Class 12 economics notes part "A"

ECONOMICS NOTES

FOR CLASS XII

(According to the Syllabus)

PART – A

UNIT I – ELASTICITY AND ITS MEASUREMENT

Demand Curve:

The demand curve is a graphical representation of the relationship between price of a good and quantity demanded for a given period of time. In a typical representation the price appears on left vertical axis, quantity demanded on the horizontal axis.

The demand curve moves downward from left to right which expresses law of demand as price of a commodity increases then quantity demanded decreases all else being equal.

Combinations	Price	Quantity Demanded
A	1	50
B	2	40
C	3	30
D	4	20
E	5	10

LAW OF DEMAND:

There exists functional relation between demand and price such that an increase in price decreases demand and vice versa. In fact, the functional inverse or adverse or negative relationship between demand and price is known as law of demand. Symbolically,

Q_d= f(P)

Mathematically,

The concept of law of demand has been defined by different economists as Alfred Marshall, F. Benham, G. Stigler and others.

According to A. Marshall,

“Other things remaining same quantity demanded increases with fall in price and diminishes with a rise in price”

- Alfred Marshall

Law of demand is also compared with SEE-SAW, a playing instrument for baby. Law of demand is defined in verse language,

“Lower the price higher the demand

Higher the price lower the demand”

The concept of law of demand can be represented by following schedule and diagram:

Combinations	Price	Quantity Demanded
A	1	50
B	2	40
C	3	30
D	4	20
E	5	10

The diagram clearly explains that as coordinates of price and demand are plotted and connected to each other then a downward sloping DD demand curve is formed which is represented as Law of Demand. The downward sloping nature of demand curve always explains negative relationship between demand and price.

Assumptions:

Ceteris Paribus, law of demand is based on following assumptions:

1. Income of consumer remains constant.

2. Price of related goods remains same in the market.

3. Taste and Fashion of consumer remains same.

4. There should not be any innovative goods in the market.

5. Tax policy of government should remain unchanged.

6. There should not be artificial scarcity in the market.

7. Consumer should be rational one where a rational consumer attempts to purchase commodities at lower prices in the market.

Exceptions/Limitations/Criticisms of Law of Demand:

1. In case of essential commodities:

Law of demand is not applicable in case of life saving essential commodities. If prices of essential commodities as food, clothes, medicine and others increase in the market even then minimum quantity of such commodities are demanded by consumers to fulfill basic needs of life. Thus, minimum quantity of demand remains same even at rising prices of essential commodities.

2. In case of prestigious goods:

In case of commodities which are connected with prestige of consumers, law of demand is practically not applicable. Eg. If price of prestigious goods as gold, jewellery and others increase in the market during marriage season even then demand for such goods do not decline.

3. In case of innovative goods:

If innovative goods are introduced in the market then such products are largely demanded despite rise in its price in practical life. Eg. Mobile phones, Television and others.

4. In case of Giffen Paradox:

According to W.W. Giffen if price of Giffen products i.e. inferior goods decline then its demand also declines simultaneously. Thus, law of demand becomes helpless and is not applicable in case of Giffen products.

5. Consumer does not remain rational all the time:

Law of demand expects consumers to be rational in the market. But in practical life consumer mostly performs irrational behaviour where if price of commodity increases even then its demand does not decline in the market.

Conclusion:

Despite certain weaknesses and limitations, law of demand is equally valid in practical life of consumers and in practical application in the market.

Demand Schedule:

The tabular representation of relationship between demand and price is known as Demand Schedule. It is classified into two categories:

1. Individual Demand Schedule/Single Consumer Demand Schedule:

It is the tabular representation of the relationship between quantities of commodities demanded by an individual consumer at different prices. In this case behaviour of only single consumer is recorded in demanding different units of commodities at different prices in the market.

Combinations	Price	Quantity Demanded by an Individual
A	1	50
B	2	40
C	3	30
D	4	20
E	5	10

The diagram clearly shows that when different combinations (A, B, C, D, E) of demand and price are plotted and connected to each other then a downward sloping DD curve is formed which is known as Individual Demand Curve. It shows the reaction of individual consumer in purchasing quantity of commodity at different prices in the market.

2. Market Demand Schedule/Aggregate Demand Schedule:

It is the tabular representation of the relationship between quantities of commodities demanded by all the consumers at different prices in the market. In fact, Market Demand Schedule shows reaction of all the consumers and transactions of all the commodities in the market. Moreover, Market Demand Schedule shows total strength of demand in the maket.

The diagram clearly specifies that when coordinates of prices and market demand are plotted and connected to each other then a downward sloping DD demand curve is formed which is known as Market Demand Curve.

Supply Curve:

Supply curve is the graphical representation of relationship between price of a good and quantity supplied for a given period of time. In a typical representation, price will appear on left vertical axis whereas quantity supplied on horizontal axis.

The supply curve will move upward from left to right which expresses law of supply i.e. as price of a commodity increases the quantity supplied also increases all else being equal.

Combinations	Price	Quantity Supplied
A	1	10
B	2	20
C	3	30
D	4	40
E	5	50

LAW OF SUPPLY:

There exists functional relation between supply and price such that an increase in price increases volume of supply and vice versa. The positive relationship between price and supply is known as law of supply.

According to Marshall,

“Other things remaining same quantity supplied increases with an increase in price and diminishes with fall in price”

- Alfred Marshall

Law of supply is also expressed in verse language as under

“Higher the price higher the supply

Lower the price lower the supply”

The approach of law of supply can be represented by following schedule and diagram:

Combinations	Price	Quantity Supplied
A	1	10
B	2	20
C	3	30
D	4	40
E	5	50

The diagram clearly specifies that as coordinates of price and supply are plotted and connected to each other then an upward sloping nature of curve is formed which is known as supply curve. Supply curve always slopes upward to the right.

Assumptions:

Ceteris Paribus, law of supply is based on following assumptions:

1. Income of consumer remains same.

2. Price of related goods remain same.

3. Cost of production remains same.

4. Tax structure of government remains same.

5. Technology remains constant.

6. Innovative goods are not produced.

7. Business environment remains same.

Exceptions/Criticisms/ Limitations of Law of Supply:

1. Price expectations of seller:

If seller expects decrease in price of commodity in near future then seller will try to sell more even if the price level is very low whereas if seller expects further increase in price of commodity seller will not sell more even if the price level is high currently.

2. Stock Clearance Sale:

When a seller wants to clear its old stock in order to store new goods a seller may sell large quantity of goods at heavily discounted price.

3. Fear of being out of Fashion:

If seller thinks that the goods are going to be outdated in near future then a seller sells more at a lower price.

4. Perishable goods:

Those goods which have very short life and become useless after that are known as perishable goods. These goods must be made available in the market at its right time whatever be its price. So seller becomes ready to sell his goods at any offered price.

Supply Schedule:

It is the tabular representation of relationship between quantities of goods supplied at specified prices in the market. Supply schedule is classified into two categories:

1. Single producer supply schedule/Individual supply schedule:

It is the tabular representation of quantity of commodities supplied in the market by an individual producer at specified prices in the market. It shows the reaction of a single producer in supplying quantity of commodity at different prices in the market.

Combinations	Price	Quantity supplied by a producer
A	1	10
B	2	20
C	3	30
D	4	40
E	5	50

The diagram clearly shows that when coordinates of supply of a commodity by an individual producer and their respective prices are plotted and connected to each other then an upward sloping nature of SS supply curve is formed which is known as Single Producer Supply Schedule.

2. Market Supply Schedule/Aggregate Supply Schedule:

It is the tabular representation of relationship between quantities of commodities supplied by all the producers in the market at different prices. Market supply schedule shows the strength of production and marketing management. It is an indicator of income employment generation and economic development.

The diagram clearly explains that as coordinates of various prices and aggregate supply are plotted and connected to each other then an upward sloping SS supply curve is formed which is known as Market Supply Curve. It shows the situation of income employment generation and economic development.

Interaction between Demand and Supply (Equilibrium Position):

Market Equilibrium is obtained in an economy through interaction between downward sloping DD demand curve and upward sloping SS supply curve. In fact, when D=S then such a case is known as Equilibrium in the market situation.

For Equilibrium

D=S

The concept of equilibrium between Demand and Supply in the market can be represented by following schedule and diagram:

Combinations	Price	Q_d	Q_s	Remarks
A	1	50	10	Q_d>Q_s
B	2	40	20	Q_d>Q_s
C	3	30	30	Q_d=Q_s
D	4	20	40	Q_d<Q_s
E	5	10	50	Q_d<Q_s

The diagram clearly explains that downward sloping Q_dQ_d demand curve and upward sloping Q_sQ_s supply curve interact with each other at point E. The equilibrium point E through equality between Q_d and Q_s i.e. Q_d=Q_s develops an equilibrium situation in the market. It is an appropriate and healthy situation of income employment generation and economic development of a country.

ELASTICITY OF DEMAND:

Concept:

Elasticity of Demand may be defined as proportionate change or percentage change in quantity demanded due to proportionate change in price of commodity.

Symbolically,

E_d/E_D/e_d = Proportionate change in Quantity demanded (Q_d)

Proportionate change in Price of Commodity

E_d =

According to K.E. Boulding,

“Elasticity of Demand may be defined as percentage change in quantity demanded which would result from 1 % change in its price”

TYPES OF ELASTICITY OF DEMAND:

1. On the Basis of Degrees:

a. Perfectly Elastic Demand

When a very small or insignificant change in price causes a very big change in quantity demanded then such a case is known as Perfectly Elastic Demand. The nature of demand curve in this case looks like a “Horizontal Straight Line”. However, Perfectly Elastic Demand is an imaginary concept and it is not found practically in market behaviour of consumers.

b. Relatively Elastic Demand

When change in price by certain proportion causes to change in demand by a bigger proportion then such a case is known as Relatively Elastic Demand. Eg. If price of commodity declines by 20% and demand increases by more than 20% then such a case is known as Relatively Elastic Demand. The nature of demand curve in this case looks like a “Flatter Demand Curve”. It is applicable in case of comfortable goods as cosmetics, perfume and others.

c. Unitary Elastic Demand:

When a change in price by a certain proportion causes to change the quantity demanded exactly by same proportion then such a case is known as Unitary Elastic Demand. Eg. If price of commodity declines by 20% and demand increases exactly by 20% then such a case is known as Unitary Elastic Demand. The demand curve in this case looks like a “Normal Demand Curve”. It is applicable in case of goods of day to day life.

d. Relatively Inelastic Demand:

When a change in price by certain proportion causes to change the demand by comparatively smaller proportion then such a case is known as Relatively Inelastic Demand. Eg. If price decreases by 20% and demand increases by less than 20% then such a case is known as Relatively Inelastic Demand. The nature of demand curve in this case looks like “Steeper Demand Curve”. It is applicable in case of construction materials.

e. Perfectly Inelastic Demand:

When change in price by certain proportion does not affect the quantity demanded at all in the market then such a case is known as Perfectly Inelastic Demand. Eg. If price increases or decreases but demand remains unaffected then it is a case of Perfectly Inelastic Demand. The nature of demand curve in this case looks like a “Vertical Straight Line”. It is applicable in case of goods like Salt, Life Saving Medicines and others.

2. On the Basis of Nature:

a. Price Elasticity of Demand:

It may be defined as proportionate or percentage change in quantity demanded due to proportionate or percentage change in price of the commodity.

Symbolically,

E_d = Proportionate change in quantity demanded

Proportionate change in Price

Notationally,

Price Elasticity of Demand is classified into five categories:

1. Perfectly Elastic Demand

2. Relatively Elastic Demand

3. Unitary Elastic Demand

4. Relatively Inelastic Demand

5. Perfectly Inelastic Demand

b. Income Elasticity of Demand:

It may be defined as proportionate or percentage change in quantity demanded due to proportionate or percentage change in income of consumer.

Symbolically,

E_y/E_i/e_i = Proportionate change in quantity demanded

Proportionate change in income of consumer

Notationally.

Income Elasticity of Demand is classified into three categories:

1. Positive Income Elasticity:

When an increase in income of consumer increases the quantity demanded in the market then such a case is known as Positive Income Elasticity. In case of Positive Income Elasticity the Demand Curve looks like an upward sloping nature of curve.

The diagram shows that quantity demanded increases by a margin of Q₁Q₂ mainly due to an increase in consumer’s income by a margin of Y₁Y₂ and therefore it is a clear case of Positive Income Elasticity.

2. Zero or Neutral Income Elasticity:

When quantity demanded remains unaffected despite the change in consumer’s income then such a case is known as Zero or Neutral Income Elasticity of Demand. The nature of demand curve in this case looks like a ‘Vertical Straight Line’.

3. Negative Income Elasticity:

When quantity demanded declines with an increase in consumer’s income then such a case is known as Negative Income Elasticity. The nature of demand curve in this case looks like a ‘Downward Sloping Curve’. Negative Income Elasticity is applicable in case of Giffen Goods or Inferior Goods.

c. Cross Elasticity of Demand:

It may be defined as proportionate change in quantity demanded of Good X due to proportionate change in price of Good Y, where Good X and Good Y are related goods i.e. Substitute or Complementary Goods.

Symbolically,

E_c = Proportionate change in quantity demanded of Good X

Proportionate change in Price of Good Y

Cross Elasticity of Demand is classified into two categories:

1. Positive Cross Elasticity of Demand:

When an increase in price of Good Y i.e. Tea causes to increase demand for Good X i.e. Coffee in the market then such a case is known as Cross Elasticity of Demand. In this case P_y and Q_X move in the same direction.

The diagram clearly shows that an increase in demand for coffee by Q₁Q₃ due to an increase in price of Tea by PP₁ is the clear case of Positive Cross Elasticity. It is applicable in substitute goods.

2. Negative Cross Elasticity of Demand:

When an increase in price of Good Y by a certain proportion causes to decrease the demand for Good X then such a case is Negative Cross Elasticity of Demand. In this case P_Y and Q_X move in opposite direction. It is applicable in complementary goods.

The diagram explains that decrease in demand for Car by QQ₃ due to an increase in price of petrol by PP₁ is the clear case of Negative Cross Elasticity of Demand.

Factors Affecting Elasticity or Price Elasticity of Demand:

1. Nature of Goods: If nature of goods available is essential for survival of human beings then elasticity of demand is inelastic. However, if goods available belong to comfortable category then elasticity of demand is elastic.

2. Effect of Substitute goods: Demand for a commodity with large number of substitutes will be more elastic. The reason is that even a small rise in its prices will induce the buyers to go for its substitutes. For example, a rise in the price of Pepsi encourages buyers to buy Coke and vice-versa.

3. Change in Income: Elasticity of demand for any commodity is generally less for higher income level groups in comparison to people with low incomes. It happens because rich people are not influenced much by changes in the price of goods. But, poor people are highly affected by increase or decrease in the price of goods. As a result, demand for lower income group is highly elastic.

4. Distribution of Wealth and Income: In case of inequitable distribution of wealth and income, elasticity of demand is generally relatively inelastic.

5. Change in Price Level: Level of price also affects the price elasticity of demand. Costly goods have highly elastic demand as their demand is very sensitive to changes in their prices. However, demand for inexpensive goods is inelastic as change in prices of such goods does not change their demand by a considerable amount.

6. Taste and Fashion: Commodities, which have become habitual necessities for the consumers, have less elastic demand. It happens because such a commodity becomes a necessity for the consumer and he continues to purchase it even if its price rises.

7. Development of Sentiment of Nationalist: If sentiment of a consumer is guided by Nationalist approach and if goods are produced within the country in sufficient quantities then elasticity of demand becomes relatively elastic.

8. Marginal Utility of Product: If a commodity is very much useful for consumer then more commodities is demanded by consumers practically and consequently useful products approach towards relatively elastic demand and vice versa.

Measurement of Price Elasticity of Demand:

1. Total Outlay Method:

The total outlay method, developed by Alfred Marshall is one of the methods of measuring price elasticity of demand. It helps to establish the relationship between change in price of a product and change in total expenditure of a consumer on that commodity. In this method we observe the direction of change in total expenditure of a buyer on a product in response to the change in its price to calculate the price elasticity of a demand. Elasticity of Demand can be measured by Total Outlay Method under three different situations and they are:

a. Relatively Elastic Demand (E_d>1)

When an increase in price reduces total expenditure and if decrease in price increases total expenditure in the market then such a case is measured as Relatively Elastic Demand. In case of Relatively Elastic Demand the change in price and change in total outlay always move in opposite direction. The nature of demand curve in this case looks like a ‘Flatter Demand Curve.’

Price (P)	Quantity (Q)	Total Outlay (PxQ)
4	100	400
2	250	500
1	600	600

The diagram shows that,

OQ₁ quantity of commodity is demanded at OP₁ price in the market.

Here,

Total Outlay = QxP = OQ₁xOP₁ = OP₁MQ₁

Now,

As Price declines from OP₁ to OP₂ demand increases from OQ₁ to OQ₂.

Now,

New Total Outlay = QxP = OQ₂xOP₂ = OP₂M₂Q₂

Since,

New Total Outlay > Old Total Outlay

i.e. OP₂M₂Q₂ > OP₁M₁Q₁ at a declining price rate in the market,

Therefore, it is measured as Relatively Elastic Demand i.e. E_d>1.

2. Unitary Elastic Demand (E_d=1)

When either increase or decrease in price does not affect total expenditure at all in the market then such a case is known as Unitary Elastic Demand. In this case if price either increase or decreases but total expenditure remains constant. The nature of demand curve in this case looks like a ‘Normal Demand Curve’.

Price (P)	Quantity (Q)	Total Outlay (PxQ)
4	100	400
2	200	400
1	400	400

Old Total Outlay = QxP = OQ₁xOP₁ = OP₁N₁Q₁

New Total Outlay = QxP = OQ₂xOP₂ = OP₂N₂Q₂

Since, OP₂N₂Q₂ = = OP₁N₁Q₁

Therefore, it is measured as Unitary Elastic Demand i.e. E_d = 1.

3. Relatively Inelastic Demand (E_d<1)

When an increase in price also increases total expenditure and decline in price decreases total expenditure in the market then such a case is known as Relatively Inelastic Demand. In this case change in price and change in total outlay move in the same direction. The nature of demand curve in this case looks like a ‘Steeper Demand Curve’.

Price (P)	Quantity (Q)	Total Outlay (PxQ)
4	100	400
2	150	300
1	200	200

Old Total Outaly = QxP = OQ₁xOP₁ = OP₁H₁Q₁

New Total Outlay = QxP = OQ₂xOP₂ = OP₂H₂Q₂

Since, OP₂H₂Q₂ < OP₁H₁Q₁

Therefore, it is measured as Relatively Inelastic Demand i.e. E_d < 1.

2. Point Method:

Point Method is also known as geometrical method which estimates elasticity of demand at a particular point of the demand curve. In a straight line demand curve, we can measure price elasticity of demand at any point by taking the ratio of the distance between those points to x-axis to the distance between the point to y-axis on the demand curve. Following formula is exercised to measure Elasticity of Demand by Point Method:

E_d = Lower Segment of the demand curve

Upper Segment of the demand curve

Following diagrammatic representation can be presented for Point Measurement of Elasticity of Demand:

Thus, it is obvious that price elasticity of demand is different at and between different points on the demand curve.

Elasticity of Supply:

It may be defined as proportionate or percentage change in quantity supplied due to proportionate or percentage change in price of commodity.

Symbolically,

E_s = Proportionate or Percentage change in Quantity Supplied

Proportionate or Percentage change in Price of Commodity

Elasticity of Supply is classified into five categories:

1. Perfectly Elastic Supply:

When a change in price by insignificant proportion causes a very big or infinite change in quantity supplied then it is known as Perfectly Elastic Supply. However, it is an imaginary concept and is not found in practical life. The nature of supply curve looks like a ‘Horizontal Straight Line’.

2. Relatively Elastic Supply:

When a change in price by certain proportion causes to change supply by a greater proportion then such a case is known as Relatively Elastic Supply. Eg. If price increases by 20% and supply increases by more than 20% then it is the case of Relatively Elastic Supply. The nature of supply curve looks like ‘Flatter Supply Curve’.

3. Unitary Elastic Supply:

When change in price by certain proportion causes to change supply by exactly same proportion then such a case is known as Unitary Elastic Supply. Eg. If price increases by 20% and quantity supplied also increases by exactly 20% then it is the case of Unitary Elastic Supply. Then nature of supply curve looks like ‘Normal Supply Curve’.

4. Relatively Inelastic Supply:

When change in price by certain proportion causes to change supply by a smaller proportion then such a case is known as Relatively Inelastic Supply. Eg. If price increases by 20% and supply increases by less than 20% then it is the case of Relatively Inelastic Supply. The nature of supply curve looks like ‘Steeper Supply Curve’.

5. Perfectly Inelastic Supply:

When change in price by certain proportion doesn’t affect quantity supplied at all in the market then such a case is known as Perfectly Inelastic Supply. In this case price either increases or decreases, quantity of supply remains unaffected or unchanged. It is also closer to imaginary concept. The nature of supply curve looks like a ‘Vertical Straight Line’.

UNIT II- THEORY OF CONSUMER BEHAVIOUR

Concept of Total Utility, Average Utility and Marginal Utility:

1. Total Utility (TU): It may be defined as sum of total satisfaction obtained by a consumer after consuming different or all units of commodities. Eg. If a consumer consumes five glasses of water and obtains 20 utils from 1^st glass of water, 15 utils from 2^nd glass of water, 10 utils from 3^rd glass of water, 5utils from 4^th glass of water and Zero utils from 5^th glass of water then when we add all the units of utilities as 20+15+10+5+0, then it will give total value of 50 utils which is known as Total Utility.

In fact, Total Utility may also be defined as sum of Marginal Utility.

Symbolically,

When Marginal Utility declines but remains positive, Total Utility continues to increase. If Marginal Utility becomes zero then Total Utility becomes Maximum. But if Marginal Utility becomes negative then Total Utility starts to decline. Due to such a movement in Total Utility, the diagrammatic shape of Total Utility curve looks like an upward sloping bending nature of curve.

2. Average Utility (AU): It may be defined as sum of Total Utility divided by units of consumption consumed by a consumer.

Symbolically,

AU = TU

Where N = units of consumption

When units of consumption increases then Average Utility starts to decline. It continues to decline but never becomes zero. Thus, the nature of Average Utility curve looks like a downward sloping curve which does not touch the x-axis.

3. Marginal Utility (MU): It may be defined as net increment in Total Utility due to an increase in additional unit of consumption.

Symbolically,

MU =

As units of consumption increases, Marginal Utility declines sharply than Average Utility. It becomes zero and eventually Marginal Utility becomes negative with an increase in units of consumption. Thus, the diagrammatic shape of Marginal Utility Curve looks like a downward sloping nature of curve which approaches to zero and also enters into negative dimension.

Units of Consumption (N)	Total Utility	Average Utility	Marginal Utility
1	20	20	20
2	35	17.5	15
3	45	15	10
4	50	12.5	5
5	50	10	0
6	45	7.5	-5
7	35	5	-10

The diagram clearly shows that as coordinates of units of consumption and Total Utility are plotted and connected to each other than an upward sloping bending nature of curve is formed which is known as Total Utility Curve. Average Utility Curve looks like a downward sloping nature of curve but never touches x-axis. However, Marginal Utility curve also looks like a downward sloping nature of curve which becomes zero and eventually enters into negative dimension as well.

Relationship between Total Utility, Average Utility and Marginal Utility:

Total Utility

Average Utility

Marginal Utility

It may be defined as

sum of total satisfaction

obtained by consumers after consuming different or all

units of commodities. It may also be defined as sum of Marginal Utility.

TU =

It may be defined as sum of Total Utility divided

by units of consumption

consumed by consumers.

AU =

It may be defined as net increment in Total Utility due to an increase in additional unit of consumption.

MU =

Units of Consumption	Total Utility	Average Utility	Marginal Utility
1	20	20	20
2	35	17.5	15
3	45	15	10
4	50	12.5	5
5	50	10	0
6	45	7.5	-5
7	35	5	-10

3. When Marginal Utility declines, Total Utility increases but Average Utility declines.

4. When Marginal Utility becomes zero, Total Utility becomes maximum but Average Utility continues to decline.

5. When Marginal Utility becomes negative, Total Utility starts to decline but Average Utility continues to decline.

6. In the initial unit of consumption, Total Utility, Average Utility and Marginal Utility always remain equal to each other.

LAW OF DIMINISHING MARGINAL UTILITY

The concept of Law of Diminishing Marginal Utility was developed by famous economist Henry Gossen as his 1^st law and therefore this law is also popularly known as ‘First Law of Gossen’. Later Alfred Marshall developed the concept of law of diminishing marginal utility at a scientific scale. According to this law when a consumer consumes different units of a commodity then from each additional unit of consumption the Marginal Utility (Additional Satisfaction) of the consumer subsequently declines.

According to Henry Gossen ‘The amount of one and same satisfaction declines as we proceed with that satisfaction until satiety is reached’.

According to Alfred Marshall ‘The additional benefit which a person derives from a given increase in the stock of a thing diminishes, other things being equal, with every increase in the stock that he already has’.

The point of satiety is known as Full Satisfaction of consumer. The concept of Law of Diminishing Marginal Utility can be represented by following schedule and diagram:

Units of Consumption (N)	Total Utility	Marginal Utility
1	20	20
2	35	15
3	45	10
4	50	5
5	50	0
6	45	-5
7	35	-10

The diagram clearly shows that when coordinates of consumption and their respective Marginal Utilities are plotted and connected to each other then a downward sloping nature of Marginal Utility Curve is formed which is known as Diminishing Marginal Utility Curve. The fifth unit of consumption shows Point of Satiety and Marginal Utility Curve then approaches to negative dimension.

ASSUMPTIONS:

Ceteris Paribus, this law is based on following assumptions:

1. Appropriate Unit of Consumption

2. Uniform Unit of Consumption

3. Continuous Consumption

4. Taste and Fashion of consumer remains same

5. Prices of Commodities also remains same

6. Consumer is rational one

7. The Marginal Utility of Money remains constant

EXCEPTIONS/LIMITATIONS:

1. Wealth for Miser: when a miser obtains additional unit of wealth then due to miserness, he/she obtains more satisfaction from each additional unit of wealth.

2. In case of Good Piece of Music: According to Prof. Taussig when a music lover listen favourable piece of music again and again then from each additional unit of music he/she obtains more satisfaction.

3. In case of Prestigious Goods: Those goods which are connected with prestige of consumers, people obtain more satisfaction from each additional unit of such goods.

4. In case of rare collectibles: Collectors of rare collectibles obtain more satisfaction from each additional unit of such commodities.

5. Wine for Drunkard: When a drunkard drinks different glasses of wine then from each additional glass he/she obtains more satisfaction.

6. Marginal Utility of Money does not remain constant: Marshall argued that marginal utility of money remains constant for all consumers but observation shows that marginal utility for rich people from additional unit of money declines but marginal utility of money for poor people increases.

LAW OF SUBSTITUTION/LAW OF EQUIMARGINAL UTILITY:

The concept of Law of Substitution or Law of Equi-Marginal Utility was developed by Henry Gossen as his 2^nd law and therefore this law is also known as ‘Second Law of Gossen’. In fact, law of equi-marginal utility is also known as Law of Substitution. According to this law a consumer spends his/her limited income on purchase of different commodities in such a way that the Marginal Utility of all commodities should be equal to each other. If Marginal Utility of all commodities are equal to each other then such a case maximizes satisfaction of consumer.

According to Alfred Marshall ‘If a person has a commodity which can be put to several uses, he will distribute it between these uses in such a way that it has same Marginal Utility in all’

The concept of Law of Equi-Marginal Utility needs to fulfill following conditions to maximize satisfaction of consumer:

MU_X = MU_Y = MU_Z

P_X P_Y P_Z

Units of Expenditure	MU of Good X	MU of Good Y	MU of Good Z
1	18 (i)	17 (ii)	16 (iv)
2	17 (iii)	16 (v)	15
3	16 (vi)	15	14
4	15	14	13
5	14	13	12
6	13	12	11

The diagram clearly shows that when a consumer consumes OX largest quantity of Good X, OY large quantity of Good Y and OZ very small quantity of Good Z then consumer obtains same level of satisfaction from all X, Y and Z commodities. Since AZ MU of Good Z = BY MU of Good Y = CX MU of Good X. Since consumer equalizes MU and therefore the total satisfaction of consumer is maximized.

ASSUMPTIONS:

Ceteris Paribus, this law is based on following assumptions:

1. Appropriate unit of consumption

2. A consumer is eligible to spend only a fraction of income at once

3. Taste and Fashion of consumer remains same

4. Income of consumer also remains same

5. Price of commodities also remains same

6. Marginal Utility of money remains constant

7. A consumer is rational one and he/she attempts to maximize satisfaction with the help of limited income

LIMITATIONS/EXCEPTIONS

1. In case of Essential commodities: Commodities which are essential for survival of human being, it becomes difficult for consumer to equalize Marginal Utility. Such commodities are purchased according to requirement rather than equalization of Marginal Utility.

2. In case of Giffen goods: In case of Giffen goods, as price decreases its demand also decreases practically and consumer do not think to equalize Marginal Utility of Giffen product in the process of purchase in the market.

3. In case of Prestigious goods: In case of prestigious goods people purchase commodities more than bearable prices. In such goods it is not possible for consumer to equalize Marginal Utility.

4. Taste and Fashion differ from consumer to consumer: The taste and fashion of vary from consumer to consumer. In case of varieties of taste and fashion, it would not be possible for consumer to equalize Marginal Utility.

5. Marginal Utility of Money does not remain constant: According to this law the marginal utility of money remains constant for all consumers. However, modern economists criticized this approach and argued that if quantity of money declines then marginal utility of money increases and vice versa.

6. In case of Indivisible goods: Those goods which are indivisible by nature it would not be possible for consumer to equalize Marginal Utility.

THEORY OF CONSUMER’S SURPLUS:

The concept of Theory of Consumer’s Surplus was developed by French Engineer and Economist Dupuit in 1844 A.D. Later on Consumer’s Surplus was developed by Alfred Marshall at a scientific scale. The difference between Potential Price (PP) and Actual Price (AP) is known as Consumer’s Surplus.

According to Alfred Marshall ‘The excess of price which would be willing to pay rather than go without the thing over that which he actually does pay is the economic measure of surplus satisfaction. It may be called Consumer’s Surplus’

According to Penson ‘The difference between what we would pay and what we would have to pay is called Consumer’s Surplus’

Symbolically,

C.S. = PP – AP

Where, PP = Potential Price and AP = Actual Price

C.S. = TU – nxMU

Where, TU = Total Utility and MU = Marginal Utility

C.S. = PP – nxP

Where, P = Price of Commodity and n = number of commodities

Marshall pointed that price of a commodity is always equal to its Marginal Utility. The concept of Consumer’s Surplus can be represented by following schedule and diagram:

Units of Commodity	PP (Total Utility)	AP (Marginal Utility)	Consumer’s Surplus
A	25	5	20
B	20	5	15
C	15	5	10
D	10	5	5
E	5	5	0
Total	75	25	50

The diagram clearly shows that when AP is subtracted from PP then the remaining shaded part of the diagram is known as Consumer’s Surplus. In the case of E unit Consumer’s Surplus does not rise because PP=AP in this case practically.

CRITICISM/LIMITATIONS

1. In case of Essential Commodities: In case of essential commodities of survival, the consumer may be ready to pay any price to fulfill basic needs of life. In such commodities potential price of consumer cannot be estimated accurately and effectively. Thus, it becomes difficult for consumer to calculate value of consumer’s surplus.

2. In case of Prestigious Goods: In order to save social prestige, consumer may be ready to pay price which goes beyond capacity. In such case potential price cannot be accurately estimated and therefore actual value of consumer’s surplus cannot be calculated.

3. In case of Indivisible Goods: In case of indivisible goods, if consumer is unable to pay entire price for indivisible product then it becomes useless to know about potential price. Therefore, value of consumer’s surplus cannot be calculated accurately.

4. In case of constant Marginal Utility of Money: Marginal Utility of Money varies according to consumer.

5. It is a hypothetical Concept: Famous Economist D.H. Robertson argued that the theory of consumer’s surplus is based on hypothetical concept. It is an opinion of Marshall which may not be observed in practical life.

IMPORTANCE

1. Theoretical Importance:

a. Value in Use: There are some products which are very much useful for consumer but prices of these products are very low. In case of such products, value of consumer’s surplus remains very high. Eg. Salt, Match box and others.

b. Value in Exchange: There are some products which are precious and prices of these products are very high but these products are not so useful for survival of consumers. In such case value of consumer’s surplus remains very low. Eg. Diamond, Jewellery and others.

2. Practical Importance:

a. Helpful to evaluate Economic Status of a Society:

If value of consumer’s surplus is very high in a society then it implies that the potential price of consumer is very high. Actual price remains same. Since potential price remains very high and therefore it helps us to conclude that the economic status of that society is located at a higher scale.

b. Helpful to develop Tax Policy:

If consumer’s surplus is high in a society then it shows that the payable capacity of people in that society is high. Thus, due to high purchasing power of common people government imposes high rate of tax to common people in that society.

c. Helpful in Export Trade Policy:

The theory of consumer’s surplus is a helpful instrument in promoting export trade of a country. If exportable products are sold in foreign market at a very high price then it implies that consumer’s surplus of that foreign market remains high. Consequently, government attempts to export maximum quantity of exportable products in that country practically.

d. In determination of Monopoly’s Price:

A Monopolist exercises price discrimination which means different prices are charged from different consumers for same product. Thus, a Monopolist sells its product at a very high price in that community where value of consumer’s surplus is high and sells its product at a lower price in community where value of consumer’s surplus remains low.

UNIT III – THEORY OF PRODUCTION

Concept of Production Function:

There exists functional relation between input and output. In fact, the functional relation between input (L,L,K,T) and output (Q) is known as Production Function.

Symbolically,

Q = f (L,L,K,T)

Where, Q = output or production, L = Land, L = Labour, K = Capital, T = Technology and f = sign of functional relation

# Fixed Factors of Production: The factors of production which are fixed in quantity in the short run are known as Fixed Factors of Production.

# Variable Factors of Production: The factors of production whose quantity can be changed in the short run are known as Variable Factors of Production.

Short Run Production Function:

A Production Function in which some factors of production are fixed and some factors are variable is called Short Run Production Function. Symbolically, a short run production function is written as:

Q = f

Where, L = Labour, K = Capital, Q = Output and bar over the variable K means that the variable is fixed.

Long Run Production Function:

A Production Function in which all the factors of production are variable is known as Long Run Production Function. Symbolically, long run production function is written as:

Q = f

Where, Q = Output, L = Labour, K = Capital and L and K are variable inputs.

TOTAL PRODUCT, AVERAGE PRODUCT AND MARGINAL PRODUCT AND THEIR DERIVATOIN:

1. Total Product (TP): Total Product may be defined as sum of total quantity of output which is produced by producer through different factors of production (L,L,K,T). TP may also be defined as sum of MP.

Symbolically,

TP = Q

TP = MP

As factor of production as labour increases then TP increases in the beginning, it reaches to maximum point and eventually TP starts to decline. Thus, diagrammatic shape of TP curve looks like an upward sloping bending nature of curve.

2. Average Product (AP): Average Product may be defined as sum of Total Product divided by units of factor of production taken as labour.

Symbolically,

AP = TP

AP = Q

In initial stage of production AP starts to increase slowly and thereafter declines slowly. It continues to decline but does not become negative. Thus, diagrammatic shape of AP curve looks like a downward sloping nature of curve but does not touch x-axis.

3. Marginal Product (MP): Marginal Product may be defined as net increment in Total Product due to an additional increase in factor of production as labour. Eg. 100 Labour produces 4000 pieces, 101 Labour produces 4250 pieces. Therefore, 1 additioanl Labour produces 250 additional pieces. Hence, Production of 250 additional pieces can be represented as Marginal Product.

Symbolically,

MP = TP

MP = Q

As factor of production increases, MP increases in beginning sharply and it continues to decline sharply, it becomes zero and finally it becomes negative as well.

The concept and derivation of TP, AP and MP can be represented by following schedule and diagram:

VF (Labour)	Total Product	Average Product	Marginal Product
1	8	8	8
2	20	10	12
3	36	12	16
4	48	12	12
5	55	11	7
6	60	10	5
7	60	8.5	0
8	56	7	-4

The diagram clearly shows that as coordinates of variable factor i.e. labour and Total Product are plotted and connected to each other then an upward sloping bending nature of curve is formed known as TP Curve. MP Curve increases sharply and declines sharply, it reaches to bottom level zero and eventually enters into negative dimension. However, AP curve increases slowly in the beginning and declines slowly as well but it does not become zero and negative practically.

RELATIONSHIP BETWEEN TP, AP AND MP

TOTAL PRODUCT (TP)

AVERAGE PRODUCT (AP)

MARGINAL PRODUCT (MP)

It may be defined as sum of total quantity

of output

produced by producer

through different

factors of production (L,L,K,T). Symbolically,

TP = Q or

TP = MP

It may be defined as sum of TP divided by units of variable

factor of production i.e. labour. Symbolically,

AP = TP/L or

AP = Q/L

It may be defined as net increment in TP

due to additional increase in factor of production i.e. labour.

Symbolically,

MP = TP/ L or

MP = Q/ L

2. The relationship between TP, AP and MP can be represented by following schedule:

VF (Labour)	Total Product	Average Product	Marginal Product
1	8	8	8
2	20	10	12
3	36	12	16
4	48	12	12
5	55	11	7
6	60	10	5
7	60	8.5	0
8	56	7	-4

3. As long as MP increases till then TP increases at an increasing rate but AP increases at a slower rate.

4. When MP declines but remains positive till then TP increases but at a declining rae whereas AP declines at a slower rate.

5. When MP becomes zero TP becomes maximum but AP continues to decline.

6. When MP becomes negative, TP starts to decline whereas AP continues to decline.

7. In initial stage of production TP, AP and MP are equal to each other.

LAW OF VARIABLE PROPORTION/SHORT RUN PRODUCTION FUNCTION/ONE FACTOR VARIABLE PRODUCTION FUNCTION:

The functional relation between inputs and outputs is known as Production Function.

Symbolically,

Q = f (L,L,K,T)

Where, Q = Output, L = Land, L = Labour, K = Capital and T= Technology

Law of Variable Proportion attempts to examine that if a factor of production preferably labour is varied keeping other factors of production constant then how is total production affected? This question is properly settled down by Law of Variable Proportion. The concept of Law of Variable Proportion has been defined by Marshall, F. Benham, G. Stigler, K.E. Boulding and others.

According to K.E. Boulding ‘As we increase the quantity of any one input which is combined with fixed quantities of other inputs, Marginal Physical Productivity of variable input must eventually decline’

Since Factors of Production are assumed to be constant only in short period of time and therefore it is also popularly known as Short Run Production Function. Since Labour is only assumed to be variable, therefore this law is also known as One Factor Variable Production Function.

The concept of Law of Variable Proportion can be represented by following schedule and diagram through following three different stages:

1. Stage of Increasing Return

2. Stage of Diminishing Return

3. Stage of Negative Return

VF (Labour)	Total Product	Average Product	Marginal Product
1	8	8	8
2	20	10	12
3	36	12	16
4	48	12	12
5	55	11	7
6	60	10	5
7	60	8.5	0
8	56	7	-4

The diagram helps to analyze three stages of Law of Variable Proportion:

1. Stage – I (Stage of Increasing Return)

In this stage as variable factor i.e. labour is increased, MP increases sharply. As long as MP increases sharply till then TP increases at an increasing rate. The corresponding point on TP (H) at which MP becomes maximum is known as Point of Inflexion. With an increase in MP, AP increases slowly. Since MP, AP and TP all increase simultaneously with an increase in variable factor therefore this stage is known as Stage of Increasing Return. Since large proportion of output is produced at a small proportion of labour cost therefore this stage is also known as Stage of Diminishing Cost.

2. Stage – II (Stage of Diminishing Return)

After the point of inflexion as variable factor i.e. labour is increased then MP declines sharply. As long as MP decreases but remains positive till then TP increases at a declining rate. When MP declines sharply then AP declines slowly. When MP approaches to zero, TP becomes maximum. Thus zero MP is known as Optimum or Ideal Stage of Diminishing Return because it helps to maximize TP. Since MP and AP start to decline but TP increases at a diminishing rate therefore this stage is known as Stage of Diminishing Return. Since large proportion of cost is incurred for small proportion of production therefore this stage is also known as Stage of Increasing Cost.

Stage of Diminishing Return is universally applicable in every sector of production as agriculture, industries, service and others. Due to its universal applicability of Stage of Diminishing Return famous American Economist Prof. Wicksteed rightly pointed that ‘This law is as universal as law of life itself’.

3. Stage – III (Stage of Negative Return)

After achieving the case of zero MP if producer continues to increase variable factor then MP becomes negative and MP curve crosses over x-axis. When MP becomes negative TP starts to decline and AP continues to decline. A rational producer does not prefer to operate production in Stage of Negative Return except some exceptional situation as production in Biratnagar Jute Mill of Nepal.

Assumptions:

1. Only one factor preferably labour is assumed to be variable.

2. The variable factor (Labour) is combined with fixed factors of production.

3. The state of Technology is assumed to be given and constant

4. Producer is rational one.

5. Production Environment is appropriate and normal.

LAWS OF RETURNS/RETURNS TO SCALE/LONG RUN PRODUCTION FUNCTION/TWO FACTORS VARIABLE PRODUCTION FUNCTION:

The functional relation between inputs and output is known as Production Function. Returns to Scale attempts to examine that if all factors of production are changed by a certain scale or proportion then how is total quantity affected? This question is properly answered by Returns to Scale or Laws of Returns.

Symbolically,

Q = f (L,L,K,T)

Since all factors of production are made variable in the long run and therefore returns to scale is also known as Long Run Production Function. Since area of land cannot be increased after a certain point and shape of technology cannot be determined in the guaranteed manner therefore if land and technology both are dropped from system of production function then labour and capital only play vital role in production management. Returns to Scale is also known as Two Factors Variable Production Function. Returns to Scale is classified into three categories:

1. Law of Increasing Return (Increasing Returns to Scale)

2. Law of Constant Return (Constant Returns to Scale)

3. Law of Diminishing Return (Diminishing Returns to Scale)

1. Law of Increasing Return (Increasing Returns to Scale)

The functional relationship between input (L,L,K,T) and output (Q) is known as Production Function.

Symbolically,

Q = f (L,L,K,T)

Where, L = Land, L = Labour, K = Capital and T = Technology

When an increase in Labour and Capital by a certain proportion causes to increase total production by a greater proportion then such a case is known as Law of Increasing Return or Increasing Returns to Scale. Eg. If an increase in Labour and Capital by 25% causes to increase total production by more than 25% then such a case is an appropriate example of Law of Increasing Return. The significant feature of Law of Increasing Return is that Marginal Product continues to increase in this stage of production. Since larger proportion of output is produced at a smaller proportion of Labour and Capital cost therefore Law of Increasing Return is also known as Law of Diminishing Cost. Moreover Law of Increasing Return is applicable in initial stage of production due to following reasons:

1. Indivisibility of Factors of Production (Suggested by Nicholas Kaldor and Mrs. Joan Robinson)

2. Dimensional Economies (Suggested by William J. Baumol)

3. Scope of Division of Labour and Specialization (Suggested by Watson)

4. Internal Economies of Scale

5. External Economies of Scale

Labour and Capital	Total Product	Marginal Product
1L+1K	10	10
2L+2K	25	15
3L+3K	45	20
4L+4K	70	25

2. Law of Constant Return (Constant Returns to Scale)

The functional relationship between inputs (L,L,K,T) and output (Q) is known as Production Function.

Symbolically,

Q = f (L,L,K,T)

Where, L = Land, L = Labour, K = Capital and T = Technology

When an increase in Labour and Capital by a certain proportion causes to increase total production by exactly same proportion then such a case is known as Law of Constant Return. Eg. If an increase in Labour and Capital by 20% causes to increase total production exactly by 20% then such a case is known as Law of Constant Return. The significant feature of Law of Constatn Return is that Marginal Product always remains constant. Since proportion of production exactly matches with proportion of cost therefore Law of Constant Return is also popularly known as Law of Constant Cost.

According to Cobb Douglas Production Function, Law of Constant Return is also known as ‘Linearly Homogeneous Production Function of First Degree’. The concept of Law of Constant Return can be represented by following schedule and diagram:

Labour and Capital	Total Product	Marginal Product
1L+1K	10	10
2L+2K	20	10
3L+3K	30	10
4L+4K	40	10

3. Law of Diminishing Return (Diminishing Returns to Scale)

The functional relationship between inputs (L,L,K,T) and output (Q) is known as Production Function.

Symbolically,

Q = f (L,L,K,T)

Where, L = Land, L = Labour, K = Capital and T= Technology

When an increase in Labour and Capital by a certain proportion causes to increase total production at a declining proportion then such a case is known as Law of Diminishing Return. Eg. If an increase in Labour and Capital by 20% causes to increase total production by less than 20% then such a case is known as Law of Diminishing Return. The significant feature of Law of Diminishing Return is that Marginal Product declines all the time in this stage of production. Since smaller proportion of output is produced at a greater proportion of Labour and Capital therefore Law of Diminishing Return is also known as Law of Increasing Cost.

Law of Diminishing Return is comprehensively applicable in every sector of production but it is more effective in agriculture. Due to universal applicability of Law of Diminishing Return, the famous American Economist Wicksteed rightly pointed that ‘This law is as universal as law of life itself’.

Reasons of Applicability:

1. Indivisibility of Factors of Production

2. Less scope of Division of Labour and Specialization

3. Internal Diseconomies of Scale

4. External Diseconomies of Scale

Labour and Capital	Total Product	Marginal Product
1L+1K	20	20
2L+2K	35	15
3L+3K	45	10
4L+4K	50	5

Q. Why is Law of Diminishing Return more effective in Agricultural Sector?

Although Law of Diminishing Return is applicable in every sector of production yet it is more effective in agricultural sector possibly due to following reasons:

1. Inelastic Nature of Land: The area of land remains fixed or inelastic and as the producer applies more and more labour and capital in the fixed nature of land then the fertility of land declines after certain point. Thus, due to inelastic nature of land Law of Diminishing Return is applicable in agricultural sector.

2. Contribution of Natural Factors: The agricultural production is basically guided by natural factors as climate, rainfall, photosynthesis, flood, drought and other natural factors. Thus, due to the contribution of Natural Factors in agricultural production, Law of Diminishing Return is effective in this sector.

3. Scattered Nature of Agricultural Plants: The agricultural plants are available in the field in scattered manner. Due to scattered manner of agricultural plants farmers cannot take care of all agricultural plants in same manner. Thus, scattered nature of agricultural production also causes to apply Law of Diminishing Return in effective manner in agricultural production.

4. Less Scope of Division of Labour and Specialization: The Division of Labour and Specialization cannot be applied in agricultural sector as effectively as applied in Industrial sector. The semi-skilled agricultural labourers perform almost all work of production. Thus, due to less scope of Division of Labour and Specialization Law of Diminishing Return is applicable in agricultural production.

5. Lack of Mechanization: The machines and equipments are not utilized as effectively as it should be in agricultural sector than that in industrial sector. Thus, less use of machines and equipments can also be represented as guiding factor of applicability of Law of Diminishing Return in agricultural sector.

6. Fertility of Land Differs: In same area of land some part may be more fertile whereas some parts may be less fertile. Consequently, as more units of labour and capital are utilized in agricultural sector then total production increases but at a diminishing rate.

7. Fertility of Land eventually Declines: According to the characteristics of land the fertility of land increases with an increase in inputs like fertilizer, pesticides and others only upto a certain point. After reaching the maximum point the fertility of land eventually declines practically. Thus, due to decline in nature of fertility of land after certain point, the fertile capacity of land eventually declines and Law of Diminishing Return becomes effective in agricultural production.

All these reasons are collectively responsible for effectiveness of Law of Diminishing Return in agricultural sector more effectively than other sectors of production.

UNIT IV – MARKET, REVENUE AND COST CURVES

Concept and Meaning of Perfect Competition/Necessary Condition or Elements or Perfect Competition:

Perfect Competition is a market situation characterized by following features:

1. Large number of Buyers and Sellers: There must be large number of buyers and sellers. There is no literal meaning of large. However, buyers compete with buyers and sellers compete with sellers in the market of perfect competition.

2. Homogeneous Product: The products in the market must remain homogeneous. It implies that size, colour, design and shape of product always remain same.

3. Single Price: There exists single price of product in the market of perfect competition. In fact prices do not vary from shop to shop in the market of perfect competition.

4. Free entry and exit of Firms: The firms in the market of perfect competition enter into industry at any time and these firms leave industry any time according to their convenience.

5. Perfect knowledge to buyers and sellers about market: In market of perfect competition buyers and sellers occupy perfect knowledge about market. Which products are available in which part of market at what price? Such and other information are logically available to all buyers and sellers in market of perfect competition.

6. Perfect mobility of Factors of Production: Factors of Production such as L, L, K, T are perfectly mobile in the market. In fact, Factors of Production can be shifted from one place to another according to convenience of buyers and sellers.

7. Absence of Transportation Cost: The transportation cost is not included in price of commodity in market of perfect competition.

8. Nominal Profit: The firms manage to earn very insignificant or nominal profit in the market of perfect competition. Thus, nominal profit is feature of market of perfect competition.

If all these components are found in a market situation then such a case of market arrangement is known as Perfect Competition. However, most features and elements of perfect competition are based on imaginary scale and therefore Perfect Competition is supposed to be an imaginary market.

Concept and Meaning of Monopoly:

The word Monopoly is derived from dual words of ‘Mono’ and ‘Poly’. Mono means single and Poly means seller. Monopoly may be defined as a market situation in which a single firm is either sole producer or seller of product with no close substitutes.

Main Features:

1. Single Producer or Seller: In Monopoly Market a single firm is either producer or seller of product. In fact, more than one producer or seller does not exist in Monopoly market.

2. No Close Substitutes: In monopoly market the product produced by monopolist does not have close substitutes. In fact, cross elasticity of demand between product of a monopolist and products of other producer must be negligible.

3. Strong Barriers to entry of firms: In monopoly market a single firm constitutes whole industry and therefore no other firms are allowed to join the monopoly market.

4. Price Maker than Price Taker: A monopolist determines high price of its product on its own terms and conditions. It therefore appears that monopolist is price maker than price taker.

5. Profit Motive: A monopolist always attempts to claim as much profit it can from consumers in market.

Concept and Meaning of Imperfect Competition:

The concept of Imperfect Competition was developed by famous economist E.H. Chamberlin and Mrs. Joan Robinson. According to Mrs. Joan Robinson a market situation which lies in between Perfect Competition and Monopoly can be described as Imperfect Competition.

Features:

1. Large number of buyers and some sellers

2. Product Differentiation

3. Price Variation

4. Advertisement as Life Breathing Element

5. Importance of Selling Cost

6. Government Intervention

7. Free Entry and Exit of Firms

8. Significant or Super Normal Profit

Mrs. Joan Robinson concluded that when some producers or firms manage to produce technically similar products and these producers compete with each other in the market to sell maximum products with a view to earn significant profit then such market arrangement is known as Market of Imperfect Competition.

Concept of Total Revenue, Average Revenue and Marginal Revenue:

Total Revenue (TR):

It may be defined as sum of product of output and selling price of a business firm in the market.

Symbolically,

TR = QxP

Where, Q = Quantity of output sold and P = Selling Price

Total Revenue may also be defined as sum of Marginal Revenue of a business firm.

Symbolically,

TR = MR

In the market of perfect competition due to system of single price the output and Total Revenue both of them increase at a same proportion and therefore diagrammatic shape of Total Revenue Curve looks like an upward sloping nature of curve which makes an angle of 45 degree with both x- and y- axes. But in the market of monopoly and imperfect competition the diagrammatic shape of Total Revenue curve looks like an upward sloing bending nature of curve.

Average Revenue (AR):

It may be defined as sum of Total Revenue divided by quantity of output sold in the market.

Symbolically,

AR = TR

AR is also compared with price of commodity.

Symbolically,

AR = TR

AR = QxP

AR = P

In the market of perfect competition AR=MR and AR and MR both remain constant. Thus, AR curve looks like a horizontal straight line. But in market of monopoly and imperfect competition AR curve looks like a downward sloping nature of curve and it does not touch x-axis.

Marginal Revenue (MR):

It may be defined as net increment in Total Revenue due to an additional unit of output sold in the market.

Symbolically,

MR = TR

In the market of perfect competition MR always remains constant and always equal to AR. So MR curve looks like a horizontal straight line. But in the market of monopoly and imperfect competition MR curve looks like a downward sloping nature of curve which crosses over x-axis and enters into negative dimension as well. It therefore implies that MR starts to decline with an increase in quantity of output sold in the market, approaches to zero and becomes negative as well.

The concept and nature of TR, AR and MR curves in the market of perfect competition and monopoly and imperfect competition can be represented by following schedule and diagram:

The diagram A clearly shows that as coordinates of output and TR are plotted and connected to each other then an upward sloping curve is formed which makes an angle of 45 degree with both the axes. Since AR = MR and it also remains constant therefore AR and MR curves always look like horizontal straight line in the market of perfect competition.

The diagram B clearly shows that due to effectiveness of Law of Diminishing Return, the magnitude of TR starts to decline after reaching highest point. Therefore, TR curve looks like an upward sloping bending nature of curve in the market of monopoly and imperfect competition. However, AR and MR curves look like downward sloping curve but MR approaches to zero and also enters into negative dimension.

RELATIONSHIP BETWEEN AR AND MR:

1. In the market of perfect competition, AR = MR.

2. In market of monopoly and imperfect competition, when AR declines MR also declines simultaneously but MR declines sharply than that of AR. When AR becomes zero TR becomes maximum and as MR becomes negative TR starts to decline.

3. When AR and MR both curves are downward sloping nature of curve then MR occupies half of the distance from y-axis.

4. When AR and MR both are downward sloping convex nature of curve then MR occupies less than half of the distance from y-axis.

5. When AR and MR both curves are downward sloping concave nature of curve then MR occupies more than half of the distance from y-axis.

6. In initial stage of sales of output AR and MR both are equal to each other.

COST:

When monetary expenses are incurred in process of production of a commodity then such expenses are referred as cost in ordinary sense. In Economics, apart from monetary expenses, cost also includes sacrifices of a producer in terms of time, sacrifice of energy, space and such other components. Such sacrifices are known as Real Costs. When monetary expenses i.e. monetary cost and real costs i.e. sacrifices of a producer are added together then it is known as Cost in Economics.

Symbolically,

Economic Cost = Money Cost + Real Cost

COST CURVES:

Short Run Total Cost and Cost Curves

1. Total Fixed Cost (TFC)

It may be defined as those costs which are independent of quantity of output. If output either increases or decreases, TFC remains unaffected.

Due to constant nature of TFC the diagrammatic shape of TFC curve looks like a horizontal straight line. Eg. Payment of Rent, Insurance Charges, Bank Interest, Depreciation and others.

Symbolically,

TFC = K

Where, K = Fixed Cost

When output becomes zero, TFC does not become zero rather it remains same. TFC is also popularly known as Overhead Cost or Indirect Cost.

2. Total Variable Cost (TVC)

It may be defined as that cost which varies directly with change in quantity of output. When quantity of output increases then TVC also increases simultaneously and vice versa. When quantity of output becomes zero then TVC also becomes zero. Due to such a feature of TVC the diagrammatic shape of TVC curve looks like an upward sloping nature of curve which always originates from origin.

Symbolically,

TVC = WxL

Where, W = Wage rate and L = Number of workers employed

TVC is also popularly known as Prime Cost or Direct Cost. Eg. Payment of Labour, Payment of Raw Materials and others.

3. TOTAL COST (TC)

It may be defined as sum of Total Fixed Cost and Total Variable Cost.

Symbolically,

TC = TFC + TVC

When output increases TC also increases and when output decreases TC also decreases but when output becomes zero TC does not become zero rather TC = TFC at zero level of output. Thus, diagrammatic shape of TC curve looks like an upward sloping nature of curve which originates from beginning point of TFC curve. Also TC curve is always located at a higher place than that of TFC and TVC curve.TC and TVC both curves look like upward sloping nature of cures but they never meet with each other.

Output	TFC	TVC	TC
0	300	-	300
1	300	300	600
2	300	400	700
3	300	450	750
4	300	500	800
5	300	600	900
6	300	750	1050
7	300	890	1190
8	300	1100	1400
9	300	1350	1650
10	300	2000	2300

The diagram clearly shows that when coordinates of output and TFC are plotted and connected to each other then a horizontal straight line is formed which is known as TFC curve. But when coordinates of output and TC curve is plotted and connected to each other then an upward sloping nature of curve is formed which is known as TC curve. TVC curve also looks like an upward sloping nature of curve.

Short Run Average and Marginal Costs

1. Average Fixed Cost (AFC)

It may be defined as sum of TFC divided by quantity of output produced.

Symbolically,

AFC = TFC

Where Q = quantity of output produced

When quantity of output increases AFC starts to decline, it continues to decline comes closer to zero but never becomes zero. Due to such a nature of AFC the diagrammatic shape of AFC looks like a downward sloping nature of curve which comes closer to x-axis but never touches x-axis.

2. Average Variable Cost (AVC)

It may be defined as sum of TVC divided by quantity of output produced.

Symbolically,

AVC = TVC

When quantity of output increases, AVC declines in the beginning, it reaches to bottom point and thereafter AVC starts to increase with an increase in quantity of output. Due to such a nature of AVC the diagrammatic shape of AVC curve looks like a correct mark or tick mark nature of curve.

AVC is also the sum of product of wage rate and reciprocal value of average product of labour.

Mathematically,

AVC = TVC

AVC = WxL

AVC = Wx1

AP_L

Since AP_L = Q/L

3. Average Cost (AC) or Average Total Cost (ATC) or SAC

It may be defined as sum of total cost divided by quantity of output produced.

Symbolically,

AC = TC

AC may also be defined as sum of AFC and AVC.

Mathematically,

AC = TC

AC = TFC+TVC

AC = TFC/Q +TVC/Q

AC = AFC + AVC

When quantity of output increases AC declines slowly in the beginning. It reaches to bottom level and thereafter AC increases slowly again with an increase in quantity of output. Due to such a nature of AC the diagrammatic shape of AC curve looks like a U shaped nature of curve. It is also known as Saucer nature of curve.

4. Marginal Cost (MC or SMC)

It may be defined as net increment in total cost due to an additional increase in quantity of output.

Symbolically,

MC = TC

MC is always independent of FC. It shows that MC is not affected by FC.

When quantity of output increases in the beginning, MC declines sharply, comes to bottom point and thereafter MC increases sharply with an increase in quantity of production. At lowest point of AC, MC and AC both are equal to each other. Thus, MC curve always cuts at lowest point of AC curve.

Output	TFC	TVC	TC	AFC	AVC	AC	MC
0	300	-	300	-	-	-	-
1	300	300	600	300	300	600	300
2	300	400	700	150	200	350	100
3	300	450	750	100	150	250	50
4	300	500	800	75	125	200	50
5	300	600	900	60	120	180	100
6	300	720	1020	50	120	170	120
7	300	890	1190	42.85	127.1	170	170
8	300	1100	1400	37.5	137.5	175	210
9	300	1350	1650	33.33	150	183.33	250
10	300	2000	2300	30	200	230	650

The diagram clearly specifies that when coordinates of output and AFC are plotted and connected with each other then a downward sloping AFC curve is formed which comes closer to x-axis but never touches it. AVC is converted into shape of correct mark nature of curve. AC declines slowly in the beginning and after reaching bottom level it increases slowly in latter stage of production and thereafter AC or SAC gets converted into English alphabet U. MC declines sharply and it increases sharply after reaching bottom point. MC curve always cuts AC curve at lowest point of AC curve.

Relationship between AC and MC or SAC and SMC:

1. Average Cost (AC)

It may be defined as sum of TC divided by quantity of output produced.

Symbolically,

AC = TC

AC = AFC + AVC

2. Marginal Cost (MC)

It may be defined as net increment in TC due to an additional increase in quantity of output.

Symbolically,

MC = TC

3. When AC declines then MC also declines simultaneously but MC declines sharply than AC.

4. When AC increases then MC also increases simultaneously but MC increase sharply than AC.

5. MC is always equal to AC at lowest point of AC.

6. In initial stage of production AC and MC always originate from same level.

Long Run Cost Curves:

Long Run Cost Curves can be summed up under three main headings:

1. Long Run Total Cost: It may be defined as sum of long run monetary and real costs. In fact, Long Run may be defined as that time period in which producer can increase the quantity of production by changing both fixed and variable costs. In long run the producer can change fixed costs like development of infrastructure, change in organizational structure and others. Likewise variable factors as change in labour force and raw materials can also be changed and modified in long run.

The money cost in long run includes all those monetary expenses which producers incur in process of production. However, real costs in long run include all the sacrifices made by producers in long run. When money and real costs are combined together then in long run it is known as Long Run Total Cost.

Symbolically,

LTC = QxLAC (LAC = LTC)

In the markets of Monopoly and Perfect Competition LTC increases in beginning, reaches to maximum point and thereafter LTC starts to decline with an increase in quantity of output. Thus, shape of LTC curve looks like an upward sloping bending nature of curve which originates from origin. It implies that if quantity of production is zero then cost also becomes zero.

2. Long Run Average Cost (LAC): It may be defined as sum of LTC divided by quantity of output produced in long run.

Symbolically,

LAC = LTC

Where Q = quantity of output produced in long run

In long run LAC decreases very slowly in the beginning, it reaches to bottom level and thereafter increases very slowly with an increase in quantity of output. Due to such movement of LAC the diagrammatic shape of LAC looks like English alphabet U. Thus, LAC is known as U-shaped nature of curve. In fact, LAC is also known as Saucer shaped curve or Envelope curve or Planning curve.

A Rational producer manages to produce optimum quantity of output at that point where lowest point of LAC touches lowest point of SAC.

The diagram shows that a producer bears high cost of production at MNL producing OQ₁, OQ₂ and OQ₃ low quantity of outputs respectively. Likewise producer manages to increase quantity of production at STR points of equilibrium tolerating high cost of production. However, point of equilibrium E is supposed to be actual case of equilibrium as it helps producer to produce OQ₄ optimum quantity of output at Q₄E minimum possible cost of production.

3. Long Run Marginal Cost: It may be defined as net increment in total cost due to an additional unit of increase in quantity of output.

LMC = LTC

A producer manages to maintain optimum quantity of output at that point where lowest point of LMC is intersected by lowest point of SMC. LMC declines sharply, it reaches to minimum point and eventually LMC increases sharply again with an increase in production.

UNIT V: THEORY OF PRICE AND OUTPUT DETERMINATION

Equilibrium of Firm:

A business firm maintains equilibrium in price and output determination mainly through two main approaches:

1. TR-TC Approach

2. MR-MC Approach

1. TR-TC Approach

A business firm manages to obtain equilibrium situation in market of Perfect Competition and Monopoly and Imperfect Competition by fulfilling two main conditions:

a. Necessary Condition

For Equilibrium

TR = TC

b. Sufficient Condition

TC must cut TR from below

The fulfillment of both these conditions emables a firm to earn optimum profit in market of Perfect Competition alongwith Monopoly and Imperfect Competition. In market of Perfect Competition TR curve looks like an upward sloping curve which develops an angle of 45 degrees with axes. In case of Monopoly and Imperfect Competition the diagrammatic shape of TR curve looks like an upward sloping bending nature of curve. Consequently, firms in market of Monopoly and Imperfect Competition manages to obtain significant profit in comparison to market of Perfect Competition.

The diagram A clearly observe that point N fulfills necessary condition because TR = TC at this point. Likewise TC cuts TR from below at same point which enables a Perfect Competition firm to obtain optimum profit in the market.

The diagram B specifies that point E maintains equilibrium state of a business firm because it also fulfills necessary and sufficient conditions. Consequently, a firm under Monopoly and Imperfect Competition manages to earn optimum profit if it maintains equilibrium point at E in the market. However, equilibrium of a firm through TR = TC approach enables a Monopoly and Imperfect Competition firm to earn more profit than the firms of Perfect Competition.

2. MR-MC Approach

A business firm maintains equilibrium situation through MR-MC approach by maintaining two main conditions:

a. Necessary Condition

For Equilibrium

MC = MR

b. Sufficient Condition

MC must cut MR from below

On the basis of fulfillment of both these conditions a business firm manages to maintain equilibrium situation in market of Perfect Competition which can be represented by following diagrams:

The diagram A shows equilibrium situation of a firm in the market of Perfect Competition. The point E fulfills necessary and sufficient condition and therefore maximum possible profit can be earned and maintained by Perfect Competition firm.

The diagram B shows equilibrium situation in market of Monopoly and Imperfect Competition. The point E in diagram B satisfies both necessary and sufficient conditions and therefore Monopoly firm alongwith Imperfect Competition manages to maintain equilibrium situation by producing OQ quantity of output.

Price and Output determination under Perfect Competition:

Perfect Competition is a market situation characterized by following conditions:

1. Large number of buyers and sellers

2. Homogeneous Product

3. Single Price

4. Free Entry and Exit of Firms

5. Perfect Knowledge to buyers and sellers about market

6. Perfect mobility of Factors of Production

7. Absence of Transportation Cost

8. Nominal Profit

Price and Output determination in Perfect Competition under Short Run:

In short run Perfect Competitive firms always remain under pressure due to limitation of time and therefore these firms have only option to increase the quantity of production by changing or modifying variable cost whereas fixed cost remains constant. Due to such a constraint Perfect Competitive firms do not remain comfortable in short run. While producing output and determining price the Perfect Competitive firms need to maintain following conditions:

a. Necessary Condition

For Equilibrium

SMC = MR

b. Sufficient Condition

SMC must cut MR from below

c. Price = AR and Cost = SAC

On the basis of fulfillment of these conditions, three situations of firms emerge in the process of price and output determination under Perfect Competition in short run which can be listed as follows:

a. Firms earning Profit

b. Firms maintaining Zero Profit

c. Firms bearing Loss

Price and Output determination in Perfect Competition under Long Run:

In long run Perfect Competition firms remain under comfortable situation because these firm can increase quantity of production by changing both variable and fixed cost of production. Such a situation helps Perfect Competitive firm to develop infrastructure, utilize raw materials and skilled workers, inefficient management is replaced by efficient management and above all produced output is sold in an appropriate market. All these components help Perfect Competitive firms to decrease cost of production and it facilitates production management of Perfect Competition in long run. While producing output and determining price Perfect Competitive firms in long run need to maintain following conditions:

1. Necessary Condition

For Equilibrium

LMC = MR

2. Sufficient Condition

LMC must cut MR from below

3. Price = AR and Cost = LAC

On the basis of fulfillment of all these conditions three categories of Perfect Competition firms develop in long run and they are:

1. Firms earning Profit

2. Firms earning Economic Profit

3. Firm maintaining Zero Profit

After fulfillment of all these conditions if there is any indication of loss a Perfect Competitive firm prefers to close production rather than bear loss.

Price and Output determination under Monopoly:

Monopoly is said to exist when a single firm is either sole producer or seller of the product with no close substitutes. It is characterized by following features:

1. Single Producer or Seller

2. No Close Substitutes

3. Strong barrier to entry of firms

4. Price Maker than Price Taker

5. Profit Motive

Price and Output determination under Monopoly in Short Run:

In short run Monopoly firm remain under pressure because it can increase quantity of output only by changing variable factor and a monopolist firm cannot change fixed factors of production. Due to such a limitation a monopolist is unable to decrease cost of production to bottom level. However, a monopolist firm claims high price from consumers due to its profit motive behaviour. While producing output and determining price a monopolist firm needs to maintain following conditions:

1. Necessary Condition

For Equilibrium

SMC = MR

2. Sufficient Condition

SMC must cut MR from below

On the basis of fulfillment of all these conditions a monopolist attempts to earn super normal profit. There are three situations that emerge in short run market regarding price and output determination in monopoly market:

1. Case of Super Normal Profit

2. Case of Zero Profit (Normal Profit)

3. Case of loss

According to Due and Clower if a monopolist firm miscalculates the situation and if demand for monopolist firm products is inadequate in market then situation forces monopolist to bear loss.

Price and Output determination under Monopoly in Long Run:

In long run a monopolist firm observes comfortable situation and comfortable production environment. Due to sufficiency of time a monopolist is able to increase quantity of production by changing and modifying both variable and fixed cost of production. Due to all these factors a monopolist minimizes the cost of production. However a monopolist does not compromise with its high price practically. Thus claim of high price by monopolist from consumers on one hand and ability of monopolist to decline cost of production on the other enables a monopolist to earn super normal profit in long run.

Main Conditions:

1. Necessary Condition

For Equilibrium

SMC = LMC = MR

2. Sufficient Condition

SMC and LMC must cut MR from below

3. Price = AR and Cost = SAC = LAC

Despite fulfillment of all these conditions if there is any indication of loss then a monopolist prefers to close production rather than bear loss in long run.

UNIT VI – FACTOR PRICING

Rent:

Rent is regarded as reward of land. The earning from land is described as rent in ordinary sense.

According to David Ricardo ‘Rent is that part of produce of Earth which is payed to the landlord for original and indestructible power of soil’

According to Marshall ‘Income derived from ownership of land is commonly called Rent’

Economic Rent:

When cost of production is declined from total earning or production of land then it is known as Economic Rent. In fact economic rent is ‘differential surplus’. Ricardian rent is known as Economic Rent.

Symbolically,

Economic Rent = Total production of land – Cost of Production

Economic Rent = Total production of land – Production of Marginal Land

In marginal land cost of production is equal to total production. The differential surplus is a major feature of economic rent. Economic Rent is comprehensively exercised in developed and developing countries.

Contract Rent:

When quantity of rent or rental charge is determined or settled down on basis of mutual understanding between farmer and tenant then it is known as Contract Rent. The terms and conditions are involved in fixation of contract rent. The market forces of Demand for Land (D_L) and Supply of Land (S_L) play vital role in fixation of contract rent. The concept of differential surplus does not exist in contract rent. The mutual understanding of landlord and tenant is prime factor which determines Contract Rent practically. However, if market force of D_L is greater than S_L then contract rent naturally increases in the market but if S_L is greater than D_L then contract rent decreases in the market.

Contract Rent is usually exercised in modern case of agricultural production in different parts of the world. Contract Rent depends on market forces of D_L and S_L and it also depends on skill of landlord and tenant. Like Economic Rent Contract Rent is also widely utilized all over the world.

RICARDIAN THEORY OF RENT:

The concept of Ricardian Theory of Rent was developed by famous classical economist David Ricardo and therefore this theory of rent is known as Classical Theory of Rent.

According to David Ricardo ‘Rent is that portion of produce of Earth which is paid to Landlord for use of original and indestructible power of soil’

In order to clarify the concept of Ricardian Rent David Ricardo presented an example of an island. Ricardo assumed that four categories of land i.e. A,B,C,D categories of land are only available in that Island. A is most fertile category of land whereas D is margin land. Margin land is least fertile land in which production of margin land is equal to cost of production. Thus, rent does not emerge in margin land. In the words of Ricardo Rent does not enter into price.

The concept of Ricardian rent is based on approach of differential surplus. The cost of production is declined from total production of land to obtain ricardian rent. The product of marginal land is assumed as cost of production by David Ricardo. Ricardo made it clear that when first group of tribal people enter the island then they select first of all A grade of land. If A grade of land is not available then they select B grade of land and thereafter if B grade of land is not available then they select C grade of land and eventually D grade of land in which production of D grade of land is equal to cost of production.

Grades of Land	Total Production	Cost of Production	Ricardian Rent
A	50	20	30
B	40	20	20
C	30	20	20
D (Marginal Land Or No Rent Land)	20	20	-

Assumptions:

Ceteris Paribus, Ricardian Theory of Rent is based on following assumptions:

1. Existence of No Rent Land

2. Scarcity of Land

3. Land possess original and indestructible power

4. Rent is related only with Land

5. Fertility of land differs

6. Long Period

7. Land is subjected to operation of Law of Diminishing Return in Agricultural sector

Criticisms:

1. History has falsified Ricardian Rent: According to David Ricardo a farmer selects land according to its fertility. The fertile land is selected first and less fertile land is selected afterwards. However, evidence shows that land is selected for cultivation according to the convenience of farmer rather than fertility of land.

2. Lack of Original and Indestructible Power of Soil: David Ricardo argued that land possess some original and indestructible qualities. Modern economists criticized Ricardo and pointed that originality of land is affected through human efforts. Eg. If fertilized is used in land its fertility increases and vice versa.

3. Wrong Assumption of No Rent Land: Ricardo argued that no rent land exists in every society in which Rent is not claimed by landowner from tenant. Observation shows that even in case of Marginal Land the government imposes Land tax. Thus, concept of no rent land is based on falicious scale.

4. Rent also enters into Price: According to Ricardo Rent does not enter into price. Observation shows that even in case of least fertile land the rent is paid by farmers to landowner.

5. Rent is not applicable only to land: Ricardo argued that Rent is mostly applicable to land only. But modern economists pointed out that rent may be applicable in machines and equipments as well. Such as Quasi Rent is applicable in machines rather than land or soil.

Wage:

The monetary reward given by an employer to an unskilled worker of grass root level is generally referred as wage in ordinary sense. In Economics when remuneration is given to a worker for his physical or mental efforts or contributions to complete a particular work in production management then payment of such remuneration is known as Wage.

According to F. Benham ‘Wages may be defined as sum of money paid under contract by an employer to a worker for services rendered’

Main Elements:

1. Remuneration for physical or mental work.

2. Contribution or reward for contribution in production management.

3. Remuneration given under contract or some other understandings.

4. Reward for efforts of workers.

Types:

1. Money Wage: When reward of worker for his/her contributions is given in monetary remuneration then it is known as Money Wage.

According to Prof. Seligman ‘Money wages are actual wages paid in money’

In fact money wages may be given by employer to worker in specified time period such as money wages per hour, per day, per week, per month and others. Money wages are also given on contract basis by employer to worker. Money wage is a global practice given by employer to worker all over the world.

2. Real Wage: When money wage is converted into different goods of requirements of worker then such a case is known as Real Wage.

According to Thomas ‘Real wage refers to net advantages to workers occupation’

Apart from conversion of money into goods, Real Wages also include some other benefits to workers given by employers as accommodation, food facility, medical services, education to children of workers and others. To sum up when employer provides other facilities apart from money wage to workers then such a case is known as Real Wage in Economics.

Subsistence Theory of Wage:

The concept of this theory was developed by physiocrats of France in 18^th century. The famous German Economist Lassallee described this theory as Iron Law of Wages. This theory of wage is also described as Brazen Law of Wages. The famous scholar and philosopher Karl Marx described this theory as Theory of Exploitation.

According to this theory an employer should provide the wage to worker just according to subsistence of life in long period. The physiocrats of France argued that if wage rate is more than subsistence level then workers produce more and more children in family. Consequently supply of worker increases in labour market in long period. If supply of labour increases then wage rate declines practically. Likewise physiocrats of France also argued that if wage rate of worker is less than subsistence level then many of their children will die due to malnutrition in society. If children die due to low wage rate then subsistence level then supply of workers declines in labour market and thereby wage rate increases upto subsistence level.

The physiocrats of France eventually argued that wage of worker should neither be more than subsistence level nor lower than subsistence level. Rather the wage rate of worker should always be equal to subsistence of life practically all over the world.

Criticisms:

1. A Misleading Approach: According to this theory an increase in wage rate causes to increase birth rate of workers in the society. But modern economists have pointed out that an increase in wage rate motivates worker to improve their living standard rather than increase the size of family. Thus a misleading approach is developed by subsistence theory.

2. A Pessimistic Approach: According to this theory the wage rate of even a skilled worker should be equal to subsistence level. Such an analysis shows that efficiency of workers does not have any meaning in production management.

3. An Injustice Theory: According to this theory the wage rate of an unskilled and skilled workers should be same i.e. just equal to subsistence level. However, observation shows that an unskilled worker receives less wage whereas an efficient worker always receives high wage. But such an approach of wage according to efficiency is defeated in this theory.

4. An Impractical Theory: This theory presents unwanted logic and arguments and therefore subsistence theory of wage is not implemented in practical field of either developed or developing countries.

Wage Fund Theory:

The concept of wage fund theory was developed by famous economist J.S. Mill. Later on J.S. Mill criticized his own theory. According to this theory the wage rate is determined by proportion between population and wage fund. In this theory population refers to active working forces who provide contribution in production management. However, wage fund refers to portion of budget which is separated by producer for payment of wage to workers. J.S. Mill assumed that wage fund always remains fixed and therefore wage rate basically depends on number of workers involved in production management.

Symbolically,

Wage Rate = Wage Fund

Population

J.S. Mill made it clear that due to constant nature of wage fund the size of population plays vital role in determination of wage. If population increases then wage rate decreases whereas if population decreases then wage rate increases in the society. To sum up J.S. Mill concluded that the proportion between wage fund and population determines wage rate in society.

Criticisms:

1. Misleading Assumption of Constant Wage Fund: According to J.S. Mill Wage fund always remains fixed. Observation shows that wage fund changes according to requirements of production. If more workers are employed in production management then wage fund increases and vice versa. Constant wage fund is not found in any countries of the world.

2. It neglects Efficiency of Workers: According to wage fund theory if population of workers increase then such a situation declines wage rate of even skilled worker in factor market. It therefore appears that wage rate of worker is guided, determined and influenced by population of workers rather than efficiency of workers.

3. Not Applicable in Practical Field: Wage Fund theory developed by J.S. Mill is based on misleading assumptions as constant nature of wage fund and others. Due to falicious assumption of this theory it is not applicable in practical field of wage determination either in developed or developing countries of the world.

Interest:

The reward of capital paid by borrower to lender is known as Interest. When lender lends money to borrower for a certain period of time then it appears that lender sacrifices his/her fulfillment of requirement for a certain period of time. Likewise, the lender faces some inconveniences while providing loan to borrower. The modern economists have argued that sacrifice and inconveniences of lender will have to be compensated by borrower by giving some extra amount of money to lender. The payment of such extra amount of money by borrower to lender is described as Interest in Economics.

According to J.M. Keynes ‘Interest is the reward for parting with liquidity for a specified period’

J.M. Keynes pointed that when a lender provides loan to borrower for speculative motive management then the liquidity (cash) is separated from lender to the borrower. Such a parting of liquidity of lender will have to be compensated by borrower by making payment of some extra amount of money which has technically been described as Interest in Economics. Interest is classified into two categories:

1. Net Interest

2. Gross Interest

Types of Interest:

1. Net Interest: It is that interest paid by borrower to lender for the use of capital. In net interest the risk of capital, inconveniences of lender and such other elements are not included. It is only the reward of lender while sacrificing capital for a certain period of time to borrower.

2. Gross Interest: It is a comprehensive and composite payment paid by borrower to lender. According to Briggs and Jordan ‘Gross Interest, the payment made by borrower to lender, is a composite payment’

Constituents of Gross Interest:

1. Net Interest

2. Remuneration against Risk: The lender manages to bear risk while giving capital to borrower. Gross Interest classifies risk into two categories:

a. Personal Risk

b. Business Risk

3. Payment of Inconveniences: A lender faces different inconveniences while giving loan to borrower. In fact, lender attempts to recover loan by visiting door-to-door of borrower. Thus, lender faces a series of inconveniences while providing loan to borrower and therefore gross interest is also supposed to be remuneration for inconveniences tolerated by lender.

4. Payment for Management: The lender manages to provide and recover capital from borrower after maturity period. Likewise lender develops and maintains account of capital given to different borrowers. Therefore, gross interest is reward of payment for management to lender.

Symbolically,

Gross Interest = Net Interest+ Remuneration against Risk (Personal and Business Risk)+ Remuneration for Inconveniences+ Payment for Management

Similarly,

Net Interest = Gross Interest- Remuneration against Risk (Personal and Business Risk)- Remuneration for Inconveniences- Payment for Management

Classical Theory of Interest:

The concept of Classical Theory of Interest is developed in leadership of Classical Economist David Ricardo. Later on Classical Theory of Interest was supported and further developed by famous Economists like Alfred Marshall, A.C. Pigou, Walrus, Taussig, F. Knight and others. According to Classical Theory of Interest ‘The Equilibrium rate of Interest is determined through demand for capital (Investment) and supply of capital (Savings)’.

A. Demand for Capital (Investment)

According to classical economists Demand for Capital (Investment) depends on rate of interest and both variables are adversely or negatively related.

Symbolically

I = f (i)

Mathematically

Where I = Investment and I = Rate of Interest

Apart from rate of interest, demand for capital (Investment) also depends on productivity of capital. However, classical economists made it clear that as amount of capital utilization increases then due to applicability of Law of Diminishing Return the productivity of capital declines and therefore shape of investment curve looks like a downward sloping nature of curve.

B. Supply of Capital (Savings)

According to Classical Theory of Interest supply of capital refers to savings and savings basically depends on rate of interest and both variables are positively related.

Symbolically

S = f (i)

Mathematically

Apart from rate of interest classical economists pointed out that supply of capital also depends on level of income, living standard of people, development of banks and financial institutions and financial environment of country. Due to positive relationship between rate of interest and savings classical economists made it clear that supply of capital curve looks like and upward sloping nature of curve.

C. Equilibrium between Savings and Investment

According to Classical Economists Equilibrium Rate of Interest is determined through interaction between Demand for Capital (Investment) and Supply of Capital (Savings).

For Equilibrium

D = S

Rate of Interest	Demand for Capital (I)	Supply of Capital (S)	Remarks
1	50	10	I > S
2	40	20	I > S
3	30	30	I = S
4	20	40	I < S
5	10	50	I < S

The diagram clearly examines that downward sloping II Investment curve and upward sloping SS Saving curve interact with each other at point E. The equilibrium point E helps to determine Oi (3 units) equilibrium rate of interest and Om (30) equilibrium demand for and supply of capital.

Criticisms:

1. An Impractical Approach: According to this theory the entire saving is needed to be converted into investment to achieve equilibrium rate of interest. The equality between aggregate savings (S) and aggregate investment (I) is pre condition of full employment. This theory is based on assumption of full employment which is a misleading approach as it is not found in practical field.

2. Misleading Relation and Narrow Concept: According to this theory saving depends on rate of interest but J. M. Keynes made it clear that saving basically depends on level of income rather than rate of interest. Rate of Interest is only a supplementary factor to affect savings which has not been described by classical theory of interest.

3. Narrow Concept of Supply of Capital: The classical theory simply focuses on savings as supply of capital. However, famous economist Knut Wicksell made it clear that derivative deposit or bank money is not included in the concept of supply of capital. Thus, it is based on narrow concept of supply of capital.

4. Lack of Proper Analysis of Marginal Efficiency of Capital: According to classical theory of interest the demand for capital (I) depends on rate of interest. However, J. M. Keynes made it clear that impact of Marginal Efficiency of Capital on investment has not been described at all in determination of Rate of Interest.

5. No Clear Distinction between ex-ante and ex-post savings and investment: The equality between savings and investment is the basic condition of determination of equilibrium rate of interest in classical theory. However, analysis shows that classical theory only focuses on ex-ante savings and investment i.e. Planned savings and investment. However, J. M. Keynes argued that ex-post savings and investment only plays the vital role in determining rate of interest which has not been described in classical theory of interest.

Profit:

The reward of entrepreneur is generally termed as Profit. The difference between Total Revenue and Total Cost is known as Profit. According to Hawley ‘Profit is the reward of risk bearing ability of Entrepreneur’. According to J. A. Schumpeter ‘Profit is the reward of Innovation of Entrepreneur’. According to Thomas ‘Profit is the reward for Entrepreneur’.

Modern Economists concluded that Profit is also reward for Uncertainty and Risk bearing ability of Entrepreneur. It implies that if an Entrepreneur focuses on Research and Development to decline cost of production on one hand and increases quality of production on the other then such Entrepreneur can generate huge revenue by selling commodity in the market. Profit is classified into two categories:

1. Net Profit

2. Gross Profit

Types of Profit:

1. Net Profit: It may be defined as remuneration for risk bearing ability of an entrepreneur. An entrepreneur bears risk in production management and therefore reward of risk bearing capacity of entrepreneur is known as Net Profit. According to Thomas ‘Net Profit is only remuneration for risk taking ability of entrepreneur’. When cost of management, interest of capital, wage of workers and such other costs and expenses are subtracted from Gross Profit then remaining amount of income is known as Net Profit.

2. Gross Profit: It may be defined as surplus amount of income over and above expenses of production. There are different constituents of Gross Profit which can be represented as follows:

Constituents of Gross Profit:

1. Net Profit

2. Reward for Factors of Production supplied by Entrepreneur

3. Maintenance Charges

4. Monopoly Profit

5. Windfall Gains

Symbolically,

Gross Profit = Net Profit+ Reward for Factors of Production supplied by Entrepreneur+ Maintenance charges+ Monopoly Profit+ Windfall Gains

Net Profit = Gross Profit- Reward of Factors of Production- Maintenance Charges- Monopoly Profit- Windfall Gains

Risk Bearing Theory of Profit/Risk Theory of Profit:

The concept of Risk Bearing Theory of Profit was developed by famous American Economist Hawley and it was supported by Alfred Marshall. According to Hawley the prime function of an entrepreneur is to bear risk. Hawley made it clear that Profit is the reward of risk bearing ability of an entrepreneur. According to Hawley Land, Labour and Capital are subsidiary or supplementary factors of production. The risk element is the prime factor which determines volume and shape of profit. An entrepreneur manages to produce commodity according to the future demand in the market.

Hawley pointed that if an entrepreneur properly estimates demand situation in the market and if he/she takes appropriate decision bearing risk in the market only then such risk bearing ability of entrepreneur helps to earn profit. However, Hawley warned that if an entrepreneur miscalculates market situation then such a situation may force the entrepreneur to bear loss. Thus, Hawley concluded that profit is the reward of risk bearing ability that the undertaker subjects himself.

Criticisms:

1. No Proper Analysis of Monopoly’s Profit: According to Hawley Profit is the reward of risk bearing ability of entrepreneur. Modern Economists argued that a Monopolist does not bear risk and uncertainties but even then manages to earn huge profit. Thus, risk bearing theory becomes helpless to analyze reasons of Monopoly Profit in the market.

2. An Entrepreneur minimizes Risk: According to Hawley the prime function of an entrepreneur is to bear risk. However, modern economists Carver argued that an entrepreneur minimizes risk rather than bearing risk. Thus, Carver concluded that Profit is the reward of risk minimizing ability of an entrepreneur than risk bearing ability of an entrepreneur.

3. No Clear Distinction between Insurable and Non-Insurable Risk: According to Hawley Profit is the reward of risk and uncertainty bearing ability of an entrepreneur. But famous American Economist Franc Knight criticized Hawley and argued that risk is of two types:

a. Insurable Risk (risk against fire, robbery and others)

b. Non-Insurable Risk (risk against change in taste and fashion of consumers)

F. Knight concluded that Profit is the reward of Non-Insurable risk bearing ability of an entrepreneur which has not been mentioned at all by Hawley in his risk theory of profit.

Uncertainty Theory of Profit:

The concept of Uncertainty Theory of Profit was developed by famous American Economist F. Knight in his famous book ‘Risk, Uncertainty and Profit’. According to F. Knight Profit is the reward of risk and uncertainty bearing ability of Entrepreneur. In fact F. Knight classified Risk and Uncertainty into two categories:

1. Certain/Uncertainty (Insurable Risk)

2. Uncertain/Uncertainty (Non Insurable Risk)

1. Certain/Uncertainty:

According to F. Knight those risks and uncertainties which are insurable at insurance companies are known as Certain/Uncertainty. Eg. Insurance against life, fire, robbery and others. According to F. Knight if an entrepreneur earn profit bearing certain/uncertainty then it is not actual profit.

2. Uncertain/Uncertainty:

According to F. Knight those uncertainties not insured at insurance companies are known as Uncertain/Uncertainty. Eg. Risk against change in taste and fashion of consumers, depression and boom in the market and others. F. Knight made it clear that if an entrepreneur manages to earn profit bearing uncertain/uncertainty then such profit is actual profit and genuine profit.

On the basis of entire analysis F. Knight concluded that Profit is the reward of Uncertain/Uncertainty bearing ability of an entrepreneur.

Criticisms:

1. Narrow Function of Entrepreneur:

According to F. Knight the prime function of an entrepreneur is to bear uncertain/uncertainty situation bearing ability of an entrepreneur. It shows that F. Knight attempted to prove that risk bearing is prime function of an entrepreneur. However, F. Knight made it clear that an entrepreneur bears many other social responsibilities such as quality management in product, preservation of consumer’s confidence and many others. But these functions of an entrepreneur are not mentioned at all by F. Knight in his theory of profit.

2. No Scope of Innovation:

According to F. Knight uncertain/uncertainty bearing ability of an entrepreneur causes to generate profit. However, modern economists as J. A. Schumpeter argued that innovation in production and cost management also plays vital role which causes to generate profit.

3. Lack of Scientific Analysis of Business Environment:

Business Environment as Boom and Depression also contributes to profit management. Thus, rise or fall in profit situation also depends on business environment of boom and depression in an economy which has not been mentioned by F. Knight in his theory of profit.

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