Business economics

Economics & Managerial Economics
Economics may be defined as a branch of knowledge dealing with allocation of scarce
resources among competing ends.
Managerial Economics may be defined as application of economics for problem solving at
the corporate level.
The problems relate to choices & allocation of resources which are basically economic in
nature & are faced by managers all the time.
The focus on managerial economics lies in identifying & solving problems faced by a
manager in a given enterprise situation & not merely on explaining his behaviour or
theorising about firm level phenomena.
As a result ,managerial economics though rooted in economic theory drawas upon &
interacts with other related disciplines.
Broadly three variables influences managerial decisions-(i) Human & behavioural
considerations (ii) technological forces (iii) Environmental Factors

Factors Affecting Managerial Decisions
Often only pure logic does not contribute to decision making.
HUMAN FACTOR
Human behavioural considerations often infuences a manager into compromising or
moderating a decision which would otherwise have made economic sense.
Example,Impact of a decision on an employee’s morale or motivation, which is outside
economic consideration, is taken into account.
Many enterpreuners prefer to do business on a modest scale fearing that expansion
would hamper their lifestyle and increase their stress levels despite the fact that clear
prospects of increased growth & better earnings await them.
A final decision is therefore taken by considering both economic factors & human
elements.
It is not uncommon for sentiments & emotions to play a part in very important decisions
even if that means a slight erosion in profits as long as there is a long term advantage.

TECHNOLOGY
In the present day business scenario, the influence of technology is too pervasive to be
ignored .
An assessment of technological alternatives ,technological measures of competitors and
new emerging technologies are critical factors in a managerial decisions on planning &
resource allocation within the enterprise.
Even short term production & marketing decisions are bound to take into account
appropriate technical inputs.
However beware that only technological options can provide a basis for decision making-
it has to be essentially an interplay of economic & technological factors.
In fact, economic considerations often decide the fate of technological applications.

ENVIRONMENT
Environmental pressures operating on the enterprise affect managerial decisions when
they are primarily economic in nature.
Economic sense may call for price rise but political & social factors often come in the
way of doing so.
Political parties, consumer groups, trade unions & community organisations constantly
put forth their view points which come in direct conflict with economic decisions.
Similarly social costs such as pollution control measures add a cost to the enterprise &
social organisations tend to come in the way of decisions which would otherwise make
economic sense.
Since the above mentioned cost cannot be ignored in the present day context,state
itself intervenes and this results in additional cost to the enterprise.

Managerial economics & Other Disciplines
It is customary to divide economics into positive & normative economics.
Positive Economics deals with description & explanation of economic behaviour.
Normative economics ,value judgement is made as to what should be done & not to be
done.
Managerial economics is a part of normative economics as its focus is more on explaining
choice & action & less on explaining what has happened.
Thus the system of logic that managerial economics uses comes from this heritage of
economic theory.
The primary task of managerial economics is to fit relevant data into the framework of
logical analysis for enabling decision.
Eg.A decision based on a linear programming approach or a pricing decision based on a
model approach.
Another branch of economics which is normative like managerial economics is public
policy analysis which is concerned with managing the government of a country.

DEMAND
Demand refers to consumer response related to purchase of goods &
services in a given market condition.
Law of demand states that other things remaining the same,rise in price leads
to a fall in demand & vice versa ie.they are inversely proportional to each
other.
1.Price of air ticket,impact on air travel/railway travel
2.Price of cylinder/impact on consumer
3.Price of petrol/impact on car demand
4.Price of diesel/impact on purchase of car
5.Price of wheat/impact on demand for rise
6.Govt.introduces rationing for essential goods,demand for these goods in
free market
7. Interest rates reduced by RBI, demand for housing
Determinants of individual demand :
(i) Price of commodity
(ii) Level of income,personal tastes
(iii) Price of substitute goods
(iv) Price of alternate goods

Demand Curve
It is the graphical representation of quantity of a commodity purchased by an
individual at a given price & time.
If the price of the commodity for a heart patient increases,it will not reduce its
demand.In that case,demand curve will have a steeper slope.
If the product concerned is not that essential & it has more substitute goods ,the
consumer will shift to other cheaper option e.g.tooth paste.The slope of the
demand curve will flatten.
Demand curve represents buyers willing to purchase at various prices assuming
other factors to be constant.
Demand curves are also taken as marginal utility curves wheras supply curves
reflect marginal cost curves.
As consumer purchases more & more of a commodity,the utilty drawn from the
extra commodity diminishes.
Diminishing marginal utility is one of the causes behind the downward sloped
demand curve.

Movement & Shift in Demand Curve
Expansion & contraction of demand leads to movement along demand curve.
Increase or decrease in demand leads to shift in demand curve.
Movement along the demand curve takes place where change in demand is caused
only due to price change.In this case,demand curve will remain the same, either
upward or downward movement along the demand curve takes place.Eg.price falls
from Rs.8 to Rs.7 & quantity purchased by consumer increases from 5 units to 7 units.
In the case of shift in demand curve,the demand increases or decreases due to shift in
other variables (income,taste,fashion etc) other than price.The price of X remains
constant but change in other variables increase the demand
viz.income,preference,price of other goods etc. Increase in demand leads to shift in
demand curve in outer direction & decrease in demand leads to shift in demand in
the inner direction.
As a result of shift in demand curve,both equilibrium price & quantity demanded will
change.

Success of a company depends upon the revenue earned by the company.
This in turn depends upon
(i) Company’s ability to offer goods & services that the customers want.
(ii) Price that the customer is ready to pay.
Demand, in other words, is nothing but sales of the firm.
Sales depends upon many things such as customer’s preference,price,income,taste &
preferences.
On the basis of the actual sales,the firm can project its future.

Individual Demand & Market Demand
Mr.X Mr.Y
Price Qty demanded quantity demanded
10 0 1
9 1 2
8 2 3
7 5 4
6 8 5
5 12 7
4 15 9
3 18 22
2 20 35
1 20 35

In the first case,Mr.X does not buy anything presuming that it is too expensive.
When the price drops to Rs.9,he purchases only one.
With the price drop, he purchases more because it is less expensive.
But he does not go for anything extra after price dropped to Rs.2
That means even after a further price fall,he will not anything more
In the case of Mr.Y,at Rs.10,he purchases atleast one wheras Mr.X buys nothing.
Upto Rs.4,he purchases at a slow rate
Below Rs.3,he purchases at a faster rate.
As price reaches Rs.2,Mr.Y does not purchase more than 35 as his requirement of that
commodity is fulfilled & he does not desire to buy more than 35 of the product.
The demand of X & Y of a given commodity at different prices gives us individual demand
curve.
When we add up all the individual demand curves,we obtain demand for the community.

Demand Analysis
Demand theory mainly based on individual demand.
But more than one firm operates in the market & each of them hold part of the market
share.
Each firm’s policy decision influences the market.
Thus individual firm’s demand is not market demand.
When many firms operate,demand curve faced by an individual firm is more important than
market demand curve for pricing & output decision.
The firm has also to consider the impact of changes in demand due to taste,preference &
price of other goods.
Pricing & output policy of the firm affect the consumer’s decision to purchase.
Firm’s demand could also be a function of pricing policy of other firms.Price cut by a firm
will obviously increase its sales at the cost of market share of the other firm.
Promotional activities would have a similar effect as above.

Demand Function
D=f(P)
It is the simplest form of demand equation where demand solely depends on price.
When other variables influence demand it is Dx=f(Px:Po;Y,T,Ut)
Dx=demand for commodity X,Px is price of X,Po is price of commodity o,T is time Ut
represents other variables.
A true demand curve which shows how sales vary with price .
This is the curve which must be involved in optimum pricing-out policy calculation.
Sometimes we see only the trend of demand ,whether it is increasing or decreasing over a
period of time t .Then we get, D=f(t)
Market demand can be expressed as Qd=f(P,I,Pz,T) ,where Qd is demand for commodity
q,I is icome,Pz=price of competitive commodity Z.,T is time.
P,I,Pz,T are independent variables that influence demand.
The linear form will be
Qd=a + bP + cI + dPz + eT
where a is the intercept,b is the price elasticity of the product for demand measured,c is
income elasticity d is cross elasticity & e elasticity with respect to time variable.

Marginal Utility
It is the satisfaction derived on the marginal or extra units of commodity
purchased.
Diminishing returns
As the consumer accumulates more & more quantity of a commodity, the
satisfaction derived by him goes on reducing with the increase in that quantity.
Direct Demand
When a consumer purchases a product for his direct consumption,the demand is
termed as direct demand.
Derived Demand
Sometimes a demand for an item depends upon the demand for the final
product.E.g.demand for labour & other inputs is created due to demand for the
final product.In tourism, demand is direct when sales take place for final
consumption.accommodation,tourist guides,vehicles for transport are derived
demand.

Composite Demand
When two products are demanded for different purposes e.g. fridge which is required
by a shop for commercial purpose & a household for domestic use.
Joint Demand
When two products are demanded at the same time,it is called Joint demand e.g.car &
petrol.
Latent Demand
When a consumer’s desire is limited by their purchasing power,a latent demand exists.
Composite Goods
Composite goods represent what is given up included in the optimal choice subject to
budget constraint.
Giffen Goods
They are highly inferior products which consumer does not buy even after a price fall.
Consumers of low income group will spend a significant portion of their income on
such goods.They keep on moving to other cheap quality items.Hence demand in such

Veblen Goods:
Opposite of Giffen Goods-they are high fashion goods-branded,high quality stuff.
Higher price will not discourage people into buying less.
There is a snob value for designer collection etc.
The rich society patronise such market & feel that if the price reduces,it would be worth
buying.
Hence the demand actually reduces if the price falls.
Price Change,Income effect & substitution effect on Demand
Price change generates two effects: Income effect & Substitution effect.
Income Effect
Eg:Suppose price of x is Rs.10 & you purchase ten units.In case price falls to Rs.6,with the
same amount of money you can buy more.
Price change will give you surplus money that is called income effect of price change.Your
real income increases by 10 – 6 = 4.

Substitution Effect
In the aforesaid case,after purchasing same amount of X,you can purchase some other
item or you can purchase more of both commodities.this is called substitution effect.
Substitute Goods
Goods which serve the same purpose such as tea & coffee.Slight change in price of one
can affect the demand for the other.Copper & aluminium is another example.
Complementary Goods
When both goods are required at the same time eg. Car & petrol/diesel.Increase in price
of one will decrease the demand for the other & vice versa.
ELASTICITY & DEMAND CURVE
If the demand curve is flat,the demand is more elasic (change in demand on account of
change in price)

Diamond Water Paradox
Diamonds have very less utility value but fetch a very high price whereas in case of water,it is
vice versa. This is called diamond water paradox
This is explained on the basis of MU –Marginal Utility.
MU for diamond is very high as it is a scarce commodity, hence it fetches a very high price.
MU of water is low as it is easily available hence its price is low.
In terms of total utility, it is high for water & low for diamond.

Factors affecting demand
1.Price of commodity
2.Disposable Income
3.Distribution of Income
4.Price of other commodity
5.Quality of goods & services
6.Availability of goods & services
7.Population
8.Taste & preference
9.Brand name
10.Advertising
11.Demonstration effect
12.Time
13.Instalment/deferred payment
14.Personal touch
15.Bandwagon effect (positive network
externality)

SUPPLY
The amount of goods & services that firms are able & willing to offer for sale over a
range of price.
Law of supply states that quantity supplied is directly proportional to price.
The supply has a +ve upward slope from left to right.
The simplest equation is Sx=f(px) where sx=supply of commodity ,px=price of
commodity x.
Low prices therefore discourges to produce more whereas high price acts as an
incentive to earn more.
Higher prices attract existing producer to increase supply & it invites new producer to
join the market.
Supply is a flow concept & stock is a part of supply .
Supply is limited to the availability of stock at any point of time.

Individual Supply Schedule
It shows the various amounts of a commodity that a particular firm wants to supply at
different prices in the market ,other factors remaining constant.
Price increase will attract new firms to enter the market.
It encourages a firm to produce more to earn more profit.
Price decrease will discourage new entrants into the market
It will also discourage the firm from producing more.
If the price falls very low even below the cost of production,a firm may not be able to
supply at all.
Thus supply & price are +vely corelated.

Market Supply schedule
The horizontal sum of all firms’ supplies at different prices gives us market supply.
The supply is directly related to market price we get a +ve slope of the curve.
The short run supply curve has a +ve slope on a/c of a diminishing marginal returns.
After a level of production, the production of additional units require more of variable
factors .
In the short period, it is not possible to increase the fixed factor part & diminishing returns
begin to operate.
The long run supply curve has a +ve slope due to presence of diseconomies of scale like
managerial inefficiency,limited resources etc.
Under competitive industry, a firm likes to reach a level Price=Marginal cost.
Thus aggregate supply curve is the total of marginal cost curves.
Industrial supply=Supply of all the firms.

Shift in Supply Curve
Shift in supply curve takes place when the product price remains the same & the firm
wants to supply more or less.
The supply curve will move to either right or left of the original curve.
There can be a change in variables other than price which affect supply, say if the firm
can produce more at a lesser cost due to improvement in technology & supply more at
the existing price.Here the supply curve will shift outwards.
Similarly if the cost of higher inputs result in increase in cost of production,the firm will
produce less ,supply less at the existing price & the supply curve will move inwards.
In both cases,there will be a change in the equilibrium price & quantity.

Expansion & Contraction of Supply
The movement along the same curve takes place when amount of supply increases or
decreases due to change in price of commodity.
If the price falls to P’ ,the amount supplied by the firm will fall by QQ’.
If the price rises,the firm will supply more of the quantity( things other than price which
might influence supply are assumed to be constant).
Factors determining supply
1.Price of Commodity
2.Price of other commodity
3.Price of factors of production
4.Production technique
5.Tax net of subsidy
6.Goal of producer

Other Factors Affecting supply
1.Production cost of goods & services
2.Price of inputs
3.Technology
4.Taxes & subsidy
5.Administered
Supply Chain
Supply Chain includes all continuous adjustments of storage of raw materials,work in
progress,finished goods from the point of production to the end users.
Outsourcing is an important example for managing supply chain in modern day’s
business.

Exceptions to Law of Supply
(a)Expectation of further change in price.
(b) Agricultural goods
© Where resources are limited
(d) High quality artistic goods
(e) Elasticity of supply & so on.
In case of art goods,antiques,rare collections ,price
rise will not increase supply due to limited availability.
Sometimes supply curve can be a vertical straight line
very perishable goods or service sector items
e.g.supply of milk which is fixed for the day.
Supply of agricultural goods cannot be increased
beyond a certain level.
Thus shape & slope of the supply curves will differ
due to various reasons that may influence supply.

DEFINITION of ‘UNEMPLOYMENT RATE”
The percentage of the total labour force that is
unemployed but actively seeking employment and
willing to work.
Percentage of total workforce who are unemployed and
are looking for a paid job.
Unemployment rate is one of the most closely
watched statistics because a rising rate is seen as
a sign of weakening economy that may call for cut in
interest rate. A falling rate, similarly, indicates a growing
economy which is usually accompanied by
higher inflation rate and may call for increase in interest
rates.

Definitions: Unemployment and the unemployment rate
To be classified as unemployed ,people must satisfy two primary criteria:
(i) they must have no job and
(ii) they must be actively seeking employment.
Those who do not have jobs and are not actively searching are considered to be
out of the labor force.
To be precise, unemployed persons are those who “had no employment during the
reference week, were available for work, except for temporary illness, and had
made specific efforts to find employment sometime during the four-week period
ending with the reference week.”
There is one exception to this rule: “persons who were waiting to be recalled to a
job from which they had been laid off need not have been looking for work to be
classified as unemployed.”1
The group classified as out of the labor force is not limited to people who don’t
desire employment. Indeed, it includes people who do not have jobs and are
interested in finding work (as signaled by the fact that they have looked for work
sometime in the past year), but gave up looking because they do not believe that
there are jobs available. Such people are classified in the survey as discouraged
workers.

While it is true that discouraged workers are in a situation similar to the unemployed,
this group typically is quite small in relative terms and exhibits a cyclical pattern similar
to the unemployed. As such, including discouraged workers in an expanded measure
of unemployment does not significantly alter the evaluation of changes in labor market
conditions overtime.
To assess labor market conditions, economists use the unemployment rate, defined
as the number of unemployed persons as a percent of the total labor force,2 rather
than the number of unemployed.
It is useful to compare the actual unemployment rate to the estimate of the “natural”
rate of unemployment or the unemployment rate that occurs when short-run cyclical
factors have fully played out—that is, wage rates in the economy have adjusted such
that overall labor demand and supply are in balance
The deviation of unemployment from its natural rate is referred to as cyclical
unemployment, or unemployment that results from short-run variation in labor
demand. The actual unemployment rate exhibits considerably more volatility than the
natural rate, because the natural rate by definition omits volatility caused by short-term
fluctuations in the labor market.

The actual rate vs. the natural rate
When the actual unemployment rate dips below the estimated natural rate, labor
markets typically are described as “tight.” When the opposite occurs, you might
start hearing about a “softer” labor market, or a labor market that has “slack.” Of
course, the comparison of the actual and natural rates of unemployment is
complicated by the fact that the latter is only an estimate of a theoretical concept,
not a number that one can explicitly measure, and considerable uncertainty
surrounds that estimate.
Types of unemployment
One might question why economies experience unemployment at all and why,
even in the most developed and prosperous economies, unemployment always
exists.
Part of the answer is that it takes time for workers to find new jobs.
Thus, even if a job that matches a person’s skills and preferences exists, it may
take some time for the person to discover that job.

The type of unemployment that exists because a job search takes time is
sometimes referred to as frictional unemployment.
In contrast,structural unemployment refers to a persistent mismatch between
labor supply and demand, arising, for example, from a shortfall of skilled workers
relative to available jobs or unbalanced growth in labor demand across regions
or industries.
As you probably suspect, policymakers typically consider frictional
unemployment to be less problematic than structural unemployment.
This is because reflects the time it takes for workers to find the jobs that suit
them best and at which they presumably will be the most productive.
Unemployment spells, defined as an uninterrupted period of months in which an
individual was unemployed, associated with frictional unemployment tend to be
short, whereas those associated with structural unemployment can be quite long.

When can high employment be problematic?
Finally, you asked what can be bad about high employment.
Most people are aware that high unemployment is not desirable.
As Federal Reserve Governor Mishkin said in a 2007 speech, high unemployment “is
associated with human misery, including lower living standards and increases in
poverty as well as social pathologies such as loss of self-esteem, a higher incidence
of divorce, increased rates of violent crime, and even suicide.”
In addition to these social costs, unemployment clearly causes economic problems for
the unemployed.
On a macroeconomic level, high unemployment implies that the economy isn’t utilizing
its resources and, therefore, is performing below its potential.
High unemployment also costs the government money in terms of increased
expenditures on social insurance programs and reduced tax receipts.

Given the above, shouldn’t policymakers try to push the unemployment rate as low
as possible?
Not quite: pushing unemployment far below its natural rate would also lead to
negative consequences, primary among them inflationary pressures.
The reason is that the maximum level of employment in the economy that is
sustainable (some refer to it as the long-run employment level) depends not on
monetary policy, but on the fundamental structure of the economy: demographics,
characteristics of the labor force, technology, natural resources, etc.
If employment is pushed above this maximum sustainable level, wages will
eventually rise as people realize jobs are abundant and thus they have some
bargaining power.
As wages rise, production costs increase, which could then be passed along to
consumers and hence the rate of price inflation rises. Price inflation has
considerable costs.
As a side note, while monetary policymakers cannot keep unemployment below the
natural rate indefinitely without negative consequences, other policymakers can
influence the structure of the economy by pursuing policies that enhance education
and productivity, thereby increasing the maximum sustainable level of employment
itself, though this is notoriously difficult to do.

Natural Rate of Unemployment
This represents the rate of unemployment to which the economy
naturally gravitates in the long run.
The natural rate of unemployment is determined by looking at the
rate people are finding jobs, compared with the rate of job
separation (i.e. People quitting).
In any given period, people are either employed or unemployed.
As a result, the sum of structural and frictional unemployment is
referred to as the natural rate of unemployment also called "full
employment" unemployment rate.
This is the average level of unemployment that is expected to
prevail in an economy and in the absence of cyclical
unemployment.

Labor Force = Employed + Unemployed
Job Separation Rate
If we assume a fixed labor force and unemployment rate (fixed at the natural
rate), the number of people losing jobs must be equal to the number of people
finding jobs. However, this model is too simple so we must consider the job
separation rate and the job finding rate to get a more accurate figure.
Where,
E = Employed
U = Unemployed
F = Job Finding Rate (This represents the fraction of unemployed people who
are able to find a job each month)
S = Job Separation Rate (This represents the fraction of employed workers
who lose their job each month)
Job Separation Rate: F * U = S * E
This equation demonstrates that the unemployment rate (U/L) is positively
related to the job separation rate and negatively related to the job finding rate.
Therefore, a higher (S) will lead to a higher unemployment rate while a larger
(F) yields a lower natural rate of unemployment. In conclusion, to reduce the
natural rate of unemployment, (S) must be reduced, or (F) must be increased.

Okun's Law
Okun's law simply states that a 1% change in the rate of unemployment will be
associated with a 2% change in output

The Natural Rate of Unemployment
The Natural Rate of Unemployment is the rate of Unemployment when the labour market is
in equilibrium.
It is the difference between those who would like a job at the current wage rate and those
who are willing and able to take a job.
The Natural Rate of Unemployment will therefore include:
frictional unemployment
structural unemployment
E.g. a worker who is not able to get a job because he doesn’t have the right skills
The natural rate of unemployment is unemployment caused by supply side factors rather
than demand side factors
Monetarists argue that the Natural Rate of Unemployment occurs when the Long Run
Phillips Curve crosses the x axis
The Natural Rate of Unemployment is sometimes known as the Non Accelerating
Inflation Rate of Unemployment or NAIRU
This is because when unemployment is 4% there is no tendency for inflation
to increase
In this example the Natural rate of unemployment is 4%. If the govt increased AD there may
be a temporary fall in unemployment but in the Long Run it would return to the natural rate
of 4%
Sometimes the natural rate is known as the full employment level of unemployment
This is because even if the economy is operating at full capacity and there is no demand
deficient unemployment then there will still be some unemployment caused by supply side
factors.

What Determines the Natural Rate of Unemployment?
M. Freidman argued the Natural rate of unemployment would be determined by institutional
factors such as:
Availability of job information. A factor in determining frictional unemployment
Skills and Education. The quality of education and retraining schemes will influence the level
of occupational mobilities.
Degree of labour mobility
Flexibility of the labour market E.g. powerful trades unions may be able to restrict the supply
of labour to certain labour markets
Hysteresis. A rise in unemployment caused by a recession may cause the natural rate of
unemployment to increase. This is because when workers are unemployed for a time period
they become deskilled and demotivated and are less able to get new jobs.
Explaining Changing Natural Rates of Unemployment
It has been argued that the UK has seen a fall in the natural rate of unemployment since the
1980s (even when growth was 5% in 1988 Unemployment was 1.6 million) This has been
explained by:
Increased labour market flexibilities e.g. unions less powerful
Privatisation has helped increased competitiveness of industry leading to more flexible labour
markets
Better education and Training
The New Deal has made it more difficult to remain on benefits

Natural Rate of Unemployment in EU
The rest of the EU has seen a rise in the natural rate of unemployment in the 1990s this could
have caused by:
Rigidity in EU labour markets e.g. min wages, max working week
Restrictions on closing factories and mandatory severance pay for workers made unemployed,
this makes firms more reluctant to set up in these countries
High degrees of unionisation resulting in wage rigidity
Generous benefits which lessen the pain of unemployment
Hysteresis effects. The cyclical recessions of the 1970s and 1980s had long lasting effects
resulting in more unemployment. However this does not appear to have effected the UK
Growing competition from Asian countries
However the rising unemployment may not just be due to the Natural rate increasing but also
due to lower economic growth. Therefore part of the unemployment is cyclical.
NAIRU and Non-Accelerating Rate of Unemployment
A very similar concept to the natural rate of unemployment is the NAIRU – non-accelerating rate
of unemployment.
This is the rate of unemployment consistent with a stable rate of inflation. If you try to reduce
unemployment by increasing aggregate demand, then you will get a higher rate of inflation.
The natural rate of unemployment can also be illustrated using the Monetarist view of the
Phillips Curve. Monetarists argue that the LRAS is inelastic. Thus increased AD only causes a
temporary increase in output and a temporary fall in unemployment.
If there is an increase in AD, firms pay higher wages to workers in order to increase in output,
this increase in nominal wages encourage workers to supply more labour and therefore
unemployment falls.

However the increase in AD also causes inflation to increase and therefore real wages do not
actually increased but remain the same. Later workers realise that the increase in wages was
only nominal and not a real increase.
Therefore they no longer work overtime. Therefore the supply of labour falls and
unemployment returns to its original or Natural rate of unemployment. It is only possible to
reduce unemployment by causing an increase in the rate of inflation. Therefore the natural
rate is also known as the NAIRU (non accelerating rate of unemployment.
This model assumes workers do not correctly predict the rate of inflation but have adaptive
expectations.
(Some economists argue workers will correctly predict higher AD causes higher inflation and
therefore there will not be even a short term fall in unemployment , this is know as rational
expectations.)

Frictional unemployment is defined as the unemployment that occurs because of
people moving or changing occupations. Demographic change can also play a role in
this type of unemployment since young or first-time workers tend to have higher-than-
normal turnover rates as they settle into a long-term occupation. An important
distinguishing feature of this type of unemployment, unlike the two that follow it, is that
it is voluntary on the part of the worker.
Structural unemployment is defined as unemployment arising from technical change
such as automation, or from changes in the composition of output due to variations in
the types of products people demand. For example, a decline in the demand for
typewriters would lead to structurally unemployed workers in the typewriter industry.
Cyclical unemployment is defined as workers losing their jobs due to business cycle
fluctuations in output, i.e. the normal up and down movements in the economy as it
cycles through booms and recessions over time.
In a recession, frictional unemployment tends to drop since people become afraid of
quitting the job they have due to the poor chances of finding another one. People that
already have another job lined up will still be willing to change jobs, though there will
be fewer of them since new jobs are harder to find. However, they aren’t counted as
part of the unemployed. Thus, the fall in frictional unemployment is mainly due to a fall
in people quitting voluntarily before they have another job lined up.
But the drop in frictional unemployment is relatively small and more than offset by
increases in cyclical and structural unemployment.

Beveridge Curve
It depicts a negative relationship between unemployment & no of job vacancies.
The curve slopes downwards as lower vacancies are associated with high rate of
unemployment.
If thev curve shifts outwards,it means that given a certain level of vacancies,we have more
unemployment.
Inward shifting of curve indicates improvement in mismatch.
The movement of this curve takes place due to following reasons:
1.The curve will move inwards depending upon the availability of new jobs.
This will happen with improvement in economy,reduced labour unrest,mobility of labour
etc.
2.If more labour joins the existing labour force,it will increase unemployment & the curve
will outwards.
3.Some employers do not tend to hire under certain conditions,in this case also the curve
will move in the outward direction.

A Beveridge curve, or UV-curve, is a graphical representation of the relationship
between unemployment and the job vacancies.
Job vacancy rate (the number of unfilled jobs expressed as a proportion of the
labor force).
It typically has vacancies on the vertical axis and unemployment on the horizontal.
The curve is named after William Beveridge and it is hyperbolic shaped and slopes
downwards as a higher rate of unemployment normally occurs with a lower rate of
vacancies.
If it moves outwards over time, then a given level of vacancies would be
associated with higher and higher levels of unemployment.
This would imply decreasing efficiency in the labour market.
Inefficient labour markets are due to mismatches between available jobs and the
unemployed and an immobile labour force.
The position on the curve can indicate the current state of the economy in
the business cycle. For example, the recessionary periods are indicated by high
unemployment and low vacancies, corresponding to a position on the lower side of
the 45 degree line, and likewise high vacancies and low unemployment indicate the
expansionary periods, above the 45 degree line.

INFLATION,UNEMPLOYMENT AND PHILIPS CURVE
• Macroeconomic policies are implemented in order to achieve government’s main
objectives of full employment and stable economy through low inflation. We can
use Philips Curve as a tool to explain the trade-off between these two
objectives.
• Philips Curve describes the relationship between inflation and unemployment in
an economy.
• You already know that the Inflation is defined by increase in the average price
level of goods and services over time.
• When there is inflation, value of money falls. A low inflation rate indicates that
average price of goods would not rise as high.
• Unemployment exist when someone is actively seeking for job but unable to find
any despite their willingness to accept the going market wage rate
New Zealand-born economist A.W Philips first put this theory forward in 1958
gathered the data of unemployment and changes in wage levels in the UK from
1861 to 1957.
He observed that one stable curve represents the trade-off between inflation
and unemployment and they are inversely/negatively related. In other words, if

For example, after the economy has just been in recession, the unemployment level will
be fairly high. This will mean that there is a labor surplus.
• As the economy has just started growing, the aggregate demand (AD) will increase and
therefore leading to an increase in employment.
In the beginning, there will be little pressure for a raise in wages.
However, as the economy grows faster and more people are employed, wages will start
rising slowly.
• This will increase the firm’s cost of production and the high costs are usually passed on
to the customers in the form of higher prices.
Therefore a decrease in unemployment has led to an increase in inflation and vice
versa.
• Not only that, unemployed might suffer from money illusion as they thought the
increase in wages offered to them represented a real wage.
They underestimate inflation by not realizing that higher wages will be eaten up by
higher prices.
Thus they will accept job more readily and this will reduce the frictional unemployment in
the short run.

The relationship we discussed above is a phenomenon in the short-run.
But in the long run, since unemployment always returns to its natural rate
(unemployment rate at which GDP at its full-employment level that is, with no
cyclical unemployment…. there is no such trade-off.
[Remember that
• When unemployment rate is below natural rate, GDP is greater than potential
output
– Economy’s self-correcting mechanism will then create inflation
• When unemployment rate is above natural rate, GDP is below potential output
– Self-correcting mechanism will then put downward pressure on price level]
Using the data from the 1950s and 1960s where the world economy tend to be
stable, Philips Curve relationship proved to be true for many economies such as
United States and UK
However, during 1967-1970 most countries such as US, Britain and France had
doubled their inflation .
This was the first sign that the downward relationship in Philips Curve was not
always true.
In 70’s the concept of a stable Philips Curve shows a break down as the economy
suffered from both high inflation and high unemployment simultaneously.
The economists refer this kind of situation as stagflation where stagnant
economies and rising inflation occurs together.

Advantages of Supply Chain
1.It manages all the bottlenecks efficiently.
2.Producer can keep a watchful eye on the increase in cost in the process & trim wasteful
expenditure.
3.Customer requirement & satisfaction can be easily known.
4.Software on SCM helps efficient management of business.
5.Alternate scenarios for processes and end results can be easily noticed & suitable
remedies adopted to run the process.
Disadvantages of Supply Chain
1.Huge cash flow has to be managed across supply chain
2.Inventory management of raw material,work in progress & finished goods involve
immense task.
3.Competent management of supply chain needs constant sharing of information across
the board .Any misinformation or short information could break the chain & result in
losses for the firm.

Equilibrium
1.Market attains equilibrium when supply equals demand.
2.Demand & supply curves intersect each other & market is cleared.
3.Price is the factor which acts a equiliser between supply & demand & brings
about equilibrium in the market.
4.Change in equilibrium reflects change in supply or change in demand or
both.
5.Thus supply & demand for a given commodity determine the equilibrium
price & quantity in a perfectly competitive market.
6.Assuming only price changes,we have
D=f(p)
S=f(p)
In equilibrium,S=D(supply=demand & the market is cleared)
7.The essence of equilibrium is that once its reached,it stays there.
8.Any change is equilibrium will be corrected by price movement.
9.If D<S,there is excess supply of goods & the producer will reduce the price.
10.This will increase demand till equilibrium is reached when market gets
cleared.
11.In equilibrium,there is no pressure on price to change.

Other Factors
1.In the previous slide,we have considered only price as the independent
variable.
2.Shift of demand & supply will occur due to change in variables other than
price.
3.These are change in income, price of substitute goods,emergence of a new
firm in the industry, technology change, taste & preference etc.
Examples:
(i) In the ’90s,due to overestimation in the demand in car market,there was
excess supply of cars.Later on price & production were adjusted & income
constraint also acted as a deteriorating factor.Presently you have a glut with
all types of cars for all income groups.
(ii) Rise in income plus credit facilities have led to a spurt in demand in Indian
car market.
(iii)Private sector now freely operated in India & an increased number in India
of white goods.Free market economy has led to price rise & in times to
come,equilibrium prices also will tend to soar higher.

Changes in own price (due to surpluses or shortages) will lead to a movement
along the demand curve.
In contrast, changes in any of the exogenous variables will lead to an inward or
outward shift in demand.
Any shock that leads to an outward shift in demand (holding the supply of that
good constant) will create a shortage of that good at prevailing market prices.
This shortage leads to an increase in market prices with corresponding
movements along the demand and supply equations until a new equilibrium price
and quantity are established.
SHIFT IN EQUILIBRIUM PRICE

Market for Automobiles
•The market in this example will be for automobiles (assumed to be a complement with
gasoline.
• The exogenous shock will be an increase in the price of gasoline. Given this
shock, consumers will drive less and begin to purchase fewer autos at each and every
price.
•This reaction will lead to a surplus of this good and thus a decrease in the market
price.
•As the market price falls, consumers increase their rate of consumption (an
increase in quantity demanded) along the new demand schedule and producers reduce
the rate of production (a reduction in quantity supplied).
•The net result will be a decrease of both equilibrium price and quantity.
AUTOMOBILE MARKET

Market for Personal Computers
The exogenous shock will be an increase in consumer income.
Given this shock, consumers will attempt to purchase more personal computers at each and
every price.
This reaction will lead to a shortage of this good and thus an increase in the market price.
As the market price rises, consumers reduce their rate of consumption (a decrease in quantity
demanded) along the new demand schedule and producers increase the rate of production (an
increase in quantity supplied).
The net result will be an increase of both equilibrium price and quantity.

The exogenous shock will be an improvement in production technology.
Given this shock, producers will attempt to produce and sell more Cell
Phones at each and every price.
This reaction will lead to a surplus of this good and thus a decrease in the market price.
As the market price falls, consumers increase their rate of consumption (an increase in quantity
demanded) and producers reduce the rate of production (a reduction in quantity supplied) along
the new supply schedule.
The net result will be an increase of quantity and reduction in equilibrium price.

The exogenous shock will be an increase in the price of land.
Given this shock, producers will begin to build and offer for sale fewer new homes at each and
every price.
This reaction will lead to a shortage of housing and thus an increase in the market price.
As the market price increases, consumers decrease their rate of consumption (a decrease in
quantity demanded) and producers reduce the rate of production (a reduction in quantity supplied)
along the new supply schedule.
The net result will be a decrease in equilibrium quantity and an increase in equilibrium price.

DIMINISHING MARGINAL UTILITY
We define the behaviour of buyers based on the goal of maximizing the utility gained
from the purchase and consumption of this same good.
As prices fall,holding income constant, the buyer finds that his/her purchasing power has
increased allowing for buying greater quantities of a particular good.
It is also the case that, for the consumer, additional quantities of a good consumed provide
less additional satisfaction relative to previous units consumed.
This notion, known as diminishing marginal utility, implies that the consumer is willing
to pay less for these additional units as it becomes more efficient to use his/her income
for the purchase of other goods.
For the buyer, these types of behaviors typically lead to a negative relationship between the
market price (dependent variable) and quantity demanded ‘Qd’(another independent
variable).
Decisions to Consume: Individual decisions about what to consume and how much to
consume are based on the benefits/satisfaction provided by different goods and services.
In the case of a particular good, decisions about quantity are based on the benefits of
consuming one more unit (the Marginal Benefit ‘MB’) relative to the price of that good.
If the MB of a good exceeds this market price, then the consumer will receive a surplus
(consumer surplus) such that the value in consumption exceeds the necessary expenditure
for one more unit of that good.

we assume that one unique price exists such that the Quantity Supplied
by sellers is exactly equal to the Quantity Demanded by buyers. This unique price
Pe is defined to be the equilibrium price.

In the physical world we often observe equilibrium conditions or situations resulting from the
influence of physical laws.
For example: a piece of chalk resting on a table is in equilibrium.
This situation is the result of the effects of gravity and the existence of a flat
and level surface.
Gravity helps to maintain and even restore this equilibrium condition if
this position of rest is disturbed.
In our market models, we need to ask:Where does the gravity come from to establish
and maintain an equilibrium price?
The answer is in the competitive reaction of sellers and buyers to disturbances in the
market.
For example, it could be the case that the market price has been forced above equilibrium
such that supply decisions by producers with respect to output exceed the amount
demanded by consumers.
In this case a surplus is the result.
This surplus is often recognized first by the sellers through the accumulation of
inventories.

These sellers would react by cutting the price of their product relative to competing
sellers (price-cutting is how sellers compete) and by reducing the rate of production.
Buyers would react to the presence of lower prices by increasing their rate of
consumption.
This process would be expected to continue until the excess inventories have been
eliminated.

If the market price differed from the equilibrium price such that the quantity
demanded exceeded the quantity supplied, a different disequilibrium condition
known as a shortage would result.
Often, but not always, shortages are first recognized by buyers in the form
of empty shelves, queuing, and general difficulty in making a desired purchase.

These consumers react by bidding prices up in competition with other buyers (bidding is how
buyers compete) much like an auction for a single piece of art.
As these prices are bid upwards, some buyers drop out of the market reducing the overall
rate of consumption.
Sellers react to the presence of higher prices by allocating resource inputs
from other uses towards production of this particular good.
Competition provides the gravity to maintain or restore the equilibrium price
. If surpluses exist, competition among sellers force prices downwards. If shortages exist,
competition among buyers force prices upwards.

if the market price exceeds the equilibrium price, a shortage will be the result.
This shortage will induce buyers to bid prices further upwards away from the
(unstable) equilibrium price.
The result will be an eventual collapse of the market as prices approach infinity.
The unusual demand curve may be the result of speculative behavior
by buyers.
In this case, individuals are making purchasing decisions not for final consumption of
this particular good, but rather in the expectation of resale of the good at
an even higher price.
As prices are bid upwards, these expectations are confirmed thus
leading to further increases in the rate of purchase.
Ultimately, prices rise to such a level that expectations of further increases are no
longer realistic.
At this point in time, the prices that have been inflated by these expectations (much as
a bubble expands) collapse.
The speculative bubble begins to burst resulting in a collapse in the market.

In reality, surpluses and shortages are caused by changes or shifts in either the
demand or supply functions.
These shifts are the result of shocks to other (exogenous) variables that
affect supply decisions by producers or demand decisions by consumers.
Typically,outward shifts in demand will lead to an increase in both the equilibrium
price and quantity due to movement along an upward sloping supply curve.
Inward shifts of demand will have the opposite effect (a decrease in equilibrium
quantity and price).
Outward shifts in supply (along a downward sloping demand curve) will lead to an
increase in equilibrium quantity and a reduction in equilibrium price.

Usefulness of Demand Analysis
(i)Demand theory & demand analysis are useful for assessing the market.
(ii)While individual demand curve reflects individual demand,adding demand
curve at different prices gives us market demand curve.
(iii)When we add all individual demand curves,we get total demand curve for
the community.
(iv)Thus the effective demand is important which is ‘demand backed by
cash”& shows the actual purchase.
(v)The demand curve has special importance in applied economics.it sums up
the response consumers’ demand to alternative prices of its product.
(vi)It tells the management how a price change will affect the demand for one
of its products.
(vii) For normal goods & services,demand curve is –vely sloped i.e.lower the
prices,greater is the expected demand & vice versa.
(viii) The more competitive the market,flatter (more elastic) is the demand
curve & more imperfect the market,steeper is the demand curve (inelastic).
Producer has to accordingly bring down prices to increase demand.

Elasticity
(i) It is a measure of responsiveness –it is change in a variable which is
proportionate to change in another.
(ii) Elasticity of demand –proportionate change in demand due to change in
price ,income, expenditure,advertisement etc.
(iii) Flatter the demand curve,greater will be the value of the resposiveness
i.e.more elastic will be the demand.
(iv) When demand is elastic,percentage change in demand will be more than
the percentage change in price.
(v) When demand is less elastic, percentage change in demand will be less
than the percentage change in price.
D = a+bPx + cY + dt + ut
where a=intercept, Px=price of commodity X, y = income,T= time &
ut=other variables.

Demand Curve
The slope of the demand curve depends upon the elasticity of demand.
The elasticity is not constant along the demand curve.
Price elasticity of demand depends upon the slope of the demand curve,price
of the product & quantity.
As price & quantity change,elasticity also changes along the curve.
Starting from high elasticity at the top, it reduces down the curve.
Linear demand curve is given by the equation, Q= a-bp

Linear demand curve: The demand curve is often graphed as a straight line of
the form Q = a - bP where a and b are parameters.
The constant “a” “embodies” the effects of all factors other than price that affect
demand.
If income were to change, for example, the effect of the change would be
represented by a change in the value of a and be reflected graphically as a shift
of the demand curve.
The constant “b” is the slope of the demand curve and shows how the price of
the good affects the quantity demanded.[
3]
The graph of the demand curve uses the inverse demand function in which price
is expressed as a function of quantity.
More plainly, in the equation P = a - bQ, "a" is the intercept where quantity
demanded is zero (where the demand curve intercepts the Y axis), "b" is the
slope of the demand curve, "Q" is quantity and "P" is price.

Types of Elasticity of Demand
1.Price Elasticity of Demand : Relative change in quantity demanded
proportional to change in price .
2.Cross Elasticity of Demand: Relative change in demand for commodity X
due to proportionate change in price of some other goods.
3.Income Elasticity of Demand: Relative change in demand due to
proportionate change in income.
4.Advertising Elasticity of Demand: Relative change in demand due to
proportionate change in advertisement expenditure.

Measures of Price Elasticity of Demand
1.Expenditure method 2.Percentage Method
1.Expenditure Method: It gives us total expenditure incurred by the consumer
on change in price.It is obtained by price of goods X quantity.
Case I
(i) If total expenditure increases due to price fall.
(ii) If total expenditure decreases due to price rise.
Case II
(i) If total expenditure decreases due to price fall.
(ii) If total expenditure increases due to price rise.
Case III
If total expenditure does not change on account of price rise/fall, then
elasticity = 1.
Elasticity also measured as change in quantity/quantity demanded
(∆q/q)/change in price (∆p/p) = ∆q/∆p*p/q
Demand is elastic if % change in demand > % change in price.
Demand is inelastic if % change in demand <% change in price.
Unitary elasticity if % change in demand = % change in price.

Elasticity at a particular point on the demand curve is also called point elasticity of
demand.
Examples:
I
Price(Rs.) Units Total Expenditure(Rs)
8.00 2 16.00
7.00 5 35.00
Demand is elastic w.r.t. price.
II
When demand changes to 20% & price changes to 10%,elasticity=20/10=2.Here
elasticity> 1 and hence demand is elastic.
III
At price (p) of Rs.6.00 quantity demanded (q) is 10 units.
Price falls to Rs.4.00 or change in price dp=Rs.2.00
Demand increases from 10 units to 15 units i.e.dq=5
Using formula elasticity of demand Ed=dq/dp*p/q=5/2*6/10=1.5
Price elasticity > 1 which means demand is elastic.

Arc Elasticity of Demand
Arc elasticity of demand gives us elasticity calculated over a range of prices.
Sometimes we need to calculate elasticity over a range of prices & arc elasticity of demand
provides us the solution.
Instead of taking the initial or final prices,we take the average of the two.
Arc Elasticity of demand=dq/dp*p_/q_ where p_ = av.price & q_ = av.quantity
Income Elasticity of Demand
This represents % change in demand to % change in price.
=Dq/dy*I/Q, where I=Income
For normal goods & services,Generally,demand is equal to less than prortionate rise in
income i.e.e<1.
Eg: income rises from Rs.500/- to Rs.1000/-.Therefore demand for goods rises from 30 units
to 40 units.
Income elasticity of demand =dq/dy*y/q = 10/500*500/30=0.33 which is <1
Income elasticity of demand is inelastic.
.For luxury products & services,generally e >1 i.e.change in demand is greater than
proportionate change in income.

Importance of Income Elasticity
(a) Important in price determination from different phases of a
business cycle such as targeting a particular income
segment eg.middle income group.
(b) People from this group aspire for many things considered as
luxury in India e.g.foreign trips,becoming club members etc.
(c) Demand for these items is income elastic.
(d) Discounts,rebates,early bird offers etc.tend to bring in
customers for cars,tours,club memberships etc from this
income group.
(e) At the same time,customers from other income groups also
tend to join this bandwagon & the total effect is much higher.
(f) If income elasticity of demand>1,the services & products will
be of normal standard.Therefore price falls or discounts etc
increases demand.
(g) If income elasticity of demand<1,the goods or services are
considered inferior.
(h) Therefore their demand would fall even if price reduction or
discount is offered.

Income Elasticity Of Demand:
This represents % change in demand to % change in price.
=Dq/dy*I/Q, where I=Income
Income elasticity is +ve for normal goods & services.Generally,demand is equal to less
than proportionate to rise in income.
For luxury products & services,generally income elasticity >1 i.e.change in demand is
greater than proportionate change in income.
Eg: income rises from Rs.500/- to Rs.1000/-.Therefore demand for goods rises from 30
units to 40 units.
Income elasticity of demand =dq/dy*y/q = 10/500*500/30=0.33 which is <1
Iincome elasticity of demand is inelastic.
Income Elasticity of demand=% change in quantity demand / change in income
= dq/dy*I/Q
Income elasticity of demand is +ve for normal goods & services.
Generally demand is equal to or less than proportional change in income.
Example: Income of a person increases from Rs.500/- to Rs.1000/-.As a result demand
for the goods increases from Rs.30 units to 40 units.

Special Cases
1. Inferior Goods: Even when real income rises, demand does not increase & value
of income elasticity is –ve.
1. Necessities:The income elasticity is +ve but < 1 i.e. it is inelastic.
2. Luxuries: The demand for luxury goods is generally more elastic E>1.
Here a bit of reduction, rebate can attract more customers.
whether an item is considered luxurious depends upon a country’s or
place’s economic or cultural conditions.

Cross Elasticity of Demand
(1) There are many goods & services which are substitutes for each other.
(2) Some goods & services (complementary goods) are demanded together.
(3) Price change in one commodity will affect the demand for the other.
(4) These are called related goods & services.
(5) For these, change in demand for one product due to proportional change in the
price of the other is called “cross elasticity of demand”.
(6) It is given by % change in demand for commodity X / % change in price of Y
=dqx/dpy*py/px
where q=quantity, p=price,x & y are two commodities.
Following kinds of change are noticed:
(a)Cross elasticity = infinity : It is possible where the two goods are perfect
substitutes.
(b)Cross elasticity=0: The goods are not related products.
(c)1> cross elasticity >0.Cross price elasticity is not all that effective.
(d) Cross elasticity is –ve: When the two goods are complementary.
Cross elasticity of demand helps the firm to see the closeness of the substitute.

Examples of Cross Elasticity of Demand
I(i)Tour packages X & Y to the same route are homogeneous & are substitutes.
(ii)The cross elasticity between these two packages is +ve.
(iii)Rise in demand for one package would reduce the demand for the other.
(iv)Substitute makes the business more competitive.
II(i)Accommodation & transport work as complements for a tour.
(ii) Cross elasticity will be –ve.
(iii) Rise in price of accommodation & transport will increase cost of tour.
(iv) It will therefore reduce the demand for tour package.
III(i)Unique tour packages such as adventure tourism can work independently as
there are not many tour operators in this segment.
(ii)Cross elasticity of demand to price change is zero.
You also have advertisement elasticity, market share elasticity, elasticity of price
expectation etc.

Price Elasticity & Decision Making
(i) Price elasticity helps business manager to forecast demand.
(ii) If price elasticity of demand>1,the responsiveness of demand change
more than price change.
(iii) Price rise does not always increase revenue or price fall does not
always increase sales.
(iv) increase/decrease of revenue depends on demand & elasticity of
demand.
(v) Manager has to fix prices carefully so that expected revenue should
be around the actual revenue.
(vi) Firms generally try to make more profit by increasing price & expect
to bring in more customers by price reduction.
(vii) Success or failure of the above objective depends upon the elasticity
of demand for the firm’s products/services.

Opportunity Cost
It is calculated as the cost of an alternative that must be foregone/given up in
order to pursue another action.
Opportunity Cost=Cost of selected alternative – Cost of next best alternative
Mutually Exclusive Economic Alternative:
Group of choices of different utilities-goods,services,investments etc.that a person
can choose usually w.r.t. a certain time frame or a certain amount of money.eg. A
person having Rs.1000/- can buy a shirt,a tie or a DVD .But he chooses the shirt
option.
Selected or Derived Alternative:
It is that alternative that a person would opt for by giving up the opportunity to buy
the rest of the items.The derived alternative in this case would the shirt for which
he has given priority over other items.
Next Best Alternative:It is the article that he would settle for if he did not get
access to the desired article.The next best alternative would be any of the
remaining items but not all of them.

In 1936 the German Nazi leader Hermann Goering said, “We have no butter…but I ask you,
would you rather have butter or guns?…preparedness makes us powerful. Butter merely
makes us fat.”
The important word of course is or. Goering suggests that Germany has a choice – guns or
butter.
If the present level of production is 5 million guns, this means no butter is produced.
To produce 1 million tons of butter will mean moving down the PPC and only producing 4
million guns i.e. giving up 1 million guns.
This means that one gun is equivalent to one unit of butter, or as we prefer to say - the
opportunity cost of one gun is one unit of butter.
This means the opportunity cost is the same all the way along it’s length. Wherever you
measure the opportunity cost, one unit of butter always costs one unit of guns –
We say that in this case opportunity costs are constant.
In this case we made the maths simple, the ratio of guns to butter is 1:1.

In reality the relationship of one gun to one unit of butter will not always be stable
because people have different skills and not everyone is a capable gunsmith.
Not only are peoples’ abilities different, land is better suited for some purposes than
others, and the equipment used to make butter is not entirely suitable for making
guns.
If only a few guns were to be produced then we would expect that the land, labour
and capital that were best suited for this purpose to be used first.
People who are skilled designers, metal workers and those with an interest in
weapons would be employed first.
However, If we want to to produce even more guns, factors of production that are
less well suited to making guns would have to be used.
Eventually factors which are the least suited to the task have to be used if
production is to rise further.

This principal can be seen in the oil industry.
The first oil that mankind discovered was in America and was easy to get at.
The costs of production were low, but as that oil ran out we drilled in the deserts of
Arabia which were more difficult.
Then in search of more we began looking in more inaccessible places like Alaska and
the North Sea.
What this means is that as production increases the opportunity cost, instead of
remaining the same, rises.

On the diagram below there are three positions shown.
At position A it is possible for the economy to produce more guns and more butter by moving to pt B.
Producing more guns did not involve giving up any butter.
All that had to happen is that the existing economic resources had to work harder.
So position A shows an economy working at less than full capacity.
One or more of the resources, land, labour, capital or enterprise is not being fully employed.
PRODUCTION POSSIBILITY
DIAGRAMS
The production possibility boundary,
also known as a production possibility
frontier (PPF) or the production
possibility curve (PPC), shows the
maximum possible combinations of
output of two goods that an economy
can produce within a given time period.

At position B it is impossible to have more guns without sacrificing some butter,
similarly we can have no more butter unless some guns are given up.
Vilfredo Pareto was an Italian economist and he realized that when an economy was
producing at the maximum, it was necessarily true that it was impossible to make one
person better off without making someone else worse off.
We can see that at point B, if we make butter producers better off, this means we will
make gun suppliers worse off.
So being at point B is sometimes referred to as Pareto efficiency or allocative
efficiency.
It must also true that all the firms in the economy must be working efficiently, and this
we call productive efficiency. Productive efficiency means producing goods and
services at the lowest average total cost.
Pareto efficiency therefore means being at a point the economy is both allocatively and
productively efficient.
Point C is beyond the graph and is therefore impossible.

If we want the economy to grow when we are at point A we can just use resources more efficiently
.
But if we are point B we need more or better factors of production.
Whether we are at point A or point B, it is still possible to increase the potential output of the
economy
This is illustrated in the above diagram, where the PPF moves outwards from PPF1 to PPF2.

Fixed Proportion & Variable Proportion
Production is subject to fixed proportion when we have fixed ratio of inputs
for various levels of output.
With change in output, input ratio also changes.
Again production is subject to variable output when same output can be
produced with different combinations of inputs i.e.different input ratios.
Variable output arises on account of diminishing productivity factor.

Consumer’s surplus
The difference between what the consumer is willing to pay to purchase a
commodity & what he actually pays is Consumer surplus.
The surplus is created only when the consumer wants to pay more than the
market price.
It tells us the maximum a consumer will be willing to pay for a given quantity
supplied.
According to law of diminishing returns,the consumer will pay more for the first
item & less & less for every additional item.
Calculation:
Market price =Rs.50
Consumer wants to pay-for 1st item=55, 2nd item=54,3rd item=53,4th item=50
Total consumer surplus= (55-50) + (54-50) + (53-50) + (50-50) =12

If the demand for a particular commodity is elastic, CS=0
here price of the commodity matches with what the consumer is willing to pay.
When the demand is inelastic ,CS is infinite.

Elasticity of Supply
It measures the degree of responsiveness of quantity supplied to the change in
commodity’s price.
In the short run,supply tends to be inelastic & in the long run,it tends to be elastic.
At a particular price,supply equals infinity i.e.perfectly elastic ,it means that a firm
can supply any quantity at a given price.(E=infinity)
Where price change will not bring about any change in supply,it is a perfectly
inelastic supply.(E=0)
In between these two extremes, where supply can be increased proportional to
price rise,E=1 & where supply can be increased > the increase in price
,E>1(elastic) & where the supply can increased < increase in price,E<1
inelastic).

Elasticity of supply tells about the condition of production just as elasticity of
demand tells us about behaviour of demand.
A business with constant costing(pricing) has a perfectly elastic curve which
runs parallel to X axis.
Elasticity of supply measured as:
Es=% change in quantity supplied/% change in price.
= dq/dp*p/q
Supply elasticity is normally like a supply curve:
Eg: A supply curve is given as Qs=100P
Plot supply curve & calculate elasticity taking any 2 points on the curve.
P 1 2 3 4
Q 100 200 300 400

Elasticity at Point A=1 Elasticity at point B also=1
At point B,dq/dp*p/q=100/1X1/100=1
Similarly at point C,it is =1
Thus the supply curve Q=100P has elasticity=1

Revenue & Elasticity:
Revenue is the important element in every business.
It is directly related to demand for goods & services offered by a firm.
TR=price(p) X quantity(q) TR=pq
Marginal revenue is the rate of change of total revenue with increase in
sales.
dR/dq=p
Average revenue=TR/Q
Relation between marginal & total revenue
- when total revenue is increasing,marginal revenue is +ve.
- When total revenue is decreasing,marginal revenue is decreasing.
- At the maximum point of TR, MR=0
-

The demand curve of a firm is downward sloping on account
of (a) substitution effect (b) diminishing marginal utility.
Further under imperfect competition, reduction of price is
essential for additional sales.
The growth of firms is explained in terms TR.
TR w.r.t. each price can be obtained if we know demand
behaviour.
A sound pricing decision will require the above information.
Otherwise price reduction will not bring in more buyers &
increase in price will not improve revenue.

Price Elasticity & Total Revenue
When demand is elastic, discounts etc. in order to bring more customers is
resorted to.
This will increase a firm’s market share & bring more revenue thro’ more
customers.
The firm needs to compare this extra revenue with extra cost of producing
more.
If the demand is inelastic,the firm will try to hike prices which will not
reduce customer base.
In inelastic demand situation,it is not profitable to decrease price.
The total revenue will fall as cost also rises with increase in quantity.
Objective of maximum sales revenue will be achieved if a firm is able to fix
prices where demand is neither elastic or inelastic or at a point of unit
elasticity.

Elasticity Along a Straight-line Demand Curve
Elasticity denotes the percentage change in price and quantity, while the slope of a
demand curve denotes the ratio in price and quantity.
Demand Curve and Revenue
The slope of a demand curve is different from the elasticity of demand.
The former denotes the ratio in price and quantity demanded.
The latter denotes the percentage change in price and quantity demanded.
When price is high and quantity demanded is low, the demand is elastic.
If price increases, total revenue decreases.
When price is low and quantity demanded is high, the demand is inelastic.
If price increases, total revenue increases.
Elasticity changes at different prices along the linear demand curve

A firm considers a number of factors before taking a policy decision:
(i) Whether an increase in price of X will increase revenue.
(ii) When this increase in price will increase demand for Y or z.
(iii) What will happen to the sales quantity?
(iv) What will happen to sales revenue?
Relationship between price elasticity & total revenue:
Price ep>1 ep=1 ep<1
Price rises TR falls no change TR rises
Price falls TR rises no change TR falls
Exceptions:
(i) Expectation of further rise in prices
(ii) Prestige goods more demand at higher price
(iii) Superior goods & inferior goods: For superior goods,price will be followed
by demand rise & for inferior goods price fall results in fall of demand
(iv) Necessities are purchased by people in same amounts regardless of price

DRAWING DEMAND CURVES
• On one diagram, at
the same price level,
a flatter demand
curve is more elastic
Demand Cruves
0
1
2
3
4
5
6
7
8
9
10
11
12
13
0 2 4 6 8 10 12 14
Quantity
Price

TOTAL REVENUE AND DEMAND
Demand
0
1
2
3
4
5
6
7
8
9
10
11
0 1 2 3 4 5 6 7 8 9 10 11
Quantity
Price
Elasticity > 1
Elasticity < 1
Elasticity = 1
Total Revenue
0
5
10
15
20
25
30
0 1 2 3 4 5 6 7 8 9 10
QuantityPrice

ALONG A STRAIGHT LINE
• At a high price a
given change in price
is a small percentage
change, but a given
change in quantity is
a big percentage
change
• At high prices
demand is elastic
and TR increases as
price falls
Price Quantity TR
10 0 0
9 1 9
8 2 16
7 3 21
6 4 24
5 5 25
4 6 24
3 7 21
2 8 16
1 9 9
0 10 0

ALONG A STRAIGHT LINE
• At a low price a given
change in price is a
large percentage
change, but a given
change in quantity is
a small percentage
change
• At low prices demand
is inelastic and TR
decreases as price
falls
Price Quantity TR
10 0 0
9 1 9
8 2 16
7 3 21
6 4 24
5 5 25
4 6 24
3 7 21
2 8 16
1 9 9
0 10 0

TYPES OF ELASTICITY
• Elastic: when coefficient > 1
• Unit Elasticity: when coefficient = 1
• Inelastic: when coefficient < 1
• Zero Elasticity: when coefficient = 0
• Infinite Elasticity: when coefficient = ∞

ELASTIC DEMAND AND TOTAL
REVENUE
• Elastic Demand: Elasticity > 1
• Percentage change in quantity is greater than
percentage change in price
• Raise Price: quantity demanded falls more
• Higher price, lower total revenue
• Lower Price: quantity demanded rises more
• Lower price, higher total revenue

EXAMPLE OF ELASTIC DEMAND
AND TOTAL REVENUE
• Price of Tim Horton’s coffee Rises 10% from
$.95 to $1.05
• Quantity Falls 20% from 110 to 90 cups per hour
• Elasticity = 20%/10% = 2
• Total Revenue before the price rise:
$.95 * 110 = $104.50
• Total Revenue after the price rise:
$1.05 * 90 = $94.50

INELASTIC DEMAND AND TOTAL
REVENUE
• Inelastic Demand: Elasticity < 1
• Percentage change in quantity is less than percentage
change in price
• Raise Price: quantity demanded falls less
• Higher price, higher total revenue
• Lower Price: quantity demanded rises less
• Lower price, lower total revenue

EXAMPLE OF INELASTIC DEMAND
AND TOTAL REVENUE
• Price of gasoline Rises 10% from 66.5 cents to
73.5 cents
• Quantity Falls 5% from 205 to 195 litres per hour
• Elasticity = 5%/10% = .5
$.665 * 205 = $136.33
$.735 * 195 = $143.33

UNIT ELASTICITY
• Percentage change in quantity equals percentage
change in price
• Total revenue does not change.

UNIT ELASTICITY
Demand
0
2
4
6
8
10
12
0 2 4 6 8 10 12
Quantity
Price

EXAMPLE OF UNIT ELASTICITY
AND TOTAL REVENUE
• Price of gasoline Rises 10% from 66.5 cents to
73.5 cents
• Quantity Falls 10% from 210 to 190 liters per
hour
• Elasticity = 10%/10% = 1
$.665 * 210 = $139.65
$.735 * 190 = $ 139.65

ZERO ELASTICITY
• Zero Elasticity: Elasticity = 0
• Percentage change in quantity zero regardless of
percentage change in price
• An extreme case of inelastic demand.
• A Rise in price results in a proportionate rise in total revenue
• A fall in price results in a proportionate fall in total revenue

INFINITE ELASTICITY
• Percentage change in quantity is unlimited
however small the percentage change in price
• An extreme case of elastic demand.
• A rise in price results in fall total revenue to zero
because quantity demanded falls to zero
• A fall in price results in an unlimited rise in total
revenue, because quantity demanded rises without
limit
• (but you must be able to procure an unlimited quantity to sell
an unlimited quantity)

INFINITE ELASTICITY
Demand
0
2
4
6
8
10
0 2 4 6 8 10
Quantity
Price
Demand

Demand & capacity utilisation:
Due to demand fluctuation,firms often face the problem of capacity
which cannot be increased/decreased at short
notice.Egs.airlines,hotels.
Other factors are facilities & labour.
During busy season,firms often face maximum utilisation of
capacity & in lean seasons,it is under utilisation of capacity.
Most preferred situation is optimum utilisation of capacity.
Optimum utilisation means resources are utilised but not over
utilised.
Eg.Machinery & other inputs may be fully utilised during peak
season stretching the firm to its capacity.this may not be desirable.
Thus understanding of demand behaviour is a must for every
business & demand is a function of factors such as
income,taste,fashion, basic need etc.

Yield Management
With a view to meeting demand & variations in demand,a firm always in
a state of adjustment with changes in production,offer of
discounts,rebates etc.In off season,advertisements are published to
attract customers.
Yield management is called revenue management-it helps a firm to
maximise profits/revenues.
This may lead to price discrimination or quoting different prices for the
same service.This practice is common where resources to be offered
for sale are fixed,perishable & customers are willing to pay different
prices for a fixed quantity.
Eg.unsold/cancelled tourism packages are sold at throw away prices.
Similar is hotel industry.
This practice is adopted when a firm is sure that its customers would be
ready to buy its goods/services at varied prices.
Yield=actual revenue/potential revenue
where actual revenue=actual capacity utilised X average price
Potential revenue=total capacityX maximum price

Crude Oil Market
The traditional demand supply theory fails to work here.
The expectation of traders,the supply position,the futures & spot prices lead to
volatility in crude price.
At every stage,there is a MTM factor to reflect the true position.
Under efficient market conditions,spot prices increase with future prices .
This keeps investors go either long or short according to the market conditions.
If current & future prices do not go in tandem,arbitrage opportunities arise which
bring prices back in line.
Market analysts play a crucial role by providing different scenarios of price
changes ahead of traders’ findings.
Future prices reflect traders’ expectations.
Expansion of world economy increases demand for crude thereby rendering it
price inelastic.

Geo political factors play an important role in determination of crude price.
Any favourable change in a single variable can bring down the price.
This behaviour is in essence a case of dynamic disequilibrium.

Gold market
It is a volatile commodity where demand & supply equilibrium fails to
work.
Gold price is driven by a combination of international factors & local
factors.
There is lot of emotional & sentimental value attached to gold in India
.There is buying demand in festival season –earlier it was purely
jewellery but in recent years bullion demand has gone up.
Jewellery (scrap gold) is sold in times of liquidity crunch or pledged
for taking loan.
Gold price is derived from its value in US $ & normally there is an
inverse relationship between the two.
Gold price goes up when there is demand for buying from the central
banks of countries & goes down when they commence its sale.
Speculators also hold long positions in gold in good numbers.
There is hardly a case for equilibrium situation in gold market.

Consumer Behaviour
It is the study of what the consumers buy,how they buy,why they
buy & when they buy.
It attempts to understand the buyer’s decision making process
both as an individual & as a group.
General public, institutions,govt.bodies,producers can be taken
together as consumers as they purchase commodities & create
a demand for them .
Economic factors such as income ,price & non-economic factors
such as age,family size,taste & preference & education
influence consumer demand.
Social/cultural factors play a role in shaping up consumer’s
demand.
Legal factors such as govt & regulator policy influence
consumer behaviour.

Scenario in India
The average Indian consumer, earlier,would only just satisfy
his necessities with his limited resources.(simple living & high
thinking)
Days have changed & now you have the Indian consumer with
a higher per capita income,higher disposable income &
consequently, higher purchasing power.
Availability of EMI facilities, credit/debit cards, net banking,
personal loans have all contributed to increased consumerism.
A section of farmers in a number of states have become more
wealthy & contributed to rural prosperity whch has increased
demand for goods.
However, heterogenity is noticed in people’s income pattern
which influences consumer demand.
There are broadly three categories of consumers.

First Category:
More than 40% of our population is at BP level.
Most of them work in informal sector & live on the margins of society.
Their major portion of limited income is spent towards basic needs
such as food,clothing & shelter.
Of late,even the low income earners’ capacity to purchase has slightly
increased.
The result being they are able to save some money.
This saving combined with generous loans offered by many entities
enable them to have some spare cash for buying some durable
consumer goods after meeting their normal requirements.
It is well established that with rising income & food consumption
reaching saturation,there is some appetite left for non-food items also.

Second category:
This is the typical middle class group.
While their income is not very high,they are subject to social
pressures of high living with a limited savings.This sub group is the
lower middle class.
The group slightly above this tier comprises the highly skilled
,educated professionals who are able to save reasonably well and
are able to afford decent houses,good cars & even club
memberships.
This group creates significant amount of consumer demand.
Third Category: This group is negligibly small in our country.
They maintain a very high standard of living even comparable with
western countries.
Their spending on all types of luxury goods creates a good demand
in fashion & branded items ,

Consumer Behavioural Analysis
Basics:
1.Consumer preference for one good to another or one bundle of
goods to another.
2.Consumer allocates his limited income to alternative choice of
goods.
3.Consumer tries to maximise his utility & thus satisfaction subject to
his budget & preference.
Consumer Demand Theory-Approaches:
I Cardinal Utility Approach:
1.Utility is measurable & can be numbered.
2.Individual always tries to maximise his utility.
3.Diminishing marginal utility is an important factor in consumer
decision.
II Ordinal approach:
Cardinal theory was revisited & improved by Preference theory-
popularly called Indifference Curve approach.

Indifference curve Analysis or Preference Analysis
A consumer with his constraints of limited income has to decide which
goods & services to buy.This decision can be analysed w.r.t. the
following:
(a) Many goods & services available in market. Information on which
particular goods & services customer prefers is necessary.
(b) There has to be relation between consumer income & price of goods.
Budget constraint brings about a trade off between the two.
(c) Consumer may be indifferent to all combinations which give him same
level of satisfaction.He will choose that particular bundle of goods
which gives him maximum satisfaction subject to budget limitation.
(d) Consumer choice will help him to analyse demand pattern.
(e) Price change will lead to change in preference & purchase behaviour.
For simple analysis, indifference curve model includes two commodities
with given income & price of goods.

Indifference Curve:
It is a geometrical representation of two commodity models.
On a single curve,any combination of two goods will give same
level of satisfaction & represents utility function of consumer.
Therefore an individual will be indifferent to any combination on
the same curve & for this reason,this curve is called indifference
curve.
Only income & price will change the situation.
With rise in income, individual will have power to buy both
commodities & will shift to the higher IC curve.
With fall in income,he will shift to the lower IC curve.
In between 2 curves ,there are infinite curves & that is called
Indifference map.
The actual purchase will depend upon his purchasing power i.e.
budget line.

BUDGET LINE
A budget line (or, more technically, the budget
constraint ) is a schedule or curve that shows
various combinations of two products a consumer
can purchase with a specific money income.
EXAMPLE:
If the price of product A is $1.50 and the price of
product B is $1, a consumer could purchase all the
combinations of A and B shown in Table 1 with $12
of money income.

At one extreme, the consumer might spend all of his or her
income on 8 units of A and have nothing left to spend on B.
Or, by giving up 2 units of A and thereby “freeing” $3, the
consumer could have 6 units of A and 3 of B. And so on to
the other extreme, at which the consumer could buy 12 units
of B at $1 each, spending his or her entire money income on
B with nothing left to spend on A.

• This Figure, shows the same budget line graphically. Note that the graph is
not restricted to whole units of A and B as is the table. Every point on the
graph represents a possible combination of A and B, including fractional
quantities. The slope of the graphed budget line measures the ratio of the
price of B to the price of A; more precisely, the absolute value of the slope is
𝑃𝑎
𝑃𝑏
=
$1.00
$1.50
=
2
3
. This is the mathematical way of saying that the consumer
must forgo 2 units of A (measured on the vertical axis) to buy 3 units of B
(measured on the horizontal axis). In moving down the budget or price line,2
units of A (at $1.50 each) must be given up to obtain 3 more units of B (at
$1 each). This yields a slope of
2
3
.

HOW TO CALCULATE THE BUDGET
LINE
Income: $1,200
Price of X= $40
Price of Y= $30
$1200 ÷ $40 = $30
$1200 ÷ $30 = $40
40
35
30
25
20
15
10
5
5 10 15 20 25 30 35 40
Equation of the budget line
goodY
good X
𝑖𝑛𝑐𝑜𝑚𝑒 = 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑥 + (𝑝𝑟𝑖𝑐𝑒 𝑦)(𝑞𝑢𝑎𝑡𝑖𝑡𝑦 𝑜𝑓 𝑦)
𝑀 = 𝑃𝑥𝑄𝑥 + 𝑃𝑦𝑄𝑦
Qy=
𝑀
𝑃𝑦
−
𝑃𝑥
𝑃𝑦
Qx
(Qy or Y) = 40 −
$40
$30
(𝑄𝑥 𝑜𝑟 𝑋)
×

•Effects of Changes in Income
•Effects of Changes in Prices
THE BUDGET LINE HAS TWO OTHER
SIGNIFICANT CHARACTERISTICS:

• An indifference curve is the locus of
points representing all the different
combinations of two goods which yield
equal level of utility to the consumer.
INDIFFERENCE CURVES:

• Indifference schedule is a list of various
combinations of commodities which are
equally satisfactory to the consumer
concerned.
INDIFFERENCE SCHEDULE :

INDIFFERENCE CURVE IC SHOWS ALL POSSIBLE COMBINATIONS OF
APPLES AND MANGOES BETWEEN WHICH A PERSON IS
INDIFFERENT. POINT A SHOWS CONSUMPTION BUNDLE
CONSISTING OF 15 APPLES AND ONE MANGO. MOVING FROM
POINT A TO POINT B, WE ARE WILLING TO GIVE UP 4 APPLES TO
GET A SECOND MANGO (TOTAL UTILITY IS THE SAME AT POINTS A
AND B).

• The marginal rate of substitution of X for Y (MRSxy) is
defined as the amount of Y, the consumer is just willing
to give up to get one more unit of X and maintain the
same level of satisfaction.
MARGINAL RATE OF SUBSTITUTION
(MRS)

• As the consumer increases the consumption of
apples, then for getting every additional unit of apples,
he will give up less and less of oranges, that is, 8:1,
4:1, 2:1, 1:1 respectively This is the Law of
Diminishing MRS.
DIMINISHING MARGINAL RATE OF
SUBSTITUTION

• An indifference map is a complete set of indifference
curves.
• It indicates the consumer’s preferences among all
combinations of goods and services.
• The farther from the origin the indifference curve is, the
more the combinations of goods along that curve are
preferred.
INDIFFERENCE MAP :

• Indifference curves are negatively sloped
Given a combination of commodity X and commodity Y, with every
increase in X, the amount in Y should fall in order that the level of
satisfaction from every combination should remain the same.
• Indifference curves are convex to the origin
Convexity illustrates the law of diminishing marginal rate of
substitution.
• Indifference curves can never intersect each other
Indifference curves can never intersect each other because each
indifference curve represents a specific level of satisfaction. If two
indifference curves intersect each other, then at the point of
intersection, the consumer is experiencing two different levels of
utility.
PROPERTIES OF INDIFFERENCE CURVES
:

• A consumer seeks a market basket that generates the maximum
level of happiness. However, one’s money income and prices of
goods imposes a limit on the level of satisfaction that one may
attain. Thus, the income at the disposal of the consumer in
conjunction with prices of the commodities will determine the
budgetary constraint or the price line.
CONSUMER EQUILIBRIUM

• Consumer equilibrium is attained when, given his budget constraint, the
consumer reaches the highest possible point on the indifference curve. The
maximum satisfaction is yielded when the consumer reaches equilibrium at
the point of tangency between an indifference curve and the price line. At
point E, the price line is tangent to the indifference curve.
• At the equilibrium point, slope of indifference curve = slope of price line
• slope of indifference curve = MRS
• slope of price line = PX / PY
• Thus, at point E, MRS = PX / PY
• Thus, satisfaction is maximized when the marginal rate of substitution of X
for Y is just equal to the price of X to the price of Y.

Monopolistic Competition
ASSUMPTIONS
1.Each firm tries to prouce one product that is diffent from others in the
Industry.Every firm has its own downward sloped highly elastic demand curve.
Goods are close substitutes but not homogeneous.
2.Many producers ignore the action & response of others to determine their own pricing &
output policy.
3.Non-price competition is the main essence of competition in this type of market.
4.Brand loyalty gives a firm more monopoly power to fix higher price without losing its
customers & gives opportunity for more profits.
5.No entry barrier,exit is possible.In the long run,higher profit margins invites new
producers into the market.Hence market demand share among them.
6.No firms enter the market with their own brand of differentiated product & take away
customers from existing firms.
Thus in this type of market,customer has clear idea about gioods & services.Producers
will have to find ways & means to differentiate their product in the eyes of
customers.Intense competition results in a firm earning huge profits in the short run to be
satisfied with normal profits in long run.New firms will push down demand for existing
firm’s product.This results in rise in average cost & firm will make zero economic profits.

Exceptions:
Complementary goods & Substitute goods:
We need both the goods for use –car & petrol.
We use them with a limited combination.
Here there are no A,B points portion.
In same cases,the combination will the same-left & right shoe.Here A & B
will be at the same point.
In case two goods which are perfect substitutes,IC is a straight line –here
consumer is happy to consume either of the goods.

Many industries-service industries,banks financial institutions,hospitals
restaurants,retail manufacturing such as clothing,shoes,agricultural
products,bakeries,beverages etc show market structure similar to monopolistic
competition.
Advertisements,brand loyalty,other promo activities make them monopoly
producer to exploit market.
The assumption of symmetry –all competitors make the same kind of move &
try to maximise profits simultaneously.
SHORT RUN EQUILIBRIUM
The industry will attain equilibrium when MR=MC for all the firms.
___GRAPH____
LONG RUN EQUILIBRIUM
In the long run,the existing firms will not change their price as they are in
equilibrium where P=MR=MC
New firms enter the market & the economic profits of existing firms gradually
disappear.
Demand curve shifts inwards from DD to DD’.

(1)Gradual inward shifting of demand curve takes place with new
entrants.
(2)Price adjustments take place which result in equilibrium in the long
run where MR=LMC at point where LRAC is tangential to DD’.
(3) Here no more economic profits,no incentive for new entrants.
Ultimately equilibrium is achieved at P’ instead of P & gives stable
equilibrium.
(4) In the long run,there are no excess profits & conditions are similar
to that perfect competition.

Inefficiencies of Monopolistic Competition
(1) Cost of production & price become very high as compared
to the benefit it generates.
(2) Producers restrict their output & produce at levels where
AC is not minimum.
(3) Advertisements & promo drive up the price of the final
product.
(4) Hence consumer pays a very high rate.
(5) Branding & ads make consumer pay higher with getting a
better quality product.
(6) The market is also inefficient as MC<price & firm restricts
its output.
(7) When output is cut,excess capacity exists .It is believed
that even in this condition,market is not inefficient as
market produces a variety of products at lower cost & a
monopoly firm’s cost may not be the lowest.

Business economics

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