Micro Economics Meaning Nature And Scope

Economics is the study of those activities of human beings, which are

concerned, with the satisfaction of unlimited wants by using the limited
resources. Micro means the millionth part. The term micro has been taken
from the Greek word mikros meaning small. Under microeconomics we
study the individual units like a consumer, a firm, an industry, price
determination of a particular commodity etc. In short the microeconomics
deals with the study of the economic problems of a single unit like a firm or
small economic units or resource owners. The main objective of
microeconomics is to study the principles, policies and the problems
relating to the optimum allocation of resources. From the theoretical point
of view it tells us the functioning of a free enterprise economy. It explains
us how through the market mechanism goods and services produced in the
economy are distributed.
Nature and scope of Micro Economics
In the nature of economics we may consider whether it is a science or
an art. Science not only means the collection of facts but it also means that
the facts are arranged in such a manner that they speak for themselves. It
means that some laws are discovered through these facts. Thus science is a
systematic body of knowledge concerning the relationship between causes
and effects of a particular phenomenon.
Characteristics of a science
1

First of all the facts are observed. E.g. when price rise the demand
contracts.

The facts in this step are properly classified. Like if price falls how
much the demand has fallen.

After the compilation of facts and having knowledge about the

magnitude of a problem a law is framed keeping onto consideration
the cause and effect of a fact. E.g. Law of demand

The final feature of science is by applying the scientific laws to real

life. It is verified whether they are valid or not.

Thus from the above discussion it could be concluded that economics is

a science. But some economists believe that it is not an exact science.
Whether its a social science or a natural science
Arguments in favour of social science
1. Economics is a systematic study. It is the study of the interrelated
activities like production consumption and exchange of wealth.
2. Laws of economics show a cause and effect relationship between
them

3. Laws of economics are based on real experiences of life.

Arguments against economics as a natural law
1 The laws of economics are not the exact laws. Like law of economics
does not operate if there is a change in the income of the person or a
change in price of substitute goods.
2 Economics laws are far from universal applicability. These laws
cannot be applied in all situations and at all the times.
3 The laws of economics cannot be verified in the laboratories.
In
the exceptional cases even the information or the results obtained
through the application can prove to be futile.
Thus economics is not a natural science. It is a social science.
Economics As A Positive Or A Normative Science
Positive science is that science which studies an accurate and true
description of events as they happen. Thus it deals with what, how and
why. Normative science is suggestive in nature. Normative science tells us
what ought to be.
Economics as a positive science
1 Positive science is logical whereas normative science is emotional.
Therefore it is more exacts it is based on the logic.
2 If economics studies only the realities of the real world then the
chances of the disagreement are less, as the case would be if it
studies both.
3 The economists cannot make the rational judgments if they try to
analyze both what is and what ought to be.
Economics as a normative science
1. Economics would offer more meaningful
suggestions too long with the facts.

conclusions

if

it

gives

2. Economics will be more useful if it is fruit bearing too along with the
light bearing. Most of the people study economics for the fruits and not
for the light merely.
3 if the economist synchronizes the analysis of economic problems with
concrete economic policies he would save time. Else it would be difficult
if one person finds the solutions and the other tries to justify those
solutions.
Thus the argument can be put to an end only by saying that it is both the
positive as well as a normative science
Arguments in favour of economics as an art

Many economists like Marshall, Pigou etc. believe that economics is an art
also besides being a science
Economics as an art
1. Economics offer a solution to the problems of human beings. It tells us
how we can make the judicious use of our resources.
2. It is through the art that we can verify the economic laws. For
example the law of demand
3. The doubts can be removed by dividing the economics into science as
well as an art.
Arguments against art
1 Science and art are different. If economics is science it cannot be
art and if it is an art it cannot be a science.
2 Economic problems are influenced by social and political nature.
Therefore economics cannot be considered from the economic
point of view only.
UTILITY
Its the want satisfying power of a commodity.
1.

Utility is subjective. It depends upon the human wants.

2.

Utility keeps on changing with time and place.

3.

It need not be always useful.

4.

Utility has nothing to do with the morality.

Measurement of utility
It can be measured both in terms of money as well as in terms of
units. If two persons pay different sum of money for the same amount of
commodity then it is the measurement in terms of money.
Marshall, Jevons and Menger etc have tried to measure it in terms of
cardinal numbers. Pareto, Allen, Hicks etc. measured it in ordinal an term
that is Indifference curve approach.
Utility has three concepts:
1. Initial utility
2. Marginal utility
3. Total utility
Marginal utility can further be divided into Positive Marginal Utility or
Zero Marginal Utility or Negative Marginal Utility

Quantity

Total utility

Marginal utility

14

18

20

20

18

-2

Opportunity costs
Opportunity costs may be defined as the expected returns from the second
best use of the resources which are foregone due to the scarcity of
resources. E.g. if with a sum of Rs. 1 lakhs one can purchase two machines.
One yields a profit of Rs.20000 and the other a profit of Rs. 10000. Now
the buyer will forego the use which is less productive. It can also be
termed as economic rent
(Rs. 20000 Rs 10000 = Rs. 10000)
Explicit and Implicit costs
Marginal and Incremental costs
It is the change in Total costs due to the production of one more or one less
unit of a factor of production.
MC = TCn TCn-1
Incremental costs refer to the total additional costs associated with the
decisions to expand output or to add a new variety of product etc. In the
long run when firms expand their production they hire more of men,
machinery and equipments. These expenditures are included in the
incremental costs. These costs also arise due to change in the product
lines, addition or introduction of a new product, replacement of worn out
plant and machinery, replacement of old techniques of production with a
new one etc.
Sunk costs are those costs, which cannot be increased or decreased by
varying the rate of output. Example once it is decided to make incremental
investment expenditure and the funds are allocated, all the preceding costs
are considered to be the sunk costs as these costs cannot be recovered
when there is a change in the market decisions.
EQUILIBRIUM

Equilibrium is a state of balance. In fact sometimes the modern

economics is also called as an equilibrium analysis. When the forces act
in the opposite direction is in the state of rest they are called as to be in
the equilibrium. Equilibrium can be a stable equilibrium, unstable
equilibrium or a neutral equilibrium.
1)

Stable equilibrium is that equilibrium in which the object

concerned after having been disturbed reverts back to the original
state.

2)
In an unstable equilibrium a slight disturbance further evokes
disturbance.
3)

In the neutral equilibrium the disturbing forces neither bring it back

nor they
can take it away from the equilibrium position.

Short term or the long-term equilibrium

In the short run demand plays an important role in the determination
of price and in the long run both demand and supply plays an important
role.
Partial and general equilibrium
Partial equilibrium excludes certain variable and studies a few
selected items at a time. This method takes into consideration the
impact of one or two variables and keeps all others constant. E.g.
demand and supply depends upon many variables but for the sake of
simplicity we study only a few aspects.
In case of general equilibrium analysis
An analysis that treats various individual units and markets as
interrelated and attempts to trace the consequence of an economic
event is called the general equilibrium. In the process of making the
decisions the consumers as well as the firms affect the prices of the
commodities. The changes in the prices serve as signals to various
consumers and firms that affect their decisions accordingly. In this way
the changes in the prices will go on bringing the changes in the
quantities supplied and demanded until equilibrium in all the markets is
not achieved simultaneously.
Static and dynamic approaches
The word static generally means a position of rest but in economics it
means a state in which there is a continuous, regular, certain and
constant movement without any change. According to Clark there is an

absence of the following five types of changes 1) size of population 2)

supply of capital 3) methods of production 4) forms of business
organization and 5) the wants of the people.
Harrod is of the view that static analysis is concerned with the lack of
investment in the economy. In static economics we do not study about
the sequences, lags etc. its like ordinary demand and supply theory.
Example people continue to be born and die but births equal deaths so
there is no change in the numbers but the composition of population is
changing. The major drawback is that it takes us far from the actual
picture assuming the variables constant.
MICRO ECONOMICS AND BUSINESS
Microeconomics explains how an individual business firm decides to fix the
price and output of their product and what factor combination do they use
to produce them. Microeconomics is concerned with the choosing of an
appropriate course of action from the number of alternatives present for a
business. Microeconomics tells us how to make a rational choice in
allocating the scarce resources of the firm while making the decisions
regarding price, output, technology, advertising expenditure etc. A
business has to make the following decisions with the use of
microeconomics
Price output decisions that is how much qty. is to be produced and at
what prices it is to be sold.
Demand Decisions that is to estimate the correct demand so that there is
neither the shortage of the product not there is any surplus.
Choice of a technique of production that is what type of technique is to
be used whether the capital-intensive technique or the labour intensive
technique.
Even the advertisement decisions of the firm are projected with the help
of microeconomics. A firm will spend on that mode of advertising which has
the maximum reach and which has the least costs.
In the long run the firm has to decide about the location of the plant, size
of the plant or the choice of the production technique etc.
It also tells a business about the investment decisions that is what is the
rate of investment over the years or is it profitable to takeover the other
firms of not.
THEORY OF DEMAND
The demand in economics means both the desire to purchase as well
as the ability to pay for the good.
Demand is different from the quantity demanded. Demand is the
quantities that the buyers are willing and able to buy at alternative prices

during the given period of time whereas quantity demanded is a specific

amount that buyers are willing and able to buy at on price.
Nature of demand for a product
With the normal goods the demand has a negative relationship. It
means as the price of a commodity falls the quantity demanded for the
product goes up.
x
D
Price P1
P
D
Qty

Q1

The law of demand operates due to the following reasons

1

Law of diminishing marginal utility

Income effect

Substitution effect

Different uses

Size of consumer group

Exceptions to the law of demand

1

Goods having the prestige value or the articles of distinction

Giffen goods

In case of emergencies

Ignorance

INDIVIDUAL DEMAND AND THE MARKET DEMAND

Individual demand is the quantity demanded by an individual person at
different possible prices at a given point of time.

Market demand is the quantity demanded by all the persons in the

market at different possible prices at a point of time.
As demand

Bs demand

Market demand

d
Price

Price

d1

Price

d1

D
Quantity

Quantity

Quantity

Determinants of demand
The demand for X commodity is affected by the following factors
1

Price of the commodity

Prices of related goods

Income of the consumer

Tastes and preferences of the consumer

Expectation of a price change of the commodity

Population

Income distribution

h. Bandwagon Effect: it is also called

cromo effect. It means that people
undertake certain tasks as other as
also doing like that. People try to
follow
the
crowd
without
examining
the
merits
of
a
particular thing.
i. Snob Effect: preference for the
goods because they are different
from the good the community
preferred. It is the demand for the
exclusive goods.
Elasticity of demand and its determinants
Elasticity is a measure of the responsiveness of one variable to the change
in other.
Ed can be
1. Price Elasticity of demand
2. Income elasticity of demand
3. It can be cross elasticity of demand

Methods to measure the price elasticity of demand

1

Total expenditure method as given by Marshall

T
Price

E=1
E

Total expenditure
2

Proportionate method
Ed = (-) P Q

E>1

E<1

Q
3

Point elasticity method

In case of a linear demand curve

M
Price

E=
.A

E >1
. P E =1
. B E <1
O

N
Qty

Arc elasticity method

A
B
C

Determinants of elasticity of demand

1. Nature of the commodity
2. Availability of substitutes
3. Postponement of the use
4. Income of the consumer
5. Habit of the consumer
6. Time period
7. Joint demand
8. Goods with the different uses
Demand as a multivariate function or a dynamic demand function

The demand in the long run is not only influenced by the price rather it is
influences by all other factors that we have assumed constant in the short
run. The long run demand for the product depends on the composite
impact of all its determinants operating simultaneously. To estimate the
long run demand we have to take into consideration all the relevant
factors. A demand function, which describes the relationship between
demand and all its variables, is known as the multivariate demand function.
Dx = f ( Px, M, Py, T, A )
Theory of consumer behaviour
Different theories have been developed time to time to explain the
consumer behaviour. The major breakthrough was achieved in the form of
cardinal utility analysis. Marshall gave this theory.
According to this theory as a consumer goes on consuming more and more
units of a commodity the utility derived from each successive unit goes on
diminishing.
Assumptions;
1

Utility is measurable in cardinal numbers.

Marginal utility of money remains constant

Marginal utility of every commodity is independent

There is a continuous consumption f the commodity.

Every unit of the commodity consumed is same in size.

No change in the price of the commodity and its substitutes.

No change in the tastes character, fashion and habits of the consumer.

Cups
of
coffee Total utilty (utils)
consumed everyday

Marginal utility

12

12

22

10

30

36

40

41

39

-2

34

-5

______________

Exceptions
1

Good book or poem

Misers

Drunkards

Initial units

Importance
Basis of laws of consumption
Varity in consumption
Difference in value in use and value in exchange
Basis of progressive taxation.
Criticism
Cardinal measurement of utility is not possible.
Marginal utility of money is not constant.
Every commodity is not an independent commodity

Unrealistic assumptions.
Law of equi marginal utility or law of substitution
This law was again developed by Marshall. It is also known as the Gossens
second
law. According to this law, a consumer allocates his limited income in such
a way that the last unit of money spent on different commodities gives the
consumer the same level of satisfaction.
Assumptions
Same as above + consumer is a rational person
Rupees spent

MU of Mangoes

MU of Milk

12

10

II

10

III

IV

MU of mangoes

MU of milk

-------------------------------------------------

Importance
In the field of consumption
In the field of production
In the field of exchange
Distribution of income between saving and consumption.

Criticism
Consumers are not fully rational
Minute calculations are not possible
Ignorance of the consumer
Influence of fashions, customs and habits.
Cardinal measurement of utility is not possible
Constancy of marginal utility of money is not possible

Indifference curve analysis

Hicks and Allen gave this approach. An IC is a locus of all such points
located on an indifference curve, which gives the consumer the same level
of satisfaction. The different points on the depicted IC show the same level
of satisfaction.

But we must bear in mind the concepts of the Marginal Rate Of

Substitution and the Diminishing Marginal Rate Of Substitution. The MRS
is the rate at which the consumer is willing to sacrifice the number of units
of another commodity, so that his over-all level of satisfaction may remain
unchanged.
The marginal rate of substitution is the amount of one good (i.e. work) that
has to be given up if the consumer is to obtain one extra unit of the other
good (leisure).

The equation is below.

The marginal rate of substitution (MRS) = change in good X

/change in good Y
The DMRS states that the MRS of good X for good Y will go on diminishing
while the level of the satisfaction of the consumer remains the same.
Combination

Mangoes

Milk

MRS

10

3:1

2:1

1:1

Indifference Map

ASSUMPTIONS
1

Rational consumer

Ordinal utility

DMRS

Consistency in selection

Transitivity.

Properties of IC
An IC has a negative slope or that it slopes downwards

IC are convex to the point of origin

Two IC cannot intersect each other

Higher IC represents the

higher level of satisfaction

IC need not be parallel to each other

Straight line Indifference curve

Price Line or the Budget Line

It may be defined as a set of combinations of two commodities that

can be purchased if whole of the given income is spent on them.
If there is an increase in the income of the consumer, the budget line
shifts

It can also increase due to the change in the price

Consumer equilibrium through the Indifference curves

There are two conditions of the consumer equilibrium:
1) Price line should be tangent to the Indifference curve
2) Indifference curve must be convex to the point of origin.

Income effect Substitution effect and Price effect

INCOME EFFECT
Another important item that can change is the income of the consumer. As
long as the prices remain constant, changing the income will create a
parallel shift of the budget constraint. Increasing the income will shift the
budget constraint right since more of both can be bought, and decreasing
income will shift it left.

Depending on the indifference curves the amount of a good bought

can either increase, decrease or stay the same when income increases. In
the diagram below, good Y is a normal good since the amount purchased
increased as the budget constraint shifted from BC1 to the higher income
BC2. Good X is an inferior good since the amount bought decreased as the
income increases.

Price effect
These curves can be used to predict the effect of changes to the budget
constraint. The graphic below shows the effect of a price shift for good y. If
the price of Y increases, the budget constraint will shift from BC2 to BC1.

Notice that since the price of X does not change, the consumer can still buy
the same amount of X if they choose to buy only good X. On the other hand,
if they choose to buy only good Y, they will be able to buy less of good Y
since its price has increased.To maximize the utility with the reduced
budget constraint, BC1, the consumer will re-allocate consumption to
reach the highest available indifference curve which BC1 is tangent to. As
shown on the diagram below, that curve is I1, and therefore the amount of
good Y bought will shift from Y2 to Y1, and the amount of good X bought to
shift from X2 to X1. The opposite effect will occur if the price of Y
decreases causing the shift from BC2 to BC3, and I2 to I3.

How demand curve can be obtained through the price Effect

Substitution effect
Every price change can be decomposed into an income effect and a
substitution effect. The substitution effect is a price change that changes
the slope of the budget constraint, but leaves the consumer on the same
indifference curve. This effect will always cause the consumer to substitute
away from the good that is becoming comparatively more expensive. If the
good in question is a normal good, then the income effect will re-enforce
the substitution effect. If the good is inferior, then the income effect will
lessen the substitution effect. If the income effect is opposite and stronger
than the substitution effect, the consumer will buy more of the good when
it becomes more expensive. An example of this might be a Giffen good.

Applications of Indifference curves

1 In the field of consumption.
With the help of consumer equilibrium one can find out the position
of consumer equilibrium.

Consumer surplus
Money Income

No. of Ice creams

It has helped us to solve the problems of price effect, income effect

and substitution effect.

In the field of exchange

In the field of Public Finance

Effects of rationing

In the field of production.

THEORY OF PRODUCTION AND COSTS

Production function refers to the functional relationship between the
physical output and the physical inputs. Thus it is the relationship between
the quantity of output and the quantities of inputs used in the process of
production.
Example x = f ( a, b, c, d.)

Production function can be of both the fixed proportions type and the
variable proportions type.
In the fixed proportions type the labour as well as the capital are used in
the fixed proportions. Example if the technical coefficient of production is
1/5, i.e. to produce 200 units of a commodity 40 labourers are employed
then it continues to be the same for all the units.

Capital

300
200
100
5

10

15
Labour

Variable proportions type production function

In this type of the production function different factors of production can
be used to produce a given level of output.

One variable input

Law of increasing returns to a factor or diminishing costs: it occurs when
more and more units are employed and the marginal production goes on
increasing or the average costs start diminishing.
It could be due to the indivisibility of factors or the increase in efficiency
arising out of the division of labour.

AC
MP

Labour

labour

Law of Diminishing returns or the increasing returns: It occurs when

as a result of increase in the factors of production cost of production per
unit of the commodity goes on increasing.

MP

AC

Labour

labour

It could be due to the fixed factors of production or more than the optimum
production or imperfect factor substitutability between the factors.
Law of constant costs or the constant returns to the factor: It takes
place when the additional application of the variable factor increases the
output only at a constant rate.
MP

AC

Labour
Law of variable proportions

Labour

Returns to scale
When all the factors of production are increased in the same proportion
and as a result output increases more than proportionately then it is known
as constant returns to scale. Example P = f (L, K)
If both the labour and capital are increased in the same proportion
and a result there is a change in the output it will be termed as returns to
scale.
P1 = f (mL, mK)

Two variable input

Meaning of the equal product curves:

An iso product curve shows all the combinations of the two inputs
physically capable of producing a given level of output. In the able given
below we can have an estimate regarding the equal product combinations.
Combinations

Factor Z1

Factor Z2

12

Consumer side

Producer side

Indifference Curve

Isoquant

ICs are level

sets of Isoquants are level sets of
consumers utility function.
production function.
Every point on an IC
represents a combination of
consumption
goods
that
yields the same level of
utility.
Iso Product Map

Every point on an isoquant

represents a combination of
inputs that yields the same
output.

Marginal Rate of Technical Substitution Marginal Rate Of

Technical Substitution (MRTS) is the increase in productivity a company
experiences when it substitutes on unit of labour input - ie, an hour worked
by a factory worker - for one unit of capital - ie, a machine on the factory
floor.
A positive MRTS indicates that it is advantageous for a company to
make this substitution, and a negative MRTS implies that the company
would drop in productivity if it did this.

An iso cost line is that line which shows the various combinations of
two factors that can be purchased with the given amount of money.
Change in the iso cost curves

Producers equilibrium with the equal product curves

Cost Minimisation
45
C a p ita l p e r w e e k

40
35

Cost minimising
point

30
25
20
15
10

50
1000

5
0
0

10
La bour pe r w e e k

The expansion path

15

20

Deriving Long Run Total Cost

45
Ca p ita l p e r w e e k

40
35

Expansion path

30
25
20

100

15
10

50

1000

0
0

10

1600
15

20

La bour pe r w e e k

INCREASING, CONSTANT AND DIMINISHING RETURNS TO SCALE

Decreasing returns to scale
If an increase in all inputs in the same proportion k leads to an
increase of output of a proportion less than k, we have decreasing

returns to scale.
Constant returns to scale
If an increase in all inputs in the same proportion k leads to an
increase of output in the same proportion k, we have constant returns
to scale. Example: If we increase the number of machinists and
machine tools each by 50%, and the number of standard pieces
produced increases also by 50%, then we have constant returns in
machinery production.
Increasing returns to scale

If an increase in all inputs in the same proportion k leads to an

increase of output of a proportion greater than k, we have increasing
returns to scale.
RIDGE LINES OR THE ECONOMIC REGION OF PRODUCTION

Between the shaded area the factors of production can be substituted

for each other. No producer will operate at the points outside the ridge
lines, as it is an inefficient zone. The production outside the ridgelines
involves an increase in both the labour as well as capital to produce the
same amount of output. Hence this area is called the region of economic
nonsense. A rational producer will operate in the region bounded by the
two ridgelines where the iso quants are negatively sloping and marginal
products of factors are diminishing but positive.

Cost analysis
Fixed costs: These are the costs that do not change with the change in the
level of output. These costs remain fixed at all the levels of output. Even if
the output is zero these costs are to be borne by the producer.
Variable costs these are the costs, which change with the change in the
level of output. These costs rise as the level of output also goes high.
Total cost: These costs are the summation of the fixed costs and the
variable costs.
TC = FC + VC

Marginal cost
Marginal cost is the change in the total costs due to the production of one
more or one less unit of output.
Marginal cost =

the change in total costs

the change in output

Using mathematical notation where the Greek letter delta is used to signify
- change in.
MC

TC
Q

Average fixed costs: these are aobtained by dividing the fixed costs with
output

Average variable costs: these are obtained by dividing the variable costs
with the output
Average total costs: these are obtained by dividing the total costs with the
output.

Relationship between short run variable costs.

Relationship between AC and MC

Long run average cost curve

Long run average cost curve is the summation of the short run
average cost curves. Therfore it is also called the envelope curve.

The Saucer-Shaped LRAC curve

$/q

LRAC

q0

q1

Between 0 and q0: Economies of Scale

Between q0 & q1: Constant returns to scale
Between q1 and : Diseconomies of Scale

Revenue function
AR and MR curves
AR is the revenue per unit of the output sold. It is obtained by dividing
the Total Revenue with Q. Precisely it is the demand curve of the firm.
MR is the change in the TR due to the sale of one more or one less
unit of the output.
MR = TRn - TRn-1

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Total and Marginal Values

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each successive unit.
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under the curve
represents TR

Ped = -1

D = AR
Sales

MR
Copyright 2005 Biz/ed

http://www.bized.ac.uk

Total Values
Cost/Revenue

Total Revenue is price x

quantity sold. (TR = P x Q)
The
slope
of the
TR curve
A firm
facing
a downward
varies
each point.
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slopingatdemand
curve
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TR
Output/Sales

Copyright 2005 Biz/ed

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Cost / Revenue

TC

Putting the two together:

If a firm was to target revenue
maximisation as an objective,
If we
put the
diagrams
this
would
nottwo
necessarily
together with
we can
correlate
the see
profitthat profit
maximisation
occurs
where the
maximising output revenue
difference between
andTR
TC
maximisation
occursTR
where
is
greatest
(where
MC
is at a maximum (MR = =0)MR)

TR
Output/Sales

MC

D = AR
Q1

Q2

Output/Sales

MR
Copyright 2005 Biz/ed

AR, MR ()

Price ()

Deriving a firms AR and MR: price-taking firm

D = AR
= MR

Pe

D
O

Q (millions)

(a) The market

Q (hundreds)

(b) The firm

AR and MR curves for monopoly and monopolistic competition

Revenue

Revenue

AR

AR

MR
Monopoly

BREAK EVEN ANALYSIS

MR
monopolistic

PRICING UNDER PERFECT COMPETITION

Perfect competition is a market situation characterized by the
following features:
Large number of buyers and sellers
Homogeneous products
No selling costs
Same AR and MR curves
Perfect mobility
Perfect knowledge
No extra transportation costs
In the pure competition the conditions of Perfect mobility and Perfect
knowledge are missing.
SHORT RUN EQUILIBRIUM IN PERFECT COMPETITION
In the short run in perfect competition the firms may get normal
profits, super normal profits of it may incur the loss.
First of all the firm
earning the super normal profits is shown in the diagram.

Short-run equilibrium of industry and firm under

perfect competition
P

MC

Pe

AC

D = AR
= MR

AR
AC

D
O

Qe
Q (thousands)

Q (millions)

(a) Industry

(b) Firm

In the diagram the firm incurring the loss is shown but the extent of
loss should not exceed the average variable costs.

Loss minimising under perfect competition

AC
P1

AC

MC

D1 = AR1

AR1

= MR1

D
O

O
Q (millions)

(a) Industry

Qe
Q (thousands)

(b) Firm

The shut down point of the firm is given below

Short-run shut-down point

MC

AC

AVC
D2 = AR2

AR2

P2

= MR2

D2
O

O
Q (thousands)

Q (millions)

(a) Industry

(b) Firm

Long run equilibrium of the firm

Long-run equilibrium under perfect competition
Profits return
Supernormal
New firms enter
to normalprofits
P

S1
Se

LRAC
P1

AR1

D1

PL

ARL

DL

D
O

O
Q (millions)

(a) Industry

Long run equilibrium of the firm

QL
Q (thousands)

(b) Firm

Long-run equilibrium of the firm under perfect competition

(SR)MC
(SR)AC

LRAC

DL
AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

Constant cost industry

Various long-run industry supply curves under perfect competition

S1

S2

D1
O

Long-run S

D2
Q

(a) Constant industry costs

Increaing cost industry

Various long-run industry supply curves under perfect competition

P

S2

S1
b

Long-run S

c
a

D2
D1
O

(b) Increasing industry costs: external diseconomies of scale

Decreasing cost industry

Various long-run industry supply curves under perfect competition

P

S1
S2

a
c
Long-run S

D1

D2

(c) Decreasing industry costs: external economies of scale

Price and output determination under monopoly

A monopoly is a market situation in which there is
1. One seller
2. Large number of buyers
3. No entry or exit of firms
4. No distinction between firm and industry
5. Price discrimination
6. AR and MR curves downward sloping
7. No close substitutes
Causes of monopoly
1. Government policy
2. Entry lag
3. Unfair competition
4. Business mergers

Determination of price and equilibrium under monopoly

losses under monopoly

In the long run also the monopoly firm continues to earn the super normal
profits.

Discriminating monopoly

When a monopolist charges different prices from different people for the
same product, he is said to be a discriminating monopolist.

Degrees of price discrimination

First-degree price discrimination: here the monopolist charges a different
price for each unit of the commodity sold. He charges what the
consumer is willing and able to pay. Thus there is the maximum
exploitation of the consumers in this case.
Second degree price discrimination: here the buyers are divided into
different groups and from each group the monopolist charges a
different price.
Third degree price discrimination: here the monopolist splits the entire
market into a few sub markets and thus charge a different price in
each sub market
MONOPOLISTIC COMPETITION
It is a market situation in which there are a large number of small sellers,
selling differentiated but close substitute products.
Assumptions
Large number of firms and buyers
Product differentiation
Freedom of entry and exit of firms
Selling costs
Imperfect knowledge
Non-price competition
Short and long run equilibrium in monopolistic competition

FIGURE
FIGURE 1:
1: Short-Run
Short-Run Equilibrium
Equilibrium

Under
Under Monopolistic
Monopolistic Competition
Competition
MC

Price per Gallon

AC
$1.80
P

$1.50
1.40

$1.00

MR
12,000
Gallons of Gasoline per Week
Copyright 2006 South-Western/Thomson Learning. All rights reserved.

Monopolistic Competitor Taking a Loss in the

Short Run
24
MC
22
20
18

ATC

16
14

ATC is $12.80
Price is $11

12
10
8

Total Profit=(Price-ATC) X Output

=($11-$12.80) X 42
=(-$1.80) X 42
= -$75.60

4
MR

2
0

10

20

30

40

50

60

70

80

90

100

120

140

160

Output

Output is 42
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

24-7

FIGURE
FIGURE 2:
2: Long-Run
Long-Run Equilibrium
Equilibrium

Under
Under Monopolistic
Monopolistic Competition
Competition
MC

Price per Gallon

AC

$1.45
$1.35

E
D
MR
10,000

15,000

Gallons of Gasoline per Week

Copyright 2006 South-Western/Thomson Learning. All rights reserved.

Under utilization in the long run

Under-utilisation of capacity in the long run

LRAC

DL under monopolistic
competition

Q1

Q2

Group equilibrium

product differentiation in the long run

Selling costs
The costs incurred on advertising, publicity and salesmanship are
known as selling costs. The need for the advertising arises if the
buyers are not available about the product or there are many rivals
for the firm. In this case the selling cost is assumed to be a fixed cost.
By adding selling costs to the original curve the new curve so
obtained will be above the original curve. The area FP indicates the
maximum net return in this case.

MC

F
E
AR
MR

Pricing under oligopoly

Kinked demand curve

Price leadership under monopoly

Under this system one firm becomes a leader and set the price which
is to be followed by all the firms. It often happens that price
leadership is established as a result of price war between the firms
and as a result one firm comes out as a leader.
Price leadership is mainly of the following types
By a dominant firm (which produces a bulk of ots products)

Barometric price leadership (which can predict furutre well as well as

custodian of othere firms)
Aggressive price leadership ( due to aggressive price policies)

MCb
MCa
Price
D
MR
N M
Quantity
Firm A has a lower MC. The profit maximising price of firm A
is lower than the firm B. It means that now the Firm A will dictate the
terms for the firm B whose profit maximising price is higher. If B does
not follow the conditions as dictated by A then it will be ousted by A.
COURNOT MODEL OF OLIGOPOLY

s
P
c
z

0
A

In the diagram before the entrance of B, A produces the

output OA which is 1/2 of OB. The price is OC and the profits are
OAPC. B produces the output AH which is 1/4 of OB. The price falls
from OAPC to OARZ total profit being OHQZ. When B produces the
AH which is of the whole the total output left for A is ( 1 ) =
3/8. What is now not produced by A is produced by B that is (1-1/8) =

5/16. Now A may react by producing

(1 5/16) = 11/32.
This process will continue till equilibrium utput and price
are reached.