Ncert XII Micro Economics

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INTRODUCTORY MICROECONOMICS

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1.1 Central Problems of an Economy 1.2 Production Possibility Curve and Opportunity Cost 1.3 Micro versus Macro Economics

Welcome to the science of economics. Yes, economics is a social science, like chemistry is a physical science. It is true that there are no test tubes and sophisticated equipment required to study economics, but just as physical sciences are means to understand how the real physical world around us works our planet, the solar system or the universe in economics, we try to understand how the economy of a particular region, a country, or the global economy works. There are principles or laws of economics (parallel to laws of chemistry or physics). With the help of these principles, we analyse how an economy works. What is economics after all? There is no universally accepted, single, definition of it. But we can understand what it is about. Many non-economists think that it only concerns the matters of money how to make or manage money. Not true. Economics is about making choices in the presence of scarcity. The notions, scarcity and choice, are very important in economics. You may not see these words in all chapters to come, but they are in the background throughout. Scarcity and choice go together: if things were available in plenty (literally) then there would have been no choice problem; you can have anything you want.

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Unfortunately, this may be true only in heaven, not in the real world. Even the richest person on earth would have to face scarcity and make choice. If nothing else, time is scarce. Ratan Tata, a leading industrialist of India, between 6 p.m. and 8 p.m. in a particular evening, may have to decide whether to go to a musical concert, or just keep working in his office. Think about the length of syllabi of various subjects that you have to cover before the final exam. We do not need to convince you that time is scarce. Likewise, food, clothing, housing, clean air, drinkable water etc. are scarce in every country in the world, except that the degree of scarcity varies. The point is that problems of choice arise because of scarcity. The study of such choice problems, at the individual, social, national and international level is what economics is about. 1.1 CENTRAL PROBLEMS OF AN ECONOMY: WHAT, HOW AND FOR WHOM There are many choice problems that any particular economy attempts to solve within a given time period. For example, during the fiscal year 1998-99, 71.3 million tons of wheat was produced in India.1 Output of food grains in general is not entirely determined by external factors like1 2 3

rainfall etc. It is partly influenced by how much of land is used to raise food grains, by the application of fertilisers, by the supply of power to agricultural sector etc. And these are consequences of individual choice as well as policies by the government. Thus Indias wheat production in a given year is, partly, an outcome of choice. India, as many other countries, does not produce jet planes. But it produces helicopters, small air-crafts for training purposes as well as some fighter planes. 2 This also reflects a choice problem.3 Not only what goods a nation should produce is a problem of choice, so is how or in which method a good is to be produced. Usually, there is more than one method to produce a given commodity. For example, agricultural activity is more labour -intensive in India than in developed countries like US, France or Germany. Who is paid how much is also a choice problem from the economys viewpoint. There are differences in pay or salary across occupations. For instance, in the latter half of 1990s the beginning salary (including allowances) for a Class I government servant was between Rs. 1.5 lakhs to Rs. 2 lakhs per annum. In comparison, on the average, a computer programmer in

The source is Ministry of Finance, Government of India, Economic Survey 2000-2001, published in 2001. These are produced by Hindustan Aeronautics Limited (HAL). We recommend you to visit its website: www.hal-india.com. It contains pictures and brief descriptions of different aircrafts produced by HAL. You may argue that India does not produce jet planes because it does not have the necessary technology. However, having a technology or not can be seen as a choice problem. Many technologies can be purchased if we decide to pay for it. But we do not and should not buy any available technology even if we can afford it. We have to weigh the benefits from having a technology against the cost of acquiring it.

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India was receiving Rs. 2.58 lakhs per annum in 1999.4 Various economic problems facing an economy can be categorised into three types. These are the so-called what, how and for whom problems. They arise due to scarcity. What to be: What goods and services are produced and in what quantities? For example, in the fiscal year 199798, the Indian economy produced 82.1 million tons of cement. Why is it 82.1 million tons, not 40 million tons? In the same year India produced 9.8 million bicycles.5 What factors determine these quantities? And so on.6 How to be: How (i.e. by which methods) would the goods and services be produced? Should garments in India be produced by relatively labour intensive or machine-intensive methods? What techniques of production are to be used? For whom to be: Given that various goods and services are available to an economy, who gets how much to consume? This essentially refers to who earns how much or who has more assets than others. For example, how much a computer engineer consumes is based on his earnings compared to a chemical engineer or a high-school teacher? This is the for whom question. It refers to distribution of income and wealth in the society.4

In a market-oriented or capitalist economy, these fundamental problems are solved by the market. There is a price, which is influenced by the forces of demand and supply. These forces guide which goods and how much is to be produced and consumed. For example, alu bhujia is produced in the Indian economy because the technology of making alu bhujia is available, the cost of producing and supplying it is not too high and there is demand for alu bhujia. This illustrates how the what problem is solved in a market-oriented economy. Suppose that the oil production in the world market declines drastically for some reason. This will increase the price of diesel and petrol world-wide. A taxi company in Ludhiana, which was running 10 taxis, will now wish to convert some of them to CNG (compressed natural gas). In other words, the method of production of taxi service will change. This example illustrates how the how problem is solved. As another example, if there is an increase in demand for computer hardware and software by businesses and households, this will push up the demand for services by computer engineers. As a result, their salaries (prices) would increase. These

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See Ed.Frauenheim, India Inc., TechWeek, September 20, 1999 (also see http://www.techweek.com). This salary figure, stated in US dollars, is $6,000. At the 1999 dollar-rupee exchange rate of $1 = Rs. 43, it becomes Rs. 2.58 lakhs. The source is Economic Survey 2000-2001, Ministry of Finance, Govt. of India, 2001. These are examples of goods or commodities that have physical dimensions. Services refer to tasks being performed for someone, e.g., a hair-cut, education, doctors advice etc. What problem applies to services as well.

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engineers would now have more purchasing power (money and wealth) and can buy more goods and services than before. This is an example of how the solution of for whom problem changes over time. The following chapters examine in detail how these central problems are addressed in a market-oriented economy.

Alternatively, in a centrally planned economic system, which was in practice in the former Soviet Union and other East European countries till the late 1980s, these problems are addressed in a very direct way by the government. See Clip 1-1 for details.7 Clip 1-2 provides an account of the demerits of a central planning system relative to a capitalist system.

CLIP 1-1A Centrally Planned Economy*In a centrally planned economy, there is a central planning authority, a wing of the government. It decides which goods and how much should be consumed and produced in the economy within a given span of time, say within a year or in five years. These are like targets. They are set according to the overall growth and development strategy for the economy that is considered desirable by the members of the planning authority. Once the total production target levels are fixed, they are then allocated over different factories, which are supposed to deliver the amounts required. Realise that production of any particular good (e.g. bicycles) requires other goods as well (e.g. steel, rubber pedals etc.) In turn, these other goods require different other goods as well. Hence it is a massive planning process that takes into account simultaneous production of thousands of goods. This is how the what problem is attended. With respect to the how question, factories are government-owned and the method of production is chosen by the planning authority. Thus the how problem is solved by the government. Properties are government-owned too. It also determines salaries of various skills. Hence the for whom problem is solved by the government also. In other words, all three central problems are essentially addressed by the government in a direct way by command so-to-speak. That is why a centrally planned economy is also called a command economy.7

However, no economy in the world is cent per cent centrally planned or market-oriented. If both the private sector (i.e. market forces) and the government play almost equal roles in the functioning of the economy, then such an economy is called a mixed economy. Otherwise, if government or public sector activities are dominant, we call it a centrally planned economy (e.g. the former Soviet Union). If private sector activities are dominant, we call it a market-oriented or a capitalist economy (e.g. United States and Japan). The Indian economy, until the end of the seventies, was a very much a mixed economy. It is still considered a mixed economy today, but since the 1980s has been gradually moving towards a market-oriented economy. It is much less controlled and private firms operate in a much more liberalised environment now, than in 1960s or 1970s. * All Clips are NETs (not for exams and tests).

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1.2 PRODUCTION POSSIBILITY CURVE AND OPPORTUNITY COST From a general discussion about economics and how an economy works, we now move to a specific issue and look at it analytically. It sets the tone for the type of economic analysis to come in the following chapters. To begin with, suppose that Mr. Kheti Lal, a farmer in U.P., owns 50 acres of land for cultivation. He can grow wheat or sugar cane or both. Suppose that the production technologies of wheat and sugar cane are such that one acre of land yields 2500 kgs of wheat or 80 tons of sugar cane. How does Mr. Kheti Lal decide how much of land he should use for wheat and how much for sugar cane? A natural way is to first determine the various combinations of wheat and sugar cane that he can grow, given the total land he has and given the technologies of producing wheat and sugar cane. Next, he can select a particular combination, depending on profitability of raising wheat and sugar cane. We are not interested in the latter issue, but only in how much of wheat and sugar cane are feasible for Mr. Kheti Lal to produce. For example, he uses all his land in growing wheat. Then he can produce 125 tons of wheat and zero sugar cane. Instead, if he uses all his land to grow sugar cane, then he get zero wheat and 4,000 tons of sugar cane. There are, obviously, many other possibilities. For instance, he can use 30 acres of land on wheat and 20 acres

on sugar cane, and, this will give him 75 tons of wheat and 1, 600 tons of sugar cane. The important point to note here is that, as long as Mr. Kheti Lal uses all his land resource, which is given, having more of one good implies having less of the other. Interestingly, an economy as whole, whether it is market-oriented or not, faces a similar situation. At any given point of time, the technologies available to produce various goods and services as well as the resources available to an economy (meaning the size of its working population, land, buildings, machinery etc.) are all given. Evidently, an economy cannot produce an unlimited amount of any particular good or service. If all resources are used in producing a single good say, computers, only a given number of computers can be produced. Starting from a given allocation of resources to different sectors of an economy, if more resources go into one particular sector (e.g. the computers), less is available for other sectors. In order to decide which combination of goods serves the economy the best, we have to first identify various combinations that can be available to an economy (like different combinations of wheat and sugar cane Mr. Kheti Lal can grow). This is best illustrated through a concept called the production possibility curve, which will be defined in a moment. Now consider a hypothetical economy, in which two goods can be produced: cricket bats and saris.

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(Assume that all cricket bats are of the same quality and so are saris.) Suppose that if all resources of this economy (such as land and total amounts of skilled and unskilled labour available to the economy) are used in the sari sector and if they work efficiently, 75 lakh saris can be produced (within, say, a year). Assume that the same resources can produce cricket bats also. If, instead, all resources are employed in producing cricket bats, suppose that 5 thousand bats can be made. These are two production possibilities and both are rather extreme. Most likely there will be other possibilities which are intermediate. For instance, if the economy is producing 50 lakh saris, it can produce, say, 3 thousand cricket bats. Table 1.1 summarises the various production possibilities that are available to the economy. Not surprisingly, you see that as the production of one good increases that of the other falls. This is because

resources are scarce. As more resources go into one sector and produce more, less is available for other sectors and they will produce less than before. Let us now plot these possibilities, namely, (0, 75), (1, 70) etc. and join the line segments.8 This gives rise to a curve as shown in fig. 1.1(a). (Ignore panel (b) for the moment.) It measures one good along the x-axis and the other on the y-axis. This is the production possibility curve of our hypothetical economy. If we consider an economy in which, more realistically, there are numerous production possibilities, not just 6 as in Table 1.1, then we get a smooth curve as shown in fig. 1.1(b). This is how a production possibility curve (PPC) is normally exhibited. Formally, it is defined for a two-good economy, and, it shows various combinations of the two goods that can be produced with available technologies and with given resources, which are fully and efficiently employed. Equivalently, the

Table 1.1 Production Possibilities Production of Cricket Bats Production of Saris (in thousands) (in lakhs) Possibility A Possibility B Possibility C Possibility D Possibility E Possibility F8

0 1 2 3 4 5

75 70 62 50 30 0

An introduction to graph plotting and joining points is given in Appendix 1.

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PPC shows the maximum amount that can be produced of one good, given the amount produced of the other good. A

(a)

India) or resources work inefficiently (e.g. machines or plants are kept idle), then the economy will operate strictly within the PPC, e.g. at point G, (see fig. 1.1(b)). It should be clear however that, by definition, an economy cannot operate at any point outside of the PPC, such as at point H. Moreover, assuming that the economy is operating on the curve, we cannot, without further information, say the exact point of operation. It depends on preferences and tastes of individuals in the economy. You should realise that, although PPC is defined in the context of a two-good economy, the idea behind it is general and holds for any number of goods. It illustrates the maximum production capabilities of an economy at a given point of time. 1.2.1 Marginal Opportunity Cost, Increasing Marginal Opportunity Cost and the Shape of the PPC

(b) Fig. 1.1 Production Possibility Curve

PPC is downward sloping, because more production of one good is associated with less of the other.9 Note that the PPC does not show or say which point the economy will actually operate on. It only shows the possibilities. The economy may not be even operating on the curve. For example, if there is unemployment (as true for a country like9

We already know that, along a PPC, more production of one good means some sacrifice of the other good. The rate of this sacrifice is called the marginal opportunity cost of the expanding good. Go back to Table 1.1. Starting from possibility B, if the production of cricket bats increases by one unit (to 2), 70 62 = 8 lakh saris need to be forgone. Hence, at the production possibility C, the marginal opportunity cost of cricket bats is equal to 8 lakh saris. Similarly, when 3 thousands bats are produced, the

The concept of downward sloping is explained in Appendix 1.

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marginal opportunity cost (per thousand bats) is 12 lakh saris, and, so on. Generally, the marginal opportunity cost of a particular good along the PPC is defined as the amount sacrificed of the other good per unit increase in the production of the good in question. Note that marginal means additional, and, it is a very important notion in economics. You will see repeated use of it in later chapters. Table 1.2 is an expanded version of Table 1.1 and lists the marginal opportunity cost of cricket bats. We observe that, as the production of cricket bats increases, its marginal opportunity cost increases (from 5 to 8, 8 to 12 and so on). These numbers are indicated in column (3). Why does the marginal opportunity cost increase? The economic reason is that, as more and more of a good is produced, factors producing it become marginally less and less productive. Hence more and more of the other good has to be sacrificed to ensure a unit (given) increase of the former good. Table 1.2

Increasing marginal opportunity cost implies that the PPC is concave to the origin. If, instead, the marginal opportunity cost were decreasing, you can check, by constructing an example, that the PPC will look convex. Finally, if the marginal opportunity cost were constant, the PPC will be a straight line; an important example of this will be studied in Chapter 8. Typically however, the marginal opportunity cost of a particular good on the PPC is increasing and therefore the PPC is concave [as shown in fig. 1.1(b)]. 1.2.2 Opportunity Cost A More General Concept The concept of opportunity cost is very important and universal - not specific to PPC. Most generally, the opportunity cost of a given activity is defined as the value of the next best activity. As an illustration, suppose that you are a doctor having a private clinic in New Delhi and your annual earnings are Rs. 8 lakhs. There are two other alternatives to having a clinic in New Delhi. Either you can work in a government hospital

Marginal Opportunity Cost along the PPC Production of Saris (in lakhs) 75 70 62 50 30 0 Marginal Opportunity Cost of Bats (in saris) 5 8 12 20 30

Production of Cricket Bats (in thousands) 0 1 2 3 4 5

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in New Delhi, earning Rs. 4 lakhs annually, or you can open a clinic in your home town, Mumbai, which would have generated an annual income of Rs. 3 lakhs. Then your opportunity cost of having a clinic in New Delhi is Rs. 4 lakhs because you forego an income of Rs. 4 lakhs from the second best alternative of working in a government hospital. In the context of PPC, there are only two goods, and therefore, the opportunity cost of (additionally) producing one has to be defined in terms of the only remaining good.

then the economy can produce more of both goods. That is, the PPC can shift to the right, such as from AC to FH in fig. 1.2. It may be noted at this point that the following chapters contain many analytical constructs or curves (like PPC), which will be derived from economic considerations. It will be good idea for you to go through Appendix 1 thoroughly now, if you have not done so already. 1.3 MICRO VERSUS ECONOMICS MACRO

Fig. 1.2

Shift of the PPC

1.2.3 Shift of the PPC We now return to our discussion of the PPC. Note that, although a given PPC shows that, if the production of one good goes up, the (maximum) production of the other must fall, you should not however think that an economy can never produce more of all goods. Over time, if the technologies progress or if the resources available to an economy (such as different types of equipment, the sizes of unskilled and skilled labour force etc.) grow,

So far we have discussed in general what economics is about, and analytical concepts like PPC and opportunity cost. The discipline of economics is vast, and, it has many branches or sub-disciplines. Out of them, there are two core branches, called microeconomics and macroeconomics. The former refers mostly, but not exclusively, to the analysis of scarcity and choice problems facing a single economic unit such as a producer or a consumer. Consider an example of producing a service say, hair-cut. If you own a barber shop, how many barbers should you hire? How many persons should you serve per day on the average? What price are you going to charge for a crew-style haircut? As another example, given your monthly pocket money, how many ice creams and chocolates you are going to buy? These are questions of individual choice. Microeconomics deals with the principles behind such choices.

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On the other hand, macro economics deals with the behaviour of aggregates such as real Gross Domestic Product (GDP), employment, inflation etc. What determines the real GDP or inflation rate

in an economy? What policies can reduce the rate of unemployment in a developing country like India? And so on. This book is designed to cover some basic principles of microeconomics.

CLIP 1-2Capitalism Versus Central Planning*We all know that the Soviet Union along with its economic system - broke down in the late 1980s. Even the Chinese economy that used to be centrally planned is moving vigorously towards a market system today. Why did the central planning system fail? While the ultimate goals of a central planning system are same as that of a market-oriented economy, i.e., improvement of standard of living of people, the means of achieving them in the former suffers from two inherent flaws, namely, (a) lack of coordination and (b) lack of individual incentives. A modern economy produces millions of different kinds of goods and services. Obviously, a central coordination of activities in all or most of these sectors is bound to fail because of unanticipated events or just human error. And a failure to achieve the targeted level of production in one sector will create problems for many other sectors. Equally or probably more serious is the problem of individual incentives. Since which goods and how much to be produced are already decided by a central body and there is no immediate or adequate reward for innovation, there is little incentive to discover new or better quality products. Also, guranteed life-time employment in the government-run industries or businesses provided no incentive to work sincerely or efficiently. Work according to ones ability remained only an ideal, as there was little reward for it. On the other hand, the market economy provides an opportunity and incentive for individuals to take risks, which is essential for inventions and to voluntarily work according to ones ability. Individual freedom is respected and rewarded definitely more so than in a centrally planned system. The capitalist system has its serious problems too. Fluctuations, i.e., periodic recessions or depressions, are problems of one kind. Profit-oriented businesses may disregard the adverse impact of industrial activity on local or global environment. Such problems call for government restrictions, but only in selective and discrete ways. They do not imply that direct government control over most economic activities in the economy as in centrally planned economies is the right solution.

* We need not mention NET in every clip.

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SUMMARYl l l l l l l l l

Economics is a social science. Economics is concerned with the study of individual and social choice in situations of scarcity. There are three central problems facing any economy, namely, what, how and for whom. The what problem refers to which goods and services will be produced in an economy and in what quantities. The how problem refers to the choice of methods of production of goods and services. The for whom problem concerns with the distribution of income and wealth. In a capitalist or market-oriented economy, these problems are addressed through the operation of markets. Normally, the production possibility curve is concave to the origin. It is because of increasing marginal opportunity cost. A production possibility curve shifts out due to technological progress or increases in the supply of resources available to an economy or both.

EXERCISES

Section I1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 What is economics about? Name any two central problems facing an economy. Define the production possibility curve. Define marginal opportunity cost along a PPC. What does increasing marginal opportunity cost along a PPC mean? Define opportunity cost. What is microeconomics? What is macroeconomics?

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Section II1.9 1.10 1.11 1.12 1.13 1.14 1.15 1.16 1.17 Explain how scarcity and choice go together. Economics is about making choices in the presence of scarcity. Explain. What are the central problems of an economy and why do they arise? Explain any two central problems facing an economy. Explain the central problem of what with examples. Explain the central problem of how with examples. Explain the central problem of for whom with examples. Why does the PPC look concave to the origin? An economy produces two goods: T-shirts and cell phones. The following table summarises its production possibilities. Calculate the marginal opportunity costs of T-shirts at various combinations. T-shirts (in millions) 0 1 2 3 4 5 1.18 1.19 Cell phones (in thousands) 90,000 80,000 68,000 52,000 34,000 10,000

Draw the production possibility curve for the example of Mr. Kheti Lal in the text. Suppose you have to practice question-answers for two subjects: mathematics and social science. You have 8 hours to study. You are very good at answering multiple choice questions in mathematics: 20 questions per hour, while you are not that good in answering such questions in social science: 12 questions per hour. Derive your production possibility schedule and plot it. (The two goods here are (i) mathematics questions practised and (ii) social science questions practised.)

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1.20 1.21 1.22 1.23

1.24 1.25 1.26 1.27 1.28

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Give two examples of under-utilisation of resources. An economy always produces on, but not inside, a PPC. Defend or refute. Define opportunity cost and explain it with the help of an example. Suppose that you choose the science stream. You had two other options: the arts stream (A) or the commerce stream (C). If you would have chosen (A), you would have expected a career, offering you Rs. 3 lakhs annually. If you would have chosen (B), you would have expected a career, giving you Rs. 4 lakhs annually. What is your opportunity cost of choosing the science stream? (Note: It is only a hypothetical example.) Massive unemployment shifts the PPC to the left. Defend or refute. Which factors lead to a shift of the PPC? Give two examples of growth of resources. Why do technological advance or growth of resources shift the PPC to the right? A lot of people die and many factories are destroyed because of a severe earthquake in a country. How will it affect the countrys PPC? Distinguish between microeconomics and macroeconomics.

Section III1.30 A country produces two goods: green chilli and sugar. Its production possibilities are shown in the following table. Plot the PPC in a graph paper and verify that it is concave to the origin. What is the pattern in the table that gives rise to the concave shape of the PPC? Green Chilli Possibility A Possibility B Possibility C Possibility D Possibility E Possibility F 100 95 85 70 50 25 Sugar 0 1 2 3 4 5

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CONSUMER CHOICE AND THE DEMAND CURVE In Chapter 1 it was stated that, in a marketoriented economy, the central problems of what, how and for whom are solved through forces of demand and supply for various goods and services. Who demands a particular good and who supplies it? This depends on the type of good or service in question. Consider a final product such as alu bhujia.1 As consumers, households are the demanders of alu bhujia and companies like Bikanerwala and Leher are the suppliers. Another example is the service of a computer programmer. This service is demanded by companies or firms. Who are the suppliers of this service? The households, because some members of some households work as computer programmers. In summary, in case of final goods and services, households demand them and firms supply them. In case of services that are required for production, households are the1

2.1 Consumer's Equilibrium 2.2 Meaning and Determinants of Demand 2.3 Market Demand Curve 2.4 Price Elasticity of Demand

Final goods and services include things that are consumed by households, e.g. a piece of bread, a haircut, a bicycle repair job etc. As opposed to final goods and services, there are intermediate goods (or raw materials) that are consumed (i.e. used up) by businesses. The examples are steel in a bicycle factory, wheat in a flour mill, and various automobile components in a Maruti car workshop.

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suppliers and the fir ms are the demanders. This chapter deals with households as consumers and their demand for final goods and services. How should a consumer decide how much of a product to buy? What factors do affect this decision and how? 2.1 CONSUMERS EQUILIBRIUM: THE BASIS OF THE LAW OF DEMAND Let us ignore for the moment the word equilibrium or the phrase Law of Demand, and focus on the question of how much of any particular good a consumer should demand (or buy) at a given point of time. In order to understand this, we first have to learn a few concepts. 2.1.1 Utility Concepts We begin with the notion that a consumer derives some satisfaction from consuming a product; otherwise, she would not demand it at all. This is captured by a term called total utility, defined as the total psychological satisfaction a consumer obtains from consuming a given amount of a particular good. Consider for example your consumption of gol guppa - the mouth-watering small round-shaped puffed puris, served with tamarind (imli) water and fillings.1 Imagine that you are hungry and have come to your favourite gol guppa vendor. Suppose that if you consume only one gol guppa you derive 20 units of pleasure or utility measured in some units. Let this (psychological)1

unit be called utils. Thus, the total utility from consuming one gol guppa is 20 utils. Suppose that you like gol guppa so much that eating just one increases your appetite for it. Let the second unit give an additional utility of 22 utils. Then, the total utility from consuming two gol guppas is 20+ 22 = 42 utils. In the same manner we can calculate total utility from consuming three, four or five units and so on. Besides total utility, there is another important concept called marginal utility, defined as the utility from the last unit consumed. Thus the marginal utility from consuming one gol guppa is 20 and that from consuming two gol guppas is 22. You can now notice the relationship that total utility is the sum of marginal utilities. Getting on with our story, your intensity of desire for gol guppa must fall, after consuming a certain amount, regardless of how much you like gol guppa. Suppose that, in your case, such decline in the intensity of desire starts with the third gol guppa you consume. Accordingly, let the third unit give you utility equal to a number less than 22, say, 18 utils. That is, the marginal utility and the total utility obtained from consuming three gol guppas are 18 and 42 +18 = 60 utils respectively. The next (fourth) unit gives you still less utility, say, 14 utils, and so on. This pattern of marginal utility is called the law of diminishing marginal utility. It states that, after consuming a certain amount of a good

Incase gol guppa is not known to the children, the teachers can use other popular eatable as example to explain the concept.

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or service, the marginal utility from it diminishes as more and more is consumed. If you think about it, this law is very natural and should hold for any product one consumes. In fact it is considered as a fundamental psychological law. You will see the critical role of it a little later. Let us resume our story once again. When you have already consumed quite a few gol guppas say 8, and you are very full in your stomach suppose that the next (9th) unit gives zero utility. Imagine what will happen if you keep gulping more. Suppose that eating the 10th unit makes you vomit! This is obviously not a pleasant experience and should give you negative satisfaction. Accordingly, let the utility associated Table 2.1 Units Consumed of Gol guppa 0 1 2 3 4 5 6 7 8 9 10

with the 10th unit be -7 utils. That is, the marginal utility of ten gol guppas is -7 utils. (If you are crazy and still eat more, each additional one can only give you more negative utility.) Table 2.1 summarises your experience with gol guppa in terms of marginal utility and total utility up to 10 units of consumption. Columns (2) and (3) present the marginal and total utility schedules. 2.1.2 How many Gol Guppas will you consume or buy?

From Table 2.1, it is clear that if you are a rational (not crazy) consumer, you will eat less than 10 gol guppas, since consuming 10 or more gives you negative marginal utility. If gol guppas

Marginal and Total Utility Marginal Utility (in utils) 20 22 18 14 11 8 4 2 0 -7 Total Utility (in utils) 0 20 42 60 74 85 93 97 99 99 92

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were free, i.e., its price were zero, you would have consumed 8 or 9 units at which your total utility is at its maximum. But as long as you pay something for it, you may not wish to consume so many. You would like to know how much utility you could have obtained if you had spent some amount on other items, e.g., ice cream, chocolate etc. In other words, exactly how many gol guppas you will eat would depend not only on marginal and total utility from consuming gol guppas, but also on the price of gol guppas, and, how much a rupee is worth to you in terms of other goods. We now define marginal utility of one rupee as the extra utility when an additional rupee is spent on other available goods in general. Suppose that, for you, it is 4 utils and let the price of gol guppa be Rs. 2 per piece. Having the information on price and marginal utility of a rupee, we can determine how many gol guppas you will consume. Consider first whether you will buy just one gol guppa. From consuming only one, you obtain utility equal to 20 utils (from Table 2.1). Since the marginal utility of a rupee is 4 utils, we can say that, from consuming one gol guppa, you get utility worth Rs. 20/4 = Rs. 5. On the other hand, you pay and thus sacrifice Rs. 2 for it. Hence you will buy the first unit. Similarly, from the second unit, you get utility worth Rs. 22/4 = Rs. 5.50, while you pay only Rs. 2. Hence you will buy the second gol guppa also. We keep on making such comparisons for successive units. For

example, the 5th gol guppa is worth having it since it gives Rs. 11/4 = Rs. 2.75 worth of utility, which is greater than the price. What happens with the 6 th gol guppa is a bit different. It gives you utility worth Rs. 8/4 = Rs. 2, which is equal to the price. Will you buy it? The answer is that you will be indifferent, that is, whether or not you buy the 6th unit does not make any difference. However, it is clear that you will not buy (consume) more than 6. Because, at any level of consumption beyond 6, the marginal utility in terms of rupees is less than the price (you can check this directly). Hence we have found the answer to our query: you will buy 5 or 6 gol guppas. The above comparisons between how much of marginal utility in terms of money you get and the price you pay implies that, at either of these two levels of consumption, the difference between the total utility in terms of money and your total expenditure on gol guppas (defined as price quantity purchased) is maximised. Table 2.2 illustrates this. Its second column gives total utility in terms of money, defined as total utility divided by the marginal utility of one rupee (equal to 4 utils in this example). Column (3) gives your total expenditure or spending on gol guppas. The last column gives the difference between these two columns; this is like the net gain to a consumer. We see that this difference is maximised (equal to Rs. 11.25) when your gol guppa consumption is either 5 or 6. Having gone through the example, we can now understand why this

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Table 2.2

Difference between Total Utility in Terms of Money and Total Expenditure Total Utility in terms of money (Rs.) 0 5 10.50 15 18.50 21.25 23.25 24.25 24.75 24.75 23 Total Expenditure (Rs.) 0 2 4 6 8 10 12 14 16 18 20 Difference (Rs.) 0 3 6.50 9 10.50 11.25 11.25 10.25 8.75 6.75 3

Amount Consumed of gol guppas 0 1 2 3 4 5 6 7 8 9 10

section is titled Consumers Equilibrium. The word equilibrium, frequently used in economics, means a position of rest. In this example, you will rest, stop or, as economists say, attain consumers equilibrium at 5 or 6 gol guppas. Because you do not want to consume less or more than these quantities. In general, we can then say that consumers equilibrium with respect to the purchase of one good is attained when the difference between total utility in terms of money and the total expenditure on it is maximised. 2.1.3 The General Principle From the example just worked out, we can now derive the general principle of

consumers equilibrium with respect to any particular good. Recall that one of our answers is 6 gol guppas. Ignoring the other answer for the moment, note that, at this level of consumption, the marginal utility in terms of money (Rs. 2) is equal to price (Rs. 2). This is indeed the principle and we can state this in two alternative ways. That is, the consumer s equilibrium is attained when(A) Marginal Utility of a Product Marginal Utility of a Rupee = Its Price(B ) Marginal Utility of a Product Its Price

Or

= Marginal Utility of a Rupee.

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In particular, the condition (A) says that the marginal utility of a product in terms of money be equal to its price. Sometimes, this is loosely stated as marginal utility is equal to price. Now go back to the example once again and see that the consumers equilibrium is also attained at 5 gol guppas, where the principle is not satisfied. This possibility exists because gol guppas are not perfectly divisible: they cannot be measured continuously like points on a straight line. If, instead, a product is perfectly divisible and thus can be measured continuously, for example by weight on a weighing scale, there will be just one level of consumption at which the consumers equilibrium is achieved, with condition (A) [or (B)] met. We do implicitly assume from now on that a product is perfectly divisible and thus treat (A) or (B) as the condition of consumers equilibrium.2 2.2 MEANING AND DETERMINANTS OF DEMAND Our analysis of consumers equilibrium implies that the price of a product is an important factor in determining how much of the product a consumer will be willing to buy within a given time period. It is because, as the product price changes, the ratio of marginal utility to price changes so that the consumers equilibrium will occur at a different level of consumption.

This forms the basis of defining demand for a particular good by a consumer: it is the quantity of the good that she is willing to buy at different prices within a given period of time. However, the price of a product is not the only factor that influences how much a consumer should buy of that product. For example, if there is a taste change, it will change the marginal utilities from a product, and, the consumers equilibrium condition will be fulfilled at some other level of consumption even when there is no change in price. Moreover, while our preceding analysis is confined to one good (e.g. gol guppa), in reality, a consumer buys many goods. The consumers equilibrium analysis with respect to many goods (which is outside our scope) suggests two other factors, namely, prices of related goods and income. This is quite natural. If a person consumes, for example, tea and coffee, then a change in the price of tea should affect her consumption of coffee and vice versa. Also, if income changes, different amounts can be bought even when the prices of goods and services she consumes remain unchanged. The last three factors just mentioned are called the determinants of demand. They are namely,

2

Nothing essential or important is gained by deviating from this assumption. The only modification is that, when a good is not perfectly divisible, the condition (A) or (B) holds either exactly or approximately.

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(a) prices of related goods, (b) income and (c) tastes. 3 The next question is how the own price of a product as well as these three factors affect the quantity demanded of a particular good. 2.2.1 Own Price: The Law of Demand To isolate its effect, hold the other factors constant and ask how the quantity demanded of a product changes as its own price changes. The answer is summarised as what is called the Law of Demand. It states that other things remaining unchanged, as the own price of a commodity increases, the quantity demanded of it by a consumer falls. Other things refer to the prices of related goods, income and tastes. Suppose that, for a particular family, within a month, Table 2.3 lists its quantities demanded of apples at different prices, which are consistent with its consumers equilibrium. The left column lists various prices, while the right column lists the corresponding quantities demanded. It is assumed that the prices of related goods, family income and tastes are kept fixed at some pre-determined levels.3

The law of demand in tabular form is called a demand schedule. If we graph a demand schedule, we obtain a demand curve. It typically measures own price along the y-axis and quantity demanded on the x-axis. The demand curve corresponding to the demand schedule in Table 2.3 is shown in fig. 2.1. We see that the demand curve is downward sloping. It is because an increase in the own price lowers the Table 2.3 Own Price (in Rs.) 12 13 14 15 16 17 A Demand Schedule Quantity Demanded of Apples 24 17 12 9 7 6

quantity demanded. Each point of the demand curve shows the quantity demanded that is consistent with consumers equilibrium. Why is the Demand Curve Downward Sloping? Isnt it obvious that the demand curve is downward sloping? That is, as

Apart from (a), (b) and (c), there may be other determinants of demand for a good, e.g., future price expectation. Consider an essential product, say, edible oil or sugar. Suppose there is a weather prediction that your village or town will be hit by a severe cyclone in the next three days. You would then anticipate that supply interruptions would occur and prices of these commodities would skyrocket. If you are a rational consumer, you would buy more of these commodities now (and store them) even if prices, income or tastes do not change. Moreover, taste changes can occur not only because of natural changes in a persons liking, but also due to advertising of products.

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Table 2.4 Marginal Utility Schedule and the Demand Schedule Quantity of T-shirts 1 2 3Fig. 2.1 Demand Curve Corresponding to Table 2.3

Marginal Utility of T-shirts 75 70 65 60 55 50 45

4 5 6 7

the own price increases, the quantity demanded of a product falls. Interestingly, it is not. There is a reason behind it, namely, the law of diminishing marginal utility. Indeed, the demand curve is essentially the marginal utility curve.4 Consider Table 2.4, which lists the marginal utility from consuming T-shirts. Mark that, for simplicity, diminishing marginal utility sets in with the very first unit of consumption. Assume further, again for simplicity of exposition, that the marginal utility of a rupee is equal to 1 util. Then, our consumers equilibrium condition (A) can be stated as Marginal Utility = Price. To begin with, suppose that the price of a T -shirt is Rs. 45. The consumers equilibrium condition holds at 7 T-shirts consumed. This can4

be restated as follows. The quantity demanded of T-shirts is 7 when the price is Rs. 45. Thus the pair (45, 7) will be on the demand curve. Similarly, suppose that the price of T -shirts increases to Rs. 65. The consumers equilibrium condition now holds at 3 T-shirts consumed, that is, at price Rs. 65, the quantity demanded is 3. Hence the pair (65, 3) will be on the demand curve too. Likewise, we can determine that all other points on the marginal utility schedule are points on the demand schedule. This means that the marginal utility curve itself is the demand curve, and, the demand curve is downward sloping because of the law of diminishing marginal utility.

An intuitive way to see this is that, as a consumer buys more of a good, her marginal utility decreases and therefore she is willing to pay less per unit. This can be turned around to say that if the price of a product falls, a consumer buys more of it.

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2.2.2

Determinants of Demand

Now turn to the remaining factors that affect the quantity demanded of a particular product, or, what we have called the determinants of demand. Change in Price of a Related Good Suppose that Mrs. Das, who lives next door to you, has a weakness for sweets. Burfi and gulab jamun are her favourites. Suppose that burfis become more expensive: from Rs. 5 a piece to Rs. 8 a piece. How will this affect Mrs. Dass demand for gulab jamun? It will increase. Why, because burfi and gulab jamun are substitutes of each other in consumption. Consider another example: that of tea and coffee. The same should happen to the demand for tea if the price of coffee rises or vice versa, because tea and coffee are also substitutes. We say that good A is a substitute of good B if an increase in the price of good B increases the demand for good A. On the other hand, consider tea and sugar. Sugar is complementary to tea Table 2.5

in consumption. Thus, if the price of tea goes up, the quantity demanded of tea should fall, which will reduce the demand for sugar. Another example of a pair of complementary products is petrol and cars. If the price of petrol rises, the quantity demanded of cars should fall. In other words, good A is said to be complementary to good B if an increase in the price of good B decreases the demand for good A. These examples illustrate cross price effects: how the demand for one particular product is affected by a change in the price of another. Numerical examples of cross price effects are given in Tables 2.5 and 2.6. In Table 2.5, note that as the price of coffee rises from Rs. 200 to Rs. 250, the quantity demanded of tea increases for any given price of tea. For example, given price of coffee = Rs. 200, at tea price equal to Rs. 170, the quantity demanded of tea is 11, whereas, given coffee price = Rs. 250, at the same tea price (Rs. 170), the quantity demanded of tea is 18. The demand schedules of

Effect of an Increase in the Price of Coffee on Demand for Tea Quantity Demanded of Tea when Price of Coffee (per kg) = Rs. 200 20 11 5 2 1 Quantity Demanded of Tea when Price of Coffee (per kg) = Rs. 250 28 18 10 7 4

Price of Tea (per kg) Rs. 150 170 190 210 230

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Table 2.6

Effect of an Increase in the Price of Tea on Demand for Sugar Quantity Demanded of Sugar when Price of Tea (per kg) = Rs. 170 20 14 9 6 5 Quantity Demanded of Sugar when Price of Tea (per kg)= Rs. 200 12 7 4 2 1

Price of Sugar (per kg) Rs. 5 8 11 14 17

tea given in column (2) and (3) of Table 2.5 are graphed in Figure 2.2. We see that demand curve for tea when the price of coffee is Rs. 250 lies to the right of that when the price of coffee is Rs. 200. Hence, an increase (a decrease) in the price of a substitute good shifts the demand curve for a product to the right (left). Similarly, in Table 2.6, notice that, as the tea price increases from Rs. 170 to Rs. 200, the quantity demanded of sugar decreases for any given price of sugar. Figure 2.3 graphs Table 2.6. The demand curve for sugar when tea price is Rs. 200 lies to the left of that when the sugar price is Rs. 170. Thus, an increase (a decrease) in the price of a complementary good shifts the demand curve for a product to the left (right). A Change in Income Suppose that you only buy peanuts and ice cream from your pocket money. Ice cream is your favourite but it is costly. You like peanuts much less, but

Fig. 2.2

Change in demand due to increase in the price of a substitute good

they are cheap. Suppose that your pocket money increases. Will you buy more of ice cream, more of peanuts or both? We bet that you will buy more ice cream. Whether you will buy more peanuts is not clear. Very likely, you will buy less of peanuts, not because your taste changes but because you can afford more ice cream, which is your favourite. Hence, generally, we can say that, as income increases, a consumer may

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buy more or less of a product. If she buys more (e.g. ice cream), then we say that the product in question is a normal

those, for which demand falls as income rises. Table 2.7 presents numerical examples of both normal and inferior goods. Observe that, at any given price, as income increases, quantity demanded of the normal good increases (by comparing columns (2)-(3)) and that of the inferior good decreases (by comparing columns (5)-(6)). These are graphed in figs. 2.4 and 2.5. The original demand curve for the normal good, when income is Rs. 300, is indicated by the line NN0 in fig. 2.4. This represents the column pair (1)-(2). The new demand curve, when income of Rs. 400, is marked by NN 1 that represents the column pair (1)-(3). Hence an increase in income shifts the demand curve to the right if the good is nor mal. For the inferior good, the demand curves are indicated by FF 0 (original) and FF 1 (new) in

Fig. 2.3 Change in demand due to increase in the price of a complementary good

good. If she buys less (e.g. peanuts), then we say that it is an inferior good. Put differently, nor mal goods are those, for which demand increases as income increases. Inferior goods are Table 2.7 Own Price

Normal and Inferior Goods An Inferior Good Own Price Quantity Quantity Demanded: Demanded: Income = Income = Rs. 300 Rs. 400 3 4 5 6 7 8 20 17 14 11 8 5 15 12 9 6 3 0

A Normal Good (Quantity (Quantity Demanded: Demanded: Income = Income = Rs. 300 Rs. 400 15 12 9 7 5 3 19 16 13 11 9 7

1 2 3 4 5 6

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fig. 2.5. Thus an increase in income shifts the demand curve to the left if the good is inferior. In the real world, there are much fewer examples of inferior goods than normal goods. Yet there are important examples. In India, cereals as a single category of goods (that includes rice, wheat, bajra, jowar etc.) constitute an inferior good. Within this category, the inferior-good characteristic applies to bajra, jowar, maize and related cereals. A Change in Tastes Finally, consider a taste change. Suppose you are impressed by an advertisement in TV, in which your favourite actor drinks Coca Cola, and, as a result, your liking for Coca Cola increases. This will shift your demand curve for Coca Cola to the right. This is an example of a favourable change in tastes. An unfavourable change in taste will imply the opposite. We can then sayFig. 2.5 Change in demand due to increase in income (Inferior Good)

that a favourable (an unfavourable) change in tastes shifts the demand curve to the right (left). A taste change may result from a change in a persons liking, or, from some other source. If, for instance, for health reasons, you have to consume more of a product although you dont like it, this is also considered a taste change. 2.2.3 Change in Quantity Demanded Versus Change/ Shift in Demand We have seen that the quantity demanded of a product depends on own price and other factors like prices of related goods, income and tastes. The law of demand refers to the effect of a change in the own price. A graphical representation of this is the demand curve, which is downward sloping. A change in the own price causes a movement along a given demand curve: higher (lower) the price, less (more) is the quantity demanded.

Fig. 2.4 Change in demand due to increase in income (Normal Good)

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Such a movement is called a change in the quantity demanded. In contrast, when a change in any other factor causes a (left or rightward) shift of a demand curve, we call this a change in demand. The distinction between the two concepts is illustrated in fig. 2.6. Fig. 2.6(a) illustrates a change in the quantity demanded. There is a price change from P0 to P1. As a result, there is a movement along the same demand curve from A to B. The quantity demanded changes from Q0 to Q1. In contrast, fig. 2.6(b) shows a change in demand, meaning a shift of a demand curve from DD0 to DD1 due to a change in the prices of related goods, income or tastes. 2.3 MARKET DEMAND CURVE We have studied consumers equilibrium and the determinants of demand for a good from the perspective of a single individual. How do we get the demand curve of a product by all individuals together in an economy, e.g., the economy of a region or a country? The economy-wide demand curve for a particular product is called the market demand curve. It is obtained by summing up the demand curves across consumers or households. Consider the market for, say, gulab jamun. Suppose that there are three consumers in the market: Amar, Akbar and Anthony. If at the price equal to Rs. 3 a piece, Amar demands 5, Akbar 6 and Anthony 8 per week, then the total quantity demanded is 19. Hence

(a) Change in Quantity Demanded

(b) Change in Demand Fig. 2.6 Change in Quantity Demanded Versus Change in Demand

(3, 19) is a point on the market demand curve. Repeat the same exercise for other possible prices and obtain the corresponding points. Plot the points, join them and you get the market demand curve. A numerical example is given in Table 2.8. Individual demand schedules are given by column pairs (1)-(2), (1)-(3) and (1)-(4). The column

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pair (1)-(5) gives the market demand schedule. Note that for each row (price), the entry in column (5) is the sum of corresponding entries in columns (2), (3) and (4). These individual demand schedules and the market demand schedule are graphed in fig. 2.7. Amars, Akbars and Anthonys demand curves are respectively marked by their names. The right most line is the market demand curve. This is obtained by horizontally summing the individual demand curves. What are the determinants of the market demand curve? They are the determinants of the individual demand curve described earlier plus how many consumers buy the product, that is, (a) prices of related goods; (b) income levels across individuals, or Table 2.8

what we can call, the distribution of income; (c) consumers tastes (d) the number of consumers who buy the product, or what we can call, the market size.5 2.4 PRICE ELASTICITY DEMAND OF

We have seen how various factors like own price and income affect the demand for a commodity. The direction of change was our focus - whether the quantity demanded increases or decreases as price, income or other factors change. The concept of elasticity captures the magnitude of change or the degree of responsiveness. For example, the price elasticity of demand quantifies the effect of a change in own price on the quantity demanded.

Individual and Market Demand Schedules for Gulab Jamun Amars Demand 7 6 5 4 3 2 Akbars Demand 15 10 6 3 1 0 Anthonys Demand 13 10 8 7 6 5 Market Demand 35 26 19 14 10 7

Price of Gulab Jamun in Rs. 1 2 3 4 5 65

Many multinational firms today look at the Indian or the Chinese market as very lucrative, because of their market sizes, which refer to the huge number of consumers in these countries.

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Fig. 2.7 Individual and Market Demand Curves

2.4.1 Definition and Formulas Formally, Elasticity of demand is defined as(C ) Price elasticity of demand = e D % change in the quantity demanded = % change in the own price

Since the changes in price and quantity along a demand curve occur in opposite directions, the ratio of % change in quantity demanded and that in the own price is negative in sign. Hence attaching a negative sign in front of the ratio makes the sign of eD positive. Some other textbooks define the price elasticity the same way as above, except for the minus sign. But there is no reason to get confused. Strictly speaking, our definition gives the absolute value of the elasticity, which is, often, referred to as elasticity.

Along a given demand curve, let the original price be P0 and the original quantity be Q0. Suppose that the price increases to P 1 and the quantity demanded falls to Q1. Then the % changes in price and quantity demanded are respectively equal to [(P1P0)/P0]100 and [(Q1Q0)/Q0]100. Thus (C) can be written as

(D ) e D =

(Q1 Q0 ) / Q0 . (P1 P0 ) / P0

If we further denote a change in quantity as Q and a change in price as P, we can also write(E ) eD = Q/Q0 . P / P0

Consider the following numerical example. Suppose that in your home town, rasgoolas were being available at Rs. 5.00 per piece and the residents of

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the town were buying 1200 rasgoolas per day. Now they become more expensive for some reason, at Rs. 5.50 per piece. Fewer people are eating rasgoolas and many who eat, are eating less. Suppose that the people in the town are now buying 960 rasgoolas per day. What is the price elasticity of demand? We have to do some arithmetic. The % change in the price is equal to [(5.50 5.00)/5.00] 100 =10. The % change in quantity is equal to [(960 1200)/1200] 100 = 20. Hence, eD, the price elasticity, is equal to 20/10 = 2. Properties 1. A very desirable property of the elasticity formula in measuring the degree of responsiveness is that it is independent of the choice of units. It is because any percentage change of a variable is independent of units. 2. If two demand curves intersect, at their point of intersection, the elasticity associated with the flatter demand curve is higher. This is exhibited in fig. 2.8. The demand curves DD and DD intersect at the point C. At this point, P0 is the price of the product. The claim is that, at price P0, the elasticity is greater along the flatter demand curve DD. Why? Because the original quantity demanded is the same, equal to D0, along both demand curves, and, if there is an increase in price, say to P1, the quantity demanded falls more along the flatter demand curve (by amount D2D0 as compared to

D1D0 along DD). This implies that, while the % change in price is the same along both demand curves, the % change in quantity demanded is greater along DD. Therefore, price elasticity associated with DD is higher. 3. Higher the value of the price elasticity, greater is the degree of responsiveness of quantity demanded to price. In particular, if eD>1, then the % change in quantity demanded must exceed the % change in price. We then say that the product demand is elastic (e.g. jewellery). If eD 1

No Change

eD > 1eD < 1 eD < 1

eD = 1

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instance, if because of a price increase, the total expenditure increases, then the product demand must be inelastic. You can readily verify that from Table 2.9. This link, via price elasticity, between changes in price and total expenditure has important practical implications. Return once again to the rasgoola example. Suppose that there is only one (giant) halwai shop in town, who sells rasgoolas. If you are the halwai shop owner and are

thinking about increasing the price of rasgoola, wouldnt you want to know if a price increase would increase or decrease your total sales in rupees? From a sellers perspective, the total value of sales is usually called total revenue and note that total revenue is equal to the total expenditure by the consumers.9 Hence the relationships between elasticity, price change and total expenditure are important from the viewpoint of decision making by a producer or a firm.

SUMMARYl l l l l l l l l

Total utility is equal to the sum of marginal utilities. A rational consumer will never consume that much of a product such that the marginal utility from it is negative. At the consumers equilibrium, the difference between total utility in terms of money and the total expenditure on a good is maximised. Consumers equilibrium is attained when the condition that the marginal utility in terms of money is equal to the price is met. The law of demand defines demand curve, which is downward sloping. The demand curve is downward sloping because of the law of diminishing marginal utility. The demand curve is essentially same as the downward sloping portion of the marginal utility curve. A shift of the demand curve is caused by a change in the prices of related goods, a change in income or a change in tastes. An increase in the price of a substitute good causes an increase in demand or a rightward shift of the demand curve, while an increase in the price of a complementary good causes a decrease in demand or a leftward shift of the demand curve. As income increases, the demand for a product increases or decreases, i.e., the demand curve shifts to the right or left, depending on whether the good is normal or inferior.

l

9

We will see the use of the term total revenue in Chapters 4, 6 and 7.

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A favourable taste change increases the demand for a good, i.e., shifts the demand curve to the right; an unfavourable change does the opposite. Market demand curve is obtained by horizontally summing up the individual demand curves. The determinants of market demand curve are prices of related goods, distribution of income, tastes and the market size. The price elasticity of demand is independent of the choice of units. When two demand curves intersect, the elasticity associated with the flatter demand curve is greater. Greater the availability of close substitutes of a product, the higher is the price elasticity of demand for a product. Typically, the demand for luxury products is elastic and that for necessary goods is inelastic. Greater is the share of the total budget spent on a particular good, the more elastic is the demand for it. Longer the time horizon, the more elastic is the demand for a product. If the demand curve is vertical (horizontal), the price elasticity is zero (infinity). In case of elasticity equal to one, the demand curve is a rectangular hyperbola. Given that the demand is a straight line, the point elasticity is equal to the lower segment divided by upper segment of the demand curve at that point. If demand is elastic (inelastic), an increase in the price of the product leads to a decrease (an increase) in the total expenditure on the product. In case of a unitarily elastic demand, a change in price leaves the total expenditure on the product unchanged.

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l

l

EXERCISES

Section I2.1 2.2 Define total utility. Define marginal utility.

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2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14

How is total utility derived from marginal utilities? State the law of diminishing marginal utility. Give the meaning of demand. Name two determinants of the demand. List the factors that cause changes in demand. What is the law of demand? What is a demand schedule? Give an example of a pair of commodities that are substitutes of each other. Give an example of a pair of commodities such that one of them is complementary in consumption to the other. If the price of good X rises and it leads to an increase in demand for good Y, how are the two goods related? If the price of good X rises and this leads to a decrease in demand for good Y, how are the two goods related? Define price elasticity of demand.

Section II2.15 A persons total utility schedule is given below. Derive her marginal utility schedule. Amount Consumed 0 1 2 3 4 5 2.16 Total Utility 0 10 25 38 48 55

A persons marginal utility schedule is given below. Derive her total utility schedule. (Assume that the total utility of consuming zero is zero.)

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Amount Consumed 1 2 3 4 5 6 2.17 2.18 2.19

Marginal Utility 7 10 8 6 3 0

2.20

2.21 2.22 2.23 2.24 2.25 2.26 2.27 2.28 2.29

2.30 2.31

What is consumers equilibrium. State the condition of consumers equilibrium. Starting from an initial situation of consumers equilibrium, suppose that the marginal utility of a rupee increases. Will it increase or decrease the quantity demanded of the product? Ice creams sell for Rs. 30. Lakhmi, who loves ice cream, has already eaten 3. Her marginal utility from eating 3 ice creams is 90. Suppose further that, for her, the marginal utility of one rupee is 3. Should she eat more ice cream or should she stop? Explain the determinants of demand. What is meant by cross price effects? Give two numerical examples to illustrate this. What is meant by one good being a substitute of another? What is meant by one good being complementary to another? Differentiate between substitute and complementary goods. How will an increase in the price of coffee affect the demand for tea? How will an increase in the price of tea affect the demand for sugar? Suppose that good A is a substitute of good B. How will an increase in the price of good B affect the demand curve for good A? Suppose that good A complementary to good B in consumption. How will an increase in the price of good B affect the demand curve for good A? Give two examples of normal goods and two examples of inferior goods. How does an increase in income affect the demand curve for a normal good?

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2.32 2.33 2.34 2.35 2.36

How does an increase in income affect the demand curve for an inferior good? Define (a) complementary goods, (b) substitute goods, (c) inferior good and (d) normal good. Distinguish between a change in quantity demanded and a change in demand. How is the market demand curve derived from the individual demand curves? There are four consumers of a fruit called Smile. They are Isha, Ifraah, Ila and Ibema. Their demand curves for Smile are given below. Derive the market demand curve. Quantity Quantity Quantity Demanded by Demanded by Demanded by Ifraah Ila Ibema 7 6 5 4 3 2 15 12 9 6 3 0 8 6 4 2 0 0

Price Quantity (Rs.) Demanded by Isha 1 2 3 4 5 6 16 11 7 4 2 1

2.37 2.38 2.39

2.40

2.41

Explain the determinants of the market demand curve. Distinguish between individual and market demand curves. Originally, a product was selling for Rs. 10 and the quantity demanded was 1000 units. The product price changes to Rs. 14 and as a result the quantity demanded changes to 500 units. Calculate the price elasticity. Which of the following commodities have inelastic demand? Salt, a particular brand of lipstick, medicine, mobile phone and school uniform. Draw diagrams showing elasticity equal to (a) zero, (b) one and (c) infinity.

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2.42 2.43 2.44 2.45 2.46

2.47

2.48

2.49 2.50

Draw a straight line demand curve. Choose any three points on it and compare the point elasticities at these three points. Consider the above straight line demand curve. Compare the point elasticities between the points A, B and C. The price elasticity is 2. The % change in price is equal to 5. Find the % change in quantity. The price elasticity is 0.5. The % change in quantity is 4. What is the % change in price? As the price of peanut packets increases by 5%, the number of peanut packets demanded falls by 8%. What is the elasticity of demand for peanut packets? As the price of a product decreases by 7%, the total expenditure on it has gone up by 3.5%. What can we say about the elasticity of demand for this product? The price of cauliflower goes up by 8% and the total expenditure by a family on cauliflower goes up by 8%. What can we say about the elasticity of demand for cauliflower by this family? Show the effect of an increase in price on total expenditure depending on the values of price elasticity. A dentist was charging Rs. 300 for a standard cleaning job and per month it used to generate total revenue equal to Rs. 30,000. She has since last month increased the price of dental cleaning to Rs. 350. As a result, fewer customers are now coming for dental cleaning, but the total revenue is now Rs. 33,250. From this, what can we conclude about the elasticity of demand for such a dental service?

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2.51 2.52

If a product price increases, a familys spending on the product has to increase. Defend or refute. Determine how the following changes (or shifts) will affect market demand curve for a product. (a) A new steel plant comes up in Jharkhand. Many people who were previously unemployed in the area are now employed. How will this affect the demand curve for colour TVs and Black and White TVs in the region? (b) In order to encourage tourism to Goa, the Government of India suggests Indian Airlines to reduce air fare to Goa from the four major cities, Chennai, Kolkata, Mumbai and New Delhi. If the Indian Airlines reduces the air fare to Goa, how will this affect the market demand curve for air travel to Goa? (c) There are train and bus services between New Delhi and Jaipur. Suppose that the train fare between the two cities comes down. How will this affect the demand curve for bus travel between the two cities?

Section III2.53 Discuss how the market demand curve is derived from the individual demand curves and the determinants of market demand. Explain why consumers equilibrium is attained when the marginal utility of a product in terms of money is equal to its price. Suppose there are three consumers in a particular market: Leander, Andre and Tim. Their demand schedules are given in the following table.

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Price Quantity Demanded Quantity Demanded Quantity Demanded by Leander by Andre by Tim 1 2 3 4 5 60 50 40 30 20 55 40 25 10 0 24 13 5 0 0

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2.56 2.57

(a) Derive the market demand schedule and plot the market demand curve. (b) Suppose Andre drops out of the market. Derive the new market demand curve. (c) Suppose Andre stays in the market and another person, Marat, joins the market, whose quantity demanded at any given price is half of that of Leander. Derive the new market demand curve. Why does the demand curve slope downwards? Explain the factors affecting the magnitude of price elasticity of demand.

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U N I T- I I IPRODUCER BEHAVIOUR AND SUPPLY

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CHAPTER

3AND

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COSTS

3.1 Production

3.2 Costs

In Chapter 2 we studied the consumers behaviour. In Chapters 3 and 4 we will be concerned with the producers behaviour. In this chapter in particular, we study important concepts associated with production and costs. A producer or a firm is in business to maximise profit.1 By definition, profit earned by a firm is equal to its total revenues minus the total costs. As an example, suppose that you are in the business of making hammers, and, during a month, you produce and sell 500 hammers. They are selling at the price of Rs. 20 each. Then the total revenues generated are equal to price quantity, that is, Rs. 20 500 = Rs. 10,000. Producing hammers requires inputs such as labour, building, equipment and raw materials. This is a technological relationship. In turn, inputs have to be paid. The sum total of payments to all inputs is the total cost of production. Let the total cost of making 500 hammers over the month be Rs. 6,500. Then your profit is equal to Rs. 10,000 Rs. 6,500 = Rs. 3,500.

1

In this chapter and others, we will use the term profit or profits. Both are correct uses.

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The above example is illustrative of some important linkages. On one hand, the amount produced, or, what is called output, is linked to total revenues in the product market. On the other hand, output is linked to inputs via technology, which is called production function (to be defined in a moment), and, the employment of inputs leads to their payments. This chain links output to costs.

output. In section 3.2, we will analyse that between output and payments to inputs. The link between output and revenues will be examined in Chapter 4 (and in Chapter 6 also). 3.1 PRODUCTION 3.1.1 Production Function The most basic concept here is what is called the production function, defined as a technological relationship that tells the maximum output producible from various combinations of inputs. For instance, a firm employs only two factors or inputs, say, labour (measured in hours) and land (in acres), and, Table 3.1 lists some factor combinations and the corresponding output levels. 1 hour of labour and 2 acres of land produce at the most 5 units output, 2 hours of labour and 4 acres of land produce at the most

Fig. 3.1

Linkages

These linkages are depicted in fig. 3.1. In Section 3.1, we will study the relationship between inputs and

Table 3.1 Production Function Labour (in hours) A B C D E F G H 0 1 2 3 4 5 6 7 Land (in acres) 0 2 4 6 8 10 12 14 Output (in units) 0 5 11 18 24 30 35 40

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11 units of output, and so on. It is normally assumed that inputs work to the best of their efficiency. Hence, instead of maximum output, we just say output, e.g., 2 hours of labour combined with 4 acres of land produce 11 units of output.2 Note that the notion of production function is not just confined to two inputs. There can be other inputs like capital, raw material etc.3 3.1.2 Returns to an Input A production function given in the tabular form such as in Table 3.1 does not reveal much about the contribution of a single factor towards production. A reasonable way to assess this will be to vary the employment of one input while keeping the employment of other inputs fixed. Three concepts arise in this experiment. One is total product or total physical product, denoted by TPP. It simply defines the total output at a particular level of employment of an input when the employment of all other inputs is unchanged. The next one is marginal product or marginal physical product (MPP). This is defined as the increase in the total physical product per unit increase in the employment of an input when the employment of other inputs is given.4 When the employment of an input changes, we call it a variable input.

Finally, we define Average Product or Average Physical Product (APP) as the TPP per unit employment of the variable input, i.e., APP = TPP/L, where L is the level of employment of the variable input. These are also respectively called total, marginal and average returns to an input. A numerical example showing a TPP schedule is given in Table 3.2, where the variable input, L, is called labour. If we graph a TPP schedule, we get a total physical product curve. Table 3.2 A Total Physical Product Schedule Labour Hours employed (L) 0 1 2 3 4 5 6 7 8 9 Total Physical Product (TPP) 0 10 22 33 43 51 56 56 48 36

2 3 4

Table 3.1 gives only some, not all, possible combinations of inputs and output. Also, we can differentiate between unskilled labour and skilled labour. These are respectively similar to the concepts of total utility and marginal utility discussed in Chapter 2.

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Fig. 3.2 shows the TPP curve for the TPP schedule given in Table 3.2.

Fig. 3.2 The Total Physical Product Curve Corresponding to Table 3.2

the MPP at L = 2, which is 12, is equal to the difference between TPP at L = 2, which is 22, and TPP at L = 1, which is 10. The MPP schedule corresponding to the TPP schedule in Table 3.2 is given in column (2) of Table 3.3. Likewise, the APP schedule, given in column (3) of Table 3.3, is obtained through dividing TPP by L in Table 3.2. The graphs of an MPP schedule and an APP schedule are respectively called the marginal physical product curve and the average physical product curve. These graphs corresponding to Table 3.3 are given respectively in figs. 3.3 and 3.4. Note the following : 1. It is not true that the concepts of TPP, MPP and APP are applicable to

The marginal physical product, MPP, is derived from the total physical product, TPP, just as marginal utility is obtained from total utility. For instance, Table 3.3

Marginal Physical and Average Physical Product Schedules Marginal Physical Product (MPP) 10 12 11 10 8 5 0 -8 -12 Average Physical Product (APP) 10 11 11 10.75 10.20 9.33 8 6 4

Labour Hours employed (L) 0 1 2 3 4 5 6 7 8 9

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one particular input (e.g. labour) and not to others (e.g. land or

Fig. 3.3

The Marginal Physical Product Curve Corresponding to Table 3.3

variable input increases. This relationship is verified from TPP and MPP schedules. In Table 3.2, TPP increases up to L = 6; from Table 3.3, we see that MPP is positive in this range. In Table 3.2, TPP decreases from L = 8 onwards; in Table 3.3, MPP is negative in this range. 4. Although we have derived MPP and APP from TPP above, in general, given any one of these, we can derive the other two. Suppose MPPs are given to us. Then we can get TPP by adding MPPs (as TPP is the sum of MPPs). Once we get TPP, we can readily obtain APP by applying its definition. Similarly, if the APPs are known, we get TPP by multiplying APP with the level of employment. Then MPPs are obtained by applying its definition. Law of Variable Proportions and Law of Diminishing Returns As we will see later in this chapter and in the next, the most important schedule (curve) from our viewpoint is the marginal physical product schedule (curve). We notice from fig. 3.3 that the MPP initially increases with an increase in the employment of the input in question, then it diminishes and finally it becomes negative. This pattern of MPP is called the Law of Variable Proportions. Put differently, this law outlines three stages of production. In stage I, when the level of an inputs employment is sufficiently low, its MPP increases. In stage II, it decreases but remains positive, and, finally, in stage

Fig. 3.4

The Average Physical Product Curve Corresponding to Table 3.3

equipment). It is applicable to all inputs, but one at a time. 2. Since MPPs are additions to the TPP, TPP is the sum of MPPs ( just as total utility is the sum of marginal utilities). For example, in Table 3.2, the TPP at L = 3 is equal to 33. In Table 3.3, the MPPs at L = 1, 2 and 3 add up to 33. 3. The MPPs being additions to the TPP also implies that if MPP is positive, TPP must be increasing and if MPP is negative, TPP must be decreasing as the level of the

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III, it becomes negative. In our example, stage I holds till L = 2, stage II is operative between L = 3 and L = 7, and, stage III sets in at L = 8. Note that in stages I and II, TPP increases with the employment of the variable input as MPP in this range is positive. But in stage III, it decreases since MPP is negative. Closely associated with this law is another important law, called the law of diminishing marginal product or the law of diminishing marginal returns (which is similar to the law of diminishing marginal utility). More briefly, it goes by the name of the law of diminishing returns. This says that, the employment of other inputs remaining the same, as more of a particular input is used in production, after a certain level, its marginal physical product decreases with further employment of it. Fig. 3.5 illustrates these laws more clearly. Suppose that the input can be measured continuously like points on a line, not just in integer units like 1, 2, 3 etc. Then the resulting TPP, MPP and APP curves will look smooth. A smooth MPP curve is drawn in fig. 3.5. We observe that the MPP increases between 0 to A. This region marks stage I. The MPP diminishes but remains positive between A to B, which marks stage II. From the point B onwards, it is the stage III, wherein the MPP is negative. Diminishing returns holds in stages II and III. The reason behind the law of variable proportions or the law of diminishing returns is fundamentally

the same. As the employment of a particular input gradually increases while all other inputs are kept unchanged, the factor proportions become initially more suitable for production, but, after a certain level, the variable factor can work with other given inputs only less efficiently, that is, factor proportions become increasingly unsuitable for production. The significance of these stages of production is that a profit-maximising firm will never operate in stage III. It is because, by entering stage III, a firm will have to incur higher costs on one hand (as it is hiring more of the input), and, at the same time, since output is falling, in the output market, it will get less revenues. This implies that profits will be less. It is not obvious at this point, but we will learn in Chapter 7 that a profit-

Fig. 3.5 Three Stages of Production and Diminishing Returns

maximising firm will not operate in stage I either. That leaves out only stage II, in which the marginal returns to an

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input is positive but diminishing. From the viewpoint of the operation of the firm, this is the most relevant stage. Finally, note that the law of diminishing returns implies that the MPP curve is inverse U-shaped. In turn, this implies that the APP curve is inverse U-shaped also. 3.1.3 Returns to Scale

Suppose that, instead of increasing one input at a time, you increase the employment of all inputs by the same proportion (e.g. by 20%). The effect of this change on output is captured by the notion of returns to scale. Of course, the output is going to increase. But by how much? Will it increase (a) by more than 20%, (b) by less than 20% or (c) exactly by 20%? The possibilities (a), (b) and (c) respectively illustrate increasing returns to scale, decreasing or diminishing returns to scale and constant returns to scale. In other words, suppose all inputs are increased by a given proportion. Increasing (respectively decreasing) returns to scale hold when output increases more (respectively less) than proportionately. Constant returns to scale hold when output increases exactly by the proportion in which inputs are increased. You should not make the mistake that the ter ms decreasing, diminishing or constant mean that the output decreases or remains5

constant: the output always increases when all inputs are increased.5 The production function outlined in Table 3.1 contains stages showing all three types of returns to scale. For example, from B to D there are increasing returns to scale. Why? In combination B, 1 unit of labour and 2 units of land produce 5 units of output. Compared to B, the combination C has double the amount of each input, but output (equal to 11) is more than double of the output at combination B. Similarly, from C to D, inputs increase by 50% but output increases by more than 50% (as 18 is more than 50% higher than 11). Likewise, you can calculate that, in the range from D to F, there are constant returns, and, finally from F onwards there are decreasing returns to scale. 3.2 COSTS We now move on to discuss some cost concepts. As fig. 3.1 suggests, cost concepts are very much related to concepts associated with the production function. This point will be clearer as we go along. 3.2.1 Short Run

Fixed and Variable Costs At a given point of time, a firm faces two types of costs: fixed costs and variable costs. Fixed costs are those that do not vary with the level of output. (These are also called overhead

This holds as long as the MPP of each factor is positive, i.e., the firm is not operating in stage III.

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costs.) For example, you operate a garment factory. You pay a fixed rent for the factory building, fixed insurance payments for your machinery against fire etc. These are independent of how many garments per month you produce. There is a time element in interpreting these costs as fixed. That is, even if these costs are fixed at any given point of time or within a short time period, in a long run horizon, you can think of renting more or less space, having more or less number of machinery depending on your business outlook for the future. Hence the rent and insurance costs etc. that are fixed in the short run can vary in the long run. In other words, fixed costs are present only in the short run, not in the long run. Note that these notions of short run and long run do not refer to any particular calendar time. They refer only to different periods of planning horizon by producers in an industry. Hence, they can vary from one industry to another. Having noted this difference, we return to the short run situation. Besides fixed cost, there are variable costs those that change with the level of output, e.g., labour costs and costs of raw materials. If you want to produce more garments, you have to buy more cotton and other raw materials, hire more workers and so on. Variable costs increase with output. Instead of being termed simply fixed and variable cost, these are formally

called Total Fixed Cost (TFC) and Total Variable Cost (TVC). Total cost (TC) is then, by definition, total fixed costs + total variable costs. Table 3.4 presents a numerical example. Notice that TFC, given in column (2), do not change with output. But TVC, given in column (3), does. The columns (2) and (3) against column (1) are respectively total fixed cost and total variable cost schedules. Graphs of these schedules are the total fixed cost curve and the total variable cost curve respectively. Figure 3.6 depicts these, together with the tot

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