CA Foundation Economics - Notes

CA Foundation: Economics
SR Name Weightage Marks Distribution

No.
1 Business Economics-Basic 15%-20% 9-12 marks

Concepts
2 Utility Analysis andConsumer 35-40% 21-24 marks

Behaviour
3 Demand Analysis
4 Supply Analysis
5 Production Concepts
6 Cost and Revenue

Concepts
7 Market Forms andPrice – 25%-30% 15-18 marks

output
Determination
8 Business Cycle 15%-20% 9-12 marks

Business Economics-Basic Concepts
Chapter 1:
Nature & Scope of Business
Economics
Unit 1: Introduction
1. Definition.
The word ‘Economics’ originates from the Greek work ‘'Oikonomia’ which can be divided
into two parts:
(a) ‘Oiko’, which means ‘House’, and
(b) ‘Nomia’, which means ‘Management’.
Thus, Economics means ‘House Management’.
Till 19th century, Economics was also known as ‘Political Economy’
2. Fundamentals of Economics.
1. Human beings have unlimited wants, and

2. The means to satisfy these wants are relatively scarce.
These two fundamentals forms the subject matter of Economics.
3. Meaning and role of decision making in Economics
Decision making arises only if there is choice available.

In other words, the question of choice arises because our productive resources such as land,
labour, capital, and management are limited and can be employed in alternative uses.
The management of business unit generally needs to make strategic, tactical and operational
business decisions.
Types of business decisions.

 Continue or shut down decision-Should our firm be in this business or shut down?
 New Product-Should the firm launches a product, given the highly competitive market
environment?
 Make or buy- Should the firm make the components or buy them from other firms?
Marketing- Which marketing strategy should be chosen? How much should be the
marketing budget
Decision making on the above as well as similar issues is not simple and
straightforward as the economic environment in which the firm functions is highly
complex and dynamic.
4. Business Economics
 Business Economics may be defined as the use of economic analysis to make business
decisions involving the best use of an organization’s scarce resources. - Joel Dean
 Business Economics, also referred to as Managerial Economics.
 The theories of Economics provide the tools which explain various concepts such as
demand, supply, costs, price, competition etc., Business Economics applies these tools
in the process of business decision making and is also known as Applied Economics.
 Business economics is not only valuable to business decision makers but also useful
for managers of “not-for-profit” organisations.
.
5. Micro and Macro Economics
Difference between Micro and Macro Economics

Micro Economics Macro Economics
The term is derived from Greek work The term is derived from Greek work “Makros’
‘Mikros’ which means ‘Small’ which means ‘large’
“Micro Economics is the study of particular It analyses and establishthe functional
firm, particular household, individual price, relationship between large
wages, income, individual industries, aggregates”- Prof. Mc. Connel
particular commodities”- Prof. Boulding
It is the study of economic behavior of It is the study of overall economic
individual firm or industry in national phenomena as a whole rather than its parts.
economy. It is applied to external or environmental
It is applied to internal or operational issues.
issues.
It is also called as ‘Price Theory’ as it It is also called as ‘Income Theory’ as it
explains the composition of total production. explains level of total production, total
consumption, total savings and total
investment and the rice or fall in these levels
Micro economics deals with issues like- Macro - economics deals with issues like-
(i) Product pricing; (i) National Income and National Output
(ii) Factor pricing, (ii) The level of employment and rate of
(iii) Location of industry. economic growth.
(iv) Consumer behavior, (iii) The general price level and interest rates;
(v) Behavior of firms. (iv) Balance of trade and balance of payments,
(vi) The economic conditions of a section of (v) External value of currency.
society, etc.
(vi) The overall level of savings and investment;

(i) Lock out in TELCO (i) Per capita income of India.
(ii) Finding the causes of failure of X & co. (ii) Underemployment in agricultural sector.
6. Nature of Business Economics
The Nature of Business Economics is described as under-
1. Business Economics is a Science-

(a) Science is a systematized body of knowledge which establishes cause and effect
relationships. It follows scientific methods and empirically tests the validity of the
results.
2. Business Economics is an art as it involves practical application of rules and principles

for the attainment of set objectives.
3. Micro Economics based- Since Business Economics is concerned more with the
decision-making problems of individual establishments, it relies heavily on the
techniques of Microeconomics. F
4. Macro Analysis based - Business unit is affected by its external environment such as,
the general price level, income and employment levels in the economy and government
policies with respect to taxation, wages and regulation of monopolies, interest rates,
exchange rates, industries, prices, distribution.
5. Use of Theory of markets and Private Enterprises-Business Economics uses the theory
of markets and private enterprise. It uses the theory of the firm and resource allocation
in the backdrop of a private enterprise economy.
6. Inter-Disciplinary- Business Economics is interdisciplinary in nature as it

incorporates tools from other disciplines such as Mathematics, Operations Research,
Management Theory, accounting, marketing, Finance, Statistics and Econometrics.
7. Pragmatic Approach- While Micro-Economics is abstract and purely theoretical and

analyses economic phenomena under unrealistic assumptions, Business Economics is
pragmatic in its approach as it tackles practical problems which the firms face in the
real world.
8. Normative and positive –
Points Positive Economics Normative Economics

Meaning 1. It states 'what is' or it makes a 1. The term, ‘normative’ is
real description of an economy. derivedfrom the word ‘norm’ or
a ‘standard’ implying ‘what
2. It explains relationship between oughtto be’.
cause & effect and there will be
novalue judgments/suggestions. 2. It passes value
judgments/suggestions
Examples • Planned economies • Reducing inequality should be
allocate resources via major priority for mixed
government departments. economy.
• The average level of growth in the • Changing the level of interest
economy was faster in the 1990s rates is a better way of
than the 1980s. managingthe economy than
• Analysis of the relationship using taxationand government
betweenthe price and quantity expenditure.
demanded. (Law of demand). • Govt. ought to guarantee that
farmer's income will not fall if
harvest is poor.
7. Scope of Business Economics
The scope of Business Economics may be discussed under the two heads given below-
 Microeconomics applied to operational or internal Issues
 Macroeconomics applied to environmental or external issues
1. Microeconomics applied to operational or internal Issues:
Operational issues include all those issues that arise within the organization and fall within the
purview and control of the management. These issues are internal in nature.
Example: Issues related to product decisions, technology and factor combinations, pricing and
sales promotion, financing and management of investments and inventory are a few examples of
operational issues. The following Microeconomic theories deal with most of these issues.
a) Demand Analysis.
b) Demand Forecasting.
c) Cost analysis.
d) Production analysis
e) Inventory Management
f) Market Structure and Pricing Policies
g) Resource Allocation
h) Profit analysis.
i) Risk and Uncertainty Analysis
j) Theory of Capital and Investment.
2. Macroeconomics applied to environmental or external Issues

The major macro-economic factors relate to:
1) The type of economic system.

2) Stage of business cycle.
3) The general trends in national income, employment, prices, saving and investment.
4) Government’s economic policies like industrial policy, competition policy, monetary and
fiscal policy, price policy, foreign trade policy and globalization policies.
5) Working of financial sector and capital market.
6) Socio-economic organizations like trade unions, producer and consumer unions and
cooperatives.
7) Social and political environment.
Unit 2: BASIC PROBLEMS OF AN ECONOMY AND ROLE OF

PRICE MECHANISM
1. Central Economic Problems.
a) All countries, without exceptions, face the problem of scarcity because their resources are
limited and these resources have alternative uses.
b) The central economic problem is further divided into four basic economic problems.
i. What to produce?
ii. How to produce?
iii. For whom to produce?
iv. What provisions (if any) are to be made for economic growth?
2. The 4 Central Economic Problems.
a) What to produce?
1) Every Society has also to decide in what quantities each of these goods would be
produced.
b) How to Produce?
c) The society has to decide the method of production, i.e. whether to use labour-
intensive techniques or capital - intensive techniques. For whom to produce?
1) Society has to decide on how the goods (and services) should be distributed among the
members of the society.
d) What provisions (if any) are to be made for economic growth?
i. Therefore, a society has to decide how much saving and investment (i.e. how much
sacrifice of current consumption) should be made for future progress.)
3. The Capitalist Economy.
Capitalist economy, also known as free market economy

or laissez-faire economy is an economic system in which
all means of production are owned and controlled by
private individuals for profit.
3.1 Solution to central Economic problems under Capitalist Economy
Capitalist economy uses the impersonal forces of market demand and supply or the
price mechanism to solve its central problems.
Problem Solution
What To a) In a capitalist economy the question regarding what to produce is
produce? ultimately decided by consumers who show their preferences by
spending on the goods which they want.
How to a) An entrepreneur will produce goods and services choosing that

produce? technique of production which renders his cost of production
minimum.
b) If labour is relatively cheap, he will use labour- intensive method and if
labour is relatively costlier he will use capital-intensive method.
For Whom to a) Goods and services in a capitalist economy will be produced for those
produce? who have buying capacity.
What a) Consumption and savings are done by consumers and investments are
provisions done by entrepreneurs.
are to be
made for c) Whereas, Investment decisions depend upon the rate of return on
economic capital. The greater the profit expectation (i.e. the return on capital), the
growth? greater will be the investment in a capitalist economy.
3.2 Characteristics Capitalist Economy.
a) Right to private property.

b) Freedom of enterprise.
c) Freedom of economic choice.
d) Profit Motive.
e) Consumer Sovereignty.
f) Competition.
g) Absence of Government Interference.
3.3 Merits Capitalist Economy.
a) Self-regulating and works automatically through price mechanism.

b) Greater efficiency and incentive to work, due existence of private property and profit
motive.
c) Faster economic growth, since the investors try to invest in only those projects which
are economically feasible.
d) Optimum allocation of the available productive resources of the economy.
e) High degree of operative efficiency.
f) Lower cost of production, as every producer tries to maximize his profit by employing
methods of production which are cost-effective.
g) Better standard of living of consumers as competition forces producers to bring in a
large variety of good quality products at reasonable prices ensuring maximum
satisfaction to consumer.
h) Incentive for innovation and Technological progress.
3.4 Demerits Capitalist Economy.
a) Precedence of property rights over human rights.

b) There is vast economic inequality and social injustice, Inequalities reduces the
aggregate economic welfare of the society.
c) Economic inequalities lead to wide differences in economic opportunities and perpetuate
unfairness in the society.
d) Exploitation of labour is common under capitalism. Very often this leads to strikes and
lock outs. Moreover, there is no security of employment.
e) Consumer sovereignty is a myth as consumers often become victims of exploitation.
f) There is misallocation of resources as resources will move into the production of
luxury goods. Less wage goods will be produced on account of their lower profitability.
g) Less of merit goods like education and health care will be produced.
h) Capitalism leads to the formation of monopolies .
Socialist Economy
The concept of socialist economy was propounded by Karl Marx and Frederic Engels in
their work ‘The Communist Manifesto’ published in
1848.
Following are the characteristics of Socialist Economy
a) Collective Ownership of means of production-

1) Major factors of productions are collectively owned by
the community, represented by the state.
b) Centrally planned economy-

1) There is a Central Planning Authority to set and accomplish socioeconomic goals.
c) Absence of Consumer Choice-

1) Freedom from hunger is guaranteed, but consumers’ sovereignty gets restricted by
selective production of goods.
2) The right to work is guaranteed, but the choice of occupation gets restricted.
d) Relatively Equal Income Distribution-

1) A relative equality of income is an important feature of Socialism.
e) Minimum role of Price Mechanism or Market forces-

1) The prices prevailing under socialism are ‘administered prices’ which are set by the
central planning authority on the basis of socio-economic objectives.
f) Absence of Competition-Since the state is the sole entrepreneur; there is absence of

competition under socialism.
1.1 Merits of Socialist Economy
a) Equitable distribution of wealth and income and provision of equal opportunities for
all help to maintain economic and social justice.
b) Rapid and balanced economic development since the central planning authority
coordinates all resources in an efficient manner according to set priorities.
c) Planned Economy.
d) Minimum Wastage and optimum utilisation of resource- Wastes of all kinds are
avoided through strict economic planning. Since competition is absent, there is no
wastage of resources on advertisement and sales promotion.
e) Unemployment is minimized, business fluctuations are eliminated and stability is
brought about and maintained.
f) The absence of profit motive helps the community to develop aco-operative
mentality and avoids class war. This, along with equality, ensures welfare of the
society.
g) Socialism ensures right to work and minimum standard of living to all people.
h) Labourers and consumers are protected from exploitation by the employers and
monopolies respectively.
i) There is provision of comprehensive social security under socialism and this makes
citizens feel secure.
1.2 Demerits of Socialist Economy
a) Inefficiency and delays, corruption, red-tapism, favoritism, etc. may exist due to
predominance of bureaucracy.
b) All material means of production and nearly all economic activity are under the control
and direction of state. This restricts freedom of individual.
c) Socialism takes away the basic rights such as the right of private property.
d) Consumers have no freedom of choice. Therefore, what the state produces has to be
accepted by the consumers.
e) No importance is given to personal efficiency and productivity. This acts as a
disincentive to work.
f) The extreme form of socialism is not at all practicable as it restricts personal
freedom.
4 Mixed Economy
a) The mixed economic system depends on both
markets and governments for allocation of
resources.
b) In mixed economy there are three sectors of industries-
1) Private Sector.
2) Public Sector.
3) Joint Sector.
4.1 Merits Mixed Economy
a) Economic freedom and existence of private property which ensures incentive to

work and capital formation.
b) Price mechanism and competition forces operating in the private sector promoting
efficient decisions and better resource allocation.
c) Consumers are benefitted through consumers’ sovereignty and freedom of choice.
d) Appropriate incentives for innovation and technological progress.
e) Encourages enterprise and risk taking.
f) Advantages of economic planning and rapid economic development on the basis of
plan priorities.
g) Comparatively greater economic and social equality and freedom from exploitation
due to greater state participation and direction of economic activities.
h) Disadvantages of cut-throat competition averted through government’s legislative
measures such as environment and labour regulations.
4.2 Demerits Mixed Economy
a) Excessive controls by the state results in reduced incentives and constrained growth of
the private sector.
b) Poor implementation of planning, higher rates of taxation, lack of efficiency,
corruption, wastage of resources.
c) Undue delays in economic decisions and poor performance of the public sector.
Chapter 2:
Utility Analysis and Consumer
Behaviour
1. Utility.
1. Utility is Power of a commodity to satisfy human wants. In Other words, want

satisfying power of a commodity is called as utility.
2. Utility is subjective term and differs from person to person
3. Utility does not mean usefulness. Therefore even the items like cigarettes, liquor, etc
may be said to have utility from economic point of view
4. In Economics the concept of utility is ethically neutral.
5. Utility theories seek to explain how a consumer spends his income on different goods
and services so as to attain maximum satisfaction.
2. Difference between Cardinal and Ordinal Approach to utility
Cardinal Approach Ordinal Approach

Assumptions Utility is measurable and Utility cannot be expressed in
quantifiable aspect and can be terms of money, i.e. Utility is not
expressed in numbers quantifiable
Rationale Human satisfaction can be expressed Human Satisfaction is
in monetary terms, psychological phenomenon and
cannot be measured quantitatively
Economists Alfred Marshall Hicks and Allen

Approach • Law of diminishing marginal Indifference curve approach
and utility.
Theories • Law of Equi-Marginal utility
3. Cardinal Approach
3.1 Difference between Total utility and Marginal utility
Total Utility- The sum total of utility derived from different units of commodity consumed
by a consumer is called as total utility.
Marginal Utility-It is the additional utility derived from additional unit of a commodity.
Marginal Utility can also be defined as change in the total utility resulting from one- unit
change (tun-tu(n-1)) in consumption of commodity, per unit of time.
3.2 Assumptions under Marginal utility analysis and cardinal approach
1. Cardinal Measurability of Utility-

Cardinal Measurability of Utility means that the utility is measurable and quantifiable.
Utility is measured in utils.
2. Independence of Utilities-
Utilities derived from different commodities are independent of one another and does
not affects one another. And the total utilities derived by the person is the sum total of
individual utilities.
3. Constant Marginal Utility of Money-
a) Money is measuring rod of utility.
b) It is assumed that marginal utility of money is constant
4. There is continuity in consumption.
5. Different units are assumed to be homogenous or identical in nature.
3.3 Law of diminishing Marginal utility
Law:
a) The Law of Diminishing Marginal Utility states that all else equal as consumption
increases the marginal utility derived from each additional unit declines.
Example:
Mr. Raj likes to eat Oranges. The first Orange he eats gives him lots of satisfaction.
The second Orange he eats gives him lesser satisfaction than the earlier one and so
on. If he eats 9 Oranges in a row continuously, he may lose interest in oranges. In
other words utility goes on reducing and reaches zero and further negative.
Quantity of Oranges consumed per day Total utility Marginal Utility

0 0 0
1 60 60
2 110 50
3 150 40
4 180 30
5 200 20
6 210 10
7 210 0
8 200 -10
9 180 -20
Conclusion:
1. Total Utility increases at diminishing rate.
2. Marginal Utility is Downward Sloping curve, moving from left to right
3. Marginal utility is negatively sloped curve.
4. Where Marginal Utility is negative, Total utility decreases.
5. Marginal utility goes on decreasing and becomes negative beyond a certain point of
time.
3.4 Assumptions and Exception to Law of Marginal utility
Following are the assumption to law of Diminishing Marginal utility and law will hold good
only if these Assumptions are met:
1. Standard Units- The law will hold good when units are of suitable size.
2. Homogeneous units- Different units consumed should be identical in all respect
3. Constant Taste/ fashion- The Fashion, habit or taste of the consumer must remain
constant. If the liking of the person increases on additional consumption the law will not
hold good.
4. Continuous consumption- There should be no time gap between consumption of one
unit and another unit. Therefore Consumption of one Orange per day for 9 days will not
have diminishing marginal utility, but 9 Oranges in one day will be covered by this law.
5. Cardinal approach- Law applies only if cardinal approach to measurement of utility is
assumed.
Exceptions to Law-
1. Personal Aspects- law of Diminishing Marginal utility does not apply to music, hobbies,
etc where personal preference is dominant.
2. Money is excluded- law of Diminishing Marginal utility does not apply money and items
like gold, etc. where a greater quantity may increase the lust for it.
3. Other possessions- Utility may be affected by presence or absence of articles which are
substitute or complimentary. Example- utility of coffee may be affected by availability
sugar.
3.4 Significance of Law
The law of diminishing marginal utility has following significance-

1. Law of diminishing marginal utility forms the basis of Law of demand.
2. Price and MU moves together up and down. If price changes, its MU also changes
accordingly.
3. Marginal utility varies inversely with the supply. If the supply is greater, its MU will be
less.
4. MU of the goods increases as the quantity of complementary goods with the consumer
increases- Example, Tea and sugar are complementary goods. If more tea is acquired
MU of sugar also increases.
5. MU of the goods decreases as the quantity of substitute goods with the consumer
increases. Example, tea and coffee are substitute goods. If Consumer purchases more
coffee, MU of tea decreases.
3.5 Law of Equi- marginal utility

As per the law of Equi- marginal utility, If marginal utility of money spent on
commodity X is greater than marginal utility of money spent on commodity Y, then the
consumer will withdraw some money from purchase of Product Y and will spent on
purchase of X, till MU of money in two cases becomes equal.
And
The consumer will attain maximum satisfaction, and will be in equilibrium when
MU of money spent on various goods that he buys, are equal.
3.6 Consumer surplus and Consumer Equilibrium

Consumer’s Equilibrium:
a) As per the law of diminishing marginal utility, the additional consumption of item leads
to decreasing MU.
b) The consumer will be willing to buy a commodity, as long as the MU( additional
satisfaction) derived is equal to price of the commodity. In other words, consumer will
not buy a commodity if the price he pays is more that the additional satisfaction he
derives.
c) Thus the consumer is in equilibrium when price of the commodity = Marginal utility.
d) Similarly for more than two products, consumer will be in equilibrium if-
MU X = MU Y = MU Z
Price X Price Y Price Z
e) The consumer will attain maximum satisfaction, and will be in equilibrium when MU of
money spent on various goods that he buys, are equal.
Consumer Surplus:
1. Consumer surplus means, what a consumer is ready to pay – what he actually
pays.
2. The consumer continues to buy a commodity till MU = Price of the commodity
3. For all the earlier units purchased, MU > price paid. This difference is called as
consumer’s surplus
Example: consider the schedule in 3.1.1
Quantity of Oranges Total Marginal Price Consumer’s
consumed per day utility Utility Surplus in rupees
0 0 0 0 0
1 60 60 40 20
2 110 50 40 10
3 150 40 40 0
4 180 30 40 -10
5 200 20 40 -20
6 210 10 40 -30
7 210 0 40 -40
8 200 -10 40 -50
9 180 -20 40 -60
Conclusions:
a) Consumer is in equilibrium at 3 units, where price = MU.
b) Consumer surplus is INR 20 and INR 10 at consumption level of 1 Orange and 2
oranges respectively.
3.6 Limitations to Consumer surplus
1. The concept of Consumer’s surplus is relevant only if cardinal approach to

measurement of utility is assumed.
2. Consumer’s surplus cannot be measured precisely, since it is difficult to measure the
MU of different units of commodity consumed by a person.
3. Consumer’s surplus derived is affected by availability of substitutes.
4. In case of necessaries, consumer’s surplus is infinite since the MU of first few units
are infinitely large.
5. Concept of consumer’s surplus does not apply in case of prestigious items such as
Diamond, gold.
6. It is assumed that MU of the money is constant, which is unrealistic. As more purchases
are made and consumer’s stock of money diminishes, MU of money also changes
4. Ordinal Approach.
The Ordinal approach to utility analysis was given by Hicks and Allen and hence it is also
called as Hicks and Allen Approach.
4.1 Indifference curve analysis- Assumptions
1. Ordinal Approach to utility-

a) This means that UTILITY is not measurable in monetary terms.
b) A person can express satisfaction derived from consumption of commodity, in
relative or comparative term.
2. Consistency in ranking-
a) As per ordinal approach it is assumed that the consumer has consistent
consumption pattern.
b) If a consumer prefers X to Y and Y to Z , this automatically means that he must
prefer X to Z.
3. Rational Consumer- It is assumed that the consumer is rational and possesses full
information about all the relevant aspects of economic environment in which he lives.
4. Ranking and preferences-
a) The consumer is capable of ranking all combination of goods according to
satisfaction they yield.
b) If a consumer prefers A to B then he cannot tell quantitatively how much he prefers
A over B.
5. Number of Goods-
a) If combination A has more quantity than combination B, then A must be preferred
over B. This is because the customer prefers more to less, and tries to maximize
his satisfaction.
4.2 Indifference curve analysis
1. An Indifference curve is a curve which represents all those combination of goods which
gives same satisfaction to the consumer.
General assumption in consumer behavior under Indifference curve analysis is that more
goods are preferred to less of them.
Example
Combination Roses Lilies Marginal Rate of
substitution ( MRS)
A 15 1 -
B 11 2 5 Roses per lily
C 8 3 4 Roses per lily
D 6 4 3 Roses per lily
E 5 5 2 Roses per lily
4.3 Indifference Map
1. A set of indifference curves is called as Indifference Map.

2. An indifference map depicts complete picture of customer’s taste and preferences.
3. The consumer is indifferent for any combination lying on same IC.
4. However he prefers combination on Higher IC to combinations on lower IC, as the

combinations of higher IC give more satisfaction. So IC4 > IC3>IC2>IC1.
5. Farther the IC from the origin, higher is the satisfaction level.
Indifference Map
4.4 Marginal rate of Substitutions

1. Marginal rate of substitutions (MRS) indicates how much of one commodity is
substituted for how much of another commodity.
2. MRS is indicated by Slope of IC curve at a particular point. Thus, MRS indicates
movement along an IC.
3. MRS show decreasing trend similar to concept of diminishing marginal utility.
4.5 Property of indifference curve
Properties of indifference curve are-
1. Downward sloping to right-
2. Convex to the origin-
3. All point on an IC gives same satisfaction-
4. Higher level of satisfaction-
In an indifference map, every higher IC gives higher satisfaction to the consumer.
5. Non Intersecting
No two IC will cut/ intersect/touch each other
Utility Analysis and Consumer Behaviour
Budget line
1. A Budget line shows all those combinations of

two goods which a consumer can buy
spending his given money income on two
goods at their given prices.
2. Budget line is also called as Price line, Price
opportunity line, Price- income line,
Budget constraint line.
3. Every point on Budget line represents full
spending by the consumer.
4. A Point below budget line represents under
spending by the consumer (Point U), while any
point above the budget line will be beyond the
reach of consumer (Point O)
Consumer Equilibrium under indifference curve approach

1. However his objective of buying higher quantity of goods is restricted by Budget line
Relationship of MRS and price at equilibrium,

1. At equilibrium, slope of price line is equal to slope of Indifference curve.
2. Slope of the line is PX/PY.
3. Slope of indifference curve indicates Marginal rate of substitution of X for Y.
MRSXY=MUX/MUY.
4. Hence at equilibrium MRSXY=MUX/MUY= PX/PY, alternatively, MUX/ PX = MUY/PY.
Page 2.10
Chapter 3- Demand Analysis
Chapter 3:
Demand Analysis
Part A. - Basics
1. Meaning
Effective demand of any goods or services depends on the following factors
(a) Desire for a specific commodity,
(b) Resources/Means to purchase the desired commodity. Unless desire is backed by
purchasing power or ability to pay, and willingness to pay, it does not constitute demand,
(c) willingness to use those means for that purchase,
Two things are to be noted about the quantity demanded.

(a) The quantity demanded is always expressed at a given price.
(b) The quantity demanded is a flow. And not a single isolated purchase. Hence we express
demand as ‘so much quantity per period of time’.
1. Price of the commodity:

(a) Other things being equal, the demand for a commodity is
inversely related to its price.
(b) This means that a rise in the price of a commodity brings
about a fall in the quantity purchased and vice-versa.
2. Price of related commodities-Related commodities are of two types: (a) complementary goods
and (ii) competing goods or substitutes.
(a) Complementary goods- Complementary goods are those goods

which are consumed together or simultaneously. When two
commodities are complements, a fall in the price of one (other
things being equal) will cause the demand for the other to rise.
For example; tea and sugar, automobile and petrol, andpen and
ink. (Indirect relation)
(b) Substitute goods- Two commodities which can be used with

ease in place of one another. When goods are substitutes, a fall
in the price of one (ceteris paribus) leads to a fall in the quantity
demanded of its substitutes. Demand of a commodity is directly
related with price of substitute goods. For example, tea and
coffee, ink pen and ball pen, are substitutes for each other and
can be used in place of one another easily. (Direct relation)
3. Income of the consumer
(a) In most cases, the larger the average money income

of the consumer, the larger is the quantity demanded
of a particular good.
(b) However, there are some commodities for which the quantity demanded decreases with an
increase in money income beyond this level. These goods are called inferior goods.
4. Tastes and preferences of consumers-

(a) The demand for a commodity also depends upon the tastes and preferences of consumers and
changes in them over a period of time.
Tastes and preferences of consumers are also influence by
‘Demonstration effect’ or ‘bandwagon effect’, i.e. by seeing
another person use a particular product/ commodity.
(b) Also sometimes, when a product becomes common among all,
some people decrease or altogether stop its consumption. This is
called ‘snob effect’. Highly priced goods are consumed by status
seeking rich people to satisfy their need for conspicuous
consumption. This is called ‘Veblen effect’
5. Population aspect-
(a) Size of the population
(b) Composition of population: If there are more old people in a
region, the demand for spectacles, walking sticks, etc. will be
high.
(c) The level of National Income and its Distribution:
i. If the national income is unevenly distributed [few very rich
people while the majority are very poor], the propensity to
consume of the country will be relatively
less and consequently, the demand for consumer goods will be less.
ii. However, if the distribution of income is more equal, then the propensity to consume of
the country as a whole will be relatively high indicating higher demand for goods.
(d) Consumer-credit facility and interest rates: Availability of credit facilities induces people
to purchase more than what their current incomes permit them.
6. Apart from above, factors such as government policy in respect of taxes and subsidies, business
conditions, wealth, socioeconomic class, group, level of education, marital status, weather
conditions, salesmanship and advertisements, habits, customs and conventions also play an
important role in influencing demand.
Part B- Theory of Demand

1. Law of Demand
Law of Demand:
(a) Other things being equal, if the price of a commodity falls, the quantity demanded of it will
rise and if the price of a commodity rises, its quantity demanded will decline.
(b) There is an inverse relationship between price and quantity demanded, other things being
equal.
Other Factors remaining constant-
The other things which are assumed to be equal or constant are:-
(a) Prices of related commodities (complementary goods or substitute goods)
(b) Income of consumers
(c) Tastes and preferences of consumers, and
(d) Such other factors which influence demand.
If these factors which determine demand also undergo a change, then the inverse price-demand
relationship may not hold good. Thus, the constancy of these other factors is an important assumption
of the law of demand.
Illustration:
Price Quantity demanded
5 10
4 15
3 20
2 35
1 60
2. Features of the Demand Curve
1. Demand curve slopes downwards from left to right

2. Demand curve is negatively sloped
3. Demand curve is also called Average Revenue curve (ARC).
3. Rationale of the Law of Demand
Other things being equal, if the price of a commodity falls, its Demand quantity will rise, and Vice-
versa. This is due to the following reasons
1. Law of diminishing marginal utility
(a) Consumer will buy more quantity at lower price because they want to equalise the marginal
utility of the commodity and price.
(b) The Diminishing Marginal utility and equalising price is the cause of downward sloping of
demand curve
2. Substitution effect:
(a) When the price of a commodity falls, it becomes relatively cheaper than other commodities.
(b) So, consumers now substitute the commodity whose price has fallen for other commodities
which have now become relatively expensive.
(c) Therefore total demand for the commodity whose price has fallen increases
3. Income effect:
(a) When the price of a commodity falls, the consumer can buy the same quantity of the
commodity with lesser money.
(b) In other words, as a result of fall in the price of the commodity, consumer’s real income or
purchasing power increases.
(c) This increase in the real income induces him to buy more of that commodity. Thus, the
demand for that commodity (whose price has fallen) increases. This is called income effect.
4. Arrival of new consumer:

(a) When the price of a commodity falls, more consumers start buying it because some of those
who could not afford to buy it earlier may now be able to buy it.
5. Different uses:
(a) Certain commodities have multiple uses. If their prices fall, they will be used for varied
purposes and therefore their demand for such commodities will increase
(b) On the other hand, when the price of such commodities are high (or rises) they will be put to
limited uses only.
4. Exceptions to the Law of Demand
1. Conspicuous goods:
(a) Articles of prestige value or snob appeal or articles of
conspicuous consumption are demanded only by the rich
people and these articles become more attractive if their
prices go up.
(b) This was found out by Veblen in his doctrine of “Conspicuous
Consumption” and hence this effect is called Veblen effect or
prestige goods effect.
(c) Example- Higher the price of diamonds, higher is the prestige value attached to them and
hence higher is the demand for them.
2. Giffen goods:
(a) Those goods which are inferior, with no close substitutes easily
available and which occupy a substantial place in consumer’s
budget are called ‘Giffen goods’
(b) Such goods exhibit direct price-demand relationship.
(c) Sir Giffen found out that as the price of bread increased, it caused
a large decline in the purchasing power of the poor people that they
were forced to cut down the consumption of meat and other
more expensive foods. Since bread, even when its price was higher than before, was still the
cheapest food article, people consumed more of it and not less when its price went up.
(d) Examples of Giffen goods are- Bajra, low quality rice and wheat etc
3. Conspicuous necessities:
(a) The demand for certain goods is affected by the
demonstration effect of the consumption pattern of a social
group to which an individual belongs.
(b) Due to their constant usage these goods have become
necessities of life.
(c) For example, TVs, refrigerators, coolers, cooking gas etc.
4. Future expectations about prices:

(a) When the prices show increasing trend, consumers tend to buy larger quantities of such
commodities, expecting that the prices in the future will be still higher
(b) For example, when there is wide-spread drought, people expect that prices of food grains
would rise in future. They demand greater quantities of food grains even at the higher price.
5. Irrational consumer- It is assumed that consumers are rational and knowledgeable about
market-conditions. However, at times, consumers tend to be irrational and make impulsive
purchases without any rational calculations about the price and usefulness of the product.
6. Demand for necessaries

(a) Irrespective of price changes, people have to consume the minimum quantities of necessary
commodities. Example- cooking gas, Petrol.
7. Ignorant consumer: A household may demand larger quantity of a commodity even at a higher price
because it may be ignorant of the ruling price of the commodity.
8. Speculative goods: In the speculative market, more will be demanded when the prices are rising
and less will be demanded when prices decline. Example stocks and shares showing increasing
trend.
5. Expansion and contraction in Demand
Meaning- Expansion and contraction in demand

takes place as a result of change in price, while the
other factors influencing demand remains constant.
Example-
(a) Expansion- When the price falls from P to P’ the quantity demanded increases from M to N, on
the same demand curve. Thus this downward movement along the same Demand curve is called
as Expansion of demand.
(b) Contraction- When the price rises from P to P’’ the quantity demanded decreases from M to L,
on the same demand curve. Thus this Upward movement along the same Demand curve is called
as Contraction of demand.
Note- Expansion of Demand is also called as Extension of Demand

Term Meaning Effect
Expansion/ Extension of Quantity demanded Increases, Downward movement along same
Demand due to decrease in price Demand curve
Contraction of Demand Quantity demanded decreases, Upward movement along same
due to increase in price Demand curve
6. Increase in Demand
Meaning- Increase or decrease in demand as a result of changes in factors other than price, while
price remains constant.
Shift of Demand Curve- Increase or decrease in demand

indicate rightward/leftward shift of the Demand curve
respectively.
Example
Current level of demand is depicted by demand curve D0
Increase in Demand-When the curve shifts rightward from
D0 to D3, it is called as increase in demand. Increase in
Demand happens when more quantities are demanded at
each price.
Decrease in Demand- When the curve shifts leftward from
D0 to D2, it is called as decrease in demand. Decrease in
Demand happens when lesser quantities are demanded at each price.
Reasons for Increase in Demand

• Rise in income,
• Rise in the price of a substitute,
• Fall in the price of a complement,
• Change in tastes in favour of this commodity,
• An increase in population, and
• Redistribution of income to groups who favour this commodity
Reasons for Decrease in Demand
• Fall in income
• Fall in the price of a substitute,
• Rise in the price of a complement,
• Change in tastes against this commodity,
• Decrease in population, and
• Redistribution of income away from groups who favour this commodity.
7. ‘‘Movement along’’ vs ‘‘shift of’’ Demand
Movement along Demand curve Shift of Demand curve

1 Demand curve remains the same There is shift in Demand curve itself
2 This happens due to price change while This happens due to changes in factors other
the other factors remains constant than price, price remaining constant
3 It may be Expansion or contraction It may be Increase or Decrease in Demand
4 Expansion=Downward movement Increase= Rightward shift
Contraction= Upward movement Decrease= Leftward shift
Part C-Elasticity of Demand

1. Elasticity of Demand
Meaning:
(a) the percentage change in quantity demanded divided by the percentage change in one of the
variables on which demand depends
Factors affecting demand and name of their elasticity

Factors Name of Elasticity Denoted by
Price of the commodity Price Elasticity EP
Income of the consumer Income Elasticity EI
Price of the related product Cross Elasticity EC
Availability of the substitute Substitution Elasticity ES
2. Price Elasticity of Demand
1. Meaning:
(a) Price elasticity of demand is measured as the percentage change in quantity demanded
divided by thepercentage change in price, other things remaining equal.
2. Formula:
Price Elasticity of Demand = (EP) = % change in quantity demanded
% change in Price
= (Change in quantity/Original quantity) x 100

(Change in price/ Original Price) x 100
= (Δ q/ q) x (p/ Δ p)
= (Δ q / Δ p) x ( p/ q)
Here q= quantity, p= price, Δq = change in quantity, Δp=change in price
3. Negative sign -since price and quantity are inversely related (with a few exceptions), price
elasticity is negative. But, for the sake of convenience, we ignore the negative sign and consider
only the numerical value of the elasticity.
4. Example
Quantity Price % change in quantity demanded= (3500-5000) ÷ 500= 30%
5000 100 % change in price =(150-100) ÷ 50%
3500 150 Therefore EP= 30% ÷ 50%= 0.6
3. Measuring Price elasticity of demand
1. Percentage change or proportional Method [ Refer point 2 above]

2. Point Elasticity- Method of derivative [Refer point 4 below]
3. Point Elasticity –Method of Graph [ Refer point 5 below]
4. Arc Elasticity Method [Refer point 6 below]
5. Total Outlay Method [ Refer point 7 below]
4. Point Elasticity – method of Derivative
Meaning
a) In point elasticity, we measure elasticity at a given point
on a demand curve.
b) The concept of point elasticity is used for measuringprice
elasticity where the change in price is infinitesimal
(very small)
c) Point elasticity makes use of derivative rather than
finite changes in price and quantity.
Formula
Ep = -dq p ÷ dp q
Where dq /dp is the derivative of quantity with respect to price at a point on the demand curve, and
p and q are the price and quantity at that point.
5. Point Elasticity – Graphical method
a) This method is applicable only for Straight- line Demand curve touching both the axes.
b) Under Graphical method Elasticity is calculate using
the following formula-
EP= Lower Segment
Upper segment
6. Arc Elasticity of Demand or Mid Point Elasticity
1. Arc Elasticity is a measure of average responsiveness to Price

change exhibited by a Demand curve over some defined arc of
Demand curve
2. Since point elasticity differs at various points on Demand curve,
Arc elasticity takes average of two prices and quantities to
measure Elasticity
3. EP= q1-q2 x p1+p2
q1+q2 p1-p2
7. Total Outlay Method
Meaning:
In Total Outlay method, Elasticity is calculated by analysing the change in Total expenditure or
Outlay of the household.
Explanation:
1. However by this method we can only say whether the demand for a good is elastic or inelastic;
we cannot find out the exact coefficient of price elasticity.
Elasticity Situation Effect Example
EP < 1 • Price and Expenditure moves in same direction. Demand is Situation E, F, G
• As the price of a commodity decreases, total said to be
expenditure on that commodity decreases. less
• As the price of a commodity increases, total elastic, or
expenditure on that commodity increases. inelastic
EP = 1 • Total Expenditure remains Unchanged. Demand is Situation C, D, E

• Due to change in price, Total expenditure on that said to be
commodity remains unchanged. unit
elastic
EP > 1 • Price and Expenditure moves in opposite Demand is Situation A, B, C

direction. said to be
• As the price of a commodity decreases, total elastic
expenditure on that commodity increases.
• As the price of a commodity increases, total
expenditure on that commodity decreases.
The Relationship between Price elasticity and Total Revenue (TR)

Demand
Elastic Unitary Elastic Inelastic
Price Increase TR Decreases TR remains same TR Increases
Price decrease TR Increases TR remains same TR Decreases
Moves in opposite direction Remains same Moves in same direction
Situation Quantity Demanded (In units) Price Total Outlay

A 1000 50 50000
B 1500 40 60000
C 2000 37.5 75000
D 2500 30 75000
E 3000 25 75000
F 3500 20 70000
G 4000 15 60000
8. Interpretation of the numerical values of elasticity of demand
1. Perfectly inelastic
Numeric Value EP =0
Description Quantity demanded does
not changes as price
changes
Nature of the curve Vertical line Parallel to Y
Axis
2. Inelastic or less elastic

Numeric Value Greater than zero but less
than one 0<EP <1
Description Quantity demanded
changes by smaller
percentage than price
Nature of the curve Relatively steeper Demand
curve
3. Unit Elastic
Numeric EP =1
Value
changes exactly by
same percentage as
price
Nature of the 45 degree straight
curve line
Or rectangular
hyperbola
4. Elastic
Numeric Value 1<EP <∞
changes by larger
percentage than price
Nature of the curve Relatively flatter demand
curve
Numeric Value EP =∞
Description Purchasers are
prepared to buy all they
can obtained at some
price and none at all at
an even slightly higher
price
Nature of the curve Parallel to X axis
-
8. Determinants of price Elasticity
1. Availability of substitutes:
➢ Goods which typically have close or perfect substitutes have

highly elastic demand curves.
➢ Goods which do not have close substitute or few substitutes
have less elastic demand curve.
2. Position of a commodity in a consumer’s budget:

➢ Goods having higher proportion of consumers’
spending are more elastic to demand. Eg. Clothing,
provisions and groceries, milk etc.
➢ Goods having lower proportion of consumers’ spending
are less elastic to demand. Eg. Matches, button, salt.
3. Number of uses to which a commodity can be put:

➢ Commodity having possible multiple uses, have more elasticity
to demand. Eg. Milk has several uses. If its price falls, it can be
used for a variety of purposes like preparation of curd, cream,
ghee and sweets.
4. Time period:
➢ The long run demand for a commodity is more elastic. This is because consumer has a longer
run to adjust his consumption pattern accordingly. E.g. the prices of petrol increases, the
consumer can do little in short run, whereas in long run, he can buy more fuel efficient car.
➢ The short run demand for a commodity is less elastic to change in price.
5. Consumer habits:
➢ If the consumer is not habitual to a commodity, demand for that particular commodity is more
elastic and vice-versa.
6. Tied demand:
➢ Goods which have autonomous demand on their own are more elastic
➢ Goods which have tied or joint demand are less elastic. Eg. Modular kitchen and oven.
7. Nature of the need that a commodity satisfies:

➢ In general, luxury goods are price elastic while necessities are price inelastic or less elastic to price
change.
8. Price range:
➢ Goods which are in medium range of price level are more elastic to price change.
➢ Goods which are in very high price range or in very low price range have inelastic demand.
-
Meaning: Income elasticity of demand is the degree of responsiveness of quantity demanded

of a good to changes in the income of consumers, while the other factors are constant. It is denoted
by Ei.
Formula:
Ei =Percentage change in quantity Demand change in quantity X 100
= Original quantity
Percentage change in income Change in income X 100
Original income
=∆q × i
q ∆i
Ei = Income elasticity of demand; ∆ q Change in demand; q = Original demand; i = Original
money income; ∆ i = Change in money income.
Note-Income effect is positive, so Income Elasticity of demand is also positive. However there
may be negative Income Elasticity in case of inferior goods.
Income Elasticity of Demand

It refers to amount of change in demand for a commodity due to change in income. It is
the degree of responsiveness of demand to a change in income
YED/ Ey = Percentage or proportionate change in Income = % Q = Q Y

Percentage or proportionate change in demand % Y Y Q
Type of Relation Example Formula Curve

Income between
Elastic income &
demand
Positive Positive Normal Ey = 1
Income and Luxury Ey > 1
Elasticity goods Ey < 1
Negative Inverse Inferior Ey < 0

Income goods
Elasticity
-
Zero Constant Necessaries E=0
Income (No goods
Elasticity change in
demand
though
there is
change in
income)
Cross Elasticity of Demand
• Th
• It is defined as a ratio between percentage or proportionate change in demand for one

commodity and % or proportionate change in price of other commodity i.e.
Ec = % Qx or Ec = Qx Py
% Py Py Qx
Where x & y = Substitute/complimentary goods
Type of Relation between Example Formula Curve

Cross price of one
Elasticity product & demand
for other product
Positive Direct or Positive Tea & CED = 1
Cross relation Coffee, CED > 1
Elasticity (Goods must be CED < 1
substitute)
Negative Inverse relation Car & CED < 0

Cross (Goods must be Petrol
Elasticity complementary goods)
Zero Cross Constant Cloth & CED = 0

Elasticity (No change in demand salt
of one product though
there is change in price
of other product)
goods must be unrelated
-
Theory Of Supply
Chapter 4:
Theory of Supply
Part A - Basics
Meaning of supply
1. Supply refers to amount of a commodity seller is able to sell and willing to sell.
2. Ability to sell of a seller depends upon stock of a commodity; willingness to sell depends
upon price of a commodity.
Definition of Supply
The supply is defined as amount of a commodity seller is ready to sell in the market at a
certain price per unit of time.
Determinants of supply on Factors affecting supply:

Factors affecting Relation Explanation
individual supply between supply
& factor
Price Positive When price of a commodity rises supply will also rise.
Stock Positive When seller has larger stock of goods he will supply more
but if he has smaller stock of goods he will supply less.
Time Positive Relation During short time period supply will be less but during
long time period supply will be more.
Cost of Inverse Relation With the increase in cost of production supply of the
Production commodity will decrease and if cost of production
decreases supply of the commodity will increases.
Improved Positive Relation With the improvement in technique of production supply
Techniques of of the commodity will increase.
Production
Infrastructure Positive/Inverse It refers to basic facilities such as transportation,
Relation communication, power supply etc. If infrastructure is
improved in the country supply of various goods will
increase and vice –versa.
Weather Positive/Inverse If there are good weather conditions supply of certain goods
conditions Relation like agricultural products will increase and vice –versa.
Taxation policy Positive/Inverse If government reduces the taxes, business men will be
Relation encouraged to produce more and supply more but if
taxes increase business in the society will discouraged.
Hence, supply will decrease and vice –versa.
Monetary Policy Positive/Inverse If monetary policy is liberal in the country so that loans
Relation are available at low rate of interest supply of various
goods will increases in the country. This is because at a
low rate of interest business-men would borrow and
Theory Of Supply
increase the production and vice –versa.

Trade policy Positive/Inverse It refers to government policy related to exports and
Relation imports if trade policy is liberal business-men can import
the raw materials and increase the supply and vice –
versa.
Natural Positive/Inverse A country with plenty of natural resources will be able to
Resources Relation produce more amounts of different goods. Hence, supply
of goods in the country will be more.
Law of Supply
• The law of supply is explained by Dr. Alfred Marshall.
• Law of supply states that “other things being equal” there is a direct relationship between price
and supply.
Law of supply is explained by following Table & Curve

Explanation of schedule
• When the price is low at Rs. 5. 10 units supplied Price Supply
by seller 1 10
• When price starts increasing, a seller supplies 2 20
more units. 3 30
• It shows direct relationship between price of 4 40
commodity and quantity supplied. 5 50
Explanation of Curve
• In above diagram upward sloping line SS is
market supply curve.
• Upward slope indicates that there is a direct
relationship between price and supply.
Theory Of Supply
Features of Supply curve

1. Supply Curve slopes upwards from left to the right.
2. Supply Curve is positively sloped.

3. The sloping of the Supply Curve explains the Law of
Supply, which describes a direct Price—Demand
relationship.
B.3 Increase and Decrease in the Quantity Supplied
1. Meaning: Increase or Decrease in the quantity supplied takes place as a result of changes in
price, while all other factors influencing Supply remain constant.
1. Meaning: Increase & Decrease in Supply take place as a result of changes in factors
other thanprice, while price remains constant.
A. Increase in Supply: When Supply Curve shifts rightward
from So to S2, it is called Increase in Supply. It means that
more quantities aresupplied at each price.
B. Decrease in Supply: When Supply Curve shifts leftward
from So toS1, it is called Decrease in Supply. It means that
lesser quantities are supplied at each price
Theory Of Supply
Assumptions of supply Law

No change in It is assumed that cost of production does not change. This is because if
cost of cost of production decreases supply will increase even after no change in
production price.
No change in It is assumed that technique of production does not change this is
technology because technique of production is improved supply will increase even
after no change in price.
Normal weather Weather conditions must be normal. This is because if weather conditions
Conditions are bad, supply may not increase even after a rise in price.
No change in It is assumed that infrastructural facilities will remain same. This is
infrastructural because if infrastructure is improved supply will increase even after no
facilities change in price.
No change in Quantity of natural resources available in the country should not change.
amount of This is because if amount of natural resources increase, supply of various
Natural goods will increase even after no change in price.
Resources
No change in There should not be any change in the taxation policy of the government.
Taxation policy This is because if taxes are reduced supply will increase even after no
change inprice.
No change in It is assumed that monetary policy of the government does not change.
monetary and This is because if monetary policy is liberalized supply will increase even
trade policy after a no change in price.
Exceptions to law of Supply

1. Labour • In case of supply of labour, law of supply is not applicable.
supply • This is because when price of labour or wage rate increases labour supply or
number. of hours a worker is ready to work decreases. This is shown in the
following table:
Wage rate Labour Total

supply income
Rs.100/hr 12 hr. 1200/day
Rs.250/hr. 15 hr. 3750/day
Rs.700/hr. 10 hr. 7000/day
• From the table we notice that initially with the increase in wage rate labour supply increases but
when wages increase beyond a certain limit labour supply will decrease.
• This is represented by backward bending labour supply curve.
Theory Of Supply
2. Need for cash
• If a seller is going to supply his product because he needs certain amount of cash, then at lower
price he will supply more and at a higher price he will supply less.
3. Savings
• If a person wants a fixed amount of income in the form of interest then, he will save more at
a lower rate of interest and save less at a higher rate of interest.
4. Future Expectations
• With a small rise in price, if seller expects a further rise in future he will decrease the supply.
• Similarly, with little fall in price if seller expects a further fall in future he will increase the supply.
Price elasticity of supply
• Elasticity of Supply refers to the ratio between percentage or proportionate change in supply and
percentage or proportionate change in price.
No. Types Curve Equations

1. Perfectly Elastic Supply
It is a situation in which supply of a
commodity continuously change
without any change in price. In Es =
Perfectly elastic supply, the supply
curve will behorizontal
2. Relatively Elastic Supply

It refers to a situation by which Q>P
percentage change in supply of a Q1Q2 > P1P2
commodity is higher than Es> 1
percentage change in price.
E.g. Change in price is 20% &

change in supply is 40% then
40% 20% = 2 i.e Es> 1
Theory Of Supply
3. Unitary Elastic Supply Q=P

It refers to a situation by which Q1Q2 = P1P2
percentage change in demand of a Es = 1
commodity is equal to percentage
change in price.
E.g. Change in price is 10% &

10% 10% = 1 i.e. Ed = 1
4. Relatively Inelastic Supply Q<P

When percentage change in supply Q1Q2 < P1P2
of a commodity is less than Es< 1
percentage change in price.
E.g. Change in price is 10% but

6% 10% = 0.60 i.e. Ed < 1
5. Perfectly Inelastic Supply

When demand for a commodity is
fixed and it does not change for any
change in price it is described as
perfectly inelastic supply. Es = 0
In Perfectly Inelastic supply, the

demand curve will be Vertical
Methods of measurement of Elasticity of supply

1. Percentage / Proportionate Method: According to this method elasticity of supply is calculated
by dividing a % or proportionate change in supply with the % or proportionate change in price.
As explained above
2. Point Method:This method is used to find out elasticity at a point on supply curve. The elasticity
at a point on the supply curve can be measured with the help of following formula.
ES =dq p
dp q
Where
dq
dp is differentiation of supply function with respect to Price.
p = Price and q = quantity supplied
3. Arc Elasticity: when the price change is somewhat larger and we have to measure elasticity over
an arc rather than at a specific point on it, in such cases, the concept of arc elasticity is used. In arc
elasticity we use the average of the two prices and quantities (Original & new)
ES =
Theory Of Supply
Where P1and Q1 are original price and quantity respectively and

P1 and P2 are new price and quantity respectively.
EQUILIBRIUM PRICE
AND EFFECT OF INCREASE / DECREASE IN DEMAND I SUPPLY
D.1 Price Determination
1. Price Determination:
1) 'Demand' refers to the quantity of goods or services that Consumers are willing and able
to purchase / buy in a given market, at various prices, in a given period of time.
2) 'Supply'refers to the quantity of goods or services that Producers are willing and able to
offer in a given market, at various prices, in a given period of time.
3) The interaction between Demand and Supply leads to the determination of Price and
Quantity. It is the level at which both Buyers and Sellers are ready to buy / sell the product.
2. Equilibrium Price: The determination of Equilibrium Price using Demand and Supply
is explained in the following manner –
(a) Demand Curve slopes downwards
from left to right, while Supply Curve
slopes upwards from left to right.
(b) At the point E in the graph, Demand
and Supply curves meet each other.
(c) Point E constitutes the Stable
Equilibrium for the product, other
things remaining equal.
(d) The Equilibrium Price is OP, and the
Chapter 5:
THEORY OF PRODUCTION AND
COST
PART A- Production Concept
Meaning
1. According to James Bates and J.R. Parkinson “Production is the organized activity
of transforming resources in to finished products in the form of goods and services and
the objective of production is to satisfy the demand of such Transformed Resources".
2. In Economics, Production is any economic activity, which is directed at the
satisfaction of human wants.
3. Production = Creation of Utility and it also includes Creation or Addition of Value,
i.e. creation of want—satisfying goods and services.
Methods of Creation of Utility

Methods of Explanation Examples
Utility
Form Conversion of Raw material into Finished Conversion of wooden into furniture
Utility goods.
Place Changing place of resources this can be Removal of gold, coal from earth &
Utility obtained from extraction & transferring sand from sea.
goods like sand from one place to another
Time Making available material at times when Frozen eatable products.
Utility they are not normally available.
Personal Making use of personal skills in the form Skill as organizer, dancer, painter
Utility of services.
Factors of production
A. LAND
Meaning
1. Land refers to surface of the earth.
2. In economic land includes not only the surface of the
earth but it includes every free gift of nature found on
the surface of the earth, above the surface of the earth
and below the surface of the earth, i.e. natural
resources, water, air, lightning, heating, mines and fertility
of soil etc..
Characteristics
1. Natural Resources: Land is a gift of nature.
2. No Social Cost: Society has made no sacrifice in creation of land. Hence, Social cost of
land is zero.
3. Permanent factor: It is a permanent factor of production.
4. Passive factor: Land cannot produce anything of its own unless used by labour.
5. Heterogeneous factor: All land is not uniform. Fertility of land changes from plot to plot.
6. Mobility: Geographically land is immobile but occupationally it is mobile.
7. Site Value: Value of land depends upon location. A land which is located in developed
areas will have greater value.
8. Subject to diminishing returns: Land is subject to diminishing returns.
9. Supply: Supply of land is perfectly inelastic.
B. Labour
Meaning:
1. 'Labour' refers to mental or physical exertion directed to
produce goods or services, and with a view to gain an
economic reward.
2. To have an economic significance, Labour must be done with
the motive of some economic reward.
Labour Not a Labour

Services of Maid Servant. Services of Housewife.
Singing against payment of a fee. Singing in the company of friends for the sake of
Features of labour
Aspect Explanation
• Labour involves human efforts, with a view to gain an economic reward.
Human Efforts
• Human and psychological considerations come up .
• Labour is 'perishable'.
• So, a Labourer cannot store his Labour, for use at a later time. Hence
Perishable Nature Labour is said to have no reserve price.
Weak bargaining • Since there is no reserve price, Labour has a weak bargaining power.
power • However, labour laws maintain Labour Welfare, to a certain extent.
Self- Source • Labour is inseparable from the Labourer himself.

• Whereas if Labour is sold, the Producer of Labour retains the capacity
to work. Thus, a Labourer is the source of his own labour power.
• Labour may be classified as Skilled, Semi—Skilled and Unskilled Labour.

Variations • Labour power depends upon — (i) physical strength, (ii) education, (iii) skill,
and (iv) motivation to work.
• All Labour is not productive in the sense that all efforts are not sure
Productivity to produce want—satisfying goods and services.
Aspect Explanation
Peculiar Direct Relationship: Generally, Supply of Labour and Wage Rates are
relationship directly related, as per general Law of Supply. So, as Wage Rates increase, the
between Labourer tends to increase the supply of Labour by reducing the hours of
labour supply leisure.
and Wage rate Reverse Relationship at Higher Prices: He may prefer tohave more of rest
and leisure, than earning more money So, Supply of Labourreduces at very
high wage rate levels.
Reverse Relationship at Lower Prices: Similarly, when wage rates fall below
a minimum level, some more members of the family, who were not working
before, may start working to supplement the family income. So,
Supply of Labour may also increase at very low wage rate levels.
C. Capital
Meaning: Capital is that part of wealth of an individual or

community, which is used for further production of wealth,
or which yields an income.
Examples: Plant and Machinery, Tools and Accessories,

Factories, Dams and Canals, Equipments, etc.
2. Features of Capital:
Aspect Explanation
• Capital is a stock concept, which yields a periodical income which is a flow
Stock Concept
concept. Capital is not a flow concept by itself.
• Capital refers to only that part of wealth, that is used for further
production Resources lying idle will constitute wealth, but not
Capital Wealth • Capital.
Produced means • Capital is considered as 'produced means of production', unlike

of Production Land and Labour which are considered as primary or original factors of
production.
Man—made means • Capital is a man—made means of production.
/ factor
• Capital is mobile, and can flow from one use to another, one country to
Mobility another, etc. subject to certain restrictions.
• Capital is perishable.
Perishable
3. Land vs Capital:
Land Capital
(a) Free gift of nature, i.e. original or primary. Man—made or produced means of production.
(b) Indestructible and Permanent. Perishable.
(c) Lacks mobility in geographical sense. Has mobility.
(d) Quantity of land is fixed and limited. Amount of Capital can be increased.
(e) Rent from Land varies from place to place. Return on Capital is comparatively fixed.
4. Types of Capital:
1) Fixed Capital: Those types of capital goods that are used again and again for
production such as machinery.
2) Working Capital: They refer to those types of capital that are used up at once. Such as
raw materials
3) Sunk Capital: Those types of capital that have specific use hence no occupational
mobility e.g. sewing machine.
4) Floating Capital: Capital goods which have various alternative uses and occupational
mobility. E.g. A computer.
5) Money Capital: Money funds used in production is known as money capital.
6) Real Capital: It refers to real productive asset, lime Plant &Machinery.
Stages in capital Formation
Savings
Mobilization of savings
Investments
Capital formation includes following stages

1) Savings: Ability to save depends upon the income capacity of
individual. Higher savings generally follows higher income.
2) Mobilization of Savings: There should be widespread network of

banking and other financial institutions to collect public saving and
take them to prospective investor.
3) Investments: An economy should have a entrepreneurial class which is

prepared to bearthe risk of business and invest savings in productive
avenues so as to create new capital assets.
D. Entrepreneur
1. Meaning: Entrepreneur is the person who combines the various
factors of production in the right proportions, initiates the process of
production and bears the risk involved in it.
2. Features of Entrepreneurship:
(a) Entrepreneur is also called as the Organiser, Manager or
the Risk—Taker. But
Entrepreneurship is a wider term than Organization and Management of a business.
(b) Without the Entrepreneur, the other factors of production would remain unutilized or
idle. Hence, he is the catalyst in the process of using the factors of production.
(c) Entrepreneur holds the final responsibility of the business.
(d) Enterprise function gives direction to the usage of other factors of production. Land,
Labour and Capital, by themselves, will not lead to production activity.
(e) Entrepreneurship gets its reward (i.e. Profit), only after all other factors of
productionhave been rewarded, i.e. after Rent, Wages and Interest.
Functions of an Entrepreneur:
1. Initiating and Running the business
2. Risk—Bearing:
3. Innovations:
Enterprise Objective
1. Organic Objectives
Aspects Explanation
Survival 1. To stay alive in competition and ensure the continuance of its business
activity,
2. Toproduceanddistributeproductsorservicesatapricewhichenablesitto recover its
costs,
3. To meet its obligations to its Creditors, Suppliers and Employees,
4. To avoid bankruptcy or insolvency,
5. To provide the basis or growth.
Growth 1. Growth as an objective has assumed importance with the rise of Professional
and Managers, and the structural division of ownership and management in Corporate
Expansion Firms.
2. The goal that Managers of a Corporate Firm set for themselves is to maximize the
Firm's balanced growth rate subject to managerial and financial constraints.
2. Economic Objectives: These relate to the Profit Maximizing Objective and Behavior of
Business Firms, which forms one of the basic assumptions of Micro Economic Theory.
3. Social Objectives: An Enterprise lives in a society, and can grow only if it meets the needs of the
Society. Some of the major Social Objectives of Business would include—
a) To avoid profiteering and anti—social practices,
b) To create opportunities for gainful employment for the people in the society,
c)
4. HumanObjectives:
a) To ensure comprehensive development of its Human Resources or Employees',
b) To provide the Employees an opportunity to participate in decision—making in matters
affecting them,
c) To make the job contents interesting and challenging,
d) To develop new skills and abilities in Employees, and provide a work climate in which they
will grow as mature and productive individuals,
5. National Objectives:. Some of the National Objectives of Business would include —
a) To produce goods and services, according to national priorities,
b) To remove inequality of opportunities and provide fair opportunity to all to work and to
progress,
Constrains in achieving the objectives
Constrains Description
Information Business Enterprises operate in an uncertain world with lack of accurate
information.
Infrastructure Examples: Issues like frequent power cuts, irregular supply of Raw—
Materials or Non—Availability of proper transport, impact the ability of
enterprises to maximise profits.
Factors of Example: Trade Unions may place several restrictions on the mobility of
Production labour or specialised training may be required to enable workers to change
occupation. Such constraints may make attainment of maximum profits a
difficult task.
Economic Aspects such as Inflation, rising Interest Rates, unfavourable Exchange
Aspects Rate fluctuations cause increased Raw Material, Capital and Labour
Costs and affect the budgets and financial plans of Firms.
Others Due to inter—connected nature of economies, small changes in business

and economic conditions in one country, become contagious, and place
constraints in another Country, by causing demand fluctuations and
instability in Firms' Sales and Revenues.
Enterprise's Problems
Some major areas of problems in the context of Business Economics are given below —
Nature Explanation
Objective a) An Enterprise operates in the economic, social, political and cultural
environment, and hence it has — (i) Organic, (ii) Economic, (iii) Social, (iv)
Human, and (v) National Objectives — in relation to its environment.
b) Example: Profit Maximisation Objective conflicts with the objective of
increasing the Market Share which generally involves improving the quality,
reducing prices, etc.
Location of An Enterprise has to decide about the location of its Plant.

Plant
Size of The Firm has to decide whether it is to be a Small Scale Unit or Large Scale
Plant: Unit.
Physical a) A Firm has to make decision on the nature of production process to be

Facilities employed and the type of equipment to be installed — based on factors like
product design, technology available for production, required output levels, etc.
b) The Enterprise has to make a choice of equipment and processes, based on the
evaluation of their relative cost and efficiency..
Finance: There may be various problems facing the Enterprise relating to availability of
Capital at an appropriate Cost, availability of adequate Primary and Collateral Security
for obtaining Bank Finance etc.
Organisation a) Division of the total work of the Enterprise into major specialised functions,
b) Creation of proper departments for each of the specialized functions,
Structure:
c) Clear definition of the functions of all the positions and levels and establishing the
inter— relationships.
a) Discovering the target market by identifying its actual and potential customers,
Marketing:
b) Determining the marketing tools that can be used, to produce desired responses
from its target market,
c) ProperDecisionsregardingthe4P'sofMarketing—viz.
• Product: Variety, Quality, Design, Features, Brand Name, Packaging,
Associated Services, Utility, etc.
• Promotion: Communicating with Consumers — Personal Selling,
Social Contacts, Advertising, Publicity, etc.
• Price: Policies regarding Pricing, Discounts, Allowance, Credit Terms, Concessions,
etc.
• Place: Policy regarding Coverage, Outlets for Sales, Channels of Distribution,
Location and Layout of Stores, Inventory, Logistics, Supply-Chain
Management, etc.
a) Assessing and paying different types of taxes (Corporate Income Tax, GST, Customs
Legal Duty, etc.),
Compliance: b) Maintenance of records for specified number of years and showing them
for inspection by Authorities,
c) Submission of various types of information/Returns/Forms to various authorities
from time to time,
d) Adhering to various Rules and Laws(e.g. laws relating to location, environmental
protection and control of pollution)etc.
d) The problem of winning workers' cooperation—Management has to devise
Industrial special measures to win the cooperation of a large number of workers employed in
Relations:
industry.
e) The problem of enforcing proper discipline among workers,
f) The problem of dealing with organised labour and Trade Unions,.
PART B – PRODUCTION FUNCTION

Meaning:
1. Production Function is the functional relationship between physical inputs(i.e. factors of

production), and physical outputs (i.e. quantity of goods/services produced).
Cobb-Douglas Production Function
1. Output is manufacturing production and inputs used are Labour and Capital.
2. Cobb-Douglas Production Function is Q=KLaC(1-a), where Q is output, L is Quantity of Labour and
C the quantity of Capital. K and a are Positive Constants.
3. Labour contributed about 3/4w and Capital about1/4th of the increase in the Manufacturing
Production.
Short run and long run production function
Short Run Long Run

Meaning It is the period of time which is too short It is the period of time in which all the factors
for a Firm to install New Machineries / production are variable. So, the Firm will
Capital Equipments to increase be able to install new machineries /
production. Equipments, apart from increasing the units of
Labour, Materials, etc.
Fixed Only one Factor of Production is kept There is no Fixed Factor of Production in the
Factor constant or fixed. [Generally and, long—run planning horizon.
Capital or Enterprise is taken as fixed.]
Variable All Factors of Production other than the
All Factors of Production are variable.
Factor Fixed Factor are considered variable.
Fixed Factor Variable
Fixed Factor Variable
Factor
Factor
1 1
1 1
2 2
1 2
3 3
1 3
Proportion Proportion between factors changes, i.e. Quantity of Factors changes, i.e. more use
between more use of the Variable Factor, keeping Factors, keeping the proportion as constant.
Factors Fixed Factor as constant.
Theory Law of Variable Proportions is Law of Returns to Scale is applicable in
. applicable in the short—run. the long—run.
Assumptions:
The production function is based on certain assumptions;
• It is related to a particular unit of time.
• The technical knowledge during that period of time remains constant.
• The output resulting from utilization of inputs is at maximum level.
Terms Involved:
Total TP is the total output resulting from the efforts of all the factors of
Production production combined together at any time.
Average Average product or average physical product (APP) may be defined as total
Production product per unit employment of the variable input. Thus
AP = TP/Units of variable input (labour)
Marginal MP is the change in TP due to change in the quantity of variable factori.e.

Production labour. MP = Change TP I change in Labors OR
(MP) Mp = MP = TPn - TPn_1
Relationship 1. Both AP and MP can be calculated by TP.
between AP 2. When AP rises then MP also rises but MP>AP.
and MP 3. When AP is maximum then MP =AP or say MP curve cuts the AP curve at its
maximum point
4. When AP falls then MP also falls but MP<AP.
5. There may be a situation when MP decreases and AP increases but
opposite never happened.
Labour TP AP MP Analysis
1 2 2 2
Schedule MP &AP both increases; MP>AP; TP also
2 5 2.5 3
increases
3 9 3 4
4 12 3 3 MP=AP, AP = maximum
5 14 2.8 2
MP &AP both decreases, MP<AP; TP
6 15 2.5 1
increases, MP = 0, TP=maximum
7 15 2.1 0
8 14 1.7 -1
AP > MP both decreases TP decreases
9 12 1.3 -2
Relationship between Average Product and Marginal Product
Rule Relationship between AP and Points to Remember

MP
When AP rises as a result of an ❖ When AP rises, MP >AP.
1 increase in the quantity of variable ❖ MP Curve rises steeply and is higher than AP,
input, MP is more than AP. when AP increases.
❖ When AP is maximum, MP =AP.
When AP is maximum, MP=AP. So, ❖ MP declines slightly earlier than AR
the MP Curve cuts the AP Curve at ❖ MP Curve cuts AP Curve, when AP is
2 its maximum. maximum.
❖ MP Curve cuts AP Curve only from above, and not
from below.
When AP decreases due to increased ❖ When AP decreases, MP <AP.
use of the variable input factor, MP is ❖ MP Curve declines steeply than AP.
less than AP. ❖ MP may become zero and negative later,
3
but AP continues to remain positive(i.e. not
zero or negative).
Note: The above relationship is based on the Law of Variable Proportions in the same
sequence of stages as stated in that law, i.e. First Increasing, then Diminishing and then
Negative Returns.
Relationship between Total Product and Marginal Product I
Note: The point on the TP Curve when MP is maximum, is called Point of Inflexion
LAW OF VARIABLEPROPORTION
1. The Law of Variable Proportions analyses the production function with one factor as
variable, keeping quantities of other factors fixed. This Law is applicable in short run.
2. This Law is also called—Law of Proportionality , Law of Diminishing Returns, Law of

Diminishing Marginal Physical Productivity.
Assumptions:
The technology remains unchanged.
There must be some inputs whose quantity is kept fixed.
Law does not apply where factors are used in fixed proportions.
Only physical input and output are considered.
Schedule Labour TP AP MP Analysis

1 2 2 2
2 5 2.5 3 Stage-I- Law of increasing returns
3 9 3 4
4 12 3 3 MP=AP, AP = Maximum
5 14 2.8 2
6 15 2.5 1 stage-II- Law of decreasing returns
7 15 2.1 0 MP =0, TP is Maximum
8 14 1.7 -1
stage-III-Law of Negative returns
9 12 1.3 -2
Curve
Explanation to Stage 1
Reason Explanation
Full Use of (a) Initially, the quantity of Fixed Factors is abundant (and also unutilized),
Fixed in relation to the quantity of the Variable Factor.
Indivisible (b) As more units of Variable Factors are added to the constant quantity of
Factors the fixed factors, the Fixed Factors are more intensively and
effectively utilized. This causes the production to increase at a rapid
rate.
Efficiency of (a) As more units of the Variable Factors are put to use, the efficiency of
Variable the Variable Factors itself increases.
Factors (b) This is attributed to reasons like specialization of functions,
division of labour, use of standardized tools and processes, etc.
This results in higher productivity.
No Scarcity (a) Returns may diminish only when Variable Factors are affected by scarcity,
of Variable e.g. additional workers are not available.
Reaching the (a) Production Efficiency (i.e. increased output) is possible, till the right
right combination between Fixed Factors and Variable Factors is achieved.
combination
Explanation to Stage 2-
Note: Stage II is called Law of Diminishing Returns since MP and AP both show
decreasing trend. However, both MP and AP remain positive.
The Law of Diminishing Returns operates due to the following reasons —
Reason Explanation
Inadequacy 1. Once the point of right combination is reached, further increase in the
of Fixed Variable Factor will cause MP and AP to decline. This is because the Fixed
Factor Factor then becomes inadequate, in relation to the quantity of the
Variable Factor.
Less 1. Once the Fixed Factor has reached its maximum capacity, there is
efficiency of no further scope/ possibility of efficiency of the Variable Factor.
Variable
Factor
1. It is assumed that there is no perfect substitute for the scarce Fixed

Imperfect
Factor.
Substitutes
Explanation to Stage 3
Note: Stage III is called Law of Negative Marginal Returns
The Law of Negative Returns operates when the quantity of Variable Factor becomes too
Reason excessive, in relation to the Fixed Factor, so that they get in each other's ways. Due to
this, the total output falls instead of rising.
Since the second stage is the most important, So stage II will be stage of operation
and because of that in practice we normally refer to the law of variable proportion
as the law of diminishing returns.
Law of Return to scales

LAW OF RETURNS TO SCALE
Law In the long run, all factor inputs in the production function can be changed.
Types of • Increasing Returns to Scale:

returns to • Constant Returns to Scale:
scale • Diminishing Returns to scale:
Increasing 1. Increasing returns to scale occur

Returns to when a simultaneous increase
Scale in all the inputs in the same
given proportion result in a
more than proportionate
increase in the output.
2. For example, if input is
increased by 100% but the
output increases by 125%
Constant 1. Returns to scale are said to be

Returns to constant when a proportionate
Scale: increase in all the inputs
results in proportionate
increase in output. For
example if input is increased
by 100% but the output also
increases by 100%.
2. Constant return to scale is also
called 'Linear Homogeneous
Production Function'.
Diminishi 1. Diminishing returns to scale
ng occur when a simultaneous
Returns to increase in all inputs in the
scale: same given proportion result
in a less than proportionate
increase in the output.
2. For example, if Input is
increased by 100% but the
output increases only by75%
Cobb-Douglas Production Function exhibits returns to scale in production:.

Increasing returns to scale. Output increased more than proportionate to use of
a+b>1
factors (labour and capital)
a+b =1 Constant returns to scale. Output increased in same proportion with all factors.
Decreasing returns to scale. Output decreased more than proportionate to use of
a+b<1
factors (labour and capital)
Causes of the application of the law returns to scale

• Internal and external economics of scale.
• Internal and external diseconomies of scale.
Internal Economies and Diseconomies to Scale
Use of greater degree of division of Labour and specialised machinery at higher levels of
output are generally termed as Internal Economies.
Aspect Economies Diseconomies
Advantages Disadvantage
Technical 1. More specialised and efficientFurther increase in the Plant size
Machinery/Equipments can be used towill lead to high long—run cost,
produce a large output yields a lower costbecause of difficulties of
per unit of output. management, co—ordination and
2. Introduction of a greater degree of Divisioncontrol,
of Labour or Specialization, leads to
reduction in cost per unit.
Managerial 1. Specialized functional areas like Production,Difficult for Managers to exercise
purchasing, marketing, Finance, etc. can becontrol and co—ordination among
created. Each Department can also bevarious departments.
further sub—divided.
Mass Production creates the need for bulk 1. Higher quantities of Raw
(a)
purchase of raw materials and Materials may have to be
components, and leads to lower prices purchased at higher prices,
being paid for such bulk purchase. since there is an increasing
(b) Selling Costs can be minimized with the demand for that Raw Material.
Commercial existing sales staff, lower advertising costs 2. Advertising Costs tend to
per unit, etc. increase disproportionately
beyond certain levels of output.
Risk— A large Firm with diverse and multiple However, the Firm's Risk may
bearing production capability will be in a better increase of diversification instead
position to withstand economic ups and of giving a cover to economic
downs. disturbances, increases risk.
A large Firm can

Financial Financial Costs will rise more
(a) Offer better security to Bankers
proportionately after the optimum
scale of production because of
(b) Raise money at lower cost, since
relatively more dependence on
investors have confidence in it
external sources of finance.
External Economies are explained below —

Aspect Explanation
Cheaper Raw 1. Greater demand for various kinds of materials and capital equipment required
Materials and by the industry leads to exploration of new and cheaper sources of raw
Capital material, machinery and other types of capital equipment.
Equipment
Technological The use of improved and better machinery as per new techniques of production and
will enhance productivity of Firms in the industry and reduce their cost of
production.
Development 1. Workers become well—accustomed to do the various productive processes

of Skilled and learn from the experience obtained due to expansion of industry.
Labour
Growth of 1. As an industry expands, a number of ancillary industries who specialise in
ancillary production of raw materials, tools and machinery, etc. can provide them at a
industries lower price to the main industry.
Better 1. Transportation and marketing network develops to a great extent, and

transportation reduce cost of production of the Firms.
and marketing 2. Communication Systems may get modernised resulting in quick and effective
information flow.
External Diseconomies: These factors are called as External Diseconomies.

1. Rise in Factor Prices: When an industry expands, the requirement of various factors of
production increases may result in pushing up the prices of such factors of production
especially when they are short in supply.
2. Higher Costs: Too many Firms in an industry at one place may also result in higher
transportation cost, marketing cost and high pollution control cost.
3. Government Restrictions: The Government may prohibit or restrict expansion of an industry
at a particular place, by way of its policies.
Production Optimisation
Isoquant Curve
1. Isoquant Curve:
1. "Iso" means equal and "quant" means quantity. Hence, an Isoquant represents a constant
quantity of output.
2. An Isoquant is a Curve that shows all the combinations of inputs that yield the same level of
output.
2. Relationship with Consumer Indifference Curve:
1. An Isoquant represents all those combinations of inputs which are capable of producing the
same level of output.
2. Isoquants are also called Equal—Product Curves, Production Indifference Curves or Isoproduct
Curves.
3. Illustration: Consider two Factor Inputs (Labour and Capital) required for producing 100 units of a
Product. Different combinations in which the same output of 100 units of Product can be achieved
are given below.
MRTS always shows diminishing trend.
MRTS=Marginal Rate of Technical Substitution
MRTS= Change in units of capital/ change in units of labour
Combinatio Units of Labour (x) Units of Capital (y) Product Output MRTS (See Note)
A 5 9 100 units
B 10 6 100 units (9- 6)/(10-5) = 0.6
C 15 4 100 units (6 – 4)/( 15 -10) = 0.4
D 20 3 100 units (4-3)/(20-15)=0.2

Features of Isoquants:
1.
diminishing trend of MRTS

2. Isoquants are negatively sloped, i.e. downwards from left to right.
.
3. An Isoquant lying above and to the right of another Isoquant represents a higher level of
output.
4. Two Isoquants cannot cut each other, i.e. Isoquants are non—intersecting.
5. Isoquants need not be parallel.
ISOCOST LINES
Isocost Lines:
1. Isocost Line shows the various alternative combinations of two Factor Inputs, which a Firm
can buywith given amount of money.
2. It is also called Equal—Cost Lines or Budget Line or the Budget Constraint Line.
3. All points on a Budget Line would cost the Firm the same amount.
Production Optimisation
Meaning:
1. A Firm may try to minimise its cost for producing a given level of output, or it may try to
maximise the output for a given cost or outlay.
2. A Profit Maximising Firm is interested to know what combination of factors of production (or
inputs) would minimise its Cost of Production for a given output, and also the optimum level of
output.
3. This is obtained by combining the Firm's Production and Cost Functions, namely Isoquants and
Isocost Lines respectively.
Cost and Revenue Concept
Chapter 6:
THEORY OF COST AND REVENUE
PART A – COST CONCEPT
Meaning
1. Cost analysis is concerned with the financial aspects of productionrelations as

against physical aspects which were considered in production analysis.
Types of cost
1) Explicit cost and Implicit cost.

Explicit cost Implicit cost
Costs which involve payment made by the Costs which do not involve any cash
Entrepreneur to providers of other factors payment to outsiders are called Implicit
of production, i.e. Land, Labour and Costs.
Capital,
Recorded in books of accounts. Not recorded in books of account.

Rent, Wages & Salaries, Interest on Interest on own Capital, Rent of own
Loans borrowed for business, etc. premises, Salary to Entrepreneur, etc.
Out—of—Pocket Costs / Outlay Costs. Notional / Imputed / Opportunity Costs.
2). Accounting cost and Economic cost
Accounting Costs = Explicit Costs.

Economic Costs = Explicit Costs + Implicit Costs.
Comparison of Explicit and Implicit cost in different situation
Factors of Reward / The reward is Explicit Cost if — The reward is Implicit Cost if —
Production Costs
Land Rent Rent is paid to the LandlordLand is owned by the Entrepreneur.
separately.
Labour Salary/ Salary/ wages paid to employee/ Own people are employed in the firm
Wages workers
Capital Interest Capital is borrowed and used in Entrepreneur employs his own
business
funds as Capital.
Entrepreneur Profit Not Applicable Entrepreneur himself manages the
business.
3. Opportunity cost:
1. Opportunity Cost refers to the value of sacrifice made, or benefit of opportunity foregone in
accepting a next best alternative course of action.
2. If a resource can be put only toa particular use, there are no Opportunity Costs.
3. Opportunity Cost is not recorded in books of accounts. It is considered only for decision—
making and analytical purposes.
4. Examples: A person quits his job and enters into business. Here, the Salary foregone from
employment constitutes Opportunity Cost.
4. Direct cost vs Indirect Cost
Basis Direct cost or traceable cost Indirect cost or non-traceable cost

Meaning Direct costs are those which have Indirect costs are those which are not
direct relationship with a easily and definitely identifiable in
component of operation like relation to a plant, product, process or
manufacturing a product, department.
organizing a process or an activity
etc.
Example Cost of Raw Material used in Factory Rent, Electric Power, and other
manufacture, Wages paid to Worker Common Costs incurred for general
operation of business benefiting all
products jointly.
Relationship They can be generally quantified Though not quantifiable, they may bear
and expressed per unit of some functional relationship to
output, e.g. 5 kg of Raw production, may vary with the volume of
Materials per unit of product, etc. output in some definite way.
Accounting They are charged directly to Apportioned on suitable basis
product
5. Fixed costs and Variable costs
Basis Fixed Costs Variable Costs

Fixed Costs are costs that do not vary with Variable Costs are costs that vary,
Meaning
output, up to a certain level of activity. based on the level of output.
Relationship They are period—related. They are product—related.
When They are incurred even at zero level of They are incurred only when
incurred? output, i.e. even before output is produced. production commences.
Avoidable Some portion of Fixed Costs cannot be Variable Costs are avoidable costs, as it
Nature avoided even when operations are is incurred only when production takes
suspended. place.
Cost per Fixed Cost per unit of output Variable Cost per unit of output
unit decreaseswith increase in output, and generally remains constant, if Total
vice—versa, upto certain level of output. Variable Costs vary proportionately with
output.
Example Rent, Insurance, Interest on Loans, Cost of Raw Materials and Wages are
Depreciation, etc. are Fixed Costs. Variable Costs.
6. Committed cost and Discretionary costs
Particulars Committed Fixed Costs Discretionary Fixed Costs

These are Fixed Costs that arise fromthe These are Fixed Costs incurred as a
possession of —
result of management's discretion.
1. Plant, Building and Equipment (e.g.
It arises from periodic(usually yearly)
Meaning Depreciation, Rent, Taxes, Insurance
decisions regarding the maximum outlay to be
Premium etc.), or incurred; and
2. A basic organisation (e.g. Salaries of It is not fixed to a clear cause and effect
Staff) relationship between inputs and outputs.
Effect on Any reduction in Committed Fixed Costs Discretionary Fixed Costs can change from
long—term under normal activities of the Firm would year to year, without disturbing the long—
Objectives have adverse effects on the Firm's long—term term objectives of the Firm.
objectives.
Control These costs cannot be controlled. These costs can be controlled.
Inference Also known as "Unavoidable" Fixed Costs. Also known as "Avoidable" Fixed Costs.
7. Marginal Costs
Meaning: Marginal Cost is the addition made to the total cost by production of an additional unit of output.
Marginal Costs per unit = Difference in Output Quantity at those levels

Difference in Total Cost (TC) between two output levels
Behaviour of Marginal Cost Curve:
The behaviour of MC Curve is the reverse of the behaviour of the Marginal Product (MP)
Curve under the Law of Variable Proportions.
Marginal Product (MP) Curve rises first, reaches a maximum and then declines, as seen in
the Law of Variable Proportions.
So, Marginal Cost (MC) Curve of a Firm declines first, reaches its minimum and then rises.
Hence, Marginal Cost Curve of a Firm is U—shaped.
8. Other costs
Type Explanation
Historical cost Historical cost refers to the cost incurred in the past on the
and Replacement acquisition of a productive asset such as machinery, building etc.
cost Replacement cost is the money expenditure that has to be incurred
for replacing an old asset.
Incremental cost Incremental costs are related to the concept of marginal cost.
and Sunk Cost Incremental cost refers to the additional cost incurred by a firm as
result of a business decision.
For example, incremental costs will have to be incurred by a firm
when it makes a decision to change its product line, replace worn out
machinery, buy a new production facility or acquire a new set of
clients.
Sunk costs refer to those costs which are already incurred once and
for all and cannot be recovered. They are based on past commitments
and cannot be revised or reversed if the firm wishes to do so.
Examples of sunk costs are expenses incurred on advertising.
Private cost and

Private costs are costs actually incurred or provided for by firms and
Social Cost
are either explicit or implicit.
Social cost refers to the total cost borne by the society on account
of a business activity and includes private cost
and external cost.
It includes the cost of resources for which the firm is not required to pay
price such as atmosphere, rivers, roadways etc. and the cost in terms of
dis-utility created such as air, water and environment pollution.
Cost Function
1. Meaning: Cost Function refers to the mathematical relationship between cost of a product and
the various determinants of cost.
2. Variables: The following are the dependent and independent variables in a Cost Function —
Dependent Variable Independent Variable can be —

1. Total Cost or 1. Size / Quantity of Output,
2. Unitcost 2. Scale of Operations,
3. Price of Factors of Production.
4. Other relevant phenomenon having a bearing on cost, e.g.
Technology, Level of capacity utilisation, Efficiency, Time Period
under study, etc.
Short run and Long run cost Behaviour
A. Short Run Cost curves:
Meaning of shot run:
Short Run is a period in which some factors are fixed and some factors are variable.
So, law of variable proportion applies here. In short-run, only variable factors can be
varied and not fixed factor.
Types of Cost in Short- Run
1. Total fixed cost (TFC)

2. Total Variable Cost (TVC)
3. Total Cost (TC)
4. Average fixed cost (AFC)
5. Average Variable Cost (AVC)
6. Average Total Cost (ATC OR AC)
7. Marginal Cost (MC)
Total Fixed TFC is parallel to X-axis. Even at zero

cost (Short output-fixed cost remain the same in
run) the short run.
e.g. rent and insurance
Total Variable Costs are those costs that change

Variable with changes in level of output. As output
cost (TVC) is zero, cost is also zero and as output
increases cost increases. e.g. raw
material, power etc.
Semi- There are some costs which are neither perfectly variable, nor absolutely fixed
Variable in relation to the changes in the size of output. They are known as semi-
Cost variable costs.
Example: Electricity charges include both a fixed charge and a charge

based on consumption.
Short run It can be noticed that TFC is constant at

Total cost all levels of output.
behaviour
Initially TVC increases at decreasing
rate but after some time it increases at
increasing rate.
Behaviour of TVC is determined by law of
variable proportion.
TFC curve is a horizontal line starting
from y–axis.
TC curve is upward sloping starting
from y-axis.
Short Run Average Cost

Average Fixed Average fixed cost is the total fixed cost divided by the output. (Per
Cost (AFC) unit FC) or TFC/Q.
The general shape of the AFC curve is downward sloping It does not
touch the X-axis as AFC cannot be zero.
It is not 'U' shape. This curve is also called Rectangular
Hyperbola (R.H.)
Average Average variable cost is the total variable cost divided by the output.
Variable Cost (Per unit VC) or TVC/Q.
(AVC) It has 'U' shape. .
Average Total Average total cost is total cost divided by the output. (Per unit TC) or
Cost (ATC) TC/Q or AFC+AVC.
It is U shaped
Marginal Cost Marginal cost is the change in total cost due to change in the output.
(MC) MC= Change in Total Cost / Change in Qty. produced or MC =
Change Total Variable Cost / Change Qty. produced.
The MC curve is also 'U' shape.
Behaviour of AFC goes on diminishing with the

Average – increase in output but it never
costs in Short becomes zero.
- Run AVC initially declines but later on
goes on increasing.
ATC initially decreases, constant for
a while & finally goes on increasing.
MC initially decreases & finally
increases.
The point at which ATC is minimum.
It is equal to MC.
Short run cost table

Output Total Total Total Average Average Average Marginal
fixed
(Unit) variable cost fixed cost variables Total Cost Cost Rs.
cost
TFC TVC TC AFC AVC AC MC
0 10 - 10 - - - -
1 10 10 20 10 10 20 10
2 10 18 28 5 9 14 8
3 10 24 34 3.33 8 11.3 6
4 10 28 38 2.5 7 9.5 4
5 10 32 42 2 6.4 8.4 4
6 10 38 48 1.67 6.33 8 6
7 10 46 56 1.43 6.57 8 8
8 10 56 66 1.25 7 8.25 10
9 10 68 78 1.11 7.55 8.67 12
Relationship between Average Cost and Marginal Cost Curves
Rule Relationship between AC and MC Point to Remember

1 When AC falls as a result of an • When AC falls, MC < AC.
increase in output, MC is less MC Curve is lower than AC, when AC
2 When AC is minimum, MC = • When AC is minimum, MC = AC.
AC. So, the MC Curve cuts the • MC increases slightly earlier than AC.
AC
3 When AC increases due to • When AC decreases, MC > AC.
increase in output, MC is • MC Curve rises steeply than AC.
high than AC
Item Behaviour of Cost Behaviour of Curve
➢ AFC = TFC /Q. ➢ AFC Curve is negatively sloped,

➢ TFC remains constant irrespective of i.e. slopes downwards from left
AFC increase in Q. to the right.
➢ So, AFC is inversely related to Q ➢ AFC Curve will not touch the axis
since AFC cannot be = 0.
➢ AVC = TVC / Q ➢ AVC Curve will fall first, for the
➢ Upto normal capacity output, AVC output level upto normal capacity.
decreases as output increases, due to ➢ AVC Curve will reach a minimum,
AVC initial increasing returns. and then rise again.
➢ Beyond normal capacity output, AVC will ➢ AVC is not exactly a U—Shaped
rise steeply, due to the operation of Curve.
diminishing returns.
➢ AC = TC / Q (or) AC = AFC + AVC.
➢ In the initial stages, AC will decline ➢ AC Curve will fall first, due to
sharply due to fall in AFC. sharp decline in AFC.
AC or ➢ Even when AVC rises, AC continues to ➢ AC Curve will reach a minimum,
ATC decrease since the fall in AFC is greater and then rise again, due to
than the rise in AVC. increase in AVC.
➢ As output increases further, AC starts ➢ AC is a U—Shaped Curve.
increasing, since the sharp rise in AVC is
more than fall in AFC.
➢ Marginal Costs p.u. = Diff. in TC / Diff. ➢ MC Curve will fallfirst, reach
in Q. a minimum, and then rise again.
MC ➢ MC declines initially, reaches a ➢ MC is a U—Shaped Curve.
minimum, and thereafter increases. ➢ MC cuts AC from below, when AC
is minimum.
Long run average cost curve

▪ LAC Curve: A Long Run Average Cost Curve (denoted as LAC Curve) depicts the functional
relationship between output and the long—run cost of production.
All factors of production are variable in long—run, and hence everycost is variable.
▪ LAC = Least Cost:
a) In the long—run, the cost of production is the least for any given level of output, as all
individual factors are variable. So, a Firm can move from one Plant to another, acquire a bigger
Plant if it wants to increase its output, and a small plant if it wants to reduce its output.
b) The shift will be to ensure the least cost for that level of output, in the long—run.
▪ SAC (Short—Term Average Cost) Curves are called Plant Curves, and LAC (Long Run Average Cost)
Curve is called Planning Curve.
5. LAC derived from SAC: LAC Curve is derived as an envelop / tangent of all SAC Curves. Further, the
LAC Curve is a U—Shaped Curve, due to the operation of Law of Returns to Scale.
6. Selecting the suitable SAC Curve at different output levels:
In the long—run, for any output level, the Firm will examine and decide which size of plants it should
operate, so as to minimize its Cost (i.e. AC). The firm will decide on which SAC Curve it should
operate to produce a given output, so that its AC is minimum.
Note: The Firm should select the SAC, not the lowest point of that SAC.
• The points of operation, i.e. B, D, F and G need not be the minimum points of the respective
SACs. However, it should be the SAC on which the lowest cost is obtained for that level of output.
• So, the Firm will choose the appropriate lowest cost SAC for an output level, and not the lowest
point on that SAC.
• The Smooth Curve connecting points B, D and G, constitutes the LAC Curve for the Firm.
2. Deriving LAC Curve in case of numerous / infinite SAC Curves:

(a) If the Firm has choice between infinite
number of plants (with infinite SAC
Curves), the LAC Curve will be a smooth
curve enveloping all these SAC Curves.
(b) In the diagram, the LAC Curve is drawn as a
smooth curve, so as to be tangent to
each of the SAC Curves. [See Note below]
(c) If a Firm desires to produce any particular
output level, it will build a corresponding
Plant and operate on that Plant's SAC
Curve.
(d) Higher levels of output can be produced
at the lowest cost, with a larger plant, and
vice—versa.
Note: LAC Curve is tangent to each of the SAC Curves, not the minimum points of the SAC Curves. So
When LAC Curve is — LAC will be tangent to Principle

The falling portions of the Returns to Scale will first increase, due to
Declining SAC Curves. internal and external economies. So, LAC will
decline.
The rising portions of the Returns to Scale will decrease later, due to
Rising SAC Curves. internal and external diseconomies. So, LAC
will rise.
Thus, as a result of initial fall and subsequent increase in LAC, it will be a U—shaped Curve.
REVENUE CONCEPT
Meaning Revenue is sales receipts or sales proceeds.
Total Revenue It is the total money received from the sale of all units of the product.
Total Revenue = Price x Quantity (P x Q)
50 Rs. = Rs. 5 x 10 Units
Average
Revenue (AR) Average Revenue = Total Revenue/Quantity (TR/Q)
Average Revenue is always equal to Price
Marginal MR is the change in TR resulting from the sale of an additional unit of a commodity.
Revenue (MR)
Marginal Revenue = Change in TR/ Change in Qty. sold or
Marginal Revenue= TRn – TRn-1
MR, AR, TR and Marginal Revenue = Average Revenue (E – 1/E)
Elasticity of Where E = Price elasticity of demand
Demand If E = 1, Then MR = 0
If E > 1, Then MR will be Positive
If E < 1, Then MR will be Negative
Behaviour of A firm should produce at all if Total Revenue(TR) from its product is equal to or
TR, AR & MR exceeds its Total Variable Cost (TVC) or say TR > TVC (Price > AVC).
If TR = TVC, firm's maximum loss will be equal to its Fixed Cost. As we know P x Q =
TR and AVC x Q = TVC
The firm should continue production till MR = MC and MC curve should cut to MR
from below. It is equilibrium position of firm. Merely, being in equilibrium
position does not mean that firm is making profits. The actual position of profits
can be known from AR and AC curves.
Relationship between TR, AR, MR and Price Elasticity of Demand
1.Relationship between TR, AR and MR:

Qtty Price pu TR MR
(Q) (AR=P) = Y
PxQ
1 22 22 22
2 20 40 18
3 18 54 14
4 16 64 10
5 14 70 6
6 12 72 2
7 10 70 -2
8 8 64 -6
9 6 54 -10
10 4 40 -14
Summary of Relationships:
▪ If TR increases, MR will be positive.

TR and MR ▪ When TR is maximum, MR = 0.
▪ If TR decreases, MR will be negative.
▪ MR and AR both decline, but MR falls rapidly than AR.
▪ AR Curve is flatter than MR.
MR and AR ▪ MR can be zero and even negative, while AR will never cross below the X axis.
▪ At the point where MR = 0, Elasticity of Demand on AR Curve will be 1.

Meaning and Types of Market
Market basics
Meaning:
1) Market is a place where Buyers and Sellers meet and bargain over a commodity for a price.
Elements of a Market: The elements of a Market are —

1) Buyers and Sellers,
2) Product or Service,
3) Bargaining for a Price,
4) Knowledge about market conditions, and
5) One Price for a Product or Service at a given time.
Classification of Market
In Economics, generally the classification of markets is made on the basis of:
Area Time Nature of Regulation Volume of Types of

Transaction Business Competition
Local market Very Short Spot Market Regulated Wholesale Perfectly
period Market market competitive
Regional Market Short period Future Unregulated Retail Imperfectly

Market Market Market Competitive
National Market Long Period
International Very long/

Market Secular
Types of Market
The Market Structures analysed in Economics are --
1) Perfect Competition: Many Sellers selling identical products to many Buyers.
2) Monopoly: Single Seller producing differentiated products for many Buyers.
3) Monopolistic Competition: Many Sellers offering differentiated products to many Buyers.
4) Oligopoly: A Few Sellers selling competing products to many Buyers.
5) Duopoly: Duopoly is a market situation in which there are only two Firms in the market. It is
a sub—set of Oligopoly,
6) Monopsony: Monopsony is a market characterized by a Single Buyer of a product or service.
It is mostly applicable to Factor Markets in which a Single Firm is the only Buyer of a Factor.
7) Oligopsony: Oligopsony is a market characterized by a small number of large buyers. It is
also mostly relevant to Factor Markets.
8) Bilateral Monopoly: It is a market structure in which there is only a Single Buyer and a
Single Seller. Thus, it is a combination of Monopoly Market and a Monopsony Market.

Summary of Different Market
Perfect Monopolistic
Aspect Monopoly Oligopoly
Competition Competition
Number of
Many Only One Many A Few
Sellers
Homogeneous / Highly Slightly Nature of
Nature of Identical differentiated / differentiated / Differentiation
Product Product. No specialized specialized varies.
differentiation. product. product.
Ease of Entry / Free Entry / Free Entry /
Only One Seller. Only Few Sellers.
Exit Exit. Exit.
Each Firm is a
Absolute. [Firm =
Price—
Control over Nil [Firm = Price Price Maker.]
Maker for its Reasonable.
Price Taker]
own
product.
Price Elasticity Different Elasticity
of Infinity. Less Elastic. More Elastic. at
Demand Different Levels
Foodgrains, Railways, Cars, Soaps, Pharmaa, Cold
Examples Vegetables, etc. Electricity Toothpaste, etc. Drinks, etc.
Supply.
Horizontal Negatively Negatively
Demand Curve Kinked Curve.
Line. Sloped Sloped.
Profit in Long— Normal Profits Super—Normal Normal Profits —
Run Only. Profits Only.
can also be
earned.
Optimality in Each Firm is an Can operate at Idle Capacity. —
Long— Optimal Firm. sub— Not an
Run optimal level Optimal Firm.
also.
Perfect Competition
Features of Perfect Competition
Aspect Explanation
Large No of ❖ There are a large number of Buyers & Sellers who compete among
Buyers & Sellers themselves.
Homogeneous ❖ Homogeneous = Similar or Identical in nature.

Products
Free Entry / ❖ Every Firm is free to enter the market or to go out of it, at any point of
Exit time.
❖ There is a perfect knowledge, on the part of Buyers and Sellers, of the
Perfect
quantities of stock of goods in the market, market conditions, and the
Knowledge
prices.
❖ There are adequate facilities for the movement of goods from one
Transportation
place to another.
Uniform Market ❖ All firms have uniform price and all Firms individually are Price
Price Takers. They have to accept the price determined by the market forces
of Demand and Supply.
❖ Buyers have no preference as between different Sellers (since product
Indifference /
is homogeneous).
Lack of
Preference
Mobility of
❖ There is perfect mobility of factors of production.
Factors of
Production
How Demand Curve is determined
1. Uniform Market Price- In Perfect Competition, no individual Buyer or Seller will be in a

position to influence the demand or supply in the market.
2. Price Taker- All Firms individually are Price Takers. They have to accept the price
determined by the market forces of Demand and Supply.
3. Same Price- All output can be sold at the same price only. Price Elasticity of Demand is
infinity.
4. So, in Perfect Competition, D = AR = MR = Price.
Short Run price determination, Optimum output and profit Determination

For achieving Equilibrium, the conditions to be satisfied are —
MC = MR, and
MC Curve should cut MR Curve from below, i.e. MC should have positive slope.
In Perfect Competition, the short—run equilibrium of the Market and Firm is represented below
—
1. The firm is said to be in equilibrium when it maximises its profit or minimizes its loss. Merely
being in Equilibrium position does not mean that the Firm is making profits.
The actual position of profits can be known only on the basis of AR and AC Curves.
2. In the short run, a firm will attain equilibrium position and at the same time it will earn
supernormal profits, normal profits or losses depending upon its cost conditions.
Eg: In cases of losses, VC= Rs. 10 per unit, FC= Rs.5 per unit, SP= Rs. 13 per unit, we will
continue to sale in short run as atleast we are recovering Rs .3 per unit of fixed cost as
already fixed cost is sunk cost.
In the short run a competitive depending upon its average cost conditions firm may earn the
followings.
Q2
Quantity
Super profits: When a firm earn super normal
profits its average revenue are more than its average
total cost or say AR > ATC. Super profits also called
Economic Profits, abnormal profits and super
normal profits.
Normal profits: When the firm just meets its

average total cost, it earns normal profits and this
normal profit is included in average total costs.
Normal profit is normal rate of return on capital and

the remuneration for the risk bearing function of
the entrepreneur.
Losses: A firm in the short run may incur losses if

AR < ATC.
When a firm is incurring losses then firm will try to
minimize its losses and to minimize losses firm will
cover total variable costs, then losses may be equal
to or part of fixed costs.
If firm is unable to meet its variable cost, it will be
better for it to shut down.
Shut Down point: It refers to a situation when

firm is just able to cover its variable costs only.
At the shut down point, firm incurs loss of
fixed cost. The firm does not stop the
production at this point as fixed cost will still
be incurred. However, if AR further falls and is
unable to meet even AVC, then firm will shut
down the operations.
Long – run Equilibrium of a firm under Perfect Competition.
In the Long run the firms will be earning just NORMAL PROFITS, which are included in the AC,
due to -Free entry and exit of firms. To earn normal Profits, LAR should be equal to LAC or say
LAR = LAC
In the long run, following conditions are satisfied:

• The output is produced at the minimum feasible cost or minimum LAC
• Consumers pay the minimum possible price.
• Full utilization of plants is possible, MC = AC
• There is no wastage of resources. optimal allocation
• Firms earn only normal profits i.e. AC = AR.
• Firms maximize profits i.e. MC = MR, but level of profits will be normal.
• In the long run LMC = LMR = P = LAR = LAC = SMC = SAC
• When LAC falls LAC> LMC and when LAC raises LMC > LAC
Long Run Equilibrium in the Industry

The Industry is said to have attained long—run equilibrium when —
1. All the Firms are earning normal profits only, i.e. all the Firms are in long—run equilibrium,
and
2. There is no further entry or exit of Firms to / from the market.
Identification of the Supply Curve of a Perfect Competition Firm
MC curve of the firm is the firm's supply curve. In perfect competition firm, MC curve above
AVC is considered the supply curve of the firm, because when P <AVC then firm will not
supply any output and actually shutdown.
Monopoly
Aspect Explanation
Single Seller a) The word 'Monopoly' means "alone to sell". In a Monopoly, there is only
one Seller.
Firm =
Industry Since there is only one Seller, and he constitutes the entire Industry.
a) In a monopolistic market, there are strong barriers to entry of new Firms.
Entry b) Barriers to entry could be — (i) economic, (ii) institutional, (iii) legal, or
Restrictions (iv) artificial.
a) A Monopolist sells a product which has no close substitute.

No
b) The Cross Elasticity of Demand for the Monopolist's Product and any
substitutes
other product is zero or very small.
Elasticity of a) Price Elasticity of Demand for Monopolist's Product is less than one.
demand b) The Monopolist faces a downward—sloping Demand Curve.
Why Monopoly exists?

Monopoly is caused by "barrier to entry", i.e. other Firms cannot enter the market. Some reasons
for occurrence and continuation of Monopoly are -
1. Strategic Control over scarce resources, inputs or technology by a Single Firm.
2. Developing or acquiring control over a unique product that is difficult or costly for other
Companies to copy.
3. Patents and Copyrights given by Government to protect Intellectual Property Rights.
4. Governments granting exclusive rights to produce and sell a good or a service.
5. Substantial Goodwill enjoyed by a Firm .
6. Natural Monopoly due to very large economies of scale - Suppose, a Single Firm is able to
produce the industry's whole output at a lower unit cost than two or more Firms could. In such
case, it is often wasteful (for Consumers and the economy) to have more than one such Supplier
because of the high costs of duplicating the infrastructure, e.g. Telephone Service, Natural Gas
Supply, Electrical Power Distribution, etc.
7. Very high initial start—up costs may discourage new Firms from entering the market.
8. Use of Anti—Competitive Practices or Predatory Tactics, (e.g. Limit Pricing or Predatory
Pricing) intended to do away with existing or potential competition.
9. Business Combinations or Cartels (Note: This is illegal in most countries) where former
Competitors co—operate on pricing or market share.
Effects of Monopoly-
Some negative effects of Monopolies are as under —
1. Higher Prices for Consumers,
2. Loss of Consumer Surplus,
3. Inability of Consumers to substitute the goods or services, with a more reasonably priced
alternative,
4. Transfer of Income from Consumers to Monopolists,
5. Restriction of Consumer Sovereignty consume goods they desire,
6. Payment of lower prices by Monopolies to their Suppliers (of goods and services), i.e. lower
Factor Payments,
7. Lower levels of Output, that what would be produced in a competitive environment,
8. Ability of Monopolist to influence political process and thereby obtain a favourable
legislation,
9. Lack of Innovation,
10.Lack of Productive and Allocative Efficiency,
Is monopolist a Price Maker or Price taker?
1. In Perfect Competition, Firms are Price—Takers, i.e. they take the price determined by market
forces, and determine only their optimum output.
2. However, a Monopolist has to determine Output and also the Price for his product.
3. Since Price and Demand Quantity are inversely related, the Monopolist has to carefully try to
attain the equilibrium level of output, at which his profits are maximum.
Determination of Demand/ Revenue curve
1) Demand Curve of a Monopolist Firm is the same as

Market Demand Curve for the product. (Since Firm =
Industry).
2) Market Demand Curve indicates the quantity that
the Buyers will be ready to buy at various prices, and is
negatively sloped, i.e. falls from left to right.
3) Hence, Market Demand Curve = Firm's Demand
Curve = Average Revenue (AR).
4) Relationship between AR & MR under Monopoly:
a) Both AR and MR are negatively sloped (downward sloping) curves.
b) MR Curve lies half—way between the AR Curve and the Y—axis, i.e. it cuts the
horizontal line between Y axis and AR into two equal parts.
c) AR cannot be zero, but MR can be zero or even negative.
Short Run price determination, Optimum output and profit Determination
For achieving Equilibrium, the conditions to be satisfied are —

MC = MR, and
MC Curve should cut MR Curve from below, i.e. MC should have positive slope.
1. Profits / Losses: At Short—Run Equilibrium Level,

The Monopolist may make — (a) Super—Normal
Profits, or (b) Normal Profits (sometimes), or (c) Losses,
which can be known based on his AC Curve.
Super profits: To earn super profits AR >ATC.

Losses: When a monopoly firm will incur losses then AR

<ATC.
Long – run Equilibrium of a firm under monopoly

Long run Equilibrium: Super profit (LAR > LAC):
• Monopoly firm in the long run gets abnormal

profits. It is so because the new firms are not
allowed to enter the market. To earn super profit
LAR > LAC.
Price Discrimination
1. Meaning:
a) Price Discrimination occurs when a Producer sells a commodity to different Buyers, at
different prices, for reasons not related to differences in cost.
2. Objectives:
a) To earn Maximum Profit
b) To Dispose of Surplus stock
c) To enjoy Economies of Scale
d) To capture foreign markets
e) To secure equity thorough pricing.
3. Examples:
a) Doctors may charge more from a rich patient than from a poor patient, for the same
treatment.
b) Electricity Rates for home consumption in rural areas are less than that for industrial
use.
c) Export Prices of Products are cheaper than the domestic market selling price.
d) Railways charge different rates from different type of passengers e.g. AC, Non—AC, Tatkal,
etc.
4. Conditions for Price discrimination
a) Full control over supply.
b) Division of market into two or more sub-markets.
c) Different price elasticity under different markets: Monopolist charge higher price from
that market whose price elasticity is less than one and can charge lower price from that
market whose price elasticity is greater than one.
d) No possibility to resale: It should not be possible for the buyers of low-priced market to
resell the product to the buyers of the high priced market
Process of price discrimination
1. MR at Same Price: Assume that a Monopolist charges a single price of 30 for his product, and
sells them in two markets A and B, with elasticities of demand 2 and 5 respectively.
Since MR = AR x e-1/e
MR for Market A will be 30 x (2-1)/2 = 15.
MR for Market B will be 30 x (5-1)/5 = 24.
2. Impact of different MR: From the above, the following observations can be made —
a) At the same price, MR in the two markets are different, due to difference in elasticities of
demand.
b) MR is more in Market B where elasticity is high.
3. Output transfer by Monopolist:
a) If MR is higher in Market B (with high elasticity), the Monopolist will earn more profit by
transferring some quantity of the product from Market A to Market B.
b) For every unit of product transferred so, the Monopolist will gain 24 — 15 = 9
4. Effect of Output Transfer: When output quantity is transferred from A to B, the price in Market
A will increase (due to lower supply) and price will decrease in Market B (due to highersupply).
This means that the Monopolist is now discriminating between Markets A and B.
5. Point of Equality: The Monopolist will reach a point, when the MR in both markets become equal
as a result of some transfer of output. Then, it will not be profitable anymore to shift more output
from Market A to Market B.
6. Differing Prices: When this point of equality is reached, the Monopolist will be charging
different prices in the two markets — a higher price in Market A with lower elasticity of
demand, and a lower price in Market B with higher elasticity of demand. This practice of
charging different prices to different segments is known as Price Discrimination.
Monopolistic Competition
Meaning Imperfect competition is found in the industry where there are a large numbers of
small sellers, selling differentiated but close substitutes products. E.g. LUX,
HAMAM, LIRIL etc. This market contains features of both competitive and
monopoly markets.
Features • Large number of sellers and buyers
• There is free entry and exit of firms. It implies that in the long run firm will earn
only normal profits.
• Product differentiation: Each firm produces a different brand or variety of
the same product. The varieties produced are very close substitutes of one
another. Products like toothpaste, soap.
•
Features • Non price competition: -

They incur advertising costs. It is because of the need to maintain a perception
in the mind of the potential consumers that their respective brands are
different compared to other brands.
• Every firm is price maker and price taker of his own product.
• Product differentiation and Freedom of entry and exit.
• AR and MR: In monopolistic competition AR will be greater than MR but
AR/demand curve AR/MR will be more elastic than monopoly market.
PRICE-OUTPUT DETERMINATION (EQUIBRIUM OF A FIRM)

The equilibrium price and output of a monopolistically competitive firm is determined at the
point where
• MC = MR and
• MC cuts to MR from below point .
Short Run Equilibrium

Super profits- To earn super profits AR >ATC.
Losses: But if the AR < AC then firm will incur losses.

Further, a firmmay be making only normal profits
even in the short run if demand curve happens to be
tangent to the average cost curve or say AR = AC.
Long Run Equilibrium

Normal profit (LAR = LAC/ TAC)

The final equilibrium in the long run will take place at
that level of output and price at which MC = MR. The
firm, in the long-run will earn normal profits, because
there is free entry and exit of firms. This will continue
until AR curve becomes tangent to the AC curve and
abnormal profits are wiped out.
MC = MR at the point E and output is OQ1, where AR
= AC at point A. Here the firm will be making only
normal profits.
The AR curve in the long-run is not tangent to the
ATC curve at the lowest point. This shows each firm
produces at before the lowest TAC/LAC or produces
less than the optimum output and Charges from the
customers a price higher than the competitive price.
A firm under monopolistic petition has always excess
capacity but perfect competition never has excess
capacity and monopoly may or may not be
OLIGOPOLY MARKET
Meaning When there are few (two to ten) sellers in a market selling homogeneous or
differentiated but close substitutes products, oligopoly is said to exist. Consider
the example of cold drinks industry or automobile industry.
Types of • Pure / Perfect oligopoly - deals in homogeneous products- Aluminum

Oligopoly industry.Differentiated / imperfect oligopoly - deals in product
differentiated.
• Open oligopoly - New firms can enter the market and compete with existing
firms. Closed oligopoly - new entry is restricted.
• Collusive oligopoly - common understanding or collusion in fixing price
and output .Competitive oligopoly - Lack of understanding and compete
with each other.
• Partial oligopoly - when industry is dominated by one large firm i.e. price
leader. Full oligopoly - absences of price leadership.
• Syndicated oligopoly - Firms sells their products through centralized
syndicate/channel
• Organized oligopoly -: Firms organize into a central association for fixing
price, output etc.Eg : OPEC
Features • Few sellers

• Interdependence: In oligopoly, when the number of competitors is few,
any change in price, output, and advertising technique, by a firm will have
a direct effect on other
• Advertising and selling costs (Non price competition): There is a great
importance advertising and selling costs in an oligopoly market. It is to be
noted that firms in such type market should avoid price cutting and try to
compete on non-price basis (advertisement bas because if they start under-
cutting one another a type of price-war will emerge which will drivefew of
them out of the market as customers will try to buy from the seller selling
at the cheap price.
• There is no generally accepted theory of group behaviour. In oligopoly, the
members of a group agree to pull together in promotion of common interest or
they fight to promote their individual interests. Each oligopolist closely
watches the business behaviour of the other oligopolists in the industry and
then designs his moves on the basis of some assumptions of how they behave
or are likely to behave.
• Kinked demand curve / Indeterminateness of demand curve: Because
interdependence of the firms in oligopoly and because of inability of a
particular firm to pre the behaviour of other firms, the demand curve facing
an oligopolistic firm loses its definite and determinateness.
The demand curve facing an oligopolist may have a 'kink' at the level of the
prevailing suggesting stickiness in the price level. The kink is formed at the
prevailing price level at because the segment of the demand curve above the 'K'
is highly elastic and the below the 'K' is inelastic.
This difference in elasticities is due to the particular competitive reaction pattern.

Oligopolist believes that if it lowers their price below 'K', his competitors will
follow him and accordingly lower their prices, whereas if he raises the price above
the 'K', his competitors not follow his increase in price.
• Price rigidity: Price rigidity is found in the oligopolist market because when
an oligopolist lowers the price its competitors will feel that, if theydo not
follow the price cut their customers will run away and buy from the firm,
which has lowered the price.
Thus in order to maintain their customers they will also lower their prices.
Thus the upper portion of the demand curve is price elastic.
On the other hand, if a firm increases the price of its product there will be
a substantial reduction in its sales because as a result of the rise in its price,
its customers will withdraw from it and go to its competitors, which will
welcome the customers and will gain in sales. These happy competitorswill
have, therefore, no motivation to match the price rise.
The oligopolist who raises price will lose a great deal and will, therefore,refrain
from increasing price. This behaviour of oligopolists explains the inelastic
lower portion of the demand curve.
Each oligopolist will, thus, adhere to the prevailing price seeing no gain in
changing it and a will be formed at the prevailing price i. e. OP = KQ.
• Substantial barriers to entry: In oligopoly there is no free entry and no
blocked entry, we can say that there is substantial barriers to the entry.
Business Cycle
Meaning, Phases of Business cycle
Fluctuations in aggregate economic activity that an

economy experiences over a period of time, i.e.
periods of prosperity alternating with periods of
economic downturns, are called Business Cycles or
Trade Cycles.
It is reflected in fluctuations in measures of

aggregate economic activity, like Gross National
Product, Employment and Income.
Phases: The four distinct phases of the Business

Cycle are-
a) Expansion / Boom / Upswing),
b) Peak / Prosperity,
c) Contraction / Downswing / Recession), and
d) Trough / Depression).
A Trade Cycle is composed of periods of

a) Good trade characterised by rising prices and low unemployment levels.
b) Bad trade characterized by falling prices and high unemployment levels.
Features of Business cycle
a) Business cycles occur periodically although they do not exhibit the same regularity.
b) The duration of these cycles vary. The intensity of fluctuations also varies.
c) The length of each phase is also not definite.
d) Business cycles generally originate in free market economies.
e) It is difficult to make an accurate prediction of trade cycles before their occurrence.
f) Business cycles are contagious and are international in character. They begin in one country and
mostly spread to other countries through trade relations.
Business Cycle
Phases of Business cycle

Expansion:
1. Increase in national output, employment, aggregate demand, capital and consumer expenditure,
sales, profits, rising stock prices and bank credit.
2. This state continues till there is full employment of resources and production is at its maximum possible
level using the available productive resources.
3. Involuntary unemployment is almost zero and whatever unemployment is there is either frictional
(i.e. due to change of jobs, or suspended work due to strikes or due to imperfect mobility of labour)
or structural (i.e. unemployment caused due to structural changes in the economy).
4. Prices and costs also tend to rise faster. Good amounts of net investment occur.
5. Demand for all types of goods and services rises.
6. There is altogether increasing prosperity and people enjoy high standard of living due to high levels of
consumer spending, business confidence, production, factor incomes, profits and investment.
7. The growth rate eventually slows down and reaches its peak.
Peak:
1. The term peak refers to the top or the highest point of the business cycle.
2. In the later stages of expansion, inputs are difficult to find as they are short of their demand and
therefore input prices increase.
3. Output prices also rise rapidly leading to increased cost of living and greater strain on fixed income
earners.
4. Consumers begin to review their consumption expenditure on housing, durable goods etc.
5. Actual demand stagnates.
6. This is the end of expansion and it occurs when economic growth has reached a point where it will
stabilize fora short time and then move in the reverse direction.
Contraction:
1. The economy cannot continue to grow endlessly.
2. Once peak is reached, increase in demand is halted and starts decreasing in certain sectors.
3. Decrease in input demand pulls input prices down; incomes of wage and interest earners
gradually decline resulting in decreased demand for goods and services.
4. Producers lower their prices in order to dispose off their inventories and for meeting their financial
obligations.
5. Consumers, in their turn, expect further decreases in prices and postpone their purchases. With
reduced consumer spending, aggregate demand falls, generally causing fall in prices. The
discrepancy between demand and supply gets widened further. This process gathers speed and
recession becomes severe.
6. Investments start declining; production and employment decline resulting in further decline in
incomes, demand and consumption of both capital goods and consumer goods. Business firms
become pessimistic about the future state of the economy .
7. The process of recession is complete and the severe contraction inthe economic activities pushes the
economy intothephase of depression.
Business Cycle
Trough and Depression:
1. Depression is the severe form of recession and is characterized by extremely sluggish economic
activities.
2. During this phase of the business cycle, growth rate becomes negative and the level of national
income and expenditure declines rapidly.
3. Demand for products and services decreases, prices are at their lowest and decline rapidly forcing firms
to shutdown several production facilities.
4. A typical feature of depression is the fall in the interest rate. With lower rate of interest, people’s demand for
holding liquid money (i.e. in cash) increases.
5. Industries, especially capital and consumer durable goods industry, suffer from excess capacity.
6. Large number of bankruptcies and liquidation significantly reduce the magnitude of trade and
commerce.
7. At the depth of depression, all economic activities touch the bottom and the phase of trough is
reached. It isa very agonizing period causing lots of distress forall.
Question: How does the economy recover?
Example of business Cycle
Great Depression of 1930:

The world economy suffered the longest, deepest, and the most widespread depression of the
20th century during 1930s. It started in the US and became worldwide. The global GDP fell by
around 15% between 1929 and 1932. Production, employment and income fell. As far as the
causes of Great Depression are concerned, there is difference of opinion amongst economists.
While British economist John Maynard Keynes regarded lower aggregate expenditures in the
economy to be the cause of massive decline in income
and employment, monetarists opined that the Great
Depression was caused by the banking crisis and low
money supply. Many other economists blamed
deflation, over- indebtedness, lower profits and
pessimism to be the main causes of Great Depression.
Whatever may be the cause of the depression, it caused
wide spread distress in the world as production,
employment, income and expenditure fell. The
economies of the world began recovering in 1933.
Increased money supply, huge international inflow of
gold, increased governments’ spending due to World
War II etc., were some of the factors which helped
economies slowly come out of recession and enter the phase of expansion and upturn.
Information Technology bubble burst of 2000: Information Technology (IT) bubble or Dot.Com
bubble roughly covered the period 1997-2000. During this period, many new Internet–based
companies (commonly referred as dot-com companies) were started. The low interest rates in 1998–
99 encouraged the start-up internet companies to borrow from the markets. Due to rapid growth of
internet and seeing vast scope in this area, venture capitalists invested huge amountin these
companies. Due to over- optimism in the market, investors were less cautious. There was a great
rise in their stock prices and in general, it was noticed, that companies could cause their stock
prices to increase by simply adding an "e-" prefix to their name or a ".com" to the end. These
Business Cycle
companies offered their services or end products for free with the expectation that they could
build enough brand awareness to charge profitable rates for their services later. As a result, these
companies saw high growth and a type of bubble developed. The "growth over profits" mentality
led some companies to engage in lavish internal spending, such as elaborate business facilities.
These companies could not sustain long. The collapse of the bubble took place during 1999–2001.
Many dot-com companies ran out of capital and were acquired or liquidated. Nearly half of the dot
–com companies were either shut down or were taken over by other companies. Stock markets
crashed and slowly the economies began feeling the downturn in their economic activities.
Global Economic Crisis (2008-09): The recent global economic crisis owes its origin to US financial
markets. Following Information Technology bubble burst of 2000, the US economy went into recession.
In order to take the economy out of recession, the US Federal Reserve (the Central Bank of US) reduced the rate
of interest. This led to large liquidity or money supply with the banks. With lower interest rates, credit became
cheaper and the households, even with low creditworthiness, began to buy houses in increasing
numbers. Increased demand for houses led to increased prices for them. The rising prices of housing
led bothhouseholds and banks to believe that prices would continue to rise. Excess liquidity with banks
and availability of new financial instruments led banks to lend without checking the creditworthiness
of borrowers. Loans were given even to sub-prime households and also to those persons who had no
income or assets. Houses were built in excess during the boom period and due totheir oversupply in the
market, house prices began to decline in 2006. Housing bubble got burst in the second half of 2007.
With fall in prices of houses which were held as mortgage, the sub - prime households started defaulting
on a large scale in paying off their instalments. This caused huge losses to the banks. Losses in banks
and other financial institutions
had a chain effect and soon the whole US economy and the world
economy at large felt its impact.
Indicators
Meaning: Economists use changes in a variety of activities to

measure the Business Cycle and to predict where the economy
is headed towards. These are called Indicators. There are
three types of Indicators viz. (a) Leading Indicators,
(b) Lagging Indicators, and (c) Coincident or Concurrent
Indicators.
Leading Indicators:
It is a measurable economic factor that changes before the
economy starts to follow a particular pattern or trend.
Examples:
❖ Changes in Stock Prices, Profit Margins and Profits, Indices like Housing, Interest Rates
and Prices, etc. are generally seen as precursors of upturns or downturns.
❖ Value of New Orders for Consumer Goods, Capital Goods, Building Permits for Private Houses,
fraction of Companies reporting slower deliveries, Index of Consumer Confidence and Money
Growth Rate are also used for tracking and forecasting changes in Business Cycles.
Lagging Indicators:
It reflects the economy's historical performance and changes in these indicators are
Business Cycle
observable only after an economic trend or pattern has already occurred.
Examples: Unemployment, Corporate Profits, Labour Cost per unit of Output, Interest Rates,
Consumer Price Index, Commercial Lending Activity, etc.
Coincident or Concurrent Indicators:

It coincides or occurs simultaneously with the business—cycle movements.
It gives information about the rate of change of the expansion or contraction of an economy
more or less at the same point of time it happens.
Examples: Gross Domestic Product, Industrial Production, Inflation, Personal Income, Retail
Sales and Financial Market Trends like Stock Market Prices, etc.
Role/ Importance of Business cycle in Business Decision making
1. Demand Impact.
2. Expansion Decisions.
3. Policies: The period of prosperity creates more opportunities for investment, employment and
production and thereby promotes business. The period of recession or depression reduces
business opportunities and profits.
4. Production Aspects: Businesses have to properly respond to the need to alter production levels
relative to demand.
5. Market Entry / Product Launch
6. The phase of the Business Cycle is important for a new business to decide on entry into the
market, and determines the success of a new product launch.
7. Businesses are required to plan and set policies with respect to product, prices and
promotion, in tune with the stage of the Business Cycle.
Causes of Business Cycle
Internal causes
Fluctuations in Effective Demand: In a free market economy, where maximization of profits is the aim
of businesses, a higher level of aggregate demand will induce businessmen to produce more. As a
result, there will be more output, income and employment.
Fluctuations in Investment: According to some economists, fluctuations in investments are the
prime cause of business cycles. Investment spending is considered to be the most volatile
component of the aggregate demand. Investments fluctuate quite often because of changes in the
profit expectations of entrepreneurs. Or investment may rise when the rate of interest is low in the
economy. Increases in investment shift the aggregate demand to the right, leading to an economic
expansion. Decreases in investment have the opposite effect.
Variations in government spending: Fluctuations in government spending with its impact on
aggregate economic activity result in business fluctuations. Government spending, especially during
and after wars, has destabilizing effects on the economy
Macroeconomic policies: Expansionary policies, such as increased government spending and/or tax
cuts, are the most common method of boosting aggregate demand. This results in booms. Similarly,
softening of interest rates, often motivated by political motives, leads to inflationary effects and decline
in unemployment rates. Anti- inflationary measures, such as reduction in government spending,
increase in taxes and interest rates cause a downward pressure on the aggregate demand and
theeconomy slows down. At times, such slowdowns may be drastic, showing negative growth rates
Business Cycle
and may ultimately end up in recession.
Money Supply: An increase in the supply of money causes expansion in aggregate demand and in
economic activities. However, excessive increase of credit and money also set off inflation in the
economy. Capital is easily available, and therefore consumers and businesses alike can borrow at
low rates. This stimulates more demand, creating a virtuous circle of prosperity.
Psychological factors: If entrepreneurs are optimistic about future market conditions, they make
investments, and as a result, the expansionary phase may begin. The opposite happens when
entrepreneurs are pessimistic about future market conditions. Investors tend to restrict their
investments. With reduced investments, employment, income and consumption also take a
downturn and the economy faces contraction in economic activities.
According to Schumpeter’s innovation theory, trade cycles occur as a result of innovations which
take place in the system from time to time. The cobweb theory propounded by Nicholas Kaldor
holds that business cycles result from the fact that present prices substantially influence the
production at some future date. The present fluctuations in prices may become responsible for
fluctuations in output and employment at some subsequent period.
s
External Causes: The External causes or exogenous factors which may lead to boom or bust:
Wars: During war times, production of war goods, like weapons and arms etc., increases and most
of the resources of the country are diverted for their production. This affects the production of
other goods - capital and consumer goods. Fall in production causes fall in income, profits and
employment. This creates contraction in economic activity and may trigger downturn in business
cycle.
Post War Reconstruction: After war, the country begins to reconstruct itself. Houses, roads, bridges
etc. are built and economic activity begins to pick up. All these activities push up effective demand
due to which output, employment and income go up.
Technology shocks: Growing technology enables production of new and better products and
services. These products generally require huge investments for new technology adoption. This
leads to expansion of employment, income and profits etc. and give a boost to the economy.
Natural Factors: Weather cycles cause fluctuations in agricultural output which in turn cause
instability in the economies, especially those economies which are mainly agrarian. In the years
when there are draughts or excessive floods, agricultural output is badly affected. With reduced
agricultural output, incomes of farmers fall and therefore they reduce their demand for industrial
goods.
Population Growth: If the growth rate of population is higher than the rate of economic growth, there
will be lesser savings in the economy. Fewer saving will reduce investment and as a result, income and
employment will also be less. With lesser employment and income, the effective demand will be less,
and overall, there will be slowdown in economic activities.

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CA Foundation: Economics

SR Name Weightage Marks Distribution

1 Business Economics-Basic 15%-20% 9-12 marks

2 Utility Analysis andConsumer 35-40% 21-24 marks

6 Cost and Revenue

7 Market Forms andPrice – 25%-30% 15-18 marks

8 Business Cycle 15%-20% 9-12 marks

1. Human beings have unlimited wants, and

3. Meaning and role of decision making in Economics

Decision making arises only if there is choice available.

Types of business decisions.

5. Micro and Macro Economics

Difference between Micro and Macro Economics

(vi) The overall level of savings and investment;

6. Nature of Business Economics

The Nature of Business Economics is described as under-

1. Business Economics is a Science-

2. Business Economics is an art as it involves practical application of rules and principles

6. Inter-Disciplinary- Business Economics is interdisciplinary in nature as it

7. Pragmatic Approach- While Micro-Economics is abstract and purely theoretical and

8. Normative and positive –

Points Positive Economics Normative Economics

7. Scope of Business Economics

1. Microeconomics applied to operational or internal Issues:

f) Market Structure and Pricing Policies

i) Risk and Uncertainty Analysis

j) Theory of Capital and Investment.

2. Macroeconomics applied to environmental or external Issues

1) The type of economic system.

Unit 2: BASIC PROBLEMS OF AN ECONOMY AND ROLE OF

2. The 4 Central Economic Problems.

d) What provisions (if any) are to be made for economic growth?

Capitalist economy, also known as free market economy

3.1 Solution to central Economic problems under Capitalist Economy

How to a) An entrepreneur will produce goods and services choosing that

3.2 Characteristics Capitalist Economy.

a) Right to private property.

3.3 Merits Capitalist Economy.

a) Self-regulating and works automatically through price mechanism.

3.4 Demerits Capitalist Economy.

a) Precedence of property rights over human rights.

a) Collective Ownership of means of production-

b) Centrally planned economy-

c) Absence of Consumer Choice-

d) Relatively Equal Income Distribution-

e) Minimum role of Price Mechanism or Market forces-

f) Absence of Competition-Since the state is the sole entrepreneur; there is absence of

1.1 Merits of Socialist Economy

1.2 Demerits of Socialist Economy

a) Economic freedom and existence of private property which ensures incentive to

4.2 Demerits Mixed Economy

1. Utility is Power of a commodity to satisfy human wants. In Other words, want

2. Difference between Cardinal and Ordinal Approach to utility

Cardinal Approach Ordinal Approach

Economists Alfred Marshall Hicks and Allen

3.1 Difference between Total utility and Marginal utility

3.2 Assumptions under Marginal utility analysis and cardinal approach

1. Cardinal Measurability of Utility-

3.3 Law of diminishing Marginal utility