EEM Q/A Notes- LJIET
1.
OR
4.
By: - Dhruvi Bhatt
What are various forms of market and their characteristics?
OR
What is monopoly?
Differentiate between perfect competition and monopolistic competition(Dec2014,June-2015) [EEM] [LJIET]
Forms of Market Structure:
On the basis of competition, a market can be classified in the following ways:
1. Perfect Competition
2. Monopoly
3. Duopoly
4. Oligopoly
5. Monopolistic Competition
1. Perfect Competition Market:
A perfectly competitive market is one in which the number of buyers and sellers is very large, all
engaged in buying and selling a homogeneous product without any artificial restrictions and
possessing perfect knowledge of market at a time. In the words of A. Koutsoyiannis, “Perfect
competition is a market structure characterized by a complete absence of rivalry among the
individual firms.” According to R.G. Lipsey, “Perfect competition is a market structure in which all
firms in an industry are price- takers and in which there is freedom of entry into, and exit from,
industry.”
Characteristics of Perfect Competition:
The following are the conditions for the existence of perfect competition:
(1) Large Number of Buyers and Sellers:
The first condition is that the number of buyers and sellers must be so large that none of them
individually is in a position to influence the price and output of the industry as a whole. The
demand of individual buyer relative to the total demand is so small that he cannot influence the
price of the product by his individual action.
Similarly, the supply of an individual seller is so small a fraction of the total output that he cannot
influence the price of the product by his action alone. In other words, the individual seller is unable
to influence the price of the product by increasing or decreasing its supply.
Rather, he adjusts his supply to the price of the product. He is “output adjuster”. Thus no buyer or
seller can alter the price by his individual action. He has to accept the price for the product as fixed
for the whole industry. He is a “price taker”.
(2) Freedom of Entry or Exit of Firms:
The next condition is that the firms should be free to enter or leave the industry. It implies that
whenever the industry is earning excess profits, attracted by these profits some new firms enter the
industry. In case of loss being sustained by the industry, some firms leave it.
(3) Homogeneous Product:
Each firm produces and sells a homogeneous product so that no buyer has any preference for the
1
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
product of any individual seller over others. This is only possible if units of the same product
produced by different sellers are perfect substitutes. In other words, the cross elasticity of the
products of sellers is infinite.
No seller has an independent price policy. Commodities like salt, wheat, cotton and coal are
homogeneous in nature. He cannot raise the price of his product. If he does so, his customers would
leave him and buy the product from other sellers at the ruling lower price.
The above two conditions between themselves make the average revenue curve of the individual
seller or firm perfectly elastic, horizontal to the X-axis. It means that a firm can sell more or less at
the ruling market price but cannot influence the price as the product is homogeneous and the
number of sellers very large.
(4) Absence of Artificial Restrictions:
The next condition is that there is complete openness in buying and selling of goods. Sellers are
free to sell their goods to any buyers and the buyers are free to buy from any sellers. In other
words, there is no discrimination on the part of buyers or sellers.
Moreover, prices are liable to change freely in response to demand-supply conditions. There are no
efforts on the part of the producers, the government and other agencies to control the supply,
demand or price of the products. The movement of prices is unfettered.
(5) Profit Maximization Goal:
Every firm has only one goal of maximizing its profits.
(6) Perfect Mobility of Goods and Factors:
Another requirement of perfect competition is the perfect mobility of goods and factors between
industries. Goods are free to move to those places where they can fetch the highest price. Factors
can also move from a low-paid to a high-paid industry.
(7) Perfect Knowledge of Market Conditions:
This condition implies a close contact between buyers and sellers. Buyers and sellers possess
complete knowledge about the prices at which goods are being bought and sold, and of the prices at
which others are prepared to buy and sell. They have also perfect knowledge of the place where the
transactions are being carried on. Such perfect knowledge of market conditions forces the sellers to
sell their product at the prevailing market price and the buyers to buy at that price.
(8) Absence of Transport Costs:
Another condition is that there are no transport costs in carrying of product from one place to
another. This condition is essential for the existence of perfect competition which requires that a
commodity must have the same price everywhere at any time. If transport costs are added to the
price of the product, even a homogeneous commodity will have different prices depending upon
transport costs from the place of supply.
(9) Absence of Selling Costs:
Under perfect competition, the costs of advertising, sales-promotion, etc. do not arise because all
firms produce a homogeneous product.
2
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
2. Monopoly Market:
Monopoly is a market situation in which there is only one seller of a product with barriers to entry
of others. The product has no close substitutes. The cross elasticity of demand with every other
product is very low. This means that no other firms produce a similar product. According to D.
Salvatore, “Monopoly is the form of market organization in which there is a single firm selling a
commodity for which there are no close substitutes.” Thus the monopoly firm is itself an industry
and the monopolist faces the industry demand curve.
The demand curve for his product is, therefore, relatively stable and slopes downward to the right,
given the tastes, and incomes of his customers. It means that more of the product can be sold at a
lower price than at a higher price. He is a price-maker who can set the price to his maximum
advantage.
However, it does not mean that he can set both price and output. He can do either of the two things.
His price is determined by his demand curve, once he selects his output level. Or, once he sets the
price for his product, his output is determined by what consumers will take at that price. In any
situation, the ultimate aim of the monopolist is to have maximum profits.
Characteristics of Monopoly:
The main features of monopoly are as follows:
1. Only one seller: Under monopoly, there is one producer or seller of a particular product and
there is no difference between a firm and an industry. Under monopoly a firm itself is an industry.
2. Type of organization: A monopoly may be individual proprietorship or partnership or joint
stock company or a cooperative society or a government company.
3. No substitute: There is no close substitute of a monopolist’s product in the market. Hence,
under monopoly, the cross elasticity of demand for a monopoly product with some other good is
very low.
5. Restrictions to Entry and Exit: There are restrictions on the entry of other firms in the area of
monopoly product like government regulations, trademarks, patents etc.
6. Price Maker: A monopolist can influence the price of a product. He is a price-maker, not a
price-taker.
7. Unreal: Pure monopoly is not found in the real world.
8. Application of Demand curve: Monopolist’s demand curve slopes downwards to the right.
That is why, a monopolist can increase his sales only by decreasing the price of his product and
thereby maximize his profit. The marginal revenue curve of a monopolist is below the average
revenue curve and it falls faster than the average revenue curve. This is because a monopolist has
to cut down the price of his product to sell an additional unit. Monopolist cannot determine both
the price and quantity of a product simultaneously.
3
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
3. Oligopoly:
Oligopoly is a market situation in which there are a few firms selling homogeneous or differentiated products. It is difficult to pinpoint the number of firms in ‘competition among the few.’ With
only a few firms in the market, the action of one firm is likely to affect the others. An oligopoly
industry produces either a homogeneous product or heterogeneous products.
The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated
oligopoly. Pure oligopoly is found primarily among producers of such industrial products as
aluminum, cement, copper, steel, zinc, etc. Imperfect oligopoly is found among producers of such
consumer goods as automobiles, cigarettes, soaps and detergents, TVs, rubber tyres, refrigerators,
typewriters, etc.
Characteristics of Oligopoly:
In addition to fewness of sellers, most oligopolistic industries have several common
characteristics which are explained below:
(1) Interdependence:
There is recognised interdependence among the sellers in the oligopolistic market. Each oligopolist
firm knows that changes in its price, advertising, product characteristics, etc. may lead to countermoves by rivals. When the sellers are a few, each produces a considerable fraction of the total
output of the industry and can have a noticeable effect on market conditions.
He can reduce or increase the price for the whole oligopolist market by selling more quantity or
less and affect the profits of the other sellers. It implies that each seller is aware of the price-moves
of the other sellers and their impact on his profit and of the influence of his price-move on the
actions of rivals.
Thus there is complete interdependence among the sellers with regard to their price-output policies.
Each seller has direct and ascertainable influences upon every other seller in the industry. Thus,
every move by one seller leads to counter-moves by the others.
(2) Advertisement:
The main reason for this mutual interdependence in decision making is that one producer’s fortunes
are dependent on the policies and fortunes of the other producers in the industry. It is for this
reason that oligopolistic firms spend much on advertisement and customer services.
As pointed out by Prof. Baumol, “Under oligopoly advertising can become a life-and-death
matter.” For example, if all oligopolistic firms continue to spend a lot on advertising their products
and one seller does not match up with them he will find his customers gradually going in for his
rival’s product. If, on the other hand, one oligopolistic advertises his product, others have to follow
him to keep up their sales.
(3) Competition:
This leads to another feature of the oligopolistic market, the presence of competition. Since under
oligopoly, there are a few sellers, a move by one seller immediately affects the rivals. So each
seller is always on the alert and keeps a close watch over the moves of its rivals in order to have a
counter-move. This is true competition.
4
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
(4) Barriers to Entry of Firms:
As there is keen competition in an oligopolistic industry, there are no barriers to entry into or exit
from it. However, in the long run, there are some types of barriers to entry which tend to restraint
new firms from entering the industry
They may be:
(a) Economies of scale enjoyed by a few large firms;
(b) control over essential and specialized inputs;
(c) High capital requirements due to plant costs, advertising costs, etc.
(d) exclusive patents and licenses; and
(e) The existence of unused capacity which makes the industry unattractive. When entry is
restricted or blocked by such natural and artificial barriers, the oligopolistic industry can
earn long-run super normal profits.
(5) Lack of Uniformity:
Another feature of oligopoly market is the lack of uniformity in the size of firms. Finns differ
considerably in size. Some may be small, others very large. Such a situation is asymmetrical. This
is very common in the American economy. A symmetrical situation with firms of a uniform size is
rare.
5
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
4. Monopolistic Competition:
Monopolistic competition refers to a market situation where there are many firms selling a differentiated product. “There is competition which is keen, though not perfect, among many firms
making very similar products.” No firm can have any perceptible influence on the price-output
policies of the other sellers nor can it be influenced much by their actions. Thus monopolistic
competition refers to competition among a large number of sellers producing close but not perfect
substitutes for each other.
It’s Features:
The following are the main features of monopolistic competition:
(1) Large Number of Sellers:
In monopolistic competition the number of sellers is large. They are “many and small enough” but
none controls a major portion of the total output. No seller by changing its price-output policy can
have any perceptible effect on the sales of others and in turn be influenced by them. Thus there is
no recognized interdependence of the price-output policies of the sellers and each seller pursues an
independent course of action.
(2) Product Differentiation:
One of the most important features of the monopolistic competition is differentiation. Product
differentiation implies that products are different in some ways from each other. They are
heterogeneous rather than homogeneous so that each firm has an absolute monopoly in the
production and sale of a differentiated product. There is, however, slight difference between one
product and other in the same category.
Products are close substitutes with a high cross-elasticity and not perfect substitutes. Product
“differentiation may be based upon certain characteristics of the products itself, such as exclusive
patented features; trade-marks; trade names; peculiarities of package or container, if any; or
singularity in quality, design, color, or style. It may also exist with respect to the conditions
surrounding its sales.”
(3) Freedom of Entry and Exit of Firms:
Another feature of monopolistic competition is the freedom of entry and exit of firms. As firms are
of small size and are capable of producing close substitutes, they can leave or enter the industry or
group in the long run.
(4) Nature of Demand Curve:
Under monopolistic competition no single firm controls more than a small portion of the total
output of a product. No doubt there is an element of differentiation nevertheless the products are
close substitutes. As a result, a reduction in its price will increase the sales of the firm but it will
have little effect on the price-output conditions of other firms, each will lose only a few of its
customers.
Likewise, an increase in its price will reduce its demand substantially but each of its rivals will
attract only a few of its customers. Therefore, the demand curve (average revenue curve) of a firm
under monopolistic competition slopes downward to the right. It is elastic but not perfectly elastic
within a relevant range of prices of which he can sell any amount.
6
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
(5) Independent Behavior:
In monopolistic competition, every firm has independent policy. Since the number of sellers is
large, none controls a major portion of the total output. No seller by changing its price-output
policy can have any perceptible effect on the sales of others and in turn be influenced by them.
(6) Product Groups:
There is no any ‘industry’ under monopolistic competition but a ‘group’ of firms producing similar
products. Each firm produces a distinct product and is itself an industry. Chamberlin lumps
together firms producing very closely related products and calls them product groups, such as cars,
cigarettes, etc.
(7) Selling Costs:
Under monopolistic competition where the product is differentiated, selling costs are essential to
push up the sales. Besides, advertisement, it includes expenses on salesman, allowances to sellers
for window displays, free service, free sampling, premium coupons and gifts, etc.
(8) Non-price Competition:
Under monopolistic competition, a firm increases sales and profits of his product without a cut in
the price. The monopolistic competitor can change his product either by varying its quality,
packing, etc. or by changing promotional programs.
7
EEM Q/A Notes- LJIET
2.
OR
4.
By: - Dhruvi Bhatt
Explain difference between a) perfect competition and monopolistic competition
b) Monopoly and Oligopoly.
OR
What is monopoly?
Differentiate between perfect competition and monopolistic competition(Dec2014,June-2015) [EEM] [LJIET]
3.
Explain price determination method in the following a) perfect competition
b)monopolistic competition b) Monopoly and Oligopoly
PRICE DETERMINATION UNDER PERFECT COMPETITION MARKET:
 In prefect competition, price is determined by the market forces of demand and supply.
 All buyers and sellers are price takers and not price makers. Buyer represents demand
side in the market.
 Every rational buyer aims at maximizing his satisfaction by purchasing more at lower
price and lower at higher price. This is called demand behavior of buyer i.e. Law of
Demand.
 Seller represents supply side in the market. Every rational seller aims at maximizing his
8
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
profits by selling more at higher price and lesser at lower price.
 This is called supply behavior of seller i.e. Law of supply.
 But at a common price, buyer is ready to demand a particular quantity of goods and
seller is also ready to supply exactly the same quantity of goods to buyer, such common
price is called 'Equilibrium Price' and such quantity is called 'Equilibrium Quantity'.
 "Equilibrium Price is a price which equates both demand and supply".

The single firm takes its price from the industry, and is, consequently, referred to as
a price taker. The industry is composed of all firms in the industry and the market price
is where market demand is equal to market supply. Each single firm must charge this
price and cannot diverge from it.
 The firms trying to sell at price below P will face excess demand and will not be able to
accommodate the demand of many customers. So they will have to increase price at that
point. Similarly firms charging higher price will not be able to survive in the market as
customers will divert to low price competitors.
 Example:
 Table - Sample Demand and Supply Schedules ↓
 It is the price at which total demand is exactly equal to total supply. Graphically it is the
9
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
point where DD curve and SS curve intersect each other.
Graph - Equilibrium Price Determination ↓
 In the above graphical diagram, the following points have been observed :1. On X axis, quantity demand and supplied per week has been given and on Y axis, price
has been given.
2. Buyers are purchasing more at lower price and vice versa. This negative relationship is
shown by downward sloping DD curve.
3. Sellers are selling more at higher price and vice versa. This positive relationship is
shown by upward sloping SS curve.
4. Rs. 30 is that price at which demand equates supply (300 units). So, Rs. 30 is an
equilibrium price and 300 units is an equilibrium quantity.
5. Suppose, price fails to Rs. 20/-, So this results into increase in demand (as per Law of
Demand) and decrease in supply (as per Law of Supply). Since DD > SS, i.e. because
of low supply, sellers will be dominant and competition will be among buyers, this
leads to rise in price level. (i.e. from Rs. 20 to Rs. 30) Again price will come back at
original level i.e. equilibrium price (Rs. 30).
6. Suppose, supply exceeds demand (DD < SS) now buyers become dominant and
competition will be among sellers. This leads to downfall in price. (i.e. from Rs. 40 to
Rs.30). Again price will come back to original level. i.e. equilibrium price (Rs. 30).
7. Such automatic adjustment by demand and supply forces will keep single price in
market.
10
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
DETERMINATION OF PRICE IN MONOPOLY
 It would be a mistake to suppose that the monopolist will always push up his prices
higher and higher.
 If he does so, he must consider the effect of such a procedure on demand which will
shrink as price rise.
 The monopoly firm cannot compel the consumer to buy at higher prices. A very
important point to be borne in mind is that unlike competitive firm, a monopoly firm
will have a downward sloping demand curve and his average revenue will fall as the
output is increased, because the buyers will take up larger quantities only at lower. The
monopolist can charge a higher, but he will sell less.
 If he wants to sell more, he has to lower his price.

 In all cases, the price will be fixed in such a way that the net monopoly revenue is
maximum. We can illustrate the fixation of monopoly price with the help of a sample
schedule.
Outp
ut in
units
1000
2000
4000
8000
Cost
per
units
in Rs
5
7
10
15
Total
Cost in
Rs.
5000
14000
40000
120000
Price /
Unit
30
25
20
16
Total
Revenue
in Rs
30000
50000
80000
128000
Net
Monopoly
revenue
25000
36000
40000
8000
 The maximum profit or the net monopoly revenue will be realized when the output is
4000 units at this level the net monopoly revenue is maximum, that is, Rs 40000.
 In monopoly the average revenue curve will slope downwards.
 Further the marginal revenue per will also be falling and it will be steeper occupying a
low level than the Demand curve.
 The reason is since the Demand is falling the extra units sold will be fetch less and
lesser revenue in the market.
 In the case of perfect competition, both Demand and MR is the same horizontal line
parallel to X access and equal to the price.
 But in monopoly, this is not so. The Demand curve will be at a higher level sloping
down; the MR curve will be at a lower level sloping down.
 The principle of profit maximization is the same as that of perfect competition.
 The monopolist will maximize his net monopoly revenue by keeping the marginal cost
and the marginal revenue at the same level. The following diagram illustrate monopoly
equilibrium and price fixation.
11
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
Y
MC
P
Q
S
R
AC
D
MR
O








M
Output
X
D = Demand of Monopoly firm
MR = Marginal Revenue
AC = Average Cost
MC = Marginal Cost
OM = Equilibrium Output
OP = Price at Monopoly
E = Equilibrium point where MR = MC
PQRS = Net Monopoly Revenue
To Summarize:
 A monopolist can take market demand as its own demand curve
 The firm is a price maker but it cannot charge a price that the consumers will not bear
 A monopolist has market power which is the power to raise price above marginal cost
without fear of losing supernormal profits to new entrants to a market
 In this sense, demand acts as a constraint on the pricing-power of the monopolist
 Assuming that the monopolist aims to maximize profits (where MR=MC), the
Monopoly Price is given at point P in the diagram
12
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
• PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION
 Assume that the market for jeans is monopolistically competitive. In Figure 13.1a, we show
the demand curve, D, for one firm in this market, Tight Jeans.
 The demand curve’s position depends strongly on the prices of other jeans, as well as the
variety available. Thus, in drawing the demand curve for Tight Jeans, we assume that the
number of other firms in the industry is fixed.
 Furthermore, we assume that the prices charged by other firms do not change when Tight
Jeans varies its price. (Changes in the prices charged by other firms would cause the
demand curve for Tight Jeans to shift.)
 The basis for assuming other firms’ prices as given is that Tight Jeans represents only a
small part of the total jeans market. While a lower price for its jeans will cause some
customers to shift from other brands, the loss for each brand will be small enough to be
unnoticeable, or at least not to provoke a reaction. Given the behavior of other firms in the
market, let’s consider how Tight Jeans determines price and output.
 Because its demand curve is downward-sloping, marginal revenue is less than price, and
profit maximization calls for operating where marginal revenue equals marginal cost. If the
firm has the cost curves shown in Figure 13.1a, it produces an output of Q1 and charges a
price of P1. The resulting economic profit equals the shaded area. In terms of the diagram,
the position of the monopolistically competitive firm resembles that of a monopoly.
However, there are two important differences.
 First, Tight Jeans is only one among a number of firms producing a similar
product, and so the demand curve is not the market demand curve for jeans; it is
13
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
only the demand curve for jeans produced by one firm.
 Second, under monopolistic competition, as distinct from pure monopoly, entry
into the market is unrestricted. When existing firms are making profits, other
firms are attracted to the market. Thus, the equilibrium in Figure 13.1a cannot be
a long-run equilibrium because profits are being realized. It could represent a
short-run equilibrium, but with the entry of other firms, the demand curves
facing each existing firm will shift.
 Under monopolistic competition, long-run equilibrium is attained as a result of firms
entering (or leaving) the industry in response to profit incentives.
 In the present example, entry continues to occur until firms in the market are no longer
making economic profits.
 How will the entry of other firms affect existing firms like Tight Jeans in Figure 13.1a?
New firms will increase the industry’s total output, as well as provide for a wider variety of
differentiated products. Both of these effects shift existing firms’ demand curves
downward, leading to a general reduction in the industry’s level of prices and, from that,
lower profits. (It is also possible that entry will lead to higher prices for some inputs,
causing cost curves to shift upward as in an increasing-cost competitive industry, but we
will ignore this possibility.)
 Entry and output adjustments by existing firms will continue until economic profits are
zero; only then will there be no further incentive for other firms to enter the market. Figure
13.1b shows a position of long-run equilibrium for Tight Jeans. The firm’s demand curve
has shifted down to D, a position where it is just tangent to the average cost curve at point T
 The profit-maximizing output is now Q2 with a price of P2; at this price and output Tight
Jeans makes zero economic profit.1 All rival firms will be in a similar situation, making
zero economic profit in long-run equilibrium. Their cost and demand curves, however, need
not be identical because they are not producing exactly the same products. For this reason,
there may be a range of prices prevailing in equilibrium. Given the similarity among the
differentiated products within a monopolistically competitive market, prices are likely to
vary over a small range.
 A Big Mac and a Whopper need not be the exact same price, for example, but it would be
surprising if the prices differed substantially.
 Firms in a monopolistically competitive industry compete not only on price, but also by
variations in their products intended to attract customers. The range of differentiated
products in a market is not fixed, and firms often introduce new variations they believe will
be profitable.
 For instance, when Coca-Cola introduced its caffeine-free Coke, it was betting that enough
consumers wanted to limit caffeine intake for the line to be profitable.
 The company was right, and for a time it found itself in the position shown in Figure 13.1a,
making a profit. But once it was recognized that this was a profitable way to differentiate
cola drinks, other firms followed suit. Coca-Cola’s profit eroded as the market moved
toward a long-run equilibrium.
14
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
PRICE DETERMINATION UNDER OLIGOPOLY
 The most important cooperative model of oligopoly is the cartel model.
 A cartel is an agreement among independent producers to coordinate their decisions so
each of them will earn monopoly profit. Because cartels are illegal under the antitrust laws
in the United States (though, surprisingly, not in many other countries), they are not
common here.
 We begin by considering what happens if firms in a competitive industry form a cartel, and
then extend the results to oligopolistic markets
 Let’s see how a group of firms in a competitive market can earn monopoly profits by
coordinating their activities.
 We assume that the industry is initially in long-run equilibrium, and then we identify the
short-run adjustments (with existing plants) that the industry’s firms can make to reap
monopoly profits for themselves. Figure 13.7b shows the industry equilibrium with a price
of P and an output of 1,000 units. Figure 13.7a shows the competitive equilibrium for one
of the firms in the industry. Note that initially, the firm faces the horizontal demand curve d
at the market-determined price and produces an output of 50 units. To simplify matters,
suppose that there are 20 identical firms in the industry, each producing 50 units of output.
 Next, the firms form a cartel and agree to restrict output to attain a higher price. Each firm
agrees to produce an identical level of output, equal to one-twentieth of total industry
output because there are 20 firms. The cartel agreement has the effect of changing the
demand curve facing each firm. Before the agreement, if one firm alone reduced output, its
action would not appreciably affect price, as shown by the firm’s horizontal demand curve
d. Now, however, other firms match a restriction in output by one firm, so when one firm
15
EEM Q/A Notes- LJIET




5.
By: - Dhruvi Bhatt
cuts output by 15 units, all firms match the reduction, industry output falls by 300 units, and
price rises significantly.
The demand curve showing how price varies with output when firms’ output decisions are
coordinated in this way is the downward-sloping curve d* in Figure 13.7a. At any price, the
quantity on the d* curve is 1/20 that on the industry demand curve. Faced with this
downward-sloping demand curve, the firm’s profit-maximizing output occurs where its
short-run marginal cost curve SMC intersects the new marginal revenue curve mr*.
Output is 35 units, and because all 20 firms reduce production to the same output level,
total output falls to 700 units and the price rises to P1. Each firm is now making an
economic profit. Indeed, the idealized cartel result is just the same as if the industry were
supplied by a monopoly that controlled the 20 firms.
Figure 13.7b illustrates the result, with the short-run supply curve SS (the sum of the SMC
curves of the firms) intersecting the industry marginal revenue curve MR at an output of
700 units and a monopoly price of P1.
By forming a cartel and restricting output to achieve the monopoly equilibrium, the firms
maximize their combined profit. Figure 13.7b shows the total market effect of the
coordinated output reduction by the 20 firms; Figure 13.7a shows the effects on each firm
individually. Firms can always make a larger profit by colluding rather than by competing.
Acting alone, competitive firms are unable to raise price by restricting output, but when
they act jointly to limit the amount supplied, price will increase. As we will see in the next
subsection, however, achieving a successful cartel in practice is not as simple as it may
seem.
Explain: “National income” and stock and flow concept.
National Income Definition
“The labour and capital of a country acting on its natural resources produce annually a certain net
aggregate of commodities material an immaterial including services of all kinds” – Marshall
OR
“National income consists solely of services as received by ultimate consumers, whether from their
material or from their human environments” – Fisher
OR
“National income is a collection of goods and services reduced to a common basis by being
measured in terms of money” – Hicks
The above definitions make it clear that national income is the monetary measure of –
The net value of all products and services
In an economy during a year
Counted without duplication
After allowing for depression
Both in the public and private sector of products and services
In consumption and capital goods sector
The net gains from international transactions
16
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
CIRCULAR FLOW OF NATIONAL INCOME
 The circular flow of income is a theory that describes the movement of expenditure and
income throughout the economy.
 In an economy households provide factors of production, such as labor, to firms. Firms use
these factors to produce goods and services which they sell to the households. (This is
represented by the red, inner loop in the diagram below.)
 The households then spend money on the goods and services produced by firms. This
money is then used by firms to pay the households for their work, through wages. (This is
represented by the blue, outer loop in the diagram below.) This process repeats itself and
forms the circular flow of income.
 As you can see in the diagram above, the expenditure on goods and services is equal to the
income received by households. Therefore in an economy:
National income = National expenditure
 However, not all income generated will be spent on domestically produced goods. Some of
the income is saved, used to pay taxes or spent on imported goods and services. Therefore
saving, taxation and imports are leakages in the circular flow of income.
 Likewise, sometimes there is extra spending in the economy, from investment, government
expenditure and spending on exports, which will be added to the circular flow of income.
These are called injections.
17
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
STOCK AND FLOW
There are two basic kinds of quantities.
A flow is any quantity that must be measured over a period of time.
Income is a flow.
A stock is any quantity that is measured at a single instant in time.
The amount of orange juice I drink in a month is a flow.
The amount of orange juice I have right now in my refrigerator is a stock.
The amount of water that passes over Niagara Falls in an hour is a flow.
The amount of water in all the world's oceans is a stock.
Income is a flow, whether for an individual, or with all the individuals added up to get national
income.
Everything that is done with income is also a flow: paying taxes, saving, consuming. The entire
framework that we are putting together is a system of flows.
6.
How national income is valued using constant and current approach?
National Income at Current Price:
It is the money value of final goods and services produced by normal residents of a country
in a year, measured at the prices of the current year.
For example, measurement of India’s National Income of 2013-2014 at the prices of 20132014.
It is also known as ‘Nominal National Income’.
It does not show the true picture of economic growth of a country as any increase in
18
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
nominal national income may be due to rise in price level without any change in physical
output.
Example:
Year
Quantity Produced Price
2004
2013
500
400
50
70
National
Income=Quantity*
Price
25000
28000
Here production decreases but still National income is seen to increase
So, in order to eliminate the effect of price changes, national income is also estimated at a
constant price.
National Income at Constant Price:
It is the money value of final goods and services produced by normal residents of a country
in a year, measured at base year price.
Base Year is a normal year which is free from price fluctuations.
Presently 2004-2005 is taken as the base year in India.
If we measure India’s National Income of 2013-2014 at the prices of 2004-2005, then it is
termed as ‘National Income at constant price’.
Example
Year
Quantity Produced Price
National
Income=Quantity*
Price
2004
500
50
25000
2013
400
50
20000
It is also known as ‘Real National Income’.
It shows the true picture of economic growth of a country as any increase in real national
income is due to increase in output only.
The National Statistical Commission (NSC) has suggested revising the base year to 201112 from the current base year of 2004-05 for the calculation of new Gross Domestic
Product (GDP) of the country.
7
Define: GNP, GDP, NNP,NDP, Personal income, disposal income
1. Gross Domestic Product (GDP)
Gross domestic product is the money value of all final goods and services produced within
the domestic territory of a country during a year.
Algebraic expression under product method is,
GDP = (Price of goods and service * Quantity of goods and service)
According to expenditure approach, GDP is the sum of consumption, investment,
government expenditure, net foreign exports of a country during a year.
Algebraic expression under expenditure approach is,
19
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
GDP= Consumption + Investment + Government expenditure + (Export - Import)
 Consumption (C) :
Definition: The value of all goods and services bought by households.
Includes:
Durable Goods last a long time e.g., cars, home appliances!
Nondurable Goods last a short time e.g., food, clothing!
Services intangible items purchased by consumers e.g., dry cleaning, air
 Investment (I):
Spending on capital, a physical asset used in future production
Includes:
Business fixed investment :Spending on plant and equipment
Residential fixed investment: Spending by consumers and landlords on housing
units
Inventory investment: The change in the value of all firms’ inventories
 Government spending (G)
G includes all government spending on goods and services.
G excludes transfer payments (e.g., unemployment insurance payments), because they do
not represent spending on goods and services.
 Net exports (NX) :
NX = Exports – Imports
Exports: the value of good and services sold to other countries
Imports: the value of goods and services purchased from other countries
Hence, NX equals net spending from abroad on our goods and services
2. Gross National Product (G.N.P):
Gross National Product. GNP is the total value of all final goods and services produced within
a nation in a particular year, plus income earned by its citizens (including income of those
located abroad), minus income of non-residents located in that country.
Basically, GNP measures the value of goods and services that the country's citizens produced
regardless of their location.
GNP is one measure of the economic condition of a country, under the assumption that a higher
GNP leads to a higher quality of living, all other things being equal.
GNP = GDP + NFIA(Net Factor Income from abroad)
Where, NFIA= Income earned by citizens of the country located anywhere in the world –
Income earned by foreigners in the country
20
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
3. Net domestic product (NDP)
The net domestic product (NDP) equals the gross domestic product (GDP) minus
depreciation on a country's capital goods.
Net domestic product accounts for capital that has been consumed over the year in the form
of housing, vehicle, or machinery deterioration.
The depreciation accounted for is often referred to as "capital consumption allowance" and
represents the amount of capital that would be needed to replace those depreciated assets.
If the country is not able to replace the capital stock lost through depreciation, then GDP
will fall.
In addition, a growing gap between GDP and NDP indicates increasing uselessness of
capital goods, while a narrowing gap means that the condition of capital stock in the
country is improving.
It reduces the value of capital that is why it is separated from GDP to get NDP.
NDP= GDP- Depreciation
4. Net national product (N.N.P)
It refers to the net production of goods and services in a country during the year.
It is G.N.P. less depreciation during the year.
N.N.P. = G.N.P. – Depreciation for the given year
It is also called national income at market prices.
It is a useful concept in study of growth economics as it takes into consideration the net
increase in the
total production of the country.
5. Personal Income (P.I)
This is the actual income received by the individuals and households in the country from all
sources.
It denotes aggregate money payments received by the people by way of wage, interest,
profits, and rents.
It is the spendable income at current prices available to individuals.
Corporate income taxes and payment towards social security measured will not be available
for individuals i.e. they are earned but not received, so these have to be deducted from what
is earned.
Payments such as old age pensions, widow pensions, etc. that accrue to people i.e. they are
received but not earned, and so they have to be added.
P.I. = National Income – Income earned but not received +Income received but not
earned
P.I. = National Income – corporate taxes – undistributed corporate profits – social
security contributions + transfer payments
Transfer payments may be by government or business transfers, interest paid by
government, dividends, etc.
21
EEM Q/A Notes- LJIET
By: - Dhruvi Bhatt
6. Disposable Personal Income (D.I)
The whole of personal income is not available for consumption as personal direct taxes
have to be paid.
What is left after payment of personal direct taxes is call disposable income.
D.I = P.I. – personal taxes, property taxes and insurance payments
This is the amount available for individuals and households for consumption.
It is not that the entire D.P.I. is spent on consumption.
A part of it may be saved, therefore
What remains after saving is called the personal outlay, which represents the community’s
demand for goods and services.
22