Unit 3: Business Economics mind map

What economics studies, the great economists and their books, and the basic macro ideas that appear in questions.

Scope and method

Scarcity, micro and macro economics

Economics studies how people choose when wants are unlimited and resources are limited. Micro looks at single units. Macro looks at the whole economy.

• Scarcity is the excess of wants over the means to meet them.
• Microeconomics: product pricing, consumer behaviour, factor pricing.
• Macroeconomics: national income, unemployment, savings and investment, balance of payments.
• Location of industry belongs to micro.

Unemployment is a problem of the whole economy, so it is a macro topic. How a single shop sets its price is micro. Consumption means using goods and services to satisfy wants. Aggregate output is the total output of the economy.

Definitions of economics and the price scissors

Robbins defined economics as a science of choice under scarcity. Marshall said demand and supply decide price together.

• Robbins (1932): science of ends, scarce means and alternative uses.
• Marshall: demand and supply are like the two blades of a pair of scissors.
• Classical thinkers stressed supply. Austrian thinkers stressed demand.

Robbins' idea is the scarcity definition. His key words are unlimited ends, scarce means and alternative uses. Marshall said it is pointless to ask which blade of scissors cuts the paper.

Decision making in business economics

Applied economics follows steps from the goal to the action. Each step feeds the next.

• Define objectives.
• Identify business issues.
• Collect and analyse data.
• Develop courses of action, then select and implement.

A manager should know what the firm wants before looking at data. Once the options are built, one is chosen and carried out. This order appears in arrange-the-steps questions.

Macro ideas: Okun's law, gravity model and investment

A few macro rules of thumb are tested by name.

• Okun's law links GDP growth with changes in unemployment.
• Gravity model: trade between two countries rises with their size and falls with distance.
• Investment rises when interest rates fall.

Okun's law says that when unemployment rises, output falls below its potential by more than the rise in unemployment. The gravity model borrows from physics. Big economies pull each other more strongly, and distance weakens the pull.

Business cycles and the consumption economy

Economies move through booms and slumps. Questions ask for the order of famous crises.

• Great Depression: 1929 to the 1930s.
• Dot-com bubble burst: 2000-2001.
• Global financial crisis: 2007-2009.
• Covid pandemic: 2020.

A consumption economy has rising population and rising consumption. It also yields more indirect tax. But heavy home spending pulls in imports, so it does not export more than it imports.

Economists and their books

Classical economists and their works

Match questions pair an economist with a book and a year. Learn the list as one table.

• Adam Smith: The Wealth of Nations (1776).
• Thomas Malthus: Principle of Population (1798).
• David Ricardo: Principles of Political Economy and Taxation (1817).
• Karl Marx: Das Kapital (1867).

Smith also coined the metaphor of the invisible hand, in the Theory of Moral Sentiments (1759). He also set out the theory of absolute advantage. Marshall wrote Principles of Economics (1890). Hicks wrote Value and Capital (1939). Leontief is linked with input-output economics.

Ideas from passages

Why macroeconomic models struggle

Macroeconomics studies totals, so it cannot test its ideas by repeated experiments. Its models can fail when many small truths are added up.

• Aggregating billions of micro truths into one macro truth causes crisis in models.
• Macro variables elude repeated experiments.
• Models can only be back-tested on data of uncertain quality.

What holds for one person or firm may not hold for the whole economy. Economics did well in explaining buyers, firms and how markets find efficient prices. After the Great Depression, it learned to study aggregate variables such as GDP, employment and inflation.

Welfare, inclusive growth and populism

Welfare that is aimed at one group can distort markets and keep inequality alive. Even-handed welfare and cluster-based growth are suggested in the passage.

• Sectarian targeting of welfare introduces market imperfections and perpetuates inequality.
• A promise to one group paid for by another is a zero-sum game.
• India's corrected growth story: cluster-based growth with even-handed welfare delivery.

In a zero-sum game, one party's gain is exactly another's loss. Promises to vote banks fit this idea. The Centre's fiscal deficit target was set at 5.9 per cent for 2023-24.

How a consumer chooses: cardinal and ordinal utility, indifference curves, rationality, price and income effects, and the special goods.

Utility and indifference curves

Cardinal utility and diminishing marginal utility

The cardinal approach says utility can be counted in numbers, called utils. Marginal utility falls as consumption rises.

• Assumptions: utility is measurable and additive.
• The marginal utility of money is constant.
• The consumer is rational and wants to maximise satisfaction.
• Diminishing marginal utility of money is not an assumption.

The law of diminishing marginal utility needs suitable units, a rational consumer and cardinal utility. Total utility is the sum of marginal utilities. Marginal utility is the extra utility from one more unit.

Ordinal utility and indifference curves

The ordinal approach only ranks preferences. An indifference curve joins combinations that give the same satisfaction.

• A higher indifference curve means higher satisfaction.
• Curves slope downward and are convex to the origin.
• Two curves never intersect and are never tangent.
• Utility is ranked, not measured, so its magnitude does not matter.

The slope of an indifference curve is the marginal rate of substitution. It falls as you move right, which makes the curve convex. Imperfect substitutes give a convex curve. Perfect substitutes give a straight line. Intersecting curves would give two satisfaction levels at one point, which is impossible.

Consumer equilibrium and consumer choice

Under the ordinal approach, the consumer is in equilibrium where the budget line touches the highest indifference curve.

• Needed: indifference map, price line, tangency point.
• At tangency the slope of the curve equals the price ratio.
• The price line shows a constant price ratio.

The map shows what the consumer likes. The budget line shows what the consumer can buy. The best point is where they touch. The theory of consumer choice builds up from utility, to indifference curves, to the budget line, to equilibrium, to the demand curve.

Consumer rationality and bounded rationality

A rational consumer wants more, knows what she likes, acts for her own gain and has information.

• Non-satiation: more is better than less.
• Clarity and transitivity of preferences.
• Economic selfish motive and possession of information.
• Bounded rationality: limits from preferences, intelligence and environment.

Risk-return optimising is an investor's trait, not a consumer's. Herbert Simon's bounded rationality says people look for a satisfactory choice, not the best. Satiety of demand is not an assumption. Non-satiation is.

Price effect and special goods

Price, income and substitution effects

A price change has two parts. The substitution effect changes demand because the good is relatively cheaper. The income effect changes demand because real income has changed.

• Substitution effect: switching to or from alternatives.
• Income effect: becoming better or worse off.
• In the real world, the substitution effect is usually much larger.
• The reason: a consumer spends only a small share of income on any one good.

If a good takes a small share of the budget, a price change hardly changes real income, so the income effect is small. A fall in price raises purchasing power. A utility maximiser who sees one price fall will have higher purchasing power and higher total utility. Money income does not change.

Giffen goods and inferior goods

A Giffen good is an inferior good whose negative income effect overwhelms the substitution effect. Its demand curve slopes upward.

• All Giffen goods are inferior goods.
• Not all inferior goods are Giffen goods.
• The income effect of a price rise is larger than the substitution effect.

A poor family spends most of its income on coarse grain. When the price of grain rises, the family cannot afford meat, so it buys even more grain. Demand rises with price.

Veblen, snob and bandwagon effects

These effects explain why demand sometimes rises with price or depends on what others buy.

• Veblen effect: conspicuous consumption. Demand rises as price rises.
• Snob effect: wanting to be different. Demand falls as more people buy.
• Bandwagon effect: demand rises as more people buy. A positive network effect.

The Veblen buyer wants to show off with a costly good. The snob buyer wants exclusivity. The bandwagon buyer wants to follow the crowd. The substitution effect is the response to a relatively cheaper good.

What moves demand, how responsive it is, how revenue changes with price, and how a firm forecasts its sales.

Demand and its determinants

Determinants of demand and the law of demand

Demand depends on price, income, tastes, population and the prices of related goods. The law of demand says price and quantity move in opposite directions, other things equal.

• Increase demand: higher income, higher price of a substitute, stronger taste.
• A higher price of a complement lowers demand.
• Assumptions of the law: income, tastes and related prices are constant.
• Inflation rate is not one of those assumptions.

A change in the good's own price causes a movement along the curve. A change in any other factor shifts the curve. Price ceilings and equilibrium come after this.

Why the demand curve slopes downward

An ordinary demand curve slopes downward because of the income effect, the substitution effect and utility-maximising behaviour.

• A price fall raises real income.
• The good becomes cheaper relative to others.
• A rational consumer buys more at lower prices.

Risk aversion is not a reason. The three reasons together make the downward slope. Marginal utility also falls as the consumer buys more, so only a lower price will make the consumer buy more.

Equilibrium price from demand and supply

Equilibrium price is where quantity demanded equals quantity supplied. It is the market-clearing price.

• Set D = S and solve for price.
• Substitute price back to check.
• An equilibrium persists once it is reached.

If demand is 10,000 - P and supply is 1,000 + 4P, set them equal. 10,000 - 1,000 = 4P + P. So 9,000 = 5P and P = 1,800. At this price, both are 8,200 units.

Price ceiling and other price controls

A price ceiling is a legal maximum price. Set below equilibrium, it creates shortage.

• Quantity demanded exceeds quantity supplied.
• Buyers who cannot buy pay more illegally, so black marketing arises.
• Hoarding by sellers can follow.
• A glut is the result of a price floor, not a ceiling.

A cap on rent below the market rent makes more people want flats than there are flats. Some turn to illegal deals. A glut needs a price above equilibrium.

Elasticity

Price elasticity and total revenue

Price elasticity of demand measures how much quantity responds to a price change. Whether revenue rises or falls depends on it.

• Elastic (more than 1): a price fall raises total revenue.
• Inelastic (less than 1): a price fall lowers total revenue.
• Unitary (equal to 1): total revenue does not change.
• A rise in price with a rise in revenue means inelastic demand.

Total revenue is price times quantity. If a price rise of 20 per cent cuts quantity only 5 per cent, revenue rises. That is inelastic demand. On a rectangular hyperbola demand curve, elasticity is 1 at every point, though the slope keeps changing.

Factors and products by price elasticity

Demand is more elastic when substitutes are plentiful. It is least elastic for cheap necessities.

• Salt is the most inelastic: a necessity, cheap and with no substitute.
• Rank by increasing price elasticity: necessities, differentiated products, durable goods, homogeneous products.
• More and better substitutes mean higher elasticity.

Buyers can easily switch away from a homogeneous product, so its demand is very elastic. Brand loyalty makes a differentiated product less elastic. Necessities are needed whatever the price.

Income elasticity

Income elasticity shows how demand responds when income rises. It sorts goods into inferior, necessities, normal goods and luxuries.

• Negative: inferior goods.
• Between zero and one: necessities.
• More than one: luxuries.
• Elasticity = percentage change in quantity / percentage change in income.

Ranked from lowest to highest, income elasticity runs: inferior goods, necessities, normal consumption goods, services, luxuries. For a firm with a product of low income elasticity, rising incomes do not help much, so product improvement is the sensible choice.

Cross elasticity

Cross elasticity shows how demand for one good responds to a change in the price of another.

• Substitutes: cross elasticity is positive.
• Complements: cross elasticity is negative.
• Elasticity = percentage change in demand for A / percentage change in price of B.

If tea gets dearer, people buy more coffee, so tea and coffee are substitutes. If petrol gets dearer, demand for cars falls, so they are complements. With cross elasticity of -0.8 and a 20 per cent price rise in B, demand for A falls by 16 per cent.

A price-elasticity calculation

Use elasticity to find the new quantity after a price change. Work in percentages first.

• Percentage change in price from old and new price.
• Percentage change in quantity = elasticity x percentage change in price.
• New quantity = old quantity x (1 + change).

Price falls from Rs 100 to Rs 60. That is a fall of 40 per cent. Elasticity is 1.5, so quantity rises 60 per cent. From 30 units it becomes 48 units.

Average revenue, marginal revenue and elasticity

Marginal revenue is linked to price and elasticity by one formula.

• MR = AR x (e - 1) / e, or P x (1 - 1/e).
• At e = 1, MR = 0 and total revenue is at its peak.
• At e greater than 1, MR is positive.

Price is Rs 10 and elasticity is 2. MR is 10 x (2 - 1) / 2 = Rs 5. The formula comes from differentiating total revenue. A monopolist always produces where e is above 1.

Forecasting

Steps and problems in demand forecasting

A systematic forecast follows set steps. It also has known problems.

• Steps: specify objectives, fix the time perspective, choose a method, collect data, estimate and interpret.
• Problems: specification error and cyclical variation.
• A forecast is not more reliable the further it looks ahead.

A specification error means the model has the wrong variables or form. Business cycles upset forecasts. The further the forecast, the less reliable it is.

Estimating a demand equation by regression

Regression estimates how demand depends on price, income and other variables.

• Specify the model.
• Obtain data on each variable or a proxy.
• Decide the functional form.
• Estimate slope coefficients, then evaluate the results.

The theory decides which variables go in. Data follows. Then you pick a form such as linear or log. After estimation, you test whether the signs and fit make sense.

Revenue

Total, average and marginal revenue

Total revenue is price times quantity. Average revenue is revenue per unit. Marginal revenue is the extra revenue from one more unit.

• TR = P x Q. AR = TR / Q = price.
• MR = change in TR for one more unit.
• Under perfect competition AR = MR. Under monopoly MR is below AR.

A price-taking firm sells every unit at the market price, so MR equals price. A firm facing a falling demand curve must cut price to sell more, so MR falls faster than AR. For a straight-line demand curve, MR falls twice as fast.

Movement, shift and surplus

Movement along a curve versus a shift of the curve

A change in the good's own price moves along the demand curve. A change in any other factor shifts the whole curve.

• Own price change: movement along the curve.
• Income, tastes, related prices, population: shift of the curve.
• A rise in demand shifts the curve to the right.

Keep the two ideas apart. 'Change in quantity demanded' is a movement. 'Change in demand' is a shift. UGC NET uses the words carefully, so read them in the stem.

Consumer surplus

Consumer surplus is the gap between what a buyer is willing to pay and what is actually paid.

• It is the buyer's gain from trade.
• Perfect price discrimination removes it completely.
• Monopoly reduces it by raising price and cutting output.

A buyer who values a good at Rs 80 and pays Rs 50 enjoys a surplus of Rs 30. A seller who charges Rs 80 to that buyer takes all of it. That is why first-degree discrimination takes all the surplus.

How inputs become output and cost: production function, returns, isoquants, short-run and long-run costs, and economies of scale.

Production

Production function and the law of variable proportions

A production function shows how output depends on inputs. In the short run, one input varies and the law of diminishing returns applies.

• Total product rises while marginal product is positive.
• Total product is maximum when marginal product is zero.
• The law assumes one variable input, given technology, homogeneous units and given input prices.
• Q = -L^3 + 5L^2 + 10L is a short-run function with diminishing returns.

Marginal product first rises, then falls, then turns negative. Total product peaks when marginal product reaches zero. Average product equals total product divided by units of the variable factor.

Isoquants and the marginal rate of technical substitution

An isoquant joins input combinations that give the same output. Its slope is the marginal rate of technical substitution.

• Isoquants slope downward and are convex to the origin.
• They do not intersect and are not tangent.
• Higher isoquants mean more output.
• MRTS = the capital given up for one more unit of labour = MPL / MPK.

MRTS falls as more labour is used, which makes the isoquant convex. Do not mix up MRS, the consumer's trade-off along an indifference curve, with MRTS, the firm's trade-off along an isoquant.

Returns to scale and the Cobb-Douglas function

Returns to scale look at what happens when all inputs change in the same proportion. The Cobb-Douglas function shows them by the sum of its exponents.

• Q = A x L^a x K^b. The inputs are multiplied.
• a + b more than 1: increasing returns.
• a + b = 1: constant returns. a + b less than 1: decreasing returns.
• A function with both K and L variable is a long-run function.

With Q = 10 K^0.6 L^0.8, the sum is 1.4, so returns increase. In the CES function, the scale parameter r decides: more than 1 means increasing returns. Increasing returns arise from specialisation, better use of machines and savings in advertising and procurement.

Characteristics of inputs and long-run functions

A production function rests on three input characteristics. A long-run function lets all inputs vary.

• Substitutability, complementarity and specificity.
• The law of equal proportion is another name for changing all factors in the same proportion.
• Q = A K^a L^b is long run because both inputs vary.

Substitutability lets labour replace machines. Complementarity means inputs work together, like a driver and a car. Specificity means some inputs suit only one use. Functions with only L variable are short-run functions.

Marginal and average product, and short run versus long run

Marginal product cuts average product at its highest point. The short run has a fixed input. In the long run all inputs vary.

• When MP is above AP, AP rises.
• When MP is below AP, AP falls.
• Short run: at least one input fixed. Long run: all inputs variable.

The relation between marginal and average product is the same as between marginal and average cost. A good new score pulls an average up. A poor one pulls it down. Returns to a factor belong to the short run. Returns to scale belong to the long run.

Costs

Explicit, implicit, sunk and other costs

Costs differ by whether money is spent, whether the cost can be recovered, and whether it affects a decision.

• Explicit cost needs an outlay of money.
• Implicit cost is the value of the owner's own inputs.
• Sunk cost is already committed and cannot be recovered.
• Marginal cost is the change in total cost for one more unit.

Rent paid on a hired building is explicit. The rent of an owned building, which the owner could have earned elsewhere, is implicit or imputed. Accounting profit subtracts only explicit costs. Economic profit subtracts implicit costs too.

Shut-down point and economic profit

In the short run a firm should keep producing as long as revenue covers variable cost. If revenue falls below variable cost, it should shut down.

• Compare average revenue with average variable cost.
• Fixed cost has to be paid either way in the short run.
• Shut-down means complete cessation: no buying, no manufacturing, assets sold, capital returned.

Suppose revenue covers variable cost but not all fixed cost. Producing still reduces the loss. If revenue is below variable cost, producing adds to the loss.

Average cost and marginal cost curves

Marginal cost cuts average cost at its minimum. Average fixed cost always falls.

• AC = AFC + AVC.
• When MC is below AC, AC falls. When MC is above AC, AC rises.
• At minimum AC, AC = MC.
• AFC is a rectangular hyperbola and cannot be U-shaped.

In the short run, total fixed cost does not change, so the change in total cost equals the change in total variable cost. AVC, AC and MC curves can all be U-shaped. When AC is constant, AC equals MC, not that AC is below MC.

Economies of scale and the long-run average cost curve

Economies of scale mean that long-run average cost falls as output rises. The traditional long-run average cost curve is U-shaped. Empirical studies suggest L-shaped.

• Gains from specialisation, bulk buying and fuller use of machines.
• Diseconomies arise when the firm becomes too hard to manage.
• Economies of scope: lower average cost from making two complementary products in one firm.

U shape: costs fall, then rise. L shape: costs fall steeply and then stay flat. The shapes generally listed are U and L. Internal economies are gains inside the firm, external economies are gains from the industry's size.

Cost formulas to remember

Total, average and marginal cost are linked by simple formulas. Questions test them in short-run settings.

• TC = TFC + TVC. AC = AFC + AVC.
• AFC = TFC / Q. MC = change in TC / change in Q.
• Short run: TFC does not change, so change in TC = change in TVC.
• Output is optimum where AC = MC, the point of minimum average cost.

Marginal cost is rising when AC is below MC and AC is rising. When the fall in AFC is bigger than the rise in AVC, AC falls. When the rise in AVC is bigger, AC rises.

How price and output are set under perfect competition, monopoly, monopolistic competition and oligopoly, plus price discrimination and game theory.

Perfect competition and monopoly

Perfect competition: price and output

A perfectly competitive firm is a price taker. It is in equilibrium where marginal revenue equals marginal cost.

• Short run: MR = MC is the equilibrium condition.
• Long run: AR = MR = AC = MC.
• Long-run profit is normal only, because of free entry and exit.
• Firms are in industry equilibrium when price equals long-run marginal cost.

The full set of equalities holds only in the long run. In the short run a firm can earn super-normal profit or make a loss. The firm shuts down when price falls below average variable cost. When many firms can operate efficiently, perfect competition uses resources best.

Monopoly: equilibrium and social cost

A monopolist is the sole seller. It is in equilibrium where MR = MC. It can choose price, but only along the demand curve.

• The MR curve has twice the slope of the AR curve for a straight-line demand.
• A monopolist can earn normal profit, a loss or super-normal profit.
• Even with normal profit, it produces less than its optimum capacity.
• Social cost: lower output at a higher cost and price.

A monopolist restricts output to raise price. The result is a deadweight loss, which is the loss of social welfare because mutually useful trades do not occur. A monopolist cannot charge any price it likes, because the demand curve limits sales.

Price discrimination

Price discrimination means charging different prices for the same product. It needs market power, separable markets and different elasticities.

• First degree: each buyer pays the maximum price, so the seller takes all consumer surplus.
• Second degree: prices differ by quantity bought.
• Third degree: different prices in separate markets, with MR = MC in each.
• Free entry is not a condition. Multiple close substitutes are not a condition.

The firm charges more where demand is less elastic. Buyers in the cheap market must not be able to resell in the dear market. Under perfect discrimination, consumer surplus falls to zero and output rises to the competitive level.

Excess capacity and selling costs

Excess capacity means a firm does not use its plant fully. It is not found under perfect competition.

• Monopoly, monopolistic competition and oligopoly can have excess capacity.
• Selling costs have a different purpose in each market form.
• Perfect competition: increase market size.
• Monopoly: inform buyers. Oligopoly: survival.

In perfect competition each firm produces at the minimum point of average cost in the long run. In monopolistic competition equilibrium lies on the falling part of the AC curve. Selling costs under monopolistic competition aim to influence buying behaviour.

Perfect competition: features and pricing strategies

A perfectly competitive market has many sellers, identical products and free entry. A firm in a market with close substitutes uses going-rate pricing.

• Homogeneous products and a price taker firm.
• Free entry and exit.
• Going-rate pricing: price at or near the market price.
• Other methods: full cost pricing and product bundling.

A petrol pump sets its price at the level of the pumps around it, because buyers would otherwise switch. Transfer pricing applies inside a group, not between competitors.

Monopolistic competition and oligopoly

Monopolistic competition

Many small firms sell differentiated products. Entry and exit are easy. Each firm has some market power.

• Firms are small relative to the market.
• Entry and exit are easy.
• Each firm faces a downward-sloping demand curve.
• Chamberlin's equilibrium involves price, product nature and advertising outlay.

Brands such as soaps and restaurants are close substitutes but not identical. Each firm faces a relatively highly elastic curve. The product is differentiated, so the firm has a small amount of market power.

Oligopoly: features and kinked demand

A few sellers compete, entry is restricted, and each firm's decision depends on rivals. Sweezy's kinked demand curve explains price rigidity.

• Few sellers, many buyers.
• Entry barriers and interdependence.
• Kinked curve: rivals match a price cut but not a rise.
• Oligopoly is the most common form in manufacturing.

Above the kink, demand is elastic, so raising price loses customers. Below the kink, demand is inelastic, so cutting price gains few customers. So firms leave price where it is. Oligopoly leads to more technological change than other forms, because rivals compete through innovation.

Cartels, price leadership and non-collusive models

Oligopolists may collude or act alone. A cartel is the extreme case of non-price competition.

• Cartel: firms agree on price and output.
• Cartels are hard to sustain with different costs or differentiated products.
• Price leadership: dominant firm, barometric, or low-cost firm.
• Non-collusive models: Cournot, Bertrand, Edgeworth.

In barometric price leadership, a well-informed firm announces changes and rivals follow. It need not be the biggest. In dominant-firm leadership, the big firm sets price and small firms take what they can sell. Real oligopoly has no single general price theory.

Game theory: Nash equilibrium and Stackelberg

Game theory studies strategic choices. A Nash equilibrium is where each player's strategy is best given the others' choices.

• Nash equilibrium: no player gains by changing alone.
• Prisoner's dilemma: each plays a dominant strategy, but cooperation would pay more.
• Stackelberg: leader moves first and takes about two-thirds of the market.

In a Stackelberg leader-follower game with linear demand, the leader sells twice as much as the follower. Two petrol pumps that cannot gain by changing their own price are in a Nash equilibrium.

Market comparisons and concentration

Market forms differ in the number of sellers, pricing power and elasticity. Concentration is measured by ratios and the Herfindahl index.

• Number of sellers, descending: perfect competition, monopolistic competition, oligopoly, duopoly.
• Pricing power, ascending: perfect competition, monopolistic competition, oligopoly, duopoly, monopoly.
• Degree of monopoly: concentration ratio, Herfindahl index, elasticity reciprocal.

The Herfindahl-Hirschman index is the sum of the squares of market shares. Zero means countless tiny firms. Below 1,000 is unconcentrated. 1,000 to 1,800 is moderately concentrated. Above 1,800 is highly concentrated, with a high cartel risk. The maximum is 10,000.

Contestable markets and the definition of an industry

A market is contestable when entry is free and exit is costless. An industry is a group of firms with close substitutes.

• Baumol's theory: even few sellers compete vigorously if entry and exit are free.
• The objective test of an industry is a high cross-price elasticity.

Potential entrants keep a few sellers honest. If profits rise, newcomers move in at once, and they can leave without loss. Homogeneity of products is not the test, because related brands can still be in one industry.

Summary of market forms

Market forms at a glance

A single table can hold the main differences. Learn it before the exam.

• Perfect competition: many sellers, identical goods, price taker.
• Monopolistic competition: many sellers, differentiated goods.
• Oligopoly: few sellers, interdependence.
• Monopoly: one seller.

The equilibrium rule is the same in all forms: MR = MC. What changes is the shape of the demand curve and the freedom of entry. UGC NET also asks for the order of sellers, pricing power and elasticity.

What firms really aim for, the theories of profit, and how many workers a firm hires.

Objectives of the firm

Profit maximisation conditions and alternative objectives

Profit is highest where MR = MC and MC cuts MR from below. Managerial theories offer other goals.

• First-order condition: MR = MC.
• Second-order condition: MC cuts MR from below.
• Baumol: sales revenue maximisation, subject to minimum profit.
• Marris: growth rate maximisation.

Williamson says managers maximise their own utility. Cyert and March say firms satisfice, which means they aim for satisfactory levels rather than maximum ones. Rothschild proposed long-term survival. Marris's prudent financial policy rests on the debt-equity ratio, the liquidity ratio and the retention ratio.

Theories of profit

Accounting profit and economic profit

Accounting profit is revenue less paid-out costs. Economic profit also subtracts implicit costs.

• Accounting profit: total revenue minus explicit costs, including manufacturing and overhead.
• Economic or pure profit: residual after all contractual costs and normal returns.
• Normal profit is a cost of staying in business.

A person who runs her own shop forgoes a salary elsewhere. That forgone salary is an implicit cost. Accounting profit ignores it. Economic profit counts it.

Theories of profit and their authors

Several economists explained profit in different ways. A match question pairs each with its author.

• Rent of ability: F. A. Walker.
• Dynamic theory: J. B. Clark.
• Risk theory: F. B. Hawley.
• Innovation theory: Joseph Schumpeter. Uncertainty theory: Frank Knight.

Walker said superior managers earn a rent. Clark said profit arises from change in a dynamic economy. Hawley said profit pays for bearing risk. Schumpeter said it rewards the innovator. Knight said profit comes from bearing uncertainty, which cannot be insured.

Factor markets

Demand for labour

A competitive, profit-maximising firm hires labour up to the point where the wage equals the value of the marginal product of labour.

• VMP = marginal product of labour x price of output.
• The VMP curve is the demand curve for labour.
• Hire more as long as MRP is greater than MRC.

A firm will not pay a worker more than the value the worker adds. When extra revenue from a worker exceeds the extra cost of hiring, the firm hires more. It stops where the two are equal.

How government and the central bank steer the economy: monetary versus fiscal policy, inflation causes and measures, and public finance.

Policy and inflation

Monetary policy versus fiscal policy

Fiscal policy changes government revenue and spending. Monetary policy controls money supply and credit.

• Fiscal policy: taxes and expenditure.
• Monetary policy: money supply, cost and availability of credit.
• Monetary policy supports growth by creating favourable conditions. It cannot cause growth by itself.
• GST has reduced the room for fiscal policy.

A common trap swaps the two definitions. Policy rate changes pass through to lending rates and mortgage rates. Since GST replaced many indirect taxes with one shared tax, the Centre and the states have fewer tax tools to steer growth.

Measures and causes of inflation

CPI and the GDP deflator measure inflation. The Phillips curve, misery index and Fisher effect do not measure it directly.

• Demand-pull inflation: excess demand.
• Cost-push or supply-constrained inflation: supply disruptions and energy price spikes.
• Policy for excess demand is unsuited to inflation from supply disruption.
• The remedy for supply shocks is to stimulate additional supply.

Raising interest rates cuts demand, which helps against excess demand. Against supply-driven inflation, it only hurts growth. Stepping up production helps more. This follows a passage read in a past paper.

Public finance: revenue expenditure and fiscal deficit

Revenue expenditure does not create an asset or reduce a liability. Capital expenditure does.

• Revenue expenditure: debt relief to farmers, fertiliser subsidy, grants to states.
• The fiscal deficit target for the Centre for 2023-24 was 5.9 per cent of GDP.
• The CAG can report a different estimate of the fiscal deficit than the government.

Running costs and subsidies are revenue spending. Building a bridge is capital spending. A passage in a past paper noted that the government's fiscal deficit estimate and the CAG's estimate differed.