KANNUR UNIVERSITY

SCHOOL OF DISTANCE EDUCATION

SIM ON
MICROECONOMIC ANALYSIS

CONTENTS
1. ECONOMICS AS A SOCIAL SCIENCE; WHAT ECONOMICS IS ABOUT?
Basic concepts:
Scarcity and Choice: Production Possibility Curve: Economic growth; shifts in PPC: Scarcity, choice and
economic growth: The Price System and Alternatives: Uses of Price Theory: Price Theory and Income
Theory: Positive and Normative Theory: Scarcity: Rationality: Basic Economic Problems: Economic
Systems: Primitive economy: Free market economy: Planned or command economy: Mixed economy:
How does Market Mechanism resolve the Basic Economic Problems? Opportunity Cost: Work-leisure
choices: Government spending priorities: Investing today for consumption tomorrow: Making use of
scarce farming land: Economic Models: Role and significance of Assumptions in Economic Models: Role
and significance of Prediction in Models: Role and significance of Analysis in Models: Relative role and
significance of Assumptions, Prediction and Analysis in a Model: Testing of Economic Models:
Equilibrium: Partial and General Equilibrium: Static, Comparative Static and Dynamic Equilibrium:
Classification of Markets: Degree of Monopoly Power and the Market Imperfection:
2. CONSUMERS BEHAVIOUR; HOW DOES CONSUMER RESPOND TO CHANGES AROUND HIM?
Theory of Demand:
Traditional Theory of Demand: Theory of Consumers Behaviour: Characterization of Consumer
Theories: Cardinal Utility Theory: The Law of Diminishing Marginal Utility: Exception to the Law
Diminishing Marginal Utility: Equi -Marginal Utility Principle: Derivation of Demand Curve from EquiMarginal Utility Principle: Derivation of Demand Curve from the Law of Diminishing Marginal Utility:
Cardinal Utility Theory and the Concept of Consumers Surplus: Applications of the Cardinal Utility
Theory: Limitations of the Cardinal Utility Theory: Modifications to Cardinal Utility Theory: Ordinal Utility
Theory: Indifference Curve Analysis: Indifference Curve Approach: Assumptions of the Indifference
Curve Analysis: Indifference curves: Marginal Rate of Substitution: The Rationale of the Law of
Diminishing Marginal Rate of Substitution: Properties of Indifference Curves: Budget Line: Slope of the
budget line: Consumers Equilibrium: Change in Money Income and its Effects on Quantity Purchased of
a Good; Income Consumption Curve [ICC]: ICC of an Inferior Good: Effects of Price Change on Quantity
Purchased of a Good; Price Effect; Price Consumption Curve [PCC]: The PCC of a Geffen Good: Splitting
up of Price Effect into Income Effect and Substitution Effect: Derivation of Demand Curve from
Indifference Curve Analysis: Derivation of Demand curve of the Geffen Good: Geffen Paradox:
Applications of the Indifference Curve Analysis: Superiority of the Indifference Curve Analysis over the
Traditional, Marshallian, Cardinalist Utility Theory: A comparative Study of the Indifference Curve
Analysis and the Traditional Marshallian Cardinal Utility Theory: Limitations of the Indifference Curve
Analysis: Revealed Preference Hypothesis: Axioms of the theory: Assumptions: Methodology:
Advantages of the Revealed Preference Theory: Limitations of the Revealed Preference Theory:
Derivation of indifference curves from the Revealed Preference Theory:

Individual and Market Demand: From Individual Demand to Market Demand: Individual Demand:
Individual Demand Function: Individual Demand Schedule: Individual Demand Curve: Market Demand
Schedule: Market Demand Curve: Elasticity of Demand: Price Elasticity of Demand: Types of Price
Elasticity of Demand: Measurement of Price Elasticity of Demand; Alternative methods: Point Elasticity
Method: Arc Elasticity Method: Factors Determining the Price Elasticity of Demand: Income Elasticity of
Demand: Income Elasticity of Demand and the Engel Curve: Cross Elasticity of Demand: Cross elasticity
of demand for substitutes: Cross elasticity of demand for complementary goods: Uses and Applications
of Elasticity of Demand: The Law of Demand: Movements on the Demand Curve and Movements of the
Demand Curve: Exceptions to the Law of Demand: Linear Expenditure Systems
3. PRODUCERS BEHAVIOUR; HOW DOES PRODUCER RESPOND TO CHANGES AROUND HIM?
Theory of Production: Role of the Firm in Production: Subject matter of the theory of production:
Importance of the theory of production: Meaning and Definition of Production: Production Process:
The Long Run and the Short Run: Production function: Production function taking one factor as variable
and others as fixed: Production function taking all factors as variable factors: Homogenous and Non
homogenous Production Function: Mathematical & Empirical production Function: Cobb-Douglas
Production Function: Short run Production Schedule: Law of Diminishing Returns or Law of Diminishing
Marginal Productivity: Long run Production Function and Isoquants: Variants of long run production
function: Isoquants: Slope of Isoquant; MRTSLK: Why does the MRTSLK diminish? Isoquant Map:
Isoclines: Properties of Isoquants: Laws of Production: Law of Variable Proportions: Laws of Returns to
Scale: Mathematical illustration of the LRS: Varying Returns to Scale: Causes of Varying Returns to Scale:
Technological progress and Production Function: Production Function of Multiproduct Firm; Production
Possibility Curve [PPC]: Derivation of PPC: Slope of the Contract Curve: Derivation of the Production
Possibility Curve: Slope of the Production Possibility Curve: Technical Progress and the PPC: Isorevenue
Curve and Economic Efficiency: Slope of the isorevenue curve: Producers Equilibrium: Single Product
Firm's Equilibrium: Equilibrium of Multiproduct Firm: Derivation of Cost Functions from Production
Functions:
4. PRODUCERS BEHAVIOUR; HOW CAN PRODUCER RESPOND TO CHANGES AROUND HIM?
Theory of Cost: Cost Functions: Traditional Theory of Costs: Short Run Costs: Fixed Costs: Variable
Costs: Average and Marginal Costs: A comparative Analysis of AFC, AVC, AC and MC: Relationship
between the Productivity and Costs: Envelope Relationship [LAC]: Long run Marginal Cost [LMC]: An
alternative Version of LAC: Internal Economies and Diseconomies: External economies and
Diseconomies [Externalities]: Modern Theory of Costs: Short run Costs: Average Variable Cost [AVC]:
Short run Average Cost [SAC]: Short run Marginal Cost [SMC]: Long run Costs: A Comparative Study of
Traditional and Modern Theories of Costs: Superiority of the Modern Theory over the Traditional
Theory:
5. MARKET FOR GOODS; HOW DO BUYERS AND SELLERS RESPOND IN EXTREME MARKET SITUATIONS?
Perfect Competition: Features of Perfect Competition: Individual firms demand curve: Rationale of
Marginalist Rule: Equilibrium of the Firm and Industry: Short run equilibrium of the Firm: Closing down

Point: Derivation of short run supply curve of the firm: Short run Equilibrium of the Industry: Long run
Equilibrium of the Firm: Long run Equilibrium of Industry: Perfect Competition and Optimal Allocation of
Resources:
Monopoly: Meaning and Definition: Pure Monopoly: Natural monopoly: Causes of Monopoly: Features
of Monopoly: Demand and Revenue of the monopolist: Equilibrium of the Monopolist: Short run
equilibrium of the monopolist: Long run equilibrium of the monopolist: A Comparison of Monopoly with
Perfect Competition: Price Discrimination: Possibility and Profitability of Price Discrimination: Bilateral
Monopoly:
6. MARKET FOR GOODS; HOW DO BUYERS AND SELLERS RESPOND BETWEEN EXTREME MARKET
SITUATIONS?
Monopolistic Competition: Evolution of new market model: Concept of Monopolistic Competition:
Product Differentiation: Product Differentiation and the Demand Curve: Features of Monopolistic
Competition: Price and output determination under monopolistic competition [Equilibrium solution in
Large Group Model of Chamberlain]: Assumptions of Chamberlins Large Group Model: Model I:
Equilibrium with entry of new firms: Model II: Equilibrium with price competition: Model III: Equilibrium
with price competition and entry: Theory of Excess Capacity: Chamberlins Interpretation of Excess
Capacity: Advertisement and Selling Costs: Concepts of Industry and Product Group: A comparative
study of monopolistic competition and perfect competition: Monopolistic Competition and Social
Welfare; A critical Analysis: Criticism of Chamberlains Model:
Oligopoly: Meaning and Definition: A few examples to oligopoly: Causes of oligopoly: Features of
Oligopoly: Sweezys Kinked Demand Model: Kinked demand curve: Price and output determination:
Changes in costs and the equilibrium price: Changes in demand and the equilibrium price: Defects of
kinked demand model:
7. MARKET FOR FACTORS OF PRODUCTION; WHO GETS WHAT?
Theory of Distribution: Subject matter: Why do we require a separate theory for factor pricing?
Productivity Concepts: Total Physical Product [TPP]: Average Physical Product [APP]: Marginal Physical
Product [MPP]: Total Revenue Product [TRP]: Average Revenue Product [ARP]: Value of Marginal
Product [VMP]: Marginal Revenue Product [MRP]: Marginal Productivity Theory of Distribution:
Criticism of the theory: Modern Theory of Distribution: Derivation of Demand for factors of production:
Supply of Factors of Production: Factor Price Determination: Criticism of Modern Theory of Distribution:
Product Exhaustion Theorem: Factor pricing under conditions of Perfect competition in Product and
Factor Markets: Factor pricing under conditions of Perfect competition in Factor Market and imperfect
competition [monopoly] in Product Market: Factor pricing under conditions of Imperfect competition
both in Factor Market [monopsony] and in Product Market [monopoly]:
8. WELFARE ECONOMICS; WHAT OUGHT TO BE?

Social Welfare: Meaning and definition: Criteria of Social Welfare: Gross National Product: Benthams
Criterion: Cardinalist Criterion: Pareto Optimality Criterion: Kaldor-Hicks Compensation Criterion:
Bergsons Criterion: Marginal Conditions of Pareto Optimality: Maximum Social Welfare: Grand utility
possibility frontier: Social welfare function: Welfare maximising state or The Point of Bliss:
Determination of the Welfare Maximising Output Mix: Welfare Maximisation and Perfect Competition:

1. ECONOMICS AS A SOCIAL
SCIENCE; WHAT ECONOMICS IS
ABOUT?
Basic concepts:
Scarcity and Choice: Production Possibility Curve: Economic growth; shifts in PPC: Scarcity, choice and
economic growth: The Price System and Alternatives: Uses of Price Theory: Price Theory and Income
Theory: Positive and Normative Theory: Scarcity: Rationality: Basic Economic Problems: Economic
Systems: Primitive economy: Free market economy: Planned or command economy: Mixed economy:
How does Market Mechanism resolve the Basic Economic Problems? Opportunity Cost: Work-leisure
choices: Government spending priorities: Investing today for consumption tomorrow: Making use of
scarce farming land: Economic Models: Role and significance of Assumptions in Economic Models: Role
and significance of Prediction in Models: Role and significance of Analysis in Models: Relative role and
significance of Assumptions, Prediction and Analysis in a Model: Testing of Economic Models:
Equilibrium: Partial and General Equilibrium: Static, Comparative Static and Dynamic Equilibrium:
Classification of Markets: Degree of Monopoly Power and the Market Imperfection:

What economics is about?

Introduction:
Man, basically, is a pleasure seeking animal. Thus, he likes to have more wealth and income,
the means to pleasure. Unfortunately, the resources that the individuals occupy are limited compared to
their needs and wants. Thus, they need to use their resources in optimal way to get maximum possible
satisfaction. How to get more and how to make the best use of what is available is the economic
problem of every economy. This economic problem is the subject matter of the price theory. Prices are
instruments that allocate resources material and human services among alternative uses. Prices
determine what goods and services are produced, how they are produced, and who gets them.
Scarcity and Choice:
Human beings have unlimited numbers of wants, but the resources that they needed to
satisfy these wants are limited and scarce. Quantities of land and natural resources, both renewable and
nonrenewable, are less compared to human needs and wants. Human efforts and skill needed to
produce goods and services also are limited as functions of scarce time. Materials, natural as well as
manmade and mans capacity to utilize them are limited and scarce compared to his needs and wants.
The quantity of food, cloth and shelter is scarce. If we use more resources in the production
of houses, we get less in the production of others. This trade off exists not only between resources but
between individuals as well. Not everyone can have more of everything at the same time. To get more
of some things, people must accept less of other things. If more is given to the Johns, less is available for

the Smiths. To make more food, more people must be farmers and fewer will be available to produce
other things. If more land is devoted to housing, less is available for growing crops. Choice of resources
stems out of these tradeoffs.
Individuals have to choose what they want from among the scarce resources. If they choose
more of a thing, they must choose less of another thing. Scarce resources are allocated according to
their choice. Resource movement from one good to another is guided by price system.
Production Possibility Curve:
The choice at the national level can be explained with the use of production possibility curve
(PPC). Production possibility curve is a graphical device which shows various combinations of two
commodities that can be produced with a given resource endowment.
We imagine a simple economy producing only wheat and cloth. As in figure 001, if all the
resources are used for the production of wheat the economy can produce OA units of wheat, but no
cloths. On the other hand, if all the resources are used for the production of cloth the economy can
produce OB units of cloth, but no unit of wheat. If the resources are divided between wheat and cloth,
the economy can produce a combination of wheat and cloth. The curve AB in figure 001 is the PPC. It
shows all the possible combinations of wheat and cloth which could be produced, given the factor
endowment. All combinations of the PPC are technically efficient. The region above AB curve shows
desirable but not possible combinations (C is an example to this). Combinations inside the area OAB
(below PPC) are possible but not desirable since they are technically inefficient (D is an example to this).
The PPC is concave to the origin. Its slope is determined by the MRPTxy [Marginal Rate of
Product Transformation of X for Y] which is defined as the rate at which X good is transformed into Y
good, given the factor endowment. Ipso facto, the MRPTxy is increasing as we move from left to right
along the PPC. This is the reason for the concavity of the PPC.

Figure 001

Economic growth; shifts in PPC:

PPC can shift outward or inward. PPC is normally shifting outward. There are two reasons for
this.
1. Enhancement of factor endowment and
2. Improvement in technology
Improvement in technology enables us to get more output from the same quantity of
resources. The PPC shifts outward as the economy grows with technological improvements and /or
enhanced factor endowment.
The figure 002 illustrates the shift in PPC due to economic growth. If productive resources
increase the PPC will shift outward to the right, showing that more of both the goods can be produced
than before. The new PPC would be A1B1. Further, when the economy makes progress in technology the
PPC will shift to the right indicating the possibility of producing more of both the goods given the factor
endowment.

Figure 002

Scarcity, choice and economic growth:

The shifting of PPC outward due to economic growth also depends upon choices. This is
shown in figure 003 and figure 004.

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Figure

003

Figure 004

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Figure 003 shows an economy which allocates fewer resources for investment goods and
more resources for consumption goods. This type of allocation will shift outward the PPC marginally.
This shows low economic growth. On the other hand, as figure 004 shows, the economy allocates more
resources for investment goods and fewer for consumption goods. As a result, the PPC shifts outward by
a large extent. This indicates high economic growth. In short, economic growth itself depends upon the
choices made by the economy between investment goods and consumption goods.
The Price System and Alternatives:
When choices must be made, prices are helpful. Where each scarce resource carries a price,
each person can decide whether a unit of a resource is worth its price. The price serves to allocate the
good or service among potential users. Prices play two important roles. They are:
1. Giving information:
Their first role is to give information. A price indicates to all concerned the value of a good or
service. Such information is important to households in planning consumption expenditures and to firms
in planning production activities. If the right information is given through prices, the plans of consumers
and producers will be consistent. That is, buyers will want to by what sellers want to sell.
2. Giving incentives:
The second role of price is to give incentives. When a price is actually paid or received, the
parties to a sale take a keen interest in the price. A change in price can induce many changes in
behaviour. If plans are inconsistent, a change in price may induce buyers and sellers to make new
decisions about buying and selling in ways that will achieve consistency1.
No individual will work and save if adequate incentives are not provided in the form of high
wage and interest. Similarly, the firms will not produce goods and services and bear risk if sufficient
incentives (profits) are not given to them. Profit earned by the firms depends upon prices of goods and
services produced and the prices of resources. Profit serves as incentives for the firm to produce goods
and services. Firms can earn more profits if they produce goods and services more efficiently.
The two roles of prices go together. Prices must be announced on everything, but if they are
not actually used for transactions, they will be ignored. Or prices might give strong incentives, but if they
carry the wrong information, the plans of buyers and sellers will be inconsistent. Prices are important for
both information and incentives.
A system of prices to carry information and incentives throughout an economy is essential to
a complex, modern society. An industrial economy has literally millions of prices. Some prices change
continuously, some change daily; few stay constant more than a few months at a time. As consumption
and production conditions change, prices change to reflect the values. Without prices the modern
1

Watson & Getz; Price Theory & Its Uses, Revised 5th Edition 1995, A.I.T.B.S. Publishers & Distributors, and
Delhi.

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economy could never possess the subtlety, the attention to detail, and the adaptiveness that are
achieved with prices.
With out prices resources must be allocated in other ways. If resources are scarce, yet are
made available without charge, consumers must line up to get their share. Or some other formal system
has to be used to decide who gets what. Government can provide the goods to people through a
distribution centre. In a traditional society, a caste system may define who is entitled to particular
goods. Although these alternative systems have actually allocated resources in many societies, they
provide little information about the relative values of different commodities and they offer little
incentives for users to put resources to their best uses. Thus, price systems dominate modern
economies. Price theory, however, analyses the allocation of resources and can be used to evaluate
nonprice systems of allocation as well as allocations resulting from the use of markets and prices.
In a free enterprise economy market prices are strong guidelines for the allocation of
resources. However, in other forms of economy market prices may not be the sole guidelines for
resource allocation. For instance, in a centrally planned economy like that of the former Soviet Union,
market prices do not exist, and, instead of them, planning is the way to allocate resources. Practically, in
most economies, market, through its price networks, and the state, through its planning systems,
together allocate the resources. Thus, the state and market are the two extreme entities for resource
allocation. Of these extremities, which one is more efficient than the other is a matter of age old
controversy. State versus Market is a topic of hot debate even today. Trial and Error Model of Oscar
Lange is one of the powerful theoretical rationales of efficiency of state in resource allocation. However,
capitalist counterpart of this socialist model seen in the mainstream economic theory does not agree
with efficiency in resource allocation through states planning. The mainstream price theory hardly
tolerates any alternative to the price system in efficient resource allocation.
Uses of Price Theory:
Price theory is useful to understand the operations of a market economy, either laissez faire
or regulated. None of the modern economies is fully capitalist or socialist. Modern economies are mixed
in character. They consist of both private and public enterprises. These economies differ only in relative
share and performance of public and private enterprises.
Knowledge of price theory is indispensable to anyone who wants a clear understanding of
how the private enterprise sector of the economy functions. It is useful to know the functions and
efficiency of the state and the public sector as well. Moreover, it is useful to analyse the relative
performance of private and public sectors. Following are a few important hints to the uses of price
theory.
1. It explains the determination of prices of various goods [product pricing] and resources [factor
pricing].
2. It explains the conditions of efficiency both in consumption and production.
3. It explains how through market mechanism goods and services produced in the economy are
distributed.

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4.
5.
6.
7.
8.

It is useful to analyse the operations and relative performance of individual firms and industries.
It is useful to observe the efficiency of public enterprises and public distribution system.
It is useful to understand the impact of regulatory agencies.
It is useful to evaluate the efficiency of investments in various private and public projects.
It is useful to understand how the producers and consumers are optimizing their scarce
resources.
9. It is useful to understand how the salaries and allowances of employees are revised.
10. It is useful to understand how the scarce resources flow into their most efficient uses.
11. It is useful to understand how the markets, both product and factor, are cleared.
12. It is useful to find proper curative and preventive measures in times of crisis due to exogenous
factors.
13. It is useful to provide a strong foundation to the macroeconomics.
14. It is useful to understand the elasticity of tax and taxable capacity of nation.
Price Theory and Income Theory:
The two main branches of modern economic theory are price theory and income theory.
Price theory is often referred to as microeconomics. It deals with analysis of small units of the economy.
It is concerned with the study of product pricing, factor pricing and economic efficiency. Its counter part,
the income theory is also known as macroeconomics. It is the analysis of the economy as a whole. It is
concerned with the determination of broad aggregates of the economy like national income, national
output, employment, inflation, balance of payments and inequality. The basic issues of macro
economics are unemployment, inflation, economic growth, inequality and their interrelations. Thus, the
basic contents of the macroeconomics are: the theory of national income and employment, theory of
general price level [inflation and deflation], monetary and fiscal policies and the theory of economic
growth.
Positive and Normative Theory:
Economic theory can be used to describe an economic phenomenon or to prescribe certain
things to be happened. Thus it can be descriptive or prescriptive. Thus, the economic theory can broadly
be divided into two as positive theory and normative theory.
Descriptive theory is called positive theory. Positive theory is concerned with facts. It states
what is but not what ought to be. Quantity demanded of a commodity is an inverse function of its
price is an example to positive statements. We can see this type of positive statements in positive
economics. Positive theory connects events and says one causes the other.
Normative theory prescribes an event or policy action. It entails value judgments as to the
desirability of certain events. Employment Guaranty Programme is to be implemented to eradicate
rural poverty is a prescription of a policy action. This type of prescriptions can be seen in normative
theory. Normative theory says what ought to be. It is dealing not only with facts but with values as well.
Some economists make only positive theories as they view that when operating at
normative level economics is no longer a pure science. They are very wary of making any normative

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statement. For them, the problems of positive theory, of understanding just how things work, are
difficult enough. Moreover, they recognize the serious difficulties in evaluating alternative outcomes.
Some other economists suggest that systematic evaluation of outcomes is desirable. In this regard it is
safe to conclude that the economics is both positive and normative.
Scarcity:
Economics is the study of how economic agents, like producers and consumers, collectively
or individually choose scarce resources that have alternative uses to satisfy wants which are unlimited
and of varying degrees of importance. It explains how economic agents could solve economic problems
optimally. Scarcity of resources is the main constraint in optimizing economic problems. Since resources
are scarce, economic agents will have to choose among alternatives to find the optimal solution. Thus,
the problem of choice, and hence the very crux of economics, arises from scarcity of resources. That is,
the root cause of all economic problems is the scarcity. For instance, unemployment is essentially the
scarcity of jobs and inflation, the scarcity of goods.
Lionel Robbins defined economics in terms of this basic economic problem. According to him,
economics is a social science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses.
Rationality:
Economics assumes that the economic agents are rational. Rationality refers to acting for
optimal result keeping in view the ends and means; the objectives and constraints. Rationality implies
that: 1) All possible courses of actions are known to economic agents, 2) Economic agents are able to
separate all such courses of actions into two categories: feasible and unfeasible, 3) Based on the
available information, the economic agents are in a position to assess the outcomes of choosing a
particular feasible course of action among a set of alternatives, 4) The economic agents can rank the
outcomes of alternatives according to priorities, and 5) The economic agents can choose the course of
action which occupies the highest position in the order of priority.

Basic Economic Problems:

Every economy faces three fundamental questions in its functioning. They are:
1. What goods and services are to produce and in what quantity? [Production]
2. How to produce these goods and services? [Allocation]
3. How the goods and services so produced are to be distributed among the households?
[Distribution]
Economic Systems:
An economic system is best described as a network of organisations used by a society to
resolve the basic problem of what, how and for whom to produce. There are various forms of economic
systems to deal with the basic economic problems. The nature of an economic system depends on how

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the basic economic problems are resolved and who co-ordinates the decisions of millions of economic
agents. The two extremities of economic systems are the laissez faire capitalism and the command
economic system. Between these extremities we can see a wide variety of mixed economic systems.
Practically, most economies of the contemporary world are mixed in nature though they vary
considerably in degrees of compromise between capitalism and socialism [command economy].
Economic systems can be classified into the following categories.
1. Primitive economy: Where decisions about what, how and for whom to produce are based on
custom and tradition. Land and natural resources are typically held in common. The economy works
according to the principle, each according to his ability to each according to his needs.
2. Free market economy: Where households own resources and free markets allocate resources
through the workings of the price mechanism. An increase in demand for a good or service raises its
price and encourages firms to switch additional resources into the production of that good or
service. The amount of products consumed by households depends on their income and household
income depends on the market value of an individuals work and his entitlement on productive
resources. In a free market economy there is a limited role for the government. Indeed in a highly
free market system, the government limits itself to protecting the property rights of people and
business using the legal system, and it also seeks to protect the value of money or the value of a
currency. In a market economy, market mechanism co-ordinates the economic decision making of
millions of economic agents. It helps the economic system decide what to produce, how to produce
and for whom to produce. Consumer demand determines what to produce, competition forces the
firms to decide how to produce most economically and factor ownership and factor prices
determine the purchasing power of individuals, which determines for whom the goods are to be
produced.
3. Planned or command economy: In a planned or command system typically associated with a
socialist or communist economic system, scarce resources are owned by the state (i.e. the
government). The state allocates resources, and sets production targets and growth rates according
to its own view of people's wants. The final income and wealth distribution is decided by the state.
In such a system, market prices play little or no part in informing resource allocation decisions and
queuing rations scarce goods. In a command economy, central planning authority determines the
resource allocation, production targets and prices [accounting prices]. In such an economy, the state
owns all the productive resources like land, factories, financial institutions, and distribution stores.
Thus, the state through the central planning process determines the production, allocation and
distribution.
4. Mixed economy: In a mixed economy, some resources are owned by the public sector
(government) and some resources are owned by the private sector. The public sector typically
supplies public, quasi-public and merit goods and intervenes in markets to correct perceived market
failure. In a mixed economy, market mechanism and planning process together resolve the basic
economic problems. In such an economy, government supplies roads, railways, defense, pension,
health and educational services directly to the citizens. Profit motivated private firms as well as joint
enterprises also are allowed to supply many of these services. In addition to the provision or supply
of public or private goods, the government also interferes in the markets to control prices and acts
for distributional changes
How does Market Mechanism resolve the Basic Economic Problems?

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In a market economy, consumers demand determines what goods and services are to be
produced and how much of each good and service to be produced. Consumers are assumed to act in a
rational manner so as to maximise their economic welfare. They spend their income [which they earned
by supplying productive services] on various products in such a way so as to maximise their economic
welfare.
Given the consumers demand, the firms decide how to produce the required goods and
services in the most efficient manner so as to maximise their profits. This results in the optimal
allocation of scarce resources. The resolution of distribution problem is done by the ownership
[entitlement] pattern of factors of production and the system of pricing [factor ownership and factor
pricing].
Figure 005

Opportunity Cost:
There is a well known saying in economics that there is no such thing as a free lunch! Even
if we are not asked to pay a price for consuming a good or a service, scarce resources are used up in the
production of it and there must be an opportunity cost involved. Opportunity cost measures the cost of
any choice in terms of the next best alternative forgone. Many examples exist for individuals, firms and
the government.

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Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a week is the lost
wages foregone. If you are being paid Rs60 per hour to work at a local factory, if you choose to take a
day off from work you might lose Rs480 from having sacrificed eight hours of paid work.
Government spending priorities: The opportunity cost of government spending of Rs10 billion on
investment in health service might be that Rs10 billion less is available for spending on education or
transport network.
Investing today for consumption tomorrow: The opportunity cost of an economy to invest resources in
new capital goods is the current production of consumer goods sacrificed. We may have to accept lower
living standards now to accumulate more capital equipment so that long run living standards can
improve.
Making use of scarce farming land: The opportunity cost of using arable farmland to produce wheat is
that the land cannot be used in that production period to harvest potatoes.
Economic Models:
The stylized world envisioned by economic theory seems only a distant cousin to the [real]
world . The real world that we see around us is much complicated. Interactions and the cause and
effect relations that we see in economic theory are simplified [sometimes, oversimplified] versions of
complicated reality. Abstraction from unimportant detail is necessary to understand the functioning of
anything as complex as an economy.
2

Economic theory aims at the construction of models which describe the economic behaviour
of individual units [consumers, firms, government agencies, etc.] and their interactions which create
economic system of a region, a country or the world as a whole. The purpose of economic models is to
discover the real world economic phenomena. The real world economic phenomena are very
complicated, and thus, are tough to understand as such. Economic models abstract the reality to make it
simple and understandable.
An economic model is a simplified representation of a real economic situation. It, however,
includes the main features of the real economic situation which it represents. A model airplane lacks
many of the features of a real airplane, but the model exhibits the essentials of what an airplane is and
what it does. So, too, economic models are stripped down to the essentials. A model of the pricing of
carpet does not include the tens of thousands of facts that have to do with carpet.
A models power stems from the elimination of irrelevant detail, which allows the economist
to focus on the essential features of the economic reality he is trying to understand. It implies
abstraction from reality which is achieved by a set of meaningful and consistent assumptions. The
assumptions are used to simplify the phenomenon or behavioural pattern.

William J. Baumol and Alan S. Blinder; Economics; Principles and Policy; 3rd Edition, HBJ

18

The degree of abstraction from reality depends on the purpose for which the model is
constructed. There is no such thing as one right degree of abstraction for all analytical purposes. The
optimal degree abstraction depends on the objective of the analysis. A model that is a gross
oversimplification for one purpose may be needlessly complicated for another.
Since many things are left out, the models must be used cautiously. In a particular application
one of the omitted things might turn out to be crucially important. A model in which business executives
always act so as to maximize their profits has to be modified when it is applied in circumstances where
they dont.
Role and significance of Assumptions in Economic Models:
As we have already mentioned, a model achieves abstraction from reality by a set of
assumptions. The series of assumptions in any particular model are chosen carefully so as to be
consistent, to retain as much realism as possible, and to attain a reasonable degree of generality. The
number and nature of assumptions will depend on the purpose of building the model
Assumptions play a significant role in economic models. They should be consistent. They
should also be realistic as much as possible. However, there is no agreement among economists
regarding the realism of assumptions in a model. The views of economists range from Friedmans
position to Samuelsons position. Friedman argues that the predictive capacity but not the realism of
assumptions is important as far as an economic model is concerned. Samuelson, on the other hand,
holds the view that the realism of assumptions is one of the most important attributes of an economic
model.
Role and significance of Prediction in Models:
A model should not be judged simply in terms of the realism of the assumptions underlying
it. Rather, a models validity depends also on the degree of fairness in prediction. A model based on less
realistic assumptions may predict a phenomenon accurately. For instance, the assumption that
consumers act rationally in making buying decisions may be inconsistent with modern psychology, yet
theories that predict consumers behaviour based on rational calculations may predict economic
behaviour well enough.
Role and significance of Analysis in Models:
Besides prediction, an economic model also allows analysis. Analysis implies the explanation
of the behaviour of economic units, consumers or producers. From a set of assumptions we derive
certain laws which describe and explain with an adequate degree of generality the behaviour of
consumers and producers.
Relative role and significance of Assumptions, Prediction and Analysis in a Model:
What is the most important attribute of a model? The answer depends on its purpose, the
use to which one puts the model. Predictive capacity is important when the purpose of the model is

19

forecasting the effects of a certain change in a variable. Realism of assumptions and analytical power are
important when the model is used to explain why a system behaves as it does. Ideally a model should
fulfil all the criteria. It should be the best predictor of the behaviour of the system and provide the most
complete explanation of this behaviour on the basis of fairly realistic assumptions. However, such an
ideal model is rarely seen in practice, one reason being that the relationships in a model change
continuously over time. Another reason is the inadequate skill of the model builders. A person who gives
the best forecasts does not necessarily also provide the most accurate explanations. The model builder
must specify the primary purpose of his model before constructing it. He should then build the model in
such a way as to best attain its primary objective, even if this course of action means that the model will
not be suitable for other secondary objectives. In particular, the number and nature of the assumptions
of the model, its degree of detail [or the level of aggregation] and the amount of information it can yield
will depend on the purpose of building the model3.
Testing of Economic Models:
Economic models can be tested by statistical analysis of factual data. It can be executed
quickly with computers. A model cannot be confirmed by an appeal to facts; but it can be refuted. If the
refutation is conclusive, the model should be thrown away and a new and better one devised. Thus, a
model should be constructed in such a way so as to be testable, that is, to be capable of being verified or
refuted when confronted with the true economic facts.
Equilibrium:
Price theory also explains how consumers, producers or firms attain their equilibrium.
Equilibrium refers to a condition which is stable and has no tendency to change. If a person or an
economic entity considers a situation as the best attainable under the prevailing conditions, it implies
that any change from it is undesirable. The current situation is, therefore, that of equilibrium.
Partial and General Equilibrium:
We can study economic relations by applying the ceteris paribous assumption or otherwise.
If we use the ceteris paribous assumption in economic model the approach is called the partial
equilibrium approach. Under this approach we assume that other things are constant. Here we seek
how the relevant variables get in equilibrium, given the other things. Alfred Marshall is called as the
champion of the partial equilibrium approach.
On the other hand, under general equilibrium approach, we seek how the general
equilibrium of a set of variables is established simultaneously. Simultaneous equation system helps us in
this regard. Leon Walras is called the champion of the general equilibrium approach.
Static, Comparative Static and Dynamic Equilibrium:

A. Koutsoyiannis; Modern Microeconomics, 2nd Edition 1979, Macmillan.

20

Economic theory makes use of various methods to analyse equilibrium. They are static,
comparative static and dynamic methods. Until recently, the whole price theory in which we explain
determination of equilibrium prices of products and factors in different market categories was mainly
static analysis. This was because the values of the various variables, such as demand, supply, and price
were taken to be relating to the same point or period of time. Micro static equilibrium is the equilibrium
at given moment of time under perfect competition, determined by the intersection of the given
demand and supply functions.
Static analysis is concerned with explaining the determination of equilibrium values with a
given set of data and dynamic analysis explains how with a change in the data the system gradually
grows out from one equilibrium position to another. Midway between the static and dynamic analyses is
the comparative static analysis. Comparative static analysis compares one equilibrium position with
another when the data have changed and the system has finally reached another equilibrium position. It
does not analyse the whole path as to how the system grows from one equilibrium position to another
when the data have changed; it merely explains and compares the initial and final equilibria.
Static analysis gives us still picture of equilibrium for observation. Comparative static
analysis facilitates a comparative study of still pictures of equilibria. Dynamic analysis presents us movie
picture of equilibria to know how the initial equilibrium was disturbed and the new one was established
and also the process of change from one equilibrium position to another.
Classification of Markets:
Markets can be classified into various categories on the basis of different criteria. An
analytically useful classification of the market is possible on the basis of the following criteria.
A. Number of buyers and sellers,
B. Degree of homogeneity of products,
C. Availability and closeness of substitutes,
D. Possibility of entry and exit, and
E. Interdependence among the firms
Based on these criteria, markets are classified into the following categories:
1. Perfect competition:
Perfect competition is a market structure characterised by the existence of a large number of
sellers selling homogenous products, which are perfect substitutes of each other, to a large number of
buyers under conditions of free entry and exit.
2. Monopoly:

21

Monopoly is a market with one and only one seller selling a product, which has no form of
substitute, to a large number of buyers under conditions of strong barriers to entry of sellers.
3. Monopolistic Competition:
Monopolistic Competition is a market in which a large number of sellers sell their differentiated
products, which are close substitutes to each other, to a large number of buyers in a situation of free
entry and exit.
4. Oligopoly:
Oligopoly is a form of market in which a few sellers, whose actions are closely interdependent,
sell their homogenous or differentiated products to many buyers under conditions of strict ban on entry
of sellers.
5. Duopoly:
Duopoly is the limiting case of oligopoly in which two firms, whose actions are closely
interdependent, are selling their homogenous or differentiated products to many buyers under
conditions of strict ban on entry of sellers.
6. Monopsony:
Monopsony is a market in which many sellers sell their products to a single buyer in a situation
where entry of new buyer is strictly banned.
7. Oligopsony:
Oligopsony is a market characterised by a few buyers buying a product from many sellers in a
situation of strong barriers to entry of buyers.
8. Bilateral monopoly:
Bilateral monopoly is the market where a single seller sells a product to a single buyer under
conditions of strict ban on entry of both sellers and buyers.
Degree of Monopoly Power and the Market Imperfection:
Degree of Monopoly Power4 [ = (P-M) P] is a good measure of imperfection of a market. The
greater the value of degree of monopoly power, the greater will be the degree of imperfection of the
market. For instance, monopoly, the most imperfect form of market, is with the highest degree of
monopoly power. Whereas, perfect competition, the most perfect form of market is with the lowest
degree of monopoly power [=0].
**********
4

Where, P is the price and M, the marginal cost.

22

Sample Questions:
Part A; Multiple Choice Questions:
1. Basic reason for choice is
A] Rationality. B] Risk. C] Utility. D] Scarcity.
2. An improvement in technology leads to ------------- in PPC.
A] Upward shift. B] Downward shift. C] No change. D] Undesirable change.
3. Basic economic problems of an economy are not much related to
A] Production. B] Allocation. C] Exchange. D] Distribution.
4. PPC shows ------------- between two products
A] Trade off. B] Association. C] Exchange. D] Distribution.
5. Who among the following was the champion of General equilibrium approach?
A] Marshall. B] Clark. C] Walras. D] Jevons.
6. Static analysis gives a ------------------ of equilibrium.
A] Movie picture. B] Still picture. C] Both movie picture and still picture. D] Either a
movie picture or a still picture
7. Under perfect competition degree of monopoly power is -----------A] Greater than zero. B] Less than zero. C] Equal to Zero. D] Equal to one.
8. ------------- implies abstraction from reality which is achieved by a set of meaningful and consistent
assumptions.
A] Equations. B] Functions. C] Economic functions. D] Economic model.
9. Who among the following argues that the predictive capacity but not the realism of assumptions is
important as far as an economic model is concerned?
A] Samuelson. B] Schumpeter. C] Friedman. D] Robinson.
10. -------------- refers to a condition which is stable and has no tendency to change.
A] Economic model. B] Economic system. C] Equilibrium. D] Economic function.
Part B; Short Questions:
1. What is economic model?

23

2. What are the basic problems of an economy?

3. What is opportunity cost?
5. Define oligopoly.
6. What is PPC?
7. What is Partial Equilibrium Approach?
8. What is comparative static analysis?
9. Define General Equilibrium Approach.
10. What is an economic system?
Part C; Short Essay Questions:
1. What is role of assumption in an economic model?
2. How does market mechanism solve the basic problems of an economy?
3. Briefly explain the uses of price theory.
4. What is role of prediction in economic model?
5. Explain the trade of between products and scarcity of resources with the help of PPC.
Part D; Essay Questions:
1. Which are the important economic systems? How do they solve basic economic problems?
2. Define economic model. Explain the relative role of assumptions, analysis and prediction in economic
models.
3. Explain the role and significance of scarcity and choice.
4. Explain the important types of markets?

24

2. CONSUMERS BEHAVIOUR; HOW

DOES CONSUMER RESPOND TO
CHANGES AROUND HIM?
Theory of Demand:
Traditional Theory of Demand: Theory of Consumers Behaviour: Characterization of Consumer
Theories: Cardinal Utility Theory: The Law of Diminishing Marginal Utility: Exception to the Law
Diminishing Marginal Utility: Equi -Marginal Utility Principle: Derivation of Demand Curve from EquiMarginal Utility Principle: Derivation of Demand Curve from the Law of Diminishing Marginal Utility:
Cardinal Utility Theory and the Concept of Consumers Surplus: Applications of the Cardinal Utility
Theory: Limitations of the Cardinal Utility Theory: Modifications to Cardinal Utility Theory: Ordinal Utility
Theory: Indifference Curve Analysis: Indifference Curve Approach: Assumptions of the Indifference
Curve Analysis: Indifference curves: Marginal Rate of Substitution: The Rationale of the Law of
Diminishing Marginal Rate of Substitution: Properties of Indifference Curves: Budget Line: Slope of the
budget line: Consumers Equilibrium: Change in Money Income and its Effects on Quantity Purchased of
a Good; Income Consumption Curve [ICC]: ICC of an Inferior Good: Effects of Price Change on Quantity
Purchased of a Good; Price Effect; Price Consumption Curve [PCC]: The PCC of a Geffen Good: Splitting
up of Price Effect into Income Effect and Substitution Effect: Derivation of Demand Curve from
Indifference Curve Analysis: Derivation of Demand curve of the Geffen Good: Geffen Paradox:
Applications of the Indifference Curve Analysis: Superiority of the Indifference Curve Analysis over the
Traditional, Marshallian, Cardinalist Utility Theory: A comparative Study of the Indifference Curve
Analysis and the Traditional Marshallian Cardinal Utility Theory: Limitations of the Indifference Curve
Analysis: Revealed Preference Hypothesis: Axioms of the theory: Assumptions: Methodology:
Advantages of the Revealed Preference Theory: Limitations of the Revealed Preference Theory:
Derivation of indifference curves from the Revealed Preference Theory:
Individual and Market Demand: From Individual Demand to Market Demand: Individual Demand:
Individual Demand Function: Individual Demand Schedule: Individual Demand Curve: Market Demand
Schedule: Market Demand Curve: Elasticity of Demand: Price Elasticity of Demand: Types of Price
Elasticity of Demand: Measurement of Price Elasticity of Demand; Alternative methods: Point Elasticity
Method: Arc Elasticity Method: Factors Determining the Price Elasticity of Demand: Income Elasticity of
Demand: Income Elasticity of Demand and the Engel Curve: Cross Elasticity of Demand: Cross elasticity
of demand for substitutes: Cross elasticity of demand for complementary goods: Uses and Applications
of Elasticity of Demand: The Law of Demand: Movements on the Demand Curve and Movements of the
Demand Curve: Exceptions to the Law of Demand: Linear Expenditure Systems

25

THEORY OF DEMAND
Introduction to Traditional Theory of Demand:
What makes the exchange value or price of a good is a question that asked by scholars
from time immemorial. In their discussions on this topic they came across a puzzle, later called as the
water-diamond paradox. Even philosophers like Aristotle had discussed this paradox with their disciples
to seek a solution. However, this paradox was introduced in economics by Adam Smith, the father of
political economy, while he was delivering a lecture on the theory of demand to his students in Glasgow
University. He said, commonsense suggests that the price of a commodity must somehow depend on
what that good is worth to consumers on the amount of utility that commodity offers. Yet, he pointed
out, there are cases in which a goods utility apparently has little influence on its price. He gave us two
examples, diamond and water. Water, which is very essential to life and there fore undoubtedly of
enormous value to us, is generally sold at a very low price. On the other hand, diamonds cost thousands
of rupees even though their use value [utility] is quite limited. This puzzle, called water-diamond
paradox, remained unresolved for about a century since its appearance in 1760s.
The water-diamond paradox helped stimulate the invention of what is perhaps the most
powerful set of tools in the economists toolkit. Path breaking contributions of economists like Alfred
Marshall are worth mentioning in this regard.
As already mentioned, for about a century, the paradox remained as unresolved. Adam
Smith and his successors had approached this paradox with their total utility concept. As it is well known
today, the price of any commodity has no much dependence on its total utility. Price may be high or low
irrespective of high or low total utility. For instance, water, being a very essential good for life, has high
total utility and diamonds, having limited use and it not being an essential good for life, have lesser total
utility. But the price of diamonds far exceeds that of water.
William Stanly Jevons, related to whom the Utilitarian Era [Jevonian Era] is popularly
known, invented a marginal concept of utility, called the Final Degree of Utility. With this tool he was
about to resolve the paradox. However, his attempt to resolve the paradox was not successful since his
tool was not scientific and sharp. A few years after Jevons invention, Marshalls Law of Diminishing
Marginal Utility [Law of Satiable Wants] and Equi-Marginal Utility Principle [Law of Substitution]
successfully resolved the paradox, as a great discovery to end the mystery5.
Theory of Consumers Behaviour:
Price of every commodity in a competitive market is determined by the twin forces of
market, namely the demand and the supply. Adam Smith identified these forces and their role in each
market and in the whole economy, and he called them as the Invisible Hands of Market Mechanism.
However, he did not develop a complete theory of either the demand or the supply.

Details of how the paradox is solved are explained at a subsequent part of this chapter

26

A scientific theory of demand should find all the important determinants of demand.
Many theories available until recently have identified a very few determinants of demand, and above all,
they have reduced the role of demand theory to the establishment of the Law of Demand which states
that the quantity demanded of a good is an inverse function of its price, ceteris paribous. However,
unlike this traditional approach, some recent developments in the theory of demand take a multiplicity
of demand determinants simultaneously for observation. According to this modern approach to the
demand theory, demand, being it a multivariate function, should be analysed by taking all the important
demand determinants simultaneously in to account.
According to the traditional theory of demand, the major factors determining the demand
for a good are its own price, prices of other goods, consumers income and tastes. Marshall and some
Utilitarians like H H Gossen, adopting the partial equilibrium analysis [using ceteris paribous
assumption], enquired the relationship between quantity demanded of a good and its price. They
wanted to prove the inverse relationship between quantity demanded of a good and its price, that is,
the Law of Demand. For this purpose they developed the Cardinal Utility Theory which presents us the
celebrated Law of Diminishing Marginal Utility and the Equi-Marginal Utility Principle.
As a challenge to the Cardinal Utility Theory, J R Hicks and R G D Allen6 developed their
Ordinal Utility Theory, the Indifference Curve Analysis.
Questioning the subjectivity of Cardinal and Ordinal utility theories, Paul A Samuelson7 put
forward his Choice Reveals Preference Hypothesis, the Revealed Preference Hypothesis, which is a
utility free approach to the consumers behaviour.
All these theories with the help of some assumptions establish the Law of Demand. These
theories, however, explain the consumers behaviour only under conditions of certainty, that is, in the
situation of consumers choice involving no risk.
Von Neumann and Oscar Morgenstern8 developed a theory of consumers behaviour,
popularly known as the Modern Utility Theory [N-M Index], which explains consumers choice involving
risk. Friedman, Savage9 and Markowitz made further extension to the utility theory by incorporating the
nature of change in income in to the analysis. All these developments associated with the modern utility
theory belong to the cardinal mainstream. Another outstanding theoretical development in the field of
theory of consumers behaviour is the State Preference Theory10. It, like the N-M Index, deals with
consumers behaviour under conditions of uncertainty. How ever, unlike the N-M Index, it deals with
uncertain states which consist of certain events.

J. R. Hicks and R. G. D. Allen; A reconstruction of the Theory of Value, 1928

P. A. Samuelson; Consumption theory in Terms of Revealed Preference, Economica, N. S. XV [1948]
8
J. V. Neumann and O. Morgenstern; Theory of Games and Economic Behaviour, 1949
9
M. Friedman and L. J. Savage; The Utility Analysis of Choice Involving Risk, Political Economy,
Aug.1948
10
John Green; Consumer Theory
7

27

Table 001

MARSHALLIAN THEORY

JEVONIAN THEORY

GOSSEN'S THEORY

28

UNCERTAINTY

CERTAINTY

BEHAVIOURIST

INTROSPECTIVE

ORDINAL

THEORY

CARDINAL

CHARECTERISATION OF CONSUMER THEORIES

HICKSIAN THEORY11

X
12

LANCASTRIAN THEORY

SAMUELSONIAN THEORY
X

NEUMANN-MORGENSTERN THEORY

STATE PREFERENCE THEORY

LEXICOGRAPHICAL ORDERING THEORY13

CARDINAL UTILITY THEORY

Cardinal utility theory, the oldest version of the theory of consumers behaviour, coins out
some powerful marginalist concepts and infers some fundamental laws explaining consumers
behaviour and establishing the Law of Demand. In the traditional literature of economics we see a
number of cardinal theories of consumers behaviour. Marshall, Pareto, Jevons and Gossen were the
greatest exponents of the Cardinalism.

Assumptions of the theory:

Cardinal utility theory is based up on the following assumptions.
1. Cardinal Utility: Utility is measurable in monetary term.
2. Constant marginal utility of money, : Money being a measuring rode of utility must
have constant marginal utility.
3. Rationality: The consumer is a rational person who always tries to maximize his
total utility subject to some constraints.
4. Certainty: The consumer acts under conditions of certainty.
5. Homogeneity: All units of the good are homogenous in all respects. A comprehensive
scale of preference: The consumer has a comprehensive scale of preference using which he
can assess the strength of his preference towards any good or any bundle of goods.
6. Utility is a function of the quantity of the good: The consumer derives utility from the
quantity of the good he possesses or consumes. Commodity has alternative uses:
Commodity that the consumer consumes has alternate uses.
7. Nonsatiety: commodity is scarce and thus not over supplied to the consumer.
8. Income of the consumer is constant: The consumer has a given income which is
spent on various goods.
9. Consumer has given tastes and preference: Consumers attitude towards the
good remains the same.

11
12

13

J. R. Hicks; Value and Capital, 1946

K. J. Lancaster; A New Approach to Consumer Theory, 1966

W. J. Baumol; Economic Theory and Operation Analysis, Prentice-Hall of India,

P 201

29

Oldest versions of the cardinalist theory had used some more restrictive assumptions
like independent utility and additive utility assumptions. These assumptions, however, are not only
very restrictive but unnecessary as well. Thus, later cardinalists rejected these assumptions.
Based on these assumptions, the cardinal utility theorists [cardinalists] like Marshall put
forward two fundamental laws related to consumers behaviour. They are; 1] the Law of Diminishing
Marginal Utility, and 2] the Law of Equi-Marginal Utility.

The Law of Diminishing Marginal Utility:

The Law of Diminishing Marginal Utility, a cardinalist explanation to the consumers
behaviour, is mainly an intellectual work of the great neoclassical economist, Alfred Marshall. He called
his law as the Law of Satiable Wants. However, the contributions of economists like Walras, Menger,
Bohm-Bawerk, Pareto, Edgeworth and Gossen also are to be worth mentioning when we trace the
evolution of the law of diminishing marginal utility.
According to Marshall, The additional benefit which a person derives from a given
increase of his stock of a thing diminishes with every increase in the stock that he already has14. It
means that the more of a good a consumer has, the less will be the marginal utility from additional unit.
In other words, when a consumer consumes more and more homogenous units of a commodity
continuously, he derives less and less utility from additional units.
The Law reveals the general human tendency that the marginal utility of a commodity
that we derive successively from its additional units will decline as its stock in our hands increases.
Using a hypothetical case of consumption of a commodity by a consumer we can illustrate
the law of diminishing marginal utility15 as shown in table 002.
Table 002
NUMBER OF UNITS

TOTAL UTILITY

MARGINAL UTILITY

[IN KG]

[IN Rs.]

[IN Rs.]

16

16

30

14

14

Alfred Marshall; Principles of Economics

Subjective terms like utils are avoided in finer versions of the Cardinal Utility Theory. We also express the
marginal utility directly in money terms.
15

30

42

12

52

10

60

66

70

72

72

10

70

-2

11

66

-4

12

60

-6

Graphical Illustration of the Law Diminishing Marginal Utility:

The Law of Diminishing Marginal Utility can be explained graphically as follows.
In upper panel of figure 001, quantity of good X is measured on horizontal axis and total utility on
vertical axis. In lower panel, quantity of good X is measured on horizontal axis and marginal utility on
vertical axis. The curve TU shows the total utility. The curve has two segments. These segments are
distributed on either sides of point C. The positively sloped segment left to point C shows increasing
total utility and the negatively sloped segment right to point C shows decreasing total utility. Point C
shows that the total utility function is at maximum [saturation point].
In lower panel of figure 001, the curve MU shows the marginal utility. This curve has
two distinct segments, ac and ce. The segment left to the point c shows positive marginal utility and
the segment right to the point c shows negative marginal utility.
It is clear from the figure that the marginal utility of good X diminishes with every
increase in its stock. For instance, the marginal utility declines from M1 to M2 as the quantity of X rises
from Q1 to Q2 and it declines to zero when the quantity rises from Q2 to Q3. Point c [where the
quantity of X is Q3], called the saturation point, is corresponding to the maximum total utility [point C].
If consumer continues the consumption of good X, marginal utility of it turns to negative. For instance,
when the quantity rises from Q3 to Q4 the marginal utility turns to negative [M3]. The MUx curve has a
negative slope signifying the fact that every increase in stock of a good leads to a decrease in its
marginal utility.

Figure 001

31

The total utility curve [TU] has two distinct segments, AC and CE. The positively sloped
segment AC, which is concave downward, shows that the TU is increasing but at a diminishing rate when
the stock of good X increases. On the other hand, the negatively sloped segment CE shows that the TU is
decreasing when the stock increases beyond a certain point [point C].
Exception to the Law Diminishing Marginal Utility:

1. It is not applicable in the case of collection of antiquity:

In the case of collection of antiquity, say collection of old paintings, and old things of
historical importance, the collector gets increasing marginal utility.
2. It is not applicable in the case of collection of stamps and coins:
A person who collects stamps or coins gets increasing marginal utility from additional
pieces.
3. It is not applicable in the case of consumption of liquor:
It is said the addicts of liquor get increasing marginal utility from additional dozes of liquor at least up to
a particular level of consumption.
4. It is not applicable in the case of money income:

32

Law of Diminishing Marginal Utility has nothing to say about the marginal utility of money
income. Modern economists like Friedman, Savage and Markowitz put forward their theories dealing
with marginal utility of money income which state some factors like the level of income, speed and
intensity of increase in income and other peoples income as the determinants of the marginal utility of
money income. They state increasing as well as diminishing marginal utility of money income as two
possible cases depending up on the factors mentioned above.
Most of the exceptions of the Law, however, are due to the violation of assumptions, and not
the inconsistency.
Conclusion:
By observing the law of diminishing marginal utility we get its basic premise that the marginal
utility of a commodity is an inverse function of its stock. From this premise we can find out that the
water, the stock of which is very large for an individual, has very little marginal utility. On the other
hand, the stock of diamonds, being it scarce, is very little for an individual and, consequently, its
marginal utility is very large.
Though it has a few exceptions, most of which, however, are outcomes of violation of
assumptions of the law, it still remains as one of the fundamental laws of economics. It along with the
Equi-Marginal Utility Principle helps derive the Law of Demand.
Equi -Marginal Utility Principle:
Equi-marginal utility principle infers the marginal conditions of equilibrium of a consumer. It
states the marginal conditions, called the Neo-Classical propositions of consumers equilibrium, of
maximization of utility. The marginal conditions of equilibrium of a consumer who purchases a single
commodity, say, X which has a price Px:
Suppose the consumer has a given amount of money income, Y, which he can spend on X partly
or fully. Under these conditions the consumer is in equilibrium when the marginal utility of X is equal to
its market price. Symbolically, we have:
MUx = Px
Or
MUx/Px = 16
Given that the is a constant equal to one, we have,
MUx = Px

16

shows the constant marginal utility of money.

33

If the marginal utility of X is greater than its price [MUx > Px], the consumer can increase
his total utility [from good X] by purchasing some more units of it. Similarly, if the marginal utility of X is
less than its price [MUx < Px], the consumer can increase his total utility [from good X] by cutting down
some units of it, and, there by, keeping some units of income unspent. Therefore, the consumer attains
the maximum of his utility from good X when MUx = Px
Mathematical derivation of the equilibrium conditions:
The utility function is:
U = f [X]17
Where U is total utility and X the quantity of the good. The consumer who seeks the maximum utility
tries to increase the difference between total utility [U] and the expenditure [Px. X].
That is, maximize the difference,
U Px. X.
The first order condition of maximization is that the first derivative of the function is zero. Thus:
U / X = [Px. X]/X = 0
Rearranging the equation, we get:
U / X = Px
Or
MUx = Px

The marginal conditions of equilibrium of a consumer who purchases two commodities, say, X and Y
which have prices Px and Py, respectively:
When there are two commodities, the condition for equilibrium of the consumer is the
equality of the ratios of the marginal utilities of the individual commodities to their prices.
That is:
MUx/ Px = MUy/Py =
Since MUx = Px and MUy = Py,
17

In old versions, using the additivity and independent utility assumptions, the utility function is stated as
U = f1[x1] + f2[x2] + +f2 [xn].

34

We have MUx/ Px = MUy/Py =

Generalization of the marginalist rule: [The marginal conditions of equilibrium of a consumer, who
purchases N number of commodities, where N = 1 to n]
If there are N number of commodities, where N = 1 to n, which have prices P1, P2, Pn, respectively,
the condition of equilibrium of the consumer is the equality of the ratios of the marginal utilities of the
N number of commodities to their prices. That is,
MU1/ P1 = MU2/P2 = .. = MUn/ Pn =
Graphical illustration of the Equi-marginal utility principle:
Figure 002

In figure 002, we take MUx / Px and MUm [] vertically and quantity of X

horizontally. The straight line parallel to X axis shows the constant marginal utility of money [] and the
negatively sloped curve MUx / Px shows the ratio of marginal utility of X to its price. The
condition of equilibrium of the consumer is fulfilled at point E where MUx/Px = . Corresponding to
this equilibrium, the consumer purchases OQ quantity of the good.
Derivation of Demand Curve from Equi-Marginal Utility Principle:
Figure 003

35

In upper panel of figure 003, we take MUx / Px and MUm [] vertically and the
quantity of X horizontally. The straight line parallel to X axis shows the constant marginal utility of
money [] and the negatively sloped curves MUx / Px show the ratio of marginal utility of X to
its various levels of price. Given the marginal utility schedule, points,

E1, E2

and

E3

show the

equilibrium at prices Px1, Px2 and Px3, respectively. Quantities corresponding to these equilibriums are
X1, X2 and X3, respectively. As price falls from Px1 to Px2 the consumer reaches at a new equilibrium,
e2, and corresponding to this equilibrium, he purchases an additional quantity, X1 X2. Similarly, when
price falls from Px2 to Px3, the quantity purchased rises from X2 to X3.
In the lower panel of figure 002, we show the quantity demanded of good X horizontally and
its price vertically. Points a, b and c are derived from the points, E1, E2 and E3, respectively.
Equilibrium point E1 shows that the maximum price that the consumer is prepared to pay
for the commodity, when its quantity is X1, is Px1 which is equal to the marginal utility. This information
helps us frame one combination of the quantity demanded of the good and its price, a. That is, the
consumer demands X1 quantity when price is equal to Px1.
Similarly, equilibrium point E2 shows that the maximum price that the consumer is ready to
pay for the commodity, when its quantity is X2, is Px2 which is equal to the marginal utility. This
information helps us find another combination of demand and price, b, which consists of X2 quantity
demanded and P2 price.
The third combination of demand and price, c, also is derived in the same way from the
equilibrium point E3.

36

Taking all these combinations of demand and price, a, b and c, we can draw the demand
curve DD in the lower panel. The demand curve so derived in the figure has its usual negative slope
signifying the inverse relationship between the quantity demanded of a good and its price. Thus, the
Equi-Marginal Utility Principle with the back support of the Law of Diminishing Marginal Utility verified
and proved valid the celebrated Law of Demand.
Derivation of Demand Curve from the Law of Diminishing Marginal Utility:
Holding the inference of the Equi-marginal utility Principle that the maximum price that the
consumer is prepared to pay for a commodity is equal to its marginal utility, we can derive the demand
curve of a commodity from the Law of diminishing marginal utility.
Figure 004

In figure 004, MUx is shown in first panel and Px in second panel vertically. Horizontally we
show the quantity of X in both the panels. Negative slope of the MU curve shows that the marginal
utility of good X diminishes with every increase in its stock, that is, the operation of the Law of
diminishing marginal utility. The consumer derives MU1 marginal utility from X1 quantity. It means that
the consumer is prepared to pay a price to X1 quantity equal to MU1. The price P1 in second panel is
equal to MU1. Thus, we derive a combination, a, of price and quantity demeaned from the

37

combination of MU1 marginal utility and X1 quantity. In this way we derive the combinations b and c
of demand and price, in the second panel.
Joining the combinations, a, b and c by a smooth curve we get the demand curve DD in the
second panel. The demand curve DD so derived has its usual negative slope signifying the inverse
relationship between the quantity demanded of a good and its price.
Conclusion:
As we get the Law of demand proven by the Law of diminishing marginal utility and the Equimarginal utility principle, we are definitely in a position to resolve the age old Water-Diamond Paradox.
As water has a very large stock, its marginal utility to the consumer is very low and the price that he is
prepared to pay for it, which is equal to the marginal utility, also is very low. Thus, water, though it has
high total utility, has very low price. On the other hand, the stock of diamond being very low, its
marginal utility to the consumer is very large and the price that he is prepared to pay, which is equal to
the marginal utility, also is very large. Though the works of several economists helped resolving the
paradox, credit goes mainly to Alfred Marshall since his intellectual works, the Law of Satiable Wants
and the Law of Substitution are the most scientific and systematic works led to find out the most
accurate answer to the question which remained unanswered for about a century. William Stanly
Jevons, for instance, tried a lot with his Final Degree of Utility concept to resolve the paradox but
simply failed due to its unscientific nature. J M Keynes, while comparing the theoretical contributions of
Jevons and Marshall, made a remarkable commend as, Jevons saw the kettle boil and he cried out with
the delighted voice of a child; Marshall too had seen the kettle boil, but he sat down silently to build an
engine18.
Cardinal Utility Theory and the Concept of Consumers Surplus:
The concept of consumers surplus was first formulated by Dupuit in 1844. He used it to
measure social benefits of public goods. However, it was Alfred Marshall who presented this concept to
us with its present scope and dimension. He popularised the concept with the publication of the
Principles of Economics in 1890. Marshalls consumers surplus concept is based up on his law of
diminishing marginal utility and its fundamental assumption of constant marginal utility of money.
Marshall defines consumers surplus as, excess of the price which a consumer would be
willing to pay, rather than go with out a thing over that which he actually does pay, is the economic
measure of this surplus satisfaction..it may be called consumers surplus.
For every commodity, there is maximum price that the consumer is prepared to pay. If
actual price happens to be greater than this maximum price, he will leave the market with out buying it.
However, the actual price that he does pay to a commodity is, by and large, less than the maximum
price. The maximum price that he is ready to pay for a commodity is its marginal utility [Equi-marginal
18

J M Keynes: General Theory of Employment Interest and Money.

38

utility principle]. The marginal utility of a good is diminishing as his stock of the good increases [Law of
diminishing marginal utility]. As he consumes more and more quantity of a good, his marginal utility
from that good diminishes and he stops the buying of the good when its marginal utility equal to price
[MUx = Px]. That is, he pays price equal to marginal utility for the marginal unit he bought. It means he
pays price less than marginal utility for intra marginal units.
Total utility from a good that the consumer bought is equal to the sum of its marginal
utilities. That is, TUx = MUx. The consumer is ready to pay an amount of money equal to TUx =
MUx to a quantity of the good which has a total utility equal to TUx = MUx. But he actually pays
an amount of money less than the TUx = MUx. That is, there is benefit or satisfaction over
and above the cost he incurred for the purchase of the particular quantity of the good. This
surplus is called as the consumers surplus.
It can be illustrated in a better way by a hypothetical schedule as follows.
Table 003
1

Number of units of X

Px [Rs]

MUx [Rs]

Surplus [Rs]

18

10

16

14

12

10

Total

48

78

30

In table 003, first column shows the number of units of good X, the second shows the
price of X [Px], the third shows the marginal utility of X [MUx] and the last shows the surplus from each
marginal unit. In column third, the MUx is diminishing as the number of units in the first column
increases. As shown in column one, the price paid to each unit is Rs8. The consumer reaches in
equilibrium when he buys 6 units at the constant price Rs8 since his MUx = Px.
As shown in the last column, the consumer gets a surplus equal to Rs10 when he buys one
unit at price Rs8. This surplus is the difference between the MUx = Rs18 [this is the maximum price that
the consumer is ready to pay for that unit] and the Px = Rs8 [the price actually paid]. From the last
column we can read out the surplus from each unit.
The consumers surplus added together in the last column is equal to Rs30. This is equal to
the difference between the totals of second and third columns. The total of second column, Rs48, is the

39

total amount of money spent for 6 units of the good. Where as, the total of third column, Rs78 is the
total utility [MUx] from 6units of the good. The difference between second and third column totals is
equal to Rs30, the total of last column [78 48 = 30].
Graphical Illustration of Consumers Surplus:
In figure 005, the shaded area shows the Consumers Surplus. When 6 units are bought, the
MUx gets equal to Px and the consumer is in equilibrium. He gets a total consumer surplus equal to 30
[shaded area].
In figure 006, DD1 is the demand curve. When the consumer buys OX quantity of the good at price equal
to OP, he pays an amount of money equal to OPAX. This amount OPAX is less than the total benefit or
utility derived. Where, the total utility is equal to ODAX. The difference, PDA is the total consumers
surplus.
Figure 005

Figure 006

40

Applications of the Cardinal Utility Theory [Marshallian Utility Analysis]:

1. It explains consumers behaviour:
The theory explains not only the general tendency that the marginal utility of a good
diminishes with every increase in its stock but the broader conditions of equilibrium of the consumer.
The consumer who purchases a single commodity, X, is in equilibrium when the marginalist rule MUx/Px
= or MUx = Px is fulfilled. Similarly, when he buys two goods, X and Y, the equilibrium
condition is MUx/ Px = MUy/Py = . If he buys N number of goods, that is 1 to n number of
goods, then the equilibrium condition is MU1/ P1 = MU2/P2 = .. = MUn/ Pn = .
2. It explains Water-Diamond Paradox:
The Law of diminishing marginal utility and the Equi-marginal utility principle help us to
resolve the age old Water-Diamond Paradox, a paradox introduced in economics by Adam Smith.
3. It helps derive the Law of Demand:
The Law of Demand can be derived from the Law of diminishing marginal utility and the
Equi-marginal utility principle, two important mile stones of the Cardinal utility theory.
4. It explains the concept of Consumers Surplus:

41

The Law of diminishing marginal utility can explain the concept of consumers surplus.
Consumers surplus19, another contribution of Marshall, is the difference between the price that the
consumer is prepared to pay at the maximum and the price that he actually paid for a commodity.

Limitations of the Cardinal Utility Theory [Marshallian Utility Analysis]:

1. Cardinal utility assumption is unrealistic:
The assumption that the utility is cardinally measurable is unrealistic. Utility is a subjective
phenomenon and a mental entity. Thus, it is not quantifiable by any means.
2. Assumption of constant marginal utility of money is unrealistic:
Money, like any other goods, satisfies human wants, and thus, it has its own utility. It is wrong to
believe that the marginal utility of money is constant. It does not explain consumers choice involving
risk:
There are various instances in which consumers face situations of choice involving risk.
Gambling, for instance is a case where the consumers choice involves risk. Marshall neglected such
cases human reality by saying gambling is an economic blender.
3. Consumers may not be rational always:
Cardinal utility theory is based on the assumption that the consumer is rational who deals under
certainty with a very comprehensive scale of preference. The consumer in reality faces a lot of
uncertainty. Moreover, his scale of preference is not at all comprehensive. Consequently, no consumer
can be always rational in the real word.
4. It fails to explain the Geffens Paradox:
Marginal utility of money being a constant, the Geffens paradox gets no explanation from
Cardinal utility theory. It cannot explain the negative [perverse] income effect of a price change.
5. It fails to explain the case of joint goods and complementary goods:
Cardinal utility theory explains consumers equilibrium only for competitive goods. It hardly
facilitates an explanation of complementary goods and joint goods.
6. It fails to explain the splitting up of price effect in to income effect and substitution effect:
Cardinal utility theory cannot split up the price effect in to income effect and substitution effect.
This is because it takes the marginal utility of money as a constant.
7. It is basically a single commodity model:
Cardinal utility theory is basically a single commodity model. It cannot explain multiple
commodity model. T. Majumdar remarked, Marshallian demand theorem cannot genuinely be

19

42

derived from the marginal utility hypothesis except in a one-commodity model with out contradicting
the assumption of constant marginal utility of money20
8. It applies the defective introspective method:
Cardinal utility theory applies the psychological introspective method which, unlike the
behaviourist method, seldom stores up any information regarding consumers actual choice. It is not a
practical method to observe consumers behaviour.
9. It assumes too much but infers too little:
It is generally said that the Cardinal utility theory assumes too much but infers too little. It is
based up on large number of assumptions most of which are unrealistic.
Modifications to Cardinal Utility Theory:
The traditional cardinal utility theory fails to explain some important problems related to
consumers behaviour. Important among them are the cases of Geffen goods, joint goods and the
complementary goods. Modern economists like Mark Blaug, W. J. Fellner and Richard Bilas made
modifications to the traditional cardinal utility theory by relaxing the assumption of constant marginal
utility of money. They have incorporated the diminishing marginal utility of money in to the model. This
made them capable of explaining some problems like Geffens paradox.

ORDINAL UTILITY THEORY

Introduction:
Many economists, who call themselves as ordinalists, believe that measurement of
subjective utility on an absolute scale is neither possible nor necessary. They question the validity of the
introspective data of the Neo-classical [Marshallian] cardinal utility and maintain that all consumers
behaviour can be described in terms of preferences, or orderings [rankings], in which the consumers
need only state which of two collections of goods they prefer, with out reporting on the magnitude of
any numerical index of the strength of their preference. The cardinal utility theory was attacked by
critics from many angles mainly because of its unrealistic assumptions. Cardinal utility assumption, one
of the basic assumptions of the cardinal utility theory, has been criticised vehemently by economists like
J. R. Hicks, R. G. D. Allen and P. A. Samuelson. J. R. Hicks and R. G. D. Allen, in their famous work A
Reconstruction of the Theory of Value, developed an Ordinal utility assumption in-lieu- of the Cardinal
utility assumption. In their view, utility, a subjective phenomenon and a mental entity, cannot be
measured cardinally. More over, they argue that the measurement of utility is neither practical nor
necessary a practice in the theory of consumers behaviour. They opine that the theory of demand and
the consumers behaviour can be analysed in a more practical and logically consistent way by
incorporating the ordinal utility assumption. They, through the ordinal utility approach, infer the same
Marshallian conclusions regarding the conditions of consumers equilibrium. This new approach to the
20

T. Majumdar, Measurement of Utility, 1966

43

theory consumers behaviour made sweeping changes in economic theory and led to the invention of a
number of ordinalist theories. Hicks and Allen, how ever, did not abandon the method of introspection
of the traditional utility theory. They applied the introspection for ranking of utilities of different
combinations of goods.

Indifference Curve Analysis:

Indifference curve, an analytical tool, was invented by Edgeworth but he used it only
for showing the possibilities of exchange between two individuals and not for explaining consumers
demand. Indifference curve became a strong analytical tool of the consumers demand theory with the
launching of Indifference Curve Analysis. J. R. Hicks and R. G. D. Allen published their path breaking
intellectual work A Reconstruction of the Theory of Value in the year 1928. In this celebrated work they
introduced the indifference curve analysis, a new ordinalist theory of consumers behaviour. Hicks
reproduced the theory and modified the original version in his book Value and Capital in the year 1939.
If we trace behind the origin of indifference curve, we can see many literature of a
number of theorists. For instance, Pareto, Fisher and Johnson made unique contribution in this field.
However, none of them made an indifference curve analysis of consumers demand. In 1915, Slutsky, an
Italian economist published an essay On the Theory of Budget of the Consumer [a remarkable work on
indifference curve theory]. It remained unnoticed outside Italy. It was in 1928, Hicks and Allen published
their work A reconstruction of the Theory of Value. There are a lot of differences between Hicks and
Slutskys versions. Though we discuss both the versions in mainstream economic theory, indifference
curve analysis is called mainly after the names of J. R. Hicks and R. G. D. Allen; as Hicks-Allen indifference
curve analysis.
Indifference Curve Approach:
Though the indifference curve analysis is independent of the defective cardinal measurability
of utility assumption, it applies the technique of introspection for ranking of combinations of goods
according to consumers preference or indifference. It, unlike Marshallian theory which is a cardinalistintrospective theory, is an ordinalist-introspective theory.
It applies the ranking or ordering method to analyse the consumers behaviour. Hicks and
Allen, unlike Samuelson, have used the weak ordering method in which the possibilities of both
preference and indifference are taken in to account. For example, if A and B are two combinations of
goods, the consumer using his scale of preference can tell whether he is indifferent between the
combinations or preferring one combination to the other. Samuelson has used the strong ordering
method in which only the possibilities of preference are considered. He did not notice the possibilities of
indifference.
Assumptions of the Indifference Curve Analysis:
Indifference curve analysis is based up on a few assumptions. They are described as follows.

44

1. Ordinal utility assumption:

Ordinal utility assumption, the very corner stone of the indifference curve analysis, signifies
that the consumer using his scale of preference is able to rank any number of combinations of goods
available to him. It, however, involves no measurement of utility. Utilities are only compared but not
measured. Suppose that there are two bundles of goods, A and B. The consumer is able tell whether he
prefers A to B [A P B] or B to A [B P A] or he is indifferent between A and B [A I B].
2. The consumer has a comprehensive scale of preference and indifference:
The consumer has a scale of preference and indifference using which he can rank any number
of combinations of goods available to him. This scale is very comprehensive, and thus, the consumer is
able to rank combinations of any number of goods.
3. The consumer is a rational individual:
The consumer using his comprehensive scale of preference tries always to maximize his total
satisfaction, subject to certain constraints.
4. The consumer deals under conditions of certainty:
The consumer makes his choice under conditions of certainty. He knows with certainty what
his income is, what the price of the good is and what the cost and benefit related to the purchase of the
good are.
5. Continuity assumption:
Unlike the Marshallian assumption of continuity in consumption, Hicks and Allen apply the
assumption of continuity in substitution. This assumption ensures counting of even the minutest change
in the quantity of goods. It gives smoothness to the indifference curve.
6. Transitivity assumption:
It means, if there are three combinations A, B and C, and if A is greater than B and B is greater
than C, then A is greater than C. Similarly, if A is indifferent to B and B is indifferent to C, then A is
indifferent to C.
7. Non-Satiety assumption:
It means that the consumer is not reached at saturation point of any commodity. In other
words, the consumer is not sated for any good. This happens only when he is not over supplied with the
goods.
Tools used in indifference curve analysis:
The main tools applied in indifference curve analysis are the indifference curves and the
budget lines.

45

Indifference curves:
An indifference curve is the locus points of combinations of two goods, say X and Y, given the
satisfaction. In other words, it is a curve which includes only those combinations of two goods
corresponding to which consumer gets same satisfaction. That is, all combinations of an indifference
curve give equal satisfaction to the consumer, and thus, are equally preferred.
Before analysing the indifference curve we may take an indifference schedule, from which the
indifference curve is formed, for observation. An indifference schedule is a table which shows the
combinations of two goods, say X and Y, given the satisfaction.
Table 001
INDIFFERENCE SCHEDULE
1
COMBINATIONS OF GOODS

QUANTITY OF GOO X

QUANTITY OF GOO Y

4
MRSxy

18

13

1:5

1:4

1:3

1:2

1:1

In table 001, combinations of goods are shown in first column and the quantities of X and Y
goods in second and third columns, respectively. Last column shows MRSxy [the details of which will be
described subsequently]. As we move from combination A to B and from B to C and so on, more and
more units of X are used in place of Y. That is, the quantity of X rises at the expense of Y. However, the
satisfaction of the consumer remains the same. Here X is substituted for Y at a rate called the marginal
Rate of Substitution [MRSxy]. As the consumer substitutes X for Y, this rate, as shown in table 001, is
subject to a decrease. For instance, when the quantity of X rises from 1 to 2 the quantity of Y decreases
from 18 to 13. That is, X is substituted for Y at a rate 1:5, means 1 X for 5 Y. Similarly, when the quantity
of X rises from 2 to 3 the quantity of Y decreases from 13 to 9. That is, X is substituted for Y at a rate 1:4,
means 1 X for 4 Y. The MRSxy, the rate at which X is substituted for Y, given the satisfaction, is
decreasing with every progress in the substitution of X for Y.
Now we may analyse the indifference curve with a diagram [figure 001] as follows.
Figure 001

46

In figure 001, quantity of X is measured along X axis and that of Y along Y axis. The curve I in
figure 001, the indifference curve, shows all those possible combinations of X and Y which give same
satisfaction to the consumer. As already mentioned, the consumer has a comprehensive scale of
preference and indifference, and thus, he has a number of indifference curves, one ahead of the other.
This set of indifference curves is called the indifference map. An indifference map is a cluster of
indifference curves; each of them shows a particular level of satisfaction. An indifference map is shown
in figure 002.
Figure 002

47

In figure 002, a set of indifference curves forming an indifference map is shown. The
indifference curves I1, I2, I3 and I4 represent four levels of satisfaction. The higher the level of
indifference curve the greater would be the level of satisfaction, and vice versa.
Marginal Rate of Substitution between X and Y [MRSxy]:
Marginal rate of substitution between X and Y [MRSxy], as already mentioned, is the rate
at which X good is substituted for Y good, given the satisfaction of the consumer. Ipso facto, the MRSxy
declines with every substitution of X for Y. This can be graphically explained [figure 003] as follows.
In figure 003, A, B, C and D are combinations of X and Y on the indifference curve I1. As the consumer
moves from A to B he gives up Y1 Y2 quantity of good Y for X1 X2 additional quantity of good X, given the
satisfaction. Here the MRSxy is:
MRSxy = -Y/X
Where, -Y represents the decrease in the quantity of good Y and X the increase in the quantity of
good X. Here the consumer gives up Y1Y2 quantity of Y for an additional unit of X equal to X1X2. The
MRSxy corresponding to the movement from A to B is:
MRSxy = -Y/X
= Y1Y2/X1X2
Similarly, corresponding to a movement from B to C, the MRSxy is:

48

MRSxy = -Y/X
= Y2Y3/X2X3
Likewise, the MRSxy for a movement from C to D is:
MRSxy = -Y/X
= Y3Y4/X3X4
In the figure 003, X1X2= X2X3= X3X4. On the other hand, Y1Y2> Y2Y3> Y3Y4.
Thus, we have;
Y1Y2/X1X2 > Y2Y3/X2X3 > Y3Y4/X3X4.
That is, the MRSxy decreases when we move along the indifference curve from left to right.
Figure 003

Reason for the diminishing marginal rate of substitution

Or
The Rationale of the Law of Diminishing Marginal Rate of Substitution:

49

Law of diminishing marginal rate of substitution functions basically due to the operation of
the law of diminishing marginal utility which states that the marginal utility of a commodity diminishes
with every increase in its stock. The stock of X increases and that of Y decreases when good X is
substituted for good Y. For instance, as shown in figure 003, when we move from point A to point B, the
quantity of X rises from X1 to X2 and that of Y falls from Y1 to Y2. However, combinations A and B show
same satisfaction since they fall on the same indifference curve. When the consumer substitutes X1X2 of
X for Y1Y2 of Y, the quantity of Y decreases, as a result, there is a decrease in the satisfaction of the
consumer. This decrease in satisfaction must be compensated by the increase in satisfaction from the
additional quantity of X.
Since the marginal utility of X falls when its stock rises and the marginal utility of Y rises when
its stock falls, consumers satisfaction cannot be maintained as given if X and Y are substituted at a
constant rate. The consumer has to give up less and less quantity of Y for every additional quantity of X.
That is, MRSxy diminishes with every substitution of X for Y. This diminishing MRSxy gives convexity to
the indifference curve.
Thus, the law of diminishing marginal rate of substitution functions basically due to the
operation of the law of diminishing marginal utility.
As is clear from the above explanation, the slope of the indifference curve is determined by the
ratio of marginal utilities of X and Y goods. That is,
MRSxy = MUx/MUy
Properties of Indifference Curves:
Indifference curves have a number of properties which hold good until all assumptions of it
are not relaxed. Following are the important properties of the Indifference curves.
1. Indifference curves have a negative slope:
An indifference curve, as shown in figure 004, has a negative slope which signifies the trade
off between the quantities of the goods X and Y. It means that in order to maintain the same level of
satisfaction an increase in the quantity of X must be followed by a decrease in the quantity of Y. Thus,
the negative slope alone is suitable to the indifference curve.
Figure 004

50

If it were positively sloped, there would be direct relation between quantities of X good and Y
good. In such a situation same level of satisfaction cannot be maintained at all points of the indifference
curve. Similarly, zero or infinite slope shows either X increases with out a decrease in Y or Y increases
with out a decrease in X. In both these cases, as in the positive slope case, same level of satisfaction
cannot be maintained. Thus, a typical indifference curve is always negatively sloped.
2. Indifference curves are smooth and continuous:
An indifference curve, as shown in figure 005, is smooth and continues. These smoothness
and continuity are due to the continuity assumption. Continuity assumption holds that there is
continuity in the substitution between goods. It also ensures counting of even the minutest change in
the quantity of goods.
3. Indifference curves are convex to the origin:
An indifference curve, as shown in figure 005, is convex to the origin. Its convexity is due to
the diminishing marginal rate of substitution [DMRSxy]. In figure 005, A, B, C and D are combinations of
X and Y goods on the indifference curve I. As the consumer moves from A to B he gives up Y1Y2 quantity
of good Y for X1X2 additional quantity of good X, given the satisfaction. Here the MRSxy is:
MRSxy = -Y/X
= Y1Y2/X1X2

51

Similarly, corresponding to a movement from B to C, the MRSxy is:

MRSxy = -Y/X
= Y2Y3/X2X3
Likewise, MRSxy for a movement from C to D is:
MRSxy = -Y/X = Y3Y4/X3X4
In the figure 005, X1X2= X2X3= X3X4. However, Y1Y2> Y2Y3> Y3Y4.
Thus, we have;
Y1Y2/X1X2 > Y2Y3/X2X3 > Y3Y4/X3X4. It means that the MRSxy diminishes with every
substitution of X for Y.
Figure 005

If MRSxy were increasing, the indifference curves would be concave to the origin. On the
other hand, if MRSxy were constant, the indifference curves would be a straight line with negative slope.
However, a typical indifference curve is convex to the origin signifying the DMRSxy or the operation of
the law of diminishing marginal rate of substitution.
4. Indifference curves at higher levels show higher level satisfaction:
In an indifference map, as shown in figure 002, higher the indifference curves, higher would
be the level of satisfaction, and vice versa. This is because the consumer always prefers more quantity of

52

any good to its less quantity. For instance, a basket which contains 2 apples and 2 oranges would be
superior to another basket which contains 1 apple and 1 orange to any consumer.
A higher indifference curve consists of more quantities of either X or Y or both. Thus, the
consumer always prefers all combinations of a higher indifference curve to all combinations of a lower
indifference curve. It means higher indifference curves show higher level satisfaction.
5. Indifference curves never intersect each other:
In an indifference map, two or more indifference curves never intersect each other. This can
be explained with a diagram [Figure006] as follows.
Figure 006

This property can be proved with the help of two premises: 1] The Principle of Preference
for Large, that is, the Consumer always prefers more quantity of any good to its less quantity; and 2] the
Transitivity Principle which says that if there are three combinations A, B and C, and if A is greater than B
and B is greater than C, then A is greater than C. Similarly, if A is indifferent to B and B is indifferent to C,
then A is indifferent to C.
In figure 006, two indifference curves are shown as intersecting each other at point A. We
can prove this as illogical and inconsistent. Point A consists of X1 of X good and Y1 of Y good. Point B
consists of X2 of X good and Y2 of Y good. Similarly, point C consists of X2 of X good and Y3 of Y good.

53

On the basis of transitivity principle we can infer the following conclusion:

A is indifferent to B since both are on same indifference curve, and A is indifferent to C since both are on
same indifference curve. If A is indifferent to B and again A is indifferent to C, then A is indifferent to C.
On the basis of the principle that the Consumer always prefers more quantity of any good to
its less quantity we can draw the following inference:
Combination B lies on a higher indifference curve compared to combination C. It means that
combination B consists of more quantity of Y good and same quantity of X good compared to the
combination C. Thus the consumer prefers combination B to combination C.
Here we get illogical and inconsistent conclusions. This due to the intersection of the
indifference curves, which is illogical and inconsistent. Thus, ideal indifference curves never intersect
each other.
6. Indifference curves never touch the axis:
An indifference curve cannot touch any of the axes. The case shown in figure 007 is impossible
one. A typical indifference curve never touches any of the axes. It reveals the rational behaviour of the
consumer that he has no undue preference or addiction to any particular good. That is, the consumer
has no monomania, an irrational behaviour. If the consumer has monomania we get a position as
figure 007 shows. In figure 007, indifference curve touches Y axis. It means that there is a unique
combination A which consists of only Y but no X.
A true indifference curve, however, does not touch any of the axes. Rationality assumption
gives no scope for monomania.
Figure 007

54

7. Indifference curves fall in the nonsatiety region:

An ideal indifference curve, as shown in figure 008, falls in the nonsatiety region.
Figure 008

55

In figure 008, the area OY*SX* is the nonsatiety region. In this region, the consumer is sated
neither for X nor for Y. He faces scarcity of both X and Y. This is because he is not over supplied with
either X or Y. The base of this property is, thus, the nonsatiety assumption. Point B shows that the MUx
= Zero. The corresponding quantity of X is X*. With this quantity the consumer is fully sated for X.
Similarly, point A shows that the MUy = Zero. The corresponding quantity of Y is Y*. With this quantity
the consumer is fully sated for Y. The nonsatiety region is with in the area OY*SX*. Thus, only the
segment AB [of the circle] constitutes the typical indifference curve. It falls in the nonsatiety region.
If we relax the nonsatiety assumption we get indifference curves as concentric circles21.
These are the fabulous properties of the indifference curves. They exist as long as the
assumptions of the indifference curve analysis are maintained.
22

Budget Line

Another great device applied in the indifference curve analysis is the budget line or price line.
The indifference curve does not ask the consumer which combination he believes will give him the most
for his money. It is merely a hypothetical ranking of various combinations of commodities. Unlike the
indifference curve, the budget line involves monetary elements. A budget line is the locus points of
combinations of two goods, given the cost. It, unlike the indifference curve, is a straight line. It consists
21
22

William J. Baumol; Economic Theory and Operations Analysis

Watson calls it as budget constraint

56

of all those possible combinations of X and Y goods, and the purchase of each leads to same outlay.
Thus, budget line indicates what amounts of the commodities a given amount of money can buy.
We need two sets of information to construct a budget line. They are; 1] the amount of money
that the consumer possesses to spend on X and Y goods [let us call it as budget, ], and 2] the prices of X
good [Px] and Y good [Py]. Suppose the budget [] is Rs.200 and the price of X is Rs.20 and the price of Y
is Rs.40.
That is, we have the information;
= Rs.200
Px= Rs.20
Py= Rs.40
If the consumer spends his entire budget, Rs.200, for buying good X he could buy 200/20 = 10
units of X, but no unit of Y. Let us call this combination as A which consists of 10 units of X and 0 unit of
Y. On the other hand, if the consumer spends his entire budget, Rs.200, for buying good Y he could buy
200/40 = 5 units of Y, but no unit of X. Let us call this combination as B which consists of 0 unit of X and
5 units of Y. We can plot these combinations in a graph to make the budget line. The advantage is that
both the tools, the budget line and indifference curve, can be drawn in the same diagram which is a
space of quantity of X good against of quantity of Y good. The extreme combinations A and B can be
shown in a diagram [figure 009] as follows.
Figure 009

57

In figure 009, as in the case of indifference curves, we measure the quantity of X good
horizontally and that of Y good vertically. Point A shows the extreme combination, which consists of 10
units of X and 0 unit of Y. Similarly, Point B shows the extreme combination, which consists of 0 unit of X
and 5 units of Y. If we join these extreme combinations, A and B by a straight line we get the budget line
BA. The budget line BA consists of an unlimited number of combinations including A and B. What is
common to these combinations is that the budget is the same. That is, the purchase of each of these
combinations results in same outlay. The consumer is able to choose any combination on the budget
line BA or inside the area OBA [the actual choice, however, depends upon not only the budget line but
the indifference curve as well]. The area OBA is called the opportunity region. Budget line being a
constraint made by the given income [budget] and prices, consumers actual selection of a combination
will be with in the opportunity region. However, the consumer, being a rational person seeking the
maximum possible satisfaction, will not spoil his opportunity by selecting a combination below the
budget line. He, thus, will be in equilibrium definitely with a combination on the budget line. All
combinations outside the opportunity region are beyond the reach of the consumer. A corner solution
either at point A or B also can be discarded on the basis of logically consistent assumptions23.
Slope of the budget line:
The budget line has slope equal to the ratio of prices of the two goods. If we take the quantity of
X good horizontally and that of Y good vertically we get the budget line with slope equal to the ratio of
price of X to price of Y. That is, slope of the budget line is equal to Px/Py.
23

Corner solution shows, as already explained earlier, irrational behaviour of the consumer.

58

Proof;
In figure 009, the budget line BA has a slope equal OB/OA. Where, OB is equal to the maximum
quantity of Y good which could be bought by the budget Rs.200. It is equal to 200/40, that is, /Py
[Budget divided by Py]. Similarly, OA is the maximum quantity of X good which could be bought by the
budget Rs.200. It is equal to 200/20, that is, /Px [Budget divided by Px].
Thus, the slope of the budget line BA = OB/OA
= /Py /Px
= Px/Py
= 200/40 200/20
= 20/40
Consumers Equilibrium; Indifference Curve Approach:
Now we have the tools, the budget line and indifference curve, using which we can explain
the consumers equilibrium, the core subject of the indifference curve analysis. According to the
indifference curve approach, a consumer is in equilibrium when he realises the maximum possible
satisfaction subject to the income-price constraints. This happens when he chooses the optimal
combination of the X and Y goods. Indifference curve analysis states some conditions for the consumers
equilibrium. These conditions include both marginal and total conditions.
The marginal condition is:
MRSxy = MUx/MUy = Px/Py.
Where, MRSxy = MUx/MUy is the slope of the indifference curve, and Px/Py the slope of the budget line.
The total condition is the convexity of the indifference curve.
It means that the consumer is in equilibrium at a point where the slope of the budget line is
equal to the slope of the indifference curve which is convex to the origin. This can be explained
graphically [figure 010] as follows.
Figure 010

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In figure 010, we take the given budget line AB along with a set of indifference curves. Given
the constraints, money income and prices of X and Y goods, the consumer makes an optimal choice at
point e. Corresponding to this choice, he buys OX quantity of X good and OY quantity of Y good.
Combination e satisfies all the conditions of the equilibrium. That is, the slope of the indifference curve
is equal to the slope of the budget line or MRSxy = MUx/MUy = Px/Py. Moreover, the relevant
indifference curve I2 is convex to the origin.
Change in Money Income and its Effects on Quantity Purchased of a Good; Income Consumption
Curve [ICC]:
Income of the consumer is definitely a strong determinant of the quantity demanded of a good.
Indifference curve analysis measures the change in the quantity demanded of a good with respect to a
change in money income of the consumer, a facility seldom available in the traditional utility theory. The
device, Income Consumption Curve [ICC], a valuable contribution of the indifference curve analysis,
presents us an easy look in to the income-demand relationship. An ICC is the locus points of tangency
between successive budget lines and indifference curves, given the price ratio Px/Py. It shows how the
consumer moves in the most desirable way from one indifference curve to another as his money income
increases. Each point of the ICC fulfils the equilibrium condition of the consumer, MRSxy = MUx/MUy =
Px/Py. We can explain the income effect of a change in money income with the help of the ICC as
follows [figure 011].
Figure 011

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In figure 011, given the Px/Py, AB, CD, EF and GH are different budget lines at different levels
of money income, OA, OC, OE and OG, respectively. The budget line AB is tangent to the indifference
curve I1 at point e1. Corresponding to this equilibrium, the consumer buys OX1 quantity of good X and
retains OY1 money income. Points, e2, e3 and e4 are equilibrium points at income levels, OC, OE and OG,
respectively.
It is clear from the figure that the consumer moves from equilibrium e1 to e2 as his income
increases from OA to OC. Corresponding to this income change, there is an increase in the quantity
purchased of good X, that is, from OX1 to OX2. Similarly, the quantity purchased of good X rises from
OX2 to OX3 when the income increases from OC to OE. The same trend is seen when we move from the
money income OE to OG.
Thus, it is clear from the figure 011 that every increase in money income is followed by an
increase in quantity purchased of good X. In the case of all normal goods we can see this positive
relation between the quantity demanded and the money income. Thus, for a normal good the ICC
moves to north-east direction. It means that the income effect of a change in money income is positive
for normal goods. Income effect of a change in money income is the change in the quantity purchased of
a good with respect to a change in money income.
ICC of an Inferior Good:

61

The income effect of a change in money income is not positive for all goods. The ICC of an
inferior good moves to north-west direction indicating that the income effect is negative [perverse]. For
such goods, an increase in money income reduces their quantity purchased. We can explain the ICC of
an inferior good by a diagram [figure 012] as follows.
Figure 012

In figure 012, when money income increases from OA to OC, the budget line shifts from AB to
CD. As a result, the consumer moves from equilibrium e1 to e2, and the quantity purchased of the good
falls from OX1 to OX2. That is, the quantity purchased of the good falls when money income rises.
Same trend can be seen when we move from equilibrium e2 to e3 corresponding to a rise in
the money income from OC to OE, and again from e3 to e4 when money income rises from OE to OG.
All these cause and effect relations reveal that the quantity demanded of an inferior good is an
inverse function of the money income of the consumer.
Effects of Price Change on Quantity Purchased of a Good; Price Effect; Price Consumption Curve [PCC]:
The effect of price change on quantity demanded of a good was a subject of serious enquiry
for all most all price theorists including Hicks and Allen. Indifference curve analysis facilitates a scientific
observation of the price effect. Price effect is the effect of price change on quantity demanded of a

62

good. Indifference curve analysis presents us a very useful tool, the price consumption curve, for the
observation of price effect. A typical price consumption curve [PCC] is shown in figure 013.

Figure 013

In figure 013, given the money income as OA, AB is the initial budget line which is a tangent
to the indifference curve I1 at point e1. Point e1 shows the initial equilibrium of the consumer.
Corresponding to this equilibrium he purchases OX1 quantity of X good and retains OY1 of his money
income. Given the money income as OA, a fall in the price of X good leads to a shift in the budget line
from AB to AC. The new budget line AC is a tangent to a higher indifference curve I2 at point e2. Point e2
represents the new equilibrium of the consumer. Corresponding to this equilibrium he purchases OX2
quantity of X good and retains OY2 of his money income. As is clear from the figure 013, a fall in price of
X good leads to an increase in its quantity demanded, given the money income and prices of other

63

goods. If we move from equilibrium e2 to equilibrium e3, we can see the same trend of price effect. That
is, the quantity demanded of X good rises from OX2 to OX3 when the Px falls further.
It reveals the general tendency that a fall in the price of a good leads to an increase in its
quantity demanded, and vice versa. In other words, as the celebrated law of demand states, the
quantity demanded of a good is an inverse function of its price.
In figure 013, we get the PCC by joining the successive equilibrium points, e1, e2 and e3, by a
smooth curve. Thus, the PCC is the locus points of different equilibrium at different levels of price of the
good. It shows the change in quantity demanded of a good with respect to a change in its price. It
normally moves to north-east direction revealing the fact that the quantity demanded of a good is an
inverse function of its price. However, the PCC of all goods does not have the same trend.

The PCC of a Geffen Good:

Geffen Good is an inferior good. However, all inferior goods are not Geffen Goods. Geffen
Good is that inferior good in case of which the quantity demanded varies directly [opposite to the law of
demand] with its price. That is, a fall in the price of a Geffen Good leads to a decrease in its quantity
demanded, and vice versa.
Figure 014 represents the PCC of a Geffen good. In the figure, the PCC moves to north-west
direction indicating that the quantity demanded of the Geffen Good decreases with every fall in its price,
given the money income. In Figure 014, we can take either money income or the quantity of good Y,
which is not a Geffen good, on vertical axis, and the quantity of good X, a Geffen good, on horizontal
axis.
Figure 014

64

In figure 014, AB is the initial budget line. Given the money income OA, AB is a tangent to the
indifference curve I1 at point e1. Point e1 shows the initial equilibrium of the consumer. Corresponding
to this equilibrium consumer purchases OX1 quantity of X good and retains OY1 of his money income.
Given the money income OA, a fall in the price of X good leads to a shift in the budget line, from AB to
AC. The new budget line AC is a tangent to a higher indifference curve I2 at point e2. Point e2 represents
the new equilibrium of the consumer. Corresponding to this equilibrium he purchases OX2 quantity of X
good and retains OY2 of his money income. Where, OX2 is less than OX1. It means that the quantity
purchased of X good decreases when its price falls.
Similarly, a further fall in Px leads to shift the budget line from AC to AD. The budget line CD is a
tangent to a higher indifference curve I3 at point e3. Point e3, thus, represents the new equilibrium of
the consumer. Corresponding to this equilibrium he purchases OX3 quantity of X good and retains OY3
amount of his money income. Where, OX3 is less than OX2. It again reveals the fact that the quantity
demanded of a Geffen good is an inverse function of its price.
Splitting up of Price Effect into Income Effect and Substitution Effect:
Price effect, as already explained, is the net effect of a price change on quantity demanded. For
a normal good the net effect of a price fall is an increase in its quantity demanded, and vice versa. This
price effect can be split up into two as income effect and substitution effect. Where, income effect of a
price change is the change in the quantity demanded of a good with respect to a change in real income
of the consumer due to a change in the price of the good. That is, a fall in the price of a good raises the
real income of the consumer, which in its turn, tempts him to buy more quantity of that good, given his

65

money income and prices of other goods, and vice versa. Substitution effect of a price change is the
change in the quantity demanded of a good due to its substitution for other good{s}24, or other wise,
when its price changes. For instance, when the price of good X falls, it becomes relatively cheaper than
its substitutes. As a result, the consumer has a tendency to use more of X and less of its substitute{s}. It
means, when price of X falls, X becomes cheaper than Y, a substitute, and consequently, the consumer
substitutes X for Y. Here the quantity of X good rises at the expense of Y good. This increase in the
quantity purchased of X good at the expense of Y good is the substitution effect of a fall in the price of X
good.
On the other hand, a rise in the price of a good makes it relatively dearer than its substitute{s}.
For instance, when the price of good X rises, it becomes dearer than good Y, its substitute. As a result,
the consumer substitutes good Y for good X. It leads to a decrease in the quantity purchased of good X,
and an increase in the quantity purchased of good Y.
Figure 015 can be used to explain the splitting up of price effect in to income effect and
substitution effect [Hicksian version].
In figure 015, we take money income [or good Y] on vertical axis and the quantity of good X,
a normal good, on horizontal axis. Given the money income as OA, the consumer has a budget line AB
which is a tangent to the indifference curve I1 at point e1. Point e1, thus, represents the initial
equilibrium of the consumer. Corresponding to this equilibrium, he purchases OX1 of good X and retains
OY1 of his money income. Given the money income, a fall in the price of good X leads to shift in the
budget line from AB to AC. That is, the opportunity region is enlarged from OAB to OAC.
Let us apply the celebrated tool of Compensating Variation Technique [CVT]. CVT is an
analytical device to absorb or to nullify the change in the real income with respect to a price change
hypothetically. This is applied to nullify both the increase and decrease in the real income. When there is
an increase in the real income of consumer due to a fall in price, we take away consumers money
income to the extent by which the increased real income could be absorbed completely. In Hicksian
version, this compensation places the consumer at his original indifference curve I1as in figure 015.
When we apply the CVT, we gat a new budget line, called the compensated budget line. The line HH in
the figure is the compensated budget line. The compensated budget line HH is parallel to the budget
line AC. It means the price ratio is unchanged between AC and HH.
Figure 015

24

To be read as good or goods.

66

The compensated budget line HH cannot be a tangent to the indifference curve I1

at the point e1, the original equilibrium point. It is a tangent to the indifference curve I1 at the point e2.
That is, the consumer reaches in to a new equilibrium at point e2. Corresponding to this new equilibrium
at point e2, he purchases OX2 quantity of good X. That is, he purchases an additional quantity of good X
equal to X1X2. This increase in the quantity of good X is definitely free from any effect of an increase in
the real income.
This increase in the quantity of good X is the substitution effect of a price
fall. The consumer now gets an opportunity to buy more units of the cheaper X good in place of some
units of its substitute whose price remains unchanged. In other words, he substitutes X good for other
goods [or money income]. It leads to an increase in the quantity purchased of good X. In figure 015, the
quantity X1X2 is an exact measure of the substitution effect.
If we relax the CVT, that is, giving back the amount of money income to the consumer, the
budget line shifts from HH to AC. The budget line AC is a tangent to a higher indifference curve I 2 at
point e3. Actually we have created a hypothetical equilibrium, e2, between the initial equilibrium e1 and
the final equilibrium e3 by the application of the CVT. Now the consumer, corresponding to the
equilibrium e3, purchases, as figure 015 shows, OX3 quantity of good X. That is, he purchases an
additional quantity of good X equal to X2X3. This additional quantity equal to X2X3 measures the income
effect of the price change. This additional quantity of good X equal to X2X3 is completely free from the
substitution effect.

67

In the figure 015, the net price effect is equal to X1X3. This price effect, X1X3, is equal to the
income effect and substitution effect added together. Where, the substitution effect is equal to X1X2
and the income effect equal to X2X3. Thus, X1X3 = X1X2 + X2X3 or the price effect is equal to the
substitution effect plus the income effect.
Derivation of Demand Curve from Indifference Curve Analysis:
Perhaps the main responsibility of the Indifference Curve Analysis is the verification of the law
of demand. The Hicks and Allen indifference curve analysis, the celebrated ordinalist introspective utility
theory, is successful in verifying not only the law of demand but its notorious exception, the Geffen
Paradox, as well. We can derive the demand curve of normal, inferior or Geffen goods from the
indifference curve analysis. This is definitely the superiority of the indifference curve analysis over the
original Marshallian version25 of the cardinal utility theory.
We can explain the derivation of demand curve by a diagram [figure 016] as follows.
In upper panel [figure 016], we measure money income on vertical axis and quantity of good
X, a normal good, on horizontal axis. In lower panel, we measure price of good X vertically and the
quantity demanded of good X horizontally. The consumer has a money income equal to OM. Given the
money income, MA is the initial budget line which is a tangent to the indifference curve I1 at point e1.
Thus, point e1 shows the initial equilibrium corresponding to which the quantity that the consumer likes
to purchase is OX1. We can find the price corresponding to the budget line MA by dividing OM, the
money income by OA, the maximum quantity of X which could be bought by OM. Let us assign
numerical values to OM and OA. Suppose OM is equal to Rs.200 and OA is equal to 10. Then Px =
OM/OA = 200/10 = 20. Let us call this price as P1.
In lower panel, now we get a combination of Px and the quantity demanded of good X. They
are, P1 and X1, respectively. This combination is represented by the point a.
Similarly, given the money income, the budget line MB which is a tangent to the indifference curve I2 at
point e2 shows a lower level of Px. Point e2 represents the new equilibrium corresponding to this lower
level of Px. This lower level of Px can be found by dividing OM, the money income by OB. Assigning a
value to OB equal to 20 we get the new Px, say P2, equal to OM/OB = 200/20 = 10. Thus, we get a new
combination of Px and the quantity demanded of good X. It is represented by point b in the lower level.
Likewise, given the money income, the budget line MC, which is a tangent to the indifference
curve I3 at point e3, shows a lower level of Px. Point e3 represents the new equilibrium corresponding to
this lower level of Px. This lower level of Px can be found by dividing OM, the money income by OC.
Assigning a value to OC equal to 25 we get the new Px, say P3, equal to OM/OC = 200/25 = 8. Thus, we
get a new combination of Px and the quantity demanded of good X. It is represented by point c in the
lower level.

25

Modern version of the Marshallian Utility theory is able to analyse the Giffen Paradox.

68

The combinations a, b and c, of Px and quantity demanded of good X are directly derived from
equilibrium points e1, e2 and e3, respectively. Let us interpret the combinations a, b and c. Combination
a shows that the consumer demands OX1 quantity of good X when its price is equal to P1 [20]. Similarly,
as combination b shows, he demands OX2 quantity of good X when its price is equal to P2 [10]; and as
combination c shows, OX3 quantity of good X when its price is equal to P3. It is clear that
P1=20>P2=10>P3=8. When the price is P1, the consumer demands OX1 quantity of good X. When the
price falls from P1 to P2, he demands OX2 quantity of the good. Similarly, when the price falls from P2 to
P3, he demands OX3 quantity of the good. Where, the OX1 < OX2 < OX3. It is clear from the figure 016
that when the price falls from P1 to P2 the quantity demanded rises from OX1 to OX2, and when the
price falls further from P2 to P3 the quantity demanded rises from OX2 to OX3. That is, every fall in the
price of good X leads to an increase in its quantity demanded, and vice versa.
Figure 016

In the lower panel, by joining the combinations a, b and c by a smooth curve we get the
demand curve, DD. The demand curve, DD has a negative slope which reflects the inverse relationship
between the quantity demanded of a good and its price, that is, the celebrated law of demand.

69

Thus, the indifference curve analysis, through its ordinal utility approach, has proven the law
of demand as valid. The great achievement of this analysis is that it involves no cardinal measurement of
utility. The ordinalist approach to the theory of consumers behaviour has contributed a strong and
logically consistent proof to the law of demand. Thus, the indifference curve analysis is a path breaking
contribution in the theory of demand.
Derivation of Demand curve of the Geffen Good:
Geffen good is that good in case of which the quantity demanded is a direct function of its
price. That is, its quantity demanded decreases with a decrease in its price, and vice versa. It is an
inferior good. However, all inferior goods are not the Geffen good. Goods like potato, which have a low
price and are common items in household budget, were experienced historically as the Geffen good.
We can derive the demand curve of the Geffen good by a graph [figure 017] as follows.

Figure 017

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In upper panel [figure 017], we take the money income vertically and the quantity of the
Geffen good X horizontally. Points, e1, e2 and e3 are three equilibria at three levels Px. These three levels
of Px are P1 = 6, P2 = 4 and P3 = 3, respectively.
Equilibrium e1 reveals that, given the money income as OM = 120, the consumer likes to buy OX1
quantity of good X. The budget line corresponding to this equilibrium is MA which reflects a price equal
to P1. Where, P1 is equal to 6 since OM = 120 and OA = 20
Similarly, equilibrium e2 reveals that, given the money income as OM = 120, the consumer
likes to buy OX2 quantity of good X [where, OX2 < OX1]. The budget line corresponding to this
equilibrium is MB which reflects a price equal to P2. Where, P2 is equal to 4, since OM = 120 and OA =
30.
Likewise, equilibrium e3 shows that, given the money income as OM = 120, the consumer likes
to buy OX3 quantity of good X [where, OX3 < OX2]. The budget line corresponding to this equilibrium is
MC which reflects a price equal to P3. Where, P3 is equal to 3 since OM = 120 and OA = 40.
In lower panel of figure 017, we take the price of good X, the Geffen good, vertically and its
quantity demanded horizontally. We derive three combinations of quantity demanded of good X and its
price in the lower panel. These three combinations are e1, e2 and e3. They are derived directly from the
equilibrium points, e1, e2 and e3, respectively.
Combination e1 shows that the consumer demands OX1 quantity of the good at the price P1.
When the price comes down from P1 to P2, the quantity demanded decreases from OX1 to OX2.
Likewise, the quantity demanded further decreases from OX2 to OX3 when the price falls from P2 to P3.
It means that every fall in the price of the Geffen good is followed by a decrease in its quantity
demanded. If we move back from point c to point b, we can experience an increase in quantity
demanded from OX3 to OX2 as price rises from P3 to P2.
In the figure 017 we derived three points of combinations, a, b and c, of quantity demanded of
the Geffen good and it price. If we join all these three combinations, a, b and c, by a smooth curve we
get a demand curve. The demand curve DD so derived in the figure 017 is with a positive slope. Its
positive slope signifies that the quantity demanded of the Geffen good is directly related to its price.
That is, a fall in the price is followed by a decrease in quantity demanded, and vice versa.
Derivation of Demand curve of the Geffen Good through the ordinal utility approach is
definitely a path breaking contribution of Hicks and Allen.
Geffen Paradox:
Geffen Paradox is one of the notorious exceptions to the law of demand. The paradox is
associated to the name of a Scottish economist, Robert Geffen. He was contemporary to Alfred Marshall
the great neoclassical economist. He invented a pertinent exceptional case to the law of demand. He
made correspondence with Marshall regarding the paradoxical case he invented. Scholars and writers

71

gave importance to the paradox when it was brought in to the mainstream economic theory. The
essence of the paradox is as follows.
Certain inferior goods like potato are very common in the household budget. The goods, like
potato, generally, have low price. Consumers, most often, use much quantity of these goods not only
because they are cheaper than many other goods, but also because the amount of money left after their
purchase is too little to buy, at least, a minimum quantity of another good, say a superior good Y
towards which their appeal is very strong. These goods are called the Giffen goods. When the price of
the Giffen good falls the consumers can find certain surplus money in their budget after the allotment of
money to buy it. This means an increase in their real income. This surplus, as such, is insufficient to buy
the minimum quantity of the superior good Y, towards which their appeal is very strong. Then, they
reallocate their budget. They cut short the quantity of the inferior good X [Giffen good] to buy certain
quantity, at least a minimum, of the good Y [Superior good]. What really happened here is that the
quantity demanded of the inferior good [Giffen good] is decreased with a fall in its price. It means that
the quantity demanded of Giffen good is a direct function of its price.
We have seen that the demand for certain inferior goods is a direct function of their price.
However, this paradoxical behaviour is not true for all inferior goods. There are very many inferior goods
in case of which, as usual, quantities demanded are inverse functions of their prices.
Geffen good is that inferior good in case of which the substitution effect is weaker than the
negative income effect. Substitution effect of a price change of all goods is always negative. The
statement, Substitution effect of a price change is always negative is the celebrated Law of Substitution
or the Slutskys Law.
No good is an exception to the Slutskys Law. Irrespective of the nature of goods, that is,
whether they are inferior, superior or normal goods, they are substituted for others [substitutes] when
they are relatively cheaper.
However, the income effect of a price change may not always positive. For normal goods it
is positive. But for some inferior goods the income effect of a price change is not positive. It is seen as
negative for such goods.
However, for many inferior goods the demand is still an inverse function of price. Why it is
like that? The reason is that the negative substitution effect is very powerful to overcome the negative
income effect. For Geffen good, the negative Substitution effect is too weak to cancel out the negative
income effect. Consequently, for Geffen good, the demand is a direct function of price.

Applications of the Indifference Curve Analysis:

Indifference curve analysis, the great ordinalist introspective approach to the theory of
consumers behaviour, has a number of applications in a wide variety of fields of economics. We may
explain a few important ones of them as follows.

72

1. It explains consumers equilibrium:

Indifference curve analysis explains consumers equilibrium in a more scientific way. It derives the
condition of consumers equilibrium in a logically consistent way. The condition of consumers
equilibrium derived by the indifference curve analysis is: MRSxy = MUx/MUy = Px/Py. Where, MUx/MUy
is the slop of the indifference curve and Px/Py that of the budget line. Figure 015 illustrates the
consumers equilibrium26.
2. It helps derive the law of demand in a more realistic way:
Indifference curve analysis derives the law of demand in a more scientific way. It, thus,
reinforces the law of demand.
3. It can be used to evaluate direct and indirect taxes:
We can evaluate the effect of a new tax policy through the indifference curve analysis. We
can tell whether direct or indirect is suitable in the new tax policy.
4. It splits up price effect in to substitution effect and income effect:
5. It explains the Geffen Paradox:
Geffen paradox, one of the notorious exceptions to the law of demand, can be explained
by the indifference curve analysis
6. It explains the demand for non-Geffen inferior goods:
Indifference curve analysis infers that the quantity demanded of an inferior good, if it is not
a Geffen good, is inversely related to its price. In case of this good, though the income effect is negative,
the substitution effect is strong enough to maintain the law of demand in tact.

7. It reinforces the Slutskys Law of Substitution:

The celebrated Slutskys Law of Substitution, the substitution effect of a price change is
always negative, is strengthened by the indifference curve analysis.

8. It measures the consumers surplus with out measuring utility:

The concept of consumers surplus has got a better measurement with the invention of
the indifference curve analysis
9. It is very useful in intertemporal analysis:
Indifference curve analysis is very useful to explain consumers choice between present
consumption and future consumption.
10. It is useful to find the optimal choice between income and leisure:
Indifference curve analysis is very useful to explain a workers choice between income and
leisure.

26

Readers are suggested to use appropriate figures available in back pages.

73

Superiority of the Indifference Curve Analysis over the Traditional, Marshallian, Cardinalist Utility
Theory:
1.

Indifference curve analysis avoids the unrealistic cardinal utility assumption:

Ordinal utility theorists, Hicks and Allen avoid the unrealistic cardinal utility assumption and, in
lieu of it, they have used the more realistic ordinal utility assumption.
2.

It avoids the unrealistic assumption of constant marginal utility of money:

The indifference curve analysis applies neither a measuring rod of utility nor the concept of
measurement of utility.
3.

It can explain a number of economic problems and phenomena:

The indifference curve analysis explains a number of economic problems and phenomena which
are not explained by the cardinal utility theory.
4. It is a multi-commodity model:
The Marshallian cardinal utility model, MUx = Px, is basically a single commodity model. On the
other hand, the indifference curve analysis can accommodate any number of goods.
5. Scientific analysis of Slutskys law and price effect:
Unlike the Marshallian cardinal utility model, the indifference curve analysis facilitates a
scientific treatment of the celebrated law of substitution of Slutsky. It proves the substitution effect of a
price change is always negative.
6. It assumes too little but infers too much:
It is generally blamed that the Marshallian cardinal utility theory assumes too much and infers
only too little. On the other hand, indifference curve analysis assumes too little and infers too much.
A comparative Study of the Indifference Curve Analysis and the Traditional Marshallian Cardinal
Utility Theory:
There are many differences as well as similarities between the indifference curve analysis and
the traditional Marshallian cardinal utility theory. Let us explain some of these leading similarities and
differences as follows.
A] Differences:
1. Ordinal Vs. cardinal assumptions:
The traditional utility theory assumes that the utility is measurable. On the other hand, the
indifference curve analysis assumes that the utility is immeasurable but comparable.
2. Marginal utility of money:

74

The traditional utility theory uses money as a measuring rod of utility. On the other hand, the
indifference curve analysis does not use any such measuring rod of utility. The traditional utility theory
assumes that the marginal utility of money is constant. On the other hand, the indifference curve
analysis does not assume that the marginal utility of money is constant.
3. Price effect:
The traditional utility theory cannot split up the price effect into substitution and income
effects. On the other hand, the indifference curve analysis splits up the price effect into substitution
effect and income effect in a scientific way.
B] Similarities:
1. Certainty:
Both the traditional utility theory and the indifference curve analysis apply the certainty
assumption. They do not analyse consumers choice involving risk or uncertainty.
2. Continuity:
Both the traditional utility theory and the indifference curve analysis apply the continuity
assumption. However, the Marshallian continuity assumption shows the continuity in consumption, the
Hicksian continuity assumption shows continuity in substitution.
3. Rationality:
Both the traditional utility theory and the indifference curve analysis assume that the consumer
is a rational person who tries to maximise his total utility or satisfaction.
4. Introspection:
Both made use of the psychological method of introspection to analyse consumers behaviour.
5. Condition of equilibrium:
Both stipulated the condition of consumers equilibrium as MUx/MUy = Px/Py.
6. Consumers scale of preference:
In both the theories, the consumer is assumed to have a scale of preference which is very
comprehensive to include all the combinations of all available commodities.
Limitations of the Indifference Curve Analysis:
1. Old wine in new bottle:
In Hicksian inference analysis the consumer is in equilibrium when the marginal condition
MUx/MUy = Px/Py is fulfilled. This condition is nothing other than the celebrated neoclassical

75

proposition developed by Marshall. Thus, the indifference curve analysis is called as the old wine in
new bottle.
2. Defective introspection:
Hicks and Allen criticised the Marshallian theory for its defective assumptions and methodology.
They developed their so called superior theory, however, with out avoiding the defective method of
introspection. The introspection, being a psychological method, is not at all practical in studying the
behaviour of consumer27.
3. No behaviourist treatment:
It fails to utilize the superior behaviourist method in consumers theory.
4. A midway house analysis:
Indifference Curve Analysis is neither a pure armchair theorizing nor a complete empirical
analysis. Prof. Schumpeter calls it as a midway house analysis.
5. It fails to analyse consumers choice involving risk:
Indifference curve analysis, like the Marshallian cardinal utility theory, cannot explain
consumers choice involving risk. In practical life consumers have to face a lot of situations of choice
involving risk. For these cases the indifference curve analysis has no word to spell.
6. It fails to analyse strong ordering:
Hicksian indifference curve analysis applies the weak ordering approach for ranking. It, in
several respects, is inferior to the strong ordering approach of Paul A. Samuelson.
REVEALED PREFERENCE HYPOTHESIS
Introduction
The concept of revealed preference was introduced into the literature on consumers
behaviour by Samuelson28. He himself was the pioneering architect and main contributor of the revealed
preference theory29. Among the others who contributed to the development of this theory are H. S.
Houthakker30 and I. M. D. Little31

27

We will see its details when we discus the Revealed Preference Theory of Samuelson.
P. A. Samuelson; A note on the pure theory of consumers behaviour
29
P. A. Samuelson; Consumption Theory in Terms of Revealed Preference, Economica, N. S. XV, 1948
30
H. S. Houthakker; Revealed Preference and Utility Function, Economica, 1950
31
I. M. D. Little; A Reformulation of the Theory of Consumers Behaviour, Oxford Economic Papers,
1949
28

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Samuelson introduced an altogether new approach to the theory of consumers

behaviour. This is called the behaviourist ordinalist approach. The motives which led him to embark on
this approach were the following:
1. His dissatisfaction with the introspective method of both the cardinalists, like Marshall and the
ordinalists, like Hicks and Allen. In particular, although the ordinal approach represented an
improvement on the cardinal approach, it was not completely free from the vestiges of
cardinalism. This is reinforced by the assumption of continuity of indifference curve.
2. In the ordinal approach, the construction of the indifference map may require quite a bit of
introspective information from the consumer. He must be able to state his preferences among
all possible combinations of commodities.
3. And, the difficulty confronted on providing convexity to the indifference curve.
Though the indifference curve analysis made sweeping changes in the theory of
consumers behaviour, it also created gloominess of increasing dissatisfaction among scholars regarding
the realism of its assumptions, especially the rationality, continuity and nonsatiety assumptions.
Economists of that age were longing much for an effective alternative of the introspection. It was at this
time of dissatisfaction and hunger the revealed preference theory appeared in the mainstream of
economics literature. As H. K. Manmohan Singh says, If we were to sum up the course of development
of the pure theory of demand, we would describe it as a move from psychological to behaviouristic
explanation of consumers behaviour in economic markets. The utility theory was purely subjective. It
sought to explain observed consumers behaviour in terms of motivation and psychological valuation.
The indifference curve analysis took the observed behaviour as an ultimate fact. It did not seek to
explain it. To that extent it released the theory of consumers choice from psychological implications.
But until a satisfactory method of deriving quantitative counterparts from empirical analysis is
discovered of which there seems to be no promise the indifference curves remain a sort of
psychological postulate32.
Samuelson, in his approach, proposed to drop all vestiges of utility. Unlike the earlier
two approaches, his approach is behaviourist, and hence, objective. He, with the help of a few axioms,
made a scientific theory of consumers behaviour.
Axioms of the theory:
Samuelsons theory stands upon some axioms. They are explained as follows.
1. Rationality:
Samuelson used the axiom of rationality with an altogether different connotation.
Rationality signifies that the consumer always prefers bundles of goods that include more quantities.
That is, more quantity of a good is preferred to its less quantity.
2. Choice reveals preference:
The consumer, by choosing a collection of goods in any one income-price situation
[defined by the prices of goods and consumers income], reveals his preference for that particular
32

H. K. Manmohan Singh; Demand Theory and Economic Calculation in a Mixed Economy, George Allen and
Unwin Ltd, 1963, p. 64

77

collection. The chosen bundle [collection] is revealed to be preferred among all other alternative
bundles available under the income-price situation.
Figure 001

Suppose there is an income-price situation OAB, as shown in figure 001, open to the
consumer. All combinations of X and Y goods on the price-income line AB, and all other combinations
inside the opportunity region OAB are feasible to the consumer. However, the rationality axiom directs
him to choose combinations only on the line AB.
Again suppose that the consumer, as shown in figure 001, has chosen combination K,
given the income-price situation. Through this choice he reveals his preference to the combination K
over all other available combinations, like N, M and L. That is, K is revealed to be preferred over N, M, L
and other possible combinations.
3. Consistency:
This axiom signifies that if the consumer prefers combination A over combination B in
an income-price situation, he cannot prefer B to A in a changed income-price situation if both are still
available to him. In brief, if A is preferred to B, then B cannot be preferred to A.
This axiom means that the behaviour of consumer is always consistent. J. R. Hicks
calls this axiom as the two term consistency.

78

4. Transitivity:
It means that if there are three combinations A, B and C available to the consumer in
a particular income-price situation, and of these combinations if he prefers A to B and B to C, then A is
preferred to C. That is, if A is preferred to B and B is preferred to C, then A is also preferred to C.
Symbolically, if A>B and B>C, then A>C.
J. R. Hicks calls this axiom as three term consistency.
Assumptions:
Samuelsons theory is based on the following assumptions. These assumptions,
unlike the utility theories, are not only small in number but fairly realistic as well. They are as follows.
1. Consumer has given tastes and preference:
It is assumed that the consumers tastes and preference remain unchanged in the
analysis period.
2. Positive income elasticity of demand:
Samuelson states his hypothesis based upon the Engels law. That is, an increase in
income of the consumer is followed by an increase in demand, and vice versa.
Based upon these assumptions, Samuelson states the Fundamental Theorem of
Consumption Theory, that is, the quantity demanded of a good is an inverse function of its price.
Methodology:
Samuelson applies the strong ordering method in his theory. Unlike Hicks, he says that
the consumer has a definite and strong order of preference. The choice of a particular combination out
of various alternatives reveals the definite preference of the consumer, and any possibility of
indifference about the alternative combinations stands completely ruled out. This strong ordering is not
a matter of convenience. As T. Majumdar33 says, The rejection of indifference in Samuelsons theory,
therefore, is not a matter of convenience but dictated by the requirements of his methodology.
Unlike the indifference curve analysis, the revealed preference theory makes use of
the behaviourist method. Under this method, actual choice of the consumer alone reveals his
preference. A single choice is enough to infer that the chosen combination is superior to all other
combinations which were not chosen though they also were possible to make a choice. In this way, we
can say whether one combination is superior or inferior to the other.
Samuelsons choice reveals preference postulate is a definite objective observation. It
is called as the behaviourist approach to the theory of consumers behaviour. The revealed preference
theory, as we have already mentioned, applies the ordinalist method along with this behaviourist
approach. Thus, Samuelsons theory is a hybrid variety called behaviourist ordinalist theory.

33

T. Majumdar; Measurement of Utility

79

With this methodology, Samuelson states his hypothesis which he calls as the
fundamental theorem of consumption theory. It is as follows.
Any good [simple or composite] that is known always to increase in demand when
money income alone rises must definitely shrink in demand when its price alone rises
It means that, given the positive income elasticity of demand, the quantity demanded
of a commodity decreases when its price rises. That is, the quantity demanded of a good decreases
when its price rises. We can test this hypothesis by a diagram [figure 002] as follows.
Figure 002

In figure 002, money income [or good Y] is measured vertically and quantity of good X
horizontally. Given the money income OA, the budget line [price-income line] of the consumer is AB.
This price-income situation opens the consumer an opportunity region equal to the area OAB. Let us
suppose that the consumer reveals his preference by choosing the combination K. This choice also
reveals that all other combinations in the opportunity region OAB are inferior to the combination K.
Corresponding to the choice of K the consumer buys OX1 quantity of good X.
Let the price of good X now increase. The budget line shifts inwards to AC. The new
opportunity region is OAC. Now the question is that what would be the quantity of the good X that the

80

consumer buys at this high price. We can prove that this quantity will be definitely less than the initial
quantity OX1.
Let us apply the compensating variation technique [CVT]. We give an additional amount
of money income, equal to AT, to the consumer so that that he is rightly compensated for the price rise.
The compensated budget line TS passes through the point K. It is parallel to the budget line AC. The new
opportunity region is OTS. The consistency postulate proposes that there is no chance to a choice of a
combination right side of point K, either on the line KS or in the triangle KX1S. This is because all these
combinations were proved inferior to K. Our rational consumer is consistent in behaviour. To him P was
inferior to K. Thus, K cannot be inferior to P. Thus, he will not buy a quantity of good X greater than OX1
at this new high price. If it is so, what would the possible quantity be purchased of at the new high
price? He may choose either K or a combination left to K. If he chooses K itself, then he buys the same
quantity [OX1] of good X. On the other hand, if he chooses a combination left to K on the line TK, say
combination W, then he purchases less quantity of good X than before. If, for instance, he chooses W,
then he buys OX2 quantity of good X in this changed income-price situation. Where, OX2 is less than the
OX1.
Let us relax the CVT. Taking back the AT amount of money income from the
consumer; we get the budget line AC. Given the positive income elasticity of demand, the quantity
purchased of good X must fall below OX1. That is, the subtraction of income will necessarily reduce the
consumers consumption of X in the new price-income situation. Thus, he may choose a combination on
the new budget line AC corresponding to which the quantity of X is less than OX1. He cannot choose K
since it is beyond his reach. Suppose he chooses the combination Q on the new budget line AC. Then he
purchases OX3 quantity of X which is less OX1. Thus, it is undoubtedly proven that the law of demand is
true and valid. That is, an increase in price of a good is followed by a decrease in its quantity demanded.
Samuelson terms the move from W to Q as the income effect and the move from K to
W as the overcompensation effect34. The overcompensation effect is different from the Hicksian
substitution effect, the movement along the same indifference curve.
Let us analyse Samuelsons hypothesis for a fall in price. For this purpose we can state
the hypothesis as:
Any good [simple or composite] that is known always to decrease in demand when
money income alone falls must definitely expand in demand when its price alone falls
It means that, given the positive income elasticity of demand, the quantity demanded
of a commodity increases when its price falls. That is, the demand for a good expands with a fall in its
price. We can test this hypothesis by a diagram [figure 003] as follows.
In figure 003, AB is the initial budget line, given the money income and the Px.
Suppose that the consumer reveals his preference by choosing the combination K. This choice also
34

Samuelson; Consumption theorems in terms of overcompensation rather than indifference comparisons,

Economica, 1953, p. 5

81

reveals that all other combinations in the opportunity region OAB are inferior to the combination K.
Corresponding to the choice of K the consumer buys OX1 quantity of good X.
Let the price of good X now decrease. The budget line shifts outwards to AC. The new
opportunity region is OAC. Now the question is that what quantity of the good X that the consumer buys
at this low price. We can prove that this quantity will be definitely more than the initial quantity OX1.

Figure 003

We take some amount of money income, equal to AT, from the consumer so that that he is
rightly compensated for the price fall. The compensated budget line TS passes through the point K. It is
parallel to the budget line AC. The new opportunity region is OTS. The consistency postulate proposes
that there is no chance to a choice of a combination left side of point K on the line KT. This is because all
these combinations were proved inferior to K. To him P was inferior to K. Thus, K cannot be inferior to
P. Thus, he will not buy a quantity of good X less than OX1 at this new low price. If it is so, what would
the possible quantity be purchased of at the new low price? He may choose either K or a combination
right to K. If he chooses K itself, then he buys the same quantity [OX1] of good X [this happens after the
compensation]. On the other hand, if he chooses a combination right to K on the line SK, say
combination W, then he purchases more quantity of good X than before.

82

Giving back the AT amount of money income to the consumer; we get the budget line AC.
Given the positive income elasticity of demand, the quantity purchased of good X must rise above OX1.
That is, the addition of income will necessarily increase the consumers consumption of X in the new
price-income situation. Thus, he may choose a combination on the new budget line AC corresponding to
which the quantity of X is more than OX1. He may not choose K since he is a rational person trying to
attain the maximum possible quantity of X, given his income-price situation [possibility of choice of
combination below the budget line can be ruled out by the rationality assumption]. Suppose he chooses
the combination Q on the new budget line AC. Then he purchases more quantity of X than before. Thus,
the law of demand is, once more, verified and found correct and valid. That is, a decrease in price of a
good is followed by an increase in its quantity demanded.
It is clear from the above explanations that Samuelsons behaviourist ordinalist
approach succeeded in its task to prove that the law of demand holds good. This is the first successful
utility free analysis of the law of demand. This is one of the important inspirations behind the work of
Hicks, A Revision of Demand Theory published in 1956. In this work, Hicks proposes his logical
ordering in lieu of his indifference curve analysis.
I. M. D. Little35 and H. S. Houthakker extend the dimensions of the revealed preference
theory through their works, especially through mathematical versions. Little gives a better mathematical
version to this theory. He explains the Slutskys law [substitution effect of a price change is always
negative] through the revealed preference theory.
Advantages of the Revealed Preference Theory:
Compared to the cardinal and ordinal utility theories, the revealed preference theory has
some remarkable advantages. They are as follows.
1. It assumes very little:
Unlike utility theories, it uses very little assumptions. It does not use the assumptions like
continuity, cardinal measurability of utility and nonsatiety.
2. It redefines the rationality assumption:
The revealed preference theory redefines the rationality assumption in the theory of
consumers behaviour. It uses the rationality assumption in Paretovian sense that the consumer tries to
attain maximum quantity of any good, and not in the Marshallian sense of maximisation of utility.
3. It is free from the vestiges of utility:
It uses no utility concept. It is, thus, utility free theory of consumers behaviour. It is free
from the vestiges of utility.
4. It is more objective:
35

I. M. D. Little; Microeconomic Theory: A Mathematical Approach, Oxford University Press, London, 1957, pp.
41-42

83

It applies the behaviourist ordinalist method for analysing consumers behaviour. This
method, unlike the method of introspection, is more objective.
5. It provides an operationally meaningful foundation to the demand theory:
Through this theory, we arrive at consumers behaviour simply by observing all the acts
of choice which he performs in the market, without making any assumption about what goes on in his
mind when he makes them. Thus, revealed preference theory, as Samuelson himself declared, provides
an operationally meaningful foundation to the demand theory.
6.

It has fine mathematical versions:

Many fine mathematical versions of this theory are available in the mainstream
literature. This is due to its mathematical fitness.
7. It can derive indifference curves:
Though it is not essential, the revealed preference theory can derive indifference curves
in a logically consistent way. It proves the convexity of the indifference curves without any application of
utility concepts.
8. It can be explained through index number:
In the mainstream literature we get an explanation of this theory through index numbers.
Limitations of the Revealed Preference Theory:
Though the revealed preference theory has a number of advantages over the traditional
theories, it also is not free from criticism. Following are the important points of criticism leveled against
the revealed preference theory.
1. It provides no scope for empirical evidence:
Samuelsons methodology is inflexible and, thus, it provides no scope for any empirical
findings. If it were flexible, we could repeat an experiment of consumers choice multiple times in a
particular income-price situation, and, there by, we could infer the possible consistency of consumers
behaviour. Unfortunately, Samuelson leaves no way for empirical testing.
2. Total negation of indifference:
Samuelson applied the strong ordering method in his analysis. He totally neglected the
possibility of indifference between combinations of goods. In our day to day life we come across many
alternatives and, at least, some of which are indifferent to each other. Thus, Samuelsons negation of
indifference cannot be justified.
3. It fails to split up price effect in to substitution effect and income effect:
Though the revealed preference theory develops a very strong foundation to the demand
theory and provides valid evidence to the law of demand, it cannot split up the price effect in to
substitution effect and income effect due to the limitations of its methodology and the resulting
analytical weakness.
4. It fails to explain the law of demand when the income elasticity of demand is negative:

84

It presumes that the income elasticity of demand is positive. There are many goods in case of
which the income elasticity of demand is negative, but the law of demand is valid also for them [Inferior
but not Giffen goods]. It fails to explain the law of demand for such goods.
5. It cannot explain the Geffen paradox:
Geffen paradox signifies the inapplicability of the law of demand for Geffen goods. The
income elasticity of demand is negative for such goods. More over, the negative income effect of price
change is much powerful, more than to nullify the substitution effect. Thus, for such goods, the quantity
demanded is a direct function of their price. The revealed preference theory cannot explain this Geffen
paradox due to its methodological limitations and the resulting analytical weakness.
6. It cannot explain consumers choice involving risk:
The revealed preference theory can explain only the consumers choice under conditions of
certainty. Many situations, like buying of lottery tickets and engaging in gambling, involve consumers
choice involving risk. As a serious drawback, the revealed preference theory fails to explain consumers
choice involving risk.
Derivation of indifference curves from the Revealed Preference Theory:
Although not a matter of necessity, the revealed preference theory can derive indifference
curve and can prove its prestigious property of convexity. This is done without any association with
utility concepts. We can explain it graphically [figure 004] as follows.

Figure 004

85

In figure 004, NM is a price-income line [budget line]. On the line NM, the consumer
is assumed to reveal his preference to A, through his choice, over all other available combinations in the
opportunity region ONM. It is clear that all combinations on the budget line NM and inside the region
ONM are revealed inferior to the chosen combination A. Thus, in association with A, we can call the area
ONM as the zone of inferior baskets of goods.
Combination B is superior to A. This is because that B consists of more quantity of Y
good, but the same quantity of X good compared to A. Rationality axiom reminds us that the consumer
always prefers more quantity of any good. Thus we can infer that B is superior to A. Similarly,
combination C also is superior to A. Where, C consists of more of X but same Y compared to the
combination A.
Thus, we can say that all combinations on both AB and AC perpendiculars are
superior to the combination A. Likewise, the shaded area represents combinations superior to the
combination A. We can, thus, call the shaded area as the zone of superior baskets of goods.
The area which is between the budget line NM and the perpendicular AB does not
tell us any superiority or inferiority. Same is the case of the area between the budget line NM and the
perpendicular AC. We can, thus, call these areas as the zone of ignorance.

86

Let us draw an indifference curve with concavity, as I1. The budget line NM is tangent
to the indifference curve I1 at point A. This concave indifference curve I1 infers that the consumer is
indifferent between A and H. This inference is not matching with the consistency postulate. According to
the axiom of consistency, the consumer cannot be indifferent between A and H. To the consumer, who
revealed his preference to A over H, A is always superior to H. Thus, the possibility of concavity of
indifference curve can be ruled out.
Then, what about linearity? Let us take the line NM as an indifference curve. Given the
indifference curve NM, A is indifferent to L. This inference, however, does not match with the axiom of
consistency. Consumer has already revealed his preference to A over L. Thus, the possibility of linearity
of indifference curve also can be ruled out.
Then, can we take BAC as an indifference curve? Definitely, we cannot. The
combinations B and C were already proved superior to the combination A. Thus, BAC cannot be an
indifference curve.
Now the area remaining for observation is confined to the zone of ignorance. By
changing the prices of X and Y goods we can narrow down the zone of ignorance. By this method we get
a thin area of ignorance zone. This thin area of ignorance zone helps us draw an indifference curve, as I
in figure 004. The indifference curve I is fully consistent with the axioms of the revealed preference
theory. It is in full conformity with the consistency postulate, indeed. We can say that the consumer is
indifferent between A and any other combination on the curve I.
In brief, it is proved that we can derive the indifference curve through the revealed
preference theory in a logically consistent way. Thus, the revealed preference theory opens an indirect
way to the indifference curve analysis, and thus, makes satisfied the scholars who were dissatisfied of
dubious shapes and slopes of the indifference curves.
Conclusion:
The revealed preference theory, one of the important advancements in the theory of
consumers behaviour, is definitely a step ahead of the traditional theories. It does not hold any
unrealistic assumption or inapplicable method for analysing consumers behaviour and the law of
demand. Objectivity is its remarkable feature. It provides a sound rationale to the law of demand. It
suggests the scholars and theorists to stop their blind race behind the baffling vestiges of utility. Its
validity, as a theory of consumers choice under certainty, will survive until the invention of the
utilometer36, the great ambition of utilitarians like Jermy Bentham. How ever, its applicability is
confined to consumers choice under certainty. It seldom facilitates an explanation to consumers choice
involving risk37.

36

Colander; Economics, McGraw-Hill Irwin, fourth edition, p. 177

The reader is suggested to read the Modern Utility Theory of Neumann and Morgenstern, and also the State
Preference Theory for additional learning.
37

87

INDIVIDUAL AND MARKET DEMAND

Introduction:
The concept of demand is of immense importance to both economic theorists and business
practitioners, because it along with supply determines the price of a commodity. The price, in its turn, is
a crucial factor which determines the fortunes of producers, at a microeconomic perspective, as well as
the stability and growth of the economy, at a macroeconomic perspective. Thus, the concept of demand
along with that of supply occupies a pivotal place in economics.
People have been talking about demand and supply since time immemorial. They still do, in
every day conversation as well as in such places as the financial pages and editorial columns of
newspapers and business broadcasting of electronic media. These discussions are not confined to media
but extended over to direct serious enquiries of business firms and public policy makers.
The modern theory of demand rests on the structure built by Alfred Marshall. His magnum
opus, the Principles of Economics molded the thinking of his and the following generations of
economists all over the world to frame a systematic theory of demand. New generation economists
successfully added their contributions to the Marshallian foundations to make the demand theory more
concrete and objective.
From Individual Demand to Market Demand:
Individual Demand:
Individual demand for a good, practically, means its quantity demanded at a specific price in
given market during a specific period of time. Literally, this term signifies the desire of an individual to
buy a good at a specific price. However, economists call desires for a good as demand only when they
are backed by willingness and ability to pay. That is, in economists perspective, demand is the desire of
the consumer for a good supported by his willingness and ability to pay for obtaining it.
Individual demand for a good is a multivariate function. That is, the individual demand for a
good depends upon a multiplicity of factors. Of these factors, some are more significant compared to
others. Economists rightly from Marshall have developed the demand functions by incorporating only
the factors which seem to be very significant.
Individual Demand Function:
An individual demand function shows the functional relationship between an individuals
demand for a good and its major determinants. An individuals quantity demanded of a good depends
upon many factors. Following are the important ones among them.
1.
2.
3.
4.

Price of the good in question [Px]

Prices of related [complementary or competitive] goods [Py]
Income of the individual consumer [Y]
Consumers tastes and preference [T]

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5. Advertisement of producers [A]

6. Other individuals quantities demanded of the good [Qn]
Chasing the Marshallian partial equilibrium approach38, we can develop an individual demand
function as follows.
Qdx = {Px} Py, Y, T, A, Qn

---------------- [1]

Where, Qdx is the quantity demanded of X good, Px, the Price of X good , Py, the price of Y
good, Y, the income of the individual consumer, T, the tastes and preference of the individual consumer,
A, the advertisement of producers, and Qn, the other individuals quantities demanded of the X good.
The factors Py, Y, T, A and Qn are called shift factors, because any change in these factors, collectively
or individually, may lead to a shift in the demand curve39.The function [1] signifies that the quantity
demanded of X good is a definite function of its price, Px, given the other factors. Justification of the
mode of statement of this function is that the price of every good is the major determinant of its
demand. This is called the partial equilibrium approach to the demand theory. Under the partial
equilibrium approach, we use the ceteris paribous assumption which means other things remain the
same. As we have already conceived from the inferences of various theories of consumers behaviour,
the quantity demanded of a good is an inverse function of its price.
The individual demand function shows that, ceteris paribous, the quantity demanded of a
good varies inversely with its price. That is, more quantity of a good is demanded when its price is low,
and vice versa.
Individual Demand Schedule:
An individual demand schedule is a list of an individual consumers quantities demanded of a
good at various possible prices during a specific period of time. Following is a hypothetical individual
demand schedule of Mr. A [table 001] made on the basis of the ceteris paribous assumption.
Table 001
Demand Schedule of Mr. A

38
39

Price of good X [Rs]

Quantity demanded of good X [Kg]

It is based on the assumption ceteris paribous [other things are given]

This is explained in the coming section, Changes in Demand

89

In table 001, we see a list of various quantities demanded of good X against its different
possible prices. As table shows, quantity demanded of good X decreases with every increase in the price.
For instance, when price rises from Rs3 to Rs4, the quantity demanded falls from 4 Kg to 3 Kg and, when
price rises from Rs4 to Rs5, the quantity demanded falls from 3 Kg to 2 Kg, and so on. On the other hand,
when price falls from Rs6 to Rs5, the quantity demanded increases from 1 Kg to 2 Kg and, when price
falls from Rs5 to Rs4, the quantity demanded increases from 2 Kg to 3 Kg, and so on.
In brief, the individual demand schedule shows that the individual consumers demand for
a good varies inversely with its price.
Individual Demand Curve:
An individual demand curve is obtained by transforming the individual demand schedule in
to a graph. In figure 001, we show the individual demand curve of Mr. A. It is obtained by plotting
combinations of demand and price available in table 001.
Figure 001

In figure 001, DD is the individual demand curve. It has a negative slope signifying that the
individual consumer demands more quantity of the good when it has a low price, and vice versa. In
other words, the quantity demanded of the good is inversely related to its price. Thus, a decrease in the

90

price is followed by an increase in the quantity demanded, and an increase in the price is followed by a
decrease in the quantity demanded.
The individual demand curve in figure 001 is linear one. It, however, does not mean that
the individual demand curve is always linear. It may be linear or nonlinear.
The demand curves of different individuals may have different shapes and slopes. This is due to the
differences among the consumers regarding their response to the price change. For some consumers, a
given price change leads to a significantly large change in the quantity demanded. On the other hand,
for some other consumers, a given price change leads to a small change in the quantity demanded40.
That is, the responsiveness of quantity demanded of a good to its price varies from individual to
individual.
Market Demand Schedule:
Market demand schedule shows various quantities demanded of a good by all the buyers in a market at
various possible prices during a given period of time. We can construct a hypothetical market demand
schedule as follows.
Suppose that there are only three buyers in a market for good X. Individual
buyers, Mr. A, Mr. B and Mr. C, as shown in table 002, demand different quantities of good X at each
price and they respond differently for each price change. We can find the market demand for the good X
at each price by adding the quantities demanded of individuals.
Table 002
Market Demand Schedule
Price of good X [Rs]

Quantity demanded of good X [Kg]

Mr. A

40

Mr. B

Mr. C

Market Demand

12

25

10

21

17

13

Details are there in coming section, Price Elasticity of Demand.

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In table 002, last column shows the market demand for good X corresponding to the price
shown in first column. It is clear that the market demand for good X, like the individual demand, varies
inversely with the price.
Market Demand Curve:
Market demand curve is derived from the individual demand curves through their horizontal
summation. We can transform the market demand schedule shown in table 002 into a graph [figure
002] as follows. In the figure, we have the three individual demand curves having different slopes and
positions. The curve MD is the market demand curve which is obtained by adding individual quantities
horizontally. The market demand curve DD has a negative slope signifying the inverse relation between
the market demand for a good and its price.
Figure 002

We have seen that the individual demand curve is sloping downward from left to right.
Market demand curve, no doubt, slopes downward if all the individual demand curves have a negative
slope. If every consumer in the market buys fewer bananas when the price of bananas rises then the
total quantity demanded in the market must definitely fall.
But market demand curve may slope downward even when individual demand curves do
not, because not all consumers are alike. For example, if a bookstore reduces the price of a popular
novel, it may draw new consumers, but few customers will be induced to buy two copies. Similarly,

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people differ in their fondness for bananas. True devotees may maintain their purchases of bananas
even at exorbitant prices, while others will not eat a banana even if it is offered free of charge. As price
of bananas rises, the less enthusiastic banana eaters drop out of the market entirely, leaving the
expensive fruit to the more devoted consumers. Thus, the quantity demanded declines as price rises
simply because higher prices induce more people to kick the banana habit.
Individual demand, thus, may not be always inversely related to the price. But, in a market
for a good, by and large, there are hundreds of buyers, among them quiet a few exhibits exceptional
behaviour. Thus, the response of the total demand will be according to the law of demand. That is, the
market demand for a good varies inversely with its price.
Elasticity of Demand:
Elasticity of demand means the responsiveness of demand to its determinants. There are as
many types of elasticity of demand as there are the demand determinants. However, the most popular
types are;
1. Price elasticity of demand.
2. Income elasticity of demand.
3. Cross elasticity of demand.
4. Advertisement elasticity of demand.
Price Elasticity of Demand:
Price elasticity of demand is a popular measure of responsiveness of quantity demanded of a
commodity to its price, given the other determinants of demand. It shows the rate of change in quantity
demanded of a commodity with respect to a change in its price. It is the ratio of percentage change in
quantity demanded to percentage change in price. That is;
Ep = % change in Qdx % change in Px
Where, Ep is price elasticity of demand, Qdx, the quantity demanded of good X and Px, the price of good
X. The expression % change in Qdx shows the percentage change in quantity demanded; % change in
Px, the percentage change in price.
The above equation can be expressed mathematically as;
Ep = Q/Q P/P
Or
Ep = Q/P. P/ Q
Where, Q/Q is the relative or percentage change in quantity demanded and P/P, the relative or
percentage change in price. In the expression Q/Q, Q stands for the original quantity demanded and
Q for change in quantity demanded, that is, the difference between the original quantity and new

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quantity. Similarly, in the expression P/P, P stands for original price and P for change in price, that is,
the difference between the original price and new price.
Let us take a hypothetical demand schedule [table 003] to consider the response of
demand to price as follows.
Table 003
Px [Rs]

Qdx [Kg]

21

17

In table 003, when we consider the response of demand to price change from Rs2 to Rs3,
the initial quantity demanded [Q] is 21 Kg and change in quantity demanded [Q] is -4 Kg. Similarly,
the initial price [P] is Rs2 and the change in price [P] is Re1. Thus, we can substitute the values as
follows.
Ep = Q/Q P/P
= -4/21
= -0.190476 0.5
= -0.380952

We get a value -0.380952 for the elasticity coefficient Ep. In calculating elasticity it is
customary to disregard the minus sign to make the elasticity a positive number. In this way, a larger
elasticity number means that the demand is more responsive to price41.
Types of Price Elasticity of Demand:
Based upon the value of Ep, price elasticity of demand can be divided into five categories.
They are;
1. Perfectly elastic demand.
2. Perfectly inelastic demand.
3. Unitary elastic demand.
4. Relatively elastic demand.
5. Relatively inelastic demand.
Perfectly elastic demand:
Demand is said to be perfectly elastic when a minute change in price brings about infinitely
large change in quantity demanded. It means that the Ep has a value equal to . The horizontal straight
line PD in figure 003 represents the perfectly elastic demand. It has a slope equal to zero.
41

William J. Baumol and Alan S. Blinder; Economics: Principles and Policy, Third Edition

94

Perfectly inelastic demand:

Perfectly inelastic demand means that the quantity demanded is completely irresponsive to
price. That is, the quantity demanded is unchanged irrespective of any change in the price. The value of
Ep is equal to zero. The curve QD in figure 003 represents the perfectly inelastic demand. Its slope is
equal to infinity.
Unitary elastic demand:
Unitary elastic demand signifies that a change price brings about proportionate change in
quantity demanded. For instance, a 10% decrease in price leads to a 10% increase in quantity
demanded. Then, the Ep has a value equal to one. The rectangular hyperbola, D1D1, in figure 003,
represents the unitary elastic demand.

Figure 003

Relatively elastic demand:

95

The demand is said to be relatively elastic when a change in price brings about more than
proportionate change the quantity demanded. For instance, a 10% decrease in price leads to 20%
increase in quantity demanded. Then, the Ep has a value greater than one. The curve D2D2 in figure 003
shows the relatively elastic demand.
Relatively inelastic demand:
Relatively inelastic demand means that the quantity demanded changes less than
proportionately to the price. For example, a 10% decrease in price leads to a 5% increase in quantity
demanded. Here, the Ep has a value less than one. The curve D3D3 in figure 003 shows the relatively
inelastic demand.
In brief, the price elasticity of demand has a range as follows.
0 Ep
If Ep = , the demand is perfectly elastic.
If Ep = 0, the demand is perfectly inelastic.
If Ep = 1, the demand is unitary elastic.
If 1 < Ep < , the demand is relatively elastic
If 0 < Ep < 1, the demand is relatively inelastic
Measurement of Price Elasticity of Demand; Alternative methods:
We use the point elasticity method for measuring price elasticity of demand when changes
in price are very small. If the changes in price are not small we use the arc elasticity method.
Point Elasticity Method:
As per the point elasticity method, price elasticity of demand is the proportionate change
in quantity demanded resulting from a very small proportionate change price. It uses differential
calculus to calculate the elasticity for an infinitesimal change in price and quantity at any given point on
the demand curve.
Symbolically we may write as;
Ep = Q/Q P/P
Or
Ep = Q/P. P/Q
If the demand curve is linear as;

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Q = b0 b1.P
Its slope is dQ/dP.
Where,

dQ/dP = -b1

Substituting the value of dQ/dP in elasticity formula we get

Ep = - b1.P/Q
It implies that the price elasticity of demand varies at different points of the linear demand
curve. Graphically the price elasticity of demand at any point on a linear demand curve is equal to lower
portion of the demand curve divided by its upper portion corresponding to that point. In figure 004, Ep
at point N is equal to ND1 divided by DN.
Figure 004

In figure 004, P = P1P2, Q = Q1Q2, P = OP1 and Q = OQ1

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If we consider very small changes in P and Q, then P dP and Q dQ. Thus, substituting in the
formula for the point elasticity, we get
Ep = dQ/dP. P/Q = Q1Q2/ P1P2. OP1/OQ1 = BC/BN. OP1/OQ1
In the figure 004, the triangles NBC and NQ1D1 are similar [because each corresponding angle is equal].
Hence
BC/BN = Q1D1/NQ1 = Q1D1/OP1
Thus,
Ep = Q1D1/OP1. OP1/OQ1 = Q1D1/ OQ1
Furthermore, the triangles DP1N and NQ1D1 are similar, so that
Q1D1/ND1 = P1N/ND = OQ1/ND
Rearranging we get
Q1D1/OQ1 = ND1/ND
Thus, the price elasticity of demand at point N is
Ep = Q1D1/OQ1 = ND1/ND
That is, on a straight line demand curve, the price elasticity of demand at any point is equal to
lower portion of the demand curve divided by its upper portion corresponding to that point.
Given the graphical measurement of point elasticity, it is clear that at the midpoint of a linear
demand curve Ep = 1. We can illustrate it graphically [figure 005] as follows.
Figure 005

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In figure 005, on the linear demand curve DD1, Ep at the midpoint C is equal to 1. At point
D, Ep = and at point D1, Ep = 0. Ep is greater than one [Ep>1] between points C and D and less than
one [Ep<1] between points C and D1.

Arc Elasticity Method:

The method so far we have used is the point method. This method is applicable only for
infinitesimal changes in the price. If the change in the price is large we use the arc method. The point
method measures the point elasticity and the arc method measures the arc elasticity on a demand
curve. That is, the former measures elasticity between two points, say A and B, corresponding to a
movement from one point [say A] to another point [say B]. On the other hand, arc method measures the
average elasticity. For a movement from A to B, it measures the elasticity at the midpoint between A
and B. We can explain the measurement of arc elasticity with the help of a diagram [figure 006] as
follows.
Figure 006

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In figure 006, arc elasticity for a movement from A to B is measured at point C, the
midpoint of the line AB. Thus the arc elasticity is an average elasticity.
The following formula is used for the measurement of arc elasticity.
Ep = Q/P . [P1+P2] / [Q1+Q2]
Where, Q is the change in quantity, P, the change in price, P1, the initial price, P2, the new price, Q1,
the initial quantity and Q2, the new quantity.
We can measure the arc elasticity for a change in price from Rs2 to Rs6 [table 004] as
follows.
Table 004
Px [Rs]

Qdx [Kg]

20

16

We have
Q = 4

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P = 4
P1 = 2
P2 = 6
Q1 = 20
Q2 = 16
We can apply the equation
Ep = Q/P. [P1+P2] / [Q1+Q2]
= 4/4. [2+6] / [20+16]
= 0.222
The value of Ep [minus sign is omitted] is 0.22, much smaller than 1, thus, the demand is relatively
inelastic.
Factors Determining the Price Elasticity of Demand:
We use multiplicity of goods in our day to day life. How does their demand respond to
price? We may not reduce the number of matchbox that we buy in a week when we come to know that
its price is doubled. On the other hand, many people rush to jewelry shops when price of gold falls
marginally. A sharp and secular price hike of onion may change north Indian politics but not much its
quantity demanded! Price elasticity of demand varies from commodity to commodity. It is determined
by a number of factors. Following are the important ones among them.
1. Availability of substitutes:
If a commodity has multiple substitutes, its demand is generally seen as more elastic [A
particular brand of soap is a good example for it]. On the other had, a commodity having no substitute,
commonly, has a less elastic demand. Salt, a good we use in our kitchen, is a typical example for it.
[However, when salt is made available in packets with minor processing and brand names, each brand of
product becomes a substitute to others].
In short, the greater the number of substitutes of a good, the greater will be its price elasticity of
demand, and vice versa.
2. Nature of commodity:
By and large, necessaries have less elastic demand. For instance, people may not reduce
much of their staple food item when its price goes up. On the other hand, luxuries have more elastic
demand. Expensive costumes and ornaments are examples for it.

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In brief, the greater the necessity of a good, the greater will be its price inelasticity of demand, and vice
versa.
3. Proportion of income spent:
Price elasticity of demand for a good also depends upon the proportion of income of the
consumer spent on that good. If consumers spend a lion portion of their income upon a particular good,
its demand is, generally, seen as elastic. This is because a minor change in price of that good brings
about larger change in its expenditure. Thus, in order to keep the budget under control household has
to adjust the quantities of such goods with prices. On the other hand, a household may not care of even
a 100 % increase in the price of matchbox; because the amount spent on it is negligible compared to
total income.
To brief, the greater the proportion of income of the consumer spent on a good, the greater will be the
price elasticity of demand for that good, and vice versa.
4. Level of income:
The price inelasticity of demand for a good depends also upon consumers level of income. If
purchase of a good happens at high level of income, the demand for that good is, generally, less elastic.
That is, for many goods, rich people may not adjust quantity demanded to price. Poor people, on the
other hand, have to cut coat according to cloth.
It means, the higher the level of income at which purchase of a good takes place, the higher will be the
inelasticity of demand for that good, and vice versa.
5. Number of uses of commodity:
Certain goods are used for many purposes while others are not. For instance, electricity is
used for many purposes in a house. If it is found cheaper, it would be used for more and more purposes.
On the other hand, if it happens to be dearer than before, the household will abstain from many of its
uses.
In short, the greater the number of uses of a good, the greater will be its elasticity of demand, and vice
versa.
6. Nature of human wants:
If a commodity is used to satisfy wants which are of less urgent category, its demand is
generally seen as elastic. But many commodities are used to satisfy wants of high priority, and thus,
their consumption cannot be postponed. For instance, construction of a house may be very important
one to a person, but its beautification may not. Thus, he may construct the house by any means
irrespective of changes in prices of building materials, but may postpone a painting of it when painting
materials are found expensive for the time being.

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In brief, the greater the priority of the want towards which a good is used, the greater will be its
inelasticity of demand, and vice versa.
7. Time period:
In a longer span of time, demand for a good is generally seen as elastic. This is because people
are able change the quantity of the good according to the price when the price change persists for a
longer while. On the other hand, a short term fall in price of many goods may not lead to quick and fast
response on the part of consumers.
In short, the longer the period of time, the greater will be the elasticity of demand, and vice versa.
8. Information:
If consumers are not aware of past and present prices due to poor information, their demand
for many products will be less elastic.
That is, the better informed the consumer, the greater will be the elasticity of demand, and vice versa.
9. Nature and frequency of price change:
If the price change of a good is large and frequent, the demand for that good is generally
elastic. On the other hand, an infrequent and small change in price may not be noticed by the consumer,
and thus may not lead to significant change in demand.
In short, the greater the rate and frequency of price change; the greater will be the elasticity of demand,
and vice versa.

10. Habit:
If the use of a good is more habitual to the consumer, its demand will be generally inelastic.
Alcoholic products are the best example to it. For such products, consumers, due to addiction, are
unable to respond the price rise.
That is, the greater the orientation of a good to the habitual use, the greater will be its inelasticity of
demand, and vice versa.
11. Complementarity between goods:
Certain goods are used together. Pen and ink, bred and jam, and petrol and lubrication oil are
their examples. Such goods are called complementary goods. Complementarity between goods also is a
factor affecting the price elasticity of demand. A fall in the price of lubricant does not tempt its user to
buy more quantity of it because, there is certain proportion between lubricant and petrol.

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In short, the greater the Complementarity between goods, the greater will be the inelasticity of demand
for them.
Conclusion:
We have seen many factors governing the price elasticity of demand. These factors may act
individually or collectively. Effects of an elasticity stimulant may be absorbed by that of a retarding
factor, and vice versa. Different goods have different price elasticity of demand. Producers like to have
their products with elasticity convenient to their aims and means. Applying various sales promotional
activities like advertisement, firms may make their products less responsive to a price rise.
Income Elasticity of Demand:
Income elasticity of demand shows the responsiveness of the quantity demanded of a good
to the income of consumers. It measures the rate of change in quantity demanded with respect to
income. It is the ratio of percentage change in quantity demanded to percentage change in income. It,
normally, unlike the price elasticity of demand, is positive. Income elasticity of demand can be
symbolically stated as
Ey = Q/Q Y/Y
Or
Ey = Q/Y. Y/ Q
Where, Q/Q is the relative or percentage change in quantity demanded and Y/Y, the relative or
percentage change in income. In the expression Q/Q, Q stands for the original quantity demanded and
Q for change in quantity demanded, that is, the difference between the original quantity and new
quantity. Similarly, in the expression Y/Y, Y stands for original income and Y for change in income, that
is, the difference between the original income and new income.
Let us take a hypothetical income demand schedule [table 005] to consider the response of
demand to income.
Table 005
Y[Rs]

Qdx [Kg]

2000

21

3000

25

In table 005, we may consider the response of demand to income change. In table, the initial
income is Rs2000 and the new income, Rs3000. Thus, the change in income is Rs1000. the initial
quantity demanded [Q] is 21 Kg and the change in quantity demanded [Q] is 4 Kg. Thus, we can
substitute the values as follows.

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Ey = Q/Y. Y/ Q
= 4/1000. 2000/21
Ey = 0.3809
This specific case means that the demand is less responsive to income.
Income elasticity coefficient Ey has the following possible values.
1. If Ey = , the demand is perfectly income elastic.
2. If Ey = 0, the demand is perfectly income inelastic.
3. If Ey = 1, the demand is unitary income elastic.
4. If 1 < Ey < , the demand is relatively income elastic
5. If 0 < Ey < 1, the demand is relatively income inelastic
Income Elasticity of Demand and the Engel Curve:
Engel curve shows the relationship between the consumption [quantity demanded] of a
good and the income of the consumer. It facilitates an easy gaze on the income elasticity of demand.
Income elasticity of demand at any point of the Engel curve can be identified by observing the slope of
the curve. It can be explained as follows.
Figure 007

105

In figure 007, Engel curve [E], with different slopes and shapes, is shown. In part one, income
elasticity at point A on the Engel curve E is equal to SQ/OQ. Where, SQ is greater than OQ. Thus, Ey =
SQ/OQ > 1. Similarly, in part two, income elasticity at point A on the Engel curve E is equal to SQ/OQ.
Where, SQ is less than OQ. Thus, Ey = SQ/OQ < 1. In part three, Ey at point A on the Engel curve E is
equal to SQ/OQ. Where, SQ is less than OQ. Thus, Ey = SQ/OQ < 1. In part four, Ey at point A on the
Engel curve E is equal to SQ/OQ. Where, SQ is greater than OQ. Thus, Ey = SQ/OQ > 1.
However, for finding the exact value of Ey we need the exact values of SQ and OQ.
Cross Elasticity of Demand:
It shows the responsiveness of quantity demanded of a good to the price of its related good.
As we know, the quantity demanded of Pepsi is a function not only of its own price but the price of its
substitute, Coco cola, as well. Similarly, the quantity demanded of gas stove is a function not only of its
own price but the price of liquefied petroleum gas, also. What all this means is that the quantity
demanded of a good depends upon the price of its related good, either competitive or complementary.
Where, competitive goods are substitutes and complementary goods are the goods used together.
Cross elasticity of demand for substitutes:
It is the ratio of relative change in quantity demanded of a good [X] to the relative change in
price of its substitute [Y]. It shows the rate of change in quantity demanded of a good with respect to a
change in the price of its substitute. Symbolically, it can be stated as,

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Ec = Qx/Qx Py/Py
Or
Ec = Qx/Py. Py/ Qx
Where, Qx/Qx is the relative change in quantity demanded of X good and Py/Py, the relative change
in price of Y good. In the above expression, Qx is the initial quantity of X good, Qx, the change in
quantity of X good, Py, the initial price of Y good, and Py, the change in price of Y good.
Let us take a hypothetical cross demand schedule [table 006] to observe the measurement
of the cross elasticity of demand for substitutes as follows.
Table 006
Py[Rs]

Qdx [Kg]

24

26

In table 006, the initial price of Y good [Py] is Rs2 and the new price, Rs3. Thus, the change
in price [Py] is Re1. The initial quantity demanded [Qx] is 24 Kg and the change in quantity
demanded [Qx] is 2 Kg. Thus, we can substitute the values as follows.
Ec = Qx/Py. Py/ Qx
= 2/1. 2/24
Ec = 0.166
This particular case means that the demand for X good is less responsive to the price of Y good.
Cross elasticity of demand for complementary goods:
It is the ratio of relative change in quantity demanded of a good [X] to the relative change in
price of its complementary good [Y]. It shows the rate of change in quantity demanded of a good with
respect to a change in the price of its complementary good. Symbolically it can be stated as,
Ec = Qx/Qx Py/Py
Or
Ec = Qx/Py. Py/ Qx
Where, Qx/Qx is the relative change in quantity demanded of X good and Py/Py, the relative change
in price of Y good. Here X and Y are complementary goods. In the above expression, Qx is the initial
quantity of X good, Qx, the change in quantity of X good, Py, the initial price of Y good, and Py, the
change in price of Y good.

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Let us take an imaginary cross demand schedule [table 007] to observe the measurement of
the cross elasticity of demand for complementary goods as follows.
Table 007
Py[Rs]

Qdx [Kg]

22

20

In table 007, the initial price of Y good [Py] is Rs4 and the new price, Rs6. Thus, the change in
price [Py] is Rs2. The initial quantity demanded [Qx] is 22 Kg and the change in quantity demanded
[Qx] is 2 Kg. Thus, we can substitute the values as follows.
Ec = Qx/Py. Py/ Qx
= 2/2. 4/22
Ec = 0.1818
This particular case signifies that the demand for X good is less responsive to the price of its
complementary good Y.
Uses and Applications of Elasticity of Demand:
Why do state governments in our country discriminately prefer an additional rate of tax on
cigarettes and liquor? Prima facie, it seems to be an action on moral ground that it will reduce the
consumption of health hazardous products. Is that all behind it? Why dont the public transport
corporations of different states fix a bus fare above the fare of private buses? All these, inter alia, seek
answers related to elasticity of demand in one way or other. The elasticity of demand in general and the
price elasticity of demand in particular have greater importance and a wide range of applicability.
Following are the important applications and uses of the elasticity of demand.
1. Applications in Public Finance:
a.] Incidence of Tax: The final tax burden, that is, the incidence of tax depends very much upon the
price elasticity of demand. Thus, a thorough analysis of the price elasticity of demand is required to
redistribute the tax burden.
b.] Shifting of Tax: Whether a tax is shiftable or not depends upon the price elasticity of demand. Tax
policy can be implemented effectively only by a thorough analysis of the price elasticity of demand.
c.] Possibility of Additional Tax: The possibility as well as the economy of an additional indirect tax can
be found out only by a thorough analysis of the price elasticity of demand.
d.] Direct or Indirect Tax: A selection between direct and indirect taxes for raising additional revenue
can be made only by an extensive estimate of the price elasticity of demand.

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e.] Import and Export Duties: The volume and possibility of tax revenue through import and export
duties can be estimated only after a thorough analysis of the price elasticity of demand.
f.] Effects of Tax: Effects of tax, both direct and indirect, depend upon the elasticity of demand,
especially the price elasticity and income elasticity of demand.
2. Applications in International Trade:
a.] Terms of Trade: Terms of trade between different goods imported and exported among different
nations depend upon the price elasticity of demand for these goods.
b.] Dumping: The possibility and profitability of dumping [international price discrimination] depend
upon the elasticity of demand, especially the price elasticity and cross elasticity of demand.
c.] Balance of Payments: Various measures adopted for correcting disequilibrium in balance of
payments can be effectively implemented only by a thorough analysis of the price elasticity of demand.
d.] Import Substitution and Export Promotion: Import substitution as well as export promotion policies
can be practiced only thorough an analysis of the price elasticity of demand.
3. Applications in Pricing:
a.] Price Policies of Firms: Firms aiming at maximum profit fix their prices with due regards to the price
elasticity of demand. For instance, a firm applying the marginalist rule charges a price at a level at
which the Ep is greater than one, given that the marginal cost is greater than zero. It also considers cross
elasticity of demand when price of its product is fixed.
b.] Price Policies of Public Enterprises: Public enterprises fix prices to their products with due regards to
cross elasticity of demand that their products face from private enterprises. For instance, the public
transport corporations of different states and provinces fix a bus fare equal to that of private buses. This
is because the cross elasticity is high between these two services.
4. Applications in Advertisement:
a.] Scope of Advertisement: Advertisement, a sale enhancer, can be effectively implemented only after
a deep and wide analysis of various types of elasticity of demand. It aims at strengthening of consumers
preference towards the commodity on which the advertisement is intended to apply. However, it has no
role to play in certain markets where the demand is perfectly elastic. Similarly, it may not be a tool in
monopolists kit since he faces very low price and cross elasticity of demand. On the other hand, many
modern competitive firms, which have an oligopolistic nature, incur a remarkable amount of money for
gathering information regarding price, cross, income and advertisement elasticity of demand. This is to
design successful advertisement strategies.
b.] Possibility and Profitability of Advertisement: Possibility and profitability of advertisement depend
very much upon the elasticity of demand in general and price elasticity of demand in particular.
Advertisement has its least significance under perfect competition where the firm faces a perfectly

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elastic demand. No advertisement can make the demand inelastic in that market. But the case of
oligopolist is totally different from that of competitive firm, as far as the possibility and profitability of
advertisement are concerned. Their marginal return from advertisement depends upon the value of
price, cross and advertisement elasticity coefficients.
5. Applications in the Theory of Revenue:
a.] Marginal Revenue and Price Elasticity of Demand: We can derive the marginal revenue from the
value of price elasticity of demand. For instance, MR is equal to zero when the Ep equal to one.
b.] Average Revenue and Price Elasticity of Demand: Average revenue curve of every firm represents its
demand curve. Thus, we can measure price elasticity of demand at each level of AR or we can derive the
AR from Ep.
6. Applications in Market Classification: Though there are many types of classifications of markets,
economists prefer the classification based on elasticity of demand. This is because it facilitates a lot of
analytical treatments.
7. Applications in the Theory of Consumers Surplus: To whom the consumers surplus goes, whether to
the consumer or to the producer, depends upon the price elasticity of demand. Slope of demand curve,
thus, is very significant in the theory of consumers surplus.
8. Applications in Price Discrimination: Both the possibility and the profitability of price discrimination
depend upon the price elasticity of demand. For instance, one of the essential conditions of price
discrimination is that the monopolist must face different elasticity of demand for his product in different
markets.
9. Applications in Environmental Economics: In environmental economics, for the internalization of
externalities we often apply pollution tax [Pigouvian Tax] as well as subsidies. All these are possible only
with proper estimates of elasticity of demand.
These are only a few of the important uses and applications of elasticity of demand. Its
applicability is extended over a spectrum of fields of economics. Welfare economics, intertemporal
analysis, health economics, transport economics and energy economics are only a few examples to it.
The Law of Demand:
The law of demand states that, ceteris paribous, more quantity of a good is demanded at its
lower price, and vice versa. That is, the quantity demanded of a good is an inverse function of its price,
given the other demand determinants. It was Alfred Marshall, the author of the Principles of Economics,
who made a foundation to this law. This Marshall foundation was built mainly through the partial
equilibrium analysis. Its Walrasian counter part, the general equilibrium analysis is one of the least
discussed topics in theory of market demand. Under the Marshallian partial equilibrium analysis of
demand, we use the ceteris paribous assumption. That is, all determinants of demand other than the
price of the good in question are assumed to be constant. It is on this platform of ceteris paribous
assumption the law of demand is erected.

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We have seen that a decrease in price of a good X leads to an increase in its quantity
demanded, if other things are given. This is not synonymous to an increase in demand for good X. Then,
what is the difference between increase in quantity demanded and increase in demand? Similarly, an
increase in price of a good leads to a decrease in its quantity demanded, ceteris paribous. This is
different from decrease in demand. This topic can be explained under the head movements on the
demand curve and movements of the demand curve or changes in quantity demanded and changes in
demand.
Movements on the Demand Curve and Movements of the Demand Curve:
Or
Changes in Quantity Demanded and Changes in Demand:
A change in price of a good, as already stated, leads to a change in its quantity demanded,
ceteris paribous. It makes a movement on the demand curve, but not a movement of the demand curve.
On the other hand, a change in any other determinant of demand other than the price of the good in
question leads to a shift in demand curve, that is a movement of the demand curve. These other
determinants are called shift factors. Let us differentiate these changes as follows.
Increase in Quantity Demanded and Increase in Demand:
Or
Expansion in Demand and Increase in Demand:
Expansion in Demand means the increase in quantity demanded of a good with respected
to a fall in its price, other factors are assumed to be constant. In figure 008, a movement from R to T on
the demand curve D0D0 shows the expansion in demand. Then, what happens to the quantity
demanded of the good when there is a change in the shift factor{s}?
Figure 008

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As an example, consider the effect of an increase in income on the demand curve for
jeans. Now suppose that parents start sending more money to their needy sons and daughters in
college. If the price of jeans were to stay the same, we would expect students to use some of their
increased income to buy more jeans. For example, if the price were to remain at Rs1500, quantity
demanded might rise from 8000 units [point R] to 12000 [Point S]. Similarly, if price had instead been
Rs1000, and had remained at that level, there might be a corresponding change from T to U. In other
words, the rise in income would be expected to shift the entire demand curve to the right from D0D0 to
D1D1. Here the increase in income is followed by an increase in quantity demanded, given the price of
the good. This cause and effect relationship is termed as the increase demand. We can, thus, define the
increase in demand as an increase in quantity demanded of a good due to a change in shift factor{s}, say
an increase in income, given its price. The demand curve shifts outward, as from D0D0 to D1D1 in figure
008.
As we have seen, when there is expansion in demand, there is rightward movement on the
demand curve [from R to T in figure 008]. On the other hand, when there is increase in demand, the
demand curve itself moves rightward [from D0D0 to D1D1 in figure 008].
Decrease in Quantity Demand and Decrease in Demand:
Or
Contraction in Demand and Decrease in Demand:
Figure 009

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When price of a good rises, given the other factors, the quantity demanded will be
decreased. For instance, as in figure 009, when the price rises from Rs1000 to Rs1500, the quantity
demanded decreases from 14000 thousand unit to 8000 unit [movement from D to B]. This is called the
contraction in demand. Thus, contraction in demand can be defined as a decrease in quantity demanded
of a good due to a rise in its price, given the other factors. On the other hand, given the price of the
good, a change in shift factor may lead to a decrease in the quantity demanded. This is termed as the
decrease in demand. For instance, as shown by a movement from C to D in figure 009, the quantity
demanded decreases from 20000 units to 14000 units when there is a decrease in income of the
consumers, given the price Rs1000. Decrease in demand can be defined as the decrease in quantity
demanded of a good due to a change in shift factor{s}, say a decrease in income, given the price of the
good.
As in figure 009, contraction in demand makes a leftward movement on the demand curve,
from D to B. But a decrease in demand shifts the entire demand curve leftward from D0D0 to D1D1.

Figure 010

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In figure 010, a movement, on the demand curve DD, from point A to B shows expansion
in demand and a movement from A to C shows contraction in demand. On the other hand, a movement
from A to E shows increase in demand and from E to A shows decrease in demand. Increase in demand
leads to a shift in demand curve from DD to D1D1 and a decrease in demand leads to a shift from D1D1
to DD. Thus, it is clear that expansion or contraction in demand brings about a movement on the
demand curve while increase or decrease in demand to a movement of the demand curve.
Exceptions to the Law of Demand:
Economists from time to time have stated some exceptions to the law of demand. Following
are the important ones among them.
1. Veblen Effect:
Commodities like expensive jewelry may be purchased precisely because their price is high,
and a fall in their price might reduce their snob appeal and, therefore, perhaps, their demand. Goods of
this type are often referred to as Veblen goods, called after the name of Thorstein Veblen who first
pointed out the concepts of conspicuous consumption and status-seeking.
2. Misconception that the quality is proportional to the price:
Another exception to the law of demand occurs when quality is judged on the basis of
price-the expensive the better. For example, some people buy vegetables labeled organic even
though they become expensive than other vegetables. Even if the two kinds of vegetables are identical

114

to a biologist, some consumers may assume that the organic vegetables are superior simply because
they are expensive. If organic vegetables become cheaper, consumers might assume that they are no
longer superior, and thus, reduce their purchases.
3. Geffen Paradox:
It is said that the law of demand is inapplicable to Geffen goods. Geffen goods are the goods
in case of which the income effect of a price change is negative. More over, the negative income effect
is very powerful more than to nullify the substitution effect. Thus, for Geffen goods, a decrease in price
is followed by a decrease in their quantity demanded, and vice versa. This paradox was invented by
Robert Geffen, a Scottish economist, and hence, is called after his name as Geffen paradox.
4

Bandwagon Effect:

The bandwagon effect arises when people's preference for a commodity increases as the
number of people buying it increases. People alter their opinions regarding a commodity to the majority
view. Such a shift in opinion can occur because individuals draw inferences from the decisions of others,
as in an informational cascade. Thus, an average consumer some times buys more of a good at its high
price just because many people buy it.
5

Demonstration Effect42:

It is another possible exception. It happens when consumers imitate the way of life of rich
people. In order to keep up with johns [the rich neighbours] people may demand more quantity of a
good even at high price. This happens mainly in the case of luxuries.
6

Fear of price hike in future:

People may buy more quantity of a good when its price rises due to their fear that there
would be a price hike in the near future. Consequently, more quantity of the good is demanded at its
high price.
7

Expectation of price fall in future:

People may demand less quantity of a good at its lower price when they expect further
price fall in near future.
8

Chasing blindly behind the catchwords of advertisers:

Many consumers, especially of cosmetics and costumes, demand more quantity of goods
even at their high prices. They do so because they think that the catchwords of advertisers are the true
scale on which the quality of goods is to be measured.

42

James Duesenberry (1949) gave the name "demonstration effect" to this phenomenon

115

Conclusion:
Although many of the notorious exceptions stated above point the finger towards the law of
demand, it is to be pointed out that these are only exceptional behaviour of a few consumers in the
market, and thus, the market demand for most goods is still expected to be an inverse function of price.

Linear Expenditure Systems

Linear Expenditure Systems [LES] are models which deal with groups of commodities
rather than individual commodities. Such groups, when added, yield total consumer expenditure. LES
are, thus, of great interest in aggregate econometric models, where they provide desirable
disaggregation of the consumption function. One of the earliest linear expenditure models was
suggested by R. Stone [Economic Journal, 1954]. LES was in fact introduced by Klein and Rubin
(1947-48) in an attempt to construct a true cost of living index. The LES are usually formulated on
the basis of a utility function from which demand functions are derived in the normal way [by
maximisation of the utility function subjected to a budget constraint]. In this respect the approach of LES
is the same as that of models based on indifference curves. However, LES differ in that they are applied
to groups of commodities between which no substitution is possible, while the indifference curves
approach is basically designed for handling commodities which are substitutes. The very notion of an
indifference curve is the substitutability of the commodities concerned. Actually the indifference map of
a LES would appear as in figure 00 implying the non-substitutability of groups of commodities.
Figure

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The utility function is additive, that is, total utility [U] is the sum of the utilities derived from the various
groups of commodities. For example, assume that all the commodities bought by the consumers are
grouped in five categories:
1. Food and beverages
2. Clothing
3. Consumers durables
4. Household-operation expenses
5. Services [entertainment, transport, etc.].
The total utility is:
U = Ui
Or
U= U(A) + U(B) + U(C)+ U(D)+U(E)
Additivity implies that the utility of the various groups are independent, that is, that there is no
possibility of substitution [or complementarity] between the groups A, B, C, D and E.

117

In LES the commodities bought by the consumers are grouped in broad categories, so as to be
compatible with the additivity postulate of the utility function. Thus, each group must include all
substitutes, and complements. In this way substitution between groups is ruled out, but substitution can
occur within each group.
The consumers buy some minimum quantity from each group, irrespective of prices. The
minimum quantities are called subsistence quantities because they are the minimum requirements for
keeping the consumer alive. The income left [after the expenditure on the minimum quantities is
covered] is allocated among the various groups on the basis of prices.
The income of the consumer is, therefore, split into two parts: the subsistence income, which is
spent for the acquisition of the minimum quantities of the various commodities, and the
supernumerary income, the income left after the minimum expenditures are covered.
Specific functional forms of demand can be grouped into single equation model and
system of equation models. There are different types of system of demand equations: the
additive model, the
a priori model and non-additive models of demand systems. The LES
belong to the class of additive system of demand and the constant elasticity type demand
function belongs to the class of a priori model.
*************

Books for reading:

1. A. Koutsoyannis, Modern Microeconomics, Second Edition, McMillan

2. Campbell R McConnell, Economics: Principles, Problems and Policies Seventh Edition,
McGraw-Hill Book Company, New York
3. David C Colander, Economics, Forth Edition, McGraw-Hill Irwin, New York
4. William J. Baumol and Alan S. Blinder, Economics: Principles and Policies, Third Edition,
Harcourt Brace Jovanovich Publishers, New York
5. Hall P. Varian, Intermediate Microeconomics, A Modern Approach Seventh Edition,
Affiliated East-West Press, W.W. Norton Company.
6. K.C. Roychowdhury, Microeconomics, Tata McGraw-Hill Publishers Company,
New Delhi.
7. William J. Baumol, Economic Theory and Operation Analysis, Forth Edition,
Prentice-Hall of India Pvt. Ltd
8. Watson and Getz, Price Theory and its Uses, Fifth Revised Edition, A.I.T.B.S.
Publishers& Distributors, Delhi
Books for reference:
1. J. R. Hicks; Value and Capital 1939, 2nd ed. 1946. Oxford: Clarendon
2. Robert Jensen and Nolan Miller; Geffen Behavior and Subsistence Consumption, 2008,
American Economic Review, 97(4), pp.15531577.
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3. H. Leibenstein; Bandwagon, Snob, and Veblen Effects in the Theory of Consumers

Demand, 1950), Quarterly Journal of Economics, 64, 183207
4. K. E. Boulding; Economic Analysis; 1941, Harper & Brothers.
Economica.
5. Ferguson, Charles E; Microeconomic Theory (1972) (3rd Ed.). Homewood, Illinois: Richard
D. Irwin.
Sample Questions:
Part A; Multiple Choice Questions:
a. Which of the following is not a significant determinant of the demand for a good?
A] Price B] Expenditure C] Income D] Advertisement
b. What do you mean by a rightward movement on the demand curve?
A] Increase in demand B] Contraction in demand C] Expansion in demand
D] Decrease in demand
c. Who made the foundation to the modern theory of demand?
A] Stigler B] Hicks C] Marshall D] Walras
d. Veblen goods have -------- value.
A] Short term B] Market C] Intrinsic D] Vanity
e. Unitary elastic demand curve is ---------------A] Linear B] Nonlinear C] A parallel line D] A rectangular hyperbola
f. Who wrote the book Economic Theory and Operation Analysis?
A] Watson B] Geffen C] Baumol D] Marshall
g. Demonstration Effect is associated with the name of ------------------A] James S. Dusenberry B] K. N. Raj C] Robert Geffen D] Thorstein Veblen
h. Engel Curve normally has ----------------- slope.
A] Negative B] Positive C] Zero D] Infinite
i. Which of the following pairs are substitutes?
A] Petrol and lubricant B] Tea and coffee C] Bred and jam D] Pen and ink
j. Gas stove and liquefied petroleum gas are --------- goods
A] Geffen B] Substitutes C] Tax exempted D] Complementary
k. Delphi method is used for ------------A] Demand Forecast B] Demand function C] Demand estimates D] Demand management
l. Ram buys LED TV because many people buy it.
A] Cascading effect. B] Veblen effect. C] Bandwagon effect. D] Income effect.
m. Price elasticity is greater than one when demand is --------------

119

A] Relatively elastic. B] Relatively inelastic. C] Perfectly elastic. D] Perfectly inelastic.

n. Movement of the demand curve shows
A] Increase in demand. B] Decrease in demand. C] Change in demand. D] Change in quantity demanded.
o. Who among the following had resolved the Water-Diamond Paradox?
A] Marshall. B] Jevons. C] Walras. D] Clark.
p. Demand for a product is generally elastic when it has
A] No substitute. B] Less substitutes. C] More substitutes. D] Superior substitutes.
q. Pen and ink are
A] Perfect substitutes. B] Close substitutes. C] Competitive. D] Complementary
r. Angel curve is related more to
A] IRL. B] PPC. C] PCC. D] ICC.
s. Who among the following was the champion of the Partial Equilibrium Approach?
A] Marshall. B] Walras. C] Ricardo. D] Wicksell.
t. Which of the following is related to economic model?
A] Prediction. B] Assumption. C] Analysis. D] All of these.
u. ------- is not an essential assumption of the Law of Diminishing Marginal Utility.
A] Additivity. B] Certainty. C] Continuity. D] Rationality.

v. Which of the following is an essential condition of the revealed preference theory?

A] Rationality B] Nonsatiety C] Certainty D] Continuity
w. What is utilometer?
A] Unit of utility B] Measuring rod of utility C] Machine for measuring utility
D] None of these
x. Who among the following contributed much for the development of the revealed preference
theory?
A] Stigler B] Hicks C] Majumdar D] Little
y. Three term consistency means:
A] Transitivity B] Rationality C] Choice reveals preference D] Equilibrium
z. Revealed preference theory approves the ----------- of indifference curve.
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A] Concavity B] Same satisfaction C] Convexity D] Smoothness

a. Who wrote the book Measurement of Utility?
A] Samuelson B] Stigler C] Baumol D] Majumdar
b. Revealed preference theory belongs to the category of----------------A] Cardinalist introspective B] Ordinalist introspective C] Behaviourist ordinalist D]
Behaviourist cardinalist
c. Engels Law means:
A] Income elasticity of demand is negative B] Income elasticity of demand is positive C]
Income elasticity of demand is zero D] Income elasticity of demand is infinite
d. The statement, Substitution effect of a price change is always negative is called
A] Engels Law B] Slutskys Law C] Demand Law D] Walras Law
e. The phrase, old wine in new bottle is matching more to
A] Indifference curve analysis B] Revealed preference theory C] Law of satiable wants D]
State preference theory
f. Buridans ass died of starvation, because it could not choose either of the haystacks is used
to criticise------------A] Revealed preference theory B] Slutskys Law C] Law of satiable wants D] Indifference
Curve Analysis
Part B; Short Questions:

a. Define the law of demand

b. Distinguish between increase in demand and Expansion in demand
c. What is Demonstration Effect?
d. What is a Veblen good?
e. Define the price elasticity of demand
f. Distinguish between movements on and of the demand curve
g. Define Geffen good
h. What is advertisement elasticity of demand?
i. What are the determinants of demand for a good?
j. When does the demand curve slop positively?
k. Define two term consistency
l. Distinguish between two term consistency and three term consistency
m. What is overcompensation effect?
n. What is a Geffen good?
o. Define the rationality assumption of Samuelson
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p. Distinguish between the rationality assumption of Samuelson and Marshall

q. State the law of demand
r. State the Engels law
s. What determines an income-price situation?
t. When does the slope of a budget line change?
Part C; Short Essay Questions:
a. Explain the notorious exceptions to the law of demand.
b. Distinguish between Price elasticity of demand and Income elasticity of demand.
c. Explain the five types of Price elasticity of demand.
d. Explain the Geffen Paradox.
e. Explain the relation between Price elasticity of demand and revenue.
f. Explain the Bandwagon Effect.
g. Explain the Linear Expenditure Systems.
h. Explain the contraction, expansion, decrease and increase in demand.
i. Demand for organic vegetables expands when their price rises. Explain.
j. Differentiate the competitive goods from complementary goods.
k. Demand is always at a price. Explain.
l. Briefly explain the ICC.
m. What are the limitations of the Law of Diminishing Marginal Utility?
n. Price effect = Substitution effect + Income effect, Explain
o. Explain Samuelsons Fundamental Theorem of Demand.
p. Elucidate the differences between Marshallian and Hicksian theories of Consumers
behaviour.
q. Explain the behaviourist ordinalist method of the revealed preference theory.
r. Distinguish between Hicks ordinalism and Samuelsons ordinalism.
s. Explain the evolution of the revealed preference theory.
t. Explain the relative advantages of the revealed preference theory.
u. State the major defects of the revealed preference theory.
v. Explain the important axioms of the revealed preference theory.
w. How does Samuelson deviate from Marshallian rationality assumptions?
x. Explain the association of the revealed preference theory with the Engels law.
y. How does Samuelson rule out the possibility of indifference?
z. Choice reveals preference axiom infers only preference but not indifference. Explain.
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a. Differentiate the strong ordering with weak ordering.

b. How far an improvement is the revealed preference theory over the indifference curve
analysis?
c. How does Price elasticity of demand vary between necessities and luxuries?
Part D; Essay Questions:
a. Explain the important factors determining the Price elasticity of demand.
b. Explain the important applications of the Price elasticity of demand.
c. Explain the exceptions to the law of demand.
d. State the law of demand. Illustrate it with graphs and tables. Cite suitable examples.
e. Explain different types of elasticity of demand with suitable examples.
f. Explain the consumers equilibrium with the help of the Indifference Curve Analysis.
g. Explain the splitting up of price effect into substitution effect and income effect.
h. Explain the derivation of the demand curve from the Indifference Curve Analysis.
i. Explain the applications of the Indifference Curve Analysis.
k. Explain the Revealed Preference Theory.
l. Explain the relative merits of the Revealed Preference Theory.
m. Critically examine the Law of Diminishing Marginal Utility.
n. Derive the demand curve from Marshallian Utility Analysis.

o. Critically explain the revealed preference theory.

p. Illustrate the Choice reveals preference. How far objective is the revealed preference theory?
q. Illustrate the revealed preference theory. How does it prove the law of demand?
r. Samuelsons revealed preference theory avoids all the vestiges of utility. How far an
improvement is this theory to the traditional theories?
s. Derive the law of demand from the revealed preference theory.
t. Can revealed preference theory split up the price effect into substitution and income effects?
Explain. What is the difference between Hicks substitution effect and Samuelsons
overcompensation effect?
u. Explain the derivation of indifference curve from the revealed preference theory.

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3. PRODUCERS BEHAVIOUR; HOW

DOES PRODUCER RESPOND TO
CHANGES AROUND HIM?
Theory of Production: Role of the Firm in Production: Subject matter of the theory of production:
Importance of the theory of production: Meaning and Definition of Production: Production Process:
The Long Run and the Short Run: Production function: Production function taking one factor as variable
and others as fixed: Production function taking all factors as variable factors: Homogenous and Non
homogenous Production Function: Mathematical & Empirical production Function: Cobb-Douglas
Production Function: Short run Production Schedule: Law of Diminishing Returns or Law of Diminishing
Marginal Productivity: Long run Production Function and Isoquants: Variants of long run production
function: Isoquants: Slope of Isoquant; MRTSLK: Why does the MRTSLK diminish? Isoquant Map:
Isoclines: Properties of Isoquants: Laws of Production: Law of Variable Proportions: Laws of Returns to
Scale: Mathematical illustration of the LRS: Varying Returns to Scale: Causes of Varying Returns to Scale:
Technological progress and Production Function: Production Function of Multiproduct Firm; Production
Possibility Curve [PPC]: Derivation of PPC: Slope of the Contract Curve: Derivation of the Production
Possibility Curve: Slope of the Production Possibility Curve: Technical Progress and the PPC: Isorevenue
Curve and Economic Efficiency: Slope of the isorevenue curve: Producers Equilibrium: Single Product
Firm's Equilibrium: Equilibrium of Multiproduct Firm: Derivation of Cost Functions from Production
Functions: Linear Programming:

124

THEORY OF PRODUCTION
The fundamental decisions in an economy concern production. If nothing is produced, nothing can be
consumed- Watson and Gitz
Introduction:
We have learned [from previous chapters] the theory of consumers behaviour and the law of
demand. They describe how consumers realise their goal of maximum satisfaction or utility; or how do
they consistently behave to reach at optimum solutions. They also tell us how much the consumers
demand a good at its various possible prices. They tell us how the quantity demanded of a good
responds to its price, ceteris paribous. We have seen that the demand for a good is an inverse function
of its price. Then, what is the effect of a change in demand upon the price? Price and quantity
demanded of a good have two way relations. The price of a good in a market is determined by the
demand for and the supply of that good. Then, what determines the supply of the good? The supply of
every good depends upon its production. Thus, we need a theory of production to derive the law of
supply.
Ultimately, all supply comes from individuals. Individuals control the factors of production
such as land, labour and capital. Why do they supply these factors to the market? Because they want
something in return of their factor services. This means that industrys ability to supply goods is
dependent upon individuals willingness to supply the factors of production they control.
The analysis of supply is more complicated than the analysis of demand. In the supply process,
individuals first offer their factors of production to the market. Then the factors are transformed by
firms into goods that the individuals want. Production is the name given to that transformation of
factors into goods and services.

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To make the analysis of supply simple, we separate the analysis of supply of factors of
production43 from the supply of products. This also allows us to assume that the prices of factors of
production are constant. It simplifies the analysis of supply of products enormously. There is no problem
with doing this as long as we remember that behind any product are individuals factor supplies.
Ultimately people, not firms, are responsible for supply.
Role of the Firm in Production:
A key concept in the theory of production is the firm. A firm is an economic institution which
transforms factors of production into goods and services. A firm [1] organizes factors of production,
and/or [2] produces goods, and/or [3] sells produced goods to individuals, business firms or
government. As far as a firm is concerned, combination of activities it will undertake depends upon the
cost of undertaking each activity relative to the cost of subcontracting the work out to another firm.
When the firm only organizes production, it is called as a virtual firm. Virtual firms organize the factors
of production and subcontract out all production. But most firms are not totally virtual firms.
Firms Maximise Their Profit:
The firm plays the same role in the theory of supply that the consumers do in the theory of
demand. The difference is that whereas the consumers maximise utility, the firms maximise profit. What
is profit? Profit is defined as follows.
Profit = Total Revenue Total Cost.
In accounting, total revenue equals total sales times price [Qx. Px]; if a firm sells 2000 DVD
players at Rs3000 each, its total revenue is Rs6000000. For an accountant, total costs are the wages paid
to workers, rent paid to owners of land, machinery and building, interest paid to lenders, and actual
payments to other factors of production. If the firm, in making DVD players, paid Rs2000000 to
employees and Rs3000000 to materials, total cost is Rs5000000.
In determining what to include in total costs and total revenue, accountants focus on explicit
costs and explicit revenues. That is because they must have explicit measures that go into a firms
balance sheet and profit and loss account. For this reason, accounting profit is the difference between
explicit revenue and explicit cost. In our example, the accounting profit of the firm from DVD players is
Rs1000000.
This accountants profit is different from an economists profit. Economists have different
measures of revenues and costs, and hence have a different measure of profit. Economists include in
revenues and costs both explicit and implicit revenues and costs. Thus, their measure of profit is both
explicit and implicit revenues less both explicit and implicit costs.
What are implicit costs and implicit revenues? Implicit costs include opportunity costs of the
factors of production provided by the owner of the firm. Say that the owner of our DVD firm could have
43

Supply of and demand for factors of production are explained in the chapter The Theory of Distribution.

126

earned Rs50000 working elsewhere rather than spending his time in his own firm. Thus, the opportunity
cost of working in his own firm business is Rs50000. It is an implicit cost of that business. For
economists, total cost includes both explicit and implicit costs. Thus, to them, total cost is equal to
explicit payments to factors of production plus the opportunity costs of the factors of production
provided by the owner of the firm. Thus, the total cost of the DVD firm is equal to Rs5000000 as explicit
costs and Rs50000 as implicit costs. This is equal to Rs5050000.
Generally the implicit cost is estimated and not directly measured, that is why accountants do
not include them in to their accounts.
Implicit revenues include the increase in the value of assets. Say the DVD firm owns a multistorey building in the factory premise. Suppose that its value rises by Rs500000. This increase in value of
assets should be added to the revenue. Thus, the total revenue in economists perspective is equal to
Rs6000000 [explicit revenue] plus Rs500000 [implicit revenue]; and total cost is equal to Rs5000000
[explicit cost] plus Rs50000 [implicit cost]. Then,
Economic Profit = [Explicit Revenue + Implicit Revenue][Explicit Cost +
Implicit Cost]
= Rs6500000 Rs5050000
= Rs1450000
There is, thus, difference between accounting profit and economic profit.
Subject matter of the theory of production:
Theory of production involves mainly the following things:
1] Production function:
What is the technical relationship between inputs and outputs?
2] Laws of production:
Which are technically possible ways of expansion of output?
3] Cost of production:
What way cost can be minimised?
4] Producers equilibrium:
Which is the optimal combination of inputs, for any given level of output?
Which is the optimal combination of output, for any given set of inputs?

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Importance of the theory of production:

All most all economic activities like consumption, exchange, marketing, advertisement,
transportation, product pricing, and distribution are closely associated with the theory of production.
The reason is that the production is the base of all these activities. As Watson and Gitz (Price Theory and
its Uses) say, the fundamental decisions in an economy concern production. If nothing is produced,
nothing can be consumed. All other economic activities fall in the range between production and
consumption.
Importance of the theory of production can be specified as follows
1] Base of product pricing:
Price of every product in a competitive market is determined by its demand and supply. Supply
of every product is determined by its cost of production. Cost of production is one of the essential parts
of the theory of production. Thus, theory of production occupies a prime place in the supply a product.
Demand for a product depends very much up on the income of its buyers. This income, in its
turn, depends upon factor rewards, like rent, wage, interest and profit. Factor rewards, definitely,
depend upon demand for factors of production. Factors of production are demanded for their service in
the production. Thus, demand for products also has its roots in the theory of production.
In short, product price, being a function of demand and supply, is directly or indirectly
governed by the production, and thus, the theory of production makes the foundation of the theory of
product pricing.
2] Base of factor pricing:
Prices of factors of production in a competitive scenario are determined by their demand and
supply. Demand for factors of production depends upon their uses and productivity in the production
process. More specifically, demand for factors of production depends upon its marginal revenue
productivity (MRP). Thus, demand for factors of production is closely related to the production. As a
result, the theory of production is the base of demand for factors of production.
Supply of man made factors of production depends very much upon mans capacity to save and
invest. All this is governed mainly by the volume of his income remaining after consumption. As we have
already seen, factor rewards govern the incomes of all social classes [workers, capitalists etc]. In short,
production governs the supply of factors of production also.
Supply of skilled and trained labour and efficient organization also requires efforts and
resources of labourers and entrepreneurs. All these are possible only with income, the sources of which,
again, are factor rewards. Modification of land and raw materials also requires efforts which are possible
only with income determined by factor rewards. Thus, production has its effects on supply of almost all
factors of production.

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Supply of and demand for factors of production together determine the factor prices. Both, as
we have already seen, are governed by the production. The theory of production, thus, builds the
foundation of the law of supply, law of demand and the theory of factor pricing.
Besides these, economic activities like marketing, advertisement, transportation, and
preservation of goods also are closely related to the production. Thus, they also are some of the widely
discussed topics in the theory of production. In short, almost all economic activities in an economy are
associated directly or indirectly with the theory of production. It means that the theory of production is
the part and parcel of microeconomics.
Meaning and Definition of Production:

Production means the transformation of inputs in to output. Where, inputs are factors of
production like, land, labour, capital and organization. Output, on the other hand, is the final
product resulting from production.
The term production is used in a wider sense in the theory of production. It is not
confined to the physical transformation of matter. It includes all activities which create or add up
utility to a good, tangible or intangible. Thus, production refers to any activity which creates or
adds up utility to a good. Where, utility is defined as the want satisfying power of a good.
Utility can be created or added up through the following process.
1] Change in the physical form of goods. (Form Utility)

A farmer cultivates wheat, which through a series of activities turns into bread. Here
the physical form of the good is changed. This change in physical form of the good at different
stages creates and adds up utility. Cultivation of wheat and baking of bread and all the series of
actions happened between cultivation and baking are activities called production.
2] Spatial change in distribution of goods. (Place Utility)
Transportation of goods from one place to another may add up utility to them. If a
good is transported from a place, where it is plenty in availability, to another place, where it is
scant in availability, then the utility of it will be increased. Fishing in the distant sea and the
subsequent transporting and marketing of fish tell us how utility is added up to fish.
3] Temporal change in distribution of goods: (Time utility)
Utility can be created or added up through conservation and preservation of goods.
Certain goods or their ingredients can be stored up and preserved for a long while and, the same
can be made available to meet seasonal variations in production and supply. These temporal
changes in the distribution of goods, definitely, add up utility to goods.
Thus, activities of production are as follows:
1) An activity which increases the quantity of a good.
2) An activity which changes the form of a good.
3) An activity which changes the spatial or temporal distribution of a good.

In short, production involves not only the physical transportation of inputs in to

outputs, but all activities (like transportation, conservation, preservation, advertisement, and

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marketing) which add up utility to the outputs, as well. According to G.C. da Costa,44
Production may be defined as any activity which yields utility. This utility is mediated through
goods, or more precisely, through economic goods, which refer to commodities and services
which satisfy human wants and which are scarce, that is, for which demand exceeds supply. Thus
production may be seen as an activity which produces wealth. Production, thus, creates wealth.
Production Process:
We have seen the role and significance of firms in production. Let us discuss how do
firms control the production process.
The Long Run and the Short Run:
The production process is generally divided into a long run planning decision, in which
a firm chooses the least expensive method of producing from among all possible methods, and a
short run adjustment decision, in which a firm adjusts its long run planning decision to reflect
new information.
In the long run a firm chooses among all possible production techniques. This means
that it can choose the size of the plant it wants, and the location it wants. The firm has fewer
options in a short run decision, in which the firm is constrained in regard to what production
decision it can make.
The terms long run and short run do not necessarily refer to specific periods of time
independent of the nature of the production process. They refer to the degree of flexibility the
firm has in changing the level of output. In the long run, by definition, the firm can vary all the
inputs as it wants. In the short run some of the flexibility that existed in the long run no longer
exists. In the short run some inputs are so costly to adjust that they are treated as fixed. So in the
long run all inputs are variable; in the short run some inputs are fixed.
Production function:
Production function refers to the technical relationship between inputs and outputs,
given the technology. In other words, production function describes the ways in which inputs are
combined to produce different outputs. It also shows how a set of combinations of factor inputs
yields certain amount of output. According to Ferguson, A production function is a schedule
showing the maximum amount of output that can be produced from any specified set of inputs,
given the existing technology or state of art. That is, production function shows the maximum
possible output from a specified set of combinations of inputs, given the technology.
According to G.C. da Costa, production function defines the maximum volume of
physical output available from any given set of inputs, or the minimum set of inputs necessary to
produce any given level of output. That is, production function explains
1) The maximum quantity of output that can be produced from any given quantity of inputs, and
2) The minimum quantity of inputs required to produce a given quantity of output.
According to G.J. Stigler, The production function is the name given to the
relationship between the rates of input of productive services and the rate of output of product. It
is the economists summary of technological knowledge. It means that the production function
is the relationship between input rate and output rate.
Production function shows technical efficiency:
Production function involves no terms like, cost, price and money. These terms have no
role in technical relationship between inputs and outputs. They are used only in economic
relations. Production function does not show any economic relation. Production function
includes only the technically efficient combination of factor inputs.
44

Value and Distribution in Neo Classical and Classical Systems; G.C. da Costa

130

For instance, A and B in the following table [Table 001] are two processes or activities or
combinations of labour and capital which yield same level of output.
Table 001

Process
Factors

Labour

Capital

Prima facie, it is clear that the combination (process) B is technically inefficient. No

such technically inefficient processes have any place in the production function.
In a production function, the dependent variable [explained variable] is output and the
independent variables [explanatory variables] are factor inputs (say, Labour and Capital).
A simple specification of a production function is:
X = f (L, K)
Where, X, dependent variable, is the output, and L and K, independent variables, the Labour and
Capital, respectively. The above expression shows that the quantity of output [X] is a function of
the quantities of inputs [L and K], given the technology.
There are some popular production functions like the Cobb-Douglas production
function and the CES production function which are frequently used in applied economics and
research.
The relation between output and inputs can be analysed in a number of ways. This can
be analysed, for instance, by taking one of the factor inputs as variable while all other factors as
fixed or by taking all factors as variable factors.
1] Production function taking one factor as variable and others as fixed:
Graphical representation of the short run production function:
Figure 001

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A production function of this kind (also called as short run production function) can be stated as
follows.
X = f (L) K
Where, X is the output, L, the variable factor, and K, the fixed factor. This production function shows
that the output can be increased by an increase in the quantity of variable factor (L), given the quantity
of fixed factor [K] and the technology.

In the figure 001, X = f (L) K is the initial short run production function. It shows
various levels of output at different levels of variable input. It shifts upward to X*= f (L) K*,
when the volume of capital rises from K to K*, given the technology.
Production function taking all factors as variable factors:

Production function of this kind (also called as long run production function) can be
stated as follows

X = f (L, K)
Where, X is the Output, L, the Labour and K, the Capital

Here both the factors are taken as variable factors. Thus, output [X] can be increased by
increasing both the factors, (L and K).
Homogenous and Non homogenous Production Function:
Homogenous production function shows the technical relationship between inputs
and outputs when all factor inputs change in same proportions. For instance, the quantities of L
and K in the Production function X = f (L, K) are increased k times.

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Non homogenous production function shows the technical relationship between

inputs and output when factors of production (L, K) change in different proportions, say L is
doubled and K is tripled.
Graphical representation of the long run production function:
Figure 002

The most popular graphical device used to illustrate the long run production function is the
isoquant. In figure 002, part A shows the homogenous production function [HPF], and part B shows the
non-homogenous production function [NHPF]. Traditional economic theory concentrates up on the
homogenous production function.
45

Homogenous Production Function:

HPF refers to the technical relations between inputs and output when all factors are
changing in same proportion. It observes the change in output (X) when all factors (L, K) change
in same proportion.
Illustration of HPF:
Let us take the production function, X = f (L, K). Where, X is a given level of output.
Let us increase the level of output form X to X* by increasing Labour and Capital by k
proportion.

That is, X* = f (kL, kK)

The proportionality coefficient, k can be factored out since it is common to L and K.
Thus,
X*= k f (L, K)
45

Isoquant is further explained in subsequent sections of this chapter.

133

The proportionality coefficient k has a power, V termed as degree of homogeneity which may
have any one of the following values.

V = 1, V >1 or V<1
1) Homogenous Production Function with Increasing Returns to Scale:
Or
HPF of Degree Greater than One:
Production function is called homogenous of degree greater than one when the degree
of homogeneity is greater than one (V>1). It means that there are increasing returns to scale. HPF
of degree greater than one shows that when all inputs are increased in same proportion the output
increases more than proportionately to the inputs. For instance, when the quantities of L and K
are doubled, the output happens to be more than the twice of its previous quantity.
2) HPF with Constant Returns to Scale:

Or
Linearly Homogenous Production Function:
Or
HPF of First Degree
Linearly homogenous production function means that the degree of homogeneity is
equal to one (V=1). It shows that there are constant returns to scale. That is, when all factors (L
and K) are increased in same proportion, the output also is increased in that same proportion. For
instance, Output is doubled when factors (L and K) are doubled.
3) HPF with Decreasing Returns to scale:
Or

HPF of Degree Less than One

If the degree of homogeneity is less than one, there are decreasing returns to scale. That
is, when all inputs (L and K) are increased in same proportion, the output increases less than
proportionately to the inputs. For instance, by doubling the quantities of L and K, we get output
which is less than the twice of its initial quantity.
Using Isoquants all these production function can be better illustrated.
Mathematical & Empirical production Function:
Application of statistical and mathematical tools in economics is becoming leading trend among
economists. This promising trend has its far reaching effects in the theory of production also.
Economists have examined many actual production functions and have employed statistical and
mathematical analysis to measure the relationship between changes in physical inputs and physical
outputs. A multitude of mathematical production function with empirical evidence is available today.
Among the leading empirical production functions, Cobb-Douglas production function and CES
production seem to be the most popular ones.
The Cobb-Douglas (CD) Production Function:
Cobb-Douglas production function is one of the most popular empirical production
functions. It has greater applicability in mathematical economics, econometrics, applied economics and
economic researches. It is applicable to an industry as well to the whole economy.
The specific form of CD function for two factor inputs is given by:

134


X = AL K

.. (1)

Where, A, and are parameters whose values are restricted as A>0, 0< <1 0< <1 and + =
1.
The CD function is one of the typical and most popular neoclassical production functions.
The CD type production function obeys a number of mathematical properties that are much useful in
production theory. The parameters, and play vital role in the C D function. The parameters are
measures of the substitution of factor inputs, the share of factor inputs, the returns to scale and the
marginal products of the factor inputs.
Properties of the CD Production function:
Following are the important Properties of the CD Production function:
1) The marginal products can be expressed in terms of the average products.
A] The marginal product of labour is:
-1
MPL = X/L = AL K

= [X]L
= [X/L]
MPL = APL
MPL = (X/L) > 0

(2)

B] The marginal Product of capital is:

-1
MPK = X/K = AL K

= [X] K

-1

= [X/K]
MPK = [X/K] > 0

. (3)

2) Labour elasticity of output [Le] and Capital elasticity of output [Ke] are measured by input
coefficients, and , respectively:
Le = MPL / APL
= [X/L] / [X/L]
Le =

.. (4)

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Ke = MPK / APK
= [X/K] / [X/K]

.. (5)

3) The elasticity of substitution of the CD function is always 1 irrespective the level of inputs used
and the marginal rate of technical substitution:
Elasticity of substitution is the ratio of relative change in the input ratio to the relative change
in MRTS.

d [ K / L]
K/L
d [MRTS ]
MRTS

MPL K K
, it follows that:
MPK L L

MRTS being the ratio of marginal products,

d[MRTS]= d

MPL
K
d

MPK
L

K
d .
L

Hence,

d [ K / L] d [ K / L]
K / L = K / L 1 .. (6)
K d [ K / L]
K/L
L
K
d
L

4) The CD function is linearly homogenous:

The CD function is homogeneous of degree 1 [that is, + is the degree of homogeneity
which is equal to1]. When all the inputs are increased by times, the function (1) becomes,
X* = A(L)(K) = + ALK = + X . (7)
Where, + = 1, thus, the C D function is linearly homogeneous. There are constant returns to scale.
5) The CD function satisfies the Eulers Theorem and it is used to verify the Marginal Productivity
Theory of Distribution:
The Marginal Productivity Theory can be best explained by Eulers theorem, which is one of the
properties of homogeneous function. The Euler's theorem of the CD function is:
Total Product = Share of L + Share of K

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= L. MPL + K. MPK
= L (X/L) + K (X/K)

(7)

= L. [X/L] + K. [X/K]
= ( + )X (8)
Where, + = 1. That is, Share of L + Share of K = X.
The Euler's theorem can also be used to verify the Marginal Productivity Theory of
Distribution. When equation (7) is multiplied on both sides by the product price, P
L (X/L) P + K (X/K) P = ( + ) PX (9)
Where, (X/L)
P is the value of marginal product of labour (VMPL) and (X/K) P is the value of marginal product of
capital (VMPK). [VMP is product price times the marginal physical product]. PX is the value of the
product. The Marginal Productivity Theory states that under conditions of perfect competition in the
factor market the factors are paid according to their respective marginal product. When the price of
labour is 'w' and the price of capital is 'r' per unit input, the Marginal Productivity Theory states that:
P (X/L) = w and P (X/K) = r. The equation (9) will then become,
wL + rK = ( + )PX . 10
Where, w.L and r.K are the wage share and capital share, respectively. It is the factor payment made for
purchasing the two factor inputs. When + =1 the factor cost of production is equal to the value of
output. The total value of output just exhausts when factors are paid according to their respective
marginal products.
6) Factor intensity in production is measured by the ratio of input coefficients:
That is, factor intensity is measured by the ratio (/). The greater the value of the ratio, the
greater will be the labour intensity, and vice versa.
7) The parameter 'A' measures the efficiency of production:
Two firms with the same production technology, input magnitudes and other conditions may
be producing different levels of output. The higher level of output is due to the efficient management
of the firm. It is reflected on the value of the parameter, A. Therefore, it is known as the efficiency
parameter. The greater the value of A, the greater will be the efficiency in production, and vice versa.
Short run Production Schedule:
How does a firm combine factors of production in the short run to produce goods? Production
schedule is a guideline to the firm for doing this. A production schedule shows output resulting from
various combinations of inputs. Actual production schedule is very complicated. It may involve hundreds
of inputs, hundreds of outputs, and millions of combinations of inputs and outputs. We may take a
simple hypothetical short run production schedule [table002] as follows.
Table 002

137

Qty of Variable Factor

Total Product

Marginal Product

Average Product
0

2
1

2
4

3
6

12

4
7

19

4.75
6

25

5
5

30

5
3

33

4.71
1

34

4.25
0

34

3.77
-2

10

32

3.2
-5

11

27

2.45

In table 002, the first column shows the quantity of variable factor [say number of workers],
the second shows total product, the third, the marginal product and the last, the average product. It is
assumed that more and more units of variable factor [say labour] are combined with a given quantity of
fixed factor [say capital].

138

Total product is the sum of output produced by combining certain quantity of variable factor
with a given quantity of fixed factor. Marginal product of the variable factor is the addition to total
product with respect to a change in the units of variable factor, given the fixed factor and technology.
For instance, marginal product of labour, MPL, is the change in the total product resulting from the
employment of one more unit of labour, given the fixed factor, say capital, and technology. Symbolically,
MPL = X/L
Where, MPL is the marginal product of labour, X, the change in output, and L, the change in quantity
of labour. The table 002 shows that the MPL initially increases but diminishes eventually, and becomes
negative when the quantity of labour increases.
Average product is equal to total product divided by the number of units of variable factor
used. For instance, average product of labour, APL, is equal total product divided by the number of units
of labour used. Symbolically,
APL = X/L
Where, APL is the average product of labour, X, the total output, and L, the total quantity of labour. The
table 002 shows that the APL increases initially but diminishes eventually, when the quantity of labour
increases.

Law of Diminishing Returns or Law of Diminishing Marginal Productivity:

The law of diminishing returns or law of diminishing marginal productivity is one of the
classical laws of economics. The law is associated with the names of economists like David Ricardo.
According to David Ricardo, as we add successive units of variable factor (Labour plus Capital) to a given
quantity of fixed factor (Land), the marginal product of the variable factor diminishes. Marshall observes
it as, An increase in the capital and labour applied in the cultivation of land causes, in general, a less
than proportionate increase in the amount of product raised, unless it happens to coincide with an
improvement in the arts of agriculture. Paul A. Samuelson46 views it as An increase in some inputs
relative to other fixed inputs will, in a given state of technology, cause output to increase; but after a
point the extra output resulting from the same addition of extra inputs will become less and less.
According to G. Stigler47, As equal increments of one input are added the input of other productive
services being held constant beyond a certain point the resulting increments of product will decrease,
that is marginal products will diminish. K.E Boulding48 says, As we increase the quantity of any one
input which is combined with a fixed quantity of the other inputs, the marginal physical productivity of
the variable input must eventually decline. Boulding renames it as the law of eventually diminishing
marginal physical productivity.
46

Paul A. Samuelson ; Economics p25

G. Stigler; Theory of Price P111
48
K.E Boulding; Economic Analysis 1589
47

139

The law, thus, states that the marginal productivity of a variable factor eventually
diminishes as we add its more and more units to a given quantity of fixed factor under conditions of
given technology. However, this eventuality is still a grimy museum piece to readers.
As we have seen in table 002, the marginal product first increases, then diminishes and at
last becomes negative. Average product first increases, and after a point it also diminishes, but not
negative. It will be negative only when the total product has negative value.
We may use a diagram to illustrate the law of diminishing returns as follows.
In lower panel of figure 003, both marginal and average products are increasing initially. In dark
shaded area, the MP curve has a positive slope. This makes the TP curve bowed upward. The AP curve in
dark shaded area is with a positive slope, and it continued up to certain portion of the light shaded area
[up to the point where MP = AP]. The dark shaded area shows the increasing marginal productivity. In
the light shaded area, the MP is with a negative slope. This makes the TP curve bowed downward. The
light shaded area shows the diminishing marginal productivity. In the non-shaded area, the MP = 0 at
level of employment L2, and afterwards it is negative. This makes the negative slope of the TP curve. The
non-shaded area shows the negative marginal productivity or the diminishing absolute productivity.

Figure 003

140

If it is the trend of short run production function, what combination of the fixed and variable
factor will be selected by a rational producer. Definitely, it will not be a combination in the area of
negative marginal productivity. The rational producer will be in short run equilibrium with a combination
of factors only in the range of employment where the marginal productivity of the variable factor is
diminishing but positive. Thus, the short run equilibrium of the producer takes place in the light shaded
area in which the marginal productivity of the variable factor is diminishing but positive.
The law of diminishing returns describes what happens in production process when firms add
more and more amount of a variable factor to a fixed amount of another factor. It states that as more
and more of a variable input is added to an existing fixed input, after some point the additional output
one gets from the additional input will fall49
The law of diminishing returns or diminishing marginal productivity is sometimes called as
the flowerpot law because if it did not hold true, the worlds entire food supply could be grown in one
flowerpot.
Long run Production Function and Isoquants:
49

Colander; Economics; Forth Ed.

141

In the long run all factors are assumed to be variable, as far as an individual firm is
concerned. Thus, the firm can successfully design its production and plant capacity to realise its goal of
maximum profit. Here, unlike in short run, no factor input is an active constraint to the firm. The firm is
free to increase the quantity of any factor input as it likes to do. Thus, long run production function
shows the technical relation between inputs and outputs when all factors are variables. We can state a
long run production function as
X = f [L, N, K, S, R...]
Where, X is the quantity of output, L, the quantity of labour, N, the quantity of land, K, the quantity of
capital, S, the organizational factor, and R, the raw materials. Assuming that there are only two factors,
labour and capital, both variables, we can state the long run production function as
X = f [L, K]
Variants of long run production function:
In the long run, when all factors are variable, output can be varied in two possible ways. They
are [1] by changing all factors in different proportions, and [2] by changing all factors in same
proportion. The former is called the non-homogenous production function and the latter the
homogenous production function. Thus, the homogenous production function shows the technical
relation between inputs and outputs in the long run when all factors are changed in same proportion.
For instance, the L and K, in the production function X = f [L, K], are increased by two times. On the other
hand, the non-homogenous production function shows the technical relation between inputs and
outputs in the long run when all factors are changed in different proportions. For example, the L is
increased by two times and the K by three times. The Neoclassical theory of production has used the
homogenous production function as one of its fundamental assumptions. That is, it explains the
production relations only for homogenous production function.
Isoquants:
Isoquant is a very convenient analytical tool to explain the long run production function. It
facilitates a better graphical illustration of a two factor long run production function. Isoquant is also
called as producers indifference curve as it is analogous to the indifference curve employed in the
theory of consumers behaviour. It explains producers behaviour in the same manner the indifference
curves do the consumers behaviour.
An Isoquant is the locus points of combinations of two factor inputs, say labour and capital,
given the output. It includes all possible combinations of two factor inputs which result in same volume
of output, given the technology. In other words, an isoquant is the locus of all such combinations of two
variable inputs that are capable of producing the same level of output. An Isoquant, thus, shows the
following things:
1] A given volume of output [Dependent variable]

142

2] Quantities of two variable inputs [Independent variables]

3] Given technology [Shift factor]
4] Substitutability and divisibility of factors [Determining shapes of isoquant]
There are different types of isoquants with remarkable differences regarding the
substitutability of factors and rate of technical substitution between factors. Following are the
important ones among them.
1] Linear Isoquant
2] Input-Output Isoquant
3] Neoclassical Isoquant
4] Linear programming Isoquant
Figure 004

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1] Linear Isoquant: In part one of figure 004, the straight line AB represents a linear isoquant.
Its linearity shows perfect substitutability between the factors. It also shows the constant marginal rate
technical substitution between factors [MRTSLK is constant]. It happens when factors are perfect
substitutes of each other, having perfect divisibility.
2] Input-Output Isoquant: In part two of figure 004, the kinked isoquant X is called the input-output
isoquant. It shows zero substitutability between inputs. This is because of the strict complementarity
between the factors. Only one combination, at the point of kink, of the isoquant X is technically efficient.
This type of isoquant is frequently used in input-output analysis. This is why it is called as the inputoutput isoquant or the Leontief isoquant.
3] Neoclassical Isoquant: In part three of figure 004, the curve X which is convex to origin is the
neoclassical isoquant. It shows continuity in substitution between factors. It also shows the diminishing
marginal rate technical substitution between factors [MRTSLK is diminishing]. This is the isoquant
commonly used in mainstream economic theory.
4] Linear Programming Isoquant: In part four of figure 004, the curve X with multiple kinks is the linear
programming isoquant. Linear programming uses this isoquant to find optimal solution to the objective
function. This isoquant shows limited substitutability between factors. Substitution is possible only
between the kinks.
As already mentioned, among a multiplicity of isoquants the most common one used in
mainstream economic theory is the neoclassical isoquant which is smooth, continuous and convex to
the origin. The neoclassical theory explains production function with this isoquant. We, thus, utilise this
very same isoquant in subsequent sections of the theory of production.
How to construct an isoquant?
For the construction of an isoquant we can make use of the following schedule.
Table 003
1

Combination of

Labour

Capital

Output

Factors

[L]

[K]

[X]

36

100 Kg

28

100 Kg

1 L: 8 K

21

100 Kg

1 L: 7 K

15

100 Kg

1 L: 6 K

144

MRTSLK

10

100 Kg

1 L: 5 K

100 Kg

1 L: 4 K

100 Kg

1 L: 3 K

In table 003, first column shows combinations of L and K, second, the quantity of L, third, the
quantity of K, fourth, the quantity of output, and the last, the marginal rate of technical substitution
between L and K. All the combinations in the table show same output [100 Kg of X]. The producer is free
to move from one combination to another with out a change in output. This constancy of output can be
maintained along a straight line isoquant if there is perfect substitutability between factors [constant
MRTSLK]. The neoclassical theory, however, assumes that the factors are imperfect substitutes and
hence they cannot be substituted at a constant rate. As table shows, MRTSLK, the rate at which L is
substituted for K with out a change in output, is diminishing as producer moves from combination A to
combination B, and so on.
When producer moves from combination A to combination B, he raises the number of units of
labour from 1 to 2, and at the same time he reduces the quantity of capital from 36 units to 28 units.
That is, he substitutes 1 L for 8 K. However, the output remains the same as 100 Kg. Here the MRTSLK is
equal to 1 L: 8 K. Similarly, when he moves from combination B to combination C, he raises the number
of units of labour from 2 to 3, and at the same time he reduces the quantity of capital from 28 units to
21 units. That is, he substitutes 1 L for 7 K. As the last column of table 003 shows, every substitution of L
for K takes place at a lower and lower rate compared to previous rate. That is, the MRTSLK is diminishing
along an isoquant from left to right.
The table 003 can be transformed into a graph [Figure 005] as follows.
In figure 005, we measure the quantity of labour horizontally and that of capital vertically. The
curve with a negative slope in the graph is the isoquant. It is obtained by joining all the combinations,
from A to G in Table 003, by a smooth curve. All combinations [now, not confined to A, B, C, D, E, F, and
G] on the isoquant yield same output [100 Kg of X]. The isoquant in the graph is convex to origin. This
convexity is due to the diminishing marginal rate of technical substitution between L and K. This
happens, basically, due to the operation of the law of diminishing returns or the law of diminishing
marginal productivity [we explained in previous section].
Figure 005

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Slope of Isoquant; MRTSLK:

Slope of isoquant is equal to the MRTSLK. The MRTSLK, as already mentioned, is the rate at which
labour is substituted for capital, given the output. We can explain it with diagram [figure 006] as follows.
Figure 006

146

In figure 006, the curve X represents a true neoclassical isoquant. Its slope, as already
mentioned, is equal to the MRTSLK. The MRTSLK corresponding to a movement from point A to point B is
equal to:
MRTSLK = -K/L
= K1K2 / L1L2
Similarly, MRTSLK corresponding to a movement from point B to point C is equal to:
MRTSLK = -K/L
= K2K3 / L2L3
Ignoring the minus sign, we can say
K1K2 / L1L2 > K2K3 / L2L3
That is, MRTSLK for a movement from A to B and B to C is diminishing. In other words, the MRTSLK
diminishes along an isoquant when we move from left to right. This is why the isoquant is convex to
origin.
Why does the MRTSLK diminish? The MRTSLK diminishes due to the operation of the law of diminishing
returns. The diminishing MRTSLK signifies that the producer is able to reduce less and less quantity of
capital to employ every additional unit of labour. This is because the marginal productivity of labour
diminishes and that of capital increases when the quantity of labour increases and that of capital

147

decreases. For instance, as table 003 shows, when producer moves from combination A to combination
B, he uses an additional unit of L in place of 8 units of K. It means that the contribution of the additional
one unit of L could compensate the loss in output resulting from the withdrawal of 8 units of capital. But
for a substitution corresponding to a movement from B to C, additional one unit of L cannot compensate
the loss in output resulting from the withdrawal of 8 units of capital. This time it compensates only 7
units of capital. Here two things are happened simultaneously. The first is a decrease in marginal
productivity of L, and the second an increase in marginal productivity of K. Thus, the MRTS between L,
whose marginal productivity is diminishing, and K, whose marginal productivity is increasing, must
diminish as long as output remains the same. This happens due to the operation of the law of
diminishing returns. Thus, it is to be pointed out that the diminishing marginal rate of technical
substitution between two factors [also called as Law of Diminishing Marginal Rate Technical
Substitution] happens basically due to the operation of the law of diminishing returns.
We can, thus, state the MRTSLK as
MRTSLK = -K/L
= MPL / MPK
= X/L X/K
Isoquant Map:
The long run production function is not confined to a single isoquant, but extended to a
spectrum of isoquants. A set of isoquants with some well defined properties is called the isoquant map.
It is drawn on the assumption that the technology is unchanged. A change in technology may shift the
isoquants from their initial position50. Following figure [figure 007] shows a typical isoquant map.

Figure 007

50

This is explained in subsequent section under the title technical progress and the production function

148

In figure 007, X1, X2, X3, etc are isoquants in an isoquant map. These isoquants show
different levels of output. However, on any particular isoquant, the quantity of output is the same. The
way in which the isoquants in an isoquant map are distributed is according to the relative productivities
of factors in a given state of technology. A change in technology may alter the relative productivities of
factors, and hence, the very position of the isoquants in the isoquant map.
Isoclines:
An isocline, as shown in figure 008, is the locus points of different isoquants at which the
MRTSLK is constant. If production function is homogenous the isoclines are straight lines through the
origin. Along any one isocline the K/L ratio, as well as the MRTSLK, is constant. However, the K/L ratio
and the MRTSLK are different for different isoclines. If the production function is non-homogenous the
isoclines will not be straight but twiddly lines. In figure 008, the straight line S through the origin
represents the isocline of the homogenous production function. Along this line the K/L and MRTSLK are
constant. On the other hand, along the twiddly line S, the isocline of the non-homogenous production
function, K/L is not constant. We can draw multiple numbers of isoclines in an isoquant map.
Nevertheless, the properties of isoclines do not change.
Figure 008 facilitates an easy gaze on homogenous and non-homogenous production
functions. By observing the shape of the isocline we can say whether the production function is
homogenous or non-homogenous.

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Figure 008

Properties of [Neoclassical] Isoquants:

Isoquants have a number of unique features which are called as their properties. These
properties are based on some assumptions. They are.
a.] diminishing marginal productivity of variable factor.
b.] diminishing marginal rate technical substitution between factors.
c.] scarcity of factors of production.
d.] transitivity principle holds good.
Based on these assumptions, the neoclassical isoquant maintains the following properties.

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1] An Isoquant is negatively sloped:

An isoquant is always with a negative slope. This is due to the trade off between the
quantities of factor inputs [say L and K] for which the isoquant is drawn. That is, there is an inverse
relation between the quantities of factor inputs, given the output. If we raise the quantities both the
factors, definitely, the output cannot stand constant. It will rise, if other things are constant. Similarly, if
we raise the quantity of one factor keeping the quantity of other factor constant, definitely, the output
cannot remain constant. Considering these facts, we can rule out the possibility of positive, zero, and
infinite slopes of the isoquant. Thus, the only possibility remaining is the negative slope. There fore, a
typical isoquant, as shown in figure 009, is always with a negative slope.
In figure 009, the isoquant X is negatively sloped. As we move from A to B on the
isoquant X, the quantity of labour increases from L1 to L2 and that of capital decreases from K1 to K2.
This trade off makes the isoquant negatively sloped.

Figure 009

2] An Isoquant is convex to the origin:

Figure 010

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An isoquant, as figure 010 shows, is convex to the origin. This is due to the diminishing
marginal rate of technical substitution between the factors. Slope of an isoquant is equal to the MRTSLK.
The MRTSLK is the rate at which labour is substituted for capital, given the output. In figure 010, the
curve X represents a true neoclassical isoquant. Its slope, as already mentioned, is equal to the MRTSLK.
The MRTSLK corresponding to a movement from point A to point B is equal to:
MRTSLK = -K/L
= K1K2 / L1L2
Similarly, MRTSLK corresponding to a movement from point B to point C is equal to:
MRTSLK = -K/L = K2K3 / L2L3
Where, K1K2 / L1L2 > K2K3 / L2L3
That is, MRTSLK for a movement from A to B and B to C is diminishing. In other words, the MRTSLK
diminishes along an isoquant when we move from left to right. This is why the isoquant is convex to
origin.
3] Higher isoquant shows higher level of output:
In an isoquant map, higher isoquant shows higher level of output. This is because higher
isoquant includes combinations of more quantity of one or both of the factor inputs compared to lower

152

isoquant. More inputs result in more output. When we move upward along an isocline, quantity of
output increases. A producer always prefers a higher isoquant to a lower isoquant as he prefers more
output to less.
In figure 011, X1, X2, X3, and X4 are isoquants and the line S the isocline. As we move from a
lower one to higher one of isoquants, the volume of output gets enlarged. For instance, when we move
from A to B along the isocline, the output is increased from 100Kg to 200Kg. Similarly, a movement from
B to C shows an increase in output from 200 Kg to 300 Kg, and so on.
Thus, the higher the level of isoquant, the higher will be the level of output, and vice versa.
Figure 011

4] Two or more isoquants in an isoquant map never intersect each other:

Isoquants in an isoquant map never intersect each other. This can be proved by a diagram
[figure 012] as follows.
Figure 012

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In figure 012, two isoquants, X1 and X2, are shown as intersecting each other. We can prove
this as an improbable case. Combinations A and B are on the same isoquant X2. Thus, they show same
level of output. That is A = B, as far as the quantity of output is concerned. Similarly, Combinations A and
C are on the same isoquant X1. Thus, they show same level of output. That is, A = C. If A= B and A=C,
then, according to transitivity principle, B = C. This is not a consistent conclusion since B includes more K
but same L, compared to C. That is, B falls on a higher isoquant, compared to C, and thus, shows output
greater than that of C. This inconsistent conclusion is due to the intersection of isoquants. Thus, typical
isoquants will never intersect each other. Isoquants in an isoquant map are seen as parallel to each
other, given the state of technology.
5] Isoquant never touches the axes:
An isoquant never touches any of the axes. If it is seen otherwise, as in figure 013, it will be
contradictory to the very definition of the isoquant. As per the definition of the isoquant, a given volume
of output is produced by combining different possible combinations of two factor inputs. These possible
combinations never include zero quantity of any factor, provided that the quantity of output not equal
to zero. We need both labour and capital to produce the product X. Neither L, nor K alone can produce
any positive number of units of X. Thus, a typical isoquant cannot touch any of the axes.

Figure 013

154

6] Relevant isoquants fall in the technically efficient region of production:

Figure 014

155

As figure 014 shows, isoquants have their relevant segment in the technically efficient
region of production, the dark shaded area. In this area, marginal productivity of each factor is
diminishing when its quantity increases. This area falls between two ridge lines, lower ridge line [LRL]
and upper ridge line [URL]. Where, the LRL is the locus points of different isoquants at which the MPL is
equal to zero and the URL, the locus points of different isoquants at which the MPK is equal to zero. To
the left of URL, MPK is negative; and to the right of LRL, MPL is negative. In the technically efficient
region of production, thus, the marginal product of each factor is diminishing, but positive, with respect
to its quantity. A rational producer will select only a combination in the technically efficient region of
production. Thus, it is clear that a relevant segment of the isoquant falls in the technically efficient
region of production [that is between the ridge lines].
7] Isoquants are concentric ellipses when there is a unique maximum to the

production function:

As shown in figure 015, an isoquant map could consist of concentric ellipses. Each ellipse is
an isoquant depicting a certain level of output. Point S, where the ellipse collapses to a point, shows the
maximum quantity of output. The production function with elliptical isoquants has a unique maximum.
For such an isoquant map, the locus points of zero slope and the locus points of infinite slope on each
isoquant form the isoclines which meet at point S. The shaded area shows the technically efficient
region of production.
Figure 015

156

8] Isoquants are not concentric ellipses when there is no unique maximum to the production function:

Figure 016

157

As figure 016 shows, isoclines do not meet each other if the production function has no
unique maximum. S1 and S2 are isoclines. Here, isoclines are diverging from each other. The shaded area
in the figure shows the technically efficient region of production. In this case, the isoquants are not
concentric ellipses.
These are the important properties of isoquants. The neoclassical theory of production
maintains isoquants having these properties. Moreover, it applies the isoquants on a platform of
homogenous production function.
Laws of Production:
Laws of production explain all the technically possible ways of expanding the level of
output, given the technology. In other words, Laws of production explain how output increases when
one or more inputs change in a constant state of technology. The variation in output in response to
changes in quantities of inputs may be analysed in two ways. First, variation in output associated with a
change in a single input, while all other inputs are assumed fixed. This approach specifies returns to an
individual factor input. Second, variation in output associated with proportionate changes in all inputs.
This refers to the returns to scale. The former [returns to a variable factor] is associated with the short
run production function, while the latter [returns to scale] with the long run production function. Laws
of production, thus, explain both the short run and the long run aspects of the production function.

The neoclassical theory of production introduces a set of laws to explain the

returns to a variable factor and the returns to scale, that is, both the short run and the long run
158

aspects of production function. The neoclassical law explaining the returns to a variable factor is
popularly known as the law of variable proportions. It is a modified and improved form of the
law of diminishing returns. Whereas the neoclassical laws explaining the returns to all factors,
when they change in same proportion, are well known as the laws of returns to scale.
Law of Variable Proportions: [An Analysis of Returns to a Variable Factor]
Law of variable proportions is a modified version of the law of diminishing
returns. It explains the technically possible ways of increasing the level of output in the short run.
It explains the returns to a variable factor in the short run when the output can be increased only
by increasing the quantity of variable factor, given the fixed factor and technology. In the short
run, output is a function of variable factor, given the quantity of fixed factor{s}. The law of
variable proportions explains how the quantity of output increases when the quantity of variable
factor increases, given the quantity of fixed factor and technology. It finds a definite pattern of
input output relationship in the short run. It infers that all the major parameters of production
[TP, AP and MP] exhibit a definite pattern when the quantity of variable factor increases, given
the quantity of fixed factor and technology. Based on the pattern of movements of production
parameters the law infers three well marked stages in the short run production process.
According to John M. Cassels, if, with the same methods of production, successive
units of an input are added to a constant physical quantity of another input [or fixed combination
of other inputs], the total physical output obtained varies in magnitude through three distinct
phases51. That is, as per the law of variable proportions, there are three distinct stages in short
run input output relations. These stages are; 1] the stage of increasing returns, 2] the stage of
diminishing returns and 3] the stage of negative returns. These stages are distinguished on the
basis of the production parameters, TP, MP and AP, and the rates of growth of output and input
or the input elasticity of output [Ei].
Where the TP is the total product, the sum of output produced combining the
variable and fixed factors in varying proportions, MP, the marginal product of the variable factor
[say labour] and the AP, the average product of the variable factor. Let us state them as
TP = X
MPL = X/L
APL = X/L
Ei = X/X L/L
Where, X is the total output, X/L, the change in output with respect to change in quantity of
variable labour input, X/L, the total output divided by the number of units of variable labour
input, X/X, the rate of growth of output, L/L, the rate of growth of input, and Ei = X/X
L/L, the input elasticity of output [specifically, the labour elasticity of output].
Rate of growth of input and output [a measure of returns to variable factor] can be
obtained from the input elasticity of output [say labour elasticity of output].
Let us explain the unique features of each stage of the law as follows.

Stage of increasing returns:

51

John M. Cassels; On the law of variable proportions, A.E.A. Readings in the Theory of Income Distribution,
George Allen & Unwin, London, 1950

159

In first stage, the total product would be increasing, but there would be two phases
in this increase: In the first phase, the increase would be at an increasing rate, that is, the
marginal product of the variable input would be increasing; in the second phase, the increase in
TP would be at a decreasing rate, that is, the MP would be diminishing. However, throughout the
first stage, the MP will be above the AP of the variable input, so that the rate of increase in
output [X/X] is greater than the rate of increase in variable input.
At the boundary of the first stage, the MP = AP, where the AP is at maximum.
Stage of diminishing returns:
In second stage, the total product is still increasing, but at a decreasing rate. In this
stage, the MP is still falling and is bellow the AP. Hence, in this stage, the rate of increase in
output [X/X] is less than the rate of increase in variable input [L/L]. Throughout this stage the
AP is falling but positive. At the end of this stage, the MP is zero; correspondingly, the TP
reaches the highest level.
Stage of negative returns:
In third stage, the TP is decreasing, first at an increasing rate, and subsequently,
through most of the stage, at a decreasing rate. At the end, the TP becomes zero. During this
entire stage, except at the limits, the MP is negative. At the two limits of the stage, the MP is
equal to zero. AP, unlike MP, in this stage, is diminishing but positive. At the end of this stage,
the AP, along with MP and TP, becomes zero.
In table 004, first column shows the quantity of labour input [variable factor L],
second, the total product [TP = X], third, the marginal product of labour [MP L = X/L], fourth,
the average product of labour [APL = X/L], and the fifth, the labour elasticity of output [EL =
X/X L/L]. The highlighted rows [corresponding to 4th and 9th units of labour] show the
boundaries of first and second stages. [The closing boundary of the last stage is not shown in
table as well as in the coming diagram {017}. However, it is to be pointed out that the 3rd stage
will come to an end when the employment of {unproductive} labour reaches at an extreme level
where the MPL = APL = TP = Zero.]
In first stage [table 004], the TP first increases at an increasing rate and then at a
decreasing rate [The rate of increase is equal to MPL]; the MPL first increases, then reaches the
maximum [19], and then diminishes; the AP L, throughout the stage, increases and reaches the
maximum where the APL = MPL
In second stage, the TP, as a continuity of its trend in first stage, increases at a
decreasing rate and reaches the maximum; the MPL continues to decrease and reaches at zero; the
APL, throughout the stage, diminishes.
In third stage, the TP decreases; the MPL is negative; and the APL continues its
diminishing [but positive] trend.

160

Table 004
2

[L]

Total
Product
[TP]

Marginal
Product
[MP]

20

12

10

EL>1

39

19

13

EL>1

52

13

13

EL=1

60

12

EL<1

66

11

EL<1

70

10

EL<1

72

EL<1

72

EL=0

10

70

-2

EL<0

11

66

-4

EL<0

12

60

-6

EL<0

13

52

-8

EL<0

Average
Product

Labour Elasticity of
Output

Stages
of

[AP]

[EL]

LVP

Stage I

E L> 1

Stage II

Qty of Variable
Input

Stage III

We may explain the LVP graphically [figure 017] as follows [The diagram is not an exact
transformation of the table 004].
In first stage [figure 017], the TP curve has two distinct segments, namely OM and MN, both
with a positive slope. The segment OM is convex downward and the segment MN, concave downward.
Convexity of OM shows that the TP is increasing at an increasing rate. On the other hand, the concavity
of the NM signifies that the TP is increasing but at a decreasing rate. The MPL also has two distinct

Om and mn, the first with a positive and the second with a negative slope. The
positively sloped Om shows the increasing MPL and the negatively sloped mn, the diminishing MPL. The
segments, namely

161

APL has a single segment, jn. It is with a positive slope signifying that the APL is increasing throughout
the stage. At the boundary of the stage we have MPL = APL.
In second stage, the TP curve has a single segment NS. Its positive slope signifies that the TP
is increasing. However, its concavity shows that it is increasing at a decreasing rate. Point S shows the

nL3, in this stage. It is with a negative slope

signifying the diminishing MPL. At point L3, the MPL = zero. The APL curve also has single segment, nr, in
maximum TP. The MPL curve also has a single segment,

this stage. It is with a negative slope showing the diminishing APL. However, unlike MPL, it does not
become zero in this stage.

Figure 017

162

In the third stage, the TP curve has a single segment, rightward to point S. Its negative slope
is showing the decreasing TP. If we extend the TP curve further rightward it will reach at point where TP
will be equal to zero. Then, the TP curve gets two segments in this stage, one concave downward and
the other convex downward. They reflect the rate of decrease in the TP. The MPL curve in this stage has
a segment staying below the X axis. It shows the negative MPL. If we extend the curve further rightward,
it will reach at point where MPL = zero. If so, we can find two segments to the MPL curve in the third
stage, one with negative and the other with positive slope, but both stay below the axis. The APL curve
has a single segment in this stage. It is with a negative slope showing that the APL is decreasing. If we
further extend the APL curve continuously rightward, it also will reach at the point where APL = zero.
Thus, at the end of this stage, the entire three curves converge themselves to zero. That is, TP = MPL =
APL = 0 [figure 01852].

Figure 018
52

Reader may use it for higher learning.

163

In figure 018, all the three stages of the law are shown completely. It is only an extension of
the figure 017. In the last stage, as figure 018 shows, all the three production parameters converge to
zero at point A. In this stage, the TP curve has two distinct segments, namely SQ and QA. The former
shows that the TP decreases at an increasing rate while the latter, at a decreasing rate. Corresponding to
this the MPL curve also has two segments, namely L3q and qA. The APL curve, however, has a single
segment, rA. Throughout its length it has a negative slope. All the three curves converge to zero at the
point A.
Proof to various stages:
The condition for increasing returns to the variable labour input is that the rate of increase
in output must be greater than the rate of increase in quantity of labour. That is, X/X > L/L.

164

MPL > APL in the dark shaded area. That is;

X/L > X/L
Thus,

X/X > L/L

It means that the rate of increase in output is greater than the rate of increase in
quantity of labour. Thus, there are increasing returns to labour in the first stage.
The condition of diminishing returns to the variable labour input is that the rate of increase
in output must be less than the rate of increase in quantity of labour. That is, X/X < L/L. MPL < APL in
the light shaded area. That is;
X/L < X/L
Thus,

X/X < L/L

It means that the rate of increase in output is less than the rate of increase in
quantity of labour. Thus, there are diminishing returns to labour in the second stage.
On the boundary between the first and second stages, there is equality between
MPL and APL. That is, X/L = X/L. Thus, X/X = L/L.
The condition of negative returns to the variable labour input is that the MPL must
be negative. In the non-shaded area, the MPL is negative except at limits [At the limits MPL =
zero]. That is MPL < 0. Thus in the last stage, the returns are negative.
Causes of increasing returns:
In the initial stage, when the production starts by adding small amount of variable factor to the
fixed factor, efficient utilization of fixed factor becomes impossible. This is mainly because of the
indivisibility of the fixed factor. [Indivisibility of a factor means that its efficient utilization is possible only
at its large scale use]. Thus, when producer adds more and more units of variable factor to the fixed
factor, the fixed factor becomes more and more efficient. As a result, the returns are increasing.
More over, the scope of division of labour is increased when the quantity of variable factor
added to fixed factor increases. Division of labour, as Adam Smith said, multiplies the productivity of
factors. That is, output increases more than proportionately to variable input. As a result, the returns in
the initial stage are increasing.
Causes of diminishing returns:
However, when the variable input increases beyond a point, that is, beyond the optimal
utilization of fixed factor, there will be over utilization of fixed factor and, as a result, there will be over
depreciation of the fixed factor. This leads to diminishing returns. This also is basically due to the
indivisibility of the fixed factor. Similarly, the managerial expenses increase when the quantity of
variable factor exceeds beyond a limit. This also is responsible for the diminishing returns. Moreover,
the scope of division of labour is reduced by the over crowded variable factor. Likewise, the

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substitutability of factors gets decreased when too much of the variable factor is added to the given
fixed factor. All these factors result in diminishing returns.
Causes of negative returns:
Excessive use of a variable factor along with a given fixed factor results in negative returns. This
is because, at so larger a quantity, given the fixed factor, the variable factor becomes inefficient and
unproductive. As the old proverb says, too many cooks spoil the broth.

Importance of the LVP:

1] It overcomes the shortcomings of the law of diminishing returns: Economists like David Ricardo
developed the law of diminishing returns with a vision of agriculture in their mind. Thus, the LDR fails to
extend its wings in other fields of production other than farming. It needed an extension from farm to
firm. Neoclassical economists fulfilled this long cherished need of the ages through the invention of the
LVP. The LVP, unlike the LDR, explains all possible short run input-output relations happening in every
region at all times irrespective of any sectoral differences.
2] It highlights the limitations of factor substitutability: It reveals the fact that beyond a limit the
proportion of a factor to another cannot be increased productively. It warns that if that proportion
exceeds the limit, the total product itself will be decreased. No rational producer needs to reduce his
total product by employing an additional unproductive unit of the variable factor.
3] It throws light on disguised unemployment: Disguised unemployment is a problem seen mainly in
agrarian and over populated economies suffering from capital deficiency. In such economies, over
population is absorbed by capital deficient agricultural sector. As a result of excessive employment of
labour the marginal products turn to zero or even to negative. The LVP, thus, explains the cause and
dimensions of the disguised unemployment.
4] It highlights the importance of population control measures in over populated countries: As a result of
excessive employment of labour, a byproduct of over population, the marginal product of labour turns
to zero or negative. This means that the over population is a very strong growth retarding factor. It
should be controlled. Thus, we need not go elsewhere to find a rationale for population control as long
as the LVP holds good.
5] It is the basis of many theories: The LVP stands as a strong foundation to many economic theories. For
instance, the neoclassical and many other theories of distribution make use of the LVP not only as a
fundamental assumption but as a very strong theoretical framework, as well.
Conclusion:

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The LVP not only proposes some credible layouts of short run input-output relations, but also
engrosses a great policy implication that the rational producer has an operation ground in which the
marginal product of the variable factor is diminishing but positive. Its invention was definitely a path
breaking development in the history of economic theory.
The Laws of Returns to Scale:
The laws of returns to scale [LRS] explain the technically possible ways of increasing the
output when all factors are variable, given the technology. All factors are variable only in the long run.
Thus, the LRS refer to the long run aspect of the production function. In the long run, output can be
increased in two possible ways. First is increasing the output by increasing all inputs in same proportion.
This happens when the production function is homogenous. Second is increasing the output by
increasing all factors in different proportions. This occurs when the production function is nonhomogenous.
Neoclassical theory of production holds the homogenous production function as one of its
basic assumptions. It, thus, explains all the possible input-output relations in the long run when the
production function is homogenous. Thus, in neoclassical terminology, returns to scale refer to the
response of output to proportionate changes in inputs. Scale refers to the quantity of all inputs which
are employed in optimal combinations for specified outputs.53 According to the LRS, there are three
possible types of returns to scale. They are the increasing, constant and decreasing returns to scale.
Thus, there are three laws of returns to scale; Law of increasing returns to scale, Law of constant returns
to scale, and Law of decreasing returns to scale.
The law of increasing returns to scale shows that the output increases more than
proportionately to inputs when all inputs are increased in same proportion. The law of constant returns
to scale states that the output increases proportionately to inputs when all inputs are increased in same
proportion. The law of decreasing returns to scale shows that the output increases less than
proportionately to inputs when all inputs are increased in same proportion.
Mathematical illustration of the LRS:
Let us state a homogenous production function as follows
X = f [L, K]
Where, X is the quantity of output, L, the quantity of labour input, and K, the quantity of capital input.
Both labour and capital are variable factors.
Let output be increased from X to X*. We increase the output from X to X* by increasing labour and
capital in k proportion. Then we can state the new level of output as
X* = f [kL, kK]

53

The Methodology of Theory of the Returns to Scale; Oxford Economic Papers, 10, 1958, p. 101.

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Or
X* =k f [L, K]
=kX
Here the proportionality coefficient k, being it common to L and K, is completely factored out. This type
of production function is called as the homogenous production function. For such production functions
the isocline will be straight lines through the origin. On the other hand, when factor inputs are increased
in different proportions, the proportionality coefficient k cannot be completely factored out. This type of
production function is called as the non-homogenous production function.
For a homogenous production function, the proportionality coefficient k has a power v called as degree
of homogeneity. That is,
X* = k f [L, K]
The degree of homogeneity v is a measure of returns to scale. If v = 1, there are constant returns to
scale; if v > 1, there are increasing returns to scale; and if v < 1, there are decreasing returns to scale.
Returns to scale are measured mathematically by the input coefficients of the
production function. For instance, in Cobb-Douglas production function

b1 b2
X = b0 L K
The Returns to scale are measured by the sum [b1 + b2] = v.
Let the L and K increase by k proportion. The new level of output is

b1

b2

X* = b0 {kL} {kK}

b1 b2 {b1 + b2}

X = b0 L K k

{b1 + b2}

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=k

Thus, v = {b1 + b2}

Graphical illustration of the LRS:
Graphically, the returns to scale are measured by the distance between successive multiple
isoquants along an isocline. Along any one isocline [of HPF] the K/L ratio, as well as the MRTSLK, is
constant]. Multiple isoquants show multiple quantities of output. For instance, X1, X2, X3, and X4 are
multiple isoquants if X2 is double of X1, X3 is triple of X1 and X4 is quadruple of X1 [say X1 = 10, X2 = 20, X3
= 30 and X4 = 40].
The law of increasing returns to scale:
The law of increasing returns to scale states that the output increases more than
proportionately to inputs when all inputs are increased in same proportion. That is, given the
homogenous production function, every change in inputs leads to a more than proportionate change in
output. For instance, by doubling the inputs, output increases by more than twice its original level.
Figure 019

Graphically, along any isocline the distance between successive multiple isoquants is
decreasing when there are increasing returns to scale. In figure 019, X1, X2, X3, etc are multiple
isoquants. Along the isocline S the distance between successive multiple isoquants is decreasing due to

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increasing returns to scale. In figure 019, along the isocline S, the distance between successive multiple
isoquants, OA is greater than AB, AB is greater than BC and BC is greater than CD [OA > AB > BC > CD]. It
means that the output increases more than proportionately to inputs. For instance, when we move from
A to B the output is doubled. But it did not require doubling of inputs. Corresponding to the movement
from A to B, labour is increased from O L to O L1 and capital from O K to O K1. Where, L L1 is less than O
L, and K K1 is less than O K. That is, inputs are increased by less than twice of their original level but
output is increased by twice of its original level.
Then, what would happen if inputs were actually doubled. In figure 019, O L is equal to L 2L,
and O K is equal to K 2K. Thus, a movement from A to Z shows that the inputs are doubled, but the
resulting level of output, X* is more than twice of X1. That is, output increases more than proportionate
to inputs.
The law of constant returns to scale:
When there are constant returns to scale, the output increases proportionately to inputs.
That is, when inputs are doubled, output also is doubled. Thus, along the isocline S, the distance
between successive multiple isoquants remains the same. In figure 020, along the isocline S, OA = AB =
BC = CD. It means O L = L 2L = 2L 3L = 3L 4L, and O K = K 2K = 2K 3K = 3K 4K.
The law of decreasing returns to scale:
Figure 020

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When there are decreasing returns to scale, the output increases less than proportionately to
inputs. That is, when inputs are doubled, output will be less than twice of its original level. For instance,
as figure 021 shows, when we move from A to Z along the isocline S, inputs are doubled but the
resulting output, X* is less than the double. Thus, along the isocline S, the distance between successive
multiple isoquants increases. In figure 021, along the isocline S, the distance between successive
multiple isoquants, OA is less than AB, AB is less than BC and BC is less than CD [OA < AB < BC]. It means,
O L < L L1 < L1 L2 and O K < K K1 < K1 K2.
Figure 021

Varying Returns to Scale:

Let us explain graphically all the possible returns to scale simultaneously. Generally, in long
run production process, producer first experiences the increasing, then the constant and lastly the
decreasing returns to scale. In figure 022, varying returns to scale are shown.
In figure 022, along the isocline S, the distance between successive multiple isoquants first
decreases [OA>AB>BC], then remains constant [BC=CD], and lastly increases [CD<DE<EF].It means, there
are increasing returns from O to C; constant returns from B to D; and decreasing returns from C to F. It is
also clear from changes in inputs. Where, O L1 > L1 L2 > L2 L3; L2 L3 = L3 L4; and L4 L5 < L5 L6; similarly,
O K1> K1 K2 > K2 K3; K2 K3 = K3 K4; and K4 K5< K5 K6. All these reveal that the producer first
experiences the increasing, then the constant and lastly the decreasing returns to scale.

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The question the nature of the returns to inputs, when they are all variable, is s controversial one.
Economic theory holds that as the size of a firm increases, the firm will face successively increasing
returns, followed by constant returns, and then decreasing returns to scale. Joan Robinson stated what
has come to be known as the indivisibility thesis. According to this thesis, the reason why returns to
scale are not constant, is that inputs consist of indivisible units, each of which may not be equally well
suited for the various functions in production. If all inputs were finely divisible, like sand, it would be
possible to produce the smallest output of any commodity with all the advantages of large-scale
industry.54 In other words, we cannot have varying returns to scale when inputs are perfectly divisible.55
Figure 022

Causes of Varying Returns to Scale:

Economists do no have unanimous opinion regarding the basic cause of varying returns to
scale. Many economists like Joan Robinson, F. H. Knight, A. P. Lerner, and Nicholas Kaldor believe that
varying returns to scale are due to the indivisibility of inputs. But economists like E. H. Chamberlin argue
that the varying returns to scale are due to varying efficiency of factors resulting from varying
possibilities of specialization. William J. Baumol states dimensional economy as the major reason for
varying returns to scale. Let us explain each of these theses as follows.
1. Indivisibility Thesis: As already mentioned, economists like Joan Robinson, F. H. Knight, A. P. Lerner,
and Nicholas Kaldor state that varying returns to scale are due to the indivisibility of inputs. Certain
inputs are efficient on in their large scale use. As the scale of production expands, large scale use of such
inputs takes place. Due to the indivisibility of these inputs, they become more efficient as scale expands.
54

The Economics of Imperfect Competition; Macmillan, London, 1950.

Value and Distribution in Neoclassical and Classical Systems; G. C. da Costa , Second edition, Himalaya
Publishing House.
55

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This leads to increasing returns to scale. When production reaches at optimal scale, the inputs become
divisible, and, as a result, there will be constant returns to scale. But when scale of operation exceeds
the optimal level, factors again become indivisible. As a result, further expansion of scale leads to reduce
the efficiency of inputs. Consequently, there will be decreasing returns to scale. Thus, ultimately,
indivisibility of the inputs is the root cause of varying returns to scale.
2. Efficiency Thesis: Economists like Chamberlin disagree with the indivisibility thesis. Chamberlin says
that increasing returns to scale are possible even when the inputs are perfectly divisible. According to
him, the nature of returns to scale depends not upon the divisibility or indivisibility of inputs, but upon
the scope of specialization in production process. As the size of plant [not exactly the scale] expands, the
scope of specialization increases. This leads to increasing returns to scale. When the scope of
specialization is less, there would be either constant or decreasing returns to scale.
Technological progress and Production Function:
Figure 023

So far we explained the production function by assuming technology as constant. In real

world, technology seldom remains unchanged. The technology of firms changes very fast in our present
world which is passing through an unprecedented era of knowledge explosion and path breaking

173

innovations. Innovations are of two types, namely the innovation of production process and the
innovation of products. We focus our attention upon the innovation of process.
Technological progress will enhance the productivity of factor inputs. A specific technological
progress may make the existing technology more productive. It may also make the existing technology
less productive and, hence, obsolete.
J. R. Hicks has clarified the technical progress by classifying it in to three categories on the
basis of changes in productivities and the substitutability of factors. They are, 1] capital-deepening
technical progress, 2] labour-deepening technical progress, and 3] neutral technical progress.
1] Capital-deepening technical progress:

Technical progress is called capital-deepening when it increases marginal productivity of capital by more
than the marginal productivity of labour. That is, it enhances the marginal productivity of both labour
and capital, but the increase in marginal productivity of capital is more than the increase in marginal
productivity of labour. Graphically, Technical progress is called capital-deepening, if, along an isocline on
which the K/L ratio is constant, the MRTSLK = MPL/MPK decreases absolutely. Capital-deepening
technical progress shifts the isoquant inwards closer to capital axis. As part A of figure 023 shows,
Capital-deepening technical progress reduces the steepness of isoquant [provided that the capital is
measured along Y axis].
2] Labour-deepening technical progress: Technical progress is called labour-deepening when it
increases marginal productivity of labour by more than the marginal productivity of capital. It increases
the marginal productivity of both labour and capital, but the increase in marginal productivity of labour
is more than the increase in marginal productivity of capital. As a result, along an isocline with constant
K/L, the MRTSLK = MPL/MPK increases absolutely. It shifts the isoquant inwards closer to labour axis.
That is, as part B of figure 023 shows, the steepness of isoquant increases.
3] Neutral technical progress: Neutral technical progress, sometimes called as Hicks Neutrality,
increases the marginal productivity of labour and capital proportionally. That is, the increase in marginal
productivity of capital is equal to increase in marginal productivity of labour. When there is Neutral
technical progress, the MRTSLK = MPL/MPK remains unchanged along an isocline with constant K/L.
Neutral technical progress shifts the isoquant inwards parallel to itself. Thus, the steepness of isoquant
is unchanged. Part C of figure 023 shows the Neutral technical progress.
Isocost Line:
Isocost line is the locus of combinations of two factor inputs, given the cost. In other words, an
Isocost line includes all those combinations of two factor inputs, say labour and capital, which could be
purchased by same cost. Each combination of an Isocost line is economically efficient one.

174

How can we construct an isocost line? We need the following information to construct an
isocost line.
1] Amount of money that the producer likes to spend for buying factors, labour and capital [].
2] Prices of factors, the price of labour [w] and the price of capital [r].
Let us assign values to them as follows
The Amount of money which is meant for buying factors, labour and capital, = Rs1000, the price of
labour w = Rs100, and the price of capital r = Rs200.
That is,
= Rs1000
w = Rs100

and

r = Rs200
Suppose the producer spends the entire amount Rs1000 to buy capital. Then, he could buy 5
units of capital but zero unit of labour. That is, he can buy a maximum 5 units of capital. Let us call this
maximum quantity of capital as OA.
Then,
OA = /r = 1000/200 = 5
If the producer spends the entire amount Rs1000 on capital, he could get a combination, 5 units of
capital + zero unit of labour. Let us call this extreme combination as A.
Suppose the producer spends the entire amount Rs1000 on labour. Then, he could buy 10
units of labour but zero unit of capital. That is, he can buy a maximum 10 units of labour. Let us call this
maximum quantity labour as OB.
Then,
OB = /w = 1000/100 = 10
If the producer spends the entire amount Rs1000 on labour, he could get a combination, 10 units of
labour + zero unit of capital. Let us call this extreme combination as B.
Plotting these extreme combinations A and B, and joining them by a straight line in a two
dimensional diagram, we get an isocost line AB [figure 024].
Figure 024

175

In figure 024, AB is the isocost line. Slope of AB = OA/OB. Where, OA = /r = 1000/200,

and OB = /w = 1000/100.
That is,
Or

/r /w = 1000/200 1000/100
w/r = 100/200

That is, Slope of isocost line AB = w/r = 100/200 =

Thus, it is clear that the slope of the isocost line is equal to the ratio of factor prices, w/r.
Production Function of Multiproduct Firm; Production Possibility Curve [PPC]:
So far we discussed the production function of a single product firm, the firm producing
product X. In actual world a firm may produce multiplicity of products. Isoquant cannot explain the
production function of a multiproduct firm. Thus, we need another tool, the production possibility curve
[PPC] or product transformation curve. However, to construct a PPC we need to reduce the number of
products into two or all the products of the firm are to be grouped into two composite products.
A production possibility curve is the locus of combinations of two products, say product X
and product Y, given the factor endowment. It shows the maximum quantity one product, say X, which
can be produced for any given quantity of another product, say Y, given the factor endowment and
technology. In other words, PPC includes all possible combinations of X and Y products, given the
quantities of factor inputs and technology. That is, the PPC represents all combinations of two products
that a firm can produce by the efficient utilization of all the available resources under conditions of
constant technology. It is called transformation curve because in moving from one point to another on
it, one product is transformed into another by transferring resources from one line of production to the
other. Before drawing a PPC we may observe a schedule of production possibilities [table 005].

176

Table 005
Production Possibility Schedule
1

Combination

Quantity of X [Quintals]

Quantity of Y [Quintals]

MRPTxy

15

14

1X:1Y

12

1X:2Y

1X:3Y

1X:4Y

1X:5Y

In table 005, first column shows various combination of X and Y products which can be
produced by the effective utilization of given quantities of factors, the second column shows quantity of
product X, the third column shows quantity of product Y, and the last column, the marginal rate of
product transformation MRPTxy.56 As table shows, there is a trade off between the quantities of
products X and Y. MRPTxy is increasing.
Figure 016

56

MRPTxy is further explained in coming section.

177

We can transform the table directly into a graph as follows [figure 025]. In figure 025, quantity
of product X is measured on horizontal axis and that of Y on vertical axis. The curve, in figure 025, with
negative slope and concavity [to origin] is the production possibility curve. Its negative slope means that
the quantity of product Y decreases when quantity of product X increases. For instance, the quantity of
product Y decreases from 15 to 14 quintals when quantity of product X increases from zero to one
quintal. Similarly, the quantity of product Y decreases from 14 to 12 quintals when quantity of product X
increases from one to two quintals, and so on.
In figure 025, PP is the production possibility curve. It is negatively sloped and concave to origin.
It means, quantity of product X can be increased only by decreasing quantity of product Y, given the
factor endowment and technology [also increasing rate of transformation57 between X and Y].
The dark shaded area OPP is called opportunity region. This area, including the boundary, shows
all possible combinations of X and Y products, given the factor endowment. However, only the
combinations on the production possibility curve, PP are technically efficient.
Combinations in the light shaded area are beyond the reach of the firm, given the factor
endowment and technology. To reach in this area the firm has to adopt better technology58, given the
factor endowment. If it happens, the PPC will shift outward.

57
58

This is explained in coming section under the title MRPTXY

This is explained in coming section under the title Technical Progress and the Production Possibility Curve

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Derivation of PPC:
PPC is derived from the Edgeworth Box. We can derive a PPC as follows:
Suppose a firm produces two products, X and Y. Production functions of these products can be stated as
X = f1 [L, K] and
Y = f2 [L, K]
By using isoquants, X isoquants and Y isoquants, we can show these production functions in two
separate diagrams. If we superimpose one diagram on another, as shown in figure 026, we get the
Edgeworth Box.
In figure 026, Ox is the origin of X isoquants and Oy, the origin of Y isoquants. Ox Oy is the
Edgeworth Contract curve which is made of points of tangency between X isoquants and Y isoquants.
Each combination of L and K on the Edgeworth contract curve is optimal. On the other hand, a
combination away of the contract curve is not optimal. Let us take a few combinations for analysis.
Combination A, B and C are on the contract curve. But combination N is away of the contract
curve. A movement from N to A shows that the quantity of X remains the same as X3, but the quantity
of Y increases from Y3 to Y4. Thus, a movement from N to A is an efficient reallocation labour and capital
between X and Y products. Likewise, a movement from N to B shows that the quantity of Y remains the
same as Y3, but the quantity of X increases from X3 to X4. Thus, a movement from N to B also is an
efficient reallocation labour and capital between X and Y products. Similarly, a movement from N to C
shows that the quantities of both X and Y increase. Thus, a movement from N to C is an efficient
reallocation of labour and capital between X and Y products. All this signifies that all combinations on
the contract curve are superior to all combinations off the contract curve.
Figure 026

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Slope of the Contract Curve: Since the contract curve is made of points of tangency between X and Y
isoquants, it has a slope equal to the equalized slope of isoquants. That is,

Slope of X isoquant = MRTS(x) LK = MPL, x/MPK, x

Slope of Y isoquant = MRTS(y) LK

MPL, y/MPK, y

Thus, Slope of contract curve = MRTS(x) LK, = MRTS(y) LK

Derivation of the Production Possibility Curve: PPC is derived from the Edgeworth contract curve.
Points a, b and c of PPC, in figure 026, are derived from points A, B and C of contract curve. In figure 026,
a movement from point A to point B is the same as the movement from A to B in figure 027. As we move
from A to B on the PPC, the quantity of X rises from X3 to X4 and that of Y falls from Y4 to Y3. It means
that each point of the PPC is defined by a point of the contract curve. The PPC has a negative slope due
to the positive slope of the contract curve.

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Slope of the Production Possibility Curve: The PPC, as already mentioned, has a negative slope. It is
concave to origin. What is responsible for all this? Slope of the PPC is equal to marginal rate
transformation of one product in to another. Symbolically, the MRPTxy, read as marginal rate of product
transformation of X for Y. Thus,
Slope of the PPC = MRPTxy
Where, MRPTxy is measured as,
MRPTxy = -Y/X = MPL, y/ MPL, x = MPK, y/ MPK, x
Figure 027

Technical Progress and the PPC:

Figure 028

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Technical progress leads to outward shift in the PPC, given the factor endowment. In figure
028, the PPC shifts from AB to A1B1 due to a technical progress, given the factor endowment. It means
that more X and Y products can be produced by given quantities of factors when there is a technical
progress.
In figure 028, AB is the initial PPC which shifts outwards to A1B1. This helps the firm realise
more X or Y or both, without an increase in the quantities of inputs. For instance, a movement from N to
M shows that the quantity of product Y increases fromY1 to Y3 without a decrease in the quantity of
product X. Similarly, a movement from N to R shows that the quantity of product X increases X1 to X3
without a decrease in the quantity of product Y. a movement from N to Q shows that the quantities of
both product X and product Y are increased.
All this means that a technical progress leads to expand the production possibilities, given
the factor endowment.
Isorevenue Curve and Economic Efficiency:
A PPC shows all the possible technically efficient combinations of two products in a state of
constant factor endowment and technology. It does not involve any terms like money, price, cost and
revenue. Thus, it cannot tell whether the combinations are economically efficient or not. To identify the
economically efficient combinations of two products we need another tool, the isorevenue curve.
An isorevenue curve is the locus of combinations of two products, given the revenue.

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That is, each combination of an isorevenue curve yields the same revenue to the producer.
Before drawing an isorevenue curve we may observe an isorevenue schedule [table 006]. In table 006,
column one shows various combinations of products X and Y, column two shows quantities of product X,
column three shows quantities of product Y, column four shows price of X which is assumed as Rs5,
column five shows price of Y which is assumed as Rs10, and column six shows revenue which is assumed
as Rs100. The extreme combination A shows that the quantity of X is equal to zero and the quantity of Y
equal to 10. Likewise, the extreme combination K shows that the quantity of X is equal to 20 and the
quantity of Y equal to 0. Other possible combinations are shown between A and K. All these
combinations show the same level of revenue, Rs100. Let us transform the table 006 directly into a
graph [figure 00].
Table 006
Isorevenue Schedule
1

Combination

Qty of X [Kg]

Qty of Y [Kg]

Px [Rs]

Py [Rs]

Revenue

10

10

100

10

100

10

100

10

100

10

100

10

10

100

12

10

100

14

10

100

16

10

100

18

10

100

20

10

100

In figure 029, product X is measured on horizontal axis and product Y on vertical axis. The
straight line RR is the isorevenue curve. An isorevenue curve, as shown in figure 029, is a negatively
sloped straight line joining the axes
How can we construct an isorevenue curve? We need the following revenue equation.
R = Px. X + Py. Y

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Let R = 100, then, R = 100 = Px. X + Py. Y

Suppose, the Px = 5 and Y=0, then
R = 100 = Px. X + Py. Y
= 100 = 5. X + 0
X = 100/5
= 20
That is, X=20 and Y=0. Let us call this combination as B.
Suppose, the Py = 10 and X=0, then
R = 100 = Px. X + Py. Y
= 100 = 0 + 10. Y
Y = 100/10
= 10
That is, X=0 and Y=10. Let us call this combination as A.
Plotting these extreme combinations and joining them by a straight line we get the isorevenue
curve AB in figure 030. All combinations on the isorevenue curve show the same revenue.
Slope of the isorevenue curve: In figure 031, slope of the line AB is OA/OB.
That is, slope of the l isorevenue curve = OA/OB
Where, OA = R/Py and OB = R/Px. Thus,
OA/OB = R/Py R/Px
= Px/Py
Figure 029

184

Figure

030

That is, slope of the isorevenue curve is equal to the ratio of prices of X and Y products, Px/Py.
Figure 031

185

Producers Equilibrium:
A producer is in equilibrium when he realises his goal. Neoclassical theory assumes
maximum profit as the only goal of the firm, either a single product firm or a multiproduct firm. Where,
profit is the positive difference between revenue and cost.
That is,
=R-C
Where, is the profit, R, the total revenue, and C, the total cost.
Revenue, R, is equal to the price of the product multiplied by the quantity of the product.
That is,
R = Px. X
Where, R is the total revenue, Px, the price of product X, and X, the quantity of the product X.
If the firm produces two products, X and Y, the revenue of the firm can be stated as,
R = Px. X + Py. Y

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Where, R is the total revenue, Py, the price of product Y, and Y, the quantity of the product Y.
Cost function can be stated as,
C = w. L + r. K
Where, C, the total cost, w, the price of labour, L, the quantity of labour, r, the price of capital, and K,
the quantity of capital.
If the firm produces two products, X and Y, the total cost can be stated as,
C = {w. Lx + w. Ly} + {r. Kx + r. Ky}

The theory of producers equilibrium has the following analytical sections and subsections [table 007].
Table 007
Producer's Equilibrium
1] Single Product Firm's Equilibrium
A] Constrained Equilibrium
Cost Constrained Equilibrium

Output Constrained Equilibrium

B] Unconstrained Equilibrium [Optimal Expansion Path]

2] Multiproduct Firm's Equilibrium
A] Constrained Equilibrium
B] Unconstrained Equilibrium [Optimal Output Expansion Path]

I} Single Product Firm's Equilibrium:

As already stated, a single product firm is in equilibrium when it realises its goal of maximum
profit. Its profit function is,
=R-C
Its revenue function is,
R = Px. X
Its production function is,

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X = f [L, K]
Its cost function is,
C = w. L + r. K
Given the Px, w, and r, firms profit is a function of the quantity of product X produced and
the quantities of factor inputs [L and K] employed [that is, = f{X, L, K}]. The firm can maximise its profit
through minimization of cost as well as maximisation of output.
A single product firm is in equilibrium when the following marginal condition is satisfied.
MRTSLK = MPL/MPK = w/r
Where, MRTSLK = MPL/MPK is the slope of the isoquant and w/r, the slope of the isocost line.
1] Constraint Equilibrium of Single Product Firm:
The firm may face constraints in its operations. It may be a cost constraint or an output
constraint. A firm facing the cost constraint is not able to minimise the cost. Such a firm maximises the
profit through output maximisation, given the cost constraint. Likewise, the firm may face an output
constraint. A firm facing the output constraint is not able to maximise the output. Such a firm maximises
the profit through cost minimisation, given the output constraint.
Cost Constraint Equilibrium of Single Product Firm:
A firm facing the cost constraint has a given cost function,
C = w. L + r. K
But it can maximise its production function,
X = f [L, K]
In this situation, the firm cannot minimise its cost of production. All its operations are
constrained by the given cost function. Thus, the firm can realise its goal only in a configuration allowed
by the given cost constraint. The firm, thus, has a single isocost line. However, since it faces no output
constraint, it has a set of isoquants with which it can maximise output. In this situation, the firm gets in
equilibrium where its given isocost line is tangent to the highest possible isoquant. Figure 032 shows the
cost constrained equilibrium of the single product firm.
In figure 032, AB is the given isocost line which is tangent to the highest possible isoquant [X3]
at point E. Point E satisfies the marginal condition of equilibrium,
MRTSLK = MPL/MPK = w/r
That is, the slope of the isoquant is equal to the slope of the isocost line.

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Let us observe a few combinations of labour and capital to verify whether the equilibrium at point E is
true, consistent and unique. Point M, compared to E, falls on a lower isoquant, and thus, involves lower
output [X2]. Point E shows X3 level of output which is greater than X2. On the other hand, both M and E
show same cost since they fall on same isocost line. Thus, it is clear that the combination E is superior to
the combination M.
Point Q, compared to E, falls on a higher isoquant, and thus, shows a higher output [X4].
Thus, definitely, the combination Q is superior to the combination E. However, the combination Q is
beyond the reach of the firm as it falls outside the opportunity region OAB. Therefore, the combination
Q is desirable but not possible.
Point N, like M, falls on a lower isoquant, and thus, shows a lower output [X2]. However,
the cost involved in it is less than the cost involved in E or M. It doesnt mean that the firm will prefer N
to E. The firm always tries to produce the maximum possible output. Thus, it prefers E to N.
Figure 032

From the ongoing analysis it is clear that the firm is truly in equilibrium at point E.
Moreover, the equilibrium at point E is also consistent and unique. The firm corresponding to this
equilibrium, employs OL* of labour and OK* of capital. This is the optimal combination of factors, given
the cost constraint. It is both technically and economically efficient combination. That is point E shows
overall efficiency.

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Output Constraint Equilibrium of Single Product Firm:

A firm facing the output constraint has a given production function,
X = f [L, K]
But it can minimise its cost function,
C = w. L + r. K
In this situation, the firm cannot maximise its output. All its operations are constrained by the given
production function. Thus, the firm can realise its goal only in a configuration allowed by the given
output constraint. The firm, thus, has a single isoquant. However, since it faces no cost constraint, it has
a set of isocost lines with which it can minimise its cost. In this situation, the firm reaches at equilibrium
where the lowest possible isocost line is tangent to the given isoquant. Figure 033 shows the output
constrained equilibrium of the single product firm.

Figure 033

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In figure 033, the lowest possible isocost line [C3] is tangent to the given isoquant, X = f [L,
K], at point E. The Point E satisfies the marginal condition of equilibrium,
MRTSLK = MPL/MPK = w/r
That is, the slope of the isoquant is equal to the slope of the isocost line.
Let us anlayse a few combinations of labour and capital to identify whether the equilibrium
at point E is true, consistent and unique. Points M and E fall on same isoquant [X] and thus, show same
output [X]. However, point M falls on a higher isocost line compared to point E. Thus, E is superior to M.
Point R falls on a lower isocost line. But the level of output corresponding to point R is less compared to
point E. Thus, the firm prefers E to R.
Point E, as the above analysis infers, is the true, consistent and unique equilibrium of the
single product firm facing an output constraint. The firm corresponding to this equilibrium, employs OL*
of labour and OK* of capital. This is the optimal combination of factors, given the output constraint. It is
both technically and economically efficient combination. That is, point E shows overall efficiency.
2] Unconstraint Equilibrium of Single Product Firm:
In the long run, all factors of production are variable. There is no limitation [technical or
financial] to the realisation of firms goal. A firm, thus, may be free from constraints, both cost and
output constraints. Such a firm can realise its goal of maximum profit through cost minimisation as well
as output maximisation. The firm can maximise its profit function, = R C. Given the product and
factor prices [Px, w, and r], the profit is a function of quantities of output and inputs, that is, = f{X, L,
K}. The firm, free from cost and output constraints, has a set of isocost lines as well as a set of isoquants.
The unconstrained equilibrium of a single product firm can be explained by the device,
optimal expansion path [analogous to the ICC in indifference curve analysis]. An optimal expansion path
[OEP] is locus of points of tangency between successive isocost lines and isoquants. Each point of it is a
possible equilibrium point. It means all points of the OEP show both technically and economically
efficient combinations of factor inputs. Thus, the OEP shows the technically as well as economically
efficient ways of increasing the output [the isocline we analysed in previous section shows only
technically efficient ways of increasing the output].
An optimal expansion path, as shown in part A of figure 034, is a straight line through
origin if the production function is homogenous. On the other hand, it will be a twiddly line, as shown in
part B of figure 034, if the production function is non-homogenous.
Figure 034

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In part A of figure 034, E1 and E2 are the optimal expansion path of homogenous
production function. It is linear, and thus, has constant K/L. Besides this, along the OEP the MRTSLK = K/L
is constant. Moreover, this equilised ratio, MRTSLK = K/L is equal to w/r. This is because each point of the
OEP is an equilibrium point satisfying the condition MRTSLK = w/r.
In part B of figure 034, E is the optimal expansion path of non-homogenous production
function. It is a twiddly line, even if the ratio of factor prices, w/r, remains constant. This is due to the
fact that in equilibrium we must equate the [constant] w/r ratio with the MRTSLK. That is, these equilised
ratios are not the same at different points on the twiddly OEP.

II} Equilibrium of Multiproduct Firm:

We can explain the equilibrium of multiproduct firm using the production possibility curve
[PPC] and isorevenue curve [IRC]. The PPC explains technically efficient combinations of products. On
the other hand, the IRC explains economically efficient combinations of products. They together can
explain the overall efficiency.
Marginal condition of equilibrium of multiproduct firm is,
MRPTxy = -Y/X = MPL, y/ MPL, x = MPK, y/ MPK, x = Px/Py

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Where, MRPTxy = -Y/X = MPL, y/ MPL, x = MPK, y/ MPK, x is the slope of the PPC, and Px/Py is the slope of
the IRC. That is, the multiproduct firm is in equilibrium at point where the IRC is tangent to the PPC.
1] Constrained Equilibrium of Multiproduct Firm:
Multiproduct firm, producing X and Y products, may face a constraint in the form of
constant factor endowment. That is, it has to maximise profit from X and Y products under conditions of
given quantities of factor inputs, L and K. Under this circumstance, the firm has to find the optimal
product mix of X and Y products which maximises its revenue and profit. Figure 035 explains how a firm
finds its optimal product mix.
Figure 035

In figure 035, the Multiproduct firm is in equilibrium at point E where the highest possible
IRC is tangent to the given PPC. This shows the optimal product mix, OX* of product X and OY* of
product Y. The point E satisfies the marginal condition of equilibrium of multiproduct firm,
MRPTxy = -Y/X = MPL, y/ MPL, x = MPK, y/ MPK, x = Px/Py
2] Unconstrained Equilibrium of Multiproduct Firm:
Multiproduct firm, producing X and Y products, may be free from the constraint of constant
factor endowment. That is, it may be in a position to hire as much quantities of labour and capital as it
likes. Then, the firm in its journey of profit maximisation can reach on higher and higher PPC and IRC.
We have a tool to explain the unconstrained optimization of the Multiproduct firm. It is called as the

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optimal output expansion path [OOEP]. An OOEP shows the technically and economically possible ways
of expanding the quantities of multiple products. Each point of an OOEP is an equilibrium point. Thus,
the OOEP can be defined as locus points of tangency between successive PPCs and IRCs, given that
MRPTxy = Px/Py.
Figure 036

In figure 036, the straight line E through origin is the optimal output expansion path
[OOEP]. As the firm moves along the OOEP from left to right it expands the products optimally. Each
point of the OOEP shows the technically and economically efficient combinations of X and Y products.
Thus, the OOEP shows the overall efficiency of the firm. The multiproduct firm optimizes its production
decisions by moving along the OOEP.
Derivation of Cost Functions from Production Functions:
We have a separate chapter dealing with the theory of costs, both traditional and
modern. However, we need an entry passage to the theory of cost from production function. This
section is intended to facilitate the same.
Production function, as we have already explained, deals with technical relation between
inputs and outputs, and thus, we state the production function as,

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X = f [L, K]
It reveals that the quantity of output depends upon the quantities of inputs, given the technology.
Output is a direct function of inputs. That is, production function is a direct function. On the other hand,
costs are derived functions. They are derived from production functions. Cost function, for instance,
represented by an isocost line can be stated as,
C = w. L + r. K
If we take factor prices, w and r as constant, we can state that the cost is an indirect function of
quantities of factor inputs, L and K. In other words, the cost function is derived from the production
function. That is,
C = {f [L, K]}
Or

C = {X}

We can derive cost functions from production functions mathematically or graphically. For
this we need the following assumptions.
1. Production function is linearly homogenous [v = 1], and
2. Factor prices [w and r] are constant.
Graphical Derivation of Cost Functions from Production Functions:
A rational producer always chooses the optimal process of production when he takes
production decisions in the long run. As we have already explained, an optimal expansion path shows
the optimal way of increasing the level of output in the long run. When he chooses the optimal
combination of labour and capital, from among a large number of production processes, he is said to be
in equilibrium at a point of time. Given the factor price ratio, he continues to apply the same production
process. That is, he moves upward along the same optimal expansion path as long as w/r remains the
same, provided that the pattern of distribution of isoquants remains unchanged. In other words, he uses
the least cost combinations of factor inputs over a period of time.
Given the linearly homogenous production function [constant returns to scale], output
increases proportionately to inputs when all inputs are increased in same proportion. Suppose that the
production function is linearly homogenous and the optimal Capital: Labour ratio, K/L is 3/2, and the
factor prices w = r = Rs2. The table 008 shows the production and cost functions simultaneously.
In table 008, the first column represents the combinations of L and K, the second, the
quantity of labour, the third, the quantity of capital, the fourth, the optimal K/L, the fifth, the quantity of
output, the sixth, the total cost, and the last, the average cost. We get total cost in 6th column by
applying the cost function,
C = w. L + r. K.

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For instance, the TC corresponding to combination A is,

C1 = 2 x 3 + 2 x 2 = 10.
Similarly, the TC corresponding to combination B is,
C2 = 2 x 6 + 2 x 4 = 20.
The AC in last column is,
AC = TC/X
For instance, the AC corresponding to combination A is,
AC = TC/X = 10/1 = 10.
Similarly, the AC corresponding to combination B is,
AC = TC/X = 20/2 = 10.

Table 008
Combined production and cost schedule
1

Combination of
L and K

Qty of L
[Hours]

Qty of K
[Hours]

K/L

Qty of X
[Kg]

TC

AC=MC

1.5

10

10

1.5

20

10

1.5

30

10

12

1.5

40

10

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15

10

1.5

50

10

18

12

1.5

60

10

21

14

1.5

70

10

24

16

1.5

80

10

In table 008, the TC is increasing at a constant rate, given that w = r = Rs2. That is, marginal
cost [C/X] is constant and equal to average cost [C/X]. Column 5 [function of columns 2 and 3] shows,
the output increases proportionately to inputs, when inputs increase proportionally [linearly
homogenous production function]. For instance, corresponding to a movement from A to B, the output
is doubled when inputs are doubled. This input output relation [production function] and cost output
relation [cost function] can be explained graphically as follows.
Figure 037

In figure 037, OE is the optimal expansion path [its linearity shows linearly homogenous
production function]. The isocost lines, from C1 to C6, have same slope, w/r = 2/2 = 1. These isocost
lines are tangent to the isoquants, from X1 to X6, on the linear optimal expansion path, OE. Each point
of it is a tangency between the isoquant and isocost line, and thus, an optimal combination of L and K.
The optimal expansion path OE in figure 037 shows various levels of output corresponding to
different optimal combinations of L and K. It also shows the optimal cost of production for each level of
output. The TC curve in Figure 038 is derived from the optimal expansion path OE in figure 037. It shows
the total cost at each level of output.

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In figure 039, the horizontal straight line AC represents the average cost. It shows constant
AC. It means, the AC is constant at all levels of output.
Figure 038

Figure 039

Linear Programming:

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George B. Dantzig is the founder of the simplex method of linear programming, but it was
kept secret and was not published until 1947 since it was being used as a war-time strategy. But once it
was released, many industries also found the method to be highly valuable. Another person who played
a key role in the development of linear programming is John von Neumann, who developed the theory
of the duality. Leonid Kantorovich, a Russian mathematician who used similar techniques in economics
before Dantzig and won the Nobel Prize in 1975 in economics.
Dantzig's original example of finding the best assignment of 70 people to 70 jobs
emphasizes the practicality of linear programming. The computing power required to test all possible
combinations to select the best assignment is quite large. However, it takes only a moment to find the
optimum solution by modeling problem as a linear programme and applying the simplex algorithm. The
theory behind linear programming is to drastically reduce the number of possible optimal solutions that
must be checked.
In the years from the time when it was first proposed in 1947 by Dantzig, linear
programming and its many forms have come into wide use worldwide.

It has become popular in

academic circles, for decision scientists (operations researchers and management scientists), as well as
numerical analysts, mathematicians, and economists who have written hundreds of books and many
more papers on the subject. Though it is so common now, it was unknown to the public prior to 1947.
Actually, several researchers developed the idea in the past. Fourier in 1823 and the well-known Belgian
mathematician de la Valle Poussin in 1911 each wrote a paper describing today's linear programming
methods, but it never made its way into mainstream use. A paper by Hitchcock in 1941 on a
transportation problem was also overlooked until the late 1940s and early 1950s. It seems the reason
linear programming failed to catch on in the past was lack of interest in optimizing.
"Linear programming can be viewed as part of a great revolutionary development which has
given mankind the ability to state general goals and to lay out a path of detailed decisions to take in
order to 'best' achieve its goals when faced with practical situations of great complexity. Our tools for
doing this are ways to formulate real-world problems in detailed mathematical terms (models),
techniques for solving the models (algorithms), and engines for executing the steps of algorithms
(computers and software)."
Definition of Linear Programming:
Linear Programming is the maximisation [or minimisation] of a linear function of variables
subject to constraints of linear inequalities
The process of taking various linear inequalities relating to a given situation and then finding the
best obtainable value satisfying the required conditions is formally known as linear programming. Linear
Programming is also called as Mathematical Programming and Activity Analysis.

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Basic Concepts in Linear Programming:

1. Optimisation and Choice:
The problem which seeks to maximize or minimize a linear function (e.g. profit or cost expressed
in some variables) subject to certain constraints as determined by a set of linear inequalities is called an
optimization problem. The central feature of Linear Programming is that it gives actual numerical
solutions to problems of making optimum choices when the problems have to be solved within definite
bounds or constraints.
2. Linearity:
Linear Programming is concerned with linear relations. That is, the relations between variables
are in the form of linear function or straight line.
Linearity is both a simplifying assumption and a useful statement about variables [say, inputs and
outputs] relations that often prevail. It simplifies the mathematical programming. Constant Returns to
Scale and Constant Average Cost are best examples to linearity in Production Theory. Empirical evidence
also supports that for a long range of output the returns and average cost are constant.
Not all Mathematical Programming are linear. Nonlinear, or Curvilinear, programming
techniques set up problems like those in conventional theory, where curves instead of straight lines
show the relations. In economic theory nonlinear problems are often solved by integer programming.
3. Process:
A process is another basic concept in linear programming. A process, also called an activity, is
a way of doing things. In economics, a process is a combination of particular inputs to produce a
particular output. A firm may face a number of processes. A typical linear programming problem is to
find the optimum combination of processes that is, the combination that minimises costs or maximises
outputs when there are constraints.
4. The Objective Function:
The objective function, also called the criterion function, states the determinants of the
quantity to be maximised or to be minimised. Profits or revenues are the objective function when they
are to be maximised. Costs are the objective function when the problem calls for them to be minimised.
5. Constraints:
Constraints, also called restraints, are limitations. They are the limits to our objectives, both
minimisation and maximisation. The budget is a constraint to the consumer. If a firm is maximising
revenue, then it is limited by, or constrained, by its factor endowment. Thus, maximisation or
minimisation of the objective function is subject to the constraints. In linear programming, constraints
are stated in the form of inequalities [using and ]. Constraints are of two types. They are the technical
constraints and the non-negativity constraints. The non-negativity constraints show the irrelevance of
negative quantity of certain variables, say, -10 units of a commodity.

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6. Feasible Solutions:
Feasible Solutions can be explored after the constraints are established. Feasible Solutions are
those that meet, or satisfy, the constraints. Feasible solutions for the consumer are of the possible
combinations of commodities that can possibly be bought, given the consumers income and the prices
of the commodities. Similarly, one kind of feasible solution for the firm consists of all the combinations
of two inputs that lie on or to the right of an isocost line.
7. Optimum Solutions:
Optimum Solution is the best of the feasible solutions. Sometimes linear programming results
in finding several feasible solutions, all equally good and all better than any others. Then there is no
single optimum.
Methods of Linear Programming:
There are two popular methods of linear programming, one geometrical [graphical method] and
one mathematical [simplex method].
Graphical method:
Let us consider a simple linear programming problem to understand maximisation. A firm
producing two outputs X and Y, within certain constraints, tries to maximise its profits. The problem of
the firm is to find out the optimal product mix
Problem 1:
Maximise Z = 5x +
Subject to

3y
.

The feasible region determined by the system of constraints, 3x + 5y 15,

5x + 2y 10, x 0, and y 0, are as follows.

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The corner points of the feasible region are O (0, 0), A (2, 0), B (0, 3), and
The values of Z at these corner points are as follows.

Corner point Z = 5x + 3y
0(0, 0)

A(2, 0)

10

B(0, 3)

9
Maximum

Therefore, the maximum value of Z is

Problem 2:
Minimise Z = 3x + 5y
Such that

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, and x, y 0,

The feasible region determined by the system of constraints,

is as follows.

It can be seen that the feasible region is unbounded.

The corner points of the feasible region are A (3, 0),

, and C (0, 2).

The values of Z at these corner points are as follows.

Corner point Z = 3x + 5y
A(3, 0)

9
7

C(0, 2)

Smallest

10

As the feasible region is unbounded, therefore, 7 may or may not be the minimum value of Z.
For this, we draw the graph of the inequality, 3x + 5y < 7, and check whether the resulting half
plane has points in common with the feasible region or not.

203

It can be seen that the feasible region has no common point with 3x + 5y < 7 therefore, the
minimum value of Z is 7 at

Problem 3:
Maximise Z = 3x + 2y
Subject to

The feasible region determined by the constraints, x + 2y 10, 3x + y 15, x 0, and y 0, is as

follows.

The corner points of the feasible region are A (5, 0), B (4, 3), and C (0, 5).
The values of Z at these corner points are as follows.
Corner point

Z = 3x + 2y

A(5, 0)

15

B(4, 3)

18

Maximum

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C(0, 5)

10

Therefore, the maximum value of Z is 18 at the point (4, 3).

Problem 4:
Minimise Z = x + 2y
Subject to

The feasible region determined by the constraints, 2x + y 3, x + 2y 6, x 0, and y 0, is as

follows.

The corner points of the feasible region are A (6, 0) and B (0, 3).
The values of Z at these corner points are as follows.
Corner point

Z = x + 2y

A(6, 0)

B(0, 3)

It can be seen that the value of Z at points A and B is same. If we take any other point such as (2,
2) on line x + 2y = 6, then Z = 6
Thus, the minimum value of Z occurs for more than 2 points.
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Therefore, the value of Z is minimum at every point on the line, x + 2y = 6

************

Sample Questions:
Multiple Choice questions:
1. ---------- is called producers indifference curve.
A] Transformation curve. B] Contract curve. C] Equal product curve. D] Supply curve.
2. Producer is in equilibrium in the range of production where
A] MP = 0. B] MP is negative. C] MP is diminishing D] MP is diminishing but positive
3. Which of the following is the condition of increasing return as per the Law of Variable Proportions?
A] X/L < X/L. B] X/L > X/L. C] X/L = X/L. D] X/X = L/L.
4. Production Possibility Curve shows
A] Opportunity cost. B] Sunk cost. C] Production cost. D] Money cost.
5. Distance between successive multiple isoquants ----------- when there are increasing returns.
A] Increases. B] Remains the same. C] Decreases. D] Doubles.
6. Externalities determine the ------------- of cost curves.
A] Frequency. B] Slope. C] Position. D] Shape.
7. Flat stretch of the SAVC shows
A] Reserve capacity. B] Excess capacity. C] Marked capacity. D] Added capacity.
8. A factor is perfectly divisible when different units of it are --------------- productive.
A] Differently. B] Equally. C] Increasingly. D] Decreasingly.
9. ----------------- is called the input elasticity of output.
A] X/L L/X. B] X/L X/L. C] X/X L/L. D] L/L.
10. MRTSLK is equal to -------------------A] MPL/MPK. B] MPK/MPL. C] MC/AC. D] MUx/MUy
Part B; Short Questions:
1. Define marginal product.

206

2. What is marginal rate of technical substitution?

3. Define the isoquant.
4. What is isocost line?
5. State the condition of producers equilibrium in isoquant approach.
6. What is implicit cost?
7. What are the important types of isoquants?
8. What is input elasticity of output?
9. State the Cobb-Douglas production function.
10. What is Flowerpot Law?
11. What is technical efficiency?
12. What is average product?
13. State the stages of the LVP.
14. What is degree of homogeneity of production function?
15. Define homogenous production function.
16. What is output expansion path?
17. Define the PPC.
18. Define linearly homogenous production function.
19. What are externalities?
20. State the names of the laws which govern the relationship between inputs and outputs in the long run.
Part C; Short Essay:
1. Briefly explain the important types of isoquants.
2. Briefly explain the Law of diminishing returns.
3. Explain the Cobb-Douglas production function.
4. Explain the equilibrium of a multi-product firm.
5. Explain the least cost combination of inputs.
6. Explain the elasticity of substitution and input elasticity of output.
7. Explain the equilibrium of single product firm with the help of isoquants.

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8. Distinguish between the returns to scale and returns to a variable factor.

9. Distinguish between isocline and expansion path.
10. Explain production function.
Part D; Essay Questions:
1. Explain producers equilibrium with the help of isoquants and PPC.
2. Explain the Laws of returns to scale.
3. Explain the Law of variable proportions.
4. Explain the properties of Cobb-Douglas production function.
5. Explain the important properties of the isoquants.

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4. PRODUCERS BEHAVIOUR; HOW CAN

PRODUCER RESPOND TO CHANGES
AROUND HIM?
Theory of Cost: Cost Functions: Traditional Theory of Costs: Short Run Costs: Fixed Costs: Variable
Costs: Average and Marginal Costs: A comparative Analysis of AFC, AVC, AC and MC: Relationship
between the Productivity and Costs: Envelope Relationship [LAC]: Long run Marginal Cost [LMC]: An
alternative Version of LAC: Internal Economies and Diseconomies: External economies and
Diseconomies [Externalities]: Modern Theory of Costs: Short run Costs: Average Variable Cost [AVC]:
Short run Average Cost [SAC]: Short run Marginal Cost [SMC]: Long run Costs: A Comparative Study of
Traditional and Modern Theories of Costs: Superiority of the Modern Theory over the Traditional
Theory:

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THEORY OF COSTS
Introduction:
Prices of products are determined by the interaction of the forces of demand and supply.
Theories of demand and consumers behaviour explain the factors underlying demand. The basic factor
underlying the ability and willingness of firms to supply a product in the market is the cost of
production. Production of every commodity requires the use of resources which, because of their
relative scarcity, bear price tags. The quantity of any product which a firm is willing to supply in the
market depends upon the prices [costs] and productivity of the resources essential to its production as
well as the price which the product will bring in the market. Thus, the concept of cost occupies a
significant place in economic theory.
Cost Functions:
We use most often the cost functions in cost theory. Cost functions are derived functions.
Production function, as we have learned, shows functional relations between inputs and outputs. For
instance, X= f (L, K), shows the technically efficient processes of producing a given level of output. Cost
function can be stated as:
C=f(X)

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= f {f (L, K)}
Where, X=f (L, K) is a direct function and C=f(X) is a derived function.
Theory of costs, both traditional and modern, distinguishes between short run and long run
costs. Short run is a period during which some factors of production [for instance the capital
equipments] are fixed. On the other hand, long run is a period during which all factors are variable. The
short run costs are the costs of the firm when some of its factors of production are fixed, and thus, some
of its costs also are fixed. Thus, in the short run, some costs are fixed while others variable.
On the other hand, long run costs are the costs of the firm when all of its factors of
production are variables, and thus, all of its costs are variable costs. In the long run, no factor of
production of the firm is fixed, and thus, no cost is fixed. Both in the short run and in the long run, total
cost of a firm is multi variable function. That is, the TC is determined by many factors. We can write the
short run and long run cost functions as:
Short run cost function, C = f(X, T, Pf, K), and
Long run cost function, C = f(X, T, Pf)
Where, C = Total cost
X= Output
T= Technology
Pf= Prices of factors of production, and
K= Fixed factor of production.
We can reduce these cost functions as C = f(X) on the basis of ceteris paribous assumption.
That is, we assume that the factors, T, Pf and K as unchanged. If they are constant, we can state cost
function as C = f(X). The factors, T, Pf and K are shift factors. Graphically, changes in these factors lead to
shift in the cost curves. For instance, a technical improvement brings down the cost curves, and an
increase in factor prices shifts the cost curves upward. Similarly, an increase in the capital stock of the
firm may improve its productivity in the short run, and thus, may shift downward its cost curves.
The short run costs are the costs during a given period in which the firm faces a number of
constraints. The firm finds very little flexibility in its operations in the short run. The long run costs, on
the other hand, are planning costs or ex ante costs. They are costs in a period of time which is long
enough to optimize firms activities or to plan its activities to realise the optimal results. This is because
the firm faces the lowest number of constraints in the long run.
Theory of costs, both traditional and modern, distinguishes between internal and external
economies and diseconomies. Internal economies and diseconomies are within the firm and are
determined by the actions of the firm. No other firm is responsible for it. External economies and

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diseconomies are from external sources, and are not due to the capability of the firm. They emerge as
benefits or otherwise to the firm from external sources, say due to the activities of other firms.
[Mandeville provides his classical examples of external economies in his book, Fable of Bees. His
example of Apple Grower and Bee Keeper is the celebrated one in this respect.] External economies
and diseconomies are also called as externalities or non-marketed interdependence. They show nontraded detriments or benefits among the firms.
Internal economies and diseconomies mold the shape of the cost curves of the firm.
Internal economies lead to decreasing unit cost while internal diseconomies to increasing unit cost.
Thus, whether the unit cost is increasing or decreasing depends upon firms internal economies and
diseconomies.
Traditional theory infers U-shaped average and marginal cost curves in the long run since
it projects internal economies in initial phase of expansion of output and internal diseconomies in the
final phase of expansion of output. In other words, increasing returns to scale in the initial phase and
decreasing returns to scale in the final phase of expansion of production are responsible for the U-shape
of the average and marginal cost curves in the long run.
Traditional Theory of Costs
The chief architects of the traditional theory, the Neo-classical economists, begin their
illustration of cost theory with a clear-cut analytical distinction between short run and long run. Short
run is a period of time during which the firm faces a number of constraints, and thus, all of its productive
operations are confined to the constraints. The firm has some factors [like capital] as constant and
others as variable. On the other hand, long run is a period during in which all factors of the firm are
variable. The firm faces very little constraints in the long run. Thus, it can plan its productive activities in
the way to optimize the results. Long run cost curves show how the firms plant is planned in order to
optimize its activities for achieving its goals.
Short Run Costs:
In the short run, total costs of the firm consist of total fixed costs and total variable costs.
That is, TC = TFC + TVC.
Fixed Costs: Fixed costs are those costs which in total do not vary with changes in output. Fixed costs
are associated with the very existence of the firms plant and therefore must be paid even if the firms
quantity of output is zero. Fixed costs of the firm include (1) interest on firms bonded indebtedness, (2)
rental payments, (3) a portion of depreciation on capital equipments and buildings, (4) insurance
premium, and (5) salaries of top management and key personnel.
Variable Costs: Variable costs are those costs which increase with the level of output. They include
payments for (1) materials, (2) fuel, (3) power, (4) transportation services, (5) labour [excluding of
managerial staff] and all other running expenses.
Table 001: Total Cost Data [Hypothetical]

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Total Product
{X}
0
1
2
3
4
5
6
7
8
9
10

Total Fixed Cost {TFC}

100
100
100
100
100
100
100
100
100
100
100

Total Variable Cost

{TVC}
0
90
170
240
300
370
450
540
650
780
930

Total Cost
{TC = TFC + TVC}
100
190
270
340
400
470
550
640
750
880
1030

As table 001 shows that the TFC remains the same as 100 at all levels of output. TVC, on the
other hand, increases with every increase in the quantity of output. Thus, the TC, which is the sum of
TFC and TVC, also increases with output. As production begins, variable costs will for a time increase by
a decreasing rate. This, in table 001, happens up to 4th unit of output. Beyond the 4th unit, however,
variable costs rise by increasing rate for each successive unit of output. The explanation of this
behaviour of variable costs lies in the Law of Variable Proportions. Because of increasing returns, smaller
and smaller increases in the amounts of variable inputs will be needed for a time to get successive units
of output produced. Total cost, thus, increases at a decreasing rate. But when diminishing returns are
happening larger and larger additional amounts of variable inputs are required to produce successive
units of outputs. TC, thus, increases at an increasing rate.
Figure 001

In figure 001, TFC starts from point F on the vertical axis. OF shows the amount of fixed costs.
TVC starts from the origin. It shows that the TVC is an increasing function of output. TC starts from point
F. The TVC and TC curves have same shape [broad inverse S shape] reflecting the Law of Variable

213

Proportions. The gap between TC and TVC [which is equal to the TFC] remains the same at all levels of
output.
Average and Marginal Costs:
Average Fixed Cost: AFC = TFC/X. Graphically, AFC is rectangular hyperbola.
Figure 002

Average Variable Cost: AVC = TVC/X. Graphically, the AVC at each level of output is derived from the
slope of a line drawn from the origin to the point on the TVC curve corresponding to the particular level
of output.
Derivation of AVC Curve:
In figure 003, upper panel shows the TVC curve and lower panel shows the AVC curve,
derived from TVC curve. To produce 2 units of output, the firm has to incur AVC equal to 50 Rupees. This
is calculated by dividing 100 by 2. This is equal to the slope of the line oa. Similarly, the AVC of producing
4 units is equal to the slope of the line ob. The line with lowest slope can be drawn from the origin to
the TVC curve is oc. The AVC of producing 10 units of output is equal to the slope of the line oc. That is,
the AVC is the minimum for 10 units of output. Slope of the line od is greater than that of oc. It means
that the AVC is rising after the10th unit of output.
Points A, B, C and D in the lower panel are derived from the slopes of oa, ob, oc and od,
respectively. By joining the points A, B, C and D we get the AVC curve in the lower panel. The AVC curve

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has a U-shape. This is due to the broad inverse S shape of the TVC curve, which ultimately is due to the
operation of the Law of Variable Proportions.

Figure 003

Average Cost: AC = TC/X or AC = AFC + AVC. AC at any level of output is equal to the slope of the line
drawn from the origin to TC curve corresponding to the particular level of output. Modus operandi of
derivation of AC is similar to that of AVC.
Derivation of AC curve:
In figure 004, upper panel shows the TC curve and lower panel the AC curve, derived from TC
curve. Firm has to incur AC equal to X1Q for producing OX1 output. This is equal to the slope of the line
oq. The Ac at OX2 level of output is equal to the slope of the line or. The line from the origin to the TC
having the lowest slope is os. Thus, the AC is the minimum at OX3 level of output. The slope of ot is

215

greater than that of os. It means that the AC is increasing after OX3 level of output. Points Q, R, S and T
in the lower panel are derived from the slopes of the lines oq, or, os and ot, respectively. By joining the
points Q, R, S and T we get the AC curve in the lower panel. The AC curve, like the AVC curve, has a Ushape. Its U-shape is due to the broad inverse S shape of the TC curve, which ultimately is due to the
operation of the Law of Variable Proportions.
Though the AVC and AC curves have same shape their position is different [Figure 006].
Minimum point of the AC curve happens after the minimum point of the AVC curve.
Figure 004

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Marginal Cost: MC = C/X. It is the change in total cost [TC] with respect to change in output [X].
Graphically, MC at any level of output is equal to the slope of the tangent to the TC curve corresponding
to that particular level of output.
Derivation of the MC Curve:
In figure 005, upper panel shows the TC curve and the lower panel the MC curve, derived
from the TC curve. Firms MC at OX1 level of output is equal to the slope of the tangent aa [equal to
X1J]. Similarly, the firm has a marginal cost equal to X2K, equal to the slope of the tangent bb, at OX2
level of output. The tangent [cc] with the lowest slope can be drawn only at point l. It means that the
MC is at minimum at the level of output OX3. Beyond the level of output OX3, the slope of the tangent
to the TC curve is increasing. It means that the MC is increasing after OX3 level of output. For instance,
the slope of dd is greater than that of cc, and thus, the MC at OX4 level of output is greater than the MC
at OX3 level of output

Figure 005

217

.
In the lower panel, points J, K, L and N are derived from the slopes of the tangents aa, bb, cc
and dd, respectively. By joining these points we get the MC curve. The MC curve also has a U-shape
reflecting the Law of Variable Proportions. However, the position of MC is different from that of AC [and
also of AVC]. The minimum point of AC curve happens after the minimum point of MC curve. The
minimum point of AVC curve is between the minimum points of MC curve and AC curve [Figure 006].
A comparative Analysis of AFC, AVC, AC and MC:
In figure 006, AFC [Average Fixed Cost] curve is a rectangular hyperbola. As output expands,
the AFC diminishes rapidly in the initial period, but slowly in later period. This is because the TFC is being
divided successively by increasing number of units of output.
The SMC [Short run Marginal Cost] curve is U shaped. It has its minimum point at L. The
SAVC [Short run Average Variable Cost] curve is U shaped. It has its minimum point at M. The SAC [Short
run Average Cost] curve also is U shaped. It has its minimum point at N. The U shape of SMC, SAVC and
SAC reflects the Law of Variable Proportions.
It is clear from the figure that the SMC reaches its minimum point [at L] firstly, the SAVC
reaches the minimum point [at M] secondly, and the SAC reaches the minimum point [at N] lastly. The
SMC is passing through the minimum points of SAVC and SAC.
Figure 006

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We can state the following points of inference about the relationship between average
and marginal cost curves.
MC and AC Curves:
1. If MC is less than AC, then AC is decreasing.
2. If MC is equal to AC, then the AC is at its minimum.
3. If MC is greater than AC, then AC is rising.
MC and AVC curves:
1. If MC is less than AVC, then AVC is decreasing.
2. If MC is equal to AVC, then the AVC is at its minimum.
3. If MC is greater than AVC, then AVC is rising.
AVC and AC Curves:
1. Minimum point of AVC curve is left to the minimum point of AC curve.
2. AVC curve is asymptotical to AC curve with respect to expansion of output.
3. There is a narrow range of output which lies between the minimum points of AVC and AC curves.
4. AC = AVC + AFC.
5. The gap between AC curve and AVC curve is diminishing with respect to output due to the decreasing
AFC.
Relationship between Productivity and Costs:
The shapes of the cost curves are mirror image reflections of the shapes of the
corresponding productivity curves. (The corresponding productivity curve is an implicit function in which
marginal productivity curve is related to output rather than inputs. At each output there is an implicit
number of labours which would supply that output.) When one is increasing, the other is decreasing;
when one is at minimum, the other is at maximum.
Figure 007

219

As figure 007 shows the SMC and SAVC are mirror images of the MPL and APL, respectively.
The SMC is at minimum when MPL is at maximum and the SAVC is at minimum when APL is at
maximum.
Long run Costs:
In the long run, as already stated, all factors of production are variable to a firm. Thus, all
costs are variable costs. In other words, there is no fixed cost in the long run. The Neo-classical
economists draw a broadly inverse S shaped long run total cost [LTC] curve in their theory of cost. Its
inverse S shape is due to the operation of the Laws of Returns to Scale. Unlike the short run total cost
curve, the LTC curve begins from the origin due to the absence of fixed cost.
Economies and diseconomies play important roles in long run production decisions of the
firm. Both the long run and the short run total cost curves are inverse S shaped. But it is important to
remember that the reasons why they have their inverse shape are quite different. The assumption of
initially increasing and then eventually diminishing marginal productivity [ the Law of Variable
Proportions] accounts for the inverse S shape of the short run total cost curve [and of the U shape of the
MC and AC curves]. Economies and diseconomies of scale account for the inverse S shape of the LTC
curve [and of the U shape of the long run MC and AC curves].

220

Figure 008

Figure 008 shows the LTC curve and the STC curve. The figure also facilitates a comparison
between them. In the figure, STC has its point of inflection at a. On the other hand, the LTC has its
inflection at point A. That is, the point of inflection of STC is left to that of LTC. It also means that the
SAC, as figure 009 shows, has its minimum point corresponding to point a of the STC curve [at X1 level of
output]. But the LAC reaches the minimum point corresponding to the point A of the LTC curve [at X2
level of output].
Figure 009

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Envelope Relationship [LAC]: Since in the long run all factor inputs are flexible, while in the short run
some inputs are not flexible, long run cost will always be less than or equal to short run cost at the same
level of output. To see this, let us consider a firm that had planned to produce 100 units of output but
now adjusts to produce more than 100 units. We know that in the long run the firm chooses the lowest
cost method of production. In the short run it faces an additional constraint: All expansion must be done
by increasing only the variable input. That constraint increases the average cost compared to what
average cost would have been planned by the firm. If it didnt, the firm would have chosen that new
combination of inputs in the long run. The envelope relationship, as figure 010 shows, is the relationship
between long run and short run average costs.
Why it is called an envelope relationship should be clear from the figure 010. Each SAC
curve touches [is tangent to] the LAC curve at one, and only one, output level; at all other output levels,
SAC exceeds LAC. The LAC curve is an envelope of SAC curves.
Figure 010

222

Another insight to note about this envelope relationship is the following: When there are economies of
scale and the firm has chosen a plant size that is efficient, given output, its short-run average costs will
fall as it increases production. Technically, this must be the case because the SMC curve goes through
the minimum point of the SAC curve, and the minimum point of the SAC curve is to the right of the
efficient level of production in the long run [figure 011]. That means that at output OX1, SMC2 has to be
below SAC2 and SAC is falling. Intuitively, what is happening is that at output OX1, firms fixed costs are
high. Now demand increases the firm increases production. Firms average fixed costs are high; its
marginal costs are low; and initially the fall in average fixed costs more than offsets the increased
marginal costs. Once marginal cost exceeds SAC, which no longer is the case.

Figure 011

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Only when the firm is at the minimum point of the LAC curve [at output OX2], the
SAC3 curve is tangent to the LAC curve at a point where the SMC curve intersects both the curves
[Figure 012]. For large markets, this point is the optimal production level of a firm.
Figure 012

224

LAC of a firm shows how the firm is planning its plants and taking decisions in the long
run. Thus, the LAC curve is also called as firms planning curve. It is on the basis of this curve that the
firm is optimizing its production.
Long run Marginal Cost [LMC]: The LMC curve is derived from the SMC curves [m1, m2, m3 etc.], but it
does not envelop them. The LMC is formed from points of intersection of the SMC curves with vertical
straight lines drawn from the points of tangency of the corresponding SAC [a1, a2, a3 etc.] curves and
the LAC curve. Figure 013 shows the derivation of the LMC curve.
In the figure, drawing a vertical straight line from point a [tangency between SAC (a1) and
the LAC] we get the point A [intersection between SMC (m1) and the vertical straight line]. Points B, C
and D are derived in the same way. By joining the points A, B, C and D we get the LMC curve.
The LMC curve, as figure shows, is U shaped like the LAC curve. The U shape shows the
Laws of Returns to Scale. Increasing returns lead to decreasing costs and decreasing returns to
increasing costs. Thus, the internal economies and diseconomies are the factors responsible for the U
shape of the LAC and LMC curves.
Figure 013

An alternative Version of LAC:

Some economists, like Stigler, disagree with the Neoclassical economists regarding the U shape of the
LAC [and thus of the LMC] curve. They draw a saucer like LAC curve. The LAC curve has a flat stretch over
a range of output at which the LAC [and thus the LMC] is the minimum. Empirical evidence also

225

invalidates the single minimum point of the Neoclassical LAC curve. The Law of Constant Returns to
Scale is the reason for the flat stretch of the LAC. If there are no economies and diseconomies of scale
the unit cost of production may remain constant. In figure 014, the flat stretch of the LAC curve, NM,
shows that the firm has constant returns to scale over the range of output X1X2.

Figure 014

Internal Economies and Diseconomies:

As we have already stated, the shape of the long run cost curves is determined by the internal
economies and diseconomies. Internal economies lead to decreasing unit costs and internal
diseconomies to increasing unit cost. Hence the LAC and LMC curves have their U shape. Let us explain
the internal economies and diseconomies in some detail with examples.
Economies of scale: We say that there are economies of scale in production when long run average
costs decrease as output increases. For example, if producing 40,000 DVD players costs the firm 16
million rupees [400 each], but producing 200, 000 DVD players costs the firm 40 million rupees [200
each], there are significant economies of scale associated with choosing to produce 200, 000 rather than
40, 000 DVD players.
In real world production process, at low levels of production economies of scale are
extremely important because many production techniques require a certain minimum levels of output
to be useful. For example, we cannot build a mini aluminum plant for producing a few kilograms of
aluminum per year. This is because the inputs are mostly seen as indivisible. Their efficient use is

226

possible only with a certain minimum scale of operation. The cost of an indivisible input for which a
certain minimum amount of production must be undertaken before the input becomes economically
feasible to use.
Diseconomies of Scale: As figure 015 shows, the LAC starts to rise after the optimum level of
production. This is due to the diseconomies of scale in production. For example, if producing 200, 000
DVD players costs the firm 40 million rupees [200 each] and producing 400, 000 DVD players costs the
firm 100 million rupees [250 each], there are diseconomies of scale associated with choosing to produce
400, 000 rather than 200, 000. Diseconomies of scale usually, but not always, start occurring as firms get
large.

Figure 015

Diseconomies of scale could not occur if production relationships were only technical
relationships. If that were the case, the same technical process could be used over and over again at the
same cost. In reality, however, production relationships have social dimensions, which introduce the
potential for important diseconomies of scale into the production process in two ways:
1. As the size of the firm increases, monitoring costs generally increases.
2. As the size of the firm increases, team spirit or morale generally decreases.
Absence of Economies and Diseconomies; the Constant Returns to Scale:

227

Figure 016

Sometimes in a range of output a firm does not experience either economies of scale or
diseconomies of scale. In this range there are constant returns to scale where LAC does not change with
an increase in output. Constant returns to scale are shown by the flat portion of the LAC curve in figure
016. Constant returns to scale occur when production techniques can be replicated again and again to
increase output. This occurs before monitoring costs rise and team spirit is lost.
External economies and Diseconomies [Externalities]:
There are many situations in which the effect of an individuals action is not fully reflected in
market prices, and there is a difference between private and social costs and benefits. When the action
of an economic decision maker creates benefits for others, for which he is not paid, there occurs an
external economy for the others. When the action of an individual agent creates costs for others for
which he does not pay, there occurs an external diseconomy for the others.
The term externality refers to both external economies and diseconomies. These
externalities are not marketed. Thus, they are called non-marketed interdependence. The market prices
do not reflect the externalities. Thus, when there are externalities, the market prices may give wrong
signals to producers in resource utilization.
Externalities, as already stated, affect the position of the cost curves of the firm [Figure
017]. External economy in production may lead to a downward shift in the cost curves. On the other
hand, external diseconomy in production may lead to an upward shift in the cost curves.
Figure 017

228

Modern Theory of Costs

Modern economists deviate much from the traditional theory of costs. They disagree
with neoclassical economists regarding the U shape of average and marginal cost curves. They have both
theoretical and empirical inferences to invalidate the U shape of average and marginal cost curves. For
instance, George Stigler59 introduced a saucer like SAVC curve in 1939 with the argument that the firms
builds plants with reserve capacity to obtain flexibility in production. Other economists who made
remarkable contributions to the modern theory of costs include P.W.S. Andrews60, R. Harrod61, P.J.D.
Wiles62 and Sargent Florence63. Economists like Sargent Florence have put forward L shaped LAC curve.
Modern economists with empirical support draw average and marginal cost curves, both
short run and long run, in a significantly different manner compared to the neoclassical economists. The
shape of the long run cost curves in modern theory has got much attention from economists mainly due
59

George Stigler, Production and Distribution in the Short Run , Journal of Political Economy [1939].
P.W.S. Andrews, Manufacturing Business , Macmillan, 1949.
61
R. Harrod, Economic Essays , Macmillan, 1952.
62
P.J.D. Wiles, Price, Cost and Output, Blackwell, 1961.
63
Sargent Florence, The Logic of British and American Industry , Routledge & Kegan Paul, 1961.
60

229

to its policy implications. Economies of large scale production as rationale to the L shaped LAC curve
have been proven valid empirically. This empirical evidence itself is the superiority of the modern theory
over the traditional theory.
Short run Costs in the Modern Theory of Costs:
Like traditional theory, modern theory makes a practical distinction between short run
and long run costs. In the short run some costs are variable while others as fixed. Thus, we have AVC and
AFC curves in the short run.
Average Fixed Cost [AFC]: Fixed cost is the cost of indirect factors, that is, the cost of the physical and
personal organization of the firm. Fixed costs of a firm include the costs incurred for:
1.
2.
3.
4.
5.
6.

The salaries and other expenses of managerial staff.

The salaries of staff involved directly in the production, but paid on a fixed term basis.
The wear and tear of machinery.
The maintenance of buildings.
The maintenance of land and other overheads.
Certain rate of profit.
The firm builds up its plants in the most convenient way to meet seasonal and cyclical
fluctuations in demand for its product. Thus, the plant of the firm will have a capacity larger than the
current average sales. That is, the firm makes a reserve capacity to have a built-in-flexibility in its
operations. The reserve capacity will give the firm greater flexibility for repairs of broken-down
machinery without disrupting the smooth flow of production process.
The firm wants to have more freedom to increase its output if demand increases. All
entrepreneurs hope for growth of their firms. In view of anticipated increases in demand they build
some reserve capacity, because they would not like to let all new demand go to their rivals, as this may
endanger their future hold on market. It also gives them some flexibility for minor alterations for their
products in view of changing tastes and preference of consumers.
Technology and various overheads also demand for a reserve capacity. Moreover,
administrative staff also will be hired at such numbers as to allow some increase in the production of the
firm. In short, the businessmen will not necessarily have the plant which will give them the lowest cost
today, but rather that equipment which will allow them the greatest possible flexibility, for minor
alterations of their products or their production technology.
However, this reserve capacity of the firm does not invalidate the basic properties of
the AFC curve. It still continues as the rectangular hyperbola [Figure 018].
Average Variable Cost [AVC]:
The variable costs in the modern theory, as they are in traditional theory, include the
cost incurred on:
1. Direct labour which varies with the quantity of output.

230

2. Raw materials which also vary with the quantity of output.

3. Running expense of machinery, an increasing function of output.
The SAVC curve in modern theory has a saucer-like shape. It has a flat stretch over a
wide range of output. As figure 019 shows, the flat stretch corresponds to the built-in-the-plant reserve
capacity. Over this range the SAVC is equal to the SMC, both being constant over a wide range of output
[X1X2].To the left of the flat stretch, the SMC lies below the SAVC, while to the right of the flat stretch
the SMC lies above the SAVC. The falling portion of the SAVC shows the reduction in costs due to the
better utilization of the fixed factor and the consequent increase in productivity of the variable factor(s).
The rising part of the SAVC curve shows decreasing productivity of variable factor(s). All these happen
mainly due to the indivisibility of the fixed factor.
Figure 018

Figure 019

231

The flat stretch of the SAVC curve, as already stated, shows the reserve capacity of the
firm. The range of output X1X2 in figure 019 reflects the reserve capacity. The flat stretch shows that the
modern firm, unlike the firm in the traditional theory, has no unique minimum point, but a number of
points at which the SAVC is the minimum. It means that there is no change in the variable cost when the
firms output increases from X1 to any level up to X2. Thus, the firm can meet an increased demand up
to the level X2 without any increase in variable cost.
Short run Average Cost [SAC]:
SAC is obtained by adding the AFC and SAVC. That is, SAC = AFC + SAVC.
In figure 020, AFC curve is a rectangular hyperbola, the saucer-like curve is the SAVC, and the
doted curve is the SMC. The SAC curve in the figure is obtained by adding vertically the AFC and the
SAVC. The gap between SAC and SAVC shows the AFC.
Figure 020

232

Short run Marginal Cost [SMC]:

SMC is the addition to the total cost when an additional unit of output is produced. Thus,
SMC is the slope of the TC curve. The SMC curve in modern theory coincides with the SAVC curve over
the flat stretch of the latter. To the left of point a, the SMC is less than SAVC. The SMC firstly decreases
and reaches the minimum. After the minimum point it rises and reaches to the level [minimum] of SAVC
at point a. In the range between points a and b, the SMC is equal to the SAVC. However, the SMC
increases after the point b. To the right of point b SMC is greater than SAVC [and SAC]. The shape of
SMC and SAC curves in modern theory, as figure 020 shows, is totally different from that of the same in
traditional theory.
Long run Costs in the Modern Theory of Costs:
In the long run, modern theory distinguishes between two types of costs, namely 1)
production costs and 2) managerial costs. In the long run, all costs are variable costs. According to
modern economists, in the long run, as production expands, average production costs decrease
continuously due to the economies of large scale production. The average managerial costs, as
production expands, initially decrease, but at very large scale of production increase slowly. That is
production costs decrease due to economies but managerial costs increase due to diseconomies as
production scale expands. However, the production economies most often cancel out the managerial
diseconomies. In such cases the long run average cost remains constant for very large scale of
operations. Thus, LAC curve is L shaped. Consequently, the LMC curve coincides with the LAC curve
when the latter is constant. In certain cases the production economies are more than to compensate the
managerial diseconomies. In such cases the long run average cost continues to decrease with every
expansion of output. Thus, the LAC curve slopes downward, firstly at increasing and eventually at

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decreasing rates. Similarly, the LMC curve slopes downward but lies below the LAC curve. The gap
between the LAC and LMC will be decreasing gradually.
Graphical Illustration of LAC and LMC Curves:
Figure 021

As figure 021 shows, the LAC first falls and, at large scale of operations remains constant.
The LMC first falls, subsequently reaches the minimum and then rises up to the point where the LAC is
equal to the LMC. At large scale of operations the LMC coincides with the LAC, and both remain
constant.
A Comparative Study of Traditional and Modern Theories of Costs:
The traditional theory of costs is based upon the fundamental tenets of the neoclassical
theory of production. It gives us a broad framework of the cost concepts. It infers U shape to the
average and marginal cost curves both in the short run and in the long run. However, the neoclassical
theory is not suitable to the cost structure, capacity building and utilization, and managerial framework
of modern firms. Moreover, it lacks empirical support in the present business scenario. A cost theory as
strict derivative of the neoclassical laws of production seldom matches with empirical findings. Thus,
many economists became skeptical regarding the validity of the neoclassical theory. They started
developing more relevant theories of costs. Empirical evidence supports very much their theories.
Major Deviations of Modern Theory from the Traditional Theory:
Following are the important deviations of modern theory from the traditional theory.

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1. Traditional theory uses the LVP and LRS as its unshakeable assumptions. Modern theory adds a
few factors to the LVP and LRS when they are used as assumptions.
2. Traditional theory derives U shaped SAVC curve. Modern theory derives saucer like SAVC curve.
3. Traditional theory derives U shaped SAC curve. Modern theory derives V shaped SAC curve.
4. Traditional theory finds single minimum point to SAVC curve. Modern theory finds a flat stretch
to the SAVC curve.
5. Traditional theory infers that the LVP molds the U shape of the SAVC, SAC and SMC curves.
Modern theory infers that the U shape of the SAVC, SAC and SMC curves is disturbed by the
reserve capacity of the modern firms.
6. In traditional theory, SMC curve intersects the SAVC curve at the single minimum point of the
latter. In modern theory, the SMC coincides with the SAVC along the flat stretch.
7. Traditional theory does not accommodate the reserve capacity as a factor affecting the AFC.
Modern theory accommodates the reserve capacity as a factor affecting the AFC.
8. Traditional theory derives U shaped LAC curve. Modern theory derives L shaped and
continuously diminishing LAC curve.
9. In traditional theory, LAC curve is an envelope of SAC curves. In modern theory, LAC curve is not
an envelope of SAC curves.
10. In traditional theory, LMC curve intersects the LAC curve at the single minimum point of the
latter. In modern theory, the LMC curve coincides with the LAC along the flat stretch.
Superiority of the Modern Theory over the Traditional Theory:
Modern theory is superior to the traditional theory on the following grounds.
1. Modern theory has empirical support while the traditional theory lacks the same.
2. Modern theory, when compared to traditional theory, is more suitable to business firms of
today.
3. Modern theory is extensively used in modern theories of pricing. Applicability of the traditional
theory is confined to the perfectly competitive models of pricing.
4. Modern theory has much relevance in the Limit Pricing Theories. Traditional theory fails to
explain many of the practical phenomena of limit pricing.
5. Modern theory justifies the built-in-flexibility [due to the reserve capacity] of modern firms, a
phenomenon strange to the traditional theory.
***************
Sample Questions
Multiple Choice Questions:
1. U shape of the short run cost curves in neoclassical theory shows the operation of -----------A] Law of diminishing returns. B] Laws of returns to scale. C] Law of variable proportions. D]
Law of externality.
2. In traditional theory AFC is ----------------------------.
A] Broad inverse S shaped curve. B] Horizontal straight line. C] U shaped curve. D] Rectangular
hyperbola
3. Which of the following is not a stage of the LVP?

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A] Increasing return. B] Decreasing return. C] Diminishing return. D] Negative return.

4. Who wrote Value and Distribution in Classical and Neo-Classical Systems?
A] Samuelson. B] J. Hirshleifer. C] Mark Blaug. D] G. C. De Costa.
5. Cost functions are -------------------- functions.
A] Direct. B] Intuitive. C] Derived. D] Indirect.
6. Which of the following is a fixed cost?
A] Overhead cost. B] Labour cost. C] Fuel cost. D] Advertisement cost
7. In modern theory, SAVC is equal to -------- over the flat stretch.
A] SMC. B] SAC. C] LMC. D] LAC
8. ------------- is called sunk cost.
A] Variable cost. B] Fixed cost. C] Short run cost. D] Long run cost.
9. Optimal output in the long run is produced at -----------A] Minimum TC. B] Minimum AVC. C] Minimum AFC. D] Minimum AC
10. Who wrote Principles of Economics?
A] Adam Smith. B] Paul Samuelson. C] Joseph A. Schumpeter. D] Alfred Marshall.
Part B; Short Questions:
1. Define SAVC
2. Distinguish between marginal cost and average cost.
3. What is optimal output?
4. State the important items of fixed cost of a firm.
5. Distinguish between fixed and variable cost.
6. What makes the shape of cost curves?
7. Distinguish between short run and long run costs.
8. What is reserve capacity?
9. What are the important items of short run variable cost?
10. Define cost function.
11. Distinguish between production function and cost function.

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12. Define the LMC.

13. Why there is no fixed cost in the long run?
14. What is sunk cost?
15. What is envelop curve?
Part C; Short Essay Questions:
1. Briefly explain the factors affecting the shapes and position of the cost curves.
2. Explain the features of short run costs.
3. Explain the major differences between the traditional and modern cost theories.
4. Why do we call the LAC curve as planning curve?
5. Explain the reasons for the broad inverse shape of the short run total cost curve.
6. Explain the unique features of the modern theory of cost.
7. Distinguish between the internal and external economies.
8. Why do firms keep reserve capacity?
9. Explain how firms utilize their productive capacity in the long run.
10. Explain the reasons for the U shape of the marginal and average cost curves.
Part D; Essay Questions:
1. Explain the important features of the traditional theory of cost.
2. Explain the important differences and similarities between the traditional and modern theories of cost.
3. Explain how do the LVP and LRS govern the shapes of the cost curves?
4. Explain the short run and long run cost concepts of the traditional theory.
5. Critically examine the traditional theory of cost.

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5. MARKET FOR GOODS; HOW DO

BUYERS AND SELLERS RESPOND IN
EXTREME MARKET SITUATIONS?
Perfect Competition: Features of Perfect Competition: Individual firms demand curve: Rationale of
Marginalist Rule: Equilibrium of the Firm and Industry: Short run equilibrium of the Firm: Closing down
Point: Derivation of short run supply curve of the firm: Short run Equilibrium of the Industry: Long run
Equilibrium of the Firm: Long run Equilibrium of Industry: Perfect Competition and Optimal Allocation of
Resources:
Monopoly: Meaning and Definition: Pure Monopoly: Natural monopoly: Causes of Monopoly: Features
of Monopoly: Demand and Revenue of the monopolist: Equilibrium of the Monopolist: Short run
equilibrium of the monopolist: Long run equilibrium of the monopolist: A Comparison of Monopoly with
Perfect Competition: Price Discrimination: Possibility and Profitability of Price Discrimination: Bilateral
Monopoly:

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MARKET
Meaning and Definition:
In economists perception, a market is not merely an organised exchange operating in a well
defined physical location. It refers to a set of sellers and buyers whose activities affect the price at which
a particular commodity is sold. It is an institutional arrangement in which sellers and buyers come across
with a commodity for exchange at a mutually agreed price.
Using certain criteria we can classify the markets into various categories64. These broad classes
of markets fall between two extremities, namely the perfect competition and the monopoly.

Perfect Competition
Perfect competition is a market structure characterised by the existence of a large number of
sellers selling homogenous products, which are perfect substitutes of each other to a large number of
buyers under conditions of free entry and exit.
Features of Perfect Competition:
A perfectly competitive market has the following features:
64

A detailed classification of the markets is given in the first chapter.

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1. Large number of buyers and sellers: Each seller and buyer constitutes so small a portion of the
market that their decisions have no effect on the price. This feature rules out trade associations or other
collusive agreements strong enough to affect price.
2. Homogeneity of product: The product offered by any seller is identical to that supplied by any other
seller [Example: wheat of a given grade]. Consumers do not care from which firm they buy since the
products are homogenous. Under this condition, trade marks, brand loyalty etc. are completely absent.
3. Freedom of entry and exit: New firms desiring to enter the market face no barriers to entry. Similarly,
if production of a good proves unprofitable to any firm, it can closedown its business. [However, entry
and exit mechanism is a long run phenomenon.]
4. Sellers and buyers are price takers: Since the number of sellers and buyers is very large and each
constitutes only a negligibly smaller portion of the market, neither the seller nor the buyer has a control
upon price of the commodity. Sellers and buyers are price takers and not price makers. Individual firm,
for instance, cannot raise the price of its good by reducing the quantity supplied, because, such an
action will have negligible effect on the market supply.
5. Products are perfect substitutes: Products, being homogenous, satisfy the same physical wants; they
are perfect substitutes [technical and economic substitutes]. They have same prices also.
6. Advertisement has no role: Products, being homogenous, need not be advertised. Firms cannot apply
advertisement or any other sales promotional activities to strengthen consumers preference towards
their products.
In short, product homogeneity rules out the scope for advertisement and it makes the products
perfect substitutes of each other. No seller has any monopoly power [ = (P-M) / P]
Likewise, since the number of buyers is large, and each constitutes only a negligibly smaller part
of the market demand, no buyer has any control upon the market price. That is, the buyer also is a price
taker. He lacks any monopsony power.
7. Profit is the only goal of the firm: Firms have a single goal to pursue which is the maximisation of the
profit. This goal is realised when the firm applies the Marginalist Rule [MC = MR]. That is, the firm
realises its goal of maximum profit when it produces that particular level of output corresponding to
which its MC is equal to MR.
8. No government regulation: Under this market, there is no form of governmental interference like tax,
subsidy, rationing and licensing. Thus, perfect competition is a laissez-faire market model.
A market structure with the features so far explained is termed as pure competition which,
theoretically, is narrower than the perfect competition. Perfect competition has the following two more
unique features in addition to the above features.

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9. Perfect knowledge and information: Each seller and buyer has complete information and knowledge
of the market regarding the price, supply, demand, cost etc. (It is assumed that gathering market
information involves no costs.)
10. Perfect mobility: Not only the products supplied but also the factor inputs needed for production
have perfect mobility through out the market (industry). This mobility maintains homogenous prices of
goods and factor inputs in the whole industry. [It is assumed that the transport cost is zero.]
These are the features of the perfect competition. A market with these features is seldom seen in
the real world. It is more imaginary than practical. We can see a few markets of agricultural goods as
near to this form of market.
Why, then, do we spend time studying perfect competition? It is under perfect competition that
the market mechanism performs the best. So, if we want to learn what markets do well, we can put the
markets best foot forward by beginning with perfect competition. As Adam Smith suggested, perfectly
competitive firms use societys scarce resources with maximum efficiency. And as Friedrich Engels
suggested, perfectly competitive firms serve consumers tastes effectively. So by studying perfect
competition, we learn just how much an ideally functioning market system might accomplish.
Figure 001

Individual firms demand [Average revenue] curve:

Under perfect competition, individual firm, which is being a price taker, has a demand curve
[average revenue curve] which is perfectly elastic. Figure 001 shows the demand curve of the

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competitive firm. The AR is constant to the firm since the price is given. As a result, its MR also is
constant65.
Rationale of Marginalist Rule:
As already mentioned, the firm is in equilibrium when its MC = MR. That is, the level of output
which gives the maximum profit to the firm is corresponding to the equality between the MC and MR.
Profit function, =R-C, is at maximum when its first derivative,
R/X C/X = 0
or
MC = MR,
and its second derivative,
R/ X - C/X is less than zero or slope of the MC curve is greater than slope
of the MR curve.
That is,
=R - C
Differentiating the function with respect to the output, X, we get, [when it is at maximum]
/ X = R/ X C/ X = 0
That is,
R/ X = C/ X
Or, MC = MR
Second derivative of the function is,
R/X - C/X < 0
That is, slope of the MC curve is greater than that of the MR curve.
Application of marginalist rule and the equilibrium analysis are shown in the following figure.
In figure 002, the firm is in equilibrium at point E where the first and second order conditions of
marginalist rule are satisfied. The firm corresponding to this equilibrium produces OXe quantity of
output which ensures the maximum profit when it is sold at price OP.

65

Relation between the price and revenue is explained in the theory of production.

242

Point A satisfies the first order condition [MC = MR] but not the second order condition [slope of
MC curve > slope of MR curve] of the equilibrium. Thus, the equilibrium is unique. This unique
equilibrium is realised at point where the MC curve is intersecting the MR curve from below. At this
point MC = MR and the slope of the MC curve > slope of the MR curve.

Figure 002

Equilibrium of the Firm and Industry:

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Analysis of equilibrium of perfectly competitive market, as we have seen in the theory of

production and costs, has two broader aspects, namely the short run equilibrium and the long run
equilibrium. Likewise, the equilibrium analysis extended to the firm [the smallest producing unit in the
market] and the industry [the sum of all firms producing homogenous products]. Both in the short run
and in the long run the firm has a single goal to pursue which is the maximisation of the profit.
Short run equilibrium of the Firm:
In the short run the firm is in equilibrium at point where its short run MC is equal to MR.
Corresponding to this position, the firm may enjoy abnormal profit or incur loss. The former takes place
when AR > AC and the latter when AR< AC. In figure 003, the firm is in short run equilibrium at point E
where its short run MC is equal to MR. Corresponding to this equilibrium position, the firm enjoys
abnormal profit equal to the shaded area, PEBA.
Figure 004 shows firms short run equilibrium at point E where its short run MC is equal to MR.
Corresponding to this equilibrium position, the firm incurs loss equal to the shaded area, PABE.
Closing down Point:
Expecting abnormal profits in the future, the firm may continue production and sale with short
run loss. This depends upon the price level and the variable cost of the firm. The firm continues
production and sale until the closing down point. Closing down point is the point at which the market
price [P] is equal to the average variable cost [AVC]. This is shown in figure 005 at point W where the
demand curve [AR curve] intersects the AVC curve. If short run price falls below the AVC, the firm will be
compelled to shutdown its business.
Figure 003

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Figure 004

245

Figure 005

In figure 005, points A, B, W and C are different points at which firms SMC curve intersects its
MR curve. When the market price is OP, the firm is in equilibrium at point A where its MC = MR. When
the price falls to P1 [that is, the AR curve shifts downward] the firm reaches at new equilibrium at point
B and produces a quantity less than its previous level. The firm incurs a loss at price OP1 since AR < AC.
However, the firm will continue the production.
Similarly, when price falls to OP2 the firm reaches at a new equilibrium at point W
corresponding to which its AVC is equal to the market price. Now the firm incurs increased loss.
However, the firm will continue production at this closing down point as long as its AVC is covered by
the market price. The reason is that the firm has expectation of future profit and, moreover, it is able to
meet the current expenditure [variable cost] through its internal funds [from the sales revenue].
If price falls below the closing down point, say from OP2 to OP3, the firm cannot continue the
business. It will have to mobilize funds from external sources. In such a situation, mounting loss will
compel the firm to shut down its business.
Derivation of short run supply curve of the firm:
Firms short run supply curve is derived from its SMC curve. Figure 006 shows the derivation.
The supply curve is derived from the portion of the SMC curve above the point W [closing down point].

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When the price is OP3 the firm is in equilibrium at point A corresponding to which it produces
OX3 quantity of output. We derive point N in second part of the figure from point A in first part.
Likewise, we derive points M and S from points B and W, respectively. However, supply curve
has no portion below the point S. It means that the supply curve of the firm begins at the closing down
point. The supply curve so derived has its usual positive slope signifying the direct relation between the
quantity supplied and price. We get the market supply curve through the horizontal summation of
individual supply curves.
Figure 006

Short run Equilibrium of the Industry:

Given the market demand and supply, the industry is in equilibrium at that price which clears the
market. It is realised at point where the market demand is equal to market supply. In figure 007, the
industry is in equilibrium at pint E where DD curve [Market demand curve] is intersecting the SS curve
[[market supply curve]. However, individual firms have different positions corresponding to the industry
equilibrium.
Firm A is in equilibrium at point e1 corresponding to which it enjoys an abnormal profit equal to
the shaded area, Pe1a1b1. Firm B is in equilibrium at point e2 corresponding to which it incurs a loss

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equal to the shaded area, Pe2a2b2. It means that corresponding to short run industry equilibrium
individual firm may enjoy abnormal profit or incurs loss.
As figure 007 shows, the market supply [equal to market demand] is OX. It is the sum of supplies
of individual firms. Equilibrium positions of individual firms will change when market price changes [AR
curve shifts].

Figure 007

Long run Equilibrium of the Firm:

Figure 008

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Figure 008 shows long run equilibrium of the individual firm. The initial market price
[determined corresponding to the intersection of SS and DD at point E] is OP. At this short run price the
firm has its short run equilibrium at point e where it earns abnormal profits equal to the shaded area
Peba. This abnormal profit leads to the entry of new firms into the market. Entry of new firms leads to
rightward shift in market supply curve from SS to S1S1. The new market price is OP1. At the new price
OP1 the individual firm has its demand curve AR1 [equal to MR1]. New equilibrium of the firm is
realised at point e1 where it has a tangency position. The AR curve of the firm is tangent to its LAC curve.
Thus the firm gets only normal profit. Given the normal profits of individual firms, there is no possibility
for entry or exit.
Point e1, thus, represents the long run equilibrium of individual firms. All firms in the long run can
earn just normal profits. Individual firms long run equilibrium e1 shows LAC = LMC = SAC = SMC = MR =
AR = P. This long run equilibrium is stable and will continue until there is a change in the cost or demand
conditions.
If individual firms in the short run incur loss, the mechanism of exit of firms will bring about the
long run equilibrium. That is, mounting loss will compel the firms, probably the weakest, to leave the
market. Exit of firms will lead to leftward shift in the market supply curve and hence to a rise in the
market price. Increased market price will take the AR curve upward and consequently firms loss will
disappear.
Thus, long run equilibrium in perfect competition is realised though the entry [exit] mechanism.
Figure 009

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Long run Equilibrium of Industry:

In figure 009, the industry is in long run equilibrium at point E where the market supply is equal to
market demand. OP is the equilibrium price and OX the equilibrium quantity.
Individual firms have a unique position corresponding to the long run equilibrium of the industry.
Second part of the figure 009 shows this unique position of the individual firms. Individual firms have a
tangency solution at point e where their LAC = LMC = SAC = SMC = MR = AR = P. All firms are getting just
normal profit
Perfect Competition and Optimal Allocation of Resources:
Economists from Smith to Mill and Marshall to Knight treated the perfect competition as an
ideal and unique form of market structure which became one of the basic assumptions of most of their
theories. Economists who follow the foot steps of classical and neoclassical economists also argue that
the perfect competition is the market structure more efficient and socially desirable than any other
types of market. Thus, in mainstream economic literature it is treated as ideal form of market which
makes a situation synonymous to Pareto optimum. That is, perfect competitive equilibrium is
synonymous to the Pareto optimum.
Perfect competition, thus, leads to efficient and optimal allocation of resources. The optimality
is shown by the following conditions which prevail in the long run equilibrium of the perfectly
competitive industry:
a) The output is produced at the minimum possible cost.
b) Consumers pay the minimum possible price which is equal to the marginal cost of the product, that is,
price = opportunity cost.

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c) Each firm utilizes the productive capacity if their plant optimally so that there is no wastage of
resources.
d) Firms earn only normal profits so that the possibility of inequality in the society is minimal.
Figure 010

In the long run these conditions prevail in all perfectly competitive markets, so that resources
are optimally allocated in the economy as whole. If we assume for simplicity that there are only two
commodities [X and Y] produced in the economy we may present the allocation of the given resources
of the economy with the familiar PPC. The preferences of the consumers in the economy may be shown
by community indifference curves. Given the PPC and consumers preferences, perfect competition will
lead to the optimal allocation of resources under the following conditions:
Firstly, if the consumers sovereignty, expressed by the price system [uncontrolled by any
government intervention], reflects the correct ranking of preference of the community.
Secondly, if there are no unexhausted economies of scale in any one industry.
Finally, if resources and technology are given; there is no growth in the economy and no technical
progress.

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If the above conditions are fulfilled, perfect competition leads to the optimal resource allocation
defined by the point of tangency of the given PPC with the highest possible indifference curve. In figure
010, optimal allocation of resources is reached at point E. The economy uses up all the available
resources [point E lies on the PPC] and consumers attain the highest possible welfare, given the
available factors of production. The optimal allocation is attained at the prices Px and Py at which the
levels of output of the two commodities are OX and OY.

Monopoly
Meaning and Definition:
Monopoly is a market structure in which one firm makes up the entire market. It is a market
situation in which the firm faces no competitive pressure from other firms. That is, under monopoly, the
single firm constitutes the entire industry. Thus, monopolists product has no substitutes.
Pure Monopoly: A market is said to operate under pure monopoly when there is a single seller in the
market who, under conditions of strict barriers to entry, supplies the entire product which is unique and
has no sort of substitute. In most cases, government makes use of such situations of pure monopoly to
start up public utilities with a view to avoid monopolistic exploitation of consumers.
Natural monopoly: Natural monopoly emerges out of cost advantages [economies of large scale
production]. In some industries, economies of large scale production are so extreme that the industrys
output can be produced at far lower cost by a single firm than by a number of smaller firms. In such
cases, there is a natural monopoly, because once a firm gets large enough relative to the size of the
market for its product, its natural cost advantage will enable it to drive the competition out of business.
Causes of Monopoly:
Monopoly emerges due to barriers to entry into market. These barriers are possible in
different forms. Following are the important types of barriers to entry of new firms in a market, which
are also the causes of the monopoly.
1. Monopolistic ownership of raw materials: Monopolistic ownership of strategically important raw
materials used in the production of certain commodities makes strong barriers to entry. Those firms
who lack ownership in such raw materials are unable to enter into the market.
2. Secrecy of technology: Firms are unable to enter the market when they lack the knowledge of
producing a commodity. As a result, the firm which possessing the knowledge of producing the
commodity gets monopoly power.
3. Patent right: The firm which occupies patent right either on the product or on the process of
production can enter the market and start the monopoly business.
4. Licensing: As part of government policy, a firm may get license to start a business. That firm can act as
monopolist.

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5. Economies of large scale production: Giant enterprise which possesses remarkable economies of
large scale production can control the entire market.
6. Geographical factors: Due to geographical factors, certain markets can support only a single producer
or seller who can act as monopolist.
7. Merging or amalgamation: Merging or amalgamation of small firms leads to the formation of a single
giant firm which can act as monopolist.
8. Collusion of firms: In order to prevent entry of new firms existing firms may enter into collusion. It
may be in the form of a cartel or price leadership. This leads to the emergence of monopoly.
9. Limit pricing: Existing firm may practice a limit price policy which will make the firm a monopolist.
10. Heavy investment: Certain business requires heavy initial investment to begin. It prevents the entry
of many firms in the market. It, on the other hand, allows a giant firm having bulk finance to run the
business as a monopolist.
Features of Monopoly:
Monopoly as a market structure has some unique features. They are as follows:
1. Single firm: In a monopoly market, there is a single firm to produce and sell the commodity. It faces
no rivalry or competition from any other firm in the industry. The single firm constitutes the entire
industry.
However, there are many buyers for the product of the monopolist in the market. No individual
buyer in the market can control the price of the product of monopolist.
2. Barriers to entry: No new firm can enter into a monopoly market. This is because there are strong
barriers to the entry. These barriers may be in the form of government regulations, cost advantages,
statutory arrangements or other hurdles.
3. Absence of close substitutes: In a monopoly market, monopolists product has no form of substitutes.
That is, due to the existence of strong barriers no new firm can enter the market with a substitute of
monopolists product.
4. Firm is a price maker: The monopolistic firm in the market exercises strong control upon the price of
its product. It can change the price by altering the quantity of its product [it can either change the
quantity of sale of its product by altering its price or it can change the price by altering the quantity of its
product, but not both simultaneously].
5. Low price elasticity and cross elasticity of demand: In a monopoly market, the product of monopolist
faces very low price elasticity and cross elasticity of demand.

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6. Monopolist may discriminate the buyers: Unlike competitive sellers, monopolist possesses some
special powers using which he can discriminate his buyers by charging different prices for the same
product.
7. High degree of monopoly power: Monopolist is empowered with high degree of monopoly power [
= (P-M)/ P]. He can charge a price higher than his marginal cost.
However, buyers of monopolists product have no monopsony power [the power of buyer to
control the price].
8. Profit is the only goal of the monopolist: Monopolist pursues a single goal which is the maximisation
of profit. This goal is realised when the monopolist produces that particular level of output
corresponding to which his MC is equal to MR.
Demand and Revenue of the monopolist:
As already mentioned monopolist faces a less elastic demand for his product. That is, the
demand curve of the monopolist is negatively sloped. Moreover, it is steeper than that of any other
firm. It means that the monopolist can exercise greater control upon the price of his product. In other
words, monopolist is a strong price maker.
A negatively sloped demand curve of the firm signifies that the firm could raise its price by
reducing the quantity or expand the sale by reducing the price. Firms demand is represented by its
average revenue [AR] curve. The firm, thus, has a negatively sloped AR curve. Unlike the AR curve of the
competitive firm, monopolists AR curve deviates from its marginal revenue [MR] curve. As quantity
increases, the price [which is always equal to the AR] falls, and keeping in line with the AR, the MR also
falls. Moreover, the gap between the AR and MR is widening as function of the quantity.
Figure 001 shows the AR and MR curves of the monopolist. As figure shows, the gap between
the AR and MR is widening when the quantity increases. The MR curve is passing through the central
point [B] of the perpendicular PA. Thus, the triangle PDB is equal to the triangle BAC. This is because
OPAX = ODCX.

Figure 001

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Equilibrium of the Monopolist:

Since the single firm constitutes the whole industry in monopoly there is no separate analyses
of firms equilibrium and industry equilibrium. That is, firms equilibrium is synonymous to industry
equilibrium as far as monopoly is concerned. However, we have the short run and long run analyses of
equilibrium of the monopolist.
Both in the short run and in the long run the monopolist has a single goal to pursue which is the
maximisation of the profit. This goal is realised when the firm applies the marginalist rule [MC=MR].
That is, the firm gets in equilibrium when it produces that particular level of output corresponding to
which its MC=MR].
Proof:
Profit function of the firm is at maximum when its first derivative is 0,
and its second derivative, is less than zero.
That is,

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=R-C
Differentiating the function with respect to the output, X, we get, [when it is at maximum]
/ X = R/ X C/ X = 0. That is,
R/ X = C/ X Or, MC = MR
Second derivative of the function is R/X - C/X < 0
That is, slope of the MC curve is greater than that of the MR curve.
Short run equilibrium of the monopolist:
In short run, the monopolist maximises his profit when he equates his MC to MR. He realises
the maximum profit, as figure 002 shows, at point E where both the conditions of equilibrium are
satisfied [MC=MR and slope of MC curve > slope of MR curve]. Corresponding to this short run
equilibrium, the monopolist produces OXe quantity of output which he plans to sell at OPe price. He
enjoys an abnormal profit equal to PeABC, the shaded area.
Figure 002

Long run equilibrium of the monopolist:

In the long run, monopolist faces much flexibility in his operations and planning so that he could
maximise his long run abnormal profits. However, uncertainty is there in the level of productive capacity
utilization of the monopolist. He may be in long run equilibrium with any of the following possibilities:

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1. Long run equilibrium with sub-optimal plant,

2. Long run equilibrium with optimal plant, and
3. Long run equilibrium with over-optimal plant
These three possibilities are explained graphically as follows:
1. Long run equilibrium with sub-optimal plant: As figure 003 shows, the monopolist is in long run
equilibrium at point E with a sub-optimal plant. The firm is producing the level of output OXe which is
less than the optimal level [the level corresponding to the minimum point of the LAC curve]
Figure 003

2. Long run equilibrium with optimal plant: In figure 004, the monopolist is in long run equilibrium at
point E where he produces the optimal level of output, the level of output corresponding to the
minimum point of the LAC curve. He is utilizing productive capacity optimally. That is, there is no excess
capacity or over utilization.
3. Long run equilibrium with over-optimal plant: In figure 005, the monopolist is in long run equilibrium
at point E with an over-optimal plant. He is utilizing the productive capacity excessively so that his unit
cost increases with additional units of output. The level of output produced, OX, is more than the
optimal level.

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Concludingly, monopolist, with greater certainty, maximises his profit in the long run, but
the level of his plants capacity utilization is quiet uncertain.

Figure 004

Figure 005

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A Comparison of Monopoly with Perfect Competition:

Using the following criteria we can compare monopoly with the perfect competition:
1. Goal of the firm
2. Assumptions of the market models
a) Nature of product
b) Number of sellers and buyers
c) Entry conditions
d) Cost conditions
e) Degree of knowledge
f) Demand condition
g) Interdependence among the sellers

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h) Dynamism of the model

3. Values of relevant variables at long run equilibrium
a) Price
b) Output
c) Profit
d) Capacity utilization
Comparing the monopoly model with the perfect competition model we may get the following
conclusions:
1. Goal of the firm: Both the monopolistic and perfectly competitive firms have the unique goal of
maximum profit.
2. Assumptions of the market models:
a) Nature of product: Under perfect competition firms supply homogenous products which are
perfect substitutes of each other. Under pure monopoly the firm supplies a unique product. However,
product homogeneity is not an essential condition of the monopoly.
b) Number of sellers and buyers: In a perfectly competitive market there is a large number of sellers.
On the other hand, in a monopoly market, there is single seller.
The number of buyers is large both in monopoly and in perfect competition.
c) Entry conditions: Entry of new firms is completely banned under monopoly. On the other hand,
entry is free under perfect competition.
d) Cost conditions: Both the monopolistic and perfectly competitive firms have the U-shaped cost
curves reflecting the LVP and LRS.
e) Degree of knowledge: Degree of knowledge is assumed as perfect both in monopoly and in perfect
competition.
f) Demand condition: Monopolist faces less elastic demand whereas the competitive firm faces
perfectly elastic demand.
g) Interdependence among the sellers: Interdependence among firms is assumed away both in
monopoly and in perfect competition. Thus, firms actions are independent.
h) Dynamism of the model: Both the models are basically static in structure.
3. Values of relevant variables at long run equilibrium:

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From the figure 006 we get following conclusions regarding the long run values of the relevant
variables.
a) Price: Monopolist charges a price higher than that of the competitive firm [Pm>Pc].
b) Output: Monopolist produces an output less than that of the competitive firm

[Xm<Xc].

c) Profit: Monopolist earns abnormal profits, but the competitive firm only the normal
[Shaded area shows the abnormal profit of the monopolist].

profit

d) Capacity utilization: Competitive firm is sure to be in long run equilibrium with an optimal plant,
but the capacity utilization of the monopolist is uncertain. Figure 006, however, shows the possibility of
monopolists long run equilibrium with a sub-optimal plant. [Xc is optimal and Xm, the sub-optimal
outputs].
From the above explanation it clear that the monopoly is far away from the perfect
competition as far as social values are concerned. Under monopoly, the consumers are exploited. Thus,
monopoly is antisocial. Monopoly, being antisocial, is controlled by the government either by
interference or by direct nationalization.
Perfect competition, on the other hand, is an ideal market model which holds a number of
social values like, optimal allocation of resources, low price and cost of production. It, according to many
economists, is synonymous to the Pareto Optimality.
Figure 006

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Price Discrimination: [Discriminating Monopoly Model]

Price discrimination, a phenomenon related to monopolist, is the process of selling same or
similar commodity to different buyers at different prices. It is to enhance the monopoly profit that a
monopolist practices the price discrimination. The product sold by a discriminating monopolist may be
homogenous or slightly different. In many cases the product that the monopolist is offering to different
buyers is slightly varied. Different seat arrangement in a theatre, aircraft or train is a typical example to
it.
Possibility and Profitability of Price Discrimination:
Price Discrimination is possible only when the following conditions are fulfilled.
1. Different elasticity of demand in different markets: Monopolist can practice the price discrimination
only when he faces different markets under his domain with different elasticity of demand.
2. Absence of reselling: There should be no possibility of reselling, the process of selling a good, which
was bought from a low price market, in high price market.
Given the cost of monopolist, his profit is an increasing function of his revenue. Thus, if price
discrimination increases the revenue of the monopolist, we can say that the price discrimination is
profitable.
We may construct a model of price discrimination on the basis of certain assumptions as follows:

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1. There are two markets both dominated by the monopolist.

2. The two markets [market one and market two] have demands with different elasticity. D1 and D2 are
the demand curves of market one and market two, respectively. Where, D1 is more elastic than D2.
3. Total demand, D, of the monopolist is derived through the horizontal summation of D1 and D2. That
is, D = D1 + D2. Similarly, the corresponding MR is derived through the horizontal summation of MR1
and MR2, marginal revenue curves in different markets. Thus, MR = MR1 + MR2.
4. Reselling is absent.
5. Monopolist knows his MC with accuracy.
Given these conditions, the discriminating monopolist has to decide two things which are:
1. How much quantity is to be produced?
2. How to allocate production and sale between two markets?
Figure 007

As figure 007 shows, D = D1 + D2 is the total demand curve and MR = MR1 + MR2 the
corresponding marginal revenue curve of the monopolist. MC curve intersects the MR curve at point e
where the monopolist is in equilibrium. That is, point e defines the total quantity to be produced.

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If monopolist practices no price discrimination, he will charge a common price OP to his

product in both the markets. He can sell OX quantity. Then, he derives a total revenue [R1] equal to
OPAX, revenue without price discrimination. Now we need to compare this revenue without price
discrimination [R1] to the revenue with price discrimination [R2].
D1 is the demand curve in market one and D2 the demand curve in market two. MR1 and MR2
are the corresponding marginal revenue curves. D1 is more elastic than D2.
Monopolist is in equilibrium at point e1 in market one where MR1 is at the level of monopolists
MC. Thus, the monopolist has to sell OX1 quantity at OP1 price in market one. It gives him a revenue [r1]
equal to OP1FX1.
Monopolist is in equilibrium at point e2 in market two where MR2 is at the level of monopolists
MC. Thus, the monopolist has to sell OX2 quantity at OP2 price in market two. It gives him a revenue [r2]
equal to OP2EX2.
Monopolists total revenue [R2] from price discrimination is equal to OP1FX1 + OP2EX2. R2 = r1
+ r2. This is definitely greater than his revenue without price discrimination [R1].
Proof:
OX1 = X2X and OX2 = X1X.
PP2 = P1P
R1 = OPAX
R2 = OP1FX1 + OP2EX2
= OP2EX2 + X2CBX
Since PP2ED > CDAB, R2 > R1. Thus price discrimination is profitable.
Degree of Price Discrimination:
On the basis of the number of prices charged by the discriminating monopolist we can
classify the price discrimination into three, namely 1) the first degree price discrimination, 2) second
degree price discrimination, and 3) the third degree price discrimination. If the monopolist charges two
prices for his product, he is practicing the third degree price discrimination. Whereas, he practices the
second degree price discrimination when he charges more than two prices for his product but the
number of prices should be less than the number of units sold. On the other hand, the monopolist
practices the first degree price discrimination when he sells each unit of the commodity at a different
price. That is the number of prices is equal to the number of units sold.
In figure 008, Part A shows third, Part B, the second and Part C, the first degree of price
discrimination. As Part A shows, the firm charges two prices, OP and OP1 and earns a revenue equal to

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OP1ABCX2 which is greater than OPCX2, the revenue when a unique price OP is charged. Here third
degree price discrimination increases the revenue by PP1AB [dark shaded area].
As Part B shows, the monopolist charges more than two prices [three prices in this specific
example] which gives him a revenue equal to OP2RSTUVX3 which is greater than OPVX3, the revenue
when a unique price OP is charged. Here second degree price discrimination increases the revenue by
PP2RSTU [dark shaded area].
Figure 008

In Part C, the monopolist sells each unit of his product at a different price. That is, the number
of prices is equal to the number of units of the commodity. Here his revenue is ODAX which is greater
than OPAX, the revenue when a unique price OP is charged. That is, first degree price discrimination
raises his revenue by PDA.
Price Discrimination and Consumers Surplus:
Figure 009

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It is through the appropriation of consumers surplus that the monopolist enhances his revenue when
price discrimination is practiced. In the absence of price discrimination, consumers get the consumers
surplus. For instance, if monopolist charges a unique price OP, consumers get a surplus equal to PDA,
the shaded area in figure 009. When he charges two prices [OP and OP1], as in Part A of figure 008, he
appropriates PP1AB area [dark shaded area] of the consumers surplus. And to that extent his revenue
increases.
As figure 008 shows, the greater the number of prices charged the greater will be the portion of
the consumers surplus appropriated by the monopolist. In first degree price discrimination the
complete portion of the consumers surplus is appropriated by the monopolist.
Bilateral Monopoly:
Bilateral monopoly is a rare market situation characterised by the existence of a single
seller [monopolist] who sells his commodity to a single buyer [monopsonist] under conditions of strict
ban on entry of new buyers and sellers. As an example, we can cite the situation in which a mining firm,
which is the only producer of a strategically important chemical, supplies its product to a company
which is the sole buyer of the chemical which is used in the production of certain destructive weapons.
Here the seller is a monopolist and the buyer a monopsonist.
Figure 010

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Traditional economic theory with its normal tools of demand and supply fails to find a
solution to the price and output determination problem in a market situation of bilateral monopoly. This
is because of the absence of a mutually agreed price between the seller and buyer. Seller, the
monopolist, likes to sell his good at a relatively higher price while the buyer, the monopsonist, tries to
buy the good at a relatively lower price. Compromise between the seller and buyer is absent not only in
price but in quantity of the product, as well. Under conditions of bilateral monopoly economic theory
leads to indeterminacy which can be settled only through the incorporation of non-economic variables
into the model.
In figure 010, equilibrium of the monopolist is defined by the intersection of his MR and
MC curves [point e1]. He likes to sell OX1 quantity at OP1 price. This is the profit maximising position of
the monopolist.
On the other hand, equilibrium of the monopsonist is defined at point e where his marginal
expenditure Curve [ME] intersects the demand curve of the monopolist. Corresponding to this
equilibrium, monopsonists price is determined by his supply curve. Monopolists MC curve is the supply
curve as far as the monopsonist is concerned. Thus the monopsonist likes to buy OX2 quantity of the
good at OP2 price.
Here, with the help of economic theory, we get the upper and lower limits of price and
quantity. We can find the actual price and quantity with which the buyer and seller come to an
agreement only by the introduction of some non-economic variables.

267

Reference Books:
1. William J. Baumol and Alan S. Blinder, Economics: Principles and Policies,
Third Edition, Harcourt Brace Jovanovich Publishers, New York.
2. Campbell R McConnell, Economics: Principles, Problems and Policies
Seventh Edition, McGraw-Hill Book Company, New York
3. David C Colander, Economics, Forth Edition, McGraw-Hill Irwin, New York
4. A. Koutsoyannis, Modern Microeconomics, Second Edition, McMillan
5. Hall P. Varian, Intermediate Microeconomics, A Modern Approach Seventh Edition,
Affiliated East-West Press, W.W. Norton Company.
6. Watson and Getz, Price Theory and its Uses, Fifth Revised Edition, A.I.T.B.S.
Publishers& Distributors, Delhi
7. William J. Baumol, Economic Theory and Operation Analysis, Forth Edition,
Prentice-Hall of India Pvt. Ltd.
8 K.C. Roychowdhury, Microeconomics, Tata McGraw-Hill Publishers Company,
New Delhi.
************
Sample Questions:
Part A; Multiple Choice Questions:
1. Closing down point of the firm is corresponding to
A] AC = AR. B] MC = MR. C] AC = P. D] AVC = P.
2. Marginalist rule states --------------- as condition of firms equilibrium.
A] MC = MR. B] MC = AC. C] AC = AR. D] MC = AR.
3. Which of the following is correct to perfect competition?
A] Full cost pricing. B] Cartels. C] Standardized products. D] Price discrimination.
4. Which of the following is least significant to the concept of market in economics?
A] Price. B] Commodity. C] Time. D] Place.
5. Under perfect competition degree of monopsony power is

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A] Equal to zero. B] Equal to one. C] Greater than zero. D] Greater than one.
6. If --------------------- is possible price discrimination is impossible.
A] Monopoly. B] Elasticity difference. C] Product standardization. D] Reselling.
7. Perfectly competitive firms are
A] Price makers. B] Price takers. C] Interdependent. D] Sales maximisers.
8. Who can control price in a bilateral monopoly market?
A] Only the monopolist. B] Only the monopsonist. C] Both the monopolist and the monopsonist. D] Neither the
monopolist nor the monopsonist.
9. What is more relevant as far as a pure monopoly is concerned?
A] More than 60 % coverage of the market. B] Advertisement. C] Product differentiation. D] Standardized product.
10. Perfect competition is a --------------------- model.
A] Laissez faire. B] Interventionist. C] Centrally planned. D] Regulated.
Part B; Short Questions:
1. Define perfect competition.
2. What is bilateral monopoly?
3. Define the closing down point.
4. What is natural monopoly?
5. Distinguish between the price taker and price maker.
6. Define price discrimination.
7. What is reselling?
8. What is product homogeneity?
9. What are perfect substitutes?
10. What is marginalist rule?
Part C; Short Essay Questions:
1. Briefly explain the degree of price discrimination.
2. Briefly explain the productive capacity utilization of the monopolist.
3. Explain the equilibrium conditions of a firm in a perfectly competitive market.

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4. Monopolist, unlike the competitive firm, is a price maker. Examine.

5. Explain the major differences between monopoly and perfect competition.
6. Explain the major differences between pure competition and perfect competition.
7. Explain the problem indeterminacy of bilateral monopoly.
8. Competitive equilibrium is synonymous to Pareto Optimality. Explain.
9. Explain the degree of monopoly power.
10. How does entry mechanism wipe out abnormal profit and loss in a perfectly competitive market?
Part D; Essay Questions:
1. Explain the price and output determination in a perfectly competitive market.
2. Explain the features of perfect competition.
3. Explain the equilibrium of a monopolist. Compare it with that of a competitive firm.
4. Explain the features of a monopoly market.
5. Compare monopoly with perfect competition on the basis of long run equilibrium.
6. What are the important factors responsible for the emergence of monopoly? How can it be controlled?
7. Monopolist can determine either the quantity or the price but not both. Examine.
8. Explain the capacity utilization of perfectly competitive firm and monopoly firm.
9. Monopolist can enjoy abnormal profits both in the short run and in the long run. Explain.
10. Explain the discriminating model of monopoly.

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6. MARKET FOR GOODS; HOW DO

BUYERS AND SELLERS RESPOND
BETWEEN EXTREME MARKET
SITUATIONS?
Monopolistic Competition: Evolution of new market model: Concept of Monopolistic Competition:
Product Differentiation: Product Differentiation and the Demand Curve: Features of Monopolistic
Competition: Price and output determination under monopolistic competition [Equilibrium solution in
Large Group Model of Chamberlain]: Assumptions of Chamberlins Large Group Model: Model I:
Equilibrium with entry of new firms: Model II: Equilibrium with price competition: Model III: Equilibrium
with price competition and entry: Theory of Excess Capacity: Chamberlins Interpretation of Excess
Capacity: Advertisement and Selling Costs: Concepts of Industry and Product Group: A comparative
study of monopolistic competition and perfect competition: Monopolistic Competition and Social
Welfare; A critical Analysis: Criticism of Chamberlains Model:
Oligopoly: Meaning and Definition: A few examples to oligopoly: Causes of oligopoly: Features of
Oligopoly: Sweezys Kinked Demand Model: Kinked demand curve: Price and output determination:
Changes in costs and the equilibrium price: Changes in demand and the equilibrium price: Defects of
kinked demand model:

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Monopolistic Competition
Evolution of new market model:
For years, most economic theorists dealt with only two workable models of the behavior of the firms: the
Monopoly model and the Perfect Competitive model. The core of the Classical micro-economic theory from
Marshall [Alfred Marshall, Principles of Economics] to Knight [F. H. Knight, Risk, Uncertainty and Profit] was
constituted by the theories of Perfect Competition and Monopoly. Pure competition and pure monopoly are the
extremities of market structures. Most market structures that we see in the real world fall somewhere between
these two poles. Thus, the economic models of market existed in Classical and Neo-Classical economic literature
hardly explain any of the real world market situations.
Pure competition does not match with real world market situation. The assumption of product
homogeneity in pure competitive model does not fit the real world market. Moreover, advertising and other
selling activities widely practiced by businessmen could not be explained by the model of perfect competition.
Finally, the real world market phenomenon that most firms expand their output with falling costs does not
match with the Neoclassical tangency solution on an infinitely elastic demand curve of individual firm. This has
led to the Great Cost Controversy of 1920s. This controversy began with the publication of the pioneering work
of Piero Sraffa, The Laws of Returns under Competitive Conditions. Sraffa pointed out that the falling cost
dilemma of the Neo-Classical theory could effectively be solved by the introduction of a negatively sloped
demand curve for the individual firm. This, according to Sraffa, could facilitate a more theoretical and
operational solution to the real world market situations.

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Monopoly in its pure form also is far away from realities. Thus, the monopoly models fail to explain many
market phenomena like free entry and sales promotional activities. Practically, most of the markets of a wide
variety of goods are neither purely competitive nor monopolistic, but a mixture of both. In other words, most
market situations fall somewhere between these two extremities.
It was only in the latter half of 1920s that economists like P. Sraffa, H. Hotelling and F. Zeuthen
recognized the limitations of pure competition and monopoly models and pointed out that the reality lies
somewhere between these two extremities. Tracing the foot steps of these economists, two monumental works
appeared in 1933, these were, The Economics of Imperfect Competition written by Joan Robinson and The
Theory of Monopolistic Competition written by E. H. Chamberlin. Both emphasized that the real world market
structure combines the elements of both competition and monopoly. Despite the substantial difference in their
analytical approach and methodology, they could arrive at surprisingly similar conclusions regarding the solution
for the firm and market equilibrium.
Concept of Monopolistic Competition:
A market is said to operate under conditions of monopolistic competition if it satisfies the following
essential conditions:
1. Numerous Participants: That is, many buyers and sellers, all of whom are small,
2. Heterogeneity of products: That is, as far as the buyer is concerned, each sellers product is at
least some what different from others, and
3. Freedom of entry exists in the market. That is, though the products are differentiated, the
firms are free to enter [and exit] the market.
Thus, we can define a monopolistic competitive market as an institutional arrangement in which a large
number of sellers sell their differentiated products to a large number of buyers under conditions of free entry
and exit.
Product Differentiation
In contrast to pure competition, monopolistic competition has the fundamental feature of product
differentiation. Purely competitive firms produce standardized products which are technical, economic, and
hence, perfect substitutes of each other. They can be sold only at same price.
In real world market, each firm produces a product different from its rivals product. For example, a
number of firms produce cosmetic products, but the product of each differs from its rivals in one or more
respects. Soaps, footwear, toothpaste and garments markets give us a better picture of product differentiation.
Product differentiation has more dimensions than it seems to be prima facie. It may be real or fancied. It
can be real when the inherent characteristics of the product are different, or fancied when the products are
basically the same, yet the consumer, persuaded by advertisement or selling activities, feels that the products
are different. In other words, the products supplied by different firms may be really different in regarding the

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quality of the products or they may be different due to the imaginary differences created through advertising,
sales packages, and use of trade marks and brand names. Whatever the case is, real or fancied, the aim of
product differentiation is to make the product unique in the mind of consumer.
Though the products are differentiated, they are close substitutes with high price and cross elasticity of
demand. Only homogenous products, as seen under perfect competition, can be perfect substitutes. Products
under monopolistic competition are differentiated, but they serve same physical wants of consumers. Thus, they
are close substitutes. Being close substitutes, they face keen competition from rival products, and hence, they
have high price and cross elasticity of demand.
The effect of product differentiation is that the producer has some discretion in the determination of
the price. He is not a price-taker, but has some degree of monopoly power which he can exploit. However, he
faces the keen competition of close substitutes offered by other firms. Hence the discretion over the price is
limited. That is, there are elements of monopoly and competition under this market condition, hence, the name
monopolistic competition is very relevant.
Product Differentiation and the Demand Curve:
Product differentiation as the basis for establishing a negatively sloped demand curve was first
introduced in economic theory by P. Sraffa. Yet it was Chamberlin who elaborated the implication of the product
differentiation for the pricing and output decision as well as for the selling strategy of the firm. Chamberlin
suggested that the demand is determined not only by the price policy of the firm, but also by the style of the
product and the selling activities of the firm. Thus, Chamberlin introduced two additional policy variables in the
theory of firms: the product itself and selling activities. The demand curve for the product of the individual firm
incorporates these dimensions.
Product differentiation makes the firm a price maker, and hence, its demand curve a negatively sloped
one. On the other hand, free entry and exit make the market very competitive. The combined effect of product
differentiation and free entry makes the market a market of competing monopolists. That is, each firm faces an
elastic demand curve which shifts when:
1. The style, service, or selling strategy of the firm changes,
2. Competitors change their price, output, service or selling policies,
3. Tastes and incomes of consumers change,
4. Prices or selling policies of products from other industries change.
Figure 001 shows the demand and revenue conditions of the firm.
Figure 001

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In figure 001, the curve AR is the demand or average revenue curve of the individual firm. The
curve MR shows marginal revenue of the firm. Negative slope of the average revenue [demand curve]
and marginal revenue curves shows the degree of imperfection in the market.
Features of Monopolistic Competition:
Introduction
Monopolistic Competition, a mixture of competition and monopoly, has greater practical
relevance. It explains a number of market phenomena that we see in the actual markets. Excess
capacity, advertisement, selling cost, falling cost industry and its conformity with normal profit, etc. are
a few examples. Credit goes to E H Chamberlain and Mrs. Joan Robinson for developing the theoretical
foundations of this market structure. However, the elementary tools of it were supplied by Prof. Piero
Sraffa.
Following are the important features of Monopolistic Competition:
1. Large number of buyers and sellers.
Under this market, there are many sellers, perhaps a few hundreds or a few thousands. As an
example we can cite the case of modern soap making firms. Each firm constitutes a very small part of
the market. Thus, there exists very keen competition in the market. Like the number of sellers, the
number of buyers also is very large.

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2. Free entry and exit.

Under this market, no form of barriers to entry or exit exists. This free entry makes the
number of firms very large. The factors like brand loyalty, product uniqueness, advertisement and selling
activities, though they have to play some role as policy variables, are too weak to act as barrier to entry.
Thus, any firm can enter or exit the market if it likes to do so.
The two features explained above make the market very competitive. Under this condition,
firms have to struggle a lot for existence and survival. This is the condition we have seen under pure
competition.
3. Product differentiation.
Each firm in the market sells a different product compared to that of others. That is,
products are differentiated. Preparing the products with different packages, varying services, guarantees
and warranties offered, changing stiles and scales of advertisement and other sales promotional
activities etc. make each product unique and different from others. This product differentiation may be
either real or fancied. Real differentiation shows the real qualitative change in the product. On the other
hand, fancied differentiation shows imaginary differences created through promotional activities like
advertisement and salesmanship. Product differentiation, real or fancied, strengthens the preference of
consumers towards various products. It makes each product unique.
4. Greater role of advertisement and other sales promotional activities.
As already mentioned, advertisement is often used along with other sales promotional
activities to make the product different. As we see in the real world market, firms spend bulk of their
funds for advertisement and other sales promotional activities. And in some cases this expenditure far
exceeds the production cost. Advertisement, according to Chamberlain, also is subject to economies and
diseconomies of scale.
5. Firm is a price maker.
Unlike the competitive firm, the monopolistically competitive firm is a price maker. The
firm has some control up on the price and supply decisions. It can charge a different price to its product
compared to the prices of its rivals products.
6. Degree of monopoly power is greater than zero.
Unlike the competitive firm, monopolistic competitive firm has some degree of monopoly
power ( = P-M/P). That is, it can charge a price higher than its marginal cost. It means its long run
tangency solution takes place not at the minimum point of the average cost curve, but at its falling
segment.
Monopolistic competition, unlike pure competition, gets a different position as per the
features 3, 4, 5, and 6 mentioned above. The firm has some monopolistic power. It has freedom to
decide its price and sales policies.
7. High price and cross elasticity of demand.

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The firms, though supply differentiated products, face high price elasticity of demand. That
is, the individual demand curve is very elastic, and hence, flat. Similarly, the firm faces high cross
elasticity of demand from rival products.
8. Products are close substitutes.
Though differentiated the products under monopolistic competition, they are substitutes of
each other. They serve the same physical wants, but not same psychological wants. However, unlike the
competitive products, the products of monopolistic competitive firms are close substitutes and not
perfect substitutes.
9. Advertisement and other sales promotional activities.
Unlike the competitive firm, monopolistic competitive firm utilizes the possibilities of
advertisement and other sales promotional activities. This results in incurring of selling cost. According
to Chamberlain, selling cost, like the production cost, is subject to economies and diseconomies of scale.
Thus, the average selling cost curve has a U- shape.
10. Existence of excess capacity.
Unlike the competitive firm, monopolistic competitive is in long run equilibrium with a suboptimal plant. It cannot produce the optimal output, the output corresponding to the minimum point of
the LAC curve. Thus, excess capacity is an inevitable feature [evil feature] of monopolistic competition.
11. Profit is the only goal of the firm.
A monopolistic competitive firm always [both in the short run and in the long run] pursues a
single goal, namely, the maximum profit.
12. Marginalist rule governs the equilibrium.
Like all Neo-classical models of the market, the model of monopolistic competition rests fully
up on the marginalist rule [MC = MR]. That is, the firm realises its goal when MC = MR. Thus, it is a
market model which incorporates many practical market phenomena in to the Neo-classical model. It is
truly a hybrid variety of the Neo-classical model.
Conclusion
As we have seen already, the theoretical developments made by E. H. Chamberlain and Mrs.
Joan Robinson, and the pioneering works of Prof. Sraffa have led to the formation of a new market
model which explains many of the practical phenomena of the real world. This path breaking invention
paved ways for a number of revisions and restatement of market models, and hence, it led to sweeping
changes in the theory of firm.
Price and output determination under monopolistic competition:
Or

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Equilibrium of the monopolistic competitive firm:

Or
Equilibrium solution in Large Group Model of Chamberlain:
Being a Neo-classical model, the monopolistic competitive model best utilizes the marginalist
rule, as the rule which governs equilibrium. According to this rule, the firm is in equilibrium when it
produces that particular level output corresponding to which its MC = MR. Where, the MC is C/ X and
MR is R/X.
Proof to the MC=MR approach:
Profit function, =R-C, is at maximum when its first derivative, R/X C/X = 0 or MC =
MR, and its second derivative, R/ X - C/X is less than zero or slope of the MC curve is greater
than slope of the MR curve.
That is,
=R - C
Differentiating the function with respect to the output, X, we get,
/ X = R/ X C/ X = 0
That is,
R/ X = C/ X
Or, MC = MR
Second derivative of the function is,
R/X - C/X < 0
That is, slope of the MC curve is greater than that of the MR curve.
Application of marginalist rule and the equilibrium analysis are shown in the following figure.
Figure 002

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In the figure 002, point e fulfils all the conditions of firms equilibrium. It fulfils the first order
condition, MC=MR, and the second order condition, slope of the MC curve is greater than slope of the
MR curve. Corresponding to the equilibrium, the firm produces OX quantity of output, and it sells the
output at price equal to OP.
Assumptions of Chamberlins Large Group Model:
Chamberlin uses the following assumptions to simplify his model. Some of these assumptions
are highly restrictive and unrealistic. However, he relaxes most of these assumptions at a latter stage of
his analysis.
1.
2.
3.
4.
5.
6.
7.
8.

Large number of buyers and sellers in the product group

Differentiated products
Free entry and exit of firms
Profit maximization is the only goal of the firm
Factor prices and technology are given
The firm behaves as if it knew its cost and revenue with certainty
Long run consists of identical short runs
All firms have identical cost structure and demand conditions [heroic assumption].
With these assumptions we can explain firms equilibrium and groups equilibrium in a single
figure. Chamberlain developed three large group models. They are:
1. Model I: Equilibrium with entry of new firms.
2. Model II: Equilibrium with price competition, and
3. Model III: Equilibrium with price competition and entry.

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Model I: Equilibrium with entry of new firms:

Here Chamberlain assumes that there is no price adjustment on the part of existing firms. In
such a situation firms reach at long run equilibrium through entry mechanism. In the short run, it is
assumed that, all firms are enjoying abnormal profits; the market is very attractive to firms outside the
market. This leads to entry of new firms. The process of entry will continue until all firms are left with
normal profit.
The following diagram shows how long run equilibrium is realized through entry of new firms.
Figure 003

In figure 003, d1 is the initial demand curve and MR1 its corresponding marginal revenue curve.
Point e1 shows the short run equilibrium of the firm with price P1 and abnormal profit [P1ABC].
Attracted by abnormal profit, new firms enter the market and, consequently, the market is
shared among more members. As a result the individual demand curve shifts from d1 to d2 along with
the marginal revenue curve from MR1 to MR2. Given the cost structure, the firms reach at a new
equilibrium at point e2 with price P2. Corresponding to this new equilibrium, they enjoy just normal
profit. Thus, this new equilibrium is the long run equilibrium. New firms, given this long run equilibrium
position, according to Chamberlin, have no tendency to enter into the market. Similarly, the existing
firms have no tendency to leave the market since they get the normal profit. The number of firms in the
product group, according to Chamberlin, is optimal.

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If the short run position of the firms is with loss, then some firms, probably the weakest, will
leave the market. Then the market is shared among less number of firms than before. It leads to upward
shift in the individual demand curve. The process of exit and the consequent upward shift in the
individual demand curve will continue until all the remaining firms are left with normal profit.
Model II: Equilibrium with price competition:
In this model Chamberlin introduced a new tool of analysis, namely, the share-of-the market
curve [DD]. It shows the actual increase in the sale of individual firms corresponding to a price cut. It is
used along with the individual demand curve which shows the expected increase in the sales of
individual firms. Chamberlin assumes in this model that there is no entry of new firms, because the
number of firms in the product group is optimal, and thus, the long run equilibrium takes place through
the price competition.
Figure 004

Initially, as in the figure 004, it is assumed that, all firms are in run equilibrium position with
price P and quantity X. All firms enjoy abnormal profit corresponding to this position. Firms now
independently think that they could attain more sales by a price cut, say from P to P1. The expected sale
is X2. All firms, thus, independently reduce their price from P to P1. However, they could realize only a
sale equal to X1. It means, the individual demand curve shifts downward from

dd to d1d1. The new

relevant combination of price and demand is M. However, firms have a myopic behavior, and thus they
never learn from past experience. So they repeat the same mistakes. That is, they independently reduce
their price with great expectation, assuming that others will not follow suit. Each price cut, thus, is

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followed by the subsequent downward shift in the individual demand curve. This process of price cut
and the subsequent downward shift in the individual demand curve will continue until all the firms in
the group are left with normal profit. This tangency position is shown at point A where the individual
demand curve d*d* is tangent to the AC curve. This is also a point of intersection between individual
demand curve and the share-of-the market curve [D*D*]. This tangency position takes place
corresponding to the long run equilibrium point at E, where the MC curve intersects the MR curve. Now
all firms are left with normal profit. The long run price is P* and the long run output is X*.
Model III: Equilibrium with price competition and entry:
This is the complete and comprehensive large group model. The first and second models are
only the elementary materials for this complete model. Here Chamberlin assumes that the long run
equilibrium takes place both through entry and price mechanism. He states the following cause and
effect relationships:
1 Each entry leads to a leftward shift in the share-of-the market curve.
2 Each exit leads to a rightward shift in the share-of-the market curve.
3. Each price cut leads to a downward shift in the individual demand curve.
4. Each price boost leads to an upward shift in the individual demand curve.
The model can be better explained by a diagram as follows:
Figure 005

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In figure 005, point R shows the initial position of firms, corresponding to which they enjoy
abnormal profits. Attracted by the abnormal profits, new firms enter into the market and, consequently,
the share-of-the market curve shifts leftward from DD to D1D1. The new share-of-the market curve
D1D1 intersects the individual demand curve at point S where the D1D1 is also a tangent to the AC
curve. Thus, the firms get normal profit at price P1 and quantity X1.
Chamberlin argues that the price P1, the quantity X1 and the position S cannot continue for a
long while. This is because the firms individually expect that they could enlarge sales and profit through
a price cut. Each firm expects that its rivals will not follow its price cut and hence its sales would expand
remarkably. However, the reality is far away from the expectation. As each firm expects and acts the
same price cut policy independently, the actual increase in sales would be much lees than the expected
one.
Each price cut of individual firms leads to a downward shift in the individual demand curve.
For instance, when firms reduce their price independently from P1 to P2 the individual demand curve
shifts from dd to d1d1. The shifted individual demand curve d1d1 is intersecting the share-of-the market
curve D1D1 at point T. Thus, the firms incur loss equal to the area P2TAB corresponding to the reduced
price P2.
However, according to Chamberlin, the individual firms do not learn any lesson from their
past experience. Thus, they repeat the same mistakes. That is, they still expect that they could enhance
their sales through a price cut and the rivals will not follow this price cut.

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Each price cut, thus, shifts the individual demand curve downward and the firms incur
mounting loss. The doted demand curve d2d2 resulted from the price cut lies far below the AC. It means
that the individual firms incur heavy loss. The heavy loss compels some firms, probably the weakest, to
stop the business and to leave the market. As some firms exit the market, the share-of-the market curve
shifts rightward from D1D1 to D*D*. It means that the share of the remaining firms in the market gets
increased. The exit of some firms and the consequent decrease in the market supply lead to a price
boost. This takes the individual demand curve from d2d2 to d*d*.
Now the firms have their individual demand curve d*d* and the share-of-the market curve
D*D* intersecting each other at point U where the d*d* is also a tangent to the AC. Corresponding to
this position the price is P* and the quantity is X*. This combination of price and quantity [U] is derived
from the equilibrium E where the marginalist rule [MC=MR] is fulfilled.
All firms in the market enjoy normal profit corresponding to the equilibrium at point E.
Chamberlin argues that this equilibrium is the long run equilibrium. No firm in the market has a
tendency either for price cut or for price boost. Normal profit makes the market unattractive to new
firms. That is, there is no possibility for new entry in the market. Similarly, the existing firms have no
tendency to leave the market since they get the normal profit. However, this is not an outcome of
learning from past experience. Firms are still nave and their behaviour still myopic. That is, Chamberlin
infers that the long run equilibrium under monopolistic competition with normal profit is happening
without sophistication in firms behaviour and collusion among firms.
Theory of Excess Capacity:
Theory of Excess Capacity infers that, unlike competitive firms, monopolistic competitive
firms cannot produce output at the lowest possible cost in the long run. That is, the actual level of long
run output of monopolistic competitive firms is less than the optimal level. Long run equilibrium of
these firms takes place corresponding to the falling segment of the LAC curve. The firms, as the figure
006 shows, get in equilibrium at the point where MC=MRmc [MR of monopolistic Competitive Firm],
corresponding to this, they reach at a tangency solution at point M where AR [d*d*] curve is tangent
to the falling portion of the LAC curve. They cannot enlarge their capacity utilization. If they do so, that
would end up with long run loss. Normal profit concept cannot be in conformity with optimal output
as long as the demand curve of the firm is negatively sloped and the cost curves are U-shaped. It can
be consistent only with the excess capacity.
Critics are of the view that the excess capacity is an inevitable evil feature of the
monopolistic competition. It means valuable and scarce resources are wasted under monopolistic
competition. Firms are incurring huge expenses on advertisement and other sales promotional
activities. As excess capacity is an inevitable evil feature of the monopolistic competition, and the
resources being wasted, critics blame that this form of market cannot ensure maximum social welfare.
That is, this market structure fails in optimal resource utilization. Thus, this is not a socially desirable
form of market.
Figure 006

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Chamberlins Interpretation of Excess Capacity:

Unlike critics, Chamberlain gives us a new interpretation of excess capacity. According to him,
critics exaggerated the excess capacity phenomenon of monopolistic competition. He says, critics
measured the excess capacity equal to X1Xc, as shown in the figure 006. This, according to him, is much
exaggerated. Actual excess capacity, he says, is XmcXc. That is, the difference between monopolistic
competitive suboptimal output and the competitive optimal output is not too much.
He further says that the excess capacity seen under monopolistic competition, unlike critics
exaggeration, is not a curse and an anti social phenomenon. On the other hand, it is simply the cost of
product differentiation which, according to him, is a virtue. He says, in market where the goods are
differentiated, consumers can choose the good that they like the most. That is, consumers can make a
free choice according to their whims and fancies. Thus, according to Chamberlain, excess capacity is not
an evil feature of monopolistic competition, and hence, this form of market is not anti social.
Advertisement and Selling Costs:
Neoclassical model of perfect competition provides no scope for advertisement and selling
activities. Under perfect competition products being homogenous they need not be advertised and,
thus, firms incur no cost on sales promotional activities. In other words, product homogeneity stands as
rationale to the absence of selling costs under perfect competition.
Chamberlin introduced selling costs in the theory of firms for the first time. The recognition of
product differentiation provides the rationale for the selling costs. Each firm seeks to increase the

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difference between its product and the product of its rival firms through sales promotional activities like
advertisement. Chamberlin argues that the advertisement in general will increase the demand and will
make it less elastic by strengthening the preferences of the consumers for the advertised product.
Chamberlin holds that the average selling cost curve [ASC], like the average production cost
curve [APC], has a U shape reflecting economies and diseconomies of advertisement. Initially expansion
of sales will not require an equiproportional increase in selling costs, and this leads to a fall in ASC.
However, beyond a certain level of output the firm will have to spend more on advertisement per unit of
output in order to attract customers of other firms. Thus the ASC curve is U shaped. It means that there
is an optimal level of advertisement for each firm. This is corresponding to the minimum point of the
ASC curve. The segment of the ASC curve to the left of the minimum point shows the increasing returns
to advertisement. The segment of the ASC curve to the right of the minimum point shows the
decreasing returns to advertisement.
Figure 007

In figure 007, ASC is the Average Selling Cost, APC, the Average Production Cost and AC, the
Average of Total Costs. The gap between APC and AC measures the ASC. As the figure shows the ASC is
U shaped. It shows the economies and diseconomies of advertisement. Point M shows the optimal level
of advertisement.
Chamberlin has adopted the U shaped ASC for the sake of simplicity. It is very convenient to
add the U shaped ASC with the U shaped APC. Moreover, it does not violate the U shape of the
Neoclassical AC curve. However, the U shaped ASC has no empirical evidence.

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Concepts of Industry and Product Group:

Industry is a group of firms producing homogenous goods. The term, thus, best matches with
perfect competition. The firms under perfect competition supply goods which are perfect substitutes of
each other. On the other hand, under monopolistic competition, firms supply differentiated products
which are only close but not perfect substitutes. Observing this structural difference, Chamberlain
replaced the concept of industry by a more significant concept, the product group.
Product group is a cluster of firms producing differentiated goods which are close but not
perfect substitutes. The concept is most significant to monopolistic competition. Following the foot
steps of Chamberlain, in modern times, many economists use this term frequently in their market
models. Like product differentiation, nonprice competition and selling cost, the concept, product group
is really a path breaking contribution of Chamberlain.
A comparative study of monopolistic competition and perfect competition:
The actual market that we see in the real world is neither monopolistic nor perfectly
competitive; it is, indeed, a mixture of both. Thus, the most practical form of market is better called as
Monopolistic Competition, a compromise between monopoly and perfect competition. Product
differentiation, free entry and exit, large number of buyers and sellers, remarkable role of
advertisement, excess capacity, etc are its unique features.
Figure 008

For a prolific evaluation of this practical form of market, we need to compare it with the
perfect competition, the ideal and standard model. For comparison we may use the following criteria:

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1. Number of buyers and sellers

2. Entry condition
3. Nature of product
4. Substitutability of products
5. Goal of firms
6. Rule of equilibrium
7. Role of advertisement
8. Selling cost
9. Elasticity of demand
10. Degree of monopoly power
11. Cost structure
12. Price charged
13. Output produced
14. Profit enjoyed
15. Capacity utilized
1. Number of buyers and seller: Monopolistic Competition, like perfect competition, has a large number
of buyers and sellers.
2. Entry condition: Both under monopolistic competition and under perfect competition no form of
barrier exists either to entry or to exit.

3. Nature of product: Under perfect competition, the products supplied by all firms are identical
and homogenous. On the other hand, under monopolistic competition, the products of different
firms are differentiated and heterogeneous.
4. Substitutability of products: Under perfect competition the products supplied by all firms are
perfect substitutes of each other. On the other hand, under monopolistic competition, the
products of different firms are differentiated and thus, they are not perfect substitutes. However,
they satisfy same physical wants of consumers. Thus, they are close substitutes [For example,
Close up and Colgate]
5. Goal of firms: Both Monopolistic competitive and perfectly competitive firms have a single goal to
pursue. This unique goal is the maximum profit.
6. Rule of equilibrium: Both Monopolistic competitive and perfectly competitive firms seek their goal by
applying the Marginalist Rule, MC=MR
7. Role of advertisement: Under perfect competition advertisement has no role to play. On the other
hand, advertisement plays a significant role under monopolistic competition.
8. Selling cost: Under perfect competition no firm incurs any expense on sales promotional activities. On
the other hand, a Monopolistic competitive firm spends a significantly large amount of money for sales
promotional activities.
9. Elasticity of demand: A perfectly competitive firm faces perfectly elastic demand for its product. On
the other hand, a monopolistic competitive firm faces a demand for its product which has elasticity less
than infinity.
10. Degree of monopoly power:
Degree of monopoly power, [ = P-M/ P], of a
perfectly
competitive firm is Zero. On the other hand, a monopolistic competitive firm has certain monopoly
power. Its degree of monopoly power is greater than Zero.

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11. Cost structure: Both Monopolistic competitive and perfectly competitive firms face same cost
structure; they have U- shaped cost curves.
12. Price charged: In the short run they may fix prices greater [lower] than their AC.

However, their long run prices no longer deviate from their AC, [P=LAC].
Though both charge prices equal to LAC, the level of their prices is significantly
different. As figure 008 shows, monopolistic competitive price [Pmc] is greater than the
perfectly competitive price [Pc]. Therefore, perfect competition is more socially desirable than
monopolistic competition.
13. Output produced: As figure shows, the competitive firm produces OXc level of output which is
greater than the output produced by the monopolistic competitive firm, OXmc. Therefore, perfect
competition is far superior to the monopolistic competition.
14. Profit enjoyed: Both the competitive firm and the monopolistic competitive firm enjoy normal profit
in the long run. Thus, neither the perfect competition nor the monopolistic competition leads to
aggravate the gap between the rich and poor in the society.
15. Capacity utilized: Under the perfect competition, firms produce the optimal level of output, the level
of output corresponding to the minimum point of the LAC curve. On the other hand, under monopolistic
competition firms produce suboptimal level of output. In other words, there is excess capacity under
monopolistic competition. This excess capacity is unavoidable under monopolistic competition. It means
that resources are wasted and the cost of production is high. On this ground, perfect competition is far
superior to monopolistic competition.

Conclusion:
This comparative analysis infers clearly that though the monopolistic competition
shares many of its features with perfect competition, the former perpetuates many evils which
take this market far behind the perfect competition as far as the social values are concerned.
Excess capacity, unwanted wastage of resources on advertisement, high cost and high price are a
few important evils of the monopolistic competition.
Monopolistic Competition and Social Welfare; A critical Analysis:
Competition among the sellers enhances social welfare. Social welfare is an inverse function of
degree of monopoly power. Monopoly, thus, is anti social, and it reduces the possible social welfare.
Theoretically speaking, it can utilize resources optimally but it will never do it as and when it functions
under private sector. It perpetuates various social evils. This is the rationale for nationalization of
monopolies.
Perfect competition, a standard model of market, on the other hand, is a socially desirable
market structure. It, according to scholars, is synonymous to Pareto Optimum. Pareto optimum, a
concept after the name of Wilfredo Pareto, is a configuration in which it is impossible to make any one
better of with out making at least one worse of. Maximum social welfare is a state of Pareto optimum.
However, perfect competition can achieve the Pareto Optimum only when it is free from externalities
and indivisibilities.
Monopolistic competition, a blend of Monopoly and Competition cannot attain the maximum
social welfare. Its evil features like, excess capacity and wastage of resources take it far away from

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maximum social welfare. It takes the economy and society to a sub optimal state of welfare. However,
compared to monopoly, Monopolistic competition is a better form market. It can take the society near
to Maximum social welfare.
Criticism of Chamberlains Model:
Though Chamberlain introduced many innovating ideas, tools and methods in the theory of firm, his
model is criticized on the following grounds:
1. Heroic assumption is unrealistic.
It is wrong to assume that all firms in the product group have identical cost structure and demand
conditions. Practically, they have different cost structure and demand conditions.
2. The assumption of Identical short runs is unrealistic.
In a highly dynamic and competitive business world, as the one we see in present days, each period
of time is different from others as far as decision making is concerned. Thus, optimal decision of a firm in
one period may not be optimal decision in another period.
3. Product differentiation does not match with free entry.
Theoretically as well as practically, product differentiation itself is a possible barrier to entry of new
firms. Thus, it is very difficult to combine product differentiation with free entry mechanism.
4. Myopic behavior of Chamberlains firm does not match to real market experience.
In actual business world, firms do learn from their past experience. They never think that others
wouldnt react to their actions. They are not nave firms. Their behavior is really sophisticated. They make
use of their rich experience to correct their mistakes.
5. Chamberlain under estimates the excess capacity.
Chamberlain interprets the excess capacity, with a little bias, in a different way to make it so mild a
problem. Excess capacity, definitely, is a curse of monopolistic competition. It shows under utilization and
the consequent wastage of valuable resources.
6. Lack of empirical evidence to the U- shaped average selling cost curve.
It is only for simplicity, Chamberlain uses the U- shaped average selling cost curve. So far, there is no
valid empirical support to this over simplification.
7. Chamberlains model cannot incorporate the modern theory of cost.
Chamberlains model cannot incorporate the modern theory of cost in which most of the cost curves
lack their conventional U- shape.
8. The model is based on the outdated Marginalist rule.
Validity of the Marginalist rule is little in modern economic literature. Modern theories of firm utilize
more relevant rules of equilibrium, like the mark up rule.

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9. The inference that the weakest firm first leaves the group is not matching with the assumption of
identical cost structure and demand conditions of individual firms.
10. It hardly facilitates an incorporation of non-profit goal of firms.
The model seldom explains goals of firms like, sales revenue maximization, satisficing behavior, long
run survival and entry prevention. Its scope is limited to profit maximization goal.
11. It fails to explain the market phenomenon of interdependence among firms regarding decision
making.
12. It does not explain a solution to firms behavior under conditions of collusion.
13. It does not explain the possibility of merging of firms.
These are the important points of criticism leveled against Chamberlins Large Group Model.
Path breaking contributions of Chamberlain:
Chamberlin has made some unique contributions to the theory of firms. They are as follows:
1.
2.
3.
4.
5.
6.
7.
8.

Introduction of product differentiation as a policy variable

Introduction of selling cost in to the theory of firm
Introduction of share-of-the market curve in to the theory of firm
Introduction of non-price competition in to the theory of firm
Treatment of excess capacity
Settlement of Cost Controversy
Made the base of Kinked Demand model
Normal profit with decreasing cost industry- a logically consistent explanation

Oligopoly
Meaning and Definition:
William Fellner defines oligopoly as competition among the few. According to William J.
Baumol and Alan S. Blinder, An oligopoly is a market dominated by a few sellers, at least several of
which are large enough relative to the total market to be able to influence the market price. Campbell
R. McConnell says, When a relatively small number of firms dominate the market for a good or service,
the industry is oligopolistic. All these definitions stress up on the relative fewness of firms in the
market. What is the actual range of this fewness? Most of the market theorists have an agreement
regarding this range as 2 to 15. If it is 2, it has its limiting form, called duopoly. Most market structures
that we see in the real world have an oligopolistic nature. As Baumol and Blinder say, in most forms of
market we see the domination of a small number of giant firms. They say further about oligopoly as,
Any oligopolistic industry includes a group of giant firms, each of which keeps a watchful eye on the
actions of the others. It is under oligopoly that rivalry among firms takes its most direct and active form.
Here one encounters such actions and reactions as the frequent introduction of new products, free

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samples and aggressive advertising campaigns. Firms are engaged in a continuing battle in which
strategies are planned day by day and each major decision can be expected to induce a direct response.
Firms worry price and try to understand their rivals behavior patterns.
An observation of the above definitions can help us to draw the following important points of
inferences about the oligopoly:
1. Relative fewness of sellers. The number of firms is small enough so that each has strong control
up on the market.
2. Interdependence among the sellers regarding the decision making. The policy of one firm affects
and is affected by the policies of all other firms.
3. Keen competition among the sellers. Competition is not only for a greater share of profit but for
the existence and survival in a situation of survival of the fittest, as well.
A few examples to oligopoly:
1. Suppliers of petroleum products in a small town.
2. Gas suppliers in a small town.
3. Vehicle manufacturers in a country.
4. Cellular Phone companies in a country.
5. Cement producers in a county.
6. Steel manufacturers in a county
7. Amusement parks in a big city.
8. Alcohol manufacturers in a county.
9. Aluminum manufacturers in a county.
Oligopolies may produce homogenous or differentiated goods. Examples to standardized
[homogenous] products in the oligopoly are: steel, zinc, copper, aluminum, led and industrial alcohol.
On the other hand, automobiles, tires, soaps and cigarettes are better examples to the differentiated
goods. Oligopoly in which standardized goods are supplied is called pure oligopoly. On the other hand,
oligopoly in which differentiated goods are supplied is called differentiated oligopoly.
Causes of oligopoly or the factors responsible for the emergence of oligopoly:
Following are the important factors responsible for the emergence of oligopoly:
1.
2.
3.
4.
5.

Economies of large scale production.

Merging of firms.
Patent right
Licensing
Technological advancement.

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6.
7.
8.
9.

Innovation.
Monopolistic ownership of strategically important raw materials.
Heavy and aggressive advertisement.
Lumpiness of capital.
Oligopolistic interdependence is a matter of reality in the actual market. However, firms may or
may not recognize this interdependence. If they do recognize, the oligopoly is called sophisticated
oligopoly. If they do not recognize the interdependence the oligopoly is called nave oligopoly. In real
world markets, most firms have much experience, so that they identify and recognize the reality of the
interdependence. Thus, most firms in the market are sophisticated firms and not naive. However,
naivety of firms cannot be discarded completely. There are also instances in which many firms do not
identify and recognize the interdependence, though it is a reality.
Oligopolistic interdependence leads to much uncertainty among the firms regarding their
decision making. Those who recognize the oligopolistic interdependence worry much about price and
aggressive advertisement. And those who do not recognize need not worry at all. But such nave firms
have to pay a high price for their ignorance. They will be too unfit to survive.
Those firms who recognize the oligopolistic interdependence may act in two possible ways. They
may act and react with out any collusion. This may bring about much uncertainty to them. This type of
oligopoly is called as non-collusive oligopoly. Non-collusive oligopoly may end up with a price war.
Chamberlin, however, tells us the possibility of monopoly solution of firms with out collusion, if they do
recognize their interdependence and act accordingly [small group model of chamberlain].
Many firms who recognize the oligopolistic interdependence better try to avoid the uncertainty
emerging out of the interdependence phenomenon. They engage in collusion, tacit or open. Open
collusion is illegal in many countries, and thus, firms are engaged in tacit collusion. Collusion is of many
types. The leading collusive oligopoly models are:
1. Cartels, and
2. Price leadership.
Cartels have its variants like,
1. Joint profit maximizing cartels
2. Profit sharing cartels
3. Market sharing cartels
Price leadership is seen mainly in the following forms:
1. Dominant firm price leadership.
2. Low cost firm price leadership, and
3. Barometric price leadership.
Features of Oligopoly:
Oligopoly, a more practical form of market, has a number of unique features. Most of these
features match much with the real world situations. Thus, most markets in the real world are
oligopolistic rather than monopolistic or monopolistic competitive. Its unique features like relative

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fewness of sellers and interdependence and keen competition among sellers make this form of market
more practical. Following are the important features of oligopoly market:
1. A few sellers.
Oligopoly is a market in which a few competing sellers dominate the market. As William Fellner
says, oligopoly is competition among the few. The number of sellers may be 2 to 15. It is called
duopoly, its limiting case, when it has 2 sellers. Oligopoly is an imperfect form of market which lies
between monopoly and monopolistic competition.
2. Large number of buyers.
Number of buyers, on the other hand, is very large. That is, no buyer in this market has any
degree of monopsony power.
3. Interdependence among firms.
Perhaps the most distinguishing feature of oligopoly is the interdependence among firms
regarding their decisions. The policy of one firm affects and is affected by the policies of all other firms.
For instance, a price cut policy of one firm may lead to a series of similar policies on the part of rival
firms. That is, each action of a firm is followed by reactions of other firms.
4. Uncertainty.
Uncertainty emerging out of oligopolistic interdependence is another unique feature of this
market. No firm can predict accurately the reactions of its rivals for its actions. This uncertainty makes
the demand curve of the firm indeterminate.
5. Greater role of advertisement.
As Baumol says, It is only under oligopoly the advertisement comes fully into its own.
6. Products may or may not be homogenous.
Oligopolies may produce homogenous or differentiated goods. Oligopoly in which standardized
goods are supplied is called pure oligopoly. On the other hand, oligopoly in which differentiated goods
are supplied is called differentiated oligopoly.
7. Barriers to entry.
There are strong barriers to entry in an oligopoly market. These barriers may be in the form of
lumpiness of capital, economies of large scale production, patent right, licensing, technological
advancement, innovation, and monopolistic ownership of strategically important raw materials.
8. Firms may or may not recognize interdependence.

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As already mentioned, under oligopoly there is very strong interdependence among firms
regarding their decision making. The firms, however, may or may not recognize this interdependence. .
If they do recognize, the oligopoly is called sophisticated oligopoly. If firms do not identify and
recognize the interdependence, the oligopoly is termed as naive oligopoly.
9. Firms may or may not enter into collusion.
Firms recognizing the interdependence may enter into a collusion to avoid the uncertainty. The
collusion may be in the form of cartels or price leadership. However, all firms who recognize the
interdependence may not enter into collusion. They may act and react with out any collusion. Such firms
may face the consequences of the uncertainty. The possibility of a monopolistic solution of firms is
remote in such a situation. Similarly, the firms who do not recognize the interdependence also may not
enter into collusion. They also may face the uncertainty of oligopolistic interdependence.
10. Indeterminateness of demand curve.
Oligopolistic interdependence and the resulting uncertainty in reactions of rivals make the
demand curve of the firm indeterminate. The demand, thus, has no predictive nature under oligopoly.
Actions and reactions of firms lead to frequent shifts in the demand curve. Thus, demand curve of the
firm is indeterminate under oligopoly.
11. Price stickiness.
Economists, like, R. L. Hall, C. I. Hitch and Paul M. Sweezy infer theoretically and empirically that
the price under oligopoly is sticky due to a kink appeared on demand curve.
Sweezys Kinked Demand Model:
We can see the origin of kinked demand curve in the large group model of Chamberlin.
However, he did not develop it as an analytical tool determining the price in his model. R. L. Hall and C.
I. Hitch in their popular work, Price Theory and Business Behaviour used the kinked demand curve not
as a tool of analysis for the determination of the price and output in oligopolistic market, but to explain
why the price, once determined on the basis of the average cost principle, will remain sticky. That is,
they used the kinked demand curve to explain the phenomenon of price stickiness under oligopoly, and
not as a price determining tool.
Paul M. Sweezy in an article, Demand under Conditions of Oligopoly, published in 1939,
applied the kinked demand curve as an analytical tool of price determination under oligopoly. His
model, popularly known as the Kinked Demand Model, is one of the important models of non-collusive
oligopoly. It gives us answer to the question why price once determined is seen as rigid for a long while.
It is a very flexible model which provides a long range of cost and demand in which price once charged
according to the marginalist principle remains unchanged.
Kinked demand curve.

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Demand curve of the oligopolist is formed by the segments of individual demand curve and
the share-of-the-market curve. The former is very elastic while the latter less elastic. By virtue of
experience, firms learn the following facts:
1. A price cut by a firm does not bring about much share of the market to it, since all other firms follow
the same price cut policy. Though the total market is enlarged by the price cut, the increased market is
shared among many firms. Thus, the individual gain is very small. Understanding this fact, firms identify
the share-of-the-market curve [less elastic one] as the relevant demand curve for a price cut.
2. On the other hand, a price boost made by one firm will be followed by no other firms. The firm made
the price hike will be a net looser since it misses a large number of its customers. Thus, the firms identify
the individual demand curve as their relevant demand curve for a price boost.
As figure 001 shows, dKD1 is the relevant demand curve of the oligopolists whose behavior is
not nave but sophisticated. KD1, the segment of share-of-the-market curve, is the demand curve for a
price cut and dK, the segment of individual demand curve, is the demand curve for a price boost. Only a
nave firm will expect XX2 increase of sales from a price cut from OP to OP1, and XX3 decrease of sales
from a price boost from OP to OP2. The sophisticated firm will expect the reality in increase [XX1] and
decrease [XX4] in sales for a price cut and price boost.
Thus, the oligopolists identify dKD1 as their demand curve. The demand curve, as figure
shows, has a kink at point K. It appears at the point of intersection of the individual demand curve and
share-of-the-market curve.
Marginal revenue curve, as figure 002 shows, has a discontinued segment, AB. This
discontinuity is due to the difference in the elasticity of the demand curves. The greater this elasticity
difference, the greater would be the length of discontinuity in the MR curve, and vice versa. As shown in
the figure 002, dABM is the MR curve which has its discontinued segment, AB, corresponding to the
point of kink at K.
Figure 001

296

Sweezy follows the marginlist rule of equilibrium in his model, however, with much flexibility.
Sweezy uses the conventional [U-Shaped] cost curves in his model. As shown in the figure 003,
discontinued segment, AB of the MR curve gives a long range of cost at which the equality between MR
and MC possible.
Figure 002

297

Price and output determination:

As already mentioned, Sweezy follows the neoclassical marginalist rule [MC=MR] of
equilibrium in his model. But this is not in the strict neoclassical line. Equality between MC and MR is
possible any where in the discontinued segment, AB, of the MR curve. Thus, we cannot find a point
of intersection between the MR and MC curves. As shown in figure 003, the firm is in equilibrium in
the discontinued segment, AB, of the MR curve where its MC=MR. This equilibrium takes place
corresponding to the point of kink at K. The price corresponding to the equilibrium is OP, and the
output OX.
According to Sweezy, the equilibrium price and output always happen corresponding to
the point of kink at K. Moreover, minor changes in costs or demand may not disturb the equilibrium
and the equilibrium price.

298

Figure 003

Changes in costs and the equilibrium price:

Figure 004

299

As shown in figure 004, the price and the equilibrium are unaffected by a change in
the cost. The cost curves shift upward from AC1 and MC1 to AC2 and MC2, but, they still fall in the
range of discontinuity. Thus, the equilibrium is undisturbed. Sweezy says, as long as the cost curves
pass through the discontinued portion of the MR curve, the equilibrium is undisturbed. Empirical
evidence also highlights this theoretical inference.
Changes in demand and the equilibrium price:
A change in demand may not always disturb the equilibrium. It may not affect the
price as long as the level of kink is unchanged, as shown in the figure 005. In the figure, demand
curve shifts from dKD to d1K1D1, but the level of kink is unchanged. It shifts from K to K1. The height
of the kink is unchanged. Thus, the price corresponding to the new equilibrium is maintained as OP.
Figure 005

Defects of kinked demand model:

1. It does not define the level at which price will be set in order to maximize the profits.
2. It does not define the level of price at which the kink will occur.
3. It is a theory explaining the phenomenon of oligopolistic price stickiness but not a theory of
price determination.
****************
Reference;
1. William J. Baumol and Alan S. Blinder, Economics: Principles and Policies,
Third Edition, Harcourt Brace Jovanovich Publishers, New York.

300

2. Campbell R McConnell, Economics: Principles, Problems and Policies

Seventh Edition, McGraw-Hill Book Company, New York
3. David C Colander, Economics, Forth Edition, McGraw-Hill Irwin, New York
4. A. Koutsoyannis, Modern Microeconomics, Second Edition, McMillan
5. Hall P. Varian, Intermediate Microeconomics, A Modern Approach Seventh Edition,
Affiliated East-West Press, W.W. Norton Company.
6. Watson and Getz, Price Theory and its Uses, Fifth Revised Edition, A.I.T.B.S.
Publishers& Distributors, Delhi
7. William J. Baumol, Economic Theory and Operation Analysis, Forth Edition,
Prentice-Hall of India Pvt. Ltd.
8 K.C. Roychowdhury, Microeconomics, Tata McGraw-Hill Publishers Company,
New Delhi.
Sample Questions:
Part A; Multiple Choice Questions:
1. Which of the following is the book written by E. H. Chamberlin?
A] Economics of Imperfect Competition. B] Principles of Economics. C] Economics of Monopolistic Competition. D]
Theory of Monopolistic Competition.
2. Which of the following is not suitable to monopolistic competition?
A] Price taker. B] Price maker. C] Profit maximiser. D] Sales promoter.
3. U shape of the average selling cost curve, according to Chamberlin, is due to economies and diseconomies in ----------------------A]. Production. B] Marketing. C] Management. D] Advertisement.
4. Monopolistic competitive firm is in equilibrium with ------------------ plant in the long run.
A] Optimal. B] Over optimal. C] Sub optimal. D] Critically minimal.
5. Who introduced selling cost in the theory of firm as a policy variable?
A] Joan Robinson. B] P. Sraffa. C] F. H. Knight. D] E. H. Chamberlin.
6. Discontinuity in the MR curve in Kinked Demand Model is due to difference in the ------------- of individual
demand and share-of-the-market curves.

301

A] Smoothness. B] Linearity. C] Elasticity. D] Shiftability.

7. Which of the following is the limiting case of oligopoly?
A] Duopoly. B] Monopoly. C] Monopsony. D] Bilateral Monopoly.
8. Products of monopolistic competitive firms are ------------------ substitutes.
A] Perfect. B] Close. C] Technical. D] Economic.
9. Which of the following is not an essential feature of oligopoly?
A] Fewness of sellers. B] Indeterminacy of demand. C] Price stickiness. D] Product differentiation.
10. Kinked Demand Model gives a satisfactory explanation of
A] Price stickiness. B] Collusion. C] Advertisement. D] Product differentiation.
Part B; Short Questions?
1. Define monopolistic competition.
2. Monopolistic competitive firm is a price maker. Explain.
3. What is the role of product differentiation in monopolistic competition?
4. Define oligopoly.
5. What is fancied differentiation?
6. Define duopoly.
7. Distinguish between price taker and price maker.
8. What is the reason for the U shape of the average selling cost curve?
9. What is excess capacity?
10. What does the share-of-the-market curve signify?
Part C; Short Essay Questions:
1. Briefly explain the excess capacity of monopolistic competitive firm.
2. Explain the concept of price stickiness under oligopoly.
3. What are the important causes of oligopoly?
4. What are the major differences between monopolistic competition and perfect competition?
5. Distinguish between fancied and real differentiation.
6. What makes a kink on the demand curve?

302

7. Explain the capacity utilization of a monopolistic competitive firm.

8. Explain the role of non-price competition in monopolistic competition.
9. Distinguish between perfect and close substitutes.
10. Explain the defects of Chamberlins Large Group Model.
Part D; Essay Questions:
1. Explain the Large Group Model.
2. Explain price and output determination under monopolistic competition.
3. Critically examine the Kinked Demand Model.
4. Explain the features of monopolistic competition.
5. Explain the features of oligopoly.
6. Compare monopolistic competition with perfect competition.
7. Explain the capacity utilization of monopolistic competitive and perfectly competitive firms.
8. Explain the long run equilibrium of monopolistic competitive firm.
9. Monopolistic competitive firm can reach at long run equilibrium only with normal profit. Explain.
10. Explain price stickiness under oligopoly.

303

7. MARKET FOR FACTORS OF

PRODUCTION; WHO GETS WHAT?
Theory of Distribution: Subject matter: Why do we require a separate theory for factor pricing?
Productivity Concepts: Total Physical Product [TPP]: Average Physical Product [APP]: Marginal Physical
Product [MPP]: Total Revenue Product [TRP]: Average Revenue Product [ARP]: Value of Marginal
Product [VMP]: Marginal Revenue Product [MRP]: Marginal Productivity Theory of Distribution:
Criticism of the theory: Modern Theory of Distribution: Derivation of Demand for factors of production:
Supply of Factors of Production: Factor Price Determination: Criticism of Modern Theory of Distribution:
Product Exhaustion Theorem: Factor pricing under conditions of Perfect competition in Product and
Factor Markets: Factor pricing under conditions of Perfect competition in Factor Market and imperfect
competition [monopoly] in Product Market: Factor pricing under conditions of Imperfect competition
both in Factor Market [monopsony] and in Product Market [monopoly]:

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THEORY OF DISTRIBUTION
Introduction:
Distribution occupies a pivotal role in Economic Theory. Thus, the theory of distribution is
widely discussed at scholarly and applied levels. It is interrelated to the theories of production and
consumption. The quantity of output produced depends up on the quantities of factors utilized as well
as their prices. The volume of consumption, similarly, depends not only up on the quantities of output
produced and their prices but up on the quantities of factors utilized and their prices, as well.
Subject matter:
Theory of distribution is concerned with distribution of national income or output among the
owners of different factors of production such as land, labour, capital, and enterprise. It also deals with
pricing of factors of production. According to Samuelson, Distribution is concerned with the
determination of different peoples incomes. It studies the problem of how the different factors of
production, land, labour, capital, and entrepreneurship and risk-taking are priced in the market.
The broad outlines of how the market mechanism distributes income are to be observed with
deep analytical skill. Each person owns some factors of production [inputs] in the production process.
Many of us have only our own labour; but some of us also have funds that we can lend, land that we can
rent, or natural resources that we can sell. These factors are sold in markets at prices determined by
their supply and demand. So the determination of income in a market economy is determined by the
level of employment of the factors of production and their prices. For example, if wages are rather high

305

and are fairly equal among workers, and if unemployment is low, then few people will be poor. On the
other hand, if wages are low and unequal, and unemployment is high, then many people will be poor.
As James Madison commends, the distribution of income is perhaps the one area in economics
in which any one individuals interests almost inevitably conflict with some one elses. If a larger share of
the total income is distributed to some, a small share will be left for others.
The theory of distribution has two branches as there are two types of distribution. Distribution
may be personal or functional. Personal distribution is the distribution of national income among the
persons or individuals in a country or region. The prime concern of such a distribution is an enquiry in to
the magnitudes and sources of income. The most crucial issue related to personal distribution is
assessment of inequality and its trend. Thus, it observes the gap between rich and poor in a society. It
observes and measures the inter-group, inter-regional and international income inequalities. The tools
like Laurence Curve are commonly used for this purpose. Observations and findings on inequalities in
personal distribution help governments to frame appropriate policies. Functional distribution, on the
other hand, deals with the principles governing the pricing of different factors of production. Factors of
production like land, labour, capital and organization render services in the production process. In
return of their services, payments are made to them in the form of rent, wage, interest and profit. Thus,
functional distribution deals with distribution of national income to various groups of owners of factors
of production.
Theory of functional distribution, the most frequently discussed one in the mainstream
economic theory, has two broad branches, namely, the macro theory of distribution and micro theory of
distribution.
The macro theory of distribution deals not with the factor pricing directly. Its subject matter is the
assessment of factor shares. Thus, the macro theory of distribution is often referred to as the theory of
distributive factor shares. It observes and measures the individual factor shares out of national income.
For example, it measures the share of wage out of national income [W/Y] and its trend. Classical
economists like Ricardo and modern economists like Kaldor were much interested in this type of
distribution, i.e., distributive factor shares. Many of their distribution theories highlight the root causes
of class conflicts in a society.
Microeconomics, however, deals more with micro theory of distribution. The micro theory of
distribution explains how the factor prices are determined under various market structures. The micro
theory of distribution, thus, is also called as theory of factor pricing. It, using the tools of economics like
demand and supply, deals with the determination of wage rate, rent rate, interest rate, and profit rate.
Why do we require a separate theory for factor pricing? The answer to this question is that factors of
production, unlike the products, have some peculiarities that necessitate a separate theory of factor
pricing. These peculiarities [reasons for a separate theory of factor pricing] are as follows:
1. Demand for factors of production is not direct but derived.
2. There is joint demand for factors of production.

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3. Specificity of most factors of production makes the assessment of their costs difficult.
4. Unlike products, by and large, there is no much relation between factor prices and factor supply.
For instance, rent may rise even when the supply of land is fixed.
Along with supply of factors of production, factor productivity levels have a strong bearing up on
factor prices. Demand for each factor of production depends up on its productivity. Thus, the concepts
of productivity have greater role in the theory of factor pricing.
Productivity Concepts:
Productivity of a factor of production signifies its capacity to turn itself in to output. For
example, 100 units of labour with the help of a few machineries produce 1000 units output. These 1000
units of output show the productivity of 100 units of labour.
Various useful Productivity Concepts are explained as follows:
1. Total Physical Product [TPP]: It is the total number of units of output produced by certain units
of a factor, say labour, given the quantities of all other factors of production. For example, 100
units of labour with the help of a few machineries produce 1000 units output. This total quantity
produced can be called as the total physical product. It is a concept of productivity in physical
term.
2. Average Physical Product [APP]: It is number of units of physical product produced per unit of a
specific factor of production, say labour. It is a concept of productivity in physical term. It is the
ratio of total physical product to the number of unit of a specific factor of production, say
labour. That is, APPL=TPP/L. Where the L is the number of unit of labour.
3. Marginal Physical Product [MPP]: It is the addition made to total physical product by the
employment of one more unit of the specific factor of production, say labour. It also is a concept
of productivity in physical term.
MPPn = TPPn TPPn-1
4. Total Revenue Product [TRP]: It is the amount of money received by the producer from the sale
of total physical product. Suppose the producer gets Rs.2000 from the sale of total physical
product equal to 1000 unit. Here Rs.2000 is accounted as TRP.
5. Average Revenue Product [ARP]: It is the revenue product per unit of the specific factor of
production, say labour. It is the ratio of Total Revenue Product to the number of unit of the
specific factor of production, say labour. That is,
ARPL = TRP/ L.
6. Value of Marginal Product [VMP]: It is market value of the marginal physical product. It can be
measured as:
VMP = MPP x P,
Where, P=Market Price.

7. Marginal Revenue Product [MRP]: It is addition to the total revenue product

[TRP] by the employment of one more unit of the specific factor of production,
say labour. Symbolically, MRPL of nth unit of labour is:

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MRPn = TRPn TRPn-1.

MRP can be measured as:
MRP = MPP x MR
MRP and VMP are very useful concepts which explain a number of practical problems of
factor market like monopolistic and monopsonistic exploitation. MRP and VMP have same nature under
conditions of perfect competition in product market. But they have different nature under conditions of
imperfect competition in product market.
Illustration:
Under conditions of perfect competition in product market, AR = MR as price being a
constant. Thus, the MRP is equal to VMP under conditions of perfect competition in product market.
That is,
VMP = MPP x P,

Where, P=AR

MRP = MPP x MR
Since

MR = AR [or P],

VMP = MRP

However, under conditions of imperfect competition in product market, VMP deviates from
MRP. This is due to the discrepancy between MR and AR. Under imperfect competition in product
market, price of the product is not a constant but a variable. As price falls, the AR and MR keep a
decreasing trend when quantity output expands. Moreover, AR exceeds MR and the gap between AR
and MR is widening.
Thus, VMP = MPP x P
MRP = MPP x MR
Since

P or AR > MR
VMP > MRP

That is, VMP > MRP under conditions of imperfect competition in product market.

Table 001

MPP
in kg

TPP in
kg

Labou
r
Units

PRODUCTIVITY TERMS
IN PERFECT COMPETITION

308

IN IMPERFECT COMPETITION

MRP in Rs.

VMP in Rs.

MR in Rs.

AR in Rs.

MRP in Rs.

VMP in Rs.

MR in Rs.

AR in Rs.

6 25 25 150 150 25 25 150 150

14

8 25 25 200 200 24 23 192 184

24

10 25 25 250 250 23 21 230 210

36

12 25 25 300 300 22 19 264 228

50

14 25 25 350 350 21 17 294 238

66

16 25 25 400 400 20 15 320 240

80

14 25 25 350 350 19 13 266 182

92

12 25 25 300 300 18 11 216 132

102 10 25 25 250 250 17 9

170

90

10

110

8 25 25 200 200 16 7

128

56

11

116

6 25 25 150 150 15 5

90

30

12

120

4 25 25 100 100 14 3

56

12

13

122

2 25 25

26

50

50

13 1

Table 001 shows different productivity terms and their trends with respect to changes in the
quantity of labour inputs employed in production.
Graphical Illustration of VMP and MRP:
1. VMP and MRP under perfect competition in product market:
Figure 001

309

2. VMP and MRP under imperfect competition in product market:

Figure 002

3. MRP and ARP:

Figure 003

310

Marginal Productivity Theory of Distribution:

Marginal productivity theory of distribution is one of the most popular theories of
distribution. Its foundation was made by economists like David Ricardo. But it got its full blossom by the
intellectual works of economists like Wicksteed, Jevons, Wicksell, Clark, Marshall, Hicks, and Friedman. It
has a number of versions. The Neoclassical version is the most popular one. It can explain the pricing of
all factors, at least theoretically. Thus, this theory is also known as the general theory of distribution.
The most important point of inference of this theory is that under conditions of perfect
competition and constant returns to scale, in a static economy, the price of every factor of production is
equal to its respective marginal product.
Assumptions of the theory:
1. Perfect competition both in product and factor markets.
2. The economy is static; population, capital stock and technology are constant.
3. Producers are rational; trying to maximize profits.
4. Constant returns to scale.
5. Factor units are homogenous.
6. Perfect mobility of factors.
7. Factors are perfectly divisible.
8. Full employment.
9. Absence of externality.
10. Law of diminishing returns.
11. Factor supply is perfectly elastic.
Figure 004

311

Based on these assumptions, the theory infers the following points:

1. The price of every factor is equal to its respective marginal product:
Given the perfect competition both in product and factor markets, firm is a price taker, both
as seller of output and as buyer of factors of production. Thus, its VMP=MRP. Moreover, it faces MFC
[marginal factor cost] curve which is a horizontal straight line. This straight line also represents the AFC
[average factor cost] since MFC=AFC. It means that the firm is unable to affect the market price of
factors being it a small one among a multitude.
In figure 004, MFC, AFC and MRP [equal to VMP] are taken vertically. Units of labour are taken
horizontally, assuming labour is the factor whose price is to be determined. The producer who employs
labour is in equilibrium when his MFC [marginal wage] is equal to MRP and the slope of the MFC curve is
greater than that of MRP curve [MRP cuts the MFC from above]. The producer is in equilibrium at point
E where his MFC = MRP and the slope of the MFC curve is greater than that of MRP curve.
Corresponding to this equilibrium, the firm employs L2 units of labour at the wage equal to W.
2. Factor prices are equal to both MRP and ARP in the long run:
Competition, both in product and factor markets, makes the firms able to enjoy just normal
profit and discards the possibility of super normal profit and loss. Thus, all firms in the long run will have
an equilibrium position with AFC = MFC = MRP = ARP. This is explained in figure 005:

312

In figure 005, the firm is in equilibrium at point E where its AFC = MFC = MRP = ARP.
Corresponding to this equilibrium, the firm employs Le units of labour at the wage equal to W.
Figure 005

3. Homogenous factor prices with in the firm in the long run:

Competition, both in product and factor markets, ensures equal rates of rewards to all
factors employed by the firm.
4. Homogenous factor prices in the industry in the long run:
Competition, both in product and factor markets, ensures equal rates of rewards to all
factors employed by all firms in the whole industry.
Criticism of the theory:
1. Production is a combined effort of many factors. It is impossible to isolate the contribution of a
particular factor.
2. Marginal productivity cannot be measured accurately.
3. Inapplicable under imperfect competition.
4. It cannot explain exploitation problem.
5. Factors may be varyingly productive in different firms and industries.
6. Based on defective Law of Diminishing Returns.
7. It explains the level of employment of factors but not the determination of factor prices.
8. It neglects the supply side.
9. No regard to selling costs, transport costs and other costs other than production costs.

313

10. Producers may not be always rational.

11. Factors are not divisible.
12. Fail to incorporate externality.
Modern Theory of Distribution:
Modern Theory of Distribution emerged as an attempt to overcome the limitations of the
marginal productivity theory of distribution. It, unlike the marginal productivity theory, gives due
regards to both supply and demand factors in factor pricing. Thus, it is also known as the supply and
demand theory of distribution. Modern Theory of Distribution is an extension of the general theory of
value.
According to Modern Theory of Distribution, like the price of a product, factor price is
determined by demand and supply forces.
Assumptions:
1. Perfect competition both in product and factor markets.
2. Factor units are homogenous.
3. The Law of Variable Proportions holds good.
4. Factors are perfectly divisible.
5. Perfect mobility of factors.
6. Full employment.
Derivation of Demand for factors of production:
As far as an individual firm is concerned, its MRP curve of a factor guides it as its demand
curve. It shows various quantities of factors demanded at each factor price. Accounting the number of
firms in the industry, we can find the industry demand for the factor at each price through the
horizontal summation. It is explained in figure 006. First part of the figure 006 shows the position of an
individual firm and the second part the demand for the factor for the whole industry. DD, the demand
curve of the industry is derived from the first part of the figure. Points Q, R and S are derived from the
equilibrium points of the firm, A, B and C, respectively.
Figure 006

314

The demand curve of the factor has a negative slope reflecting the inverse relation between
the quantity demanded of the factor and its price.
Supply of Factors of Production:
Figure 007

315

As figure 007 shows, factor owners like to supply more quantity of factors at high prices, and
vice versa. Thus, according to modern theory of distribution, the quantity supplied of a factor is an
increasing function of its price. Slope of the curve SS in the above figure shows this direct relation
between quantities supplied of a factor and its price.
Factor Price Determination:
According to Modern Theory of Distribution, like the price of a product, factor price is
determined by demand and supply forces. Factor price determination is explained in figure 008. In the
figure, DD is the demand and SS the supply curves of the factor, say labour, for the whole industry. The
industry is in equilibrium at point E where the demand and supply curves of the factor intersect each
other. The equilibrium price so determined is W and the equilibrium level of employment is N. The price
may vary corresponding to changes in demand and supply.
Figure 008

316

Criticism of Modern Theory of Distribution:

Like the Neoclassical theory of distribution [MPTD], the modern theory of distribution also
has some defects. Following are the important points of criticism leveled against the modern theory of
distribution.
1. Not applicable under imperfect competition.
2. Full employment is unrealistic.
3. Factors are indivisible.
4. Fail to incorporate externalities.
5. Fail to admit costs other than production costs.
6. The Law of Variable Proportions is unrealistic.
7. Perfect mobility of factors does not exist in the real world.
8. Factor units are not homogenous in the real world.
Product Exhaustion Theorem:
Product Exhaustion Theorem has a number of versions. Its original versions are associated
with economists like Clark, Walras, Wicksel, and Wicksteed. We may explain the original version of the
theorem as follows:
According to Product Exhaustion Theorem, under conditions of Perfect competition and
Constant Returns to Scale, the total product will be exhausted when all factors are rewarded according
to their respective marginal productivity.

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Let us assume that there are only two factors, say, labour and capital, used in the process
of production. Then, the total product, X, is equal to the sum of shares of labour and capital. That is:
X = Share of Labour + Share of Capital.
When factors are rewarded according to their respective marginal productivity, the factor shares will be
as follows:
X = L.MPL + K. MPK

Taking this equation in Cobb-Douglas form, we get:

X = L. b1 X/L + K. b2 X/K
= X [b1+ b2]
Since the production function is linearly homogenous, b1+ b2 = 1
Thus,

X = X. 1
X=X

That is, product is exhausted.

Product exhaustion theorem is illustrated in the following figure:
Figure 009

318

In the figure 009, output is shown vertically and the units of factor, say labour, horizontally.
TP is the total product curve whose slope is the marginal product. At point B, the marginal product is
equal to the slope of the tangent CD. It is equal to BA / CA. It is again equal to BA / OL. That is, MPL at
point B = X/L = BA / OL.
Now, share of labour = OL. X/L
= OL. BA / OL
= BA
Given the equation X = L.MPL + K. MPK,
= L. X/L +K. X/K, we have:
K. X/K = X - L. X/L
= B L BA = AL
That is,

X = L.MPL + K. MPK
= AB + AL = Total Product = BL

It means that the total product is exhausted when it is distributed between labour and capital according
to their respective marginal productivity.

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Factor Pricing in Different Markets:

With the help of the productivity concepts, MRP, VMP, ARP, MFC and AFC, we can explain the
factor pricing in different markets. The condition of equilibrium of a firm, as far as the employment of a
factor of production is concerned, is:
1. First order condition: MRP=MFC, and
2. The second order condition: Slope of MFC curve > Slope of MRP curve.
1. Factor pricing under conditions of Perfect competition in Product and Factor Markets:
Under conditions of perfect competition in product market, AR = MR, as price being a constant.
Thus, the MRP is equal to VMP under conditions of perfect competition in product market. That is,
VMP = MPP x P,

Where, P=AR

MRP = MPP x MR
Since

MR = AR [or P],

VMP = MRP

Graphical Illustration of VMP and MRP:

Figure 010

Given the perfect competition both in product and factor markets, firm is a price taker,
both as seller of output and buyer of factors of production. Thus, its VMP=MRP. Moreover, it faces MFC
[marginal factor cost] curve which is a horizontal straight line. This straight line also represents the AFC
[average factor cost] since MFC=AFC. It means that the firm is unable to affect the market price, being it
a small one among a multitude.

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Factor pricing under conditions of Perfect competition in Product and Factor Markets can
be explained by a figure as follows:
Figure 011

In figure 011, the firm is in equilibrium at point E where the conditions of equilibrium,
MRP=MFC, and Slope of MFC curve > Slop of MRP curve, are fulfilled. The firm in its attempt to
maximize profits employs Le quantity of factor at the factor price equal to W.
2. Factor pricing under conditions of Perfect competition in Factor Market and imperfect competition
[monopoly] in Product Market:
Given the perfect competition in factor markets, firm is a price taker, as a buyer of factors
of production. It faces MFC [marginal factor cost] curve which is a horizontal straight line. This straight
line also represents the AFC [average factor cost] since MFC=AFC. It means that the firm is unable to
affect the market price, being it a small one among a very large number of firms in the industry.
But the position of the firm in the product market is different. Here the firm is not a price
taker but a price maker. Its MR is less than AR. Thus, its VMP > MRP

Proof:

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MRP = MPP x MR and VMP = MPP x P

Since

P or AR > MR
VMP > MRP.

Factor pricing under conditions of Perfect competition in Factor Market and Imperfect
competition in Product can be explained by a figure as follows:
Figure 012

In figure 012, the firm, monopolist in the product market, is in equilibrium at point E where
its MRP=MFC. The firm pays a factor price, say wage, equal to OW. It is less than the VMP. That is, wage
paid is less than the VMP. The gap between Wage and VMP is AE. This shows the exploitation under
monopoly. Mrs. Joan Robinson calls it as the monopolistic exploitation.
3. Factor pricing under conditions of Imperfect competition both in Factor Market [monopsony] and in
Product Market [monopoly]:
The firm is not a price taker but a price maker in both product and factor markets. Its MR is
less than AR. Thus, its VMP > MRP. Being a monopsonist, the firm can affect the factor price by changing

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its demand. Thus, its MFC and AFC curves have positive slope. Moreover, the MFC at any level of
employment is greater than the AFC.
Factor pricing under conditions of Imperfect competition both in factor market
[monopsony] and in product market [monopoly] can be explained by a figure as follows:

Figure 013

In figure 013, the firm is in equilibrium at point E where its MFC=MRP. Corresponding to
this equilibrium, the firm employs OL quantity of labour. However, the firm pays only a wage equal to
LW as determined by the AFC [also represents the supply of labour].
Here, the actual wage paid is LW. It is less than the MRP by the extent WE. Mrs. Joan
Robinson calls this difference between wage and MRP as the monopsonistic exploitation. In this
particular market situation, as figure shows, labour [or any other factor other than organization] is
undergone for two types of exploitation - WE the monopsonistic exploitation and EA the monopolistic
exploitation.
Reference Books:

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1. A. Koutsoyannis, Modern Microeconomics, Second Edition, McMillan

2. Campbell R McConnell, Economics: Principles, Problems and Policies
Seventh Edition, McGraw-Hill Book Company, New York
3. David C Colander, Economics, Forth Edition, McGraw-Hill Irwin, New York
4. William J. Baumol and Alan S. Blinder, Economics: Principles and Policies,
Third Edition, Harcourt Brace Jovanovich Publishers, New York
5. Hall P. Varian, Intermediate Microeconomics, A Modern Approach Seventh Edition,
Affiliated East-West Press, W.W. Norton Company.
6. K.C. Roychowdhury, Microeconomics, Tata McGraw-Hill Publishers Company,
New Delhi.
7. William J. Baumol, Economic Theory and Operation Analysis, Forth Edition,
Prentice-Hall of India Pvt. Ltd
8. Watson and Getz, Price Theory and its Uses, Fifth Revised Edition, A.I.T.B.S.
Publishers& Distributors, Delhi

Sample Questions:
Multiple Choice Questions:
1. MPP multiplied by MR is called
A] MRP. B] VMP. C] AR. D] TR.
2. Factor pricing belongs to the -------------------- theory of distribution.
A] Personal. B] Macro. C] Functional. D] General.
3. The situation in which a single firm is the sole buyer of labour power from labour market where labourers
are organized under a single trade union is a case of
A] Monopoly. B] Monopsony. C] Bilateral monopoly. D] Bilateral monopsony.
4. Quasi rent is the short run reward of -------------A] Land. B] Capital. C] Organisation. D] Labour.
5. --------------------- theory is also known as the general theory of distribution

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A] Eulers. B] Marginal productivity. C] Ricardian. D] Liquidity preference.

6. According to --------------, under conditions of Perfect competition and Constant Returns to Scale, the total
product will be exhausted when all factors are rewarded according to their respective marginal productivity
A] Law of diminishing returns. B] Law of variable proportions. C] Product exhaustion theorem. D] Equimarginal utility principle.
7. Demand for factors of production is ---------------- demand
A] Direct. B] Derived. C] Indirect. D] Effective.
8. MPP multiplied by price is equal to
A] VMP. B] MRP. C] ARP. D] AR.
9. Distribution is concerned with the determination of different peoples incomes. It studies the problem of
how the different factors of production, land, labour, capital, and entrepreneurship and risk-taking are priced
in the market.
A] Marshall. B] Robinson. C] Pigou. D] Samuelson.
10. --------------------- is equal to Total Revenue Product divided by quantity of labour
A] ARP. B] AP. C] AR. D] MRP.
Short questions:
1. Define MRP.
2. What is monopolistic competition?
3. State the Eulers product exhaustion theorem.
4. Define VMP.
5. What is TRP?
6. Define marginal product.
7. What is functional distribution?
8. Define monopsonistic exploitation.
9. Define ARP.
10. What is meant by monopsony in labour market?
Short Essay Questions:
1. Distinguish between monopolistic and monopsonistic exploitation.
2. Distinguish between functional and personal distribution.

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3. Briefly explain the Marginal productivity theory of distribution.

4. Explain Eulers Product Exhaustion theorem.
5. Explain the market situations in which workers are exploited.
Essay Questions:
1. Explain the factor pricing under conditions of perfect competition in both factor and product markets.
2. Briefly explain the modern theory of distribution.
3. Briefly explain the important productivity concepts.
4. Explain the role and significance of distribution theory in economics.
5. Demand for factors is derived demand, explain.

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8. WELFARE ECONOMICS; WHAT

OUGHT TO BE?
Social Welfare: Meaning and definition: Criteria of Social Welfare: Gross National Product: Benthams
Criterion: Cardinalist Criterion: Pareto Optimality Criterion: Kaldor-Hicks Compensation Criterion:
Bergsons Criterion: Marginal Conditions of Pareto Optimality: Maximum Social Welfare: Grand utility
possibility frontier: Social welfare function: Welfare maximising state or The Point of Bliss:
Determination of the Welfare Maximising Output Mix: Welfare Maximisation and Perfect Competition:

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Welfare Economics
Meaning and definition:
Welfare economics is that part of general economic theory which aims at evaluating alternative
social states with the objective of suggesting ways to improve social welfare. It, prima fassie, is a
normative branch of economics which deals with the problem of what aught to be and not what is.
While positive economics attempts to explain and predict economic phenomena, the welfare economics
attempts to investigate the social desirability of these phenomena, and prescribes appropriate policies
to make desirable changes in economic phenomena. Thus, welfare economics is prescriptive and not
descriptive like the positive economics. Welfare economics has its essential concern over evaluating
alternative economic situations from the point of view of the society and individual. The choice of one
economic position out of different positions involves a value judgment. Thus, unlike the positive
economics, welfare economics involves value judgments. In fact, all the ethical judgments or statements

328

related to good or bad, desirable or undesirable, made whether in an explicit or implicit way, are the
value judgments. As all value judgments are subjective, differences of opinion are bound to arise among
different individuals and groups making judgments.
Criteria of Social Welfare:
As already mentioned, welfare economics is concerned with evaluating alternative economic
situations with the objective of finding ways to realize the most desirable welfare configuration. For
instance, given the factor endowment and technology, there is a current level of social welfare, W,
which is compared with welfare situation, W*, where W* is superior to W. Welfare economics aims at
comparing W with W* and also to bring forth the W* in lieu of W.
To evaluate alternative economic situations we need some criteria of social welfare. Various
criteria of social welfare have been suggested by economists from time to time. Following are some of
the important criteria of social welfare:
1. Gross National Product:
Economists like Adam Smith accepted the growth of wealth of the economy [GNP] as a welfare
criterion. To them social welfare is an increasing function of the GNP since latter enhances the level of
employment and consumption in the economy. They believed that every increase in GNP reduces the
gap between W and W*, where W is the current level of social welfare and W* the maximum social
welfare.
The GNP criterion, however, does not take the distributional effects of economic changes.
Social welfare depends not only upon the efficient allocation of resources and the resulting growth of
GNP, but the distribution of the increased income or wealth among the people. If growth aggravates the
inequality, economic welfare cannot be said as increased. Thus, GNP criterion as such cannot be
accepted as a social welfare criterion. It should be analysed in the light of growth-equity controversy.
2. Benthams Criterion:
Jeremy Bentham, the father of Utilitarianism in England, developed a social welfare criterion
which is popular in the name Benthams Dictum. Benthams criterion is stated as, the greatest good
for the greatest number. It means that any social or economic change is an improvement on social
welfare if it leads to the greatest good (is secured) for the greatest number. The assumption implied in
this principle is that the social welfare is the sum of utilities of individuals in the society. For instance, if
there are three individuals, A, B and C, in a society, the social welfare can be expressed as:
W = UA + UB + UC
Where, W is the social welfare, UA, the utility of A, UB, the utility of B and UC, the utility of C.
Given this condition, there is an improvement in social welfare when UA + UB + UC is greater
than zero. For instance, an increase in UA + UB > a decrease in UC leads to an improvement in social

329

welfare. This is because it satisfies the conditions, 1) greatest good and 2) greatest number. In other
words, two individuals are better off while one individual worse off after the change has taken place,
but the sum of increase in utility of A and B is greater than the decrease in utility of C.
Benthams criterion, obviously, implies that A and B have a greater worthiness than C. that is,
implicit in Benthams criterion is an interpersonal comparison of the deservingness of the members of
the society. There is another difficulty with the application of Benthams criterion. This criterion cannot
be applied to compare situations where the greatest good and greatest number do not exist
simultaneously. For example assume that in a situation UA = 200, UB = 50, UC = 30, so that the total utility
in the society is 280. In another situation assume that a change occurred and UA = 100, UB = 80, and UC =
80, so that the total utility is 260. The first situation has the greatest good (280 > 260), but the second
involves a more even distribution (of smaller total good) among the greatest number.
3. Cardinalist Criterion:
Many economists proposed the use of the law of diminishing marginal utility as a criterion of
welfare. This cardinalist criterion holds that when the income or wealth of an individual increases, his
marginal utility diminishes. Thus, distribution of income and wealth has a strong bearing upon the social
welfare. This argument can be illustrated by the following example.
Assume that the society consists of three individuals; A has an income of Rs1000, while B and C
have an income Rs500 each. Consumer A can buy double quantities of goods as compared to B or C.
However, given the law of law of diminishing marginal utility, As total utility is less than double the total
utility of either B or C, because As marginal utility of money is less than that of B or C. In such a
situation, a redistribution of income in favour of B and C [an even distribution] will increase the social
welfare.
Cardinalist Criterion also has some limitations. It assumes that all individuals have identical
utility functions for money, so that with an equal income distribution all would have same marginal
utility of money. This assumption is highly restrictive. Individuals differ in their attitude towards money.
Critics also pointed out that the welfare effects of distribution cannot be explained in isolation from the
effects of resource allocation and incentives for works of different individuals.
4. Pareto Optimality Criterion:
Pareto Optimality Criterion refers to economic efficiency which can be objectively measured. It is
called after the name of the Italian economist Vilfredo Pareto. According to this criterion, any change
that makes at least one individual better off and no one worse off is an improvement in social welfare.
Such a change is Pareto Efficient.
A state in which it is impossible to make any one better off without making at least one worse
off is called Pareto Optimal. For the attainment of Pareto Optimality in an economy three marginal
conditions must be satisfied: a) Efficiency in distribution of goods among consumers (Efficiency in

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Exchange); b) Efficiency in allocation of factors among firms (Efficiency in Production); c) Efficiency in

allocation of factors among commodities (Efficiency in Product Mix).
Pareto criterion, however, fails to evaluate certain situations. It cannot evaluate situations
where a change makes some individuals better off and others worse off. Most governmental policies are
beneficial to some people while detrimental to others. We cannot use the Pareto criterion to evaluate
such policies.
5. Kaldor-Hicks Compensation Criterion:
Nicholas Kaldor and John Hicks suggested the following approach to establish a welfare criterion.
Assume that a change in the economy is being considered, which will benefit some [gainers] and
hurt others [losers]. One can ask the gainers how much money they would be prepared to pay in
order to have the change, and the losers how much money they would be prepared to pay in order to
prevent the change. If the amount of money of the gainers is greater than the amount of the losers,
the change, constitutes an improvement in social welfare, because the gainers could compensate the
losers and still have some net gain. Thus, the Kaldor-Hicks compensation criterion states that a
change constitutes an improvement in social welfare if those who benefit from it could compensate
those who are hurt, and still be left with some net gain.
The Kaldor-Hicks compensation criterion evaluates alternative situations on the basis of
monetary evaluation of different persons. Thus it implicitly assumes that the marginal utility of money is
the same for all the individuals in the society. Given that the income distribution is unequal in the real
world, this assumption is absurd. Assume, for example, that the economy consists of two individuals, A,
who is a millionaire and B, who has an income of Rs4000. Suppose that change (being considered by the
government) will benefit A, who is willing to pay Rs2000 for this change to happen, while it will hurt B,
who is prepared to pay Rs1000 to prevent the change. According to the Kaldor-Hicks compensation
criterion the change will increase the social welfare (since the net gain to A, after he compensates B, is
Rs1000). However, the gain of Rs2000 gives very little additional utility to millionaire A, while the loss
of Rs1000 will decrease a lot the wellbeing of B, who has a much greater marginal utility of money than
A. Thus the total welfare will be reduced if the change takes place. Only if the marginal utility of money
is equal for all the individuals would the Kaldor-Hicks compensation criterion be a correct welfare
measure. This criterion ignores the existing income distribution. In fact this criterion makes implicit
interpersonal comparison, since it assumes that the same amounts of money have the same utility for
individuals with different incomes.
6. Bergsons Criterion:
The various welfare criteria so far explained show that when a change in the economy benefits
some individuals and harms others it is impossible to evaluate it without making some value judgment
about the deservingness of the different individuals or groups. Bergson suggested the use of an explicit
set of value judgment in the form of a social welfare function. A social welfare function is analogous to
the individual consumers utility function. It provides a ranking of alternative states in which different

331

individuals enjoy different utility levels. If the economy consists of two individuals the social welfare
function could be presented by a set of social indifference contours (in utility space) as shown in figure
001. Each curve is the locus of combinations of utilities of A and B which yield the same level of social
welfare. The further to the right a social indifference contour is, the higher the level of social welfare will
be. With such a set of social indifference contours alternative states in the economy can be
unambiguously evaluated. For example, a change which would move the society from point B to C (or D)
increases the social welfare. A change moving the society from A to B leaves the level of social welfare
unchanged.
Figure 001

Marginal Conditions of Pareto Optimality:

There are three important marginal conditions of Pareto optimality. They are as follows:
1) Efficiency in distribution:
According to the Pareto Optimality criterion, a distribution of the given commodities X and Y
between two consumers is efficient if it is impossible by a redistribution of these goods to increase the
utility of one individual without reducing the utility of the other. In figure 002, we show the Edgeworth
box for the given commodities X and Y.
The marginal condition of efficiency in distribution is:

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MRS(A)xy = MRS(B)xy
Where, MRS(A)xy is the marginal rate of substitution of A between X and Y goods, and MRS(B)xy, the
marginal rate of substitution of B between X and Y goods. All points on the curve OAOB (Edgeworth
Contract Curve) are fulfilling this marginal condition.

Figure 002

Combination N which is away from the contract curve, on the other hand, is inferior to all
points on the contract curve. A movement from N to A shows an increase in Bs satisfaction without a
change As satisfaction. Similarly, a movement from N to B shows an increase in As satisfaction without
a decrease in Bs satisfaction. If the movement is from N to a point which lies between A and B,
satisfaction of both A and B increases. It means that all points on the contract curve are Pareto optimal.
2) Efficiency in allocation:
The marginal condition of efficiency in allocation of factors between two firms is:
MRTS(X)LK = MRTS(Y)LK
Where, MRTS(X)LK is the marginal rate of technical substitution between labour and capital in X good,
and MRTS(Y)LK is the marginal rate of technical substitution between labour and capital in Y good.

333

The marginal condition of efficiency in allocation is explained in figure 003. All combinations on
the contract curve satisfy the marginal condition, and hence, are optimal. Combination M, away from
the contract curve, is inferior to all combinations on the contract curve. A movement from M to A shows
an increase in Y good without a decrease in X good. Similarly, a movement from M to B shows an
increase in X good without a decease in Y good. On the other hand, a movement from M to any point
between A and B shows increase both in X and Y goods. It means that all combinations on the contract
curve are Pareto optimal. On the contract curve, it is impossible increase the quantity of one good
without reducing the quantity of the other.

Figure 003

3) Efficiency in product-mix:
Figure 004

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The marginal condition of optimal product-mix is:

MRPTxy = MRS(A)xy = MRS(B)xy
Where, MRPTxy is the marginal rate of product transformation between X and Y goods, MRS(A)xy, the
marginal rate of substitution of A between X and Y goods, and MRS(B)xy, the marginal rate of
substitution of B between X and Y goods. Since the MRPT shows the rate at which a good can be
transformed into another, and the MRS shows the rate at which consumers are willing to exchange a
good for another, the rates must be equal for a Pareto optimal situation to be attained.
To show this condition we use the production possibility curve and the indifference curve of a
representative consumer together. Point E in figure 004 satisfies the marginal condition of efficiency in
product mix. For attaining optimality the economy has to produce OX quantity of X good and OY
quantity of Y good.
A situation may be Pareto optimal without maximising social welfare. However, welfare
maximisation is attained only at a situation that is Pareto optimal. In other words, Pareto optimality is a
necessary but not sufficient condition for welfare maximisation.
Maximum Social Welfare:
We may explain the situation of maximum social welfare which, as already mentioned, is a
situation of Pareto optimum. However, all situations of Pareto optimum are not a situation of maximum
social welfare. In other words, Pareto optimality is a necessary but not sufficient condition for welfare
maximisation.

335

We need two tools to explain [graphically] the state of maximum social welfare. They are:
1. Grand utility possibility frontier:
Grand utility possibility frontier is derived from the production possibility curve. More
specifically, each point of the PPC gives rise to a utility possibility frontier and the curve which envelopes
all these utility possibility frontiers is called the grand utility possibility frontier [GUPF]. Each point of the
GUPF satisfies the marginal conditions of the Pareto optimum.
Figure 005

2. Social welfare function.

Social welfare function is shown by the social indifference contours. Each social indifference
contour shows a particular level of social welfare corresponding to different combinations individuals
satisfaction. A set of social indifference contours shows alternative states of social welfare. The higher
the social indifference contour the higher will be the level of social welfare.
Welfare maximising state or The Point of Bliss:
Maximum social welfare is realised at a point where the grand utility possibility frontier is
tangent to the highest possible social welfare function. Figure 005 shows the point at which the
maximum social welfare is realised. Point W* is the bliss point [the point of maximum social welfare] in
figure 005. Point W* shows the maximum social welfare in the economy, given the GUPF and social
welfare function. The figure also shows that all situations of Pareto optimum are not the state of
maximum social welfare. For instance, point W is on the GUPF, and thus, is Pareto optimal. It is a point

336

on the social indifference curve W1. Point N, on the other hand, is not on the GUPF. However, it is on a
higher social indifference curve [W1] compared to the point W. Point N is not Pareto optimal but it
shows higher social welfare compared to point W. Point W is Pareto optimal but point N is not. It means
that the mere existence of Pareto optimum does not guarantee the maximum social welfare. In other
words, Pareto optimality is a necessary but not sufficient condition for welfare maximisation.
Determination of the Welfare Maximising Output Mix:
The Bliss point shows the unique combination of As utility [UA*] and Bs utility [UB*]. However,
we can derive the unique welfare maximising Output mix [XA*, XB*, YA* and YB*] from the Bliss point.
Moreover, we can derive all the unknowns of the 2 x 2 x 2 Model [Two consumers, two commodities
and two factors model]. The unknowns are:
1. Total quantities of the two goods, X* and Y*.
2. The quantities of X* and Y* distributed between the consumers [XA*, XB*, YA* and YB*].
3. The quantities of labour and capital allocated between X* and Y* [Lx, Ly, Kx and Ky]. [There are 10
unknowns.]
The Bliss point W* is associated with a unique commodity mix on the PPC, because: W*
defines utility combination UA * UB*, which belongs to particular utility frontier. It is to be pointed out
that each utility frontier is derived from a single point on the PPC. Thus, assume that the utility
possibility frontier, to which UA* UB* belong, corresponds to the unique point W^ on the PPC FF in
figure 006. Point W^ defines the welfare maximising commodity combination Y* X*.
We next construct the Edgeworth box of exchange with precise coordinates the welfare
maximising levels of outputs Y* and X*. By examining contract curve OW^ we can locate the one point
where the utilities of the two consumers are UA* and UB*. At this point the equalized slope of the
indifference curves of consumers A and B is equal to the slope of the PPC at W^. Point W defines the
distribution of X* and Y* between the two consumers [XA*, XB*, YA* and YB* in figure 006].

Figure 006

337

Figure 007

338

In figure 007, point W shows the allocation of Labour and Capital between X* and Y*.
LX*, LY*, KX* and KY* are the optimal values of labour and capital allocated between X
and Y goods. Thus we have derived the values of all the ten unknowns.
Welfare Maximisation and Perfect Competition:
We have explained that under certain assumptions an economy can reach the point of
maximum social welfare. It should be stressed that the bliss point [and the solution of the system for the
values of the ten variables that are the unknowns in the welfare maximisation problem of the 2 x 2 x 2
model] depends only on the technological relations: the problem of welfare maximisation is purely
technocratic. It is to be pointed out that the bliss point is attained by equalizing the slopes of isoquants,
the slopes of the indifference curves, and the slope of the PPC to the [equalized] slope of the
indifference curves. Thus, the welfare maximising solution does not depend on prices. However, perfect
competition can lead to a general equilibrium situation where the three marginal conditions of Pareto
optimality are satisfied. The analysis can be extended to show that the general equilibrium solution
reached with perfect competition is the same as the situation implied by the bliss point of the welfare
maximisation problem.
A] Profit maximisation by the individual firm implies that what ever output the firm may choose as the
most profitable must be produced at a minimum cost. Cost minimisation is attained if the firm chooses
the input combination at which the marginal rate of technical substitution of the two factors is equal to
the input price ratio:
MRTSLK = w/r
Since in perfect competition all firms are faced by the same set of factor prices, it follows that:
MRTS(X)LK = MRTS(Y)LK = w/r
B] Utility maximisation by each individual requires the choice of the product-mix where the MRS of the
two commodities is equal to the ratio of their price:
MRSxy = Px/Py
Since in perfect competition all consumers are faced by the same commodity prices, it follows that:
MRS(A)xy = MRS(B)xy = Px/Py
C] At the bliss point the [equalized] slope of the indifference curves [the common MRSXY] is equal to the
slope of the PPC at W. Thus, at W, which defines the product mix that maximises social welfare that
we have:
MRPTXY = Px/Py
D] Finally, a firm in a perfectly competitive market maximises its profit by setting its marginal cost equal
to the market price of the commodity. Consequently we have:

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MRPTXY = Px/Py = MCx/MCy

Thus we have established that a perfectly competitive system guarantees the attainment of
maximum social welfare. This is the result of the maximising behaviour of firms and consumers. In a
perfectly competitive [free enterprise] system, each individual, in pursuing his own self-interest is led by
an invisible hand to a course of action that increases the general welfare of all.

Reference Books:
1. F. M. Bator, The simple Analytics of Welfare Maximisation, American Economic Review (1957)
2. P. A. Samuelson, Social Indifference Curves, Quarterly Journal of Economics (1956)
3. N. Kaldor, Welfare Propositions in Economics and Interpersonal Comparison of Utility, Economic
Journal (1939)
4. J. R. Hicks, The Foundations of Welfare Economics, Economic Journal (1939)
5. A. Bergson, A Reformulation of Certain Aspects of Welfare Economics, Quarterly Journal of
Economics (1937-38)
Books for Reading:

1. A. Koutsoyannis, Modern Microeconomics, Second Edition, McMillan

2. Watson and Getz, Price Theory and its Uses, Fifth Revised Edition, A.I.T.B.S.
Publishers& Distributors, Delhi
3. Hall P. Varian, Intermediate Microeconomics, A Modern Approach Seventh Edition,
Affiliated East-West Press, W.W. Norton Company.
Sample Questions:
Multiple Choice Questions:
1. Compensation criterion of welfare is related to ------------------------A] Hicks. B] Bentham. C] Marshall. D] Robertson.
2. Welfare economics is --------------------A] Positive. B] Normative. C] Informative. D] Intuitive.
3. In a state of Pareto optimum one individual ----------------- made better off without
making any other individual worse off
A] Cannot be. B] Can be. C] Will be. C] Will not be.
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4. Along the Edgeworth contract curve for exchange of goods between two individuals
A] MRSxy = Px/Py. B] MRS(A)xy = MRS(B)xy. C] MRTSLK = PL/PK. B] MRPTxy =
Px/Py
5. Who among the following has made the foundation of the Welfare economics?
A] Marshall. B] Clark. C] Jevons. D] Pigou.
6. ------------------- evaluates alternative situations on the basis of monetary evaluation of
different persons.
A] Kaldor-Hicks criterion. B] Benthams criterion. C] Pareto criterion. D] Pigouvian
criterion.
7. ------------------------ suggested the use of an explicit set of value judgment in the form of a
social welfare function.
A] Hicks. B] Pareto. C] Kaldor. D] Bergson.
8. Cardinalist criterion is based on ----------------------------------------A] Law of diminishing marginal utility. B] Law of diminishing returns. D] General
equilibrium analysis. D] Partial equilibrium analysis.
9. -------------------- is called the father of Utilitarianism in England.
A] Alfred Marshall. B] A. C. Pigou. C] Jeremy Bentham. D] J. B. Clark.
10. The dictum greatest good of greatest number is related more with
A] Bentham. B] Hicks. C] Kaldor. D] Benham.
Short Questions:
1. What is Welfare economics?
2. Define Pareto Optimum.
3. What is Edgeworth contract curve?
4. State the Law of diminishing marginal utility.
5. What is GDP?
6. State Benthams Dictum.
7. What is maximum social welfare?
8. What is social indifference curve?
9. Define grant utility possibility frontier.
10. What is externality?
Short Essay Questions:
1. Distinguish between Pareto Efficiency and Pareto Optimum.
2. Distinguish between positive and normative economics.
3. Explain the marginal conditions of Pareto Optimum.
4. Explain briefly the important criteria of welfare.
5. Explain the Kaldor-Hicks compensation criterion of welfare.
6. Distinguish between Partial and general equilibrium analyses.
7. Explain the theory of Bliss.
8. Explain the theory of Second Best.
9. Explain the role of externalities in welfare economics.
10. Explain the role and significance of welfare economics in the contemporary world.

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Copyright reserved to the author, Prof. K. Falgunan. M.A; M.Phil; B.Ed

Postgraduates Department of Economics and Research Centre,
Govt. Brennen College, Dharmadam, Thalassery, Kannur, Kerala,
Mobile Phone 9605631447
Telephone 04902360485
taxilahouse@gmail.com

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