Principles of Economics

Read from Book: K. K. Dewet, Modern Economic Theory, First Multicolor

Edition, 2005 (Reprint 2009); Peterson: Managerial Economics
Pages: 6 12, 13 16, 49 52, 60 63, 71 75, 79 84, 110 116, 171 176,
178 180, 181 183, 200 201, 210 212, 214 215, 234 240
Economics defined by J. E. Cairnes, J. B. Says and F. A. Walker as
Economics is the science dealing with/relating to wealth;
A Marshall: Economics on one side is a study of wealth and on the other side,
and more important side, a part of the study of man (human welfare);
L. Robins: definition of type A Economics is a science dealing with wealth
and material welfare and of type B - Economics is a science dealing with the
phenomenon arising out of scarcity of means (resources) and multiplicity of
ends (wants/demands); L. Robins own definition says, Economics is a social
science which studies human behavior as a relationship between ends (wants,
which are unlimited) and scarce means, which has alternative use and in other
words, economics is a social science concerned with allocation and proper uses
of resources for the achievement ands maintenance of growth and stability.
Summary: Economics is a social science and studies human behavior
relating to proper allocation and use of scarce resources (with or without use
of money) in order to satisfy the most of wants/demands which are unlimited,
through optimizing production, distribution and consumption now and in the
future.
 Major Economic Problems
1. What to produce: which goods and services are to be produced
and in what quantities; this involves choosing the range of goods
and servicers to produce (given that there may be many different
alternative collections of them) by allocating the available
limited resources;
2. How to produce: which among the alternative
technology/production methods or techniques to apply;
3. For whom to Produce: how the national product is to be
distributed i.e., who among the producers, suppliers of factors of
production, consumers should get how much;
4. Are the resources economically used: this refers top the
problem of efficiency in use (at present and in the future) of
resources (men, money, material);
5. Concern for full employment: this relates to the fullest possible
deployment/use of (labor and all other) resources;
6. Problem of growth: this relates to the concern for
growing/expanding/developing the economy and maintaining
stability in dynamics.
 Branches of Economics
Microeconomics: the branch of economics that deals with behavior of
individual economic (decision making) units such as consumers,
resource owners, business firms etc individual economic issues like cost
or price of a product, profit of a firm, wage of a labor etc and the subjects
include theory of demand, theory of production, theory of distribution,
pricing of a product, market types, competition etc.
Macroeconomics: concerned with aggregates and averages of the entire
economy such as national income, aggregate output, total employment,
total consumption, total savings and investment, aggregate demand and
supply, general price level etc; macroeconomics also deals with
trade/business cycles and how an economy grows.
Managerial Economics: Application of economics to the real business
and is concerned mostly about efficient and effective operation of
business firms and issues relating to economic concerns of firms;
managers.
Other branches: Engineering Economics, Health Economics, Defence
Economics, Education Economics, Transport Economics etc. [Discuss
the concept of demand and supply sides] and also, economics named
after social systems and even persons.
Issues and Importance of Study of Managerial Economics
Managerial Economics is the application of economics to the real
business activities so as to get desired business results in a
fiercely competitive environment where thousands of rivals plan
strategies to get control of the market.
Important Issues:
Production, cost and organization of firms in market place.
Topics studied:
Law of demand and elasticity of demand
Demand forecasting
Production theory returns to scale, technology, cost, revenue
and profit
Objectives of firms
Determination of prices methods, cartels, groups, leadership
Tools to judge economic efficiency break-even analysis, linear
programming, game theory etc
Micro planning project, capital budgeting, cost benefit
analysis, public investment criteria regarding turnkey projects
Business environment and social welfare.
 Where do Principles of Micro-economics fit
in managerial decision making?
The primary activities of decision making are:
Finding occasions for making decisions
Identifying possible courses of action
Evaluating the revenues and costs associated with
each course of action
Choosing the course that best meets the goals and
objective of the firm, which is maximizing the wealth
of a firm PV of net cash flows or PV () and
PV () = 1/(1+r) + 2/(1+r)2 + 3/(1+r)3 + .+ n/(1+r)n
Where, n is the profit in year n in current prices and r is
an appropriate discount rate for converting future value
into present value.
 Constraints to Decision Making
Constraints in managerial decision making involve:
Legal - including environmental laws, laws relating
to womens/child rights, provisions inconsistent with
generally accepted standards of behavior
Contractual bind the firm because of some prir
agreements
Financial maximize production subject to the
budgeted amount
Technological considerations set physical limit on
capacity/volume of production
 Circular Flow of Economic Activities

Payment for goods/service Payment for Goods/Services

Product Market

Goods and Services Goods and Services

Households Firms

Economic Resources Economic Resources

Factor Market

Income Factor Payments

 Demand Theory
Meaning of Demand:
Demand for anything at a price in a particular place/location and at a
given time (period) is the amount of it which will be bought by its
consumers; demand is always at a price, at a time, and in a location.
[demand is created on the basis for the need of a thing converted into
want for it and then to the desire for buying it supported by
his/her/their ability and wish to pay for it].
Types of Demand:
Price demand demand at various levels of prices of a product
Income demand demand for a product at various levels of income of
a consumer
Cross demand demand for a product at various levels of prices of
products related with it
Individual demand demand of an individual consumer
Market demand the total demand of all consumers for a product in a
given market
Individual sellers demand total demand for the product of an
individual firm at various prices
 Demand Theory
Demand Curve: shows the relationship between quantity demanded of a product ant its
price. Demand curves may be drawn by using a hypothetical demand schedule (table of
different quantities demanded at different prices] and normally, a demand curve slopes
downward to the right, as is depicted by the Law of Demand saying that if all other
things remain unchanged, a rise in price of a product is followed by a reduction in its
demand or, a fall in price of a product leads to an increase in demand for it.
But there are exceptions:
Case 1 when a serious scarcity is faced or anticipated (in crisis periods, rise in
necessity products may lead to increase in the demand for them; panic is the reason to
store more of such products);
Case 2 If use of a commodity confers distinctions (rise in price of prestige
products may not necessarily lead to fall in demand for them);
Case 3 when people become carried away with speculative motives (people tend to
buy more of those shares the prices of which show a rising trend);
Case 4 some times increase in income leads people to buy less of the inferior products
and switch to products that are more costly;
Case 5 if people are ignorant (tourists are often found to buy more of those products
which are sold at higher price brackets);
Products which do not follow the law of demand are called Giffen Goods, which are not
inferior goods as often conceived of.
An alternative explanation of why people may want to buy more when prices increase is
the change in a. tastes and/or fashion, income, price of other goods and also, reasons
like anticipatory change in prices, and prestige value of a product.
 Demand Analysis
Individual and Market demand: Definition/explanation.
Illustration: Max, a graduating senior has accumulated an impressive
file of tests during his college career. He plans to sell the collection to
three prospective buyers, whose demand equations are: Q1 = 30 1P, Q2
= 22.5 0.75P, and Q3 = 37.5 1.25P, where, Q1, Q2 and Q3 are
quantity demanded by the three buyers. Calculate (a) the demand
equation for Maxs tests (b) how many more tests he can sell for each
one-dollar decrease in price, (c) the charge to sell his entire collection
if he has a file of 60 tests and (d) the quantity demanded by each of
the three buyers at this price
(a) Market demand Qm = Q1+ Q2 + Q3
=30 1P + 22.5 0.75P + 37.5 1.25P = 90 3P
(b) The equation shows that an 1 dollar decrease in price will increase
the quantity demanded by 3 tests
(c) To sell the entire set of collections, i.e., Qm = 60, Qm = 90 3P or,
60 = 90 3p, which makes P = 10 and
(d) at price P = 10, Q1 = 30 10 = 20 tests;
Q2 = 22.5 0.75 x10 = 15 tests and Q3 = 37.5 1.25 x 10 = 25 tests
 Demand, Supply and Equilibrium
Law of Supply: If all other things remain unchanged, the supply
of a product increase with increase in its price or the supply of
it decreases with fall in its price.
It is the invisible play of bargaining of the buyers and sellers that
bring equilibrium in the market and at equilibrium, a certain
amount of product (the equilibrium volume) is purchased and
sold at the equilibrium price. Can be demonstrated by both
graphs and functions.
Demand Function Qd = a + bP, where b<0 and
Qs = c + dP, where d >0
At equilibrium, Qd = Qs => a + bP = c + dP
Which implies Pe = c a / b d
and Qe= a + b (c a/b d)
Specific case: Qd = 14 2P and Qs = 2 + 4P
At equilibrium, Qd = Qs => 14 2P = 2 + 4P
Solving the equations, we get Pe = 2 and Qe=10 units
 Theory of Costs
Involves three important/basic areas of managerial economics:
Resource allocation decisions;
Decisions on expanding product line;
Decisions on capital investment; there are other areas, too.
Cost has different meaning. Traditional definition tends to focus on
explicit and historical dimension of costs. The economic
approach emphasizes opportunity cost and includes both
explicit and implicit costs.
Explicit and Implicit Cost: Explicit cost are those costs that involve
an actual payment to other parties, while implicit cost
represents the value of foregone opportunities but do not
involve actual cash payments. If an input is purchased at some
price but its price is later changed, the traditional approach
makes the cost estimates based on the purchase price while the
economic approach does it on the basis of the present market
price.
Sunk cost Expenditures made in the past or to be made in future
against contractual arrangement. Example: cost of inventory,
future rental payments on a warehouse (as part of long-term
lease)
 Theory of Costs
Normal Profit: If all opportunity costs (according to the norms
demanded by the concept of economic approach) are accounted for,
the cost estimate should include normal payment for all inputs,
including managerial and entrepreneurial skills and capital supplied
by the owners of the firm. The cost includes a normal rate of profit,
which refers to profit in excess of these normal returns and
considering this, normal economic profit is determined by revenues
less all economic costs. Often normal returns to entrepreneurial skills
and capital supplied by the owners are not included as costs in the
income statement.
Marginal and Incremental Cost: Marginal cost refers to the change in
total cost associated with a one-unit change in output, while
incremental cost refers to the total additional cost of implementing a
managerial decision, such as adding a new product line, acquiring a
major competitor, developing an in-house legal staff. Marginal cost is
in fact a subcategory of incremental cost.
Opportunity Cost of a product or a factor of production is what must be
given up to acquire that product or factor and in general, the
opportunity cost of any decision is the value of the next best
alternative that must be forgone. The manager who hires an
additional secretary may have to forego hiring an additional clerk in
the shipping department.
Fixed Cost, Variable Cost and Marginal Cost
Capital Labor Output TFC AFC TVC AVC Total Marginal
Input Rate Cost Cost
10 0 0 1000 0 1000
10 2 1 1000 1000 200 200 1200 200
10 3.67 2 1000 500 367 184 1367 167
10 5.1 3 1000 333 510 170 1510 143
10 6.77 4 1000 250 677 169 1677 167
10 8.77 5 1000 200 877 175 1877 200
10 11.27 6 1000 167 1127 188 2127 250
10 14.60 7 1000 143 1460 208 2460 333
10 24.60 8 1000 125 2460 307 3460 1000

Draw curves for TFC, TVC, TC, MC, AC, AVC by using the above data; MC,
AC and AVC first decline, reach a minimum and then shift upwards;
short-run cost curves are U-shaped, long-run cost curves are flatter.
 Costs and the Concept of Profit-1
Total cost (TC), fixed cost (FC), variable cost (VC), average cost (c/q), marginal cost (c/q;
m in y = mx + c) accounting cost, explicit cost, implicit cost, economic cost (explicit
+ implicit cost),opportunity cost; revenue and break-even analysis

Calculation of Economic Profit Econ. Profit =

Sales $90,000 Revues minus all
Less: Cost of goods sold $40,000 relevant costs,
Gross profit $50,000 both explicit and
Less: Advertising $10,000 implicit
Depreciation $10,000
Utilities $3,000
Property Tax $2,000
Misc. expenses $5,000
$30,000
Net Accounting Profit $20,000
Less: Implicit Costs
Return on own capital invested $10,000
Opportunity cost ($5000 x 12) $60,000
$70,000

Net Economic Profit $50,000

[Net accounting profit implicit costs]
 Costs and the Concept of Profit-2
Suppose that you are a good dressmaker. You have 4 yards of a
material purchased for Tk 200 per yard a few years ago. You
have the options for (a) selling it now @Tk 1200 per yard and (b)
using it in making dress that may sell for Tk 7200. The making of
the dress would require 4 hours of your labor, which you can
sell elsewhere for Tk 800 per hour. Decide whether you should
make the dress or sell the material.
Soln: Revenue from sale of dress made Tk 7200
Less: cost of the material 4 x 1200 = 4800
4 hors of labor 4 x 800 = 3200
Tk 8000
(net) Economic Profit Tk. 800
Alternatively, if the material is sold
Revenue Tk 1200 x 4yds = Tk 4800
Less: Cost of material (at historic price) 4 x 200 = Tk 800
Profit = 4800 800 = Tk 4000
Clearly, making dress is not profitable
 Basic Calculations of Costs
TFC TVC TC
TC = TFC + TVC AFC =Q AVC= Q
AC = Q
TC = 15x 6x2 + x32 3
15x 6 x x d
AC = TC = = 15 6x x2 MC = (C )
x x dx

MC = derivative of Cost Function = 15 12x + 3x2

For AC to be minimum, 1st derivative of AC = 0 => 6 +2x = 0 => x = 3

and 2nd derivative of AC at x = 3 is 2, which is > 0, therefore, the AC is
minimum when the number of units x = 3 units
Similarly, we can calculate that MC is minimum when x = 2
Also, if we know the sale price per unit, we can get the revenue function,
from which we can get MR and to find the number of units produced and
sold for which profit is maximum, we can use the equation,
MR = MC and then find the value of x.
 Cost, Revenue, Profit and Firms Equilibrium-1
Total cost function C = 1000 + 10q 0.9q2 + 0.04q3
MC = dc/dq = 10 1.8q + 0.12q2
Total variable cost = Total cost fixed cost
= 10q 0.9q2 + 0.04q3
AVC = TVC/q = 10 0.9q + 0.04q2
Profit = Revenue Cost = pq (FC + q.AVC)
Or, + FC = q(p AVC) => q = (FC + )/(p AVC)
This gives the rate of output necessary to generate a
certain amount of profit
At break-even the = 0 and therefore, the break-even
volume of output is qBE = FC/(p AVC)
 Cost, Revenue, Profit and Firms Equilibrium-2
Example: FC of a firm is $10000, price per unit of its
product is $20 and AVC (MC) of the forms product is
$15. The firm has a target for a profit of $20000. The
volume of output required to achieve the target is:
q = (FC + )/(p AVC) = (10000 + 20000)/(20 15) = 6000 units

Reminder: The break-even output can be obtained from the

equation by taking = 0 i.e., the break-even volume of
output for the above firm would be
FC / = 10000 /
(p AVC) (20 15) = 2000 units

Show the graphs for FC, VC, TC, TR and the BE value
 Finding minimum average variable cost
TC = 1000 + 10Q 0.9Q2 + 0.04Q3, Find the rate of output that
results in minimum average variable cost.
Solution:
d
MC = --- (TC) = 10 1.8Q + 0.12Q2
dQ
TVC = 10Q 0.9Q2 + 0.04Q3 and AVC = 10 0.9Q + 0.04Q2
AVC will be minimum at the point of intersection of the MC and
AVC curves and therefore, for AVC to be minimum, AVC = MC
or, 10 0.9Q + 0.04Q2 = 10 1.8Q + 0.12Q2
solving which we get Q = 0, 0r 11.25
i.e, the average variable cost will be minimum when the out is
11.25 units.
Alternative Solution: Minimize the AVC function i.e., find the value
of Q for which AVC is minimum.
 Optimization of a Firms Output
Following are the cost and revenue functions for a firm:
TC = 50 + 4q and TR = 20q q2; Calculate
the volume of output for which profit would be maximum.
Profit = (20q q2) (50 + 4q) = 16q q2 50
d/ = 16 2q d/ = 0 => 16 2q => q = 8 (i) and
dq dq
d/ (d/ )= 2 < 0 ...(ii)
dq dq
Conditions (i) and (ii) indicate that the firm will have
maximum profit if the output is 8 units and the profit at
output 8 is: 8 = 16q q2 50 = 16x8 82 50 = 30 units
Alternatively,
MC = dc/dq = 4 and MR = d/dq = 20 2q and For max
MC = MR => 4 = 20 2q i.e., q = 8
implying that profit is maximum when q = 8 units.
 Consumer Behavior
Consumers equilibrium means the amount of a product Units of Toast Total Marginal
consumed that maximizes the satisfaction of a consumer.
Utility: Capacity of a product to satisfy needs; consumed Utility Utility
Marginal Utility: the utility of the last added one 1 20 20
unit consumed
Illustration: 2 18 18
Marginal Utility Theory can be explained by the 3 83 15
utility schedule as shown in the utility schedule in
Illustration. The theory suggests that 4 64 11
a. MU diminishes; b. TU is maximum when MU is zero; & 5 70 6
c. Consumer is in equilibrium when MU = 0
This means that a consumer is in equilibrium (in terms of 6 70 0
how much of a product he/she will Consume) when the 7 62 8
satisfaction from the consumption is maximum and that
level is reached by consuming up to an amount when the 8 46 16
marginal utility is zero. The theory assumes that
Utility can be measured and the measurement can be done by assigning definite numbers
(when actually, utility can not be cardinally measured, it can be measured only ordinally);
Utility of different commodities are independent (but utility of one commodity affects
that of another that means total utility is not a simple summation of utilities of individual
commodities);
From the experience of utility of a product for someone, an inference can be drawn for
utility of it for others (but utility can not be assumed through introspection); and
Utility of money is constant (not true, money has different utilities to different persons).
 x
Indifference Curve Theory
Indifference meaning and also, the meaning of indifference curve (shows all
those combinations of two products the total satisfaction from which is the
same); Suppose that the following is a hypothetical indifference schedule
(different combinations of two products consumed for which the total
satisfaction will remain the same):
Mango(y)
Combination Apples Mangoes Marginal Rate of Substitution: MRS xy y
x
1 15 1 of x for y
y
2 11 2
x
3 8 3
4 6 4
Apple(x)
5 5 5

Properties of Indifference Curves:

Downward sloping to the right; Non-intersecting; Convex to the origin;
Higher indifference curve represents higher level of satisfaction.
Also, indifference map (set of indifference curves) and for cases of exception of
the law of demand, the indifference will not be downward sloping.
Explain budget line, consumers equilibrium and PCC and ICC.
 Elasticity of Demand
Elasticity = measure for response in demand to change in
a. price of products b. income of consumers, c. price of related goods, and
d. degree of ease in substitution of a product by another one
Price elasticity of demand
ep = (proportionate change in quantity demanded of a product x)
(proportionate change in price of the product x)
ep = (q/q) (p/p ) = (dq/dp). p/q
Note that the price elasticity of demand is usually negative
The price of a product changes from Tk 10 per unit to Tk 12 and because of
this, the quantity demanded changes from 10 units to 7 units. The ep stands
at 1.5, this means that the increase in price by 1% would cause a reduction
in demand by 1.5%.
Let the demand equation is Qd = 100 4p i.e., the demand at price $10 is
100 4x10 = 60 units and the ep = (dq/dp). p/q or, 4. 10/60 = 0.67
This means that an 1% change (rise) in price will lead to a change (fall)
in demand by 0.67%.
 Price Elasticity of Demand
Determinants of ep
Availability of substitutes products having good substitutes have high ep
Proportion of income spent demand tends to be inelastic for goods and
services that account for only a small proportion of total expenditure
(demand for salt)
Time period demands are usually elastic in the long term than in the short run;
people have preference in maintaining the standards in consumption once
achieved and consumers adjust expenditures in the long run.
ep = means perfect (infinite) elasticity and an infinitesimally small reduction
in price leads to an unlimited expansion of demand
ep = 0 means zero elasticity and however much is the fall or rise in price, the
amount demanded remains the same
0<ep<()1 means relatively low elasticity, change in price causes moderate
change in the quantity demanded but still the total amount of money spent
by the consumers (revenue of the sellers) decreases with fall in its price and
increases with rise in price; demand is inelastic/less elastic and this applies
for most everyday and more or less necessity goods.
ep = ()1 means unitary elasticity and the total amount of money spent by
consumers (revenues of sellers) does not change with rise or fall in price.
ep> (1) means high price elasticity, small change in price causes fairly large
change in the quantity demanded and the total amount of money spent by the
consumers (revenue of the sellers) falls with increase in its price and rises
with decrease in price; demand is elastic and this applies for luxury goods.
 Price Elasticity of Demand
Factors determining ep
a. The nature of the commodity: ep is low for commodities which are must
buy or conventional necessities and relatively high for luxury items (radio,
TV, refrigerators, cars etc, although however, luxurious is again a relative
term).
b. Substitutes: products having substitutes are likely to be price elastic.
c. Goods having several uses: coal has several uses (cooking, heating,
industrial purposes); if coal price goes up, its use will be restricted only in
urgent purposes and demand will contract and if coal becomes cheap it will
be used widely in all purposes; in that sense products having several uses
are price elastic.
d. Goods having joint demand: if a horse carriage becomes cheap, the price
of horse may go up reducing the price elasticity of horse carriages.
e. Goods use of which can be postponed: price elasticity is high.
f. General price level: if the general price level is high, usually most products
become subject to relatively high price elasticity
g. Level of income: for people with high income, price elasticity is low for
many products.
h. Proportion of total income spent a product: products in which the
proportion of a consumers income spent is low or insignificant (for
example, expenditure by rich people in food items) are less price elastic.
 Income Elasticity of Demand
Income elasticity of demand
ei =(proportionate change in quantity demanded of a product x)
(proportionate change in income of the consumer buying it)
ei = (q/q) (I/I ) = (dq/dI). I/q
Let the demand equation is Qd = 50,000 + 5I. If someones income
(I) is Tk 10,500, Qd = 50,000 + 5x10,500 = 102,500; and
ei = (dq/dI). I/q = 5. 10,500/50,000 = 0.512
This means that the an 1% increase in income causes 0.512% increase in
the quantity of a product (for which the ei = 0.512) consumed.
Income elasticity is usually positive. But take the case of hot dogs (in the
US) it is a food for low income group of people. But if the income
of this group of people increases, they usually give up hot dogs and
switch to other types of meat. Therefore, income elasticity of hot dogs
may be negative.
Use of the concept of elasticity: pricing, targeting of products for
different market segments
 Income elasticity
ei = 1 => proportion of income spent on the good remains the same
even though income of the consumer increases or decreases
ei > 1 => proportion of income spent on the good increases with
increase in income of the consumer
ei < 1 => proportion of income spent on the good decreases with
increase in income of the consumer
ei = 0 => change in income makes no change in purchases of the good
ei < 0 => with increase in income, consumer purchases less of the
product [the example of hot dog in the previous slide].
Engels Law
Percentage of income spent on food decreases as income increases
Ernst Engel, Germany
Implication:
Farmers may not prosper as much as people in other occupations
during the periods of economic prosperity;
Food expenditures do not keep pace with increases in GDP;
Farm incomes may not increase as rapidly as incomes in general
 Cross Elasticity of Demand
The responsiveness of quantity demanded of a product x to change in the
price of another (usually, a substitute or complementary) product y
ec =(proportionate change in quantity demanded of a product x)
(proportionate change in price of another product y)
ec = (qx/qx) (py/py ) = (dqx/dpy) (py/qx )
A fall in price of a product y increases demand for its complementary
product x
Reduction in price of a product y decreases demand for its substitute
product x; however, cross elasticity is not reciprocal i.e., ec for coffee
is not the same as ec for tea, tastes of consumers, their incomes, price
of some other products matter.
Exercise: the demand for x in terms of the price for y is given by
qx = 100 + 0.5 py; calculate ec
Soln:
ec = (dqx/dpy) (py/qx ) = (150 125)/(100 - 50) (50 + 100)/(125 + 150)
= 0.27; Note: (py/qx ) should be calculated as the ratio of ranges
 Substitution Elasticity (es)
es shows to what extent one commodity can be substitute for another without
making any change in the total satisfaction derived by the consumer i.e., es is
a measure for ease or difficulty with which one commodity can be
substituted for another.
If q = quantity consumed before substitution,
q1 = quantity consumed after substitution, and
y
= (MRS of x for y after substitution) (MRS of x for y before
x
substitution)
qx y

qy x q x q1x q x y
es where 1 and
qx y qy qy qy x
qy x
 Elasticity: Problem
The demand for (Qx) for books of a publishing company is
determined as Qx = 12000 5000Px + 5I + 500Pc, where
Px = price charged for the companys books
I = per capita income of the buyers
Pc= price of the books of competing publishers
Determine the effect of
a. increase in price of the companys books on its revenues
b. rising incomes of the buyers on the sale of the companys
books
c. rise in prices of the books of the competing publishers on
the demand for the companys books
Assume that the initial values of Px, I, and Pc are $5, $10,000
and $6 respectively
 Solution to Elasticity: Problem
a. Effect of increase in price of the companys books on its revenues
The effect of increase in price can be assessed by computing price
elasticity of demand. Substituting the initial values of I and Pc in the
demand equation,
Qx = 12000 5000Px + 5(10000)I + 500(6) = 65000 5000Px
The value of dq/dp for the given demand equation is:
dQx/dPx = d/dPx (65000 5000Px)= 5000; and p/q = Px/Qx
where Px = $5 and Qx= 65000 5000Px = 65000 5000(6) = 40000
Now, ep = (dq/dp). p/q and for the given demand equation
ep = 5000 . 5/40000 = 0.625
[dq/dp= dQx/dPx = 5000, and p/q = Px/Qx where Px = $5 and
Qx= 40000]. The value of ep = 0.625 i.e., 1 < ep < 0 implies that
the companys books are price inelastic and raising the price of its
books will increase the total revenue
 Solution to Elasticity: Problem
b. Income elasticity ei = dQx/dI . I/Q
The demand function is: Qx = 12000 5000Px + 5I + 500Pc
dQx/dI = 5, and at income I = 10,000
quantity demanded Qx = 40,000 , which means that the
income elasticity ei = dQx/dI . I/Q= 5. 10000/40000 = 1.25
We find that income elasticity ei > 1. this implies that the companys books
belong to luxury goods. Since with increase in income buyers tend to buy
more of luxury goods, during the period of rising incomes, the sale of the
companys books will increase.
c. The demand function is: Qx = 12000 5000Px + 5I + 500Pc
And the cross elasticity ec = dQx/dPy . Py/Qx
The Pc in the demand curve is equivalent to Py of the cross
elasticity and ec = dQx/dPy.Py/Qx = 500. 6/4000 = 0.075
[since dQx/dPy = dQx/dPc = 500]
This implies that a 1% increase in the price of the books of competing publishers
would result in a 0.075% increase in the demand for the companys books.
 Regression Equation
Simple regression relationship between two variables
Y = a + bX, where Y may be production cost and X output.
Y = dependent variable, X = independent variable,
a = intercept on y- axis and in the given case, fixed cost
b = slope of the cost function, variable cost per unit or
marginal cost; the function may be compared with the
equation y = mx + c PRODUCTION TOTAL TOTAL
Problem: Formulate the regression PERIOD COST ($Y) OUTPUT (X)
equation and predict the cost of 1 100 0
producing 20 units of the product 2 150 5
3 160 8
Show freehand plotting of the cost 4 240 10
At the different levels of output and 5 230 15
Draw the straight line cruising 6 370 23
Through the points.
7 410 25
 Regression Equation: Soln of the Problem
Cost (Yt) Output (Xt) Yt Yav Xt Xav (Xt Xav )2 (Xt Xav)(Yt Yav )
100 0 137.14 12.29 151.04 1685.45
150 5 87.14 7.29 53.14 635.25
160 8 77.14 4.29 18.40 330.93
240 10 2.86 2.29 5.24 6.55
230 15 7.14 2.71 7.34 19.35
370 23 132.86 10.71 114.70 1422.93
410 25 172.86 12.71 161.54 2197.05
Yav =237.14 Xav = 12.29 (Xt Xav )2 (Xt Xav)(Yt Yav )
= 511.40 = 6245.71

The regression equation is: Y = a + bX, where,

b = (Xt Xav)(Yt Yav ) (Xt Xav )2 = 6245.71 511.40 = 12.21;
a = Yav bXav = 237.14 (12.21)(12.29) = 87.08
The equation therefore, is Y = 87.08 + 12.21X
Add: talk about R2 the coefficient of determination (proportion of the dependent
variable explained by the regression , value of it varies between 0 and 1; when the
value of R2 is higher it means that the regression fits the data very well.
 Production Function
Production function relates output to inputs; general
equation is: Q = f(K,L), where K is capital and L is labor;
one of the specific is the Cobb-Douglas production
function Q = AKL where A, and are constants.
Prices of inputs and the price of the output must be used
with production to determine which of the possible
input combinations is the best give the firms objective.
Marginal product: addition to total product for one extra
unit of an input and
Marginal product of capital MPk = dQ /dK = AK 1L and
Marginal product of labor MPL = dQ /dL = AKL 1
Law of diminishing marginal return: when increasing
amounts of a variable input are continued with a fixed
level of another input, a point will be reached when
marginal product of the variable input will decrease.
 Matrix of Inputs (capital and labor) and Output
CAPITAL
8 283 400 490 565 632 693 748 800
7 265 374 458 529 592 648 700 748
6 245 346 424 490 548 600 648 693
5 224 316 387 447 500 548 592 632
4 200 283 346 400 447 490 529 565
3 173 245 300 346 387 424 458 490
2 141 200 245 283 316 346 374 400
1 100 141 173 200 224 245 265 283
Labor 1 2 3 4 5 6 7 8
If 4 units of capital and 2 units of labor are used, the maximum production will
be 283 units; if K = 8 and L = 2, the output Q = 400 units , and the like.
There is a substitutability between the factors of production; there are varying
ways to produce a particular rate of output by using different combinations of
inputs
245 units can be output can be produced by using any of the combinations - K
= 6 and L = 1, K = 3 and L = 2, K = 2 and L = 3 or K = 1 and L = 6
A firm can use a labor intensive or a capital intensive process (e.g., 6 units of
capital and 1 unit of labor or 1 unit of capital and 6 units of labor to produce
the same output.
 Total, Average and Marginal Products
Ten equally skilled and diligent workers are ready to work in a
factory equipped with machines and ready stock of materials.
As workers add in, the output increases and figures on the
number of workers, total product, average product and
marginal product can be shown as under:
Av. Product (AP) No of Workers Total Product Av. Product Marginal Product
= average output 0 0
per unit and AP = TP/L, 1 2 2 2
TP = Total product 2 5 2.5 3
L = No of workers 3 9 3 4

Marginal Product (MP) 4 14 3.5 5

5 22 4.4 8
= change in output
6 40 6.7 18
Associated with one-
7 57 8.1 17
Unit change in workers
8 63 7.9 6
Q
MP = /L, 9 64 7.1 1
Q = amount of output. 10 63 6.3 1
Total Output

Total Output (Q)

Rate of labor input (L)

Average and Marginal Product

Marginal product

Average product

Rate of labor input

 Producers Equilibrium
Output at which a producer is most satisfied, usually, a level at
which the firm has the maximum profit, which can be attained
either by minimizing costs or maximizing sales.
Minimizing costs: use Isoquant and budget line - manufacturer
may use two factors of production and a number of different
combinations of the factors can yield the same amount of output.
The curve representing these combinations is called the iso-
quant/equal product curve/product indifference curve.
The producer may choose any of these combinations but his
decision on which combination he would pick depends on the
prices of the factors and his budget that may be shown by his
budget line/isocosts (also known as price line or outlay line).
Isoquant

Budget
Line
 Producers Equilibrium: Minimizing costs
Isoquant (also known as product indifference curves or
equal product curves) and isocost (also known as price
line or outlay line) curves are used to determine
efficient input rate combination for given production
rates. All points on the isoquant represent the
combination of inputs that produce the same amount of
output. Isoquants generally slope downward, are convex
to the origin and do not intersect each other.
Marginal Rate of Technical Substitution of X for Y is the
number of units of factor Y, which can be replaced by
one unit of factor X, quantity of output remaining the
same. Thus, MRTSxy = y/x
The MRTSxy generally diminishes as the quantity of X is
increased relative to quantity of Y (quantity of output
remaining unchanged). This is called the law of
diminishing marginal rate of substitution.
 Producers Equilibrium: Maximizing Revenue
Use Production Possibility curve and Iso-Revenue Line: Production Possibility
Curve represents what assortment of goods and services an economy can
produce with the resources and techniques at its disposal. Increase in the
resources at the disposal of the firm would take it to a higher production
possibility curve.
Production possibilities Good X (thousands) Good Y (thousands)
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
The question is: which of the various combinations the firm will decide to
produce? The answer is: the combination that is shown at the point of
tangency with the iso-revenue line. Production possibility curves move
upwards or downwards in a way that they remain parallel to each other. Iso-
revenue lines also do the same. Their movements, along with the shifts of
the points of tangency, determine the output expansion path.
 Producers Equilibrium
The manufacturer has a fixed amount of resources and he
can produce different combination of two goods that
may be produced by the same amount of resources.
The curve drawn by plotting the points showing such
combinations is called production possibility curve and
the manufacturer can choose any of these
combinations.
But the manufacturers choice will be determined by the
market prices of the goods and he will chose the
combination that gives him the maximum revenue.
The curve that shows the different combinations of two
goods that can give the same amount of revenue is
called the iso-revenue curve.
Production Iso-revenue
possibility curve
curve
 Returns to Scale
Q = f(K,L), if both inputs are changed by some factor output may
change to some factor h, which may be equal to , more than
or less than . Now consider the case hQ = f(k, L), where = 2
i.e., both the inputs are doubled. In such case, the Cobb-
Douglas production function Q = AKL may look like
hQ = A(2K)(2L) = 2 + (AKL) = 2 + (Q) => h = 2 +
The equation h = 2 + is derived from a production function that
uses both factors K and L increased by 2 times and the equation
shows that if both factors of production are increased by 2
times, the output increases by this increases 2 + times.
If the proportion in which the output increases is the same as the
proportion of increase of the inputs i.e., if h = 2 then + = 1
This is a situation when we have constant returns to scale.
Similarly, if h > 2, + > 1, it is a situation, when we have
increasing returns to scale and if h < 2, + < 1, it is a
situation, when we have decreasing returns to scale. Thus in
case of constant returns to scale, the function Q = AKL may be
written as Q = AKL1
 Returns to Scale: Matrix of Inputs and Output
CAPITAL
8 283 400 490 565 632 693 748 800
7 265 374 458 529 592 648 700 748
6 245 346 424 490 548 600 648 693
5 224 316 387 447 500 548 592 632
4 200 283 346 400 447 490 529 565
3 173 245 300 346 387 424 458 490
2 141 200 245 283 316 346 374 400
1 100 141 173 200 224 245 265 283
Labor 1 2 3 4 5 6 7 8
The table indicates that there is a substitutability between the factors of production.
The firm can use a capital-intensive production process or a labour intensive one.
Now, if inputs rates are doubled, the output also doubles e.g., K = 1, L = 4 q = 200
and K = 2, L = 8 q = 400, this is a case of constant returns to scale. Returns to scale
means change in output because of proportionate change in inputs.
In reality, output may increase more (or less) than in proportion to changes in inputs.
Also output may change because of change in one input while the other inputs
remains constant. In such case, the change in the output rate is referred to as returns
to factor.
The output table does not allow for determination of the profit maximizing output or
the best way to produce some specified rate of output.
 Production with one variable input
Assumes that the rate of input of one factor of production is fixed
(the period of production is not long enough to change the
input rate of that factor). The question is: how to determine the
optimal (profit maximizing) rate of employment of the variable
factor?
Say, of the two input labour and capital, capital is fixed. In that
case, the principle to be followed to optimize the level of
employment of labour is that the additional units of labour be
hired until the marginal revenue product of labour (MRPL)
equals the wage rate (w). MRP is defined as marginal revenue
times marginal product, which is in fact, the value of the extra
unit of labour. Thus the optimizing condition is MRPL = w
Similarly, if labour input is fixed, the capital stock would be varied
and the capital would be employed until the marginal revenue
product of capital equals the price of capital (r) i.e., MRPK = r

Now, MRPL = MR.MPL; but MR = TR/Q and MPL = Q /L

or, MRPL = TR/Q .Q /L = TR/L = d/dL(TR)
 Problem
The production function of Global Electronics is Q = 2K0.5L0.5 and the
marginal product function for labour and capital are given by
MPL = d/dL(Q) = 2. .2K0.5L0.5 = K/L,
and MPK = d/dK(Q) = 2. .2K0.5L0.5 = L/K
Assume that the capital stock is fixed at 9 units (K = 9). if the price of
output (P) is $6 per unit, and wage is $2 per unit, determine the
optimal (profit maximizing) rate of labour to be hired. What labour
rate is optimal if the wage rate is increased to $3 units?
Solution:
First, determine the MRPL assuming that K is fixed at 9. Note that P =
MR
MRPL = MR.MPL = P. MPL = P.K/L, = 18/L
For optimizing, MRPL = w or, 18/L = 2 which means, L = 81 i.e, 18 units
of labour should be employed
If the wage rate increases to $3, the profit maximizing condition
would be 18/L = 3 implying that L = 36
The example shows that as the price of labour increases, the firm
demands less labour i.e., the labour demand curve is downward
sloping.
 Production with two variable inputs
If both capital and labour are variable, there may be three
ways for efficient resource allocation in production:
maximize production for a given dollar outlay on labour
and capital (production possibility curve);
minimize the dollar outlay on labour and capital inputs
necessary to produce a specified rate of output (MPa/Pa
= MPb/Pb = MPc/Pc = ............ = MPn/Pn, where MPa, MPb, ....,
MPn, are marginal product of the factors A, B .....,N and
Pa, Pb, ....,Pn are the prices of these factors); If MPa/Pa >
MPb/
Pb it is advantageous for the entrepreneur to
employ more of the favtor A than of factor B. He will
employ more of one factor and less of the other till the
proportionality rule is satisfied.
produce the output rate that maximizes profit (in this
case, for each input, the marginal revenue product will
equal the input prices).
 Laws of Returns and Returns to Scale
There are three laws of returns: Law of diminishing, increasing and constant
returns. However, they are only three aspects of one law viz., the law of
variable proportions. According to law of diminishing returns applicable in
agriculture successive application of labour and capital to a given area of
land must ultimately, other things remaining the same, yield a less than
proportionate increase in produce. An industry is subject to law of
increasing returns if extra investment in the industry is followed by more
than proportionate returns i.e., the marginal product increases (with
lowering of marginal cost). This may happen by specialization of machinery
and labour. The Law of constant returns says that increased investment of
the labour and capital results in a proportionate increase in output and
whatever the output or scale of production, the cost per unit remains
unaltered.

Returns to Scale refers to the effect of doubling, trebling, quadrupling and so

on of all the inputs on the output of the product, a situation when all the
productive forces are increased or decreased simultaneously in the same
ratio. Laws of return and returns to scale are not the same thing: Laws of
returns refer to situations when some factors may be increased or
decreased and at least one factor remains unchanged, while returns to scale
refers to a situation when all factors change simultaneously in a given
proportion.
 Economies of Scale
Economies of Scale: If the scale changes (to a large proportion)
economies take place because of lowering unit costs or increased
productivity as a result of specialization of labour and inventory.
There may be diseconomies, too. For example, transportation cost
may go high, wage rates may be increased (due to increased demand
of labour for the large scale industry) etc.
Economies of scale may be understood as the benefits obtained
because of increase in the size of the firm/output. Why do
increasing returns to scale occur?
Use of technologies that are cost-efficient at high levels of
production
Specialization of labor
Economies in inventories
When do decreasing returns to scale occur?
When firms grow so large that the management cannot effectively
manage (for example, increase in costs of gathering, organizing,
transportation, reviewing information etc)
 Economies of Scope
Economies of scope: firms often find that even
without increasing the scale, per unit costs are
lower when two or more products are produced
(because of use of idle/temporarily surplus
capacity)
Economies of Scope: large-scale firms will have excess
capacity that can be used to produce other
products with little or no increase in capital costs;
Other firms may take advantage of their unique
skills or comparative advantage in marketing to
develop products that are complementary with the
firms existing product (e.g., Fisons develops a
market for its toiletry products, industries
producing other cosmetics get easier ways to
promote their products in the market that are
developed for Fisons toiletries. Other industries can
use the retail outlets selling Fisons products).
 Economies of large-scale production
Efficient use of capital equipment;
Economy of specialized labour (through division of
labour);
Better utilization/greater specialization in
management;
Economies of buying and selling; Economies of
overhead charges;
Economy in rent; Experiments and research
Advertisement and salesmanship;
Utilization of by-products;
Meeting adversity;
Cheap credit
Diseconomies of scale
Over-worked management; Individual tastes ignored; No
personal element; Possibility of depression;
Dependence on foreign markets; cut-throat
competition; International complications and war; Lack
of adaptability.
 Internal and External Economies
Technical economies (large size, linkage process, superior
techniques, increased specialization);
Managerial economies (functional specialization and
delegation of routine and detailed matters to subordinates);
Commercial economies (bargaining advantage of large firms
in purchase deals, procurement of credit etc);
Financial economies (large firms can borrow more, and on
more favourable terms);
Riskbearing economies (large firm can spread risk and even
eliminate them).

External
Economies of concentration (arising out of availability of
skilled worker, provision of better transport and credit,
advantage of localized industries etc);
Economies of information (publication of trade journals,
dissemination of research etc);
Economies of disintegration (splitting of some processes for
taking up by specialist firms).
 Theory of Production
Production: Transformation of inputs into outputs. inputs are
what a firm buys (i.e., productive resources) and outputs
are what it sells (i.e., goods and services). Production is
defined as creation of utility and more precisely,
creation/addition of value.
Production is creation of utility and utility created may be of
three types:
Form utility (physical change/transformation of one set of
goods into another
Place utility transportation of goods/services to place of
use
Time utility keeping in store till required.
The theory of production studies
factors of production and their organization,
the laws of production that govern the relations between
inputs and outputs, and among others,
the theory of population (because population supplies
labour, the most important factor of production).
 Theory of Production: Importance
The theory of production
plays an important role in the theory of relative prices,
helps in analyzing relations between costs and volumes
of outputs,
tells how manufacturers combine various inputs to
optimize the production of output,
provides a base for the theory of demand of firms for
productive resources and thus, the prices to be fixed
for the factors of production, which implies that
the theory of production has a great relevance to the
theory of distribution.
 Factors of Production
Land, Labour, Capital and Organization
Land: All natural resources (useful and scarce, actually and
potentially), which yield an income or have exchange value.
Land has features that have bearing on rent:
Land is natures gift to man
Land is permanent (original and indestructible)
Land lacks mobility in geographical sense
Land is fixed in quantity (land has no supply price i.e.,
supply of land remains the same, no matter whether there
is any change in price)
Land provides infinite variation in degrees of fertility; No
two pieces of land are alike.
 Labour
Labour: Any work whether manual or mental, which is
undertaken for a monetary consideration.
Peculiarities of labour that have bearing on its price
i.e., wage:
Labour is inseparable from the labourer himself
Labourer has to sell his labour in person
Labour does not last (it is perishable, it has no
reserve price whether one sells or holds it for some
time)
Labourer has very weak bargaining power
Changes in price of labour react rather curiously on
its supply (fall in price i.e., wage below a certain
point may increase the supply of labour; some
members of the family who did not work before,
may start seeking job).
 Efficiency of Labour
Factors that determine efficiency of Labour

racial qualities
climatic conditions
education (general and technical)
personal qualities (physique, mental alertness,
intelligence, resourcefulness, initiative, and
above all, integrity)
industrial organization and equipment
factory environment
working hours
fair and prompt payment
social and political factors
 Division of labour
Simple also called functional division of labour, is the division by
major occupations (carpenters, blacksmiths, weavers etc)
Complex No group of workers makes a complete article; the
making of an article is split into a number of processes and sub-
processes which are carried out by separate groups of people.
Territorial locations specializing in different trade or product
Advantages:
Increase in productivity; increase in dexterity and skill; facilitating
inventions; introduction of machinery; saving in time, tools and
implements; diversity in employment; promotion of large-scale
production.
Disadvantages:
Monotony; retardation of human development; loss of skill, risk of
unemployment; industry dehumanized (under division of
labour, many people combine to produce an article and
everybodys business becomes nobodys business, the workers
lose all sense of responsibility and pride in their work and thus
the industry is dehumanized)
 Capital
Capital: That part of mans wealth which is used in producing
further wealth or which yields income. Capital is not a primary
or original factor of production; it is produced means of
production, often referred to as dead labour. The term capital is
generally used for capital goods such as plant, machinery, tools,
accessories, stocks of raw material, goods in process, and fuel.
Land is not regarded as capital because, it is a free gift of nature
and it is permanent i.e, it has no mobility, while capital is
perishable and mobile.
Capital formation
increase in stock of real capital in a country and it involves making
of more capital goods such as machinery, tools, factories,
transport equipment, materials, electricity etc, which are all
used for further production of goods. Capital formation
essentially requires savings, which must be invested in order to
have new capital goods.
 Capital Formation: stages/components
The three stages of the process of capital formation are:
Creation of savings by individuals or households the level of savings in a
country depends upon the power to save and will to save. The power to
save is a function of the average level of income and the distribution of
national income. savings at the household level may be voluntary and
forced. Besides households, other important agents of savings are the
business and enterprises and the government.
Mobilization of savings transfer of savings from households to
businessmen for investment; development of capital market.
Investment of savings in real capital The primary factor that determines
the level of investment is the size of the market; other important factors are
inducement to invest, marginal efficiency of capital, and the rate of interest
(prospective yield).
An important component of capital is foreign capital (foreign savings) that
comprises
direct private investments,
loans or grants by foreign governments, and
loans or grants by international agencies.
Capital formation may take place also through deficit financing, which is newly
created money and this usually takes place by deliberate allocation of
expenditure in excess of incomes.
 Organization/Enterprise
Organization/Enterprise: two main functions of this factor of
production are
(a) organizing; and
(b) risk taking/uncertainty bearing. Entrepreneurs initiate
business, mobilize productive resources, take financial
responsibility of enterprises and play the role of investors
Another important function of entrepreneur: innovation and
initiatives of invention
 Market and Market Structure
Why do we study markets?

The most important reason is to take decision on pricing that

depends on the degree of competition faced by a firm and
control over the price. But, studying only the market factors
that determine the price is not enough. A manager is to
study also the size of the market and its segmentation for
output decision, not to speak about product differentiation
depending upon consumer preferences and choices.
 Market and Market Structure
What do we mean by market structure?
There is no single way of categorizing market structures, but four main
characteristics are often employed:
Number and size distribution of sellers number of firms providing the
product; a few large firms may dominate the market or there may be too
many firms of nearly equal size; monopoly, duopoly, monopolistic
competition, oligopoly, perfectly competitive market; the issue is who
controls the price and how?
Number and size distribution of buyers too many small purchasers of a
product or one/few firms making volume purchases; Monopsony,
duopsony; the issue is who has more bargaining power in the market?
Product Differentiation the degree that the output of one firm differs
from that of the others in a market; grading or sorting of products; brands
names; 1-dollar shops etc; Product differentiation by a firm shows the firms
ability to affect/command price low, unique, or premium price;
Condition of entry or exit ease of entry or exit; existing firms enjoy great
freedom if the entry in the market is difficult for new firms; drug
manufacturers holding a patent often prohibit other firms from making the
drug; cartel; quota; unions; globalization/liberalization of trade v/s
protectionism.
 Market and Market Structure
Perfect Competition: In fact does not exist.
Requirements for perfectly competitive market:
a large number of sellers in the market and no single seller influences the
price; sellers, in such situation, are price-takers i.e., they sell all what they
produce at market determined prices;
a large number of small buyers in the market and buyers are also price
takers;
easy entry to and exit from an industry; scope of transferring resources
from one industry to another;
homogeneity of the product the product is totally undifferentiated i.e, the
output of one firm cannot be distinguished from that of another and as a
result, the purchasing decisions are based entirely on price;
prices of all supplies are determined at the equilibrium of total market
supplies (by all firms) and the market demand (of all purchasers);
under perfect competition, the profit maximizing output is the level of
output at which the market price just equals the marginal cost (P = MC);
and a manager should shut down the operation of a firm if price of its
products goes below average variable cost;
 Market and Market Structure
Monopoly
Number and size distribution of sellers single seller
Number and size distribution of buyers unspecified
Product Differentiation no close substitutes
Conditions of entry and exit entry prohibited or difficult
For a monopolist:
The profit maximizing output is determined by the point, where
marginal revenue is equal to the marginal cost
If the entry of other firms is difficult even in the long run, the
monopolist can earn economic profit
Monopoly pricing results in allocative inefficiency because not
enough output is produced
Monopoly pricing also causes redistribution of income from
consumers to owners of the monopoly.
 Market and Market Structure
Monopolistic Competition
Number and size distribution of sellersMany small sellers; actions of small
individual sellers go unheeded by other firms
Number and size distribution of buyers Many small buyers
Product Differentiation Slightly differentiated; product of one firm is
a fairly close substitute of that of another
Conditions of entry and exit Easy entry and exit

Firms in monopolistic competition have some control over price because their
products are to some extent differentiated.
In the long run, monopolistic competition generates results similar to those of
perfect competition, and with perfect competition, although there may be
economic profits in the short run there are no economic profits in the long run.
In the short run, the representative firm in monopolistic competition maximizes
profit by equating marginal revenue with marginal cost.
 Market and Market Structure
Oligopoly:
The term means few sellers

Number and size distribution of sellers Small number of sellers;

each firm must consider
the effect of its actions on
other firms
Number and size distribution of buyers Unspecified
Product Differentiation Product may be either
differentiated or
homogeneous
Conditions of entry and exit Entry difficult

Prices in oligopoly markets are relatively rigid

(price changes are infrequent);
Rivals match price reductions and not price increases.
 Market and Market Structure
Cartels and Collusion
The oligopolistic market is characterized by some interdependence of a small number
of selling firms and each firm makes its output decisions assuming that other firms
will produce the same amount as before. However, with increase in the number of
firms within an industry, the market no more remains oligopolistic and the output
and pricing decisions become results of equilibrium as in perfect competition.
In oligopolistic industries vigorous price competition among firms tends to drive prices
down and to reduce profits. Oligopolists come to some agreement to protect this
and cartels are formal agreement between firms in an oligopolistic market to
cooperate with regard to agreed procedures on variables such as price and output.
The result is diminished competition; and cooperation over objectives such as joint
profit maximization, or avoidance of new entry.
Side payments are made between cartel members in order to induce adherence to
these objectives. cartels are results of collusive agreements taking the form of
explicit price fixing agreements, price leadership and other practices that reduce
competition between the firms in the market.
Successful collusion can improve profitability of all the firms in an industry. Also, one
firm can benefit more by cheating on the agreement and cartels have provisions of
sanctions/penalties in such cases.
 Market and Market Structure
Price Leadership
The situation in an industry where some firms take the initiative in making
price changes and other firms then follow and this can take place generally
in three forms:
Dominant form occurs within industries dominated by one large firm,
which sets the price as monopolist, after making due account for supply
from competitive fringe of small firms at each price.
Barometric leadership a method of signaling that changes in costs or
demand require a price change; barometric leadership is distinguished by
change in the identity of the leader and the price initiative is followed (or
not followed) depending upon how closely the change reflects market
conditions common to all.
Collusive leadership Characterizes oligopolistic markets where a few
established firms having similar share, as well as demand and cost
conditions; price initiative by any one firm will reflect the wishes of the
others and their implicit acceptance comprises the collusive element of this
form of leadership.
 Market and Market Structure
Barriers to Entry

In the long run, barriers to entry may be the most

important determinant of market structure.

Sources of entry barriers include control of scarce

inputs, product differentiation, legal factors, and
scale economies.

Most markets resemble monopolistic competition

and oligopoly more than perfect competition and
monopoly.