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Meaning and Definitions CHAPTER

of Economics

The word Economics originates from the Greek work Oikonomikos which can be
divided into two parts:
(a) Oikos, which means Home, and
(b) Nomos, which means Management.
Thus, Economics means Home Management. The head of a family faces the
problem of managing the unlimited wants of the family members within the limited
income of the family. In fact, the same is true for a society also. If we consider the whole
society as a family, then the society also faces the problem of tackling unlimited wants
of the members of the society with the limited resources available in that society. Thus,
Economics means the study of the way in which mankind organises itself to tackle the
basic problems of scarcity. All societies have more wants than resources.


We have now formed an idea about the meaning of Economics. This at once leads to a
general definition of Economics. Economics is the social science that studies economic
These definitions can be classified into four groups:
1. Wealth definitions,
2. Material welfare definitions,
3. Scarcity definitions,
Ada m Smith s De f inition
Adam Smith, considered to be the founding father of modern Economics, defined
Economics as the study of the nature and causes of nations wealth or simply as the study of

Alfre d Ma r shall s De f inition

Alfred Marshall also stressed the importance of wealth. But he also emphasised the role of
the individual in the creation and the use of wealth. He wrote: Economics is a study of man
in the ordinary business of life. It enquires how he gets his income and how he uses it.

Lione l Robbins De f ignition

According to Robbins, Economics is a science which studies human behaviour as a
relationship between ends and scarce means which have alternative uses.


Economic theory, as it stands today, has several branches. Of these, two are most important.
These are microeconomics and macroeconomics. We shall now briefly mention the major
features of these two branches to have an idea regarding the nature of economics.
Microeconomics is that branch of economics which is concerned with the decision-making
of a single unit of an economic system.
Macroeconomics is that branch of economics which is concerned with the economic
magnitudes relating to the economic system as a whole, rather than to the microeconomic
units like individuals or firms.
Different Branches of Economics



Individual decision-making Decision-making at the

and smaller components national level and aggregate
of the economy economic variables

Individual income National income

Aggregate consumption
Individual consumption

Individual savings National savings

Individual investment Aggregate investment

Output of an individual firm National output

Output of an industry Aggregate expenditure

Individual expenditure

Price of any product/factor General price-level

Demand/supply of any Inflation and deflation

product or a factor

Employment/unemployment Aggregate employment

in any industry or unemployment

Export or import of a given


De f inition s o f Manageria l Economics

According to McNair and Meriam, managerial economics consists of the use of

economic models of thought to analyse business situations.

M.H. Spencer and Louis Siegelman have defined managerial economics as the
integration of economic theory with business practice for the purpose of facilitating
decision-making and forward planning by management.

Natur e o f Manageria l Economics

Managerial economics has some special characteristics, and these characteristics indicate
the nature of managerial economics. Some of the important characteristic features of
managerial economics are noted below:

Managerial economics is microeconomic in nature: Economic theories can broadly be

divided into two parts, viz., macroeconomics and microeconomics. While macroeconomics
is concerned with the economic magnitudes relating to the whole economy (such as
national income, national production, etc.) microeconomics is concerned with the
decision-making of a single economic entity (such as a business firm) within this system.

Prescriptive in nature: Managerial economics actually prescribes the ways through which
a business firm can achieve its goal within its constraints. It prescribes the policies that
should be undertaken by any business firm for achieving its specific target. Hence,
managerial economics is not concerned with mere description of economic theories.

Pragmatic in its approach: Managerial economics is pragmatic in its approach

because it emphasises on the real-life problems faced by any business firm and their
possible solutions, rather than concentrating only on some abstract economic theories
(which are based on restrictive assumptions).

Scop e o f Manageria l Economics

With the continuous expansion of business world, the scope of managerial economics has
also increased to a great extent. It has become a multi-disciplinary subject, and draws not
only on economics but also on other subjects such as mathematics, statistics, accounting
theory, etc.
Though the scope and subject-matter of managerial economics have been increasing day by
day, we can mention some of the important fields of study which fall under the purview of
managerial economics. These are stated below:
1. Demand analysis,
2. Production and cost analysis,
3. Objectives of business firms,
4. Pricing policies,
5. Capital budgeting, etc.

Every business firm has to produce different products keeping an eye on the demand
pattern. So demand analysis is necessary for any business firm.
The production and cost analysis are necessary to undertake proper project planning. In
fact, in a competitive business environment, the existence of a firm depends much on
its cost-competitiveness.
Generally, the main objective of a business firm is to earn maximum profit. However, a
modern firm many have some other objectives such as maximisation of sales revenue,
minimisation of risk component, etc. Thus, an analysis of the alternative objectives of
any business firm becomes relevant.
Any business firm has to fix its product-price in such a manner that it can cover not
only its average cost of production but also create some profit margin.
Thus, analysis of pricing policy becomes pertinent. Capital-investment decisions or
capital budgeting refers to the process of planning expenditure (by any business firm)
which would generate returns over a particular time span.
So, the exercise of capital budgeting also comes under the purview of managerial
Steps in the Process of Managerial Decision-Making
Simply speaking, there are two broad steps in the process of managerial decision-making:
1. Define Objective
2. Research
3. Prepare Alternatives & choose the best
4. Implement
5. Evaluate
Functional Aspects of Decision-Making
The decision-making process in managerial economics can also be analysed from the view
point of various functions of any entrepreneur (viz., production, finance, marketing, purchase
of inputs, etc.)
The decision variables can be identified for each of those functions.

Managerial functions Decision variables

1. Production Choice of technology, factor substitutability, scale of production, type of
products/product diversification, capacity utilisation, etc.
2. Purchase of inputs Input costs, inventory control, time of purchase, etc.
3. Finance Cost of capital, sources of fund, capital structure, cash flow and fund flow,
dividend policy, etc.
4. Marketing Advertisement/selling expenses, transport costs, distribution channel, customer
care, pattern of competition, product price, etc.
5. Personnel Wages and bonus payments, incentive schemes, job rotation and training, etc.

6. Legal Tax laws, pollution control regulations, labour laws, licensing policies, export-
import policies, etc.

Economic Profit vs. Accounting Profit.

While economic profit includes theoretical estimations of loss based on opportunity cost and
value, accounting profit is the actual revenue calculations generated by bookkeepers.
In other words, bookkeepers see accounting profit in dollars that have actually been spent and
earned. As a result, a firm might generate a noticeable accounting profit, but if it experiences
a hefty loss in opportunity cost, its economic profit could be negligible.
Definition of Profit Maximization

Profit Maximization is the capability of the firm in producing maximum output with the
limited input or it uses minimum input for producing stated output. It is termed as the foremost
objective of the company.

It has been traditionally recommended that the obvious motive of any business organization is
to earn profit, it is essential for the success, survival and growth of the company. Profit is a
long term objective, but it has a short term perspective i.e. one financial year. Profit play a
vital role in the profit maximization.

It can be calculated by deducting total cost from total revenue. Through profit maximization a
firm can be able to ascertain the input output levels, which gives the highest amount of
profit. Therefore, the finance officer of an organization should, take his decision in the
direction of maximizing profit, although it is not the only objective of the company.

Definition of Wealth Maximization

Wealth maximization is the ability of a company to increase the market value of its common
stock over time. The market value of the firm is based on many factors like their goodwill,
sales, services, quality of products, etc.

It is the versatile goal of the company and highly recommended criterion for evaluating the
performance of a business organization. This will help the firm to increase their share in the
market, attain leadership, maintain consumer satisfaction and many other benefits are also

It has been universally accepted that the fundamental goal of the business enterprise is to
increase the wealth of its shareholders, as they are the owners of the undertaking and they buy
the shares of the company with the expectation that it will give some return after a period of
time. This states that the financial decisions of the firm should be taken in such a manner that
will increase the Net Present Worth of the companys profit. The value is based on two
Key Differences Between Profit Maximization and Wealth Maximization

The major differences between profit maximization and wealth maximization are:

The process through which the company is capable of increasing is earning capacity is
known as Profit Maximization. On the other hand, the ability of the company in
increasing the value of its stock in the market is known as wealth maximization.
Profit maximization is a short term objective of the firm while long term objective is
Wealth Maximization.

Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which
considers both.

Profit Maximization avoids time value of money, but Wealth Maximization recognizes

Profit Maximization is necessary for the survival and growth of the enterprise.
Conversely, Wealth Maximization accelerates the growth rate of the enterprise and
aims at attaining maximum market share of the economy.

Objectives of Firm;

Major objectives that a firm wants to achieve apart from earning profit are as follows:

An objective is something that the firm wants to achieve over a specific period of time. It is
presumed that business has the only objective of earning profit.

But today one cannot deny the fact that along with profit maximization the business also has
certain objectives towards the society as well as the nation. The business unit can prosper only
if it enjoys the support of the society. It also aims at contributing to the national goals.

a. Survival

b. Utilization

c. Growth

d. Profit
e. Revenue

a. Survival:

Profit earning is regarded as a main objective of every business unit. But it is essential for the
survival and growth of every business enterprise. To survive means, to live longer.
Survival is the primary and fundamental objective of every business firm.

The business cannot grow until and unless it survives in a competitive business world. Due to
intense global competition, survival has become extremely difficult for the organisation.

b. Growth:

Growth comes after survival. It is the second major business objective after survival. Growth
refers to an increase in the number of activities of an organisation. It is an important organic
objective of an organisation. Business takes place through expansion and diversification.
Business growth benefits promoters, shareholders, consumers and the national economy.

c. Utilisation of the scarce resources:

Resources comprises of physical, human and capital that has to optimally utilise for making
profit. The availability of these resources is usually limited. So the firm should make best
possible use of these resources, wastage of the limited resource should be avoided.

d. Profit:

The primary objective of every business is to earn profit. Profit is the lifeblood of business,
without which no business can survive in a competitive-market. Profit is the financial gain or
excess of return over investment.

It is the reward for bearing risk and uncertainty in the business. It is a lubricant, which keeps
the wheels of business moving. Profit is essential for the survival, growth and expansion of the

e. Contributes revenue to the government:

Business helps in earning more foreign exchange to the government by undertaking export
activities. The revenue of the government also increases by payment of taxes by the business
entities, which can further be used for the development of the nation.

Demand Forecasting Techniques

Definition: Demand Forecasting is a systematic and scientific estimation of future demand

for a product. Simply, estimating the sales proceeds or demand for a product in the future is
called as demand forecasting.

There are several methods of demand forecasting applied in terms of; the purpose of
forecasting, data required, data availability and the time frame within which the demand is to
be forecasted. Each method varies from one another and hence the forecaster must select that
method which best suits the requirement.

The methods of forecasting can be classified into two broad categories:

Survey Methods: Under the survey method, the consumers are contacted directly and are
asked about their intentions for a product and their future purchase plans. This method is
often used when the forecasting of a demand is to be done for a short period of time. The
survey method includes:

Consumer Survey Method

Opinion Poll Methods

Statistical Methods: The statistical methods are often used when the forecasting of demand
is to be done for a longer period.
The statistical methods utilize the time-series (historical) and cross-sectional data to estimate
the long-term demand for a product. The statistical methods are used more often and are
considered superior than the other techniques of demand forecasting due to the following

There is a minimum element of subjectivity in the statistical methods.

The estimation method is scientific and depends on the relationship between the dependent
and independent variables.

The estimates are more reliable Also, the cost involved in the estimation of demand is the

The statistical methods include:

Trend Projection Methods

Barometric Methods

Econometric Methods

These are the different kinds of methods available for demand forecasting. A forecaster must
select the method which best satisfies the purpose of demand forecasting.

Cost Concepts

Different Types of Costs with Examples:

There are several costs that a firm should consider under relevant circumstances. It is quite
essential for a firm to understand the difference between various cost concepts for the
purpose of production/business decision making. The following are the various cost
concepts/types of costs.

(A) Actual Cost

Actual cost is defined as the cost or expenditure which a firm incurs for producing or
acquiring a good or service. The actual costs or expenditures are recorded in the books of
accounts of a business unit. Actual costs are also called as "Outlay Costs" or "Absolute
Costs" or "Acquisition Costs".
Examples: Cost of raw materials, Wage Bill etc.

(B) Opportunity Cost

Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other
words, it is the return from the second best use of the firms resources which the firms forgoes
in order to avail of the return from the best use of the resources. It can also be said as the
comparison between the policy that was chosen and the policy that was rejected. The concept
of opportunity cost focuses on the net revenue that could be generated in the next best use of
a scare input. Opportunity cost is also called as "Alternative Cost".

If a firm owns a land, there is no cost of using the land (ie., the rent) in the firms account.
But the firm has an opportunity cost of using the land, which is equal to the rent forgone by
not letting the land out on rent.

(C) Sunk Cost

Sunk costs are those do not alter by varying the nature or level of business activity. Sunk
costs are generally not taken into consideration in decision - making as they do not vary with
the changes in the future. Sunk costs are a part of the outlay/actual costs. Sunk costs are also
called as "Non-Avoidable costs" or "Inescapable costs".
Examples: All the past costs are considered as sunk costs. The best example is amortization
of past expenses, like depreciation.

(D) Incremental Cost

Incremental costs are addition to costs resulting from a change in the nature of level of
business activity. As the costs can be avoided by not bringing any variation in the activity in
the activity, they are also called as "Avoidable Costs" or "Escapable Costs". More ever
incremental costs resulting from a contemplated change is the Future, they are also called as
"Differential Costs"
Example: Change in distribution channels adding or deleting a product in the product line.

(E) Explicit Cost

Explicit costs are those expenses/expenditures that are actually paid by the firm. These costs
are recorded in the books of accounts. Explicit costs are important for calculating the profit
and loss accounts and guide in economic decision-making. Explicit costs are also called as
"Paid out costs"
Example: Interest payment on borrowed funds, rent payment, wages, utility expenses etc.

(F) Implicit Cost

Implicit costs are a part of opportunity cost. They are the theoretical costs ie., they are not
recognised by the accounting system and are not recorded in the books of accounts but are very
important in certain decisions. They are also called as the earnings of those employed resources
which belong to the owner himself. Implicit costs are also called as "Imputed costs".
Examples: Rent on idle land, depreciation on dully depreciated property still in use, interest on
equity capital etc.

(G) Book Cost

Book costs are those business costs which don't involve any cash payments but a provision is
made in the books of accounts in order to include them in the profit and loss account and take tax
advantages, like provision for depreciation and for unpaid amount of the interest on the owners
(H) Out Of Pocket Costs
Out of pocket costs are those costs are expenses which are current payments to the outsiders of
the firm. All the explicit costs fall into the category of out of pocket costs.
Examples: Rent Payed, wages, salaries, interest etc

(I) Accounting Costs

Accounting costs are the actual or outlay costs that point out the amount of expenditure that has
already been incurred on a particular process or on production as such accounting costs facilitate
for managing the taxation need and profitability of the firm.
Examples: All Sunk costs are accounting costs

(J) Economic Costs

Economic costs are related to future. They play a vital role in business decisions as the costs
considered in decision - making are usually future costs. They have the nature similar to that of
incremental, imputed explicit and opportunity costs.

(K) Direct Cost

Direct costs are those which have direct relationship with a unit of operation like manufacturing a
product, organizing a process or an activity etc. In other words, direct costs are those which are
directly and definitely identifiable. The nature of the direct costs are related with a particular
product/process, they vary with variations in them. Therefore all direct costs are variable in
nature. It is also called as "Traceable Costs"
Examples: In operating railway services, the costs of wagons, coaches and engines are direct

(L) Indirect Costs

Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant, a
product, a process or a department. Like the direct costs indirect costs, do not vary ie., they may
or may not be variable in nature. However, the nature of indirect costs depend upon the costing
under consideration. Indirect costs are both the fixed and the variable type as they may or may
not vary as a result of the proposed changes in the production process etc. Indirect costs are also
called as Non-traceable costs.
Example: The cost of factory building, the track of a railway system etc., are fixed indirect costs
and the costs of machinery, labour etc.

(M) Controllable Costs

Controllable costs are those which can be controlled or regulated through observation by an
executive and therefore they can be used for assessing the efficiency of the executive. Most of
the costs are controllable.

Example: Inventory costs can be controlled at the shop level etc.

(N) Non Controllable Costs:

The costs which cannot be subjected to administrative control and supervision are called non
controllable costs.
Example: Costs due obsolesce and depreciation, capital costs etc.

(O) Historical Costs and Replacement Costs.

Historical cost or original costs of an asset refers to the original price paid by the management to
purchase it in the past. Whereas replacement costs refers to the cost that a firm incurs to replace
or acquire the same asset now. The distinction between the historical cost and the replacement
cost result from the changes of prices over time. In conventional financial accounts, the value of
an asset is shown at their historical costs but in decision-making the firm needs to adjust them to
reflect price level changes.
Example: If a firm acquires a machine for $20,000 in the year 1990 and the same machine costs
$40,000 now. The amount $20,000 is the historical cost and the amount $40,000 is the
replacement cost

(P) Shutdown Costs

The costs which a firm incurs when it temporarily stops its operations are called shutdown costs.
These costs can be saved when the firm again start its operations. Shutdown costs include fixed
costs, maintenance cost, layoff expenses etc.
(Q) Abandonment Costs
Abandonment costs are those costs which are incurred for the complete removal of the fixed
asset from use. These may occur due to obsolesce or due to improvisation of the firm.
Abandonment costs thus involve problem of disposal of the asset.

(R) Urget Costs and Postponable Costs

Urgent costs are those costs which have to be incurred compulsorily by the management in
order to continue its operations. If urgent costs are not incurred in time the operational
efficiency of the firm falls.
Example: Cost of material, labour, fuel etc

Postponable costs are those which if not incurred in time do not effect the operational
efficiency of the firm. Examples are maintenance costs.

(S) Business Cost and Full Cost

Business costs include all the expenses incurred by the firm to carry out business activities.
Costs Include all the payments and contractual obligations made by the firm together with the
book cost of depreciation on plant and equipment.

Full costs include business costs, opportunity costs, and normal profits. Opportunity costs is
the expected return/earnings from the next best use of the firms resources like capital, land
and building, owners efforts and time. Normal profits is necessary minimum earning in
addition to the opportunity costs, which a firm must receive to remain in its present

(T) Fixed Costs

Fixed costs are the costs that do not vary with the changes in output. In other words, fixed
costs are those which are fixed in volume though there are variations in the output level.. If
the time period in volume under consideration is long enough to make the adjustments in the
capacity of the firm, the fixed costs also vary.
Examples: Expenditures on depreciation costs of administrative, staff, rent, land and
buildings, taxes etc.
(U) Variable Costs
Variable Costs are those that are directly dependent on the output ie., they vary with the
variation in the volume/level of output. Variable costs increase in output level but not
necessarily in the same proportion. The proportionality between the variable costs and output
depends upon the utilization of fixed facilities and resources during the production process.
Example: Cost of raw materials, expenditure on labour, running cost or maintenance costs of
fixed assets such as fuel, repairs, routine maintenance expenditure.

(V) Total Cost, Average Cost and Marginal Cost

Total cost (TC) refers to the money value of the total resources/inputs required for the
production of goods and services by the firm. In other words, it refers to the total outlays of
money expenditure, both explicit and implicit, on the resources used to produce a given level
output. Total cost includes both fixed and variable costs and is given by TC = VC + FC

Average Cost (AC) , refers to the cost per unit of output assuming that production of each
unit incurs the same cost. It is statistical in nature and is not an actual cost. It is obtained by
dividing Total Cost(TC) by Total Output(Q)

Marginal costs(MC), refers to the additional costs that are incurred when there is an addition
to the existing output level of goods ans services. In other words, it is the addition to the Total
Cost(TC) on account of producing additional units.

(W) Short Run Cost and Long Run Cost

Both short run and long run costs are related to fixed and variable costs and are often used in
economic analysis.

Short Run Cost: These costs are which vary with the variation in the output with size of the
firm as same. Short run costs are same as variable costs. Broadly, short run costs are
associated with variable inputs in the utilization of fixed plant or other requirements.

Long Run Cost: These costs are which incurred on the fixed assets like land and building,
plant and machinery etc., Long run costs are same as fixed costs. Usually, long run costs are
associated with variations in size and kind of plant.
Break Even Analysis:


Break-even analysis is a technique widely used by production management and management

accountants. It is based on categorizing production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level
of sales volume, sales value or production at which the business makes neither a profit
nor a loss (the "break-even point").

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various
levels of activity shown on the same chart as the variation of income (or sales, revenue) with
the same variation in activity. The point at which neither profit nor loss is made is known as
the "break-even point" and is represented on the chart below by the intersection of the two

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase.
At low levels of output, Costs are greater than Income. At the point of intersection, P, costs
are exactly equal to income, and hence neither profit nor loss is made.

Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result
of investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.

Examples of fixed costs:

- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related
costs such as commission.

A distinction is often made between "Direct" variable costs and "Indirect" variable costs.

Direct variable costs are those which can be directly attributable to the production of a
particular product or service and allocated to a particular cost centre. Raw materials and the
wages those working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do vary with
output. These include depreciation (where it is calculated related to output - e.g. machine
hours), maintenance and certain labour costs.
Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of categorizing
business costs, in reality there are some costs which are fixed in nature but which increase
when output reaches certain levels. These are largely related to the overall "scale" and/or
complexity of the business. For example, when a business has relatively low levels of output
or sales, it may not require costs associated with functions such as human resource
management or a fully-resourced finance department. However, as the scale of the business
grows (e.g. output, number people employed, number and complexity of transactions) then
more resources are required. If production rises suddenly then some short-term increase in
warehousing and/or transport may be required. In these circumstances, we say that part of the
cost is variable and part fixed.

Utility Analysis of Demand: Law of Diminishing Marginal Utility

Marginal Utility is the utility at the point where the consumer stops further consumption of a

Statement and Explanation of the Law:

It is well known that the more we have of a commodity, the less we want to have more of it.
It is the experience of every consumer that as he goes on consuming a particular commodity,
each successive unit of the commodity yields him less and less satisfaction.

In other words, at each step its utility (marginal utility, not total utility) goes on decreasing.

Thus if we are very thirsty and buy a drink to quench our thirst, the drink will yield a great
deal of satisfaction at first. After the consumption of the first drink, however, we would not
like to have another, because our want has been practically satisfied. This is the case with
most of the commodities.

The following table relating to an imaginary consumer consuming rasgullas illustrates the
As the consumer goes on eating rasgullas, the additional or marginal utility goes on
decreasing. At certain point of time say for example at 7th rasgulla yields no additional
satisfaction and the 8th and 9th have a negative utility. Their consumption, instead of giving
satisfaction or pleasure, causes dissatisfaction.

Importance of the Law of Diminishing Marginal Utility:

The law of diminishing marginal utility expresses a basic principle of a consumers

behaviour. And the law is of immense use to a person in almost every walk of life.

In Taxation:

We have seen that the law is applicable in the sphere of taxation a mans income increases; he
is more heavily taxed, for the utility of money to a rich person is less than that to a poor
person. The principle of progressive taxation is based on this law.

In Determining Prices:

The law also applies to the determination of market price increase in the stock of a
commodity brings a person less satisfaction; therefore he can be induced to buy more only if
the price is lowered. Thus, great the supply, the lower should be the price to clear it, and vice

In Support of Socialism:

Socialists, take their stand on this law when they advocate a more equal distribution of
Wealth. They argue that excessive wealth in the hands of the rich is not so useful from the
social point of view, as it would be if the excess of wealth is transferred the poor. In the hands
of the poor, it will satisfy more urgent needs. It is due to the law of diminishing marginal uti-
lity that, beyond a certain point, wealth will have less utility for a rich man. If it is transferred
to the poor, it will have much greater utility.

In Household Expenditure:

The law of diminishing marginal utility regulates our daily expenditure. We know that as we
go on buying more of a commodity, its marginal utility falls. Having only a limited amount of
money at our disposal, we cannot waste it unnecessarily on a large quantity of any one
commodity. We, therefore, stop purchasing it at a point where the utility of money spent is
equal to the utility of the last unit of the commodity purchased. We spend the rest of our
money on some other commodities.

Basis of Some of Economic Laws:

Several very important laws and concepts of Economics arc based on the law of diminishing
marginal utility, e.g., the Law of Demand, the concept of Consumers surplus, the concept of
Elasticity of demand, the Law of Substitution. All these laws and concepts have ultimately
been derived from the Law of diminishing Marginal Utility

Law of Variable Proportions

Law of Variable Proportions occupies an important place in economic theory. This law is also
known as Law of Proportionality.

Keeping other factors fixed, the law explains the production function with one factor
variable. In the short run when output of a commodity is sought to be increased, the law of
variable proportions comes into operation.

Land is a fixed factor whereas labour is a variable factor. Now, suppose we have a land
measuring 5 hectares. We grow wheat on it with the help of variable factor i.e., labour.
Accordingly, the proportion between land and labour will be 1: 5. If the number of laborers is
increased to 2, the new proportion between labour and land will be 2: 5. Due to change in the
proportion of factors there will also emerge a change in total output at different rates. This
tendency in the theory of production called the Law of Variable Proportion.

As the proportion of the factor in a combination of factors is increased after a point,

first the marginal and then the average product of that factor will diminish. Benham

Law of variable proportions is based on following assumptions:

(i) Constant Technology:

(ii) Factor Proportions are Variable:

(iii) Homogeneous Factor Units:

(iv) Short-Run:

Explanation of the Law:

In order to understand the law of variable proportions we take the example of agriculture.
Suppose land and labour are the only two factors of production.

By keeping land as a fixed factor, the production of variable factor i.e., labour can be shown
with the help of the following table:

From the table 1 it is clear that there are three stages of the law of variable proportion. In the
first stage average production increases as there are more and more doses of labour and
capital employed with fixed factors (land). We see that total product, average product, and
marginal product increases but average product and marginal product increases up to 40
units. Later on, both start decreasing because proportion of workers to land was sufficient and
land is not properly used. This is the end of the first stage.

The second stage starts from where the first stage ends or where AP=MP. In this stage,
average product and marginal product start falling. We should note that marginal product falls
at a faster rate than the average product. Here, total product increases at a diminishing rate. It
is also maximum at 70 units of labour where marginal product becomes zero while average
product is never zero or negative.

The third stage begins where second stage ends. This starts from 8th unit. Here, marginal
product is negative and total product falls but average product is still positive. At this stage,
any additional dose leads to positive nuisance because additional dose leads to negative
marginal product.

Law of Returns to Scale:

Definition,Explanation and Its Types!

In the long run all factors of production are variable. No factor is fixed. Accordingly, the
scale of production can be changed by changing the quantity of all factors of production.


The term returns to scale refers to the changes in output as all factors change by the same

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale


In the long run, output can be increased by increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an increase in output due to increase in all factors
in the same proportion. Such an increase is called returns to scale.

Suppose, initially production function is as follows:

P = f (L, K)

Now, if both the factors of production i.e., labour and capital are increased in same proportion
i.e., x, product function will be rewritten as.

The above stated table explains the following three stages of returns to scale:
1. Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a situation when all factors of
production are increased, output increases at a higher rate. It means if all inputs are doubled,
output will also increase at the faster rate than double. Hence, it is said to be increasing
returns to scale. This increase is due to many reasons like division external economies of
scale. Increasing returns to scale can be illustrated with the help of a diagram 8.

In figure 8, OX axis represents increase in labour and capital while OY axis shows increase in
output. When labour and capital increases from Q to Q1, output also increases from P to
P1 which is higher than the factors of production i.e. labour and capital.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where if all the
factors of production are increased in a given proportion, output increases in a smaller
proportion. It means, if inputs are doubled, output will be less than doubled. If 20 percent
increase in labour and capital is followed by 10 percent increase in output, then it is an
instance of diminishing returns to scale.

The main cause of the operation of diminishing returns to scale is that internal and external
economies are less than internal and external diseconomies. It is clear from diagram 9.

In this diagram 9, diminishing returns to scale has been shown. On OX axis, labour and
capital are given while on OY axis, output. When factors of production increase from Q to
Q1 (more quantity) but as a result increase in output, i.e. P to P1 is less. We see that increase
in factors of production is more and increase in production is comparatively less, thus
diminishing returns to scale apply.

3. Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production situation in which output
increases exactly in the same proportion in which factors of production are increased. In
simple terms, if factors of production are doubled output will also be doubled.
In this case internal and external economies are exactly equal to internal and external
diseconomies. This situation arises when after reaching a certain level of production,
economies of scale are balanced by diseconomies of scale. This is known as homogeneous
production function. Cobb-Douglas linear homogenous production function is a good
example of this kind. This is shown in diagram 10. In figure 10, we see that increase in
factors of production i.e. labour and capital are equal to the proportion of output increase.
Therefore, the result is constant returns to scale.

Cobb-Douglas Production Function

The Cobb-Douglas production function represents the relationship between two or more
inputs, typically physical capital and labor, and the amount of outputs that can be produced.
It's a commonly used function in macroeconomics and forecast production.

In 1928, Charles Cobb and Paul Douglas presented the view that production output is the
result of the amount of labor and physical capital invested. This analysis produced a
calculation that is still in use today, largely because of its accuracy.

The Cobb-Douglas production function

In this formula, Q is the quantity produced from the inputs L and K.

L is the amount of labor expended, which is typically expressed in hours.

K represents the amount of physical capital input, such as the number of hours a particular
machine, operation, or perhaps factory.

A (may appear as a lower case b in some versions) represents the total factor productivity
(TFP) that measures the change in output that isn't the result of the inputs. Typically, this
change in TFP is the result of an improvement in efficiency or technology.
The Greek characters alpha and beta reflect the output elasticity of the inputs. Output
elasticity is the change in the output that results from a change in either labor or physical

For example, if the output elasticity for physical capital (K) is 0.60 and K is increased by 20
percent, then output increases by 3 percent (0.6/0.2). The same is true for the output elasticity
of labor (L): an increase of 10 percent in L with an output elasticity of 0.40 increases the
output by 4 percent (0.4/.1).

Indifference Curve Analysis: Concept, Assumption and Properties

In microeconomics, indifference curve is an important tool of analysis in the study of

consumer behavior.

The concept of indifference curve analysis was first propounded by British economist Francis
Ysidro Edgeworth and was put into use by Italian economist Vilfredo Pareto during the early
20thcentury. However, it was brought into extensive use by economists J.R. Hicks and R.G.D

Hicks and Allen criticized Marshallian cardinal approach of utility and developed
indifference curve theory of consumers demand. Thus, this theory is also known as ordinal

Indifference curve

An indifference curve is a locus of all combinations of two goods which yield the same level
of satisfaction (utility) to the consumers.

Since any combination of the two goods on an indifference curve gives equal
level of satisfaction, the consumer is indifferent to any combination he
consumes. Thus, an indifference curve is also known as equal satisfaction curve or iso-
utility curve.

On a graph, an indifference curve is a link between the combinations of quantities which the
consumer regards to yield equal utility. Simply, an indifference curve is a graphical
representation of indifference schedule.
The table given below is an example of indifference schedule and the graph that follows is
the illustration of that schedule.
Assumptions of indifference curve

The indifference curve theory is based on few assumptions. These assumptions are

Two commodities

It is assumed that the consumer has fixed amount of money, all of which is to be spent only
on two goods. It is also assumed that prices of both the commodities are constant.

Non satiety

Satiety means saturation. And, indifference curve theory assumes that the consumer has not
reached the point of satiety. It implies that the consumer still has the willingness to consume
more of both the goods. The consumer always tends to move to a higher indifference curve
seeking for higher satisfaction.

Diminishing marginal rate of substitution

Marginal rate of substitution may be defined as the amount of a commodity that a consumer
is willing to trade off for another commodity, as long as the second commodity provides same
level of utility as the first one.

Rational consumers

According to this theory, a consumer always behaves in a rational manner, i.e. a consumer
always aims to maximize his total satisfaction or total utility.

Properties of indifference curve

There are four basic properties of an indifference curve. These properties are

Indifference curve slope downwards to right

An indifference curve can neither be horizontal line nor an upward sloping curve.
This is an important feature of an indifference curve.

When a consumer wants to have more of a commodity, he/she will have to give up
some of the other commodity, given that the consumer remains on the same level of
utility at constant income. As a result, the indifference curve slopes downward from
left to right.

In the above diagram, IC is an indifference curve, and A and B are two points which represent
combination of goods yielding same level of satisfaction.

We can see that when X1 amount of commodity X was consumed, Y1 amount of commodity
Y was also consumed. When the consumer increased the consumption of commodity X to
X2, the amount of commodity Y fell to Y2. And, thus the curve is sloping downward from
left to right.

Indifference curve is convex to the origin

As mentioned previously, the concept of indifference curve is based on the properties of

diminishing marginal rate of substitution.

According to diminishing marginal rate of substitution, the rate of substitution of commodity

X for Y decreases more and more with each successive substitution of X for Y.

Also, two goods can never perfectly substitute each other. Therefore, the rate of decrease in a
commodity cannot be equal to the rate of increase in another commodity.
The above table represents various combination of coffee and cigarette that gives a man same
level of utility. When the man drinks 12 cup of coffee, he consumes 1 cigarette every day.
When he started consuming two cigarettes a day, his coffee consumption dropped to 8 cups a
day. In the same way, we can see other combinations as 3 cigarettes + 5 cup coffee, 4
cigarettes + 3 cup coffee and 5 cigarettes + 2 cup coffee.
We can clearly see that the rate of decrease in consumption of coffee is not the same as rate of
increase in consumption of cigarette. Similarly, rate of decrease in consumption of coffee has
gradually decreased even with constant increase in consumption of cigarette.

Thus, indifference curve is always convex (neither concave nor straight).

Indifference curve cannot intersect each other

Each indifference curve is a representation of particular level of satisfaction.

The level of satisfaction of consumer for any given combination of two commodities is
same for a consumer throughout the curve. Thus, indifference curves cannot intersect
each other.

The following diagram will help you understand this property clearer.

In the above image, IC1 and IC2 are two indifference curves and C is the point where both
the curves intersect.

According to indifference curve theory, satisfaction at point C = satisfaction at point A

Also, satisfaction at point C = satisfaction at point B
But, satisfaction at point B satisfaction at point A.
Therefore, two indifference curves cannot intersect. Yet, two indifference curves need not be
parallel to each other.

Higher indifference curve represents higher level of satisfaction

Higher the indifference curves, higher will be the level of satisfaction. This means, any
combination of two goods on the higher curve give higher level of satisfaction to the
consumer than the combination of goods on the lower curve.

In the above figure, IC1 and IC2 are two indifference curves, and IC2 is higher than IC1. We
can also see that Q is a point on IC2 and S is a point on IC2.

Combination at point Q contains more of both the goods (X and Y) than that of the
combination at point S. We know that total utility of commodity tends to increase with
increase in stock of the commodity. Thus, utility at point Q is greater than utility at point S,
i.e. satisfaction yielded from higher curve is greater than satisfaction yielded from lower

Market Analysis

Market Structure: Defined

For defining market structure we first need to understand what market is? Market is a place
where buyers and sellers meet and exchange goods or services. And now if we extend this
concept a little more, there are certain conditions which create the structure of a market. Such
conditions can be condensed in the following

Number of Buyers

Number of sellers

Buyer Entry Barriers

Seller Entry Barriers

Size of the firm

Product Differentiation/ Homogeneous Product

Market Share


The above factors are the quick reference if you need to judge the market structure and under
which one particular firm belongs to.

Classification of Market Structure

As there are lot many factors deciding on the market structure, there are lot many variations
as well determining the particular market structure in the economy. If we try to explore that
individually it might not crystallize our concept.

Thus, lets look at the following chart to understand the varied market structures
From the above chart now its clear that how the market structure can be defined by the
various factors and their way of exercising certain power over the market. However if we
consider the gradual increase of competition from least to maximum, we will come up to the
following conclusions

1. Monopoly

2. Oligopoly

3. Monopolistic Competition

4. Perfect Competition
Now lets look at some of the examples of all the market structure mentioned above so that
the concept can dig into your mind and facilitate in your application of market structure

Monopoly Companies which are state owned and entry for other players are not
allowed. If we take example from Indian perspective there is one example we can
think of is Indian railway which is the monopoly as there is no other contributor
exercising in the same market.

Oligopoly In US and other countries people buy their automobiles from different
companies. Here the buyers are many, sellers are few, and competition is high.

Monopolistic Competition Lets take a common example. Look around your

locality. There are some good numbers of restaurants serving their customers. Though
they might be producing same kind of recipes, the branding would be different. And
thats the catch of monopolistic competition. Many buyers, many sellers, almost same
product but different branding and fierce competition.

Perfect Competition Though in concept perfect competition exists, however in real

life only near perfect competition can exist. And the staple food and vegetables we
buy from the market is perfect competition. However when they start branding they
move toward oligopoly.

In case of Monopsony and Oligopsony there are almost no practical examples though
they are just the opposite of monopoly and oligopoly respectively (buyers rule).

In Conclusion

The importance of market structure in an economy cannot be over emphasized as the effect of
market structure on an economy, its development or degradation is recently been realized.
Thus we as the part of the economy need to understand the value of this concept while
dealing with others (buyers/sellers) in any market place to yield the optimum benefit and to
create win-win situation for all of us.

Selected Macro Economic Concepts

Gross Domestic Product (GDP):

National output or GDP is the most important concept of macroeconomics. When GDP
increases, it is a sign that the economy is getting stronger. While a reduction in the GDP
indicates a state of weakening economy. How is GDP really calculated?

One of the most reliable methods to measure the GDP is the expenditure approach which
totals up the following elements to calculate the GDP:

GDP = C + G + I + NX


C = total private consumption in the country

G = total government spending

I = total investment made by the countrys businesses

NX = net exports (calculated as total exports minus total imports)

In short, the GDP is the state of the economy in a snapshot. The year on year GDP growth
rate is closely monitored by investors and white it only indicates what has already happened
in a previous time period, every time the GDP data gets published, analysts alter their stance
on the future prospects of Indian economy.

Wholesale Price Index (WPI) measures the price of a representative basket of wholesale
goods including food articles, LPG, petrol, cement, metals, and a variety of other goods.
Inflation is determined by measuring in percentage terms, the total increase in the cost of the
total basket of goods over a period of time. For a list of what is included in the WPI basket
you can view this sample report. Most instruments of monetary policy in India (which are
discussed below) are used by the RBI to keep inflation under check.

Interest rates act as a vital tool of monetary policy when dealing with variables like
investment, inflation, and unemployment. The Central Bank (RBI) reduces interest rates
when it wants to increase investment and consumption in the economy. Reduced interest rates
make it easier for people to borrow in order to buy goods and services such as cars, homes
and other consumer goods. At the same time, lower interest rates can lead to inflation. When
the Central Bank wants to control inflation, it increases the rate of lending. Banks and other
lenders are then required to pay a higher interest rate to the Central Bank in order to obtain
money. They pass this on to their customers by charging a higher rate of interest for lending
money. This reduces the availability of money in the economy and helps in controlling

Fiscal Policy & Monetary Policy

Economic policy-makers are said to have two kinds of tools to influence a country's
economy: fiscal and monetary.

Fiscal policy relates to government spending and revenue collection. For example, when
demand is low in the economy, the government can step in and increase its spending to
stimulate demand. Or it can lower taxes to increase disposable income for people as well
as corporations.

Monetary policy relates to the supply of money, which is controlled via factors such
as interest rates and reserve requirements (CRR) for banks. For example, to control high
inflation, policy-makers (usually an independent central bank) can raise interest rates
thereby reducing money supply.

Instruments of Monetary Policy used by the RBI

Direct regulation:
Cash Reserve Ratio (CRR): Commercial Banks are required to hold a certain proportion of
their deposits in the form of cash with RBI. CRR is the minimum amount of cash that
commercial banks have to keep with the RBI at any given point in time. RBI uses CRR either
to drain excess liquidity from the economy or to release additional funds needed for the
growth of the economy.

For example, if the RBI reduces the CRR from 5% to 4%, it means that commercial banks
will now have to keep a lesser proportion of their total deposits with the RBI making more
money available for business. Similarly, if RBI decides to increase the CRR, the amount
available with the banks goes down.

Statutory Liquidity Ratio (SLR): SLR is the amount that commercial banks are required to
maintain in the form of gold or government approved securities before providing credit to the
customers. SLR is stated in terms of a percentage of total deposits available with a
commercial bank and is determined and maintained by the RBI in order to control the
expansion of bank credit. For example, currently, commercial banks have to keep gold or
government approved securities of a value equal to 23% of their total deposits.

Indirect regulation:

Repo Rate: The rate at which the RBI is willing to lend to commercial banks is called Repo
Rate. Whenever commercial banks have any shortage of funds they can borrow from the RBI,
against securities. If the RBI increases the Repo Rate, it makes borrowing expensive for
commercial banks and vice versa. As a tool to control inflation, RBI increases the Repo Rate,
making it more expensive for the banks to borrow from the RBI with a view to restrict the
availability of money. The RBI will do the exact opposite in a deflationary environment when
it wants to encourage growth.

Reverse Repo Rate: The rate at which the RBI is willing to borrow from the commercial
banks is called reverse repo rate. If the RBI increases the reverse repo rate, it means that the
RBI is willing to offer lucrative interest rate to commercial banks to park their money with
the RBI. This results in a reduction in the amount of money available for the banks
customers as banks prefer to park their money with the RBI as it involves higher safety. This
naturally leads to a higher rate of interest which the banks will demand from their customers
for lending money to them.
The RBI issues annual and quarterly policy review statements to control the availability and
the supply of money in the economy. The Repo Rate has traditionally been the key instrument
of monetary policy used by the RBI to fight inflation and to stimulate growth.

Comparison chart

Fiscal Policy Monetary Policy

Definition Fiscal policy is the use of Monetary policy is the process by which the
government expenditure and monetary authority of a country controls the
revenue collection to influence the supply of money, often targeting a rate of interest
economy. to attain a set of objectives oriented towards the
growth and stability of the economy.

Principle Manipulating the level of Manipulating the supply of money to influence

aggregate demand in the economy outcomes like economic growth, inflation,
to achieve economic objectives of exchange rates with other currencies and
price stability, full employment, unemployment.
and economic growth.

Policy- Government Reserve Bank


Policy Tools Taxes; amount of government Interest rates; reserve requirements; currency peg;
spending discount window; quantitative easing; open market

What is Trade Cycle

The alternating periods of expansion and contraction in the economic activity has been
called business cycles or trade cycles.
The period of high income, high output and high employment is called as the Period of
Expansion, Upswing or Prosperity.

The period of low income, low output and low employment is called as the Period of
Contraction, Recession, Downswing or Depression.

Definition of Trade Cycle

According to Keynes,

"A trade cycle is composed of periods of Good Trade, characterized by rising prices and
low unemployment percentages, shifting with periods of bad trade characterized by falling
prices and high unemployment percentages."

Features of Trade Cycle

The characteristics or features of trade cycle are :-

Movement in Economic Activity : A trade cycle is a wave-like movement in

economic activity showing an upward trend and a downward trend in the economy.

Periodical : Trade cycles occur periodically but they do not show the same

Different Phases : Trade cycles have different phases such as Prosperity,

Recession, Depression and Recovery.

Different Types : There are minor and major trade cycles. Minor trade cycles
operate for 3-4 years, while major trade cycles operate for 4-8 years or more.
Though trade cycles differ in timing, they have a common pattern of sequential
Duration : The duration of trade cycles may vary from a minimum of 2 years to a
maximum of 12 years.

Dynamic : Business cycles cause changes in all sectors of the economy.

Fluctuations occur not only in production and income but also in other variables
like employment, investment, consumption, rate of interest, price level, etc.

Phases are Cumulative : Expansion and contraction in a trade cycle are

cumulative, in effect, i.e. increasing or decreasing progressively.

Uncertainty to businessmen : There is uncertainty in the economy, especially for

the businessmen as profits fluctuate more than any other type of income.

International Nature : Trade Cycles are international in character. For e.g. Great
Depression of 1930s.

Types of Trade Cycle

Dynamic forces operating in a capitalist economy create various kinds of economic

fluctuations. These fluctuations can be classified as follows :-

1. Short-Time Cycle : This trade cycle occur for a short period of time. It is also known
as minor cycles. It lasts for about 3-4 years.

2. Secular Trends : This trade cycle occurs for a long period of time and is known as
Long term cycle. It lasts for about 4-8 years or more. It is also known as major cycle.

3. Seasonal Fluctuations : This refers to trade cycles, which take place due to seasonal
changes in the economy. For e.g. failure of monsoon can cause a downtrend in the
economy which may be followed by a good monsoon and up to trend.

4. Irregular or Random Fluctuations : These trade cycles are unpredictable and occur
during a period of strikes, war, etc., causing a shock to the economic system.

5. Cyclic Fluctuation : These fluctuations are wave-like changes in economic activity

caused by recurring phases of expansion and contraction. There is an upswing from a
trough (low point) to peak and downswing from the peak to trough caused due to
economic changes in demand, or supply or various other factors.