes and complements. In this case, the law loses its credibility.

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How Do Income and

Substitution Effects Work on
Consumer’s Equilibrium for
Giffen, Normal and Inferior
Goods?
Updated on March 24, 2020
Sundaram Ponnusamy 
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Giffen Goods Explanation

While all normal goods and many of the inferior goods obey law of demand, which states that
more quantities of commodities are demanded at less prices, there are certain inferior goods that
do not follow the law of demand. Such type of commodities are termed as Giffen Goods. In case
of Giffen goods, there is a positive relationship between price and quantity demanded. Not all
inferior goods are Giffen goods. However, Giffen goods are inferior goods. This type of
commodities are named after a renowned British statistician and economist called Sir Robert
Giffen. In case of Giffen goods, when price increases, its quantity demanded also increases.
Giffen’s observation attributes that very poor workers increase their consumption of cheap food
like bread, when its price increased. He claims that according to his study, the workers spent
large portions of their income on bread when its price increased. The reason behind this is that
they were unable to afford expensive foods such as meat because their prices also increased.
Since large portion of income was spent on bread (the cheapest food available), the workers were
unable to buy expensive foods. Therefore, consumption of bread increased even when its price
increased. This scenario causes a paradoxical situation and this paradox is popularly known as
Giffen paradox.

Income and Substitution Effects on Giffen

Goods
In figure 1, the consumer’s initial equilibrium point is E1, where original budget line M1N1 is
tangent to the indifference curve IC1 . X-axis represent Giffen goods (commodity X) and Y-axis
denotes superior goods (commodity Y). Assume that price of Giffen goods decreases. This
causes the budget line to shift outward and forms a new budget line M1N3. The consumer moves
to the new equilibrium point E3. At this new equilibrium point the quantity demanded of
commodity X decreases by X2X1. This movement represents the total price effect. Total price
effect consists of income effect and substitution effect. By drawing a parallel budget line M2N2,
we are eliminating the income effect. Hence, the consumer again moves to another equilibrium
point E2. At E2, the quantity demanded of commodity X increases by X1X3. This is because of the
substitution effect alone.
Thus, income effect = X2X1 - X1X3, which must be negative. Furthermore, the substitution effect
is positive. In this way, the income effect and substitution effect work in the opposite direction in
case of Giffen goods.
However, in the modern economy, it is difficult to find an example for Giffen paradox.
Furthermore, many economists are not ready to believe that Giffen paradox was actually
observed. Hence, with little empirical evidence it is plausible to conclude that the Giffen paradox
in real life is very unlikely.

Income and Substitution Effects on Normal

Goods
Normal goods, as the name indicate, are goods that we use in our day-to-day life. People tend to
use more of normal goods when as income increases.
Let us see what figure 2 depicts. The consumer’s original equilibrium is E1. At this point, the
budget line M1N1 is tangent to the indifference curve IC1. Suppose the price of commodity X
(normal goods) decreases and other things remain the same. The price decline shifts the budget
line to M1N3. Consequently, the consumer moves to new equilibrium point E3. Consumer’s
movement from E1 to E3 is the total price effect. Let us eliminate the income effect from the price
effect by following Hicks’ version. To do so, we draw an imaginary budget line M2N2, which is
tangent to IC1 at E2. E2 equilibrium point after the elimination of the income effect.
Hence, total price effect = X1X3
Substitution effect = X1X2
Income effect =X2X3

Income and Substitution Effects on Inferior

Goods
Inferior goods are cheap alternatives for normal goods. People use inferior goods when they are
unable to afford normal goods or expensive goods. Therefore, consumption of inferior goods by
a person decreases if income increases above a certain level. This implies that inferior goods
have strong positive substitution effect. However, when the price of an inferior good falls, the
consequence will be an increase in the quantity demanded because of significant negative
income effect.
In figure 3, X-axis represents inferior goods (commodity X) and Y-axis denotes superior goods
(commodity Y). The consumer’s original equilibrium point is E1. At this equilibrium point, the
budget line M1N1 is tangent to indifference curve IC1. If price of commodity X is reduced, new
budget line M1N2 is formed and the consumer moves to the new equilibrium point E2. At E2, the
budget line M1N2 is tangent to indifference curve IC2. Here, consumer’s movement from
equilibrium point E1 to equilibrium point E2 is the total price effect. We follow Hicks’ version to
eliminate the income effect from the price effect. To accomplish this, an imaginary budget line
M2N3 is drawn in such a way that it is parallel to budget line M1N2 and tangent to the original
indifference curve IC1 at E3. Hence, E3 is the equilibrium point after the elimination of income
effect.
Here, total price effect = X1X2
Substitution effect = X1X3
Thus, income effect = total price effect – substitution effect
i.e., income effect = X1X2 - X1X3= - X2X3
Thus, in case of inferior goods, the positive substitution effect (X1X3) is stronger than the
negative income effect (X2X3). This implies that many of the inferior goods obey the law of
demand.
The following table shows substitution and income effects of a price decline on quantity
demanded of different types of commodities:

Table 1
 Substitution
Type of Good Income Effect Total Effect
Effect

Normal Increase Increase Increase

Inferior (but not

Increase Decrease Increase
Giffen)

Giffen Increase Decrease Decrease

33

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The Hicksian Method and The

Slutskian Method
Updated on February 18, 2017

Sundaram Ponnusamy 
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Contact Author
Income and Substitution Effects of a Price
Change
A change in the price of a commodity alters the quantity demanded by consumer. This is known
as price effect. However, this price effect comprises of two effects, namely substitution effect
and income effect.
Substitution Effect
Let us consider a two-commodity model for simplicity. When the price of one commodity falls,
the consumer substitutes the cheaper commodity for the costlier commodity. This is known as
substitution effect.
Income Effect
Suppose the consumer’s money income is constant. Again, let us consider a two-commodity
model for simplicity. Assume that the price of one commodity falls. This results in an increase in
the consumer’s real income, which raises his purchasing power. Due to an increase in the real
income, the consumer is now able to purchase more quantity of commodities. This is known as
income effect.
Hence, according to our example, the decline in the price level leads to an increasing
consumption. This occurs because of the price effect, which comprises income effect and
substitution effect. Now, can you tell how much increase in consumption is due to income effect
and how much increase in consumption is due to substitution effect? To answer this question, we
need to separate the income effect and substitution effect.
How to separate the income effect and substitution effect?
Let us look at figure 1. Figure 1 shows that price effect (change in Px), which comprises
substitution effect and income effect, leads to a change in quantity demanded (change in Qx).

Figure 1
The splitting of the price effect into the substitution and income effects can be done by holding
the real income constant. When you hold the real income constant, you will be able to measure
the change in quantity caused due to substitution effect. Hence, the remaining change in quantity
represents the change due to income effect.
To keep the real income constant, there are mainly two methods suggested in economic
literature:
1. The Hicksian Method
2. The Slutskian method

The Hicksian Method

Let us look at J.R. Hicks’ method of bifurcating income effect and substitution effect.
In figure 2, the initial equilibrium of the consumer is E1, where indifference curve IC1 is tangent
to the budget line AB1. At this equilibrium point, the consumer consumes E1X1 quantity of
commodity Y and OX1 quantity of commodity X. Assume that the price of commodity X
decreases (income and the price of other commodity remain constant). This result in the new
budget line is AB2. Hence, the consumer moves to the new equilibrium point E3, where new
budget line AB2 is tangent to IC2. Thus, there is an increase in the quantity demanded of
commodity X from X1 to X2.
An increase in the quantity demanded of commodity X is caused by both income effect and
substitution effect. Now we need to separate these two effects. In order to do so, we need to keep
the real income constant i.e., eliminating the income effect to calculate substitution effect.
According to Hicksian method of eliminating income effect, we just reduce consumer’s money
income (by way of taxation), so that the consumer remains on his original indifference curve IC1,
keeping in view the fall in the price of commodity X. In figure 2, reduction in consumer’s money
income is done by drawing a price line (A3B3)parallel to AB2. At the same time, the new parallel
price line (A3B3) is tangent to indifference curve IC1 at point E2. Hence, the consumer’s
equilibrium changes from E1 to E2. This means that an increase in quantity demanded of
commodity X from X1 to X3 is purely because of the substitution effect.
We get the income effect by subtracting substitution effect (X1X3) from the total price effect
(X1X2).
Income effect = X1X2 - X1X3 = X3X2

The slutskian Method

Now let us look at Eugene Slutsky’s method of separating income effect and substitution effect.
Figure 3 illustrates the Slutskian version of calculating income effect and substitution effect.

In figure 3, AB1 is the initial budget line. The consumer’s original equilibrium point (before price
effect takes place) is E1, where indifference curve IC1 is tangent to the budget line AB1. Suppose
the price of commodity X falls (price effect takes place) and other things remain the same. Now
the consumer shifts to another equilibrium point E2, where indifference curve IC3 is tangent to the
new budget line AB2. Consumer’s movement from equilibrium point E1 to E2 implies that
consumer’s purchase of commodity X increases by X1X2. This is the total price effect caused by
the decline in price of commodity X.
Now the task before us is to isolate the substitution effect. In order to do so, Slutsky attributes
that the consumer’s money income should be reduced in such a way that he returns to his
original equilibrium point E1 even after the price change. What we are doing here is that we
make the consumer to purchase his original consumption bundle (i.e., OX1 quantity of
commodity X and E1X1 quantity of commodity Y) at the new price level.
In figure 3, this is illustrated by drawing a new budget line A4B4, which passes through original
equilibrium point E1 but is parallel to AB2. This means that we have reduced the consumer’s
money income by AA4 or B4B2 to eliminate the income effect. Now the only possibility of price
effect is the substitution effect. Because of this substitution effect, the consumer moves from
 equilibrium point E1 to E3, where indifference curve IC2 is tangent to the budget line A4B4. In
Slutsky version, the substitution effect leads the consumer to a higher indifference curve.
Thus, income effect = X1X2 - X1X3 = X3X2

QUESTIONS & ANSWERS

10

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Meaning of Opportunity Cost

and Its Economic Significance
Updated on February 27, 2020

Sundaram Ponnusamy 
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Source

 Short-Run Average and Marginal Cost Curves

 Isoquant - Meaning and Properties

Introduction to Cost Function

The relationship between cost and output is known as the cost function. Cost functions are
derived from production functions. The production function expresses the functional relationship
between input and output. In simple terms, the production function states that output depends
upon various quantities of inputs. If prices of inputs are known, we can calculate the costs of
production. The cost of production of a commodity is the aggregate of prices paid for the factors
of production used in producing that commodity.

Opportunity Cost
Modern economists have rejected the labor and sacrifices nexus to represent real cost. Rather, in
its place they have substituted opportunity or alternative cost.
The concept of opportunity cost occupies an important place in economic theory. The concept
was first developed by an Austrian economist, Wieser. The other notable contributors are Daven
Port, Knight, Wicksteed and Robbins. The concept is based on the fundamental fact that factors
of production are scarce and versatile.
Our wants are unlimited. The means to satisfy these wants are limited, but they are capable of
alternative uses. Therefore, the problem of choice arises. This is the essence of Robbins’
definition of economics.
The opportunity cost of anything is the alternative that has been foregone. This implies that one
commodity can be produced only at the cost of foregoing the production of another commodity.
As Adam Smith observed, if a hunter can bag a deer or a beaver in the course of a single day, the
cost of a deer is a beaver and the cost of a beaver is a deer. A man who marries a girl is foregoing
the opportunity of marrying another girl. A film actor can either act in films or do modeling
work. She cannot do both the jobs at the same time. Her acting in film results in the loss of an
opportunity of doing modeling work.
In the words of Prof. Byrns and Stone “opportunity cost is the value of the best alternative
surrendered when a choice is made.”
In the words of John A. Perrow “opportunity cost is the amount of the next best produce that
must be given up (using the same resources) in order to produce a commodity.”
Importance of the Concept of Opportunity Cost
1. Determination of Relative Prices of goods
The concept is useful in the determination of the relative prices of different goods. For example,
if a given amount of factors can produce one table or three chairs, then the price of one table will
tend to be three times equal to that one chair.
2. Fixation of Remuneration to a Factor
The concept is also useful in fixing the price of a factor. For example, let us assume that the
alternative employment of a college professor is work as an officer in an insurance company at a
salary of $4,000 per month. In such a case, he has to be paid at least $4,000 to continue to retain
him in the college.
3. Efficient Allocation of Resources
The concept is also useful in allocating the resources efficiently. Suppose, opportunity cost of 1
table is 3 chairs and the price of a chair is $100, while the price of a table is $400. Under such
circumstances, it is beneficial to produce one table rather than 3 chairs. Because, if he produces 3
chairs, he will get only $300, whereas a table fetches him $400, that is, $100 more.
Limitations
The concept has the following drawbacks:
1. Specific
If a factor’s service is specific, it cannot be put to alternative uses. The transfer cost or alternative
cost in such a case is zero. This is pure rent, according to Mrs. Joan Robinson.
2. Inertia
Sometimes, factors may be reluctant to move to alternative occupations. In such a case, a
payment exceeding the pure transfer cost will have to be made to induce it to take to an
alternative occupation.
3. Perfect Competition
The concept rests on the assumption of perfect competition. However, perfect competition is a
myth, which seldom prevails.
4. Private and Social Costs
A discrepancy is likely to arise between private and social costs. For example, let us assume that
a chemical factory discharges industrial refuse into a river. This causes serious health hazards,
which cannot be measured in money terms.
5. Alternatives are not clearly known
The foregone opportunities are often not ascertainable. This also poses a serious limitation of the
concept.

Other Types of Cost

Money Cost and Real Cost
Money cost or nominal cost is the total money expenses incurred by a firm in producing a
commodity. It includes the following elements:
1. Cost of raw materials
2. Wages and salaries of labor
3. Expenditure on machinery and equipment
4. Depreciation on machines, buildings and such other capital goods
5. Interest on capital
6. Other expenses like advertisement, insurance premium and taxes.
7. Normal profits of the entrepreneur
Real cost is a subjective concept. It expresses the pains and sacrifices involved in producing a
commodity. Marshall defined real cost as follows, “The exertions of all the different kinds of
labor that are directly or indirectly involved in making it; together with the abstinences or rather
the waiting required for saving the capital used in making it.”
However, real costs are not amenable to precise measurement. Modern economists therefore
prefer the concept of opportunity cost.
Private, External and Social Costs
Sometimes, there is a discrepancy between the cost incurred by a firm and the cost incurred by
the society. For example, an oil refinery discharges its wastes in the river causing water
pollution. Likewise, various types of air pollution and noise pollution are caused by various
agencies engaged in production activities. Such pollutions result in tremendous health hazards,
which involve cost to the society as a whole. A cost that is not borne by the firm, but is incurred
by others in the society is called an external cost.
The true cost to the society must include all costs, regardless of the persons on whom its impact
falls and its incidence as to who bear them.
Thus, social cost = private cost + external cost
Or external cost = social cost – private cost
 Implicit Cost and Explicit Cost
Explicit costs are those costs, which are actually paid by the firm. To put it in other words,
explicit costs are paid out costs. Explicit costs include wages and salaries, prices of raw
materials, amounts paid on fuel, power, advertisement, transportation, taxes and depreciation
charges. Explicit costs are recorded in the firm’s books of account.
Implicit costs are the imputed value of the entrepreneur’s own resources and services. In other
words, implicit costs are costs, which self-owned and self-employed resources could have earned
in their best alternative uses. It refers to the highest income, which might have been received by
him if he has let his labor, building and money to someone else. These costs are frequently
ignored in calculating the expenses of production.
Historical and Replacement Cost
Historical cost refers to the cost of an asset, acquired in the past whereas replacement cost refers
to the cost, which has to be incurred for replacing the same asset.
Increment and Sunk costs
The increment costs are the additions to costs resulting from a change in product lines,
introduction of a new product, replacement of obsolete plant and machinery, etc.
Sunk costs are those which cannot be altered, increased or decreased by changing the rate of
output and the level of business activity. All the past costs are considered as sunk costs because
they are known and given and cannot be revised as a result of changes in market conditions.

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How to Derive Consumer's

Equilibrium Through the
Technique of Indifference
Curve and Budget Line?
Updated on June 1, 2014

Sundaram Ponnusamy 
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 How Do Income Effect, Substitution Effect and Price Effect Influence Consumer's Equilibrium?
 The Hicksian Method and The Slutskian Method

Introduction
The goal of a consumer is to get maximum satisfaction from the commodities he purchases. At
the same time, the consumer possesses limited resources. Hence, he is trying to maximize his
satisfaction by allocating the available resources (money income) among various goods and
services rationally. This is the main theme of the theory of consumer behavior. Further, you
could ascertain that a consumer is in equilibrium when he obtains maximum satisfaction from his
expenditure on the commodities given the limited resources. You can analyze consumer’s
equilibrium through the technique of indifference curve and budget line.

Assumptions
1. The consumer under consideration is a rational human being. This means that the consumer
always tries to maximize his satisfaction with limited resources.
2. There prevails perfect competition in the market.
3. Goods are homogeneous and divisible.
4. The consumer has perfect knowledge about the products available in the market. For instance,
prices of commodities.
5. Prices of commodities and consumer’s money income are given.
6. Consumer’s indifference map remains unchanged throughout the analysis.
7. Consumer’s tastes, preferences and spending habits remain unchanged throughout the analysis.
Price Line or Budget Line
Price line or budget line is an important concept in analyzing consumer’s equilibrium. According
to Prof. Maurice, “The budget line is the locus of combinations or bundles of goods that can be
purchased if the entire money income is spent.”

Table 1
Total Amount Spent on
X (units) Y (units)
X + Y (in $)

4 0 8+0=8

3 2 6+2=8

2 4 4+4=8

1 6 2+6=8

0 8 0+8=8

Suppose there are two commodities, namely X and Y. Given the market prices and the
consumer’s income, the price line shows all the possible combinations of X and Y that a
consumer could purchase at a particular time. Let us consider a hypothetical consumer who has a
fixed income of $8. Now, he wants to spend the entire money on two commodities (X and Y).
Suppose the price of commodity X is $2, and the price of commodity Y $1. The consumer could
spend all money on X and get 4 units of commodity X and no commodity Y. Alternatively, he
could spend entire money on commodity Y and get 8 units of commodity Y and no commodity
X. The table given below exhibits the numerous combinations of X and Y that the consumer can
purchase with $8.
In figure 1, horizontal axis measures commodity X and vertical axis measure commodity Y. The
budget line or price line (LM) indicates various combinations of commodity X and commodity Y
that the consumer can buy with $8. The slope of the budget line is OL/OM. At point Q, the
consumer is is able to buy 6 units of commodity Y and 1 unit of commodity X. Similarly, at
point P, he is able to buy 4 units of commodity Y and 2 units of commodity X.
The slope of the price line (LM) is the ratio of price of commodity X to price of commodity Y,
i.e., Px/Py. In our example, price of commodity X is $2 and price of commodity Y is $1; hence,
the slope of the price line is Px. Note that the slope of the budget line depends upon two factors:
(a) money income of the consumer and (b) prices of the commodities under consideration.

Reasons for Many Budget Lines

(a) Consumer’s Income Change
An outward parallel shift in the budget line occurs because of an increase in consumer’s money
income provided that the prices of commodities X and Y remain unchanged (it means constant
slope - Px/Py). Likewise, a reduction in consumer’s money income creates a parallel inward shift
in the budget line.

In figure 2, LM denotes the initial price line. Assume that the prices of the two goods and
consumer’s money income are constant. Now, the consumer is able to purchase OM quantity of
commodity X or OL quantity of commodity Y. If his income increases, the price line shifts
outward and becomes L1M1. He can now buy OM1 quantity of commodity X and OL1 quantity of
commodity Y. A further increase in income causes a further outward shift in the price line to
L2M2. Price line L2M2 indicates that the consumer can buy OM2 quantity of commodity X and
OL2 quantity of commodity Y. Similarly, if there is a decrease in consumer’s income, the price
line will shift inward (for example, L3M3).
(b) Price Change
The slope of a price line is associated with the prices of commodities under consideration.
Hence, if there is a change in the price of any one of the commodities, there will be a change in
the slope of the price line. Assume that the price of commodity X decreases and the price of
commodity Y remain unchanged. In this case, the price ratio Px/Py (slope of price line) tends to
decrease. In figure 3, this scenario is denoted by the shifts in the price line from LM to LM1 then
to LM2 and so on. Conversely, if the price of commodity X rises, the price ratio Px/Py will rise.
This leads to the price line shifts from LM2 to LM1 and to LM.

Indifference Map
A set of indifference curves that shows a consumer’s preferences is known as an indifference
map. The indifference map of a consumer, since is composed of indifference curves, exhibits all
properties of a normal indifference curve. Some of the most important properties of an
indifference curve are: indifference curves are convex to the origin; they always slope
downwards from left to right; higher indifference curves indicate higher levels of satisfaction;
they do not touch any of the axes (example: figure 4).

Necessary conditions for consumer’s

equilibrium
The following are the two important conditions to attain consumer’s equilibrium:
Firstly, marginal rate of substitution must be equal to the ratio of commodity prices.
Symbolically,
MRSxy = MUx/MUY = Px/Py.
Secondly, indifference curve must be convex to the origin.

Consumer's Equilibrium
Now we have both budget lines and indifference map of the consumer. A budget line represents
consumer’s limited resources (what is feasible) and indifference map represent consumer’s
preferences (what is desirable). The question now is that how the consumer is going to optimize
his limited resources. An answer for this question would be consumer’s equilibrium. In other
words, the consumer’s equilibrium means the combination of commodities that maximizes
utility, given the budget constraint. To obtain consumer’s equilibrium graphically, you just need
to superimpose the budget line on the consumer’s indifference map. This is shown in figure 5.

At point E, consumer’s equilibrium is attained. Because the indifference curve IC2 is the best
possible indifference curve that the consumer can reach with the given resources (budget line).
The tangency of indifference curve IC2 and the price line represent the above statement. At the
point of tangency, the slope of the budget line (Px/Py) and the marginal rate of substitution
(MRSxy = MUx/MUy) are equal: MUx/MUy = Px/Py (first condition for consumer’s equilibrium).
From figure 5, we can understand that the second condition for consumer’s equilibrium
(indifference curve must be convex to the origin) is also fulfilled.
A small algebraic manipulation in the above equation gives us MUx/Px = MUy/Py, which is the
marginal utility per dollar rule for consumer’s equilibrium. Thus, all the conditions for
consumer’s equilibrium are fulfilled. The combination (X0Y0) is an optimal choice (point E) for
the consumer.
 76

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Law of Diminishing Marginal

Utility - Detailed Explanation
Updated on January 3, 2017

Syed Hunbbel Meer 

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Note: There are two laws of utility that are often discussed together: law of diminishing
marginal utility and the law of equi-marginal utility. This article explains the law of diminishing
marginal utility.
The law of diminishing marginal utility is an important concept to understand. It basically falls in
the category of Microeconomics, but it is of equal and significant importance in our day-to-day
decisions. In this article, you will find the definition of the law of diminishing marginal utility,
its detailed explanation with the help of a schedule and diagram, assumptions we make in the law
of diminishing marginal utility and the exceptions where the law of diminishing marginal utility
does not apply.
We will first start with the basic definition of ‘Utility’.
Utility:
Utility is the capacity of a commodity through which human wants are satisfied.

Law of Diminishing Marginal Utility:

The law of diminishing marginal utility is comprehensively explained by Alfred Marshall.
According to his definition of the law of diminishing marginal utility, the following happens:
“During the course of consumption, as more and more units of a commodity are used, every
successive unit gives utility with a diminishing rate, provided other things remaining the same;
although, the total utility increases.”

Utils:
'Utils' is considered as the measurable 'unit' of utility.

Explanation for the Law of Diminishing

Marginal Utility:
We can briefly explain Marshall’s theory with the help of an example. Assume that a consumer
consumes 6 apples one after another. The first apple gives him 20 utils (units for measuring
utility). When he consumes the second and third apple, the marginal utility of each additional
apple will be lesser. This is because with an increase in the consumption of apples, his desire to
consume more apples falls.
Therefore, this example proves the point that every successive unit of a commodity used gives
the utility with the diminishing rate.
We can explain this more clearly with the help of a schedule and diagram.

Schedule for Law of Diminishing Marginal

Utility:
Unit of Consumption Marginal Utility Total Utility

1 20 20

2 15 35

3 10 45

4 05 50
 Unit of Consumption Marginal Utility Total Utility

5 00 50

6 -05 45

The schedule explains that with each additional unit consumed the marginal utility increases with a
diminishing rate. After the saturation point though, the utility starts to fall.

In the above table, the total utility obtained from the first apple is 20 utils, which keep on
increasing until we reach our saturation point at 5th apple. On the other hand, marginal utility
keeps on diminishing with every additional apple consumed. When we consumed the 6th apple,
we have gone over the limit. Hence, the marginal utility is negative and the total utility falls.
With the help of the schedule, we have made the following diagram:

Saturation Point: The point where the desire to consume the same product anymore becomes
zero.

Disutility: If you still consume the product after the saturation point, the total utility starts to fall.
This is known as disutility.
When the first apple is consumed, the marginal utility is 20. When the second apple is consumed,
the marginal utility increases by 15 utils, which is less than the marginal utility of the 1st apple –
because of the diminishing rate. Therefore, we have shown that the utility of apples consumed
diminishes with every increase of apple consumed.
Similarly, when we consumed the 5th apple, we are at our saturation point. If we consume
another apple, i.e. 6th apple, we can see that the marginal utility curve has fallen to below X-axis,
which is also known as ‘disutility’.
The unit and its quality must remain same.

Assumptions in the Law of Diminishing

Marginal Utility:
For the law of diminishing marginal utility to be true, we need to make certain assumptions.
Each assumption is quite logical and understandable. If any of the assumptions are not true in the
case, the law of diminishing marginal utility will not be true.
Following are the assumptions in the law of diminishing marginal utility:
 The quality of successive units of goods should remain the same. If the quality of the goods
increase or decrease, the law of diminishing marginal utility may not be proven true.
 Consumption of goods should be continuous. If there comes a substantial break in the
consumption of goods, the actual concept of diminishing marginal utility will be altered.
 Consumer’s mental outlook should not change.
 Unit of good should not be very few or small. In such a case, the utility may not be measured
accurately.

Exceptions for the Law of Diminishing Marginal

Utility:
The law of diminishing marginal utility states that with the consumption of every successive unit
of commodity yields marginal utility with a diminishing rate. However, there are certain things
on which the law of diminishing marginal utility does not apply.
Following are the exceptions for this law:
 Desire for money.
  Desire for knowledge.
 Use of liquor or wine.
 Collection of rare objects.
Conclusion:
This concludes the explanation for the law of diminishing marginal utility. Feel free to ask any
question in the comment section below.

© 2013 Syed Hunbbe

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Advantages of the Law of

Diminishing Marginal Utility
Updated on February 27, 2020

Sundaram Ponnusamy 
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 Advantages and Disadvantages of the Marginal Utility Analysis

 The Law of Equi-Marginal Utility or Gossen's Second Law

Introduction
In social sciences, you often find that there is a wide gap between theories and their practical
application. Have you ever thought why it happens? The answer is very simple. Almost all theories
of social sciences are based on general human behavior and certain assumptions. Assumptions are
necessary to hold the theory good. However, some of these assumptions are very unrealistic and do
not work in all situations. In addition, it is hard to predict human behavior. Hence, theories that rely
on such unrealistic assumptions and unpredictable human behavior fail to work in a real life
scenario. Because of this reason, there is a wide gap between theories and their practical
application. However, the law of diminishing marginal utility is completely different in this regard.
Though the theory is derived from general human behavior, it possesses great practical importance.
Let us see how the law of diminishing marginal utility is helpful in various fields of economics.

Basis for Progressive Taxation

The law of diminishing marginal utility is one of the fundamental principles in public finance. The law
serves as the basis for progressive taxation. Adam Smith explained canons of taxation in his book
‘Wealth of Nations’. One of the canons of taxation is ‘Ability to Pay’. This means that taxes should be
imposed according to the ability of people to pay. The law of diminishing marginal utility is crucial in
determining people’s ability to pay. According to Prof. Pigou, the marginal utility of money for a poor
person is higher than that for a rich person. This is so, because a poor person possesses little
money; therefore, the utility derived from each unit of money is huge. This implies that rich people
are able to pay more as taxes than poor people are. This concept leads to progressive taxation
system, which imposes heavier tax burden on the rich. This is one of the very important practical
applications of the law of diminishing marginal utility.

Redistribution of Income

Income distribution is the core concept in public finance. What the government does through taxation
is taking away some of the resources from rich and spending them to improve the welfare of poor.
Note that when a person possesses less money, the utility derived from it is huge. At the same time,
when a person possesses more money, the utility derived from it is less because of the abundance.
When taxes are imposed on rich, some of their money is taken away. Hence, the utility derived from
the remaining money improves. At the same time, the money taken from the rich is spent to improve
the welfare of poor. This implies that the poor becomes better off now. This activity helps to attain an
egalitarian society. This process can be explained with the help of the following figure:
Let us suppose that there are two individuals (A and B) in a society. The poor man’s income is OA.
OB’ is the rich man’s income. Suppose the government imposes tax on the rich; therefore, income of
the rich is reduced by B’B. Now, the same amount of money income is transferred to the poor. This
raises the poor man’s income by AA’. From the picture, you can understand that the marginal utility
of the rich improves from D’ to D because of taxation. And the poor man’s utility declines from C to
C’. This implies that money in the hands of the poor has increased. This activity leads to an
egalitarian society.

Derivation of Demand Curve

The law of diminishing marginal utility is the basis to derive demand curve. The law further helps to
understand why the demand curve slopes downward. Click here to know how to derive demand
curve from the law of diminishing marginal utility. In addition, Go here to understand the relationship
between the law of diminishing marginal utility and downward slope of a demand curve.

Value Determination

The law of diminishing marginal utility is helpful to determine the value or price of a commodity. For
example, the law explains that the marginal utility of a commodity decreases as the quantity of it
increases. When the marginal utility falls, consumers do not prefer to pay high price. Therefore, the
seller has to reduce the price of the commodity, if he or she wants to sell more. In this way, the law
plays a crucial role in determining price of a commodity.

Water – Diamond Paradox

The principle of diminishing marginal utility is beneficial to understand the difference between value-
in-use and value-in-exchange. For instance, let us consider two commodities – water and diamond.
Water is essential for our survival (value-in-use) but it is not costly (no or little value-in-exchange).
On the contrary, diamonds are useful just for showy purpose (no value-in-use) but they are very
costly (high value-in-exchange).

Water is abundant and hence has no marginal utility. Because of this reason, want has no or little
value-in-exchange. On the contrary, diamonds are scarce and hence possess a very high marginal
utility. Therefore, diamonds have high value-in-exchange. In this way, the law of diminishing
marginal utility tells us why diamonds are highly priced when compared to water. This scenario is
often referred to as water - diamond paradox.

The following diagram provides you with more information on this paradox:

In figure 2,

UU1 - marginal utility curve for diamond

VV1 - marginal utility curve for water

OA represents the supply of diamond

OF represents the supply of water

Since the quantity of diamonds is less (OA), the marginal utility derived from diamonds is high (AB).
Therefore, diamonds are priced high (OC) as the price of a commodity is associated with its
marginal utility. Let us look at the case of water. The quantity of water is high. Therefore, the
marginal utility derived from water is less (FE). Because of small amount of marginal utility, water is
priced less (OD).

Optimum Utilization of Expenditure

The law of diminishing marginal utility is useful for individuals to determine how much money should
be spent on a particular commodity. The equilibrium point is where marginal utility is equal to price
(point E in figure 3). At this point, we can say that the individual utilizes his or her expenditure
optimally. Though we do not calculate all these things in our day-to-day purchasing activities, it
happens naturally. We do not pay a high price for a commodity that does not give us utility. In this
sense, the law of diminishing marginal utility does play an eminent role in all economic activities.

Basis for Economic Laws

Furthermore, the law of diminishing marginal utility serves as a basis for some important economic
concepts such as law of demand, consumer’s surplus, law of substitution and elasticity of demand.
l Meer
 7

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Economies of Scale - Meaning

and Types
Updated on December 17, 2016

Sundaram Ponnusamy 
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Introduction
The scale of production has an important bearing on the cost of production. It is a common
experience of every producer that costs can be reduced by increased production. That is why the
producers are keener on expanding the size or scale of production. In the process of expansion,
the producer may benefit from the emergence of economies of scale. These economies are
broadly classified into two types:
1. Internal Economies
2. External Economies
3. Internal Economies
4. External Economies
Internal Economies
When a firm expands its scale of production, the economies, which accrue to this firm, are
known as internal economies.
According to Cairncross, “Internal economies are those which are open to a single factory or a
single firm independently of the action of other firms. They result from an increase in the scale
of output of the firm, and cannot be achieved unless output increases. They are not the result of
inventions of any kind, but are due to the use of known methods of production which a small
firm does not find worthwhile.”
Internal economies may be of the following types:
1. Technical Economies
Technical economies are those, which accrue to a firm from the use of better machines and
techniques of production. As a result, production increases and cost per unit of production
decreases.
Following Prof. Cairncross, we may classify the various kinds of technical economies as follows:
(a) Economies of Increased Dimensions
Certain technical economies may arise because of increased dimensions. For example, a double
decker bus is more economical than a single decker. One driver and one conductor may be
needed, whether it is a double decker or a single decker bus.
(b) Economies of Linked Processes
As a firm increases its scale of operations, it can properly be linked to various production
processes more efficiently. For example, in order to obtain the advantage in a linkage process,
both editing and printing of newspapers are generally carried out in the same premises.
In the words of Prof. Cairncross, “There is generally a saving in time and a saving in transport
costs, when the two departments of the same factory are brought closer together than two
separate factories.”
(c) Economies of the Use of By-products
A large firm is in a better position to utilize the by-products efficiently and attempt to produce
another new product. For example, in a large sugar factory, the molasses left over after the
manufacture of sugar from out of the sugarcane can be used for producing power alcohol by
installing a small plant.
(d) Economies in Power
Large sized machines without continuous running are often more economical than small sized
machines running continuously in respect of power consumption. For example, a big boiler
consumes more or less the same power as that of a small boiler but gives more heat.
(e) Economies of Increased Specialization
A large firm can divide the work into various sub-processes. Therefore, division of labor and
specialization become possible. At one stroke, all the advantages of division of labor can be
achieved. For example, only well established big school can have specialized teachers.
2. Economies of Continuation
Technical economy is also realized due to al long-run continuation of the production process. For
example, composing and printing of 1000 copies may cost $200; but if we increase the number
of copies to 2000 it may cost only $250, because the same sheet plate which has been composed
previously can be utilized for the increased number of copies also.
3. Labor Economies
A large firm employs a large number of laborers. Therefore, each person can be employed in the
job to which he is most suited. Moreover, a large firm is in a better position to attract specialized
experts into the industry. Likewise, specialization saves time and encourages new inventions. All
these advantages result in lower costs of production.
4. Marketing Economies
Economies are achieved by a large firm both in buying raw materials as also in selling its
finished products. Since the large firm purchases its requirements in bulk, it can bargain on its
purchases on favorable terms. It can ensure continuous supply of raw materials. It is eligible for
preferential treatment. The special treatment may be in the form of freight concessions from
transport companies, adequate credit from banks and other financial treatments etc. In terms of
advertisements also, it is better placed than the smaller firms. Better-trained and efficient sales
persons can be appointed for promoting sales.
5. Financial Economies
The credit requirements of the big firms can be met from banks and other financial institutions
easily. A large firm is able to mobilize much credit at cheaper rates. Firstly, investors have more
confidence in investing money in the well-established large firms. Secondly, the shares and
debentures of a large firm can be disbursed or sold easily and quickly in the share market.
6. Managerial Economies
On the managerial side also, economies can be achieved; when output increases, specialists can
be more fully employed. A large firm can divide its big departments into various sub-
departments and each department may be placed under the control of an expert. A brilliant
organizer can devote himself wholly to the work of organizing while the routine jobs can be left
to relatively low paid workers.
7. Risk Bearing Economies
The larger the size of a firm, the more likely are its losses to be spread among its various
activities according to the law of averages.
A big firm produces a large number of items and of different varieties so that the loss in one can
be counter balanced by the gain in another. For example, a branch bank can spread its risk by
diversification of its investment portfolio rather than a unit bank. Suppose a bank in a particular
locality is facing a run on the bank, it can recall its resources from other branches, and can easily
overcome the critical situation. Thus, diversification avoids “putting all its eggs in one basket.”
8. Economies of Research
A large sized firm can spend more money on its research activities. It can spend huge sums of
money in order to innovate varieties of products or improve the quality of the existing products.
In cases of innovation, it will become an asset of the firm. Innovations or new methods of
producing a product may help to reduce its average cost.
9. Economies of Welfare
A large firm can provide welfare facilities to its employees such as subsidized housing,
subsidized canteens, crèches for the infants of women worker, recreation facilities etc.; all these
measures have an indirect effect on increasing production and at reducing the costs.

External Economies
External economies refer to gains accruing to all the firms in an industry due to the growth of
that industry. All the firms in the industry irrespective of their size can enjoy external economies.
The emergence of external economies is due to localization.
The main types of external economies are as follows:
1. Economies of Concentration
When a number of firms are located in one place, all the member firms reap some common
economies. Firstly, skilled and trained labor becomes available to all the firms.
Secondly, banks and other financial institutions may set up their branches, so that all the firms in
the area can obtain liberal credit facilities easily. Thirdly, the transport and communication
facilities may get improved considerably. Further, the power requirements can be easily met by
the electricity boards. Lastly, supplementary industries may emerge to assist the main industry.
2. Economies of Information
The economies of information may arise because of the collective efforts of the various firms.
Firstly, an individual firm may not be in a position to spend enormous amounts on research.
However, by pooling all their resources new inventions may become possible. The fruits of the
invention can be shared by all the member firms. Secondly, publication of statistical, technical
and marketing information will be of vital importance to increase output at lower costs.
3. Economies of Disintegration
When the industry grows, it becomes possible to split up production into several processes and
leave some of the processes to be carried out more efficiently by specialized firms. This makes
specialization possible and profitable. For example, in the cotton textile industry, some firms
may specialize in manufacturing thread, some others in producing vests, some in knitting briefs,
some in weaving t-shirts etc. The disintegration may be horizontal or vertical. Both will help the
industry in avoiding duplication, and in saving time materials.
Relationship between Internal and External Economies
No watertight compartmental division can be made between internal and external economies.
When a number of firms are combined into one, external economies will become internal
economies. Internal economies are due to the expansion of individual firm while external
economies arise due to the growth of the entire industry. External economies are a pre-requisite
for the growth of backward regions.

How Do Income Effect,

Substitution Effect and Price
Effect Influence Consumer's
Equilibrium?
Updated on December 15, 2016
Sundaram Ponnusamy 
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Income Effect on Consumer's Equilibrium

Income effect attributes how a change in the consumer’s income influences his total satisfaction.
Assume that the prices of commodities that the consumer purchases remain constant. Now, he is
able to experience more or less satisfaction depending upon the change in his income. Thus, we
can define income effect as the effect caused by changes in consumer’s income on his purchases
while prices of commodities remaining the same.
Figure 1 explains the effect of change in the consumer’s income on his equilibrium level.

In figure 1, Point E is the initial equilibrium position of the consumer. At point E, the
indifference curve IC1 is tangent to the price line MN. Suppose the consumer’s income increases.
This causes the budget line shifts from MN to M1N1 and then to M2N2. Consequently, the
equilibrium point shifts from E to E1 and then to E2.
Income Consumption Curve
You can obtain income consumption curve (ICC) by joining all equilibrium points E, E1 and
E2 as shown in figure 1. Normal goods generally have positively sloped income consumption
curves, which implies that consumer’s purchases of the two commodities increases as his income
increases. At the same time, this may not be applicable in all cases.

Substitution Effect on Consumer's Equilibrium

Suppose there are two commodities, namely apple and orange. Your money income is $100,
which does not change. You need to purchase apple and orange using the entire money income,
i.e. $100. Assume that the price of apple increases and the price of orange decreases. What do
you do in this case? You tend to buy more oranges and less apples since oranges are cheaper than
apples. What exactly you are doing is that you are substituting oranges for apples. This is known
as substitution effect.
The substitution effect occurs because of the following two reasons:
(a) The relative prices of commodities change. This makes one commodity cheaper and the other
commodity costlier.
(b) Money income of the consumer does not change.
Figure 2 is helpful to understand the concept of substitution effect in a simple manner.
In figure 2, AB represents the original budget line. The point Q represents the original
equilibrium point, where the budget line is tangent to the indifference curve. At point Q, the
consumer buys OM quantity of commodity X and ON quantity of commodity Y. Assume that the
price of commodity Y increases and the price of commodity X decreases. As a result, the new
budget line would be B1A1. The new budget line is tangent to the indifference curve at point Q1.
This is the new equilibrium position of the consumer after the relative prices change.
At the new equilibrium point, the consumer has decreased the purchase of commodity Y from
ON to ON1 and increased the purchase of commodity X from OM to OM1. However, the
consumer stays on the same indifference curve. This movement along the indifference curve
from Q to Q1 is known as the substitution effect. In simple terms, the consumer substitutes one
commodity (its price is less) for the other (its price is more); it is known as the ‘substitution
effect.’

Price Effect on Consumer's Equilibrium

For simplicity, let us consider two-commodity model. In substitution effect, prices of both the
commodities change (price of commodity Y increases and price of commodity X decreases).
However, in price effect, price of any one of the commodities changes. Thus, price effect is the
change in the quantity of commodities or services purchased due to a change in the price of any
one of the commodities.
Let us consider two commodities, namely commodity X and commodity Y. Price of commodity
X changes. Price of commodity Y and consumer’s income are constant.

Suppose price of commodity X decreases. In figure 3, the decline in the price of commodity X is
represented by the corresponding shifts of budget line from AB1 to AB2, AB2 to AB3 and AB3 to
AB4. The points C1, C2, C3 and C4 denote respective equilibrium combinations. According to
figure 3, consumer’s real income increases as the price of commodity X reduces. Due to an
increase in the consumer’s real income, he is able to purchase more of both commodities X and
Y.
Price Consumption Curve
You can derive the Price Consumption Curve (PCC) by joining all equilibrium points (in the
above example, C1, C2, C3 and C4). In the above figure, the PCC has a positive slope. This means
that as price of commodity X falls, the consumer’s real income increases.
Derivation of Demand Curve from Price
Consumption Curve
The price consumption curve (PCC) tells us what happens to the quantity demanded when there
is a change in price. A consumer’s demand curve also explains the relationship between the price
and quantity demanded of a commodity. Therefore, price consumption curve is useful to derive
an individual consumer’s demand curve. Though a consumer’s demand curve and his price
consumption curve give us same information, the demand curve is more straightforward in what
it tries to convey.
Figure 4 illustrates the process of deriving the individual consumer‘s demand curve from his
price consumption curve.

In figure 4, horizontal axis measures commodity A, and vertical axis represents consumer’s
money income. IC1, IC2, and IC3 denote indifference curves. Suppose the price of commodity A
continuously decreases. As a result, LN, LQ and LR are the subsequent budget lines of the
consumer. Initially, P1 is consumer’s equilibrium. At this equilibrium point, the consumer buys
OM1 quantity of commodity A.
Price of a unit of commodity A = total money income/number of the units that can be bought
with that money.
Hence, at P1 (equilibrium point – budget line is tangent to the indifference curve IC1), the price
per unit of commodity A is OL/ON. At OL/ON price, the consumer demands OM1 quantity of
commodity A.
Likewise, at OL/OQ price, the consumer is able to buy OM2 quantity of commodity A and at
OL/OR price, he buys OM3 quantity of commodity A.
If you connect all equilibrium points (P1, P2 and P3), you will be able to get the price
consumption curve.
The demand curve, as mentioned above, depicts the prices and corresponding quantities of
commodity purchased by the consumer.
For illustration purpose, suppose the consumer’s income is $40, ON = 8 units, OQ = 10 units and
OR = 20 units. With the help of this information, you can construct a demand schedule as
follows:

Table 1: Price-Demand Schedule for

Commodity A
Price of A (in $) = Total
Quantity of A
Budget Line Money Income/No. of
Demanded
Units of A

LN OL/ON (40/8 = 5) OM1 = 8 units

LQ OL/OQ (40/10 = 4) OM2 = 10 units

LR OL/OR (40/20 = 2) OM3 = 20 units

Once you have the demand schedule, you can derive an individual consumer’s demand curve as
shown in figure 5.
Figure 5 illustrates a consumer’s demand curve. If you need to construct a market demand curve,
it will be possible by a horizontal summation of individual demand curves.