Why i am paying more

He explained that it is not the total utility but the additional utility derived from the consumption of the last unit marginal utility that matters.. CHAPTER 2COST CONCEPTS AND MARKET S

Why I am Paying More

Dear Reader,

Satish Deodhar’s second book in the IIMA Business Books series, published

in collaboration with Random House, is informative and stimulating

The book begins with a clear discussion of basic microeconomic concepts,such as utility, cost, supply and demand curve, price determination, producerand customer surplus, and dead weight loss Satish next moves to a crispexposition of various forms of market competition—perfect competition,monopoly, monopolistic competition, and oligopoly He highlights variousmechanisms that producers might use to extract consumer surplus andprovides a lucid exposition of game theory, made all the clearer withexamples such as ‘Phoolan Devi and Veerappan facing prisoners’ dilemma’.The book proceeds to a description of various forms of market failure and therole of regulation in addressing them The last chapter provides retrospectionthrough the topics covered and ends with an intriguing crossword At the end

of each chapter, references afford interested readers the opportunity toexplore topics in further depth, and ready reckoners provide descriptions ofkey terms

In a deceptively simple manner, the book offers practitioners a thoroughand in-depth perspective on a broad swathe of microeconomics topics.Throughout, Satish explains these concepts in a straightforward manner,clarified with the help of simple and intuitive charts and peppered with richinstances from business and daily life

Why I am Paying More is one of a series of books authored by IIMA

professors who are not only academically proficient but also have richexperience in consulting and teaching executives These books are intended

to disseminate knowledge in relevant topics in management to practicingexecutives Written in conversational style with illustrations from the world

of practice, the books are eminently readable and applicable in daily life

I am confident you will enjoy Why I am Paying More, as you will other

books in the series Please do let us know if there are particular topics thatyou would like covered in the books published in this series

Ashish Nanda

Director

IIM Ahmedabad

Also by Satish Y Deodhar

Day to Day Economics

SATISH Y DEODHAR

Published by Random House India in 2013 Copyright © Satish Y Deodhar 2013

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EPUB ISBN 9788184005110

To Deepali, partner-in-life I met a score years ago

and

to Sylee (17) and Yash (13),

the most formidable domestic teen cartel!

Preface

Acknowledgements

0 Introduction

1 Utility and Market Demand

2 Cost Concepts and Market Supply

3 Societal Welfare, Free Enterprise, and Market Price

4 Price Ceiling, Price Floor, and the New Support Paradigm

A Note on the Author

A Note on the IIMA Business Books

This book may be considered as a sequel to my first book, Day to Day

Economics When Day to Day Economics was published, I was quite

apprehensive about the acceptance of the book by readers However, therewas a pleasant surprise in (book) store! Readers were very kind to me andthey turned out to be quite an extrovert lot They would send sporadic emails

or post reviews on blogs and online bookstores expressing their liking for thebook Students and participants from various management programmes atIIMA also complimented me for making economics accessible and relevant.While this was a humbling experience for me, readers discerningly pointedout that the book had focussed mostly on macroeconomic issues

It was suggested that I should also write a similar book on microeconomicissues—issues which would describe why in most cases economists vouchfor free enterprise system, how prices are set in different market structures,and what are the circumstances that justify government’s role in freeenterprise system These suggestions sounded almost like the Sanskrit

aphorism, Atha to Brahma Jidnyasa—an inquisitiveness to know the ultimate

reality! Writing a textbook on microeconomics would not have served thepurpose, for the market for textbooks has already become overcrowded Thechallenging task was to write a book that will appeal to the intuition of non-economists and non-academicians Hence this modest effort—a sequel to

Day to Day Economics.

This book being a sequel to my earlier book in the IIMA Business BookSeries, I must admit my continuing debt to my family members As in thepast, they endured an inescapable distraction from the comforts of a family of

four I also wish to thank many readers of Day to Day Economics who

suggested to me to write a book on economic issues relating tomicroeconomics When I was half way through this book, Random Houseand Penguin came together to form a new entity, Penguin Random House Ofcourse, while the publication of this book is being concluded under thebanner of Random House, I could now cite a live example of businessmergers in the chapter on Oligopoly If Penguin Random House has retainedthe maiden name of Random House, Radhika and Milee have continued topractice business culture of their sanguine Random House! Thanks to both ofthem for stoically yielding to somewhat moving deadlines

The book you are about to read was not penned by me alone, for I havebeen greatly influenced by my economics teachers as also by my colleagues

at IIMA I have been fortunate to assimilate information from diverse sourcessuch as academic journals, textbooks, newspapers, government documentsand the internet Unabashedly, I have relied on all of them to help me connectthe dots and further our understanding of pricing and market structures And,

of course, in the absence of the proofreaders, designers, and reviewers fromRandom House, the book could not have seen the light of the day I wish tothank them all

CHAPTER 0

INTRODUCTION

‘The basic problems of economics are simple; the hard part is to recognize simplicity when you see it The next hardest part is to present simplicity as common sense rather than ivory tower insensitivity Theory needs to teach more

of both.’

—HARRY G JOHNSON

Ever since independence, the prime ministers have been addressing the nationfrom the ramparts of the Red Fort every 15th August Perhaps with theexception of the euphoria of a few initial years, most people give the speech amiss every year Closer home, amongst our acquaintances, most of us doencounter a few persons who have a habit of talking quite a lot Our usualresponse is to either avoid such persons or reluctantly endure their presence.The purport of this is that such talk gets perceived as being ‘cheap’ becauseits supply seems to exceed demand Of course, there is no rupee priceattached to that talk, for it is a non-market activity However, the intuition weapply in such a deduction is no different than the one usually employed in themarketplace

Consider a somewhat similar situation in the marketplace A worriedclient who meets up with his lawyer for consultation behaves differently Theclient listens to the lawyer with rapt attention and knows that he has to paythe fees, perhaps handsome amount of rupees per hour The lawyer’s talk isnot free The lawyer offers a service in the market which may or may not becheap but there is a positive rupee price attached to it Like the lawyer’s

service, practically zillions of goods and services—from abacus and apples tozucchini and zyloscope—are produced, traded, and consumed in the market.And, each one has a positive price attached to it at any given point in time.What is the process through which this price discovery occurs? Are the pricesunilaterally decided by individual firms? Do households have any say insetting the prices? These are some of the questions one would like to getanswers to In fact, come to think of it, it is almost a mystery as to howcustomers choose from among zillions of products available in the market.Given their preferences for various products, household income, and theprices prevailing in the market, some activity must be taking place in theminds of the customers that guides them to make particular consumptionchoices It will be worth fathoming what goes on in the minds of customers.Price determination gets much more interesting depending upon differentmarket structures Why is it that saree emporiums and apparel shops offerheavy discounts on a few occasions during the year? Why is it that airlinetickets booked well in advance are always cheaper? Why is it that manyamusement parks and fairs in town and cities charge an entry fee at the gateand once again charge separate tickets for different rides inside? And then, ofcourse, there are many prices such as electricity tariffs and minimum wagesthat are fixed by government intervention Are such price interventions bygovernment justified and on what grounds? Such and many similar economicissues are quite relevant to customers and producers alike It is for this reasonthat one of the most influential economists of the late nineteenth and earlytwentieth century, Alfred Marshall, described economics as ‘the study of

mankind in the ordinary business of life.’ He published his book, Principles

of Economics way back in 1890, and it went on to become a standard

textbook for generations of economics students Today, of course, thetextbook market is getting increasingly overcrowded for economics ingeneral and for ‘principles of economics’ in particular As will be discussed

in this book later, the market for economics textbooks can be characterized as

a monopolistically competitive market!

Most economists seem to believe in the doctrine of free enterprise orcapitalism It does not come as a surprise when the best advocates of freeenterprise, economists such as Milton Friedman say, ‘Many people want thegovernment to protect the consumer A much more urgent problem is to

protect the consumer from the government.’ However, even John MaynardKeynes, the father of modern macroeconomics, who believed in governmentintervention to promote employment during the times of recession, seemed to

be sympathetic to free enterprise and capitalism He is alleged to have said,

‘Capitalism is the astounding belief that the most wickedest of men will dothe most wickedest of things for the greatest good of everyone.’ If economistsswear by free enterprise so much, there must be a way to explain to alayperson as to why this is so And yet, you bet there are some weak links inthe free enterprise system where government intervention is required

The issues raised above form the subject matter of what is calledmicroeconomics As an informed citizen of the modern world, one mustknow the basic ideas behind the issues that have been raised above Ofcourse, it is difficult to explain the laws of nature or their applications, eitherfrom physics or economics, purely from the standpoint of a theoretician orpurely from the standpoint of a practitioner Isaac Newton’s challenge toexplain laws of motion to a snooker world champion is no harder than theworld champion’s challenge to turn Newton into an international snookerplayer! One has to find a middle ground There is a vacuum of understandingthat needs to be filled with a book that presents principles of microeconomics

to laypersons by relating them to their day to day activities, experiences,lifestyles, anecdotes, and their understanding of history, culture, andgeography This book hopes to serve that purpose

You will agree with me that we all have been students at some point intime or another In fact, in today’s modern world we just never seize to beone The materialistic world around us is such that a student of any discipline,even a casual student of life, cannot become market worthy unless sheunderstands at least a few concepts in economics This is all the more true forsomeone who opts for a bachelor’s or a master’s programme in businessmanagement and economics If you want to understand marketing conceptssuch as price sensitivity or market segmentation, rest assured these conceptsare based on the idea of price elasticity of demand which originated ineconomics literature You may want to understand finance concepts such asmovement of stock prices and rate of returns and they were originally thoughtthrough in economics literature While learning linear programming in thedecision science courses, you will come across the term shadow prices It is

based on the economic concept of scarcity of resources and its value Theliterature on wage negotiations in human resource management gets related toeconomic concepts such as efficiency wages and bilateral monopoly Theconcept of Prisoners’ Dilemma and its economic extensions are a masterpiece

in strategic signalling and communication And, of course, a student ofinternational business has to have a sound understanding of trade theoriespropounded by economists This book cannot touch upon all these claims indetail However, you will certainly get a hint or a dash of a few in thefollowing pages

With the above objectives in mind, Chapters 1 and 2 cover twofundamental building blocks of economics—market demand curve and themarket supply curve, respectively Chapter 3 integrates the demand andsupply tools developed in the earlier chapters to demonstrate how price getsdetermined in free markets This chapter also provides the basis for the beliefthat free enterprise maximizes societal welfare Quite a few governmentinterventions, price ceilings or price floors in particular, seem to be welfarereducing Chapter 4 discusses such interventions in comparison to theiroutcomes in a free enterprise system Having understood the working ofmarkets in aggregate terms, chapters that follow address the pricing decisions

by individual firms in perfectly competitive markets followed by pricing inimperfectly competitive market conditions Specifically, on a full spectrum ofmarket structures, Chapter 5 deals with one end of the spectrum described asperfect competition and Chapter 6 deals with another end of the spectrumcalled monopoly Chapter 7 further devotes to pricing schemes that arepossible when firms have a certain degree of monopoly power where marketsare segmented

Between perfect competition and monopoly, there are two importantmarket structures—monopolistic competition and oligopoly These arecovered in detail in Chapters 8 and 9, respectively In Chapter 10,circumstances which necessitate a role for government intervention to takecare of various market failures of a free enterprise system are discussed.Finally, the book is concluded in Chapter 11 by taking a retrospective view ofwhat has been presented in the earlier chapters By the end of the book, Ihope to have achieved in part, what economist Harry Johnson had opined andwhich I have quoted at the beginning of this chapter To this end, I have

appended a crossword puzzle to the last chapter The crossword puzzle mayserve two purposes—it can be viewed as an unobtrusive self-accreditation bythe reader and a litmus test of whether or not I have succeeded, at leastpartially, in addressing the concern Harry Johnson had expressed in 1974 inthe foremost journal in economics—American Economic Review.

REFERENCES:

Johnson, H., (1974), ‘The State of Theory’, American Economic Review, Vol.

64, No 2, Papers and Proceedings of the Eighty-sixth Annual Meeting ofthe American Economic Association, May, pp 323–324

Marshall, A., (1890), Principles of Economics, London: McMillan and

Company Ltd., republished in 1920, 8th edition

READY RECKONER

Microeconomics: Study of economic behaviour of agents such as households

and firms and determination of prices and outputs in product and inputmarkets

Macroeconomics: Study of behaviour of aggregate variables in an economy

such as national income, unemployment, interest rates, and inflation

Free Enterprise: An economic system with (mostly) private ownership of

factors of production and their rewards, where economic activities aregoverned by market forces of demand and supply It is synonymous with theterm Capitalism

Capitalism: See Free Enterprise.

CHAPTER 1

UTILITY AND MARKET DEMAND

‘What makes my approach special is that I do different things I do jazz, blues, country music and so forth I do them all, like a good utility man.’

—RAY CHARLES

THE MARGINAL UTILITY

I bet you have attended quite a few parties and some were more memorablethan others Usually one enjoys going to parties because it feels good This

‘feel good’ objective has been defined in many different ways One could call

it satisfaction, welfare, benefit, or as economists would put it, utility It would

be safe to assume that one would like to maximize his or her utility whileattending the party How does one maximize this utility? Well, resembling apiece of furniture at the party does not help Assuming that one is in thecompany of interesting people, one’s utility would depend on a few importantfeatures at the party—conversation, cuisine, cocktail, and cavort If you haveonly a few hours at your disposal, a choice has to be made as to how muchtime you can spend on each of these features or activities Of course, it wouldall depend on an individual’s preference Some may want to spendsubstantive time conversing with others, some may spend a good amount oftime savouring food, some others may prefer to hang around the bar, and stillsome others would prefer to do a lot more of dancing and cavort

Whatever the individual choices, it must be true that the final minute spent

on each of the activities must be giving same additional utility (called

marginal utility) to the party goer For, if that was not so, total utility couldhave been maximized by switching a minute from one activity to the other Ifthe marginal utility derived from spending an additional minute onconversation was always higher than the marginal utility derived fromspending an additional minute on other activities, then one would only talk atthe parties Similarly, if the marginal utility of an additional minute spent atthe bar was always higher th an an additional minute spent elsewhere, onewould only have cocktails and nothing else! The fact that most choose toengage in quite a few activities shows that marginal utility of engaging in anyone activity must be declining as one does more of that activity If this wasnot so, there would have been specialization in the choice of activity Onewould either only talk or hog or cavort or drink to no end, depending uponwhich activity gave higher marginal utility per unit of time spent For analcoholic, it must be true, therefore, that the marginal utility of drinking iseither very high, does not decline with every glass, or worse, increases withevery gulp Therefore, alcoholics maximize their utility by specializing inconsumption—that of liquor alone! Thankfully, these are aberrations and notthe norm in human behaviour.

Of course, no one really sits down and calculates the marginal utilities ofdifferent activities Perhaps it simply goes against the spirit of spontaneitythat human beings demonstrate However, choices of utility maximizinglevels of each activity must be compared implicitly in one’s mind Workings

of a mind may be a black box but the mind must be making implicitcalculations taking into account the fact that there is limited time available tospare, there are a few activities available at the party that one can engage in,and that each of the activity is characterized by diminishing marginal utility.Perhaps this same idea is revealed by Ray Charles’s quote mentioned at thebeginning His satisfaction levels as a musician are highest when he engages

in different kinds of music styles The amount of time he spends on each typewould be decided implicitly in his mind where marginal utility derived perunit of time from each style of music becomes equal This is possible whenmarginal utility of engaging in each music style declines as he engages moreand more in each of the styles For, if this was not so, he would maximizesatisfaction by specializing in only one form of music which gave himhighest marginal utility per unit of time

Let us broaden this concept to product choices one makes in themarketplace Disposable income of a household is generally less than the sumtotal of the salaries of the earning members of a household, as they payincome tax Out of the disposable income, it is fair to assume that thehousehold saves some amount and the rest of the net income is available forspending on products (both goods and services) In the marketplace, from themorning alarm clock to the zero-watt night lamp—from A to Z—there areinnumerable products a household consumes every month How does thehousehold decide what to buy and how much to consume of each of theproducts? A household would like to maximize its satisfaction or utility giventhe constraint that net income per month is limited and that products available

in the marketplace have positive prices Of course, if net income was not aconstraint and/or unlimited quantity of products were available for free, thenthere would be no economic choice to be made Life would have beenuninteresting then Fortunately that is not the case and households have tomake choices Sure, like the party goers and Ray Charles, this will depend onthe individual preferences of the household However, it also depends uponthe all-important concept of diminishing marginal utility Given that the netincome available to spend on products is limited, products are positivelypriced, and marginal utility declines as a household consumes more and more

of a product, household utility is maximized when marginal utility per rupeespent on different products is equal

For the ease of exposition, consider that there are only two goods in themarketplace, A and Z The utility maximizing consumption levels of A and Zwill be determined by an implicit black-box calculation in one’s mind given

by the equation:

where MU(A) and MU(Z) represent the marginal utilities of products A and

Z and PA and PZ are their market prices What this equation tells us is thatwhen utility is maximized, a rupee spent on both products gives same level ofmarginal utility For, if it were not so, household could have increased totalutility by spending more on a product that gave higher marginal utility perrupee and spending less on the other product that gave lower marginal utility

per rupee The adjustment will continue until the equality is re-established.

The Water Diamond Paradox

The term Utility, for the satisfaction one receives on consumption of a product was

introduced by Jeremy Bentham in the late eighteenth century in England Around the same time, Adam Smith, considered the Father of Modern Economics, made a mention

in his treatise, The Wealth of Nations (1776), regarding use and

value-in-exchange for a given product He gave the famous example of the Water Diamond Paradox Diamonds have a high price, i.e., high value-in-exchange but they are unnecessary for life, i.e., low value-in-use And, conversely, water has a low price, i.e., low value-in-exchange but it is necessary for life, i.e., high value-in-use.

The economics profession had to wait till 1862 to explain this paradox That year, W.S Jevons read a paper to the British Association of the Advancement of Science introducing the concept of marginal utility He explained that it is not the total utility but the additional utility derived from the consumption of the last unit (marginal utility) that matters Essentially, it is the marginal utility that the household relates to product price, or what Adam Smith called, value-in-exchange Therefore, for someone who purchases both diamonds and water, the following must be true:

where MU(D) and MU(W) represent the marginal utilities of diamond and water and

PD and PW are the market prices of diamond and water While the total utility derived from the stock of water could be quite high compared to that from diamond, it is also true that relative to diamonds water is abundantly available Therefore, given that the marginal utilities decline with additional units of consumption, both the marginal utility and price of water are low compared to the marginal utility and price of diamonds However, when total utility derived by consuming both products is maximized, the ratio of the marginal utility to price should be same for both Moreover, there is also merit in the argument that one cannot really make interpersonal comparisons of preferences and utility That diamonds are unnecessary for life is a very subjective assessment After all, a beggar may not get two square meals a day but

he could still smoke!

Perhaps by now you would be wondering—just as weight is measured in, say kilogrammes, can utility also be measured in, say utils? Of course, the answer is a clear

‘no’ From the latter half of the nineteenth century onwards, Wilfredo Pareto and other economists argued that it is sufficient to rank utilities as higher or lower to make choices in the marketplace and one does not need to measure them cardinally An

elaborate explanation on this topic is beyond the scope of this book However, interested readers can always refer to a standard principles textbook on microeconomics (Mankiw, 2012).

THE DEMAND CURVE

The concept of diminishing marginal utility is important to understand thechoices consumers make in marketplace As explained in the box above, itdemystifies the famous Water Diamond Paradox of the marketplace Moreimportantly, the concept gives an intuitive explanation to the inverse relationbetween the price of a product and its quantity demanded Surely, at somepoint in time or another you must have formed an early opinion abouteconomics—that it is concerned with demand and supply? True, it is Andthis is when the demand curve comes into the picture

Let us continue to assume that there are only two products, apple (A) andzucchini (Z) in the marketplace Let the prices of apple and zucchini be PA =

Rs 50/kg and PZ = Rs 25/kg over a period of one month and the marginalutilities of the last kilogrammes of apple and zucchini purchased by arepresentative household during that month be 300 and 150 respectively.Given this information, the representative household must have maximizedits utility over the period since:

where the number 6 represents marginal utility per rupee spent on each of thetwo products Now suppose that the price of apple goes up to say Rs 75/kg inthe following month This would mean that MU(A)/PA = 300/75 = 4, which

is less than 6 A rupee spent on zucchini continues to give a marginal utility

of 6 per rupee and a rupee spent on apple now gives only 4 Therefore, totalutility can be maximized by reducing consumption of apples and increasingconsumption of zucchini The adjustment will continue until a rupee spentgives same level of marginal utility for both Because both products aresubject to diminishing marginal utility, increase in consumption of zucchiniwill lead to fall in its marginal utility and vice versa for apples The following

could be a possible outcome:

To cut the long story short, for a given level of net income, as price ofapple goes up, consumption of apple goes down And we now know how—asprice of apple goes up, the per rupee marginal utility of apple goes down andhence the household switches to more consumption of zucchini and less ofapple to make maximum use of its limited income This relation betweenprice and quantity demanded of a product is summarized by the Law of

Demand—ceteris paribus, i.e., other things remaining the same, as the price

of a product goes up the quantity demanded falls There is an inverse relationbetween the two This is depicted for a representative household in Fig 1below where rupee price per kilogramme of apple is measured on the verticalaxis and quantity on the horizontal axis In Fig 1 (a), the line segment ‘dd’shows the downward sloping individual household demand curve for apple

As the price of apple goes up from Rs 50/kg to Rs 75/kg the quantitydemanded falls, say from qA50 to qA75 The quantity qA could be measured in,say kilogrammes

Of course, we only considered a representative household Preferencesvary among different households and their individual demand curves will bedifferent Some will be willing to pay much higher prices and some otherswill buy too many apples at very low prices compared to many others.However, all such demand curves will be downward sloping If we were toadd such individual demand curves for all households, we get an aggregatedemand curve for apples In fact, as price goes down, not only would existingcustomers buy more apples but more customers would enter the market tobuy apples A representative market demand curve is depicted in Fig 1(b) bythe line segment ‘DD’ which shows the total quantity of apples demanded(QA) in the market at each price level We deliberately denote the quantity ofapples for market demand as QA implying that QA quantity is much largerthan the quantity qA demanded by an individual household The quantity QAcould be measured say in quintals or tonnes For simplicity of exposition wehave assumed the demand curves to be straight lines They need not be

Fig 1: Household and Market Demand for Apples

So far we have constructed the story of the process of utility maximization

by customers and its manifestation in the marketplace through the householddemand curve and the market demand curve However, demand is only oneside of the market economy The supply story forms the other side In thenext chapter, we move to building the foundation of that story

REFERENCES:

Jevons, W.S., (1871), The Theory of Political Economy, London: Macmillan

and Co, http://www.econlib.org/library/YPDBooks/Jevons/jvnPE0.html,Accessed on 31 March, 2013

Mankiw, N.G., (2012), Principles of Microeconomics, 6th edition, Delhi:Cengage Learning

Smith, A., (1776), An Inquiry into the Nature and Causes of the Wealth of

Nations, Oxford World’s Classics, New York: Oxford University Press,

Reissued in 2008

READY RECKONER

Demand Curve: A downward sloping graphical representation of the law of

demand

Marginal Utility: Additional utility derived by consuming one more (or the

last) unit of a product

Law of Demand: Ceteris paribus, i.e., other things (like income) remaining

the same, quantity demanded of a product increases as its price goes down

Total Utility: Satisfaction derived by consuming a certain number of units of

a product

CHAPTER 2

COST CONCEPTS AND MARKET SUPPLY

‘We’re not saying that you don’t need coal, but when you do mine (more) coal…

it may cost a little more, but it is the right thing to do.’

DIMINISHING MARGINAL PRODUCT

If customers demand products in the marketplace, someone has tomanufacture and sell them Firms, guided by profit motive, offer suchproducts in the marketplace, and, of course, for a price To manufacture theproduct, firms arrange to bring together factors of production For example,consider a firm in the textile industry Textile production is a very complexprocess Be it a handloom or a power loom, an entrepreneur has to procureand combine raw material, labour, land, building, and capital with hisentrepreneurial skills The raw material could be the cotton and the dyes,labour would be mostly unskilled and some skilled workers, the piece of landand the building could be either owned by the firm or rented out, and capitalwould mainly consist of the textile machinery

As per the market conditions and the consequent choices the entrepreneurmakes, the textile firm could vary its level of production While theentrepreneur could hold a dynamic vision to expand and scale up production,

he can do so only in the long run, where he has sufficient flexibility and time

to purchase additional land, buildings, and machinery However, decisions tochange production in the short run do not involve purchases of any of these

assets The only factors of production that a firm can vary in the short termare possibly the raw material, unskilled workers, water, and electricity Morecotton bales and dyes could be purchased at a short notice, more unskilledworkers can be hired as temporary workers at a short notice, and, of course,assuming that there are no shortages of water and electricity, as more andmore textile is produced, more water and electricity would be consumed.The above distinction between the factors of production in relation to theirpossible variability in a given time period is used by economists to defineshort run and long run A short run is defined as a period where at least onefactor of production cannot be varied and long run is defined as a periodwhere all factors of production can be varied A short run production functionfor a firm can be summarized by an equation such as:

where Y represents the production of textiles, the fixed amounts of capital,i.e., land, building, and machinery and L represents the variable factors such

as labour and raw material Of course, given a fixed amount of capital, asmore and more of L is used, output of textile will increase However, in asymmetric argument that we made about utility, i.e., that the marginal utilitydecreases as consumption of a product rises, the marginal product of L, i.e.the additional textile produced as a result of additional use of L keepsdecreasing as more and more units of L are used in the production process.This phenomenon is captured by an equation such as:

where ΔY/ΔL represents marginal product of labour, MP(L), i.e., increase(change) in output of textile as a result of one unit increase (change) in thefactor of production L MP(L) is to be understood as marginal product oflabour on the production side just as what we understood of MU(A) as themarginal utility of apples on the consumption side

Why would MP(L) decrease as more and more units of L are used in theproduction process? As mentioned earlier, in the short run, capital items such

as land, building, and machinery remain fixed Production of textile can beincreased only by using more of variable factors However, as one starts

using more material and labour for a fixed amount of capital, increasinglythere is crowding of variable factors on the production premises Everyadditional unit of a variable factor cannot be used as efficiently as theprevious unit For example, as more and more unskilled labour is employed

to increase production, there will be overcrowding on the shop floor,coordination problems among the workers will go up, material wastage mayincrease as there is no good provision to store and arrange for increasedstock, and intense use of the same machinery may lead to higher frequency ofbreakdowns In short, there will be overload of variable factors on the fixedfactors leading to each additional unit of L contributing lower and loweramounts to production of textiles

Let us also not forget that an important factor of production,entrepreneurship, is also a fixed factor One may arrange to procure rawmaterial, unskilled labour, and some managerial personnel in the short run;however, it is very difficult to replicate the business acumen and talent of anentrepreneur To meet increased demand, and, therefore, increasedproduction, an entrepreneur too gets overworked—he has to attend moremeetings, more phone calls, and work more intensively There are limits tohow an entrepreneur can increase efficiency in work in the face of increasedproduction requirement Increased use of raw material and unskilled labourmay increase output, however, fixity of entrepreneurial skill would lead tolower and lower marginal product of labour

INCREASING MARGINAL COST

Just as increasing the use of variable factors L increases total output oftextile; it is also obvious that increasing use of variable factors wouldincrease total cost of production And then, a logical question to ask would be

—in the short run, if the marginal product of labour MP(L) decreases as moreand more labour is used in production, would there be, similarly, increasingmarginal cost of production as more and more output is produced? Let usaddress this issue by delving further into the nature of cost of production for afirm

The textile firm that we have been talking about would incur cost toproduce textile Among other things, it will have to buy cotton bales and dyes

for a price, give wages to workers, and pay water cess and power tariff to themunicipal corporation and state electricity board All the costs mentionedabove refer to the variable factors of production, and therefore, we will callthem variable cost (VC), i.e., these costs vary with the level of output Inaddition, the firm has to pay for rent for the land or building, pay interest onthe funds borrowed to purchase the textile machinery, and also pay for thesalaries of permanent employees All these expenses are incurred on fixedfactors which do not vary with the level of output That is, irrespective of thelevel of output these expenses have to be incurred In this sense we call thesecosts fixed cost (FC) Therefore the total cost (TC) of production is:

TC = FC + VC

For simplicity of exposition, let us assume that fixed cost consists of rentand/or interest (r) paid for the fixed assets ( ) and the variable cost consists

of wages (w) paid to workers (L) Therefore, the total cost can now be written

as r times plus w times L:

If there is increase in demand and the firm wants to increase textileproduction in the short run, it will not lead to any change in the fixed cost ofproduction; however, variable cost would certainly increase If ΔY, ΔTC,ΔFC, and ΔVC represent changes in output, total cost, fixed cost, andvariable cost respectively, then marginal cost (MC), i.e., change in total costdue to increase (change) in output by one more unit, can be summarized bythe equation:

However, our analysis is simplified a bit, for we know that fixed costs do notchange in the short run, i.e., ΔFC = 0 Hence, the above equation is reducedto:

Moreover, change in variable cost is due to change in the employment of L,i.e., ΔL Hence, ΔVC is same as Δ(w*L) Further, for a given fixed wage rate( ) in the short run, therefore, Δ( *L) = *(ΔL) Thus, marginal cost turnsout to be:

Ah, but as described in the earlier section, ΔY/ΔL is nothing but MP(L), and,therefore:

The above equation says a lot about the nature of marginal cost! If theoutput is to be increased in the short run, one has to employ more variablefactors such as say unskilled labour And, as discussed in the earlier section,

as one hires more labour, the marginal product of additional labour, MP(L)keeps decreasing Given that the additional worker contributes lower andlower amount of output but he has to be paid the same fixed market wage, ,this means that marginal cost (MC), or the cost of producing an additionalunit of output, /MP(L) keeps going up Thus, marginal cost (MC) is directlyrelated to level of output in the short run As output increases in the short run

so does marginal cost (MC) Everyone would agree that more coal miningwould involve more cost, however, as quoted at the beginning of this chapter,what Kevin Richardson, the pop singer and environmentalist, was hinting atwas that additional coal mining comes at higher and higher additional cost—i.e., higher marginal cost

Café TANSTAAFL!

If you visit the heritage campus of the Indian Institute of Management Ahmedabad (IIMA), you just may end up sipping a cup of coffee at the Café TANSTAAFL The

weird sounding acronym was used by Robert Heinlein in his 1966 sci-finovel, The

Moon is a Harsh Mistress The story goes that loonies, the residents of the Moon are

revolting against their colonizers from Earth Mannie, a computer geek and protagonist who helps loonies in the uprising exclaims at one stage, ‘There Ain’t No Such Thing

as a Free Lunch’, TANSTAAFL In 1975 the term was also used as a title of a book by Milton Friedman, the recipient of the Nobel Memorial Prize in Economics.

The term originated in nineteenth century America, where pubs would offer free lunches to customers once they bought a drink The lunch consisted of salty meats and pretzels which would make customers buy and guzzle more drinks Thus, the ‘free lunch’ was not really free! Essentially, the term invokes the concept of opportunity cost That is, whatever one does at a given point in time, she misses out the opportunity

to do the next best thing she could have done In our textile firm example, rent paid for land or building is a fixed cost and will result in out of pocket expenses But what if the textile firm owns the land and building? In that case it does not make any out of pocket expenses and it will appear that the firm does not incur this fixed cost However, one must remember that the next best thing the firm could have done was to give the land or building on rent Thus, rent foregone is the opportunity cost of using the assets for textile production Firm must take into account this implicit expense in total cost Similarly, firms generally own the machinery they use in the production process Because of asset specificity, the firms may not necessarily earn good rent if they were to give machinery on rent However, the owner’s funds or the borrowed funds used to buy the machinery have the opportunity cost in terms of interest foregone or paid and get considered as expense in the total cost.

Stretching the idea further, an entrepreneur will stay in a business, say in textile manufacturing, provided she gets a remuneration which is at least as high as what she would have got elsewhere as a manager Therefore, the amount required to keep the entrepreneur in the business is a cost item in the total cost of production and represents the opportunity cost of the entrepreneur The remuneration required to keep the entrepreneur in the business in termed as normal profit Of course, the firm may earn revenue which is higher than the total cost In that case, the entrepreneur is considered

to be making supernormal profits or economic profits The profit over and above the normal profit is the reward for entrepreneurial skills and risk taking When an airline like Kingfisher does not make economic profits, the charitable way to describe the payments made to its CEO is—a salary for his or her managerial tasks, a cost item for the firm Of course, a less charitable view expressed by the famous economist and former US ambassador to India, John K Galbraith is, ‘The salary of the chief executive of a large corporation is not a market award for achievement It is frequently

in the nature of a warm personal gesture by the individual to himself.’

The name Café TANSTAAFL is a reminder, Caveat Emptor, that the time spent by

students at the cafe, that too perhaps at ungodly hours, is not free A friend may offer you a snack at the cafe and make you crack a case study for him or her—but beware, you are missing out either on much needed rest or your own preparation There is an opportunity cost of spending time at Café TANSTAAFL!

THE SUPPLY CURVE

The concepts of diminishing marginal product of labour and the increasingmarginal cost are crucial in understanding the nature of quantity supplied of aproduct in the market in relation to its price.1 If there is more demand fortextiles in the market, and if the additional cost of producing and supplyingthe additional units of textile keeps increasing, the entrepreneur would like tosupply the textiles only at a higher price Therefore, marginal cost representsthe minimum price the entrepreneur would require if he were to supply anadditional quantity of textile in the market If the marginal cost rises as thequantity supplied increases, the entrepreneur would supply the additionalunits only at a higher price Putting it differently, only if the price of textileincreases would an entrepreneur be willing to supply additional units oftextile in the market This positive relationship between price and quantitysupplied is christened as the Law of Supply—ceteris paribus, i.e., other thingsremaining the same, quantity supplied of a product will increase if the price

of the product increases

To summarize, therefore, a firm’s short run supply curve for a product isits marginal cost curve—an upward sloping curve in the price-quantity space

It represents the direct relation between price and quantity supplied by a firm.This is depicted in Fig 2 later where price of textile (PT) is measured on thevertical axis and the quantity supplied (qT, QT) on the horizontal axis Fig 2(a) shows that if a firm supplied qT1 quantity of textiles at the price PT1,higher quantities of textiles such as qT2 would be supplied only if a minimumprice of PT2 is offered Therefore, the line segment represented by ‘s’ is afirm’s supply curve

Of course, so far we considered only a representative firm’s supply curve.There are many firms in the market which would supply textiles tocustomers Different firms may have similar or somewhat different marginalcost of production depending on how efficiently those firms combine theiravailable factors of production Some firms will be willing to supply a givenquantity at a lower cost, and therefore at a lower price, compared to someother firms However, all the firms will have an upward sloping marginal costcurve, and therefore, an upward sloping supply curve If we were to add suchindividual supply curves for all firms, we get an aggregate supply curve for

textile In fact, as price keeps rising, not only would existing firms sell moretextiles in the market but less efficient firms would also be able to cover theircosts now and they would also start supplying textile in the market Arepresentative market supply curve is depicted in Fig 2(b) which shows thetotal quantity of textiles supplied (QT) in the market at each price level Wedeliberately denote the quantity of textiles for market supply as QT implyingthat QT quantity is much larger than the quantity ‘qT’ supplied by anindividual firm The line segment represented by ‘S’ is the market supplycurve For simplicity of exposition we have assumed the supply curves to bestraight lines They need not be.

We have just concluded the understanding of the basic building blocks ofeconomics Namely, we discussed the individual and market demand curvefor a product in Chapter 1 and the firm and market supply curve for a product

in the present chapter With these tools at our disposal we would now be able

to fathom two fundamental propositions in economics—i.e., one does notneed any intervention (say by the government) to set product prices, for theproverbial ‘invisible hand’ decides prices in the market, and that freeenterprise system and competition lead to welfare maximizing outcome forthe society We take up these fundamental propositions in the next chapter

Of course, while these propositions hold good for a significantly largenumber of markets, they may fail in some others We will also address suchmarket failures but at a later stage in this book

Fig 2: Firm and Market Supply Curve for Textile

Heinlein, R., (1966), The Moon is a Harsh Mistress, New York: G.P.

Putnam’s Sons

Friedman, M., (1975), There’s No Such Thing as a Free Lunch, Chicago:

Open Court Publishing Company

Maddala, G and Miller, E., (1989), Microeconomics, Theory and

Applications, international edition, Singapore: McGraw_Hill Book Co.

1 The above description is good enough to support stylized fact about the upward sloping market supply curve Due to better capacity utilization, however, MP(L) will rise and MC will fall for some initial units of labour and output, respectively See Maddala and Miller (1989) for a detailed discussion on production and cost functions We will revisit this aspect when we discuss a firm’s decision in a perfectly competitive market.

READY RECKONER

Fixed Cost: Cost of production that does not vary with the level of output.

Law of Supply: Ceteris paribus, i.e., other things (like technology)

remaining the same, quantity supplied of a product will increase as the price

of a product increases

Marginal Cost: Addition to the total cost as output increases by one more

unit

Marginal Product: Additional output derived by employing one more (or

the last) unit of a factor of production

Opportunity Cost: Reward or cost of a factor of production in its best

alternative use

Production Function: For a given product and technology, it is a physical

relation between the maximum output of a product for a given level of factors

—ADAM SMITH

MEASURING WELFARE IN A MARKET

Consumers’ Surplus

In Chapter 1 we understood the nature of the market demand for a product.Its graphic representation is a downward sloping curve in the quantity-priceaxes It represents a schedule of quantities of a product customers will buy atdifferent price levels in a given period The market demand curve, however,reveals much more than this It should be obvious to us that the success of anentrepreneur can be quantitatively measured The profit and loss account ofthe entrepreneur’s firm shows the profit made by the firm in rupee terms.However, as alluded in Chapter 1, it is difficult to quantitatively measure theutility, satisfaction, benefit, or the welfare that accrues to customers by way

of purchase and consumption of a product in the market While profits can be

cardinally measured in terms of rupees, the satisfaction derived by customers

is implicit, an intangible entity that remains with the customers—in theirmind and body, heart and soul! The market demand curve, however, ifviewed from a slightly different perspective, achieves a remarkable thing—itmeasures the total benefit that accrues to customers in a given market andthat too in rupee terms!

You may wonder as to how that is possible? Let us consider the demandfor apples we discussed in Chapter 1 Fig 3.1 shows the market demandcurve for apples—say demand for apples in India for the calendar year 2013

In panel (a) we show Rs 175 as the maximum price someone will be willing

to pay for the Xth unit of apple This maximum price is called the reservationprice of the customer However, as depicted in the diagram, let the actualmarket price of apples be Rs 75 per unit The fact that the actual expenditure

on the Xth unit of apples is Rs 75 but a customer was willing to pay Rs 175for it implies that there is an implicit net benefit of Rs 100 to that customer.The demand curve shows that the reservation price keeps falling as more andmore quantities of apple are demanded although the market price remainsfixed at Rs 75

In panel (b) of Fig 3.1 we see the total implicit net benefit to thecustomers in the apple market Since the reservation price for the Q75th unit ofapple is equal to the market price, each of the apple units consumed exceptthe Q75th unit earns some net benefit from consuming apples The sum total

of these implicit net benefits amounts to the area below the demand curve DDand above the horizontal price line of Rs 75 Economists call this implicit netbenefit as Consumers’ Surplus This consumers’ surplus, measured in rupeeterms is denoted by the shaded triangle area CS in Fig 3.1 (b) The totalexpenditure incurred on consumption of apples in this market is given by thearea of rectangle just below the triangle area CS By corollary, the totalbenefit (gross, not net) that accrues to customers is all the area under thedemand curve in the quantity interval of 0 to Q75 This equals addition of therectangle representing total expenditure and the consumers’ surplusrepresented by the triangle area CS

The idea of measuring the implicit net benefit to customers was

formalized by the economist Alfred Marshall in his book Principles of

Economics published in 1890 To paraphrase, he defined consumers’ surplus

as the extra amount over and above the market price, which one would havepotentially paid to consume a product rather than go without it However, theorigin of this concept dates back to as early as 1844 It is attributed to aFrench engineer Jules Dupuit who thought about willingness of customers topay for public works such as bridges and the worthiness of a subsidy for suchconstructions

Fig 3.1: Market Demand, Reservation Price, and Consumers’ Surplus

Producers’ Surplus

If we are able to capture the implicit net benefit, i.e., the consumers’ surplusthat accrues to customers in a product market, it would be also easier torecognize the concept of producers’ surplus in the same market Refer to Fig.3.2 (a) below Once again we assume that the market price of apples is Rs 75and Q75 units of apples get sold in the market during the calendar year 2013.Based on the discussion of supply curve in Chapter 2 and as shown in Fig.3.2 (a), the marginal cost of supplying Xth unit of apple is Rs 45 This is alsothe minimum price a producer will want to supply the Xth unit of apple This

is nothing but the producer’s reservation price for supplying the Xth unit The

difference between the market price of Rs 75 and the reservation price of Rs

45 for the Xth unit shows that the producer gets Rs 30 as the net benefit orsurplus over and above the marginal cost of supplying that unit The marginalcost keeps increasing as quantity supplied is increased and the last unit, the

Q75th unit, earns no net benefit or surplus over and above the marginal cost.Consider Fig 3.2 (b) now If we add up the surplus over all quantities ofapples produced and supplied, i.e., for Q75 units of apples, the total netbenefit to producers, i.e., the total producers’ surplus (PS) in the apple market

is denoted by the shaded triangle area PS The triangle area PS is nothing butthe area below the price line P = Rs 75 and above the supply curve over thequantity interval of 0 to Q75

Figure 3.2: Market Supply, Reservation Price and Producers’ Surplus

It is clear from the above discussion that given any market price for aproduct sold in the marketplace, both customers and producers seem to get anet benefit out of it Customers benefit over and above the expenditure theyincur on the product which we call consumers’ surplus And, producersbenefit over and above their marginal cost of producing and selling thosemany units which we call as producers’ surplus The sum total of theconsumers’ and producers’ surplus, therefore, would represent the societalwelfare generated due to the existence of the market for that product Now, atthis stage, however, three important questions arise for which we have to findanswers In the apple market example, we assumed the price to be Rs 75 per

unit How is this price decided in the market, when would the societal welfare

be maximized, and does government intervention in price determinationimprove societal welfare? We discuss answers to these questions below

FREE ENTERPRISE AND PRICE DETERMINATIONAdam Smith argued that in a free enterprise system, individuals specialize inmanufacturing only those products that they excel at They sell these productsand exchange the proceeds with others to buy other products The quotationgiven at the beginning of the chapter tells us that each one of us is guided bypromotion of self interest and inadvertently contributes to the promotion ofsocietal interest A cobbler and a tailor may be in a similar business usingsimilar tools and materials but they never make their own clothes and shoes,respectively! They specialize only in the production and sale of shoes andclothes, respectively And, in their capacity as customers, they buy all otherproducts from rest of the individuals One does not need a central planner or agovernment to decide what should be produced, for whom it should beproduced and how prices of the products are to be fixed The decisionshappen at a decentralized level through complex interactions of multitudes ofbuyers and sellers in the marketplace Smith attributed this conjuring act to

the invisible hand of the marketplace.

In the year 1817, economist David Ricardo went a step further than Smithand argued that individuals specialize in the production and sale of products

in which they have comparative advantage For example, assume thatHimachal Pradesh and Arunachal Pradesh both produce and consume applesand baby corn and that Himachal Pradesh has an absolute advantage inproducing both That is, productivity of both apples growing and baby corngrowing is higher in Himachal Pradesh as compared to in Arunachal Pradesh.However, in Himachal, if apple productivity is higher than that of baby corn,then Himachal Pradesh should specialize in growing apple and ArunachalPradesh should specialize in producing baby corn Such specialization inproduction and trade results in higher welfare as compared to no-tradesituation What is true at a national level is also true at the international level.Ricardo’s principle of comparative advantage finds its applicationprominently in foreign trade Essentially, Smith and Ricardo challenged theprotectionist policies of their predecessors, the mercantilists Of course, an