Micro Economics Theory Practice and Evaluation DR Javed Akbar Ansari

MICROECONOMICS
Theory, Practice and Evaluation
Zahid S. Mughal
Javed A. Ansari
University of Karachi Press

To our students
so as to help them seek guidance
from the intellectual foot-steps of
Imam Al-Ghazali (RA)

About Authors
Zahid Siddique is Assistant Professor of Economics in the Management Science Department at

National University of Computer and Emerging Sciences, FAST Islamabad. He has been
conducting courses in the areas of economics and business sciences for the last seven years. He
received his masters from the University of Karachi and then pursued M. Phil from Quaid-i-
Azam University, Islamabad. Currently, he is enrolled in the PhD program of Quaid-i-Azam
University, Islamabad. Major areas of his research interest include (1) comparative economic
schools of thought, (2) political economy of economics, (3) microeconomics and (4) Islamic
economics. He has published several papers in national journals and international conferences.
Javed Akbar Ansari received his MSc from London and PhD from Sussex. He has taught
Economics at City University, London and Sussex (ISIO). He has held different posts at the
United Nations Industrial Development Organization, the United Nations Centre on Transnational
Corporations, National Bank of Pakistan.
Presently, he is the Dean and Professor of Economics and Finance at the Institute of Business
Management, Karachi. He has published several articles in the reputed journals and has authored
many books (e.g. Business Ethics in Pakistan, Money and Banking in Pakistan, Financial
Management in Pakistan). Areas of his research include (1) History of economics thoughts, (2)
Monetary and Financial Economics and (3) Western Philosophy.
Contents
About Authors ................................................................................................................v
Contents ........................................................................................................................ vii
Introduction to ‘Microeconomics’ ........................................................................... xxiii
1: Why This Book? ..................................................................................................... xxiii
2: How to Use this Book ............................................................................................ xxiv
3: Learning Tools ........................................................................................................ xxv
PART 1: PRELIMENARIES
CHAPTER 1: INTRODUCTION TO ECONOMICS
1.1: WHAT IS ECONOMICS? ................................................................................................ 1

1.1.1: Scarcity ...................................................................................................................1
The Emergence of Economics .............................................................................................................. 2
Scarcity and Choice .............................................................................................................................. 3
Choice and Allocation Problem ............................................................................................................ 4
Allocation Strategies: Competition and Efficiency ............................................................................... 5
The Objective Function......................................................................................................................... 8
FYI BOX 1.1........................................................................................................9

1.2: HOW ECONOMISTS DO WHAT THEY DO? .................................................................. 9
1.2.1: Science and Knowledge ........................................................................................9
FYI BOX 1.2......................................................................................................10
Structure of an ‘Economic Theory’..................................................................................................... 10
Economics as Paradigm ...................................................................................................................... 13
FYI BOX 1.3......................................................................................................13

1.2.2: Positive Vs Normative Question ........................................................................14
The Normative Essence of Economics ............................................................................................... 14
1.3: ‘WHAT IS ECONOMICS FOR?’: THE AGENDA OF CAPITALISM.................................. 16
Economics and Politics: Link between Theory and Practice .............................................................. 17
1.4: MICRO-MACRO DISTINCTION .................................................................................. 19
Key Concepts ...................................................................................................................21
Chapter Summary ............................................................................................................22
Review Questions.............................................................................................................24
CHAPTER 2: INTRODUCTION TO CAPITALISM AND THEORY OF VALUE
2.1: THE CAPITALIST SYSTEM ........................................................................................... 27
vii
2.1.1: Capitalist Norms and Values ..............................................................................27
2.1.2: Capitalist Regulation...........................................................................................28
The Role of Economic Theory ............................................................................................................ 29
2.2: THEORIES OF CAPITALISM AND VALUE .................................................................... 30
2.2.1: What is Value? .....................................................................................................31
2.2.2: Smith: Labor Commanded or Labor Input Theory of Value? ........................... 32
2.2.3: From Smith to Ricardo: The Embodied Labor Theory of Value ....................... 34
Ricardo on Wages ............................................................................................................................... 34
Profit and Rent in the Ricardian System ............................................................................................. 34
Ricardian Politics ................................................................................................................................ 36
Labor Input Theory after Ricardo ....................................................................................................... 37
2.2.4: From Ricardo to Marx: The Abstract Labor Theory of Value............................38
Marx’s Rejection of Profit .................................................................................................................. 38
The Nature of Marx’s Economics and Politics ................................................................................... 39
2.2.5: From Labor Commanded to Utility Theory of Value: The Marginalist
Revolution or Rejoinder? .............................................................................................41
Nature of Marginalist / Utility Theory of Value ................................................................................. 41
Nature of Neoclassical Economics...................................................................................................... 42
2.2.6: From Labor Input to the Cost of Production Theory of Value: Emergence of
Social Democracy ..........................................................................................................44
Nature of Social Democrat Politics ..................................................................................................... 45
2.3: WHERE DO WE GO FROM HERE?............................................................................. 46
Chapter Summary ............................................................................................................48
PART 2: MARKETS: LIBERAL FRAMEWORK OF ANALYSIS
CHAPTER 3: DEMAND AND SUPPLY: Basic Competitive Model
3.1: DEMAND .................................................................................................................... 57

3.1.1: Determinants of Demand....................................................................................57
Own Price and Demand ...................................................................................................................... 59
FYI: B O X 3.1 ................................................................................................60

Income and Demand ........................................................................................................................... 62
Related Goods’ Prices and Demand .................................................................................................... 66
FYI: B O X 3.2 ................................................................................................67

Taste and Demand............................................................................................................................... 67
Taste and Advertisement ..................................................................................................................... 68
3.1.2: From Individual to Market Demand ..................................................................68
3.2: SUPPLY ....................................................................................................................... 72
Own Price and Supply ........................................................................................................................ 72
Input Prices and Supply ...................................................................................................................... 74
viii
Technology and Supply ...................................................................................................................... 74
Other Determinants of Supply ............................................................................................................ 75
APPLICATION BOX 3.1.......................................................................75

APPLICATION BOX 3.2.......................................................................76
3.2.2: From Individual to Market Supply ....................................................................76
3.3: THE MARKET AND EQUILIBRIUM ............................................................................. 78
Market with Excess Demand .............................................................................................................. 78
Market with Excess Supply................................................................................................................. 79
Market in Equilibrium......................................................................................................................... 80
3.4: CHANGES IN EQUILIBRIUM: HOW MARKETS ALLOCATE RESOURCES? ................... 81
3.4.1: Changes in Demand ............................................................................................81
Increase in Demand............................................................................................................................. 82
APPLICATION BOX 3.3.......................................................................84

APPLICATION BOX 3.4.......................................................................85
Fall in Demand.................................................................................................................................... 85
3.4.2: Changes in Supply ..............................................................................................86
Increase in Supply ............................................................................................................................... 86
APPLICATION BOX 3.5.......................................................................88

Fall in Supply ...................................................................................................................................... 88
APPLICATION BOX 3.6.......................................................................89

3.4.3: Simultaneous Changes in Demand and Supply................................................90
Increase in Demand and Fall in Supply .............................................................................................. 90
3.5: WHY ECONOMISTS INSIST ON EQUILIBRIUM?.......................................................... 91
Key Concepts ...................................................................................................................94
Chapter Summary ............................................................................................................95
CHAPTER 4: MARKETS and PRICE CONTROLS
4.1: PRICE-CEILING ........................................................................................................ 101

APPLICATION BOX 4.1..................................................................... 102
Non-Price Rationing ......................................................................................................................... 103
APPLICATION BOX 4.2..................................................................... 104

APPLICATION BOX 4.3..................................................................... 106
APPLICATION BOX 4.4..................................................................... 107
4.1.1: Black-Markets .................................................................................................... 107
4.1.2: Objectives of Price-Ceiling ............................................................................... 109
Consumer Affordability .................................................................................................................... 109
ix
Price Stability .................................................................................................................................... 109
Maintaining Competitive Prices........................................................................................................ 110
Income Redistribution ....................................................................................................................... 111
4.2: PRICE-FLOOR .......................................................................................................... 111
APPLICATION BOX 4.5..................................................................... 113
FYI: B O X 4.1 .............................................................................................. 114
4.3: WHY ECONOMISTS PREACH FREE-MARKETS? ....................................................... 114
Price as Information, Incentive and Allocative Device ..................................................................... 114
4.3.1: Logic behind Elimination of Price-Controls .................................................... 115
Distortion in Resource Allocation..................................................................................................... 115
Non-Money Competition .................................................................................................................. 115
APPLICATION BOX 4.6..................................................................... 116

4.3.2: Does Economics Discourage State Intervention? ............................................ 117
Key Concepts ................................................................................................................. 119
Chapter Summary .......................................................................................................... 120
Review Questions........................................................................................................... 122
CHAPTER 5: ELASTICITY
5.1: SLOPE AND ELASTICITY ........................................................................................... 125

Why not Slope? ................................................................................................................................. 126
Meaning of Elasticity ........................................................................................................................ 127
The Elasticity of Demand ................................................................................................................. 129
5.2: PRICE ELASTICITY OF DEMAND............................................................................... 129
Point Elasticity .................................................................................................................................. 130
Arc Elasticity .................................................................................................................................... 130
APPLICATION BOX 5.1..................................................................... 132

5.2.1: Classifying Price Elasticity of Demand ............................................................ 133
5.2.2: Determinants of Own Price Elasticity .............................................................. 135
Availability of Substitutes ................................................................................................................. 135
Degree of Necessity .......................................................................................................................... 135
Time Factor ....................................................................................................................................... 135
Budget Share of a Commodity .......................................................................................................... 136
5.2.3: Price Elasticity and Revenue (Expenditure) Changes...................................... 137
APPLICATION BOX 5.2..................................................................... 139
Elasticity of a Straight Line and Total Revenue Curve ..................................................................... 140
APPLICATION BOX 5.3..................................................................... 144

5.2.4: Geometric Interpretation of Price Elasticity .................................................... 145
Elasticity of Two Straight Line Demand Curves .............................................................................. 146
Elasticity of Two Pivoting Lines ...................................................................................................... 147
Elasticity of Two Intersecting Lines ................................................................................................. 148
x
5.3: INCOME ELASTICITY OF DEMAND ........................................................................... 148
5.4: CROSS PRICE ELASTICITY OF DEMAND................................................................... 150
5.5: SUPPLY ELASTICITIES .............................................................................................. 150
5.6: ELASTICITY AND CAPITALIST POLICY ..................................................................... 151
Calculating Combing Effects ............................................................................................................ 151
APPLICATION BOX 5.4..................................................................... 154

Key Concepts ................................................................................................................. 157
Chapter Summary .......................................................................................................... 158
PART 3: BEHIND MARKETS: CONSUMER AND PRODUCER BEHAVIOR
CHAPTER 6: PREFERENCES AND UTILITY
6.1: WHO IS CONSUMER? ............................................................................................... 167

6.2: CONSUMER BEHAVIOR AND THE THEORY OF CHOICE ........................................... 169
6.3: MODELING CONSUMER PREFERENCES ................................................................... 171
The Strict Preference Relation .......................................................................................................... 172
The Indifference Relation ................................................................................................................. 172
6.3.1: Assumptions about Consumer Preferences: Rationality Conditions ............. 173
The Indifference Map ....................................................................................................................... 176
Convexity and the Slope of the Indifference Curve .......................................................................... 182
Indifference Curve as Representative of Taste ................................................................................. 182
Diminishing Marginal Rate of Substitution (DMRS) ....................................................................... 184
6.4: TASTE FOR SPECIAL COMMODITIES: EXAMPLE OF IC ............................................ 185
An Economic Bad ............................................................................................................................. 186
A Useless Good ................................................................................................................................ 186
Perfect Substitutes ............................................................................................................................. 187
Perfect Complements ........................................................................................................................ 188
6.5: THE UTILITY FUNCTION .......................................................................................... 189
6.5.1: Indifference Curves and Utility Functions ...................................................... 189
APPLICATION BOX 6.1..................................................................... 190
Marginal Utility ................................................................................................................................ 192
MRS as the Ratio of Marginal Utilities............................................................................................. 194
Difference between Marginal Utility and MRS ................................................................................ 195
FYI: B O X 6.2 .............................................................................................. 196

Key Concepts ................................................................................................................ 198
Chapter Summary ........................................................................................................ 199
Review Questions ........................................................................................................ 202
xi
CHAPTER 7: BUDGET SET, CHOICE AND DEMAND
7.1: THE BUDGET SET ..................................................................................................... 207

Slope of Budget Line ........................................................................................................................ 209
7.2: CONSUMER CHOICE ................................................................................................ 211
What Does Consumer Want to Do? .................................................................................................. 211
7.2.1: Consumer Equilibrium ..................................................................................... 214
Why Tangency? ................................................................................................................................ 215
Meaning of Tangency ....................................................................................................................... 216
From Two-Goods to Infinity ............................................................................................................. 218
Consumer Sovereignty ...................................................................................................................... 218
Freedom = Income ............................................................................................................................ 219
7.2.2: Assumption of Convexity and Uniqueness of Equilibrium ........................... 220
Consumer Optimum with Concave Preferences ............................................................................... 221
7.2.3: Equi-Marginal Principle: Restating Consumer Equilibrium .......................... 222
Why Must this Condition Hold? ....................................................................................................... 225
APPLICATION BOX 7.1..................................................................... 225

Why Alternative Approaches? .......................................................................................................... 227
7.3: EXPLAINING CHOICE FOR SPECIAL TASTES ........................................................... 228
A Useless Good ................................................................................................................................ 228
An Economic Bad ............................................................................................................................. 229
Perfect Substitutes ............................................................................................................................. 230
Perfect Complements ........................................................................................................................ 231
7.3: DEMAND .................................................................................................................. 231
7.3.1: Demand Functions ............................................................................................ 232
Taste Differentials and Demand........................................................................................................ 232
Homogeneity of Degree Zero: A Property of Demand Functions .................................................... 235
7.3: CONSUMER THEORY AND UTILITARIANISM ........................................................... 236
What is Next? .............................................................................................................. 238
Key Concepts ................................................................................................................. 239
Chapter Summary .......................................................................................................... 240
CHAPTER 8: CHANGES IN DEMAND: Comparative Static Analysis
8.1: INCOME CHANGES AND DEMAND ........................................................................... 247

8.2: NORMAL AND INFERIOR GOODS ............................................................................ 249
8.2.1: Income-Consumption Path and Engel’s Curve ................................................ 251
Shape of ICP or Engel’s Curve and Flaws in Economic Reasoning ................................................. 252
Application BOX 8.1 ............................................................................................. 254

8.3: OWN PRICE CHANGES AND DEMAND ..................................................................... 254
8.3.1: Price Changes and Demand for ‘Normal’ Goods............................................. 256
xii
The Substitution Effect ..................................................................................................................... 256
The Income Effect............................................................................................................................. 256
Price Consumption Curve and Individual Demand Curve ................................................................ 258
Slope of Demand Curve: Graphical Analysis of Substitution and Income Effects ........................... 259
FYI: B O X 8.1 .............................................................................................. 263

FYI: B O X 8.2 .............................................................................................. 264
8.3.2: Price Changes and Demand for Inferior Goods .............................................. 264
Graphical Analysis of Inferior Goods ............................................................................................... 265
8.4: FROM INDIVIDUAL TO MARKET DEMAND: AN UNTOLD STORY ABOUT THE
CONTRADICTIONS OF ECONOMICS ................................................................................ 267
From One to Infinity ......................................................................................................................... 267
Economist’s Vision of Human Being and Society ............................................................................ 269
8.4.1: The Collapse Begins: The Problems of Aggregation ....................................... 269
Solution: One for All and All for One—the representative consumer .............................................. 272
APPLICATION BOX 8.2..................................................................... 274

Is it a Solution or Contradiction? ...................................................................................................... 274
APPLICATION BOX 8.3..................................................................... 275

Equilibrium in Question .................................................................................................................... 276
Why Consumer Theory at All? There is even more to surprise ........................................................ 277
FYI: B O X 8.2 .......................................................................................................... 278

Does Capitalism Allow Heterogeneous Taste and Cultures? ............................................................ 280
8.4.2: The Possibility of Discontinuous Individual Demand Curve ........................ 281
Non-Convex Preferences and Individual Demand Curve ................................................................. 281
8.5: CROSS PRICE EFFECT AND THE SLOPE OF PRICE CONSUMPTION PATH ............... 282
Key Concepts ................................................................................................................. 284
Chapter Summary .......................................................................................................... 285
CHAPTER 9: FIRM AND PRODUCTION IN CAPITALIST SOCIETY
9.1: FIRM: THE AGENT OF PRODUCTION IN CAPITALIST ORDER ................................. 291

9.1.1: The Firm ............................................................................................................. 292
Application BOX 9.1 .......................................................................... 293
The Firm and the Entrepreneur ......................................................................................................... 294
Plant and Industry ............................................................................................................................. 294
9.1.2: Legal Forms of the Firm .................................................................................... 295
Proprietorship.................................................................................................................................... 295
Partnership ........................................................................................................................................ 296
Corporation ....................................................................................................................................... 296
9.2: DYNAMICS OF PRODUCTION IN CAPITALIST SOCIETY ........................................... 298
9.2.1: How it All Got Going: Transformation to Capitalist Production ................... 298
xiii
9.2.2: Impact of Capitalist Production on Society ..................................................... 300
Capitalist Production Imposes New Social Discipline ...................................................................... 301
Application BOX 9.2 .......................................................................... 301

Capitalist Production Producing New Social Networks.................................................................... 302
Capitalist Production Eliminates the Natural Order of Life .............................................................. 303
Capitalist Production Destroys Family Institution ............................................................................ 304
Capitalist Production and Capitalist Individuality ............................................................................ 305
Key Concepts ................................................................................................................ 307
Chapter Summary ........................................................................................................ 308
CHAPTER 10: NEOCLASSICAL THEORY OF PRODUCTION
10.1: THE PRODUCTION FUNCTION ............................................................................... 313

Classification of Inputs ..................................................................................................................... 314
Economists’ Preferred Form of Production Function ....................................................................... 315
What is Capital? ................................................................................................................................ 316
Short Run and Long Run for Firm .................................................................................................... 317
APPLICATION BOX 10.1 .................................................................. 317

10.2: PRODUCTION WITH SINGLE INPUT VARIABLE: SHORT RUN ANALYSIS .............. 318
10.2.1: Returns to Factor Input .................................................................................... 319
APPLICATION BOX 10.2 .................................................................. 320
Diminishing Marginal Product.......................................................................................................... 321
Production Functions without Diminishing Marginal Product Assumption ..................................... 323
Deriving Marginal Product Curve..................................................................................................... 324
10.2.2: Evaluating Diminishing Marginal Productivity ............................................ 325
FYI BOX 10.1 ................................................................................................. 330
10.2.3: Relationship between Marginal and Average Products ................................ 330
Stages of production ......................................................................................................................... 333
10.3: PRODUCTION WITH TWO INPUTS VARIABLE : LONG RUN ANALYSIS ................. 335
APPLICATION BOX 10.3 .................................................................. 336
10.3.1: Iso-Quant Curves: Modeling Production with Several Inputs Variable ............... 337
Marginal Rate of Technical Substitution .......................................................................................... 339
Properties of Iso-quant Curves .......................................................................................................... 341
Changing a Single Input When Several Can be Changed ................................................................. 341
10.3.2: Returns to Scale ............................................................................................... 342
Increasing Returns to Scale ............................................................................................................... 344
Decreasing Returns to Scale ............................................................................................................. 345
10.3.3: Input Substitution ........................................................................................... 345
Fixed Proportion Production Function .............................................................................................. 346
APPLICATION BOX 10.4 .................................................................. 347

Why Typical Iso-Quant? ................................................................................................................... 348
xiv
Key Concepts ................................................................................................................. 351
Chapter Summary .......................................................................................................... 352
CHAPTER 11: NEOCLASSICAL THEORY OF COST
11.1: THE ECONOMIC CONCEPT OF COST ..................................................................... 359

APPLICATION BOX 11.1 .................................................................. 360
The Cost Equation............................................................................................................................. 361
11.2: CHOICE OF TECHNIQUE AS COST MINIMIZATION ................................................ 361
Stating the Problem of Cost-Minimization ....................................................................................... 362
11.2.1: Cost Minimizing Input Choice ....................................................................... 363
Graphical Solution ............................................................................................................................ 364
Uniqueness of Equilibrium and Convexity of Iso-quants ................................................................. 366
11.2.2: Firm’s Expansion Path ..................................................................................... 367
11.3: SHORT RUN COST CURVES .................................................................................... 369
11.3.1: Deriving Total Cost ......................................................................................... 369
Fixed and Variable Cost Curves ....................................................................................................... 370
The Total Cost Curve ........................................................................................................................ 372
11.3.2: Per Unit Cost Curves ....................................................................................... 372
Deriving the Marginal Cost Curve .................................................................................................... 372
Relationship between Marginal and Average Total Cost Curves ..................................................... 374
Relationship between Average Total and Average Variable Cost Curves ........................................ 377
11.3.3: The Sraffian Cost Curves ................................................................................ 378
11.4 : LONG RUN COST CURVES .................................................................................... 380
11.4.1: Long Run Average Total Cost ......................................................................... 380
Issue of Reserve Capacity ................................................................................................................. 382
11.4.2: Relation between Short-Run and Long run: The Envelop Curve ................ 383
Key Concepts ................................................................................................................ 386
Chapter Summary ........................................................................................................ 387
PART 4: FIRM IN THE OUTPUT MARKET
CHAPTER 12: PERFECT COMPETITION
12.1: STRUCTURE OF PERFECT COMPETITION ............................................................... 395

12.1.1: Implications ..................................................................................................... 395
Price Taking Behavior ...................................................................................................................... 395
Law of One-Price .............................................................................................................................. 396
APPLICATION BOX 12.1 .................................................................. 396
xv
The Fiction of the ‘Horizontal-Demand-Curve’ ............................................................................... 397
FYI BOX 12.1 ................................................................................................. 398

12.1.2: Revenue Structure of the Competitive Firm .................................................. 399
12.2: PROFIT-MAXIMIZATION AND FIRM SUPPLY ........................................................ 401
12.2.1: Choice of the Scale of Output ......................................................................... 401
The ‘Total-Condition’ ....................................................................................................................... 402
Marginalism: the Per-Unit-Condition for Profit Maximization ........................................................ 404
12.2.2: Firm Equilibrium and Derivation of the Supply-Curve ............................... 405
Profit-and-Loss ................................................................................................................................. 406
The Shut-Down Rule and the Supply Curve ..................................................................................... 407
APPLICATION BOX 12.2 .................................................................. 408

Market Supply Curve ........................................................................................................................ 409
12.3: TRANSITION TO LONG RUN EQUILIBRIUM .......................................................... 410
Market Period Supply ....................................................................................................................... 410
APPLICATION BOX 12.3 .................................................................. 411

12.3.1: Moving to Long Run Equilibrium .................................................................. 413
The Meaning of Normal Profit.......................................................................................................... 414
Alleged Efficiency of Competitive Markets ..................................................................................... 416
12.3.2: The Real Politics behind Competitive Markets ............................................. 416
A Night Watchman State .................................................................................................................. 416
Cut Throat Markets ........................................................................................................................... 417
Freedom and Market-Justice ............................................................................................................. 418
12.4: PERFECT COMPETITION IS NOT PERFECT ............................................................ 419
12.4.1: Sraffa on Perfect Competition ........................................................................ 419
Competitive Market with Constant Marginal Product ...................................................................... 420
Diminishing Marginal Product and Independence of Demand-Supply............................................. 421
What about the Real World? ............................................................................................................. 423
Key Concepts ................................................................................................................ 426
Chapter Summary ........................................................................................................ 427
Appendix Chapter 12 ................................................................................................... 431
Consumer Surplus ...................................................................................................... 431
Producer Surplus ........................................................................................................ 432
Social Welfare or Total Surplus ................................................................................. 433
CHAPTER 13: MONOPOLY
13.1: STRUCTURE OF MONOPOLY .................................................................................. 438

13.1.1: Implications ..................................................................................................... 438
Price Setting Behavior ...................................................................................................................... 439
Revenue Behavior ............................................................................................................................. 440
xvi
Algebraic Treatment of Marginal Revenue .................................................................... 441
FYI BOX 13.1 ................................................................................................. 444
13.2: PROFIT-MAXIMIZING OUTPUT AND THE MONOPOLIST’S PRICE ...................... 445
The Marginal Condition .................................................................................................................... 445
Total Condition and Shut Down Rule ............................................................................................... 447
13.2.1: Monopoly Supply Curve ................................................................................. 448
13.3: MONOPOLY POWER .............................................................................................. 449
13.3.1: Measuring Monopoly Power .......................................................................... 449
A Rule of Thumb for Monopoly Pricing........................................................................................... 449
Lerner Monopoly Power Index ......................................................................................................... 451
13.4: CREATING AND SUSTAINING MONOPOLY POWER: ENTRY BARRIERS ................ 451
Application BOX 13.1 ....................................................................... 451
13.4.1: Franchise Rights............................................................................................... 452
Why Franchise Rights? ..................................................................................................................... 453
13.4.2: Natural Monopoly ........................................................................................... 453
Sustainable Monopoly ...................................................................................................................... 456
13.4.3: Active Pricing Strategy .................................................................................... 457
Inertia Shopping Rule ....................................................................................................................... 457
13.4.4: Investment Requirements and Capital Market Imperfections ..................... 459
Application BOX 13.2 ....................................................................... 459
13.4.5: Competitive Advantages ................................................................................. 460
Application BOX 13.3 ....................................................................... 461
Capitalist Dynamics and the Emergence of Monopolies .................................................................. 461
13.5: NEED FOR REGULATING MONOPOLY AND STATE POLICY................................... 463
13.5.1: Social Cost of Monopoly: The Standard Story............................................... 463
Monopoly and Deadweight Loss ...................................................................................................... 464
13.5.2: State Instruments for Regulating Monopoly ................................................. 466
Price Regulation ................................................................................................................................ 466
Rate of Return Regulation................................................................................................................. 468
Application BOX 13.4 ....................................................................... 469

Price-Cap Regulation ........................................................................................................................ 469
13.6: COMPETITION MANIA UNVEILED: YET ANOTHER UNTOLD STORY OF ECONOMICS
......................................................................................................................................... 471
13.6.1: Horizontal Demand Curve Fallacy ................................................................. 472
FYI BOX 13.3 ................................................................................................. 475
13.6.2: No MR-Curve Fallacy ...................................................................................... 477
13.6.3: ‘P = MC Maximize Profit’ Fallacy ................................................................... 478
13.6.4: The Competition Better than Monopoly Fallacy ........................................... 480
13.6.5: Other Fallacious Arguments ........................................................................... 481
xvii
Argument from Market Dynamics .................................................................................................... 481
13.6.6: Abandon ‘one for all’ policy ........................................................................... 483
Why Economics Preach Free Competition?...................................................................................... 484
Key Concepts ................................................................................................................ 486
Chapter Summary ........................................................................................................ 487
CHAPTER 14: MONOPOLISTIC COMPETITION AND OLIGOPOLY
14.1: MONOPOLISTIC COMPETITION............................................................................. 495

14.1.1: Structure and Implications .............................................................................. 496
Marketing as Essential Ingredient of Firm ........................................................................................ 496
Monopoly Power and Negatively Sloped Demand Curve ................................................................ 497
14.1.2: Output and Pricing Decision: Equilibrium of the Firm ................................ 498
Short-Run Equilibrium...................................................................................................................... 498
Long-Run Equilibrium ...................................................................................................................... 498
14.1.3: Efficiency of Monopolistic Competition ........................................................ 500
Justifying Excess Capacity................................................................................................................ 501
14.2: OLIGOPOLY: MEANING AND EQUILIBRIUM ......................................................... 502
14.2.1: Structure of Oligopoly..................................................................................... 502
Firm Interdependence ....................................................................................................................... 502
Defining Oligopoly as Market Concentration ................................................................................... 503
14.2.2: Equilibrium in Oligopoly Markets................................................................. 506
14.3: NON-COLLUSIVE OLIGOPOLY .............................................................................. 507
14.3.1: Cournot Duopoly Model ................................................................................. 507
Output Decision of Cournot Duopolist ............................................................................................. 508
Reaction or Best Response Function of Cournot Duopolist.............................................................. 509
Determining Cournot Equilibrium .................................................................................................... 510
Stability of Cournot Equilibrium ...................................................................................................... 510
Linear Demand Curve Example of Cournot Duopoly Model ......................................... 512
Welfare Properties of Cournot Duopoly ........................................................................................... 513
14.3.2: Stackelberg Duopoly Model: First Mover Advantage ................................... 515
Two Many Cooks Spoil the Curry .................................................................................................... 517
14.3.3: Bertrand Duopoly Model: Criticism of Cournot ............................................ 518
Demand Function of the Bertrand Duopolist .................................................................................... 518
Bertrand Equilibrium and its Efficiency ........................................................................................... 518
14.3.4: The Edgeworth Model ..................................................................................... 519
14.4: COLLUSIVE OLIGOPOLY ........................................................................................ 520
14.4.1: Instability of Collusion ................................................................................... 521
APPLICATION BOX 14.1 .................................................................. 522
Oligopoly Markets as Prisoner’s Dilemma ....................................................................................... 522
14.4.2: Making Collusion Stable ................................................................................ 523
xviii
Repeated Games and Stability of Collusions .................................................................................... 523
The Kinked Demand Curve Conjecture ............................................................................................ 524
14.4.3: Cartel Pricing Analysis .................................................................................... 526
An All-Inclusive Cartel ..................................................................................................................... 526
Cartel as Dominant Firm ................................................................................................................... 527
Application BOX 14.3 ....................................................................... 529

14.4.4: Mergers and Acquisitions ............................................................................... 530
Motives for Mergers ......................................................................................................................... 530
14.4.5: Antitrust Laws: Regulating Oligopoly ........................................................... 531
Regulation Methodology .................................................................................................................. 532
Oligopoly Redefined ......................................................................................................................... 533
14.5: CONCLUSION ......................................................................................................... 534
Key Concepts ................................................................................................................ 535
Chapter Summary ........................................................................................................ 537
Labor: an inverted commodity .......................................................................................................... 547
PART 5: FIRM IN THE INPUT MARKET: INCOME DISTRIBUTION
CHAPTER 15: MARKET FOR LABOR
15.1: DEMAND FOR LABOR IN A COMPETITIVE MARKET ............................................. 547

The Meaning of Competitive Input Markets ..................................................................................... 548
15.1.1: Factor Demand with One Input Variable....................................................... 549
The Shut Down Rule Revisited ......................................................................................................... 551
Digression on Similarity between Input-Output Markets ................................................................. 552
Changes in Input Demand ................................................................................................................. 553
15.1.2: Factor Demand with Two Inputs Variable..................................................... 553
Substitution Effect of an Input Price Change .................................................................................... 554
Output Effect of an Input Price Change ............................................................................................ 555
FYI BOX 15.1 ................................................................................................. 557

15.1.3: Market Demand for an Input .......................................................................... 557
15.2: SUPPLY OF LABOR: THE IDEOLOGY OF THE INDIFFERENT WORKER................... 558
15.2.1: Time Allocation Problem ................................................................................ 559
Preferences for Leisure and Income .................................................................................................. 560
Budget Set for Leisure and Income ................................................................................................... 560
Choice for Leisure and Income ......................................................................................................... 562
15.2.2: Changes in Labor Supply ................................................................................ 562
Substitution Effect of a Wage Change .............................................................................................. 562
Income Effect of a Wage Change ..................................................................................................... 564
Slope of the Labor Supply Curve ...................................................................................................... 565
15.3: EQUILIBRIUM IN THE LABOR MARKET ................................................................. 566
APPLICATION BOX 15.1 .................................................................. 567
xix
15.3.1: The Politics behind Labor Market Analysis .................................................. 569
‘Can’t Beat the Markets’—disintegrate the unions ........................................................................... 570
To Each According to his Contribution ............................................................................................ 571
15.4: PROBLEMS WITH THE NEOCLASSICAL THEORY AND POLICY PACKAGE .............. 571
15.4.1: Backward Bending Labor Supply Curve: The Case for Interventionist Labor
Policy ........................................................................................................................... 571
15.4.2: Market Power & Labor Market: The Case for Unionized Labor................... 575
Market Power in the Output Markets ................................................................................................ 575
APPLICATION BOX 15.2 .................................................................. 578

Monopsony: Market Power in the Input Markets ............................................................................. 579
Monopsonist Vs Labor Union ........................................................................................................... 583
APPLICATION BOX 15.3 .................................................................. 585

Monopsony and the Minimum Wage Laws ...................................................................................... 586
15.4.3: Perfect Competition Equals Monopsony ....................................................... 587
15.4.4: Sraffa’s Aggregation Issues ............................................................................. 590
Key Concepts ................................................................................................................ 592
Chapter Summary ........................................................................................................ 594
CHAPTER 16: MARKET FOR CAPITAL
16.1: DEMAND FOR “CAPITAL” IN A COMPETITIVE MARKET ...................................... 602

16.1.1: Demand for Capital ......................................................................................... 602
16.1.2: Supply of Capital ............................................................................................. 604
Intertemporal Budget Set .................................................................................................................. 604
Intertemporal Preferences ................................................................................................................. 607
Optimization: Choice about Saving and Borrowing ......................................................................... 608
Effects of Changes in Interest Rate ................................................................................................... 609
16.1.3: Equilibrium in the Capital Market ................................................................. 613
16.2: EULER’S EXHAUSTION THEOREM: SOLUTION TO CLASS CONFLICT .................... 614
16.3: COMPLEXITIES CREEP IN: SOME UNTOLD PROBLEMS WITH CAPITAL MARKET
ANALYSIS ........................................................................................................................ 617
16.3.1: Sraffa on Diminishing MP and Return on Capital ........................................ 617
16.3.2: The Problematic ‘Circular Flow’ of Economics .............................................. 618
16.3.3: The Capital Controversy ................................................................................. 620
An Impossibility Theorem ................................................................................................................ 622
Implications of the ‘Impossibility Theorem’ .................................................................................... 624
Political Agendas of the Two Cambridges........................................................................................ 626
16.4: WHY ECONOMICS? ................................................................................................ 626
Is Economics Free of Ideology? ........................................................................................................ 628
16.5: ECONOMIC THEORY OF PROFIT ............................................................................ 629
Types of Risks .................................................................................................................................. 629
xx
Schumpeter’s Account of Business Cycles and Profits..................................................................... 631
Keynes on Profit ............................................................................................................................... 632
Sraffian Position on Profit................................................................................................................. 632
Key Concepts ................................................................................................................ 634
Chapter Summary ........................................................................................................ 635
CHAPTER 17: ALTERNATIVES TO MICROECONOMICS
17.1: MACROECONOMICS, KEYNESIANISM AND POST-KEYNESIANISM ........................ 641

17.2: SRAFFIANS AND MARXISTS.................................................................................... 644
17.3: ISLAMIC ECONOMICS............................................................................................. 647
17.4: INSTITUTIONAL ECONOMICS................................................................................. 650
17.5: BEHAVIORAL ECONOMICS..................................................................................... 653
Expected Utility Theory .................................................................................................................... 654
The Endowment Effect ..................................................................................................................... 654
Hyperbolic Discounting .................................................................................................................... 654
Social Preferences ............................................................................................................................. 654
17.6: MANAGEMENT SCIENCES ...................................................................................... 656
17.7: CONCLUSION ......................................................................................................... 659
GLOSSARY ..................................................................................................................... 665
xxi
xxii
Introduction
Introduction to ‘Microeconomics’
1: Why This Book?
Introductory texts used in undergraduate and post graduate courses in Pakistan are
usually those used in America and Britain. They are written for British and American students
and they present Economics as if its teachings were universally applicable––as if it did not matter
whether we were trying to organize production and trade in the market for financial services in
New York in 2011 or studying the production and distribution of ajraks in Hala. Those who learn
Economics therefore develop an understanding about how the American and British system is
supposed to be working. They have no clue of what is happening in the markets of countries like
Pakistan.
This is a particularly important deficiency in understanding as far as microeconomics is
concerned. For while the Pakistani state has been colonized, markets remain embedded in our
traditional society. Decisions about whom to employ, what to produce, where to invest, how
much to save and in what form–––all these decisions are taken on the basis of values and
preferences which are not recognized by Economic theory, since it has a historically contingent
conception of economic rationality and assumes that this “economic rationality” is universal.
Moreover market institutions as they have evolved in South Asia over the last five
thousand years are quite different in several crucial ways from the market organization and
regulation practices of present day Britain and America. Assuming that markets in Pakistan are
organized and regulated according to the presumptions of Economic theory ignores and obscures
reality and makes it difficult for students to understand how Pakistani markets really function.
The primary purpose of this textbook is to assess the usefulness of microeconomic theory
as a basis for understanding how markets actually work in Pakistan and in other “third world”
countries which have broadly similar historical experiences and social organization. Every
chapter begins with a detailed user friendly presentation of mainstream microeconomic theory.
You do not need to have read any other Economics textbook before you read this book. It covers
all the topics included in any standard microeconomics book in as much detail. The book has
been written for introductory Economics courses in BBA, MBA and MA / MSc programs and a
special effort has been made to ensure that no topic covered in the microeconomics syllabus of
these programs has been left out in this book.
Many Pakistani authors have written Economics textbooks. But none of them have tried
to assess the extent to which this theory enables the student to understand how markets really
work in Pakistan. This book tries to do this by describing the social, political and intellectual
background against which Economics as a discipline emerged, the philosophical and ideological
assumptions on which it is based and the objectives it seeks to achieve. This book thus presents a
critique of microeconomic theory and not merely an exposition. Such a critique has so far not
been produced in Pakistan.
In the development of this critique we also present arguments and assessments of a range
of “heterodox” economists such as Pierro Sraffa, Karl Marx, Theorenstein, Veblen, Rudolf
Hilferding and Joan Robinson who have pointed out the inconsistencies in microeconomic
analysis and thus identified the limits of the functionality of Economics discourse. Like them we
reject the claim that Economics is a positive science—which merely seeks to describe the world
xxiii
Introduction
of production and exchange as it really is. Sraffa, Veblen and many other have argued that
Economics does not adequately describe how modern capitalist economies function. Instead
Economics is a normative science which assesses the operations of an economy on the basis of a
specific ideal type. This ideal type is a world characterized by perfect markets, total price
flexibility and general equilibrium. Actually existing capitalist systems do not correspond to this
ideal type and Economics therefore cannot describe them accurately. It concerns itself with
prescribing rules and criteria on the basis of which their performance must be judged and
improved upon.
An obvious limitation of Economics is that its analysis and prescriptions are relevant only
to capitalist systems. The extent to which a system of production and exchange is non-capitalist
(as is the case for most Third World societies), to that extent Economic analysis is essentially
irrelevant. Most Third World rulers are trying to convert their non-capitalist societies into
capitalist ones. Economics provides them with a set of criteria on the basis of which they can
measure the extent to which they have succeeded in this effort.
Summarizing we may say that this book:
a) enables the student to cover the whole range of topics included in the syllabi of introductory
microeconomics courses. It is meant to replace standard American and British textbooks;
such as Samuelson, Lipsey, Parkin, Nicholson and Mankiw
b) introduces the students to major critiques developed by Sraffa, Joan Robinson and Rudolf
Hilferding. Standard textbooks never discuss this work because it shows up the fundamental
weaknesses and incoherence of Economics analysis. This work shows that Economics is not a
positive science. It does not describe how modern capitalist systems actually work
c) enables the student to appreciate the essentially normative nature of microeconomics analysis
and thus to understand the reasons why Economics provides an incomplete and sometimes
quite false picture of what is actually happening in Pakistani markets
2: How to Use this Book
The book is divided into 5 parts:

Part 1: Preliminaries: It consists of two chapters:
1. Introduction to Economics
2. Introduction to Capitalism and Theory of Value
Part 2: Markets: Liberal framework of analysis: It consists of three chapters:
3. Basics of Demand and Supply
4. Market and Price Controls
5. Elasticity
Part 3: Behind Markets: Consumer and Producer Behavior: It consists of six chapters:
6. Preferences and Utility
7. Budget Set and Choice
8. Demand and Changes in Demand
9. Firm and Production in a Capitalist Society
10. Neoclassical Theory of Production
11. Neoclassical Theory of Cost
xxiv
Introduction
Part 4: The Firm in the Output Market: It consists of three chapters:

12. Perfectly Competitive Market
13. Monopoly
14. Monopolistic Competition and Oligopoly
Part 5: Firm in the Input Market: Distribution of Income: It consists of two chapters:
15. Market for Labor: Determination of Wages
16. Market for Capital: Determination of Interest
The last chapter “Alternatives to Microeconomics” (Chapter 17) summarizes several alternative
approaches to an analysis of product and factor market behaviors. It provides a basis for assessing
both the role and the limitations of microeconomics analysis of capitalist systems of production
and exchange.
We present the text in a reader friendly manner with many examples worked out in the
text. The main findings of each chapter are summarized at the end. The chapters conclude with a
set of review questions answering which will enable students to assess their understanding of the
main arguments presented in the chapter.
We have tried to minimize the use of algebra and no prior knowledge of mathematics is
presumed. Special care is given to explain the meaning behind technical analysis in a simple
manner.
3: Learning Tools
Several learning tools have been incorporated the text to facilitate your understanding.
These include:
• For Your Information (FYI) Box: present ancillary material for understanding. These are
usually used for clarifying difficult material and for providing additional information about
economic theory. Relatively difficult mathematical material is also presented in these boxes
• Application Box: to create a link between economic theory and the real world.
• Chapter Summaries: Every chapter ends with a summary of its major issues. These
summaries can be used for a quick review of the chapter, especially during preparation for
examinations
• Key Concepts: Learning the vocabulary of a discipline is an important part of any course.
Key concepts are highlighted in boldface within the chapter. The complete list of key words
introduced in any chapter along with their definition is given at the end of each chapter
• Review Questions: After reading a chapter, students can check their understanding by
answering the questions posted at the end of each chapter
• Glossary: A glossary of more than 250 words is given at the end of the book to keep students
familiar with the language of microeconomics
xxv
Introduction
xxvi
PART O N E:
Preliminaries
Economics as a Framework
for Capitalist Analysis
Chapter 1: Introduction to Economics

Chapter 2: Introduction to Capitalism and Theory of Value
1
Chapter
INTRODUCTION TO
ECONOMICS
1.1: WHAT IS ECONOMICS?
Every economics textbook —Lipsey, Samuelson, Mc Connell, Mankiw—pretends that

economics answers a question that applies to all times and all societies. That question is ‘how
scarce resources should be efficiently allocated among alternative uses?’ This definition of
economics was formulated by Lionel Robbins in 1932 and it enjoys widespread acceptance
among modern economists. But is this really a general question? Have all societies in recorded
history—a period of about 8,000 years—faced scarcity? In a famous book the anthropologist
Sahlins has shown that stone-age (Paleolithic) societies in Australia have always been affluent
societies. When James Meoae, a noble prize winner, was sent by the UN in the late 1940s to
make a plan for Kiribati—a group of South Pacific Islands—he found that the Kiribatians had
everything they wanted. Why then bother with economics? Heins Arndt, a famous Australian
economist, expressed much the same perplexity after visiting Mao’s China. Historically, there
was no economics in its present formal sense in the ancient Egypt or Mesopotania, the old
Chanare Kingdoms, Greece and Rome, medieval Europe, the Khilafat-e-Rashida, Asoka, Akbar’s
India and the Ottoman Empire. Why did none of these societies experience scarcity? The answer
to this question does not rest in the inadequacy of thinking capacity of these people; rather the
key to answer lies in the acceptance of the very concept of scarcity, the heart of modern
economics.
1.1.1: Scarcity
In order to understand economics clearly, we must understand the concept of scarcity
because it is this idea that underlies ‘what economics actually is’. Scarcity does not refer to goods
that are hard for an individual to obtain today or tomorrow. Similarly, it does not mean that
something is rare or available in some limited quantity. Rather something is said to be scarce if it
is perceived as rare by consumers. To take Lionel Robbins’ famous example, ‘bad eggs’ may be
“rare”, but if people do not desire bad eggs, then even one bad egg is already “too many” in their
eyes and thus will not be regarded as rare and scarce. In contrast, if people’s desire for cars is
very great, then in their perception even a large number of cars will be “too few”, thus cars will
be regarded as scarce. The important point to note is that the subjective element of desire is an
integral part of the concept of scarcity. Scarcity does not belong to objects or resources; rather it
arises due to a mismatch between human desires and availability of resources. Something
becomes scarce for an individual when he begins to feel that he does not have as much of it as he
wants. Thus, scarcity is a subjective phenomenon—it is an outcome of desire for more.
Not all societies experience scarcity; rather scarcity is encountered by a society when the
wants of individuals living within it continuously exceed the resources that society has available
for satisfying these wants. The rate of growth of wants always exceeds the rate of growth of
resources in such a society. Wants are of course psychological. A person living in a society
characterized by scarcity not only wants all, but also wants more and more of this all. Thus even
if Bill Gates is given all the resources of the world, he can wish for all the resources in all the
universes; i.e., he can wish to create new universes. There is no limit to his desires. However, his
ability to create new resources is limited. Economists define resource as anything that can satisfy
1
a human want. Gates can never create new universes. An aspiring fast bowler cannot become
eight feet tall. Wants and desires if they are unlimited must necessarily remain unfulfilled because
Gates cannot create resources by merely wishing to do so (this point is incorporated in
microeconomic analysis through the concept of the budget line, see chapter 7).
It is important to note that in capitalist society, Gates does not merely want more of a
particular commodity, say car; rather he wants ‘more of all’ goods and services. Hence scarcity is
infinite. On the other hand, if wants are limited, scarcity can be limited. Finally, if wants are less
than the available resources scarcity is abolished. Thus, it is possible to overcome scarcity. This
idea can be expressed in a simple equation. Since scarcity (S) is the differences between wants
(W) and resources (R), we have:
S=W– R (1.1)
We can see that S can be infinite if W is infinite, positive if W > R, and negative if W < R. This is
shown in Figure 1.1.
Figure 1.1: Concept of scarcity in different societies
Religious society
Wants < Resources → Negative Scarcity
Non-capitalist society
Wants > Resources → Positive Scarcity
Capitalist society
Infinite Wants → Infinite Scarcity
The Emergence of Economics
The religious texts—both the Quran and the Bible—regard scarcity as a consequence of
the forgetfulness of death and the afterlife. Such a life is the life of the typical capitalist individual
who first appeared in Europe in the early modern period. This type of life is theorized and
justified by the philosophers of the Enlightenment and their scientific precursors (Bacon,
Descartes, Kant, Rousseau, Hume, Smith) in the seventeenth and eighteenth century) as
something just and natural.
Economics is a project of the Enlightenment movement. It appeared in France and

Scotland in the eighteenth century when capitalist individuality (individuality dominated by
infinite wants) had become widespread, capitalist society had taken roots and capitalist states
(Restoration England, Republican France, independent America) were consolidating their hold on
2
power. All pre-Enlightenment societies—ancient Greece, medieval Europe, the Khilafat-e-

Rashida—were affluent societies in the sense that there was no scarcity in these societies.
Scarcity as a separate academic concept is a product of the Enlightenment which legitimated
capitalism.
Capitalism is a way of life in which human beings are committed to the objective of
‘maximization of freedom’ and forget about or seek to push back limits and constraints. The one
constraint that cannot be pushed back infinitely is life itself. Therefore, Enlightenment sciences,
including economics, never mention death or the afterlife realities. All other constraints are in
principle relaxable provided one has the motivation to relax them. Economics presumes that
wants are unlimited and that it is natural to seek their maximum satisfaction through continuing,
never ending and eternal capital accumulation. Capitalist man is (as Rousseau said) born free and
it is in his nature to want more and more of all. Freedom produces scarcity (unlimited wants) and
economics answers the question “should wants be limitless in relation to resources” with a loud
and resending “yes”—this is the indisputable norm underlying all positive economic analysis.
Economics celebrates scarcity. It recognizes that eliminating scarcity would be eliminating freedom
and its associated justification for never ending and eternal capital accumulation. Accepting scarcity
as natural and rational is accepting the capitalist way of life.
Scarcity and Choice
Scarcity implies choice. If scarcity means that Gates does not have all that he wants, it
also means that Gates cannot fulfill all his desires with available resources, no matter how
abundant these resources may be. Gates will have to decide which desires to satisfy and which to
leave unsatisfied: choice is inevitable. This choice is made among alternative uses of resources.
To see this, consider a student who is contemplating about his future career plans after passing
intermediate exam. He might have several plans regarding his studies: he might be willing to
become a doctor because his father wants him to be this, an engineer because his mother has a
strong desire to see him an engineer, a lawyer because none of his family members have ever
done this before, an Alim-e-Deen because he has personal interest in Islam. But the problem is
that he has limited time available (24 hours a day) that he has to allocate among many daily
activities, like praying five times a day, sleeping, eating, other household activities and of course
studying. Another fact that constraints his study plans is that almost all such degree programs
presume full-time study from a student. Therefore, his desires compete with each other and a
given resource can be used to fulfill only one (or some) of them at a time. However, if the length
of a day were, say 1,000 hours, then the student would not be thinking which degree program to
choose because he could afford to attend classes of different programs at different places during
such a long day. In other words, he would not be confronted with the problem of choice if there
were no scarcity of time.
Almost all resources have several uses, i.e. can be used to satisfy more than one end before
they have been put into use for some specific end. For example, the student could use his time in
several ways before he actually takes admission in any particular discipline. Once admitted, say, in the
morning engineering program at NED, he cannot spend his morning time, say, studying at Karachi
University in the Economics department without losing his lectures at NED. To take another example,
3
a piece of land within the city can be used for many purposes: for constructing a house, for
establishing an educational institution or some office space, developing it as a playing ground or a
park, and so on. But once an educational institution has been established, this piece of land cannot be
used as a house or a park. Although some resources have multiple uses (a piece of land being used as
foot-ball and cricket ground at different times); yet using one resource in one way does involve giving
up its use in some other way at that time. A ground cannot be used for playing foot-ball and cricket at
the same time. And even if it could be used for both games at a time, it could not be used as a school.
With scarce resources, one is forced to make choices for the attainment of specific wants: trade offs
are required among desires. Thus, doing something in one way involves giving up something else. In
other words, each choice has a cost in a sense that one has to pay for the most desired alternative by
giving up the opportunity to have some other alternatives, called its opportunity cost. Opportunity
cost of a particular choice is the satisfaction that would have been derived from the next best
alternative foregone; in other words, it is the value of forgone activities in making a certain
choice or decision (see chapter 11 for details).
Choice and Allocation Problem
Why have we been dwelling so much into the concept of choice? This is because it is choice
which creates the problem of allocation. When you are facing a situation involving choice, you are
basically thinking how a given resource should be allocated among its many possible uses. A student
undertaking career planning is actually considering how to allocate his available time that can be used
in many ways. Thus, wherever scarcity of resources exists, the problem of allocating those
resources needs to be addressed. As an example, think why no one cares about who will use how
much air to breathe or sea water to drink? It is because these resources are not scarce; in the sense
that demand for them is less than their supply at zero price (this may not remain true for both air
and water due to pollution). And because they are not scarce, no allocation problem arises.
Correctly speaking, scarcity of a resource exists only if the individual’s desire for it exceeds its
supply when it is made available at zero price. The relationship between scarcity, choice and
allocation is depicted in figure 1.2.
Figure 1.2: Scarcity, Choice and Allocation
x: a Scarce Choice Allocation Problem: Not

b all can be selected at a
resource among
time for x
4
If scarcity implies allocating resources among alternative uses, how is this problem
solved? In other words, how can it be decided to which use a particular resource should be
allocated? Economists argue that since any single resource can be put to alternative uses,
optimum allocation problem requires it to be used where it produces the best results. But what is
that result and how can that result be attained?
Allocation Strategies: Competition and Efficiency

If the economic problem were merely the allocation of scarce resources, economics would be
an insubstantial discipline because this problem could be solved as easily as by drawing lottery or
some other simple scheme. Think of a university planning its BBA admissions for the year 2011.
Suppose it offers 100 seats for admissions while only 100 candidates apply against these 100
seats. Will this university face an allocation problem? No, because all applicants will, by default,
get admission (provided no minimum admission criteria exist). But assume that the number of
applicants is 500. Now the university will have to decide which candidates to select out of these
500 for the announced 100 seats; in other words an allocation problem arises. Suppose that a
meeting is called and a number of proposals are advanced. Some of them are listed below:
i) Lottery: one of the members suggests the strategy of writing down the names of all 500
candidates on paper slips and drawing 100 slips randomly. The lucky 100 whose names
appear on those drawn slips should be given admission. The beauty of this proposal is
that it requires the university to do very little evaluation and administration
ii) First-come-first-serve: Another member proposes to offer admissions only to those 100
students who are listed among the 100-earliest applicants. Or may be to those 100
applicants who happen to deposit the university fee earliest
iii) Dictatorship: Yet another person, who is probably the chief, suggests delegating all
powers to a single person or to a group of selected people who can then decide which
applicant to select as per their personal likeness
iv) Competition: Finally some one comes up with the idea of conducting an entry test and
selecting only the 100 top-scorers
All these strategies, and probably many more, are available to the university administration. Which
one should be chosen? This question cannot be answered until the objective of allocating resources
has been defined. The choice of a particular allocation strategy depends upon the objective of
allocation. For example, if the university wants to minimize time spent on allocation then the first two
of these four will be the most convenient. Will such allocation strategies be acceptable to an
economist? Obviously not. But why? To know this, let us go back to the definition of economics
which goes as: efficient allocation of scarce resources among alternatives uses. So, an economic
problem is not merely allocation, it is efficient allocation which is desired. Efficiency is another
important term which carries a specific and technical meaning in economics, but roughly
speaking it means ‘producing maximum utility and profit from given resources’. The objective (in
capitalism) is to maximize efficiency and the economic problem is to devise strategy which
allocates scarce resources among their alternative uses so that maximum utility and profit is
obtained from those resources.
In the light of this advice from an economist, which strategy should the university adopt?
Obviously, the university administration should discard the first three of these strategies because
5
they do not guarantee the attainment of efficiency. The best strategy will be competition because
it is believed that the process of competition will ensure efficiency. Let us explain this link
between competition and efficiency. Competition is a process which involves rivalry among
many individuals who are struggling against each other to obtain the same scarce resource. It
ensures efficiency because it forces the resources to flow to those individuals who are the most
deserving or who have the ability to produce profit and utility using them. The lottery system
does not guarantee that the names of students which appear on drawn slips would be of those who
deserve them the most; that is who can score maximum grades and thus be good business
administrators maximizing profits for their future employers. The final strategy alone, students
competing against each other for the same given resource (100 admission seats) is the most likely
to identify the top 100 student who would perform best in terms of examination grades among all
500 applicants in future and be the most efficient (profit maximizing) employees in the future. In
other words, they will be the best utilizers of scarce university seats; that is they will produce
maximum utility and profits from given resources. The competitive process will automatically
weed out those not interested in or not capable of maximizing utility and profit.
Efficiency is the utilization of limited resources for the maximum satisfaction of
unlimited ends. This unlimited end is capital accumulation—an ever increasing but never ending
expansion in the resources of a firm or a society. Never ending capital accumulation requires the
maximization of profit and since profits are obtained through the satisfaction of desires, the
maximization of profits is the maximization of utility in ‘pure’ capitalist society. The objective of
competition in capitalist society is thus the maximization of profit and utility—the maximization
of the rate of capital accumulation.
Economics, as capitalism’s ideology, seeks the promotion of competition (and a
particular type of competition) because non capitalist individuals and societies do not accept
competitive behavior as a moral or rational response to the problem of limited resources. The
famous incident of the formation of brotherhood between the Mohajireens and the Ansars after
Hijrah (known as ‘Mawakhat-e-Madina’) shows that competition is neither a natural nor an
inevitable response to resource limitation. Sahlins’ research—and that of many other
anthropologists’—shows that co-operation is the norm in virtually all non-capitalist societies.
Thus competitive individuality does not emerge spontaneously as believed by economists.
Creating the emotional, intellectual and spiritual characteristics that sustain competitive
individuality is a difficult task, as the IMF found out when it tried to introduce competitive markets
in the post Communist Societies of East Europe during the 1990s.
To see why competition is not a natural response to the problem of limited resources, we need
to appreciate the real essence of competition. First note that competition occurs among those
individuals who want the same resource, not just between those who have the resource and those who
want it. The possession of a particular resource by one individual will not take him away from this
rivalry for more because he wants more of what both he and others posses. To take an example,
suppose you have a cloth-shop at Jamia Cloth Market, where there are many other cloth-shops. As an
economic man, (someone who is dominated by his self-interest and lust for more) you should assume
that all other cloth-merchants in the market are your rivals, so you must try your best not only to
increase the number of your own customers, but also do your maximum to snatch the customers of
others. If you successfully implement this strategy, you will be able to force some other merchants to
quit the market, selling their shops to you and, hence, increasing your profit. That is how the logic of
6
competition works: success in competition is not only a function of your own strengths, but also a
function of your rival’s weaknesses. A successful manager is one who is able to devise a strategy
which is capable not only of increasing his company’s reputation but also of hurting his rival’s
position. That is how you get control of more resources. Since other merchants will also be competing
to deprive you of your resources, the strategic control of more resources under your possession
requires an even more efficient strategy. But, what if the shop next to your one is that of your brother?
Will you still behave in the same way? Economics says that if you are a rational individual—only an
economic man is a rational individual—you will, and you must. Suppose that someone behaves as
capitalist rationality requires him to do and forces his brother out of the market. How will such an
individual be treated by a religious society? Clearly, he will be considered a man with bad morals.
Now recall that Muslims are said to be brothers of each other according to Quran. If competing out
your own brother from business for money is considered an unworthy act, how can this competition
against other Muslims be justified?
The justification of competition is summarized in figure 1.3 which shows that there can
be more than one ways to address the issue of scarcity. The reason economists opt for ‘growth
and the optimization of resource utilization’, instead of ‘reducing wants’, is based upon their
presumption that it is the efficiency and growth that ought to be achieved in case of scarcity. This
idea becomes further clear if we focus upon the objective function of economics.
Figure 1.3: Relationship between scarcity, efficiency and competition
Unlimited Scarcity of Limited

wants Resources Resources
Economic Problem
(Make Choices or
Allocation)
(Society‘s options to deal with scarcity)
Growth Efficiency Reducing

(permanent rise (Improving the Wants
in Resources) use of available
resources)
(Desired strategy to be used for these ends)
Competition
7
The Objective Function
Let us summarize what we have discussed so far. We began with a definition of

economics and came to the conclusion that economics undertakes a project to explain how scarce
resources of a society should be allocated so that maximum wants of its citizens could be
satisfied. It is the process of competition which best solves such an allocation problem.
Microeconomics is fundamentally concerned with the description of the competitive process: its
functioning, consequences and legitimacy.
Microeconomics commits itself to a specific end. This end is capital accumulation.
Capital accumulation is ‘an end in itself’ in the sense that in capitalist society it is accumulated
for the only purpose of accumulating more capital. It is on this basis that the capitalist markets
value all goods and inputs (see chapters 16). Even in the case of the allocation of the time
resources of a person who has few or no interactions with the financial markets ‘the law of value’
(the compulsion to maximize utility / profits) plays a determining role. The objective function of
resource allocation in capitalist markets is always utility / profit maximization—utility / profit
maximization as an end in itself. To clarify this idea, let us go back to the example of career
choice. On what basis should you decide whether to become an engineer or a manager or an
Alim? In capitalist society there is overwhelming pressure to make these choices on the basis of
what you will earn, i.e., what will eventually be your ‘net worth’. In capitalist society you do
what the market expects you to do and the market rewards you for obeying its commands (this
idea is captured in ‘consumer equilibrium’, see chapter 7). You are free to obey the market and
you cannot be free in any other way, for disobeying the market is necessarily rejecting freedom.
The market is an instrument for capital accumulation and it is access to capital that can make you
free (capital is the only concrete form of freedom, see chapter 2).
This shows that behind the technical question of allocation of time lies the prior
commitment to a particular set of (normative) objectives. Economics calls this ‘efficiency’ and
defines it as the maximization of utility and profits. It is very important to note that the questions
‘what one gets utility from’ and ‘what one does with profit’ are not completely irrelevant to
economic analysis. Economics is concerned with these questions because not all sources of utility
and uses of profits lead to the objective of efficiency. It endorses only that particular source of
utility and a particular use of profits that contributes to further accumulation of capital; i.e.
‘efficiency’. Thus using profits to support the Taliban is illegal—this is called ‘money
laundering’—but using profits to bribe the Taliban to join the Karzai regime is permissible—the
former is and the later is not ‘money laundering’—because this reduces resistance to global
capitalist order. Mahish Yogi’s religious senances are acceptable because they contribute to
capital accumulation and can be submerged within the media industry while Jihadi lectures are
not prescribed because they exhort people to find “value” in Shahadat. FYI Box 1.1 gives a brief
introduction to economics by summarizing the above discussions.
8
F Y I B O X 1.1
So What is Economics?
• It is an ideology of capitalism and provides instruments for governing capitalist societies
• It presumes that the rational individual is committed to freedom; i.e. endless capital
accumulation
• It advocates an organization of individuality and society to facilitate maximization of utility
and profit. This it calls “efficiency” and regards competition among self interested individuals
as necessary means for maximizing efficiency
• It solves the technical problem of resource allocation on the basis of its normative conception
of “efficiency”. All social acts and outcomes are accepted, rejected and valued in terms of
their contribution to unending and eternal capital accumulation which is recognized as the
only valid objective function of individuals and societies
1.2: HOW ECONOMISTS DO WHAT THEY DO?
Economics is respected as a science. Science is conventionally defined as a ‘systematic

body of knowledge that aims at discovering universal truths’. The word ‘systematic” means
connecting facts in causal relationship—cause-and-effect relationship—using some appropriate
methodology (to be discussed below). For a fact to qualify as a universal truth, it must fulfill two
conditions: first the relevant fact should be impersonal, i.e. should be independent of ‘who’ is
observing it. For example, if a ball when thrown in the air by me falls on the earth but does not fall
when you throw it, then this phenomenon of ball ‘falling on the earth’ cannot be called a universal
one because it depends upon who is throwing the ball. Secondly, the fact should be impartial, i.e.
should be independent of the ‘place’ from where they are observed. For example, if the ball falls on
the earth when thrown in Karachi but does not fall in Hyderabad, then it will not be a universal fact.
In brief, a universal truth or fact is one that can be attained by any person using the same
methodology. Thus, it is believed that scientific facts are independent of ‘who’ is observing them
from ‘where’; rather they depend on ‘how’ he is observing them.
1.2.1: Science and Knowledge

When it comes to the question of knowledge, there arise two important questions: (i)
what is the source of knowledge (where and how does it come from), and (ii) what is the
guarantee that knowledge obtained by that source is valid. Science claims to be the only way to
obtain true knowledge. It thereby challenges the authority of all revealed religions, particularly
Christianity and Islam. Science was born in the early modern period and its social dominance was
made possible by the Enlightenment movement of the seventeenth and eighteenth centuries (see
FYI Box 1.2).
9
F Y I B O X 1.2
Are You Enlightened?
According to Emanuel Kant, the Enlightenment movement’s leading philosopher, you are
‘enlightened’ only if you have the following beliefs:
• There is no ultimate authority except humanity
• Every human has the equal right to define good and evil as he likes to define it and to change
the definition at his will
• Every human can obtain knowledge through reason and through reason alone
• Reason is the pursuit of self-interest in a manner which does not obstruct the pursuit of self
interest by all other human individuals
• Everyone’s self interest is realized through the maximization of freedom; i.e. maximization of
the rate of capital accumulation
• One can have no knowledge of life after death, therefore it must be forgotten
The philosophers of the Enlightenment, and especially their seventeenth century predecessors
Bacon and Descartes, argued that in order to discover universal truth (which is both impersonal
and impartial) it is necessary to adopt a pre-scientific stance—a position where from we put
meaning and value in all that we observe. That stance is the stance of humanity. It is to begin with
the beliefs that ‘man is self-determined’ (see chapter 6 for details on this topic) and this universe
is nothing more than ‘a large mechanical machine’ having no objectivity. ‘Humanity’ is different
from ‘mankind’ (the Christian conception of being). Humanity is committed to freedom while
mankind is committed to worship. Freedom is increasing satisfaction of unlimited desires. Reason
in this discourse is defined as self-interested pursuit of freedom.
Bacon and Descartes (and later Locke and Kant) argued that man becomes capable of
discovering true knowledge when he adopts a rational stance; i.e. when he seeks to master nature
for the maximum satisfaction of his unlimited desires through pushing back ‘scarcity frontiers’
(see chapter 6 to see more on rationality). This rational stance has the implication that true
knowledge must be validated with reference to experience. Knowledge which cannot be
validated, for example the economist’s standard doctrine that all humans are self interested,
cannot provide a premises of true knowledge (Kant called this ‘belief in reason’). Only those
presumptions provide the valid premises—i.e. beliefs which are in principle non-falsifiable—for
scientific knowledge which facilitate the achievement of its purpose; i.e. the mastery of nature for
the maximum satisfaction of limitless desires. Thus “all men are self interested” is a valid premise
because on this basis a knowledge system can be constructed for maximization of profit and
utility. On the other hand the presumption “there is life after death” does not qualify as a valid
scientific presumption because it disputes the rationality of capital accumulation (as an end in
itself) in this life.
Structure of an ‘Economic Theory’
Economists usually accept the validation theory called ‘falsificationism’ developed by

Karl Popper. According to this theory a statement is scientific only if it is possible to refute it by
exposing it to the test of human experience. A typical economic theory thus has the structure
10
given in figure 1.4. The diagram also illustrates an example (you will fully grasp the essence of
this example after going through chapters 3 through 8). Economic theory has following elements:
Figure 1.4: Structure of a typical economic theory and its example
Testable Policy
Presuppositions Objectives Hypothesis Recommendation
Subject to the test of experiment
Outcome
If falsified If confirmed
Change the Change Apply the

hypothesis Policy policy
Example
Demand falls
Humans are Maximize and supply Do not interfere in
utility & rises as price
self-interested markets
profit goes up
Subject to the test of experiment
If proved false
Demand Correct
rises and market
supply falls failures
as price goes
• Presupposition: that all humans are self interested—cannot be subject to the test of
experience
• Objective: the objective of self-interested humans is the maximization of utility and profit—
cannot be subjected to the test of experience
11
• Hypothesis and policies: these are based upon the presumptions and are used for the purpose
of achieving the given objective—can be subjected to the test of human experience and may
even be changed if required
• Outcome: if the hypothesis (predicted behavior) matches the data trends (actual or observed
behavior), the theory is applied to achieve the given end. If it could not stand the test of data,
either the hypothesis or policy recommendations are revised
It should thus be clear that both the presumption and the objective are given and are never
subject to the test of falsifiability through experience. The theory is a prediction derived from the
presumption for the realization of the objective. Whether the prediction is true or not can then be
tested by observation. For example, economics presumes that:
• Mr. Farooq seeks utility maximization given his income (budget constraint). This leads to the
prediction that
• He will buy the cheapest potatoes in the market
Having derived this prediction, we can then observe Farooq’s purchase behavior and validate (if
Farooq buys the cheapest potatoes) or reject (if he does not) our hypothesis. If our hypothesis is
rejected we can:
• “Rationalize” his behavior; e.g.
o by saying that the potatoes that Farooq buys give him more utility than the cheapest
potatoes and this excess of utility outweighs the excess of cost
o or that Farooq does not know which thela (cart) is selling the cheapest potatoes
o or that Mr. Farooq is ignorant. He has been buying potatoes from the same thela (the
owner of which like Farooq is a member of the Tablighi Jama’at) for the last five years
and does not “test the market”.
But remember that we can’t reject the presumption or the objective in case our hypothesis is
falsified—we can’t conclude that ‘Mr. Farooq does not maximize utility’ or that ‘Mr. Farooq is
not a self-interested human’. This is so because if we come to the conclusion that Mr. Farooq is
‘irrational’; i.e. he does not seek utility maximization through buying the cheapest potatoes, then
economics will cease to exist as it provides no other basis for developing predictions about
Farooq’s behavior. If the normative presumption that ‘Mr. Farooq ought to be rational (utility
maximizer)’ is invalidated (through an examination of Farooq’s behavior), economic
methodology becomes redundant. Economists can say nothing about how Farooq will behave, if
he is not ‘rational’ (utility maximizer). This is the reason why economists either rationalize his
behavior (as shown above) or condemn his behavior—i.e. disapprove of Farooq for not being
‘rational’. The economic policy, both micro (i.e. related to the functioning of ‘households’ and
firms) and macro (related to the functioning of the national and global economy), is
overwhelmingly focused on persuading and forcing Farooq to act ‘rationally’. It is only where
Farooq is self-interested and acts ‘rationally’ that economic methodology can predict his
behavior. Falsification applies to economic hypothesis derived from presumption—and not to the
presumption itself. If a hypothesis (theory) cannot be tested, it cannot be falsified. Since
presumptions—that all humans are rational and Farooq is a human—cannot be falsified,
Popperian methodology regards them as pre-scientific. Only the (scientific) hypotheses derived
from these (pre-scientific) presumptions can be validated or rejected. Pre-scientific presumptions
can be neither refuted nor confirmed.
12
Economics as Paradigm
Men have to be self-interested maximizers of profit and utility for economics

methodology to become operational. If men are not utility / profit maximizers, economics cannot
predict their behavior. Economics begins from presuppositions (like all other sciences) not from
observation. Economics is thus a paradigm. A paradigm consists of:
• presumption about the behavior of individuals and groups of individuals. These presumptions
reflect the “world view” of economics. This world view can be expressed as “it is natural and
rational for individuals and societies to accept capitalist norms and procedures”
• a set of fundamental laws (most importantly the ‘laws’ of demand and supply) derived from
these pre-scientific presumption provide the conceptual framework for organizing the
analysis of observable data (say the development of a model showing what price formation
should occur in the potato market)
• the application of analytical methods (essentially constrained maximization techniques) for
evaluating observable data organized on the basis of the fundamental laws [say, the analysis
of actual formation of potato prices and indication of the extent to which they deviate from
the ‘ideal’ (‘competitive, profit utility maximizing’) prices]
• the derivation of policy conclusions regarding
o Why observations differ from predictions
o How can observed behavior be made to conform to predictions of the economists
(suggestion of reform to increase the ‘efficiency’ of the potato market).
FYI Box 1.3 summaries the tasks that economists are supposed to perform as scientists.
F Y I B O X 1.3
The Tasks of Economists as Scientists
Economists are supposed to:
• accept as natural and rational the doctrine that utility and profit maximization provides the
sole basis for organizing individual and social life.
• develop a theoretical framework for conceptualization of production, consumption and
exchange on the basis of the necessary veracity of the principle of utility / profit
maximization.
• collect observable data on the basis of this theoretical framework and subject it to tests of
constrained maximization leading to an assessment of the extent to which observed behavior
conforms to theoretical predictions.
• suggest policies for making observed behavior conform to economic rationality
(maximization of utility and profit).
A particular presumption—the belief in utility / profit maximization—is the fundamental

iman (faith) of the economist. The economist is conditioned / educated to accept this iman as
natural and rational. Indeed the economics paradigm defines rationality and nature on the basis of
this iman. If Farooq does not accept utility / profit maximization as his fundamental belief, then
13
he is crazy, ignorant, deviant, unnatural and a freak. The purpose of the course on
microeconomics is to convince you to accept that profit / utility maximization is the only natural
and rational belief on the basis of which individual and social life ought to be organized.
1.2.2: Positive Vs Normative Question

It is conventional to classify science into two distinct categories, both assumed to be
independent of each other. Table 1.1 shows some broad parameters on which this sharp distinction is
said to be based on. Positive science is supposed to consist of the domain of knowledge or
propositions which in one way or the other have to do with what is the case, or what may be
expected in the future. This is said to be an area of human knowledge where scientists study the
properties, and laws governing the processes of a mechanism and its consequences as objective
reality; i.e. a reality free of human preferences, opinions and expectations. Positive propositions
take the form of descriptive statements, statements that describe some fact as it is. “Two units of
hydrogen and one of oxygen make one unit of water” is a typical example of positive
propositions.
Table 1.1: Differentiating between Normative and Positive Science

Positive Normative
(Study of physical order) (Study of people in social order)
What is? What ought to be?
Descriptive Prescriptive
Facts Value judgments
Objective Subjective
Testable Weakly testable
Wide agreements Significance disagreements
Conversely, normative science is concerned with that part of knowledge which answers the
question ‘what ought to be’ or ‘what ought not to be’ the case in a given situation. For example,
the statement ‘one should not smoke’ is normative because it is not describing some given fact as
it is, it’s prescribing or suggesting something as a personal opinion or judgment of an individual.
Normative propositions are believed to be expressions of subjective feelings that are closed to
further argumentation, whether in public or in the person’s own mind. Normative Statements are
value-judgments which reveal the relative importance a person places on some given fact. Since
positive propositions deal with facts, one can test them against real world data, while normative
propositions cannot be tested because they miss the key element of ‘objectivity’. It is due to this
impossibility of reality testing that one finds so many differences on normative questions. This
dualism between ‘is’ and ‘ought’ is supposed to separate science from ethics and the objective
from the subjective.
The Normative Essence of Economics
Let us now take up the important question whether this sharp distinction between the two
areas of sciences is possible, whether scientists, especially in the area of social sciences, can work
independent of norms and values. To see the relationship between positive and normative propositions
14
in a rather non-technical way, think of the statement ‘the world should be made free of atomic bombs
because they are capable of mass destruction in human lives’. This statement is actually made up of
two types of statements, an ought-statement (the world should be made free of atomic bombs) and an
is-statement (they are capable of mass destruction in human lives). The later statement is presented as
a justification for one’s recommendation of a world free of atomic bombs. Is it a valid argument? Is it
logically valid to justify an ought-statement (recommendation) with an is-statement (facts)? The
answer is no, because no logical link exists between these two types of statements. No normative
conclusion can be validly deduced from a set of solely positive propositions without making at
least one normative proposition. We need at least one normative statement in the premises to
deduce another normative conclusion. In order to see how could the fact that an atomic bomb is
capable of mass destruction in human lives be used to justify that it should not be made, the
structure of argument should go as:
Premise 1: Because mass destruction in human lives should not be carried out
Premise 2: Atomic bombs are capable of such mass destruction
Conclusion: Therefore, the world should be made free of them’
You can see that an-ought statement was used in premise 1 to support another ought-statement in
the conclusion. To take an example from economics, consider the policy recommendation
‘government should reduce money supply to decrease inflation’. This recommendation is based upon
a widely accepted proposition in economics that there is a positive relationship between money supply
and inflation. Can this empirical fact that money supply and inflation are positively related justify this
policy recommendation? Again the answer is ‘No’. The argument must contain one ought statement
as follows:
Premise 1: Because the welfare of humans should be increased
Premise 2: and inflation causes this welfare to decrease
Conclusion: Therefore it should be reduced by decreasing money supply
Given this relationship, now a further question arises: ‘what is the justification for increasing the
welfare of human beings?’ To defend this ought-proposition (that welfare should be increased)
you would advance another ought-statement as its justification. But you can sense that this will
involve an infinite regress because in order to defend an ought-statement, another one of the same
type will be required. And this goes on until you reach an ought-statement for which you have no
justification but accept it as a belief, a metaphysically given truth. It is this set of belief
(presupposition) which forms the basis of positive economic analysis.
All positive research in social sciences is undertaken within a presumed framework of

normative beliefs. This relationship becomes evident when we consider the fact that all social
sciences address the question ‘how should society be organized, irrespective of revealed
knowledge’. Social scientists study the ‘laws’ governing the behavior of individuals and social
institutions of a society that prioritizes maximization of freedom as its ultimate objective. It is due
15
to this anti-religious character of all social sciences that the question ‘whether an individual will
go to hell or heaven (the most important question for a religious individual and society) as a result
of living in a particular way’ is assumed away by social scientists while conceptualizing the
problem of ‘how should society be organized?’. The question whether society should be
organized for the maximization of freedom (capital accumulation) or for the service of God is not
addressed at all because maximization of freedom (capital accumulation) is believed to be a self-
evident metaphysical truth, a truth that is unchallengeable and closed to all further arguments.
The fact that economics presupposes maximization of freedom (utility / profit / capital
accumulation) as its ultimate end in itself disqualifies it to be a positive science once and for all.
This normative character of economics is evident from its justification of scarcity, utility
maximization and competitive individualism as the fabric of society. Similarly, when we rely on
an economist to tell us how allocation decisions should be made to achieve efficiency, we ask
him a normative question. The positive analysis of how to achieve efficient-resource-allocation-
process presumes the normative concepts of scarcity and efficiency (freedom / utility
maximization). Thus, it is not possible for an economist to maintain that he is merely studying the
techniques of adapting limited means to multiple ends without taking account of the source and
justifications of these ends in the first place. It is the problem of allocating scarce resources
among competing ends that is advanced as the central problem of economics. However, the
objective function (maximization of freedom, utility, profit the rate of capital accumulation) is
taken as given. This objective is of course an objective set by Enlightenment philosophy.
Economics does not justify its systemic objectives but suggests solutions for the problem of
allocating scarce resources among unlimited wants so as to satisfy maximum human desires,
irrespective of the justification of this social objective itself.
1.3: ‘WHAT IS ECONOMICS FOR?’: THE AGENDA OF CAPITALISM
The previous section has shown that economics, like all sciences, is necessarily
normative. Its positive investigative methodology is based on normative (un-proven and un-
provable) presuppositions formulated by the Enlightenment philosophers (especially Locke,
Smith, Hume, Kant and Say). Economics seeks to re-mould individual and social behavior so that
the ideals of the Enlightenment philosophers are realized. So a fundamental question arises at this
stage: what economics can and cannot do? In other words, what is its scope? Remember that
economics:
• cannot answer the question why scarcity should be presumed
• cannot answer the question why maximization of utility / profit / capital accumulation
(efficiency) should be the objective for the organization of individual and social life
• can answer the question what should be done to ensure maximization of profit, utility and
capital accumulation
• can answer the question what should not be done if we want utility, profit and the rate of
capital accumulation to be maximized
16
Thus economics is necessarily a normative and prescriptive discipline. It justifies and seeks to
provide resources for the emergence and functioning of a particular:
• Individuality
• Rationality / knowledge system
• Society
• State, and
• World order
The purpose of all these should be the maximization of utility, profit and the rate of capital
accumulation. Economics says that the individual should be self-interested. The knowledge
system should show him how he can pursue his self-interest at least cost to himself and to the
society. Society should function as a market, enabling firms and consumers to contract freely
based on their self-interest. States should guarantee contract, manage money markets and provide
support for correcting ‘market failures’. The global order should facilitate free trade and
investment flows across national frontiers and regulate international relations to ensure the
maximization of global utility / profit. This idealized economic vision of individual, society and
state is summarized in Figure 1.5. This diagram shows the theoretical model that economics is
meant to explain and justify. One cannot properly understand economic theory by abstracting
from its specific purpose—it is a tool for providing justification for the above social order.
Figure 1.5: Economics advocates this Capitalist Way of Life
A democratic
Society that government which
Individual Leads to is a sum should provide only
Maximizes a model total of This an economic
Utility of exchange justifies framework for
relationships efficient transactions
Economics and Politics: Link between Theory and Practice
Today we see politicians and bureaucrats in most part handing over the world to
economists to make it a better place to live in—a world with ever increasing possibilities of
17
capital accumulation. This subjugation of countries’ fate in the hands of economists is not
because economists have won some public election, rather it is due to the belief that economic
theory is sound and considers a big picture in understanding how the objective of capital
accumulation can be carried out most effectively. It is believed that economists know how
capitalist societies work and how they can be made to work even better. Thus:
• when government opposes minimum wage laws, it is because economics says that such laws
increase unemployment
• debates on reducing or eliminating tariffs on imported items are raised because economics
says that free trade provides more opportunities for utility / profit maximization
• when government goes for privatization policy, it is because economics says that free private
ownership of resources is more efficient
Economists believe that changes, such as the above ones, in existing social set-up will make this
world a better place because these changes will make the real world look more like their
hypothetical world of figure 1.5—a world order based on Enlightenment ideals which it seeks to
endorse.
Figure 1.6 shows the formal relationship between social theory and practice. The
objective of theory in social sciences is to provide (1) an idealized conception of society that
ought to be achieved, such as the one described in figure 1.5, and (2) policy recommendations
that are helpful in achieving this preferred world order. Since the actually existing societies are
never in accordance with the preferred one, the policy recommendations derived from a particular
theory are applied to actual societies in order to transform them to the desired one. Hence we can
identify two domains in this diagram:
• Domain of theory: is concerned with the derivation of desired social order and policies
(movement represented by solid arrows towards boxes 1 and 2)
• Domain of practice: is concerned with the application of policies for transformation of actual
societies into the desired one (movement represented by the dashed arrows)
Figure 1.6: Relationship between theory and practice in social sciences
(2) Actual
Applied on
Policies Societies
Transformation
Justifies
Social (1)
Science Justifies Desired picture
Theory of society
18
The relationship thus shows that economics cannot be studied in isolation from politics, both are
linked with each other like mind-body relation—the body (politics) obeys the commands passed on by
mind (economics). This should once again confirms that economics (and in fact all social theory
project) is essentially a moral, and not a positive, science.
It is obvious that the way of life which economics seeks to rationalize is the capitalist
way of life. It is capitalist individuality, capitalist society and capitalist state organization which
economics regards as natural and rational. It develops theories to illustrate what pure and perfect
capitalist individuality, society and state looks like. It measures actually existing individual
behavior, social organization and state policies on a scale on which 100 percent marks are given
to the behavior patterns, institutional structures and state policies which conform fully to
capitalist ideals. Economics suggests strategies for enabling individuals, societies and states to
achieve capitalist ideals.
Economics is therefore very useful both for justifying capitalist behavior and
organization at the micro and macro level and for managing capitalist households, firms, markets
and governments. There are many schools (or sects) of economic thought—classical,
neoclassical, Keynesian, post-Keynesian, Marxist, institutionalist, behavioralist, new classical,
new Keynesian etc (for their introduction, see the last chapter of this book). Among them the
most useful school in terms of its ability to justify capitalist behavior and organization and in
terms of its ability to produce a portfolio of policies for managing capitalist individualities,
markets and government is the neoclassical school which emerged in the 1870s and which
continues to dominate the economics profession today. In this book, we will focus and
concentrate on neoclassical economic analysis and attempt to assess its usefulness both for
justifying and managing capitalism.
1.4: MICRO-MACRO DISTINCTION
We have defined microeconomics as the study of competitive behavior and in this sense
the founding father of economics Adam Smith was a microeconomist as he was profoundly
concerned with the analysis of competitive behavior. The title of his famous book however is An
Enquiry into the Nature and Causes of the Wealth of Nation and the analysis in this book
concentrated on aggregates—especially on the behavior of classes. Smith’s political theory was
more clearly focused on individual behavior but this is contained in his Lectures on
Jurisprudence—a book economists never happen to read. Smith’s theory of value was also class
based and largely ignored the role of the individual producer and consumer in the determination
of price (see chapter 2).
This emphasis on aggregates (especially class) was maintained by all major classical
economists—Ricardo, Malthus, Marx, J.S. Mill—and microeconomics proper was born as a
consequence of the ‘marginalist revolution’ of the 1870s. The crucial move in this respect was the
abandonment of the labor theory of value and its replacement by utility theory of value. This
allowed the neo classical economists to abandon the notion of class and to focus attention on the
individual consumer and producer as market participants. Understanding the theory of value is
therefore crucial for understanding microeconomics. We will discuss this theory briefly in chapter
19
2 and in detail in chapters 15 and 16 which also seeks to show you why textbooks such as Lipsey,
Mc-Connell and Samuelson rarely mention value despite the crucial importance of this concept in
the economic paradigm.
Microeconomics analyzes the (competitive) behavior of individual units—households
and firms—while macroeconomics is concerned with an analysis of the aggregates of these units,
most importantly the national economy. But as capitalism has developed, this distinction between
units and aggregates has become obscure. More than 60 percent of all babies born in Denmark in
2004 were bastards and adultery has become a universal practice throughout Europe and
America. Does it make any sense to speak of ‘households’ as consuming units in these
circumstances? What is the meaning of ‘consumer sovereignty’ when consumer preferences are
routinely over determined by the trillion dollar advertising, promotion and media industries in
America. What sense is there in treating Pfizer as an economic unit (a firm) and the Congo as an
aggregate (a national economy) when Pfizer’s annual sales exceed Congo’s GDP by about 30,000
percent. Does Pfizer have no “fiscal policy” despite its extensive transfer pricing? Whose
management of money supply and credit has greater impact on world interest rates, the State
Bank of Pakistan, a Chase Manhattan, Halliburton and Mercedes not waging war in Iraq and
Afghanistan?
The last chapter of this book will try to show that macroeconomics has collapsed into
microeconomics. Capitalism creates a single, unique individuality expressed in the form of the
human person, the corporation, civil society and republic government (capitalism is a ruthless,
relentless totaliser). It allows nothing to stop the process of eternal profit-maximization, neither
the human person, nor social institutions and nor the processes and procedures of government.
Modern macroeconomics has microeconomic roots. The objective function of capitalist
units (households and firms) and capitalist aggregates of these units (governments) is the same.
They both seek the maximization of utility / profit. When we study microeconomics we study the
general principles on the basis of which value is determined within capitalist order. Value is the
organizing principle of capitalist order. Let us now turn to a brief introduction of capitalism and
the analysis of value.
20
Key Concepts
Competition is a process which involves rivalry among multiple individuals who are struggling
against each other to obtain the same scarce resource
Dynamic efficiency is to achieve the most from given scarce initial resources over time to
maintain permanent pressure of scarcity. It also refers to the generation of new resources through
innovation
Economic (wo)man is an abstract rational economic agent whose self is subordinated to his (her)
infinite desires
Efficiency means producing maximum output from given inputs or resources
Hypothesis is a proposition which affirms or denies some fact
Microeconomics a branch of economics concerned with the description of competitive process:
its functioning, consequences and legitimacy. It also provides a theoretical foundation for
legitimizing the motive of self-interest as the corner stone of society
Opportunity cost of a particular choice is the satisfaction that would have been derived from the
next best alternative foregone; in other words, it is the value of forgone activities in making a
certain choice or decision
Paradigm refers to some metaphysical beliefs regarding the behaviour of subject which form the
conceptual framework (hard core) of any scientific discipline through which the world is viewed.
It also involves some standard experimental and theoretical techniques to apply the fundamental
laws to a variety of situations in order to match paradigm with nature
Resource is anything that can satisfy a human want
Scarcity is a subjective phenomenon which refers to the degree by which people’s desire for
something exceeds its availability
Self-interest is the essence of rationality of an economic man. It is the ability of an economic man to
rank his preferences as per his personal desires
Social sciences work out the laws governing the behavior of individuals and social institutions of
a society that prioritizes maximization of freedom as its ultimate objective
Static efficiency is getting the most in terms of human satisfaction from given resources (also
called Pareto efficiency)
21
Chapter Summary
• Economics answers the question: how scarce resources can be allocated efficiently.
Economics is thus absent in all societies where wants do not exceed available resources
• Scarcity is a subjective—not an objective—phenomenon. It depends on people’s wants and
desires. If wants are unlimited resources must always be infinitely scarce
• Scarcity can be abolished only through the limitation of wants and in no other way
• Capitalist individuality is necessary for the existence of scarcity
• Only capitalist individuality experiences scarcity because it forgets death and the afterlife and
seeks maximum satisfaction of unlimited wants in this life through continuing capital
accumulation
• Scarcity implies choice among alternative options for satisfying unlimited wants. The
exercise of choice necessarily involves costs (the giving up of the satisfaction of one desire
for the satisfaction of another). Hence the exercise of choice involves the allocation of
resources among alternative uses
• Economists argue that resources should be so allocated that utility and profits are maximized.
Efficiency is defined as producing maximum utility and profit from given resources
• Competition is the method used for identifying policies for maximizing efficiency (i.e. profits
and utility). Through the competition process those not interested in and / or not capable of
maximizing utility and profit can be weeded out
• Competitive behavior is not sanctioned by societies which reject economic rationality—i.e.
the individual’s unqualified commitment to self-interested utility / profit maximization
• The scope of microeconomics is the description of the process of competition among
individuals and firms. It analyses and legitimizes competitive behavior and evaluates the
consequences of competitive organization of markets
• Competition commits the microeconomic agent to economic rationality; hence all market
participants have the same objective function—the maximization of utility / profit as an end
in itself
• If continuing utility / profit maximization is an end in itself then only those conceptions of
utility and those uses of profits can be regarded as valuable by economics which can
contribute to continuing utility / profit maximization
• Economics—like all other sciences—assumes that knowledge can be obtained only by
seeking the mastery over nature for the satisfaction of unlimited desires through the pushing
back of scarcity frontier. Such “true knowledge must be validated by experience”
• However presumptions such as “all men are self interested” cannot be subjected to the test of
experience—we can only test whether one man or a group of men are self-interested. Such
presumptions are however necessary for developing testable (falsifiable) hypotheses. Such
presumptions provide the (non falsifiable) premises of testable hypotheses. Only those
premises provide valid presumptions which enable human to achieve the purpose for which
such “knowledge” is being acquired—i.e. mastery over nature for the maximum satisfaction
of unlimited wants
• Testable / falsifiable hypotheses can be derived from valid premises. Only hypotheses and
policies generated by them can be validated by experience. Neither premises (all men are self
22
interested) nor objectives (maximize profits / utility) can be subjected to the test of human
experience. The theory is thus a prediction derived from the (non falsifiable) premises for the
achievement of a (non falsifiable) objective
• Economic theory applies only when agents—individuals and societies—behave in accordance
with its valid premises and seek to achieve its objectives. The behavior of unselfish men and
societies not concerned with profit / utility maximization cannot be explained by economics
• Economics is a paradigm. It begins from presumptions not from observation. These
presumptions reflect the world view of economics. General laws predicting human behavior
(the “laws” of supply and demand) are derived from these presumptions. These “laws”
provide a conceptual framework for the collection and organization of data which can then be
subjected to the tests of experiences. Finally policies are developed for changing individual
and social behavior so that it confirms to the economics world view as reflected in its
presumptions
• Economics is essentially normative because its positive statements are necessarily derived
from and justified by its normative (unfalsifiable) presuppositions. The positive content of
economic analysis is thus subordinated to its unjustified commitment to utility / profit
maximization as the only end in itself of both individuals and societies. Scarcity and
efficiency are both essentially normative concepts implying an unjustified commitment to
capital accumulation as the only end in itself
• Economics advocates that individual life, knowledge systems, societies, government and
world order should all be dedicated to the maximization of utility, profit and the rate of
• The way of life which organizes individual life, societies, governments and world order to
maximize utility, profit and capital accumulation is capitalism. Economics therefore justifies
capitalism and provides instruments for governing capitalist individuals, societies, states and
capitalist global order
• Economics justifies capitalism by justifying and enabling (a) Self-interested individuality (b)
competitive markets (c) market friendly states (d) a uni-polar world order. Economics regards
capitalist order as natural and rational
• Fig 1.5 and 1.6 show that policies derived from a particular conception of ideal capitalist
individuality, society and government are used to create and sustain behavior patterns which
correspond to the capitalist ideals of economic theory. The economic paradigm generates
policies which are implemented to transform individuals and societies into ideal capitalist
individuals and ideal capitalist societies
• Economics regards capitalist individually, society and government as natural and rational.
Every other type of individuality, society and state is regarded as un-natural and irrational.
Economics measures individual and social behavior on the basis of its conception of natural
and rational behavior and economic policies are instruments for transforming existing non-
capitalist individuality and society into capitalist individuality and society
23
Review Questions
1. Evaluate Robbin’s definition of economics. Is it really universal?

2. Why was there no economics before the eighteenth century?
3. How can scarcity be abolished?
4. “Only capitalist societies experience scarcity”. Do you agree?
5. What is capitalist individuality?
6. “Scarcity necessarily implies choice”. Why?
7. What is opportunity cost?
8. Why is the resource allocation problem not faced with respect to the use of air?
9. “The economic problem is not allocation, it is the efficient allocation” Discuss.
10. Define efficiency. How is it measured?
11. What is the relationship of competition to efficiency and what is competitive individuality?
12. Is competitive behavior acceptable in non capitalist societies? If not why?
13. What is the scope of microeconomics?
14. What is the objective function of all microeconomics agents?
15. How must utility be defined and what must be done with profits given the commitment to
never ending utility / profit maximization as an end in itself.
16. Distinguish “humanity” from “mankind”.
17. Which premises are valid and which are not valid premises for the construction of testable
scientific hypothesis. Give examples of both of these.
18. Describe “falsification” theory
19. Describe the structure of a typical economic theory
20. Why can economic theory not explain the behavior of “irrational” men and societies? What is
economic rationality?
21. “Economics is a paradigm”. Explain.
22. What is the fundamental iman of the economist?
23. Distinguish positive and normative sciences.
24. “Economics is essentially a normative science. It’s positive analysis is necessarily based on a
particular set of norms”. Do you agree?
25. How can you show that “All social sciences reject revealed knowledge”?
26. “Scarcity and efficiency are normative concepts”. Discuss.
27. What can’t economics do? And what can it do?
28. “Economic theory is not produced from the real world; the real world is shaped by economic
theory”. Discuss.
29. What is the role of economists?
30. “The distinction between microeconomics and macroeconomics has become obsolete”.
Briefly explain.
24
2
Chapter
INTRODUCTION TO
CAPITALISM AND THEORY
OF VALUE
Chapter 2: Introduction to the Theories of Value and Capitalism
A proper understanding of economic theory requires knowledge of the capitalist system

as a whole. Students of economics must understand the norms and values under which a capitalist
system functions, its regulatory processes and its transaction structures. Without a clear
understanding of what capitalist societies are, how capitalist governments govern, and how
capitalist markets function economic practitioners are ill prepared to understand the social and
economic context within which economic theory is to function. They cannot appreciate what is
constant and what is variable in capitalist order. They cannot correctly interpret changes in
regulatory regimes and in the ‘rules of the game’. Further, they cannot understand the inherent
(insurmountable) limits of the capitalist organization of economy, society and state. It seems
appropriate therefore to begin this book with a description of the central features of a capitalist
economy in section one. We will then briefly try to outline the theory of value and show how each
theory of value is associated with a distinct school of thought in economics. This will also show to
the students that economics as an academic discipline is specific to capitalism and despite their
internal analytical conflicts; all economic schools of thought are primordially occupied with
understanding the nature of capitalist life world and making it possible.
2.1: THE CAPITALIST SYSTEM
Capitalism as a system emerged in the fourteenth or fifteenth century in Italian City states
of Naples, Venice and Florence. By the end of the twentieth century, it was prevalent in Britain,
America, France, Germany and Japan. By the end of twentieth century, many scholars were
arguing that capitalism had become global, while others expressed the view that we were already
in a post-global age.
It is important to note that capitalism’s growth from city-state to national and global
dominance has been continuously resisted. The most famous and effective resistance so far has
been mounted by the communist regimes of the USSR and China which tried to replace market
capitalism by state capitalism. The Islamic governments of Afghanistan, Chechnya, Iran and
Sudan have also sought to distance themselves from capitalist norms, values and practices.
2.1.1: Capitalist Norms and Values
It is these norms and values which distinguish capitalism generically from other systems.
The key capitalist value is freedom; that is why capitalism is often described as a free society.
The individual in capitalist society is committed to freedom. Freedom is self-determination; the
right to do what one pleases, as long as this does not interfere with the right of other members of
society to do as they please. Capitalism claims to recognize no criteria for evaluating the worth of
personal choices. He who chooses to run a madrassah is entitled to the same right and respect as
he who chooses to manage a bar. The only unworthy act is to restrict the freedom of the
individual.
Capitalism recognizes the shortage of material resources as the most important constraint
on freedom. Society must be organized to maximize the potential for producing and consuming
goods. An increase in goods and services is a pre-requisite for increasing freedom. A person’s
ability to do whatever he wants in capitalist society is ultimately defined and limited by the size
27
of his income and wealth (i.e. the relative exchange value of physical and financial assets he
possesses). Therefore two very important values promoted by capitalism are acquisitiveness
(greed or avarice) and competition (envy or covetousness). Everyone must be induced to desire
more and more resources. Everyone in capitalist society possesses this insatiable desire for more
resources hence they must compete against each other and derive pleasure from competition.
Acquisitiveness and competition are necessary means for a continuous increase in resources. This
continuous increase in resources available for production and consumption becomes an end in
itself in capitalist society. A capitalist society accumulates and evaluates all activities in terms of
their contribution to accumulation. The fact that valuation typically takes place in financial
markets illustrates the crucially important role that finance plays in the capital accumulation
process.
There is of course nothing natural or inevitable about regarding acquisitiveness and
competition as individual and social norms. Avarice and covetousness were sins in Christianity
and the Christian social system sought to promote the virtues of poverty and charity. For over a
thousand years, the European economy was embedded in social practices which sought to
promote these Christian values. As Weber and Tawney have shown it was the rejection of these
values which led to the emergence of capitalism. This implies that a rejection of the values of
acquisitiveness and competition would lead to the down fall of capitalism.
2.1.2: Capitalist Regulation
This shows that contrary to the claims of neo and new classical economists, e.g. Hayek,
capitalism has a history. Capitalist markets invariably emerge from non-capitalist social
formations. This is true even of the United States where, for example Jaynes has documented the
legislative acts and policy measures adopted to create a labor market after the abolition of slavery
in the decades after the Civil War. The US government after 1865 enforced a legal political
system that effectively dis-enfranchised the blacks, reduced their economic power and shaped the
labor market. There was little ‘spontaneity’ in the development of capital labor relations in the
American South in the second half of the nineteenth century. In the twenty-first century
legislative and policy-making measures adopted by the World Trade Organization (WTO) are
similarly constructing technology markets by universalizing the US patent system. Once again
there is nothing spontaneous, automatic or natural about the processes of legitimization which
reduce the access of developing countries to the new technologies.
Capitalist markets and capitalist property forms are historical constructions in the
specific sense that laws and practices are required for their emergence and their sustenance.
Outcomes, of course, need not have been as intended but a certain easily definable ethos
(objectives) motivated the actions which led to the development of capitalist property.
Historically constructed markets cannot be viewed as natural outcomes of myriad unrelated
events or attributed to the natural evolution of technology.
This illustrates the fact that capitalism requires regulation. The politically legitimized
source of this regulation has traditionally been the liberal and / or nationalist state and its agencies.
But firms, labor unions and multilateral agencies such as the IMF and the WTO also undertake
regulation. Regulatory systems have their origin in national and local history. The form and
intensity of regulation continue to change over time. This brings us to the important point that
28
capitalism exists in several national versions. The history and customs prevalent in a country
determine both the pattern of capitalist regulation and the structuring of capitalist transactions.
Reading an American textbook to understand economic management in Pakistan
misguides local students. The American textbook presumes that American history, and regulatory
and transaction structures that are based upon it are universal and therefore rational. This is an
absurd assumption, for Pakistan is not America and Pakistani capitalism is not just an
underdeveloped form of American capitalism.
It is capitalism nevertheless and therefore it is quite legitimate to speak of certain generic
similarities between Pakistani and American capitalism. Regulations in both Pakistan and
America must first of all involve the legitimation (both moral as well as legal) of capitalist
property—i.e. corporatations. The control of this property is in the hands of technically skilled
managerial elite (who are not the formal owners of the assets they manage). The enforcement of
capitalist contracts is premised upon the formal equality and the factual inequality of contractees
etc. It is the duty of every capitalist state, American, Pakistani, Saudi Arabian, to preserve these
essential elements of the capitalist system. Each state has to define the scope of capitalist
property, the balance of powers between capital owners and managers, the legal form of
capitalist contracts etc. on the basis of its own history and traditions.
It is thus useful to speak of a mode of regulation: which is a set of mediations in a
(capitalist) civil society. Specifically these mediations must ensure:
(a) Systemic dominance of the desire to accumulate through the promotion of the values of
acquisitiveness and competition
(b) Continued expectation of increased access to resources for accumulation (consumer /
investor confidence)
(c) Ensuring of compatibility between claims and obligations for continuing accumulation.
Ensuring these requires the regulator to persuade everyone to prefer accumulation, sustain
consumer / investor confidence in order to develop efficiency in markets and avoid or mitigate
capitalist crisis.
Firms and banks play an important part in the regulatory process. They persuade the
public to participate as efficient contributors to accumulation. They structure rules of payment
and flows of goods and financial relationships. They create a hierarchy relating stake holders
with claims on and obligations to the collectively produced added values. These structures (laws,
rules, ordering of rights and duties in enterprises and in markets) require political legitimation;
something the state alone can provide on the basis of a socially dominant ideology (liberalism
and / or nationalism and / or social democracy). The political nature of this mediation process is a
reflection of the underlying tension between capitalism’s need to accumulate and its need to
legitimize accumulation.
The Role of Economic Theory
Economics is an off-shoot of what is today called ‘Social Theory’ developed in order to

rationalize and conceptualize the capitalist way of life. The capitalist way of life emerged out of
the Enlightenment movement which sought to promote new standards of morality—standards
that originated from the ideal of freedom. The Enlightenment scholars were pre-occupied with
the justification of newly developing (capitalist) social structures in Europe during the eighteenth
29
century. These thinkers pretended to model their thoughts on the then prevailing empiricist
methodology of physics. They deceived themselves into the opinion that moral laws and natural
human sentiments could be discovered merely by employing empirical research methods.
According to them, objective social patterns emerge unintendedly from the rational (i.e. freedom
oriented) behavior of individuals. Adam Smith was one of the leading exponents of this idea as
presented in his ‘invisible hand’ doctrine. Smith converted the principle of ‘unintended
consequence’ into an analytical tool by showing that the market economy is a self-regulating
mechanism—a mechanism that is beyond the control of the individual actors. This Smithian
project of justifying and sustaining capitalist order has remained the sole objective of all
economic schools of thought that we introduce in this chapter and in the last one. Economic
theory cannot be appreciated properly by abstracting it from its true historical background and its
role in harnessing capitalism. The next section will show how the development of economic
theory is generically related to the development of capitalism.
2.2: THEORIES OF CAPITALISM AND VALUE
Most microeconomics textbooks do not include a separate chapter on value.

Macroeconomics textbooks never mention ‘value’ at all. This might seem strange, for
determining the worth (value) of a good or an act is surely the main function that economic
theory performs.
Figurea2.1: The Skelton of Economic discipline
Adam Smith
(1776)
Labor commanded Embodied labor

theory of value theory of value
Ricardo
(1817)
Marginalist / Utility Abstract Labor Cost of production

Theory of Value Theory of Value Theory of Value
(1874) (1848) (1960)
30
But understanding the concept of ‘value’ gives us an invaluable insight, on the one hand, into the
nature and functions of economics both as a science and as a social practice and, on the other
hand, into the nature of disagreement among economists. We will see that underneath the
apparently conflicting schools of thought in economics is their disagreement on what determines
the ‘value’ of an activity.
We begin this section by seeking to develop a working definition of ‘value’ in section 1.
The skeleton of the remaining chapter is summarized in figure 2.1. We will make some
adjustments and comments on this diagram after completing our discussions from sections 2
through 6. The final section provides reasons for concentrating on neoclassical theories in the
analysis of consumption, production, distribution and the theory of economic policy in the rest of
the book.
2.2.1: What is Value?
In chapter 1 we had tried to show that it is nonsensical to make a distinction between

‘normative’ and ‘positive’ economics. Take a standard text book—say Mc Connell and Brue’s
Economics now in its seventeenth edition. It’s glossary says that:
“normative economics (is) focused on which goals and policies should be implemented.”
Positive economics on the other hand is “the analysis of facts and data to establish
scientific generalizations about economic behavior”
In order to see to what degree this distinction is meaningful consider Abdullah Zhaghzai—an
orthodox and practicing Muslim. Abdullah is a shepherd living in the mountains 15 miles north of
Pirbaba, a small town in our Sarhad (recently named Khyber Pukhtoonkhwah) province. Suppose
Khyber Bank decides to lower its loan interest rate. What “scientific generalization” can we draw
about Abdullah’s behavior? Don’t you think that the ‘observed generalizations’ or ‘behavior
patterns’ depend on the “goals and policies (Abdullah thinks) should be implemented”? If
Abdullah’s goal is to maximize profits he may rush to Khyber Bank’s branch in Pirbaba to take
out a loan. If, on the other hand, Abdullah is a Taliban supporter he may plant a bomb in the
Khyber Bank branch to frustrate its attempt to expand interest-based business in his local town.
The point is that “scientific generalizations” about “economic behavior” without
reference to norms—norms both of the observer (the economist) and the observed (Abdullah
Zhaghazai)—are not possible. These normative assumptions underlying “the analysis of facts to
yield generalization about behavior” (i.e “positive economics”) are concealed in a specific
conception of ‘economic rationality’. According to economics, Abdullah acts ‘rationally’ when
he borrows from Khyber bank in response to a fall in the loan interest rate but ‘irrationally’ when
he tries to blow it up. Economics cannot analyze such ‘irrational’ behavior. Thus a conception of
how Abdullah ought to behave necessarily underlies the economic analysis of his observed
behavior. Economists therefore seek to unearth the ‘rational’ basis of ‘irrational’ behavior—they
would claim that may be the risk involved in blowing up the Khyber bank branch is negligible
and Mulla Omar is paying Abdullah much more than any gain he could make by borrowing at the
reduced interest rate. If so Abdullah is acting ‘rationally’ for by blowing up Khyber Bank he is
maximizing his income / profit / welfare.
31
Thus the basic presumption is that for Abdullah value resides in income / profit / welfare.
What the rational individual values above all is, what Adam Smith and David Hume called,
“wealth”. The origins of economics lie in the Scottish Enlightenment (an intellectual movement
which achieved its greatest influence in the late eighteenth and early nineteenth century) and the
distinguishing feature of this school of thought was its replacement of virtue by welfare as the
purpose of both individual and social existence. Christianity of course did not recognize value
(intrinsic worth) in wealth, indeed a historically strongly entrenched Christian tradition identified
wealth (and specially its accumulation) with evil. For orthodox Christians value resided in acts
earning God’s favor and in the leading of a virtuous life. It is a significant fact that the Middle
Age and early modern period Christian theologians never identified value with price. Value
resided not in the market but in the life of the monastery and the Church.
Both David Hume and Adam Smith were passionate opponents of the Christian way of
life. Adam Smith (1723-1790) was a horrible man who beat his wife black and blue because she
attended matins (a Christian prayer offered at the time of our tahajjud). Smith and Hume argued
that seeking virtue led to wars of religion and turmoil. Men should seek not virtue but wealth,
maximize pleasure, minimize pain and a life spent in the continuous and harmonious pursuit of
wealth and pleasure was the only valuable life. Both Smith and Hume defined rationality as the
pursuit of material self interest and argued that ‘the law of nature’ compelled / conditioned men to
organize their life on the basis of the principle of net pleasure maximization. Value lay in wealth
and in wealth alone. The greater the wealth an individual or a society possessed the greater its
value. Virtues were simply instruments enabling everyone in society to harmoniously pursue his
material interest. The market was not subordinate to religion or to the political sphere which
articulated a transcendental principle of value. Value emerged in the market through capitalist
contracts and through them alone. As Smith emphasizes in his famous book The Theory of Moral
Sentiments, the moral order must be strictly subordinated to the market whose reproduction it
makes possible. The market grants people the experience of not being directly governed by
representatives of either God or kings. These thinkers saw the extension of markets into
increasing areas of life as revolutionary, liberating humanity from traditional value systems.
Increasing value is thus synonymous with increasing the wealth of nations, through the
mutually sustaining processes of expansion of the division of labor on the one hand and of the
market on the other. Value therefore resides in the commodities—and the components of the
commodities—exchanged in the market. The analysis of the components of the price of a
commodity thus became central to the determination of value.
2.2.2: Smith: Labor Commanded or Labor Input Theory of Value?
Smith’s analysis of the components of prices of a commodity is notoriously ambiguous.

At points Smith seems to be arguing that profits and rent are deductions from the product of labor
which alone bestows value on the commodity exchanged in the market. At other points (both in
The Wealth of Nations and obliquely in the Lectures on Jurisprudence) he seems to be arguing
that profit and rent do not constitute such deductions from the product of labor but represent the
32
contribution made by capital and land to the value of the commodity. In this perception profits,
rent and wages were the components of the value of a commodity.
The consensus reported in the economics profession is that Smith abandoned the theory
which says that labor is the only component of the value of a commodity—the theory which is
often known as the embodied labor theory of value—and adopted the view that labor commanded
is the most convenient measure of value. According to labor theory of value, the value of a
commodity is equal to the direct labor time needed to make a commodity. For example, if it takes
2 labor hours to produce 1kg wheat and 4 labor hours to produce 1 kg sugar, then it means that
1kg sugar will be equal to 2kg wheat in exchange. In contrast, labor commanded theory of value
says that the exchange value of a commodity is determined by the amount of labor time that could
be purchased by selling a commodity. For instance, if by selling 1kg sugar I can purchase 2 labor
hours (i.e. I can hire a labor for two hours) in the market, and by selling 1kg wheat can purchase 1
labor hour, this means that the rate of exchange between sugar and wheat will equal 1kg sugar =
2kg wheat.
If it is the case that the value of a commodity is not the number of labor hours spent in its
production but the number of labor hours that could be commanded (obtained) by its price, then it
means that profit (capital) and rent (land) also contributes to the value of a commodity. According
to this notion, the value or price of a commodity is given by the sum of profits, rent and wages:
price = wages + profit + rent
where profits and rents are not the the deductions from wages but independent value-adding
factors. Clearly, the price of the commodity would exceed the value of labor hours consumed in
its production (i.e. wages) by the amount of value contributed by capital and land to the value of
the commodity (i.e. the sum of profits and rents). Labor time component thus serves as an
accounting devise in Smith’s system and is only one component of its value.
Smith’s conception of the determinants of value (‘real price’) allows him to show that
accumulation and expansion of the division of labor and of the market is in most people’s
interest. He tries to show how price mechanism guides individuals to allocate resources to the
greatest social benefit. He distinguishes between two types of prices: natural price and market
price. ‘The natural price is the central price to which the prices of all commodities are continually
gravitating’ due to the dynamic forces of demand and supply. But Smith was less concerned in
showing how prices are fixed than in answering his critics who claimed that markets left free to
generate their own produced prices were unstable and therefore allocate resources arbitrarily.
Smith is one of the earliest theorists of capitalist society. He sees it as comprising of three great
classes; “owners of stock”—i.e. capitalists—landowners and wage earners. There is no conflict
between individual aspiration and class affiliation. Everyone gains from the continuous
accumulation of “stock” (capital) but Smith does not have a coherent theory of history. He cannot
tell us why society’s division in the three great classes, each seeking to maximize its material
interest is justified. He has no social account of the formation of wages, rent and profit. He has to
fall back upon the “law of nature” to validate rent, profit and wages. Wages are “naturally”
determined by subsistence requirements, rent by the productivity of land and profit by the
productivity of labor set in motion by “stock”. The ultimate justification of Smith’s conception of
value and of capitalist society is that these conceptions of value and of capitalist society accord
33
with nature. Capitalism, according to Smith, is the “Order of Nature”. The explanation of profit
and rent within a labor commanded theory of value had to wait around 100 years for the
development of marginalist or neoclassical theory of value. But we will come back to this theory
of value after discussing Ricardo and Marx—so that the chronological order of theoretical
development is maintained.
2.2.3: From Smith to Ricardo: The Embodied Labor Theory of Value
David Ricardo (1772-1823), the immediate follower of Smith, was worried by Smith’s
inadequate justification of capitalism as a natural order; especially the inadequacy of Smith’s
explanation of the determination of value and of the formation of rent, profit and wages. Ricardo
returned to the labor embodied theory of value accordion to which the value of a commodity
corresponds to the amount of labor time taken to produce it. Smith was puzzled by the
implication of labor theory of value that labor did not receive the full product of his work.
Ricardo argued that a consistent labor input theory of value was possible and it is in this sense
that he was developing one half of Smith’s contradictory theory of value. In his formulation of
labor input theory of value, he included both direct as well as indirect labor. The former refers to
the labor employed for a specific time and paid a wage while the later is the raw materials and
tools also produced by labor time in the past. He dismissed the labor commanded (or utility)
theory of value by asserting that in industrial society, most of the commodities are reproducible—
i.e. they are produced again and again by labor. Therefore, the relative scarcity and value of most
commodities is not some accidental phenomenon, rather produced by labor input. For Ricardo the
distinction between the use value of a commodity in consumption and its value in production was
an important one. He was primarily concerned with the distribution of income between rent,
profits and wages and the effects of changes in size of population and, to him, the above
distinction provided the basis for explaining the distribution between wages, profit and rent.
Ricardo on Wages
Wages, rent and profit in the Ricardian system could be seen as proportionate shares of a
fixed sum of value. In his analysis, wages are determined by the subsistence level—i.e. it is equal
to the labor time required to produce commodities necessary for the support of the laborer and his
family. He agreed with Malthus in arguing that increases in the wage rate induce laborers to
produce more children as they can now support larger families. But this increase in labor supply
as a result reduces wages to the subsistence level. Thus Ricardo’s wage-rate analysis is somewhat
similar to Smith’s, but as far the determination of profit and rent is concerned he differs with
Smith.
Profit and Rent in the Ricardian System
Ricardo’s analysis of prevailing rates of profit depended on the assumption of ‘natural

rate of profit’ or surplus generated from the agricultural sector. If Ricardo, continuing with the
labor input theory of value, had to avoid the puzzle that profit was not the result of exploitation
34
(labor being paid less than its full product), then he had to show that profit was the product of
nature. Hence he emphasized the importance of the agricultural sector.
Ricardo’s theory presents the origin of rent in the technical fact that different plots of
land have different degrees of fertility, so that the more fertile plots pay their owners differential
gains, with respect to the productivity of that (less fertile) plot of land which happens to be at the
margin between cultivated and non-cultivated lands. To him, no rent accrues on the least
productive land and rent rises with productivity as more fertile lands are cultivated. It thus
becomes crucial to identify this “marginal” land— i.e., that land which is the least productive
but nevertheless must be cultivated in order to satisfy the total demand for agricultural produce
[see the numerical example in the appendix to this chapter to enhance your understanding of his
theory]. This means that in any given situation, there will be:
• a ‘marginal’ plot of land—the plot at the margin or the last cultivated plot—which by
definition yields no rent
• extra-marginal plots of land—uncultivated because they are not fertile enough—and
• infra-marginal plots of land, which, besides being cultivated, also yield their owners
certain amount of rents; these being the difference between the productivities of the (more
fertile) plots of land and the productivity of the marginal land, which, though cultivated,
brings no rent.
On the basis of this formulation, therefore, it is rent—in logical order—that is
distributed first out of the national product to the land-owners. Once rent has been
distributed, what remains is to be subdivided between wages and profits. Now, in a
natural-law dominated intellectual environment, impressed by the (then emerging)
Malthusian theory of population as explained above, Ricardo (and the classical
economists in general) was convinced that there exists a “natural” wage, just above
subsistence, representing a family income at which the (average) population is induced
neither to grow nor to diminish (stationary population). Once this (natural) wage has
been distributed to the workers, the “residual” represents the profits of the capitalists-
entrepreneurs. Profits therefore depend on wages and rents.
Ricardo’s theory of rent thus endocrines his theory of value and price. The value of a
commodity is determined by the amount of labor embodied in the product of the marginal (or
least fertile) land. This value will be shared between the capitalist and the laborers. Alternatively
put, in Ricardo view “the value of the commodity (is determined) by the quantity of labor that
will suffice for their production under the most unfavorable circumstances” and rent is
determined by the difference between this value determining quantity of labor and the lesser
quantity of labor used for producing commodities of equivalent value on progressively more
fertile lands.
Ricardo’s embodied theory of labor emphasizes the determining rule of the productivity
of labor in establishing the size of the product produced by a capitalist society and available for
distribution among its three major classes. Ricardo’s theory thus separates production and
distribution but Ricardo remained concerned with the impact of changes in the relative shares of
capitalists, landlord and laborers on production and on the accumulation of capital.
35
Ricardian Politics
Ricardo, a Jewish stock market gambler, lived at the time of the Napoleonic wars of
England with France in Europe, America and India (recall Haider Ali and Tipu Sultan). During
that period, government expenditures rose rapidly which were largely financed through rising
national debt and high taxations. In order to finance its debts, the government passed the Bank
Restriction Act in 1797 which allowed the circulation of paper money not fully backed by gold.
Prices were increasing rapidly during this period and it was the problems created by this inflation
and the financing of government’s debt that Ricardo first addressed. All this put pressure on
production and less and less fertile lands had to be brought into cultivation thus raising rent and
wages (due to the rise in the price of corn). Both rent and wage constituted ‘costs of production’
from the perspective of the capitalist and hence an increase in rent and wages would lead to a fall
in the rate of profit. By determining value in terms of the productivity of labor on marginal land,
Ricardo emphasized that the ultimate source of the growth in accumulation was the growth in the
marginal productivity of labor—the productivity of labor using the least fertile resources, i.e.
those capable of yielding a product just sufficient to meet the costs of subsistence of the labor
employed and (what we now call) ‘normal’ profits. Policies should concentrate on measures
which raise labor productivity and reduce ‘the costs of production’—rent and wages. Based upon
his theory of income distribution Ricardo went on to develop his theory of crisis, but its details
are not a part of our concern in this chapter.
Ricardo also advocated free trade. He maintained that the only way in which the decline
in the rate of profit due to rising cost of production could be postponed is by importing cheap
food. Therefore Ricardo advocated the abolition of the:
• ‘Corn Laws’—which prohibited the import of food grain thus raising rent. On the basis of his
labor theory of value, Ricardo argued that cheap imports of wage foods (corn) could lower
the labor time embodied in the subsistence wage and thus allow the rate of profit to rise
• Poor Laws—state guaranteed (pitiable) minimum subsistence income for paupers—thus
reducing the burden of national debt as well as decreasing population growth. He argued that
the Poor laws did not make the poor rich but the rich poor
The abolition of the Corn Laws (in the early 19th century) was an important step in the
consolidation of capitalist rule in England. Ricardo, a Jewish gambler, saw the old English land
owning class as the principle opponent of capitalist accumulation. In his analysis, landlords were
the unproductive class in terms of creative (capitalist) value. “The interest of the landowner is
always opposed to the interest of every other class in the community” wrote Ricardo in his
Principles (published first in 1818). Ricardo advocated the conversion of land into capitalist
property so that rent income should not be “wasted” but spent productively. By imposing high
taxes on rent the capitalist state was the main instrument for converting land (and peasant labor)
into capitalist property. In this, Ricardo followed Smith who had also insisted that rent should be
the principle source of taxation.
The transition in the theory of value—from Smith’s labor commanded as a numeraire to
Ricardo’s “value as embodied labor”—is important in that it provided an ideological / theoretical
justification for capitalist rule. That is why it displaced not only Petty and Smith’s vaguer
formulations in Britain but also that of Say and Sismondi on the Continent. Ricardo rigorously
36
established the natural/technical/rational/ahistorical and therefore non-contingent and necessary

domination of capitalist order through his theory/ideology. Capitalist rule institutionalizes the
continuing and never ending growth of labor productivity. Accelerated perpetual capital
accumulation is merely a bi-directional correlate of labor productivity growth and the labor
theory of value was a natural / rational / necessary processes. According to classical political
economists, including Ricardo, not ordering life (both of private and public) to perpetuate labor
productively growth and eternal capital accumulation is to go against both nature and reason.
Christianity, on the other hand, had held that organizing society to achieve perpetual
accumulation was going against the commands of God.
Labor Input Theory after Ricardo
While developing his theory of value and income distribution, Ricardo faced a serious
problem that he could not solve. The problem was that relative prices do not in fact correspond to
amounts of labor embodied in the commodities—the assertion that exchange value originates
from labor time put into a commodity is not validated by the existence of money prices which
corresponded to the ratio of labor inputs. Moreover, the prices of commodities also change due to
changes in the distribution of income. If it is the case that relative prices also change due to
changes in income distribution, but labor inputs remain unchanged, how can Ricardo maintain
that labor inputs alone determine the rate of exchange (value) between commodities? The basic
essence of this value-price problem is faced by all schools of thought (including neoclassical
economics, see discussion on the famous Cambridge Capital Controversy in chapter 16). The
solution to this problem requires that:
i. either the rate of profit is zero—which means that we assume long run stagnation in the
economy, or
ii. only one commodity is produced and consumed in the economy
But, as is clear, both these assumptions are unrealistic.
Ricardo’s inability to resolve the value-price problem provided the foundations for two
rival theories of value, both inheriting the labor input theory of value: (1) abstract labor theory of
value by Marx and (2) cost of production theory of value (by Sraffa and others). Both of these
trends shared discontent, though of varying degree, about the desirability and future of market
capitalism as they saw in its development the seeds of stagnation, exploitation and crisis. Market
capitalism—the idea that markets are the most harmonious way of reconciling individuals’ self-
interest to the interest of all—faced criticism right from the time of its development. Ricardo was
one of its critics as he saw capitalist order prone to crisis and composed of conflicting classes—
those of landlords, stock holders and laborer. But, as Marx argued below, he did not accept (or
could not work out) the full implications of his analysis. Many others like Veblen, Keynes,
Robinson, Sraffa etc, followed him in this trend. Although these economists are denied the ‘socialist
label’ but they were all concerned over the principal problem of distribution in capitalist society. In
the upcoming section we spell out the Marxists attempt to resolve the conflict embedded in
capitalist order. The cost of production theory of value will be explained after outlining the
neoclassical response to Marxists’ critique of capitalism.
37
2.2.4: From Ricardo to Marx: The Abstract Labor Theory of Value
Ricardo’s theory of value was soon recognized as an inadequate justification of profit.

One of its major weaknesses (apart from value-price problem) was that if embodied labor is the
sole source of value, why should capitalists (and landlords) appropriate a part of its product?
Ricardo said some vague things about profits being a reward for ‘waiting’ but these apologies did
not fit into his system (these ideas were developed in “theories of interest” by Tausig and Fisher
much later). Ricardo saw no need for defending profits on moral grounds. British social order was
securely capitalist by the early 1820’s, the landlords were reconciled to capitalist dominance and
no one had the power to challenge it. Ricardo and his followers assumed that capitalist property
was as natural as the weather and the topography—for a maturing industrializing economy “there
was no alternative” in Ricardo’s view. Regarding capitalist property to be sacred (as Ricardo said
it should be) was a command of reason to these classical thinkers. Recognition of incoherence’s
in the labor theory of value led to divergent responses, as pointed out above. One direction was
taken by Marx who tried to extend labor input theory and ‘class-based’ classical analysis to its
logical conclusion.
Historically, Ricardo’s lack of confidence in the market system (as outlined in his theory
of crises) co-existed with the development of socialism as a set of ideas to understand capitalist
society and politics. The positive evaluation of market capitalism ‘as a system of harmonious
living’ was put under criticism by various schools of thought on moral grounds. Reasons for this
negative assessment of capitalism included (i) rapid increase in the income inequalities in society,
(ii) the adverse effects on the lives of the masses of factory workers and (iii) increased repression
required to maintain the new factory discipline (see chapter 9 for details). Marx linked these
(utopian) socialist critiques of market capitalism with the valuation in the market.
Marx’s Rejection of Profit
Marx assumes that the primary objective and expression of human existence is the act of
production. The realization of this objective takes forms of two sets of relationships: technical
and social relations of production. The former relates to the act of converting the material
environment into products for consumption while the later refers to the division between the
owners/controllers of the means of production and workers. It is this division of social
relationships that determines the distribution of economic surplus between the ruling class and the
workers. According to Marx, value arises in these social relationships. In Marx’s conception,
labor is the substance (value equivalence) of the commodity. Value is ‘labor for others’; labor so
far as it is socially recognized within a division of labor, labor whose social character has been
abstracted from the activity of the laborer. This socially necessary abstracted labor confronts the
laborers as ‘private property’. This abstracted socially necessary labor is homogenized though
measurement in time units. To return to Ricardo, how long it is socially necessary to produce one
bushel of corn on marginal land is the value of corn; the price every laborer must pay for
subsistence. The value of corn is thus an expression of the ‘social relation of production’—the
relations between those who produce corn and those who earn profit because they control the land
on which it is produced.
38
According to Marx labor is alienated from itself—separated from the product it creates
—through the capitalist organization of production and exchange. Capitalist organization of
production and exchange (Hegel’s ‘civil society’) makes the realization of ‘true’ human needs
impossible because of this alienation of labor. If labor is the substance of wealth (the source of its
value) then wealth created by the expenditure of a particular labor must be appropriated by the
laborer, who labored for producing that wealth. There is no moral justification for the
appropriation of this wealth by capitalists in the form of what Marx called “private property”. The
justification of this so called “private property” was first presented by John Locke—writing in the
late seventeenth century—to justify the mass slaughter of the Red Indians in America and the
wholesale looting of that continent by Europeans. Locke used this justification as an element in
his broader advocacy of the need for the secularization of society. Smith and Ricardo offered no
separate justification for ‘private property’ but accepted it as a natural foundation of the expanded
division of labor. 1 To Marx, ‘private property’ allows the capitalist not only to possess but also to
use that commodity for the subjugation and exploitation of labor. In Marx (but not in Hegel) such
‘objectified’ labor is alienated labor. If the embodied labor theory of value is accepted there is no
justification for accepting ‘capitalist’ social relationships—expressed in the universalized wage
form and profit rate—as natural and rational phenomena.
The Nature of Marx’s Economics and Politics
Marx thought (especially in The Economic and Philosophical Manuscripts) that he was
developing a moral critique of capitalism through his reformulation of Ricardo’s embodied labor
theory of value. Marx had a great respect for Ricardo for the fact that he discovered the
weaknesses in Smith’s analysis of value and price—that is why Marx called Ricardo a scientific
political economist. But Marx rejected his ahistorical approach towards understanding capitalist
society. The differentiating aspect of Marx was to reject the assumption that the problem of
valuation could be addressed by treating some aspect of human activity as given; e.g. taste or
technology. For him, the starting point was not the individual, but the means of production and
the conflict over the control of surplus value among different classes.
For Marx social structure is never static [Marx and Engels (1967)]. He presented a
materialist account of history which asserts that the material environment in every society is
shaped by that society’s dominant “mode of production” [the way people get together to produce
means of livelihood and control and allocate the resulting surplus product] of commodities that
individuals wish to use. This formulates the basis for historical materialism or economic
determinism—the view that the way we think and live is determined by prevailing material
structures of production, distribution and exchange. Marx writes that “the mode of production of
material life conditions the social, political and intellectual life process in general. It is not the
consciousness of men that determines their being, but, on the contrary, their being that determines
their consciousness”. One historically specific determined form of social relationships is
commodity exchange—a system through which people relate to each other through markets using
1
The nineteenth century reformulation of these defenses of ‘private property’ on which Marx bases his
criticism is to be found in Hegel’s Phenomenology of Mind
39
money. This particular form became dominant after the rise of capitalism where the majority of
the people sell their ability to work to those who own and control the means of production.
Social life can only be studied in terms of the relationships between the forces and
relations of production and the internal conflicting forces within this relationship. Marx outlined a
theory of history by which the relations of production correspond to a definite stage of
development of the material productive forces. But then, after further development of those forces
of production, a conflict arises between them and the existing relations of production. These
relations had formerly helped the development of the productive forces, but now they start
fettering further progress. Revolution then occurs, but only after all the productive forces in the
old society that can develop, have developed. This conflict in capitalism between private
appropriation and social production is revealed in the theory of falling rate of profit, that gives
rise to capital-labor conflict. Marx claimed that labor has the capacity to produce more use value
than its exchange value and the difference between the two is called exploitation, but disguised as
profit by capitalist. Therefore, the source of profits, according to Marx, under capitalism is value
added by workers but not paid out in wages. Once the wage is covered, the capitalist, owners of
the means of production, always have an incentive to force workers to work longer and harder
than the workers are themselves likely to do. The capitalist has to compete with other capitalist to
stay in competition by improving the product and cutting down the cost of production. But this
attempt to increase labor productivity and thereby raise profit creates a tendency for the
profitability of capital as a whole to fall. This further puts pressures by capitalist on labor force to
increase profitability, a move that creates competitive instability and furthers class struggle.
Therefore, classes struggle for power, the control over the means of production, and this is
fundamental to market capitalism and therefore capitalism is always in a danger of destroying itself
in a way which lays the foundation of a new social order. Class conflict is rooted in the essential
structure of capitalism as a system: “Those who own the means of production and those who
perform wage labor are bound together but have significantly different needs about the intensity of
production and the distribution of its proceeds”.
To Marx humanity is destined to freedom, but its struggle towards this goal has been
prevented by the presence of scarcity which has forced humanity to compulsive toil—the
necessity to work just for survival. However, with the emergence of the capitalis mode of
production, people have become productive enough to produce abundance for the first time in
history. But here Marx finds a dilemma: ‘though humanity has created means of production that
provide enough for all people to be free, yet the economic system used to industrialize production
distributes its bounty to a few wealthy people, thus artificially perpetuating the enslavement of
the masses’. In other words, what nature had denied people for centuries was now being withheld
from them by their fellow men. Though Marx appreciated market capitalism for its role in the
enhancement of productivity, but he despised it for its oppression and exploitation of workers.
Class conflict is thus fundamental to capitalism and it cannot be resolved by the actions of the
state (as believed by the social democrats outlined below). On the contrary, the state itself reflects
the imbalance of class forces and always works in favor of the dominant class interests. Marx
defines progress in terms of ever greater control by humans over their environment through the
development of the technical relations (or forces) of production. But this control over the
environment will become possible when people can control their social relationships and hence
eliminate their class conflicts. To Marx, the elimination of class conflict requires revolutionary
40
change in social relationships. He believes that workers can be brought together into
revolutionary associations which ultimately overthrow the bourgeoisie state.
2.2.5: From Labor Commanded to Utility Theory of Value: The

Marginalist Revolution or Rejoinder?
Marxist’s attack against market capitalist social relationships raised serious concerns. The
missing link between identifying markets as the primary focus of capitalist activity and the
justifying of free markets as the means to prosperity and justice was developed by a number of
writers after Marx. Behind the technical jargons was their desire to show that market capitalism is
a classless society fundamentally characterized by harmony and progress. The school of thought
that championed this classless-theoretical framework is known as Marginalism or Neoclassical
Economics.
Nature of Marginalist / Utility Theory of Value
Despite Smith’s recognition of labor commanded theory of value—i.e. value of a good is

measured by the amount what people are willing to pay for a good and what wage rate people are
willing to work—he primarily focused on the analysis of production activity and not on
consumption. But a theoretical framework which starts from what people are willing to pay or are
prepared to accept for a commodity requires a theory of valuation of commodities in use or
consumption. As stated by Cole, Cameron and Edward, ‘the logical outcome of this trend is to
stress individual choices within a framework of markets regulated by competition, with the
valuation of commodities determined by the particular subjective tastes of the individuals’.
In Britain, writers like Bentham (1748-1832), had given some credibility to the idea that
value arose from consumption, and not from production. But Bentham rested his analysis on the
debatable assumption that consumer satisfaction can be measured in numbers (cardinally).
Bentham concluded that since all human beings have a roughly equal capacity to derive utility
(pleasure) from consumption, therefore equality in consumption is desirable for the greatest
happiness of the greatest number. This conclusion of Bentham is an embarrassment to the
marginalist school of thought. Many economists [e.g. Baptiste Say (1767-1832) and Nassau
Senior (1790-1864)] continued with the labor commanded theory of value, but Smith’s project of
reconciling individual interest with that of society was fully realized in 1870’s. This time it was
expressed in mathematical terms gaining both credibility and scientific aura of social neutrality.
Whether it was due to the international exchange of knowledge or the wide spread of
socialist challenge, William Jevons (1835-1882) in Britain, Carl Menger (1840-1921) in Austria
and Leon Walras (1834-1910) in Switzerland all produced their independent books in 1874 yet
bearing a striking similarity. The trio were more influenced by Hume and Bentham than by Smith
and Ricardo and adopted utilitarianism—the view that the rational individual maximizes his
pleasure and minimizes his pain and society should seek the maximization of total net pleasure—
as a basic creed. These neoclassical economists were the first genuine microeconomists as they
relegated the question of overall economic growth and of distribution of aggregate output to
relative unimportance and price determination became the central core for their theories. For all
41
of these three, commodities have value because they are wanted, and wanted because they have
utility for individuals. Marginalists base their analysis on the presumption of universal scarcity.
Abdullah has next to nothing but he is supposed to want everything. The richest man in the world
also has unlimited wants and comparatively limited resources. Both Abdullah and this richest
man seek to maximize their total individual utility by exchanging the goods they have for the
goods they want (and can afford). If Abdullah can satisfy wants without giving anything in return
(e.g. air or the breath taking view of sunset on mountain crests) then such things hare no value
and no price. Commodities only have value in conditions of scarcity. A picture by Picasso
accidentally falling out of a traveler’s luggage will have no value in the Zhaghazi settlement but
may sell for $1 million in a New York auction. Thus value is bestowed upon commodities by
those who want them. Non-scarce goods have no value and scarcity is created by wants the utility
derived from each additional unit of a commodity (i.e. marginal utility) declines as more of that is
consumed. it is the intensity of want for this additional unit of a good that measures its value (that
is why the name comes ‘marginalism’, see chapter 7 for details). Price corresponds to the
marginal utility (and not the total utility) gained by Abdullah from the consumption of a
commodity. These prices are unique in the sense that demand and supply of a commodity can be
equated and the market cleared only at these prices the ‘just price’ or ‘equitable price’ is the price
which expresses the values (preferences) and the rationality (self-interestedness) of free and
autonomous individuals prices generated through capitalist transactional structures ensured the
optimal allocation of resources. Prices—and money in which they were necessarily expressed—
emerge naturally from the pursuit of self-interest by autonomous individuals and express the
rationality of this self-interestedness and of capitalist order in general.
Walras made an attempt to prove Smith’s indivisible hand doctrine through an algebraic
model of the economy. In this model, every market was represented by a single equation which
when simultaneously solved gave equilibrium prices and quantities for all the commodities.
However, there was a problem in Walras model: if every individual’s decision to buy and sell was
dependent upon the decision of everyone else, how does the individual find out what everyone
else is doing in the economy? Thus, the solution of his model required an all-knowing and all-
seeing auctioneer who keeps on adjusting prices until demand equals supply (see chapter 12 for
the details of this ‘auctioneer’). Walras maintained that his hypothetical mathematical model of
the market economy can be applied to any number of goods and markets to work out their
competitive equilibrium prices and quantities. This is called general equilibrium model. However,
Menger did not agree with the possibility of having perfect information for every individual in a
market economy and he therefore did not develop a general equilibrium model of the economy—
although he believed that autonomous price movements would equilibrate demand and supply. It
is since the 1870s that the labor commanded theory of value has got its powerful expression not
only in the academic circles of economics but also in the state policy making of many capitalist
countries. Despite a number of differences in analytical details, one can outline some general
similarities in such analysis.
Nature of Neoclassical Economics
The starting point of this school of thought is the individual endowed with innate tastes
and talents. Both Abdullah’s preferences and the resources with which he enters the market are
42
predetermined. They cannot be the subject of neoclassical analysis. Neoclassical analysis cannot
answer questions such as “what should Abdullah’s preferences be?” What resources should he
have before he enters the market? These—how Abdullah gets the resources he has and how his
preferences are formed—are “hidden abodes” for neoclassical economics. The individual
calculates the outcomes of his actions so as to maximize his personal utility. The taste of this
individual determines his preferences among alternative consumption patterns while his talent
determines his ability to fulfill his infinite desires through productive activity. His decision to
consume and talents to produce is coordinated by a special talent called entrepreneurship—the
mechanism through which productive inputs are combined to satisfy consumer desires. The
owners of inputs receive a reward determined by their contribution in the production of utility for
the consumers. Prices, of both goods and services, are thus derived from the preferences of free
and autonomous individuals. Value is assigned to goods and factors subjectively by free choosers.
The value of a good or ‘factor’ represents not the ‘socially necessary cost’ for its production but
the extent to which it contributes (on the margin) to the fulfillment of the (given) preferences of a
group of consumers.
The objective of economic activity in neoclassical economics is to maximize the utility of
individuals from consumption activity. These economists believe that the free markets reconcile
the interest of the individual (personal utility) to the broader social interest (social utility or utility
of everyone else). There is thus no fundamental conflict of interests within society. The state
policy that follows from this analytical tool box is:
• the creation of an environment which allows maximum freedom for individual consumption
decisions
• the removal of coercion from the market place, and
• the enforcement of voluntary capitalist contracts between individuals
Before moving any further, we can legitimately ask a question at this stage: why did
people wait for so long to discover this “desirable” way of organizing economic activities? If free
markets are the key to human welfare, then human history up to 1850 A.D. looks to be a waste of
time. The answer to this question does not rest in the inadequacy of human thinking; rather it lies
in the general change in thinking, known as the Enlightenment, which took place in Europe and
North America during the eighteenth century (see chapter 1 for details about the Enlightenment
movement). This intellectual movement emphasized ‘freedom’ as the ultimate goal and the
individual as the ‘decisive entity’ in society. Intellectuals started to worry what about we should
do on the earth now, rather than what we might do to reach heaven in the future. This
Enlightenment infused shift in thought in favor of individual liberty made its way in the vision of
Adam Smith, the unanimously accepted founder of modern economics.
It is also important to stress that the founders of neoclassicism were not concerned with
the determination of the actual prices that ruled in the markets of their time. Walras said nothing
about the determinants of house prices in nineteenth century Paris. They were presenting a “pure”
theory of price in the most general and abstract terms. They were not asking how are prices
determined in actually existing capitalist markets. They were asking how are prices determined
when capitalism is pure; i.e. when there is perfect ‘knowledge’, perfect self-interestedness (i.e.
“rationality”) and perfect-freedom to do what one pleases to do. They were thus not asking the
43
positive question “how prices are determined” but the normative question “how prices ought to be
determined”. They were measuring actually existing capitalism against “pure” capitalism and
assuming that this “pure” capitalism is (or at least ought to be) every man’s ideal. If Abdullah
does not accept this “pure” capitalism as his ideal he is inhuman, unnatural, irrational, ignorant
perhaps insane. The purpose of their policy is to move actually existing capitalism towards “pure”
capitalism.
2.2.6: From Labor Input to the Cost of Production Theory of Value:

Emergence of Social Democracy
As explained above, the development of capitalism has co-existed with a profound

pessimism which also gave economics the label of the ‘dismal science’. This pessimism appeared
in the writings of Ricardo, and more rigorously in Marx. One tradition in economics that
combines insights from the radical revolutionary Marxists and the conservative neoclassicals is
social democracy. Their theoretical foundations can be traced back to what is named as ‘cost of
production’ theory of value mainly influenced by the writings of Ricardo.
The hallmarks of the cost of production theory of value are:
• their central concern with the production,
• the resulting distribution of output between the factors of production
• and the belief that market forces left to their own will lead to inefficiency and, at worst,
stagnation
Their starting point, unlike neoclassicals, is the analysis of the material environment and
technology available to produce a given output. Available technology determines the division of
labor and the pattern of exchange in the economy. The prices of output are determined by the
costs of production. But the cost of production is determined not only by technical factors (e.g.
quantity of labor time and raw material used in the production) but by the distribution of the
output between wages and profits. The resulting division of output will depend upon the relative
bargaining strengths of the various interest groups within capitalist society which may lead to
conflict. For the cost of production theorists, though technological changes in production could be
so crucial to the society in general, yet there may be sectional opposition to the introduction of
new technology because it hurts the interests of that segment in capitalist society. For example,
the introduction of machines may be viewed as profit-maximizing endeavor form the point of
capitalists but a potential source of unemployment from the point of view of the workers. The
precise outcome depends upon the bargaining power of the two groups to negotiate with each
other. The puzzling question then is that if the gains from technological improvements cannot be
realized through the anonymous market forces, then how can society as a whole benefit from new
technology? For cost of production theorists, the answer lies in pluralist politics through which
competing groups could reach compromise, and in neutral bureaucracy seeking to remove
obstacles to technical progress by establishing appropriate institutional frameworks for mediating
conflicts and promoting class collaboration through the establishment of a ‘corporatist state’.
44
Nature of Social Democrat Politics
Social democrats lay stress on positive government action for sustaining welfare
enhancement rather than just protecting basic human rights. Their conception of justice is ‘to
favor the creation of conditions in which people have real opportunities of judging the kind of
lives they would like to lead’ and to focus ‘particularly on people’s capability to choose the lives
they have reason to value’ according to Sen. The social democrats, in general, believe in the
functionality of the market economy as the effective means for allocating resources and attaining
development. However, these economists disagree with the view that valuation determined in the
market is always desirable and efficient. They criticize the market mechanism on several grounds.
Two aspects of their position can be highlighted:
1. they condemn the free market system for the existence of large corporations which implies
that the decisions about who is to be employed and at what wage are not the outcomes of
anonymous market forces alone. Rather, these decisions are products of the power struggles
in which people are discriminated against. Thus, assistance to the unemployed and the low
paid citizens through the state budget also directly counts as ‘developmental’ since it assists
people to lead freer lives
2. distributional inequity and disparity are central to the social democratic market critique.
According to them, since markets can’t remove poverty and income inequalities, and all
citizens have the right to rising material subsistence, therefore the state is responsible for
redistributing resources towards the deprived segments of society. Poverty to them is not
simply the lack of income. It is deprivation of basic capabilities which prevents people from
participating as citizens in capitalist order and as consumers, employees and entrepreneurs in
the markets.
Based on this, they see the active role of an agency that is not subject to market forces in
resource allocation—i.e. state which is essential for maintaining capitalist order. The hall mark of
social democrats is the identification of marginalized groups and their restoration within capitalist
order. Thus social democracy is an effort to find justice within capitalism—i.e. to minimize its
inherent inequalities. Their focus is on the freedom generated by commodities, rather than on
commodities seen on their own’ because people cannot be free if they do not have the resources
to do what they like to do.
Table 2.2 summarizes major features of the three schools of thought that we have
introduced in this chapter.
45
Table 2.2: Summary of Economic Schools of thought
School of thought Source of Value Resulting Political Role of the State

Ideals
Utility theory of • Relative scarcity or • Market Capitalism • Ensure free

value utility • Self-regulating functioning of the
OR • Emphasis on anonymous market by enforcing
Neoclassical consumption activity markets achieve capitalist law and
Economics / • Value determined by the best result for order
Marginalism exchange process all economic • Minimum state
agents intervention in the
market
Socialist • Social process of • State capitalism • Public-ownership of

OR production resulting • Abolition of the resources to make a
Abstract Labor from both technical market classless society by
Theory of Value and class relationships overcoming scarcity
of power to appropriate • Resource allocation
surplus value through central
• Value is determined by planning
socially necessary labor
time embodied in
commodities
• Emphasis on
production activities
Cost of Production • Technical relations of • Nothing specific, • Active regulations

/ Recardian / production or physical but Social of markets
Keynesian / real cost Democracy is • Welfare state
Sraffian • Value is determined by consistent with it
OR commodities destroyed
Social Democrats during production
• Emphasis on
production activities
2.3: WHERE DO WE GO FROM HERE?
Though learning any single theory of economics / value is bad enough as it does not
provide complete insight into the development of economic discipline, yet we will be focusing on
neoclassical (or what was called the utility) theory of value for most of the part in this book due
to several reasons. First, the word ‘economics’ usually stands alone for ‘neoclassical economics’
in Pakistan, and, since this book is intended for students in Pakistan therefore we will be
elaborating and evaluating neoclassical school of thought. Secondly, the utility theory of value
provides a more coherent justification of capitalist order than does the labor theory of value. This
46
justification has gained relevance and importance as capitalist individuation has destroyed non-
capitalist communities and the class structures from which it has emerged and as capitalist
rationalities have displaced other (especially religious) rationalities in most spheres of individual
and social existence. Like classical political economy, neoclassical economics is also an
instrument of governance and its theory of value provides a criteria for measuring actually
existing capitalism with ‘pure’, ‘perfect’ and ‘ideal’ capitalism—it is this aspect of neoclassical
economics which makes a collapse of its ‘positive’ claims inevitable. Most neoclassical
pioneers—Jevons, Walras, Wicksell, Marshall, Pigou, Weiser—suggested reforms for moving
actually existing capitalisms of their times towards ‘pure and perfect’ capitalism. European Social
Democracy was born at least partly as a consequence of these reform suggestions and many of the
defects of late nineteenth century capitalist orders were remedied by the implementation of these
reforms suggested by neoclassical economics.
Neoclassical economics retains its permanence both because it is to date the most
coherent and profound justifications of capitalist order and because it provides several theoretical
discourses from which appropriate instruments of capitalist governance can be crafted. Both the
theoretical justification for capitalist order and the practical policies advocated by neoclassical
economists are based on its theory of value. In the rest of this book (with the exception of the last
chapter) we will try to evaluate neoclassical theories of consumption, production, distribution and
its theory of economic policy. These evaluations will try to identify the strengths and weaknesses
of neoclassical theories both as justifications of capitalist order and as basis for undertaking
reforms required for addressing capitalist policy incoherence and contradictions (especially in
Pakistan). In the final chapter we will examine some other approaches and schools which seek to
justify and reform capitalist order with regard to the organization of production, consumption and
exchange at the micro level. That chapter will seek to understand why these schools have
generally failed to supplant neoclassical economics as capitalism’s orthodox ideology, apology
and theory of policy.
47
Chapter Summary
• The central capitalist value is freedom. Freedom is self-determination––the right to do what
one pleases in a manner which does not prevent others from doing what they please
• Capitalist ideology claims to recognize no external criteria for the evaluation of personal
choices
• Free individuals are (a) acquisitive and (b) competitive. Capitalist order is based on the
promotion of these two traits and emotions
• Competitive and acquisitive societies accumulate for the sake of accumulation. All activities
are valued (in financial markets) in terms of their contribution to accumulation. Without
accumulation freedom cannot expand for the greatest constraint on freedom–––the ability to
do what everyone wishes to do––is the lack of economic resources
• Acceptance of acquisitiveness and competition as social values is neither natural nor
inevitable. Christian society regarded competition and acquisitiveness as sins and social evils
• Capitalist markets and capitalist property is not natural but historical–––created by the acts of
policy of a capitalist state and sustained by state regulation. Different capitalist states regulate
capitalist markets in different ways based on the history and traditions of that country
• All national regulation systems must (a) legitimate capitalist (i.e. corporate) property, (b)
ensure the enforcement of transaction contracts premised on the formal equality and actual
inequality of contractures
• Non-state agencies, such as firms and banks and international public and private sector, also
play an important role in capitalist regulation
• All schools of economic theory justify capitalist order as natural and rational on the basis of
the view that economic “laws” can be observed on the basis of empirical observation of
human behavior and the operation of these “laws”—that when men seek accumulation
through competition—ensures that the greatest good of the greatest number is automatically
achieved. This is Adam Smith’s theory of the “invisible hand”
• Economics is essentially a moral and normative science because its analysis of observed facts
and behaviors is necessarily based on what behavior ought to be. If actually observed
behavior is not what economists believe what it ought to be, then such behavior is regarded as
“irrational”
• According to the economists value resides in wealth not in virtue. Rationality is the
continuous pursuit of an individual’s material self-interest. Value is produced through
capitalist contracts which seek maximization of pleasure and the minimization of pain
• Value necessarily is embodied in commodities produced for the fulfillment of capitalist
contract. Therefore, estimating values requires an analysis of the components of the prices of
commodities exchanged in the market
• According to Smith the labor that can be commanded by the price of a commodity in the
market is a correct measure of its value–––not the labor time that is used into the making of a
commodity. According to the labor commanded theory of value, the value and price of
commodity is equal to the wages, rent and profit paid for its production
• Smith sees capitalist society divided into three main classes––“holders of stock”, laborers and
landlords. According to him all classes gain from a continuing accumulation of capital
(“stock”). Capital is “the order of nature” according to Smith
48
• Ricardo advocated the embodied labor theory of value––i.e. the exchange value of a
commodity by the relative labor time that goes into its production. The value created (alone)
by that labor is distributed among wages, rent and profit.
• In the Ricardian conception value is determined by the amount of labor embodied in the
product of marginal land. This value will be shared between wages, rent and profit. Rent will
be determined by differential in productivity of different qualities of lands. Wages will be
determined by the level of subsistence and profits share from value will be determined by rent
and wages
• By showing that the growth of value was based entirely on the growth of labor productivity,
Ricardo tried to demonstrate the inevitability of accepting capital accumulation as an end in
itself. Capitalism was a natural and rational system because it alone facilitated never ending
capital accumulation and therefore continuous increase in labor productivity
• However, Ricardo’s value theory was unsatisfactory in that it could not be shown that relative
prices in fact correspond to labor embodied in the exchanged commodities. Moreover, prices
change with changes in the pattern of income distribution even when labor inputs remain
unchanged
• If money prices do not correspond of labor embodied, the pattern of income distribution
generated by the market cannot be shown to correspond to any capitalist principles of equity.
Ricardo, thus, could not show that market capitalism was a just system
• To Marx value is produced by labor alone within capitalist society through the network of
class relations. Market capitalism is exploitative according to Marx because it allows ‘the
private property’ owning class to appropriate ‘surplus’ value produced by laborers who are
thus ‘alienated’ from the products of their labor.
• Marginalists reject the Marxist view that market capitalism is exploitative and argue that
market order is classless and capable of generating just outcomes
• Neoclassical economists argued that value emerges in consumption, not in production
• Neoclassical economists were utilitarians. They argued that the ethical basis for evaluating
the justice of outcomes was the ‘greatest happiness principle’. Society should seek those
transactional arrangements which yield greatest net social utility (pleasure)
• The main assumptions underlying neoclassical analysis are as follows:
o Scarcity is universal. Wants are always unlimited and resources always and necessarily
scarce. Commodities derive value from relative scarcity
o Utility derived decreases as the consumption of good increases. Price corresponds to
marginal utility
o Equilibrium prices (= marginal utility) equate demand and supply and “clear” the market.
These “equilibrium” prices are “just prices”
o These just prices emerge automatically from the pursuit of autonomous self-interested
actions of individuals and express the rationality of self-interestedness and of the
capitalist order in general
o The preferences of individuals who enter the market are given. Neoclassical economics
cannot answer the question. “What should these preferences be”
o The resources which an individual brings to the market are also given. Neoclassical
economics has nothing to say about them
49
o The owners of inputs receive incomes which is proportional to the contribution of these
inputs to production of utility for consumer. These incomes are just because they measure
the relative contributions of each input to consumer utility
o The value of a good and input is thus only determined by “free choosers”. Capitalist
markets enable all preferences to be expressed and valued in terms of their contribution to
social utility and hence every one gains from free market transactions. Capitalist society
is not built into conflicting classes but is harmonious and benevolent
o According to neoclassical economists state policy allow free functioning of markets and
the enforcement of capitalist contracts
o Neoclassical economics is concerned to show not how prices are actually formed in
capitalist markets but with how they ought to be formed. They provide a theory to
measure / assess actually existing price structures against “pure” price structures if
capitalist markets were absolutely perfect
• Social demonstrates, inspired by Keynes and Sraffa, argue that production of value and its
distribution is affected both by technological form and by the relative bargaining strength of
conflicting classes–––especially those earning profit and those earning wages.
Institutionalizing the basis of continuous negotiation both in the market (collective
bargaining) and in the state provide a basis for reconciling the interests of labor and capital
for sustaining optimum output-price configurations
• Social demonstrates advocate state intervention to offset market generated inequalities. This
they regard as essential for effective capitalist governance
• For summary of the characteristics of the major economic schools, see Table 2.2
50
Review Questions
1. Why is an understanding of capitalism necessary for a student of economics?
2. Define “freedom”. Is the claim that ‘in capitalist order there are no external criteria for
evaluating personal choices’ correct?
3. “Accumulation is an end in itself in capitalism”. Comment
4. Do you agree that competition and acquisitiveness are natural values which all societies have
to adopt sooner or later?
5. Why does one country’s capitalist system differ from that of another?
6. What are the essential functions a capitalist regulatory regime must perform and what are its
objectives?
7. What role do firms and banks play in capitalist regulations?
8. How does Adam Smith justify capitalist order?
9. What is economic rationality?
10. What is the difference between the ‘embodied’ and the ‘commanded’ labor theories of value?
11. Compare and contrast the theory of value and distribution propounded by Smith with that of
Ricardo.
12. Assess the relationship between Ricardo’s theories of distribution and his politics.
13. Show how Ricardo attempts to establish the rationality of capitalist order.
14. Assess the strengths and weaknesses of Ricardo’s theory of value.
15. Define the Marxist conceptions of ‘value’ and ‘labor’ and distinguish it from the
corresponding Ricardian conceptions.
16. Explain and evaluate Marx’s “conceptions of ‘alienation’ and ‘exploitation’.
17. Outline the main features of utilitarianism. Were Smith or Ricardo utilitarian thinkers?
18. What are the assumption underlying neoclassical economics?
19. What justification does Marginalist Economics present for capitalist order?
20. What is the neoclassical argument for saying that the pattern of income distribution which
emerges in the market is just?
21. Why do neoclassical economists regard capitalist markets and society as harmonious and not
conflicting?
22. What according to the neoclassical economists should be the objectives of state policy?
23. “Neoclassical price theory provides conclusive proof that neoclassical economics is purely
normative and not at all positive.” Discuss.
24. Outline the theory underlying the Social Democrats understanding of how capitalist markets
function.
25. Assess the social democratic critique of the market and the policies they advocate.
51
52
PART TWO
Markets
Liberal framework of analysis
Chapter 3: Basics of Demand and Supply

Chapter 4: Markets and Price Controls
Chapter 5: Elasticity
3
Chapter
BASICS OF
DEMAND AND SUPPLY

Chapter 3: Demand and Supply
If you are asked to identify a single answer that could be an appropriate one to almost all
economic questions; then you should say ‘demand and supply’. It has been said that a parrot
could be converted to an economist if trained to answer ‘it is a question of demand and supply’ to
every economic question—and there is truth in this notion. The model of demand and supply is
the mantra invoked to address all aspects of the capitalist economy ranging from consumption, to
production to distribution of income and wealth. Sections 1 and 2 of this chapter lay down the
foundations of demand-supply analysis. Section 3 then explains how the basic model of demand
and supply operates in a single (competitive) market.
3.1: DEMAND
We begin the study of markets by exploring the behavior of consumers—the logic behind
this behavior is discussed in chapters 6 to 8. When economists talk about demand, they refer to
the amount of a commodity that a consumer is willing and able to purchase. But talking about the
level of demand is not very useful; rather economists try to explore the factors that can change the
demand for a commodity from one level to another. Let us discuss these factors in turn.
3.1.1: Determinants of Demand

Determinants of demand are factors that affect a consumer’s decision regarding ‘what
amount of a commodity to purchase’ with his income. One could identify a long list of such
factors, but economics isolates the ones it regards as the most important. To understand how
many factors can affect the demand for a commodity, suppose you are standing at a chicken shop
in your local market and you are intending to purchase some kgs of chicken. You ask about its
rates from the shop keeper and he offers you a price of Rs 100/kg. At this price, you decide to
purchase, say, 4 kgs. After a few weeks when you go to the market, you find that the price has
increased to Rs 180/kg. You deem this price to be too high to purchase any amount on that day
and postpone your decision to purchase chicken and wait for the price to fall. Economists believe
that demand for a commodity is most significantly affected by changes in its own price. But
‘own price’ is only one out of many factors that can affect the demand for a commodity. Suppose
that the price of chicken remains the same, Rs 100/kg, but beef becomes very cheap, say, from Rs
240/kg to Rs 160/kg. This might encourage the consumer to purchase less chicken (say 2 kgs
instead of 4) and more beef because the demand for beef and chicken are interrelated in the sense
that they can be used in place of each other. To take another example, decrease in the price of
mobile chip connections increases the demand for mobile phones, (as in Pakistan in 2006). So,
economists argue that changes in related goods prices can also affect demand decision of a
consumer.
According to economic theory income also affects demand. Will you still be purchasing
the same amount of chicken if you lose your job, or if you receive a permanent boast in your
income? Obviously, if you are a ‘consumer’ (see chapter 6 for detailed discussion on ‘who a
consumer is’), then income changes will influence your decision of how much chicken to
purchase. So income is considered by economists to be another important factor that affects the
demand for a commodity. Similarly, a consumer’s taste with regard to a particular commodity is
57
expected to make an important impact on his demand decision; i.e. if you are a Muslim, you will
not consider purchasing pork no matter how low its price is or how rich you are (but the
economists view that you would be acting irrationally when you make such a decision). There is a
great debate among economists about where consumer taste comes from. One group believes that
it is innate or inborn while the other considers that it is determined by the society in which an
individual lives. Leaving this debate aside, we can identify one very common factor operating in
a capitalist society that is used to affect the demand decision of individuals for a commodity; and
that is advertisement. All capitalist firms devote a huge amount of their budgets on advertisement
to create a taste for their products by altering consumers’ purchasing habits. Thus, in capitalist
society taste is largely affected by advertisement. Since changes in taste can affect demand for a
commodity, therefore advertisement is related to demand through taste.
It is conventional in economics text books to mention prices of commodities, income of
consumers and taste as the major determinants of demand. But this is not an exhaustive list of all
factors that have an effect on demand for a commodity. Expectations about future prices of
commodities and income also have an effect on consumers’ demand decision. Most importantly,
it is critical to note that demand for all types of goods cannot exist independent of the
institutional, social and legal structure of a society. To understand this idea, consider what will
happen to the demand for automobiles if government introduces a law of ‘maximum 20 Km/Hour
speed limit’ on all city roads. Clearly, this will change people’s choices radically not only in
terms of automobiles used and mode of traveling, but also in their choice of residence, in their use
of time, and in the design of towns, cities and roads. Similarly, the demand for loanable funds by
the general public crucially depends upon the existence of commercial banks and state financial
policies.
It is important to note that this theory of demand applies only to capitalist market
economies. Phyllis Deane’s research on medieval England and Agleitta’s research on 11th to 14th
century France have shown that changes in demand for staples and many other traded
commodities did not respond to changes in prices or income. Changes in demand were merely a
consequence of changes in population or of upheavals caused by war. Prices remained stable for
long stretches of time—rising at the rate of half a percent per annum on average for several
centuries during the European Middle Ages. As Agleitta notes there was not major difference in
consumption patterns between the lords and the serfs in medieval. In France consumption levels
were determined by customs and conventions, and not by changes in prices of goods or income.
Economists would say that consumers were not “rational” before the seventeenth century almost
everywhere in the world. It is only in capitalist society that men become rational, say the
economists, and they become so by maximizing utility; that is by consuming more and more and
more and more.
We can summarize the theory of demand in capitalist society in a compact expression
called the demand function written as:
[ ]
 Own Price of the good [Px ], Price of related goods Py , Income [M ], 
Demand for x (Q xD ) = f  

 Taste (Advertisement) [T ( A)] 
or Q xD = f (Px , Py , M ,T ( A)) (3.1)
58
D
where Q x stands for the amount or quantity of x demanded. This is a typical demand function
which says that demand for any commodity, say x, in general depends upon the price of x, price
of all other related goods that can affect the demand for x, the amount of income the consumer
has and his (advertisement determined) taste.
Thus, we have identified the major determinants of demand in capitalist society. Let us
take each of these factors one by one and examine the nature of their relation to demand. In other
words we seek to find out ‘whether demand will increase or decrease due to change in these
factors’. To begin with let us take own price first.
Own Price and Demand
How would the capitalist consumer react if price of a commodity, say chicken, increases?
It is expected that he will reduce its demand (for reasons, wait till chapter 8). This negative
relationship between price of a commodity and its demand is known as the law of demand.
Table 3.1 uses hypothetical data to explain this law:
Table 3.1: Own Price and Demand

Price of x (Rs) Amount of x Demanded by
Nomi (Kgs)
A 40 4
B 30 6
C 20 8
D 10 10
This table says that as the price of x falls from Rs 40 to Rs 30, Nomi (the capitalist consumer)
tends to increase his demand for it from 4 to 6 kgs. The same decreasing pattern of demand holds
as further reduced price is offered to Nomi, such as Rs 20 and Rs 10. These numbers clearly
indicate that as the price of x is increasing, its demand is decreasing. This is exactly what is meant
by the negative relationship between price and demand—both of them move in the opposite
direction.
We can draw all price-quantity combinations of table 3.1 in a price-quantity graph or
space. These points are drawn in Figure 3.1 which plots price on the vertical axis and quantity on
the horizontal axis. For example, point A represents a price-quantity combination (4, 40)
containing a quantity of 4 kgs of x and a price of Rs 40. The same holds for point B showing a
combination (6, 30), C showing (8, 20) and so on. If we join all these points, we obtain a straight
line termed the demand curve, here demand curve of commodity x, Dx. This shows the amount of a
particular commodity, say x, a consumer is ready to purchase at different prices. For example, a
consumer is willing to purchase 4 kgs of x when he is offered a price of Rs 40 and 6 kgs at a price
of Rs 30.
59
Figure 3.1: The Demand Curve
Price
A (4, 0)
40
B (6, 30)
30
C (8, 20)
20
D (10, 10)
10
Dx
0 4 6 8 10 x
• The Slope of the demand curve

The slope of a curve is defined as change in the dependent variable divided by the change
in the independent variable. The slope of the demand curve is thus defined as:
Change in the demand for x
Inverse of slope of demand curve =
Change in the Price of x
∆Q xD
Inverse of the slope of demand curve = <0 (3.2)
∆Px
where the symbol ‘Δ’ (delta) indicates change in the relevant variable. Since price and demand
have a negative relationship, the slope of the demand curve must also be negative; i.e. changes in
both variables move in the opposite directions. Note that expression (3.2) measures the inverse of
the slope of the demand curve. For clarity of this idea, see FYI Box 3.1.
FYI: B O X 3.1
A Precautionary Note on the Slope of the Demand Curve
Keep one thing about the slope of the demand curve in mind. It is customary that the
slope of a curve is expressed as rise over the run—change in the variable on the vertical axis
divided by the change in the variable on the horizontal axis. For the demand curve in figure 3.1,
the slope expression will be:
∆P
Slope of demand curve = (3.1.1)
∆Q
However, this tradition is not followed in case of the demand curves. Economists normally note
60
the slope of the demand curve by the inverse of expression (3.1.1) as

∆Q
Slope of the inverse ofthe demand curve = (3.1.2)
∆P
It is for this reason that the demand curve is called the inverse demand curve. The reason for
adopting this expression for the slope of the demand curve is that while developing consumer
theory, economists consider quantity demanded of some commodity as a function of its price,
that is what should be the price of a commodity for the consumer to choose a particular level of
quantity (it is the price which determines the quantity demanded). On the other hand, the
expression (3.1.1) gives us price as a function of quantity; i.e. what should be the quantity
demanded of a commodity for a particular price to prevail in the market. Therefore, we use
expression (3.1.2) for stating the slope of the demand curve.
You might be thinking that instead of using this messy inverse expression, why don’t
economists draw demand curves with price on the horizontal axis and quantity demanded on the
vertical? You will have to wait for the answer to this question until we reach the market level
analysis. There you will see that the supply curve of a firm is its marginal cost curve, and we
have cost and price of a firm on the vertical axis because cost is a function of quantity. Therefore
we draw the demand curve with price on the vertical axis so that we may reach an equilibrium
state on the same graph. Don’t worry if you don’t understand this reasoning, you will do so when we
reach chapter 11.
Let us see how the slope of the demand curve is measured. As we said above, there was nothing
special about the numbers we assumed in table 3.1. Figure 3.2 plots a negatively sloped demand
curve with another set of values of prices and quantities demanded.
Figure 3.2: Slope of the Demand Curve
Price
A
Pa = 4
ΔPx = -2
B
Pb = 2
ΔQx = 10
Dx
Qa = 10 Qb = 20 x
Consider movement from point A to B. Recall that change in a variable is given by the difference
between its new and previous values. For example, while moving from point A to B, price
decreases from Rs 4 to Rs 2. Thus change in price from A to B is given by:
61
∆Px = Pb − Pa = Rs 2 − Rs 4 = Rs − 2 (3.3)
Similarly, change in quantity is given by:
∆Q x = Qb − Qa = 20 − 10 = 10 (3.4)
Dividing (3.4) by (3.3) we obtain:
∆Q x 10 5
Slope of the demand curve = = = = −5 (3.5)
∆Px − 2 − 1
This expression says that for each one rupee increase in the price of x, its demand
decreases by five units. Thus, the rate of change in the quantity demanded for x with respect to
price is 5 (for more on slope, see chapter 4). The negative sign behind this number indicates the
negative relationship between price and quantity demanded. Since it is a straight line, the slope
must be the same at all points along this demand curve.
Income and Demand
According to expression (3.2), income is also an important determinant of demand. So,

now pose yourself a question: ‘what will happen to the demand for a commodity if Nomi’s
income increases?’ The first answer that strikes the mind is that in capitalist society it will
increase; i.e. an increase in income leads to an increase in the capitalist consumer’s demand.
Goods whose demand increases (or decreases) due to increase (or decrease) in consumer income
are termed normal goods. Thus we have:
Change in the demand for x ∆Q xD
For normal goods in capitalist society → = > 0 (3.6)
Change in the Income ∆M
The expression (3.6) will be positive only if both ∆Q x and ΔM move in the same direction.
D
There are several commodities whose demand goes up with income in capitalist society such as
better clothing, housing equipment, cars etc. But not all goods can be ‘normal’ for a consumer,
say Nomi. A capitalist consumer can always identify a set of commodities the demand for which
does not increase as income goes up, rather it decreases. Consider the demand for hawai chappal.
If Nomi is poor, he might use it, but as he grows rich he will not increase its demand; rather he
will switch to Peshawari chappal and become ashamed of wearing hawai and his demand for
hawai will fall. Or think of the demand for bicycles. As Nomi grows richer, he purchases first a
motor cycle and then an automobile. He discards his bicycle. Goods whose demand decreases as
the income of a capitalist consumer increases are called inferior goods giving us the relationship.
For Inferior goods → = <0 (3.7)
Change in the Income ∆M
Remember that there is nothing intrinsic to commodities that make them normal or
inferior. A commodity could well be normal for one individual or society and inferior to another.
The Prophet (SAW) continued to wear footware like hawai chappals even after the conquest of
Khyber when a great deal of wealth was acquired by the Muslims. If Bill Gates considers
Khaddar cloth inferior, it does not mean that there is something ‘wrong with’ Khaddar cloth;
rather it merely reflects the attitude of Gates for this commodity. It is quite possible that the same
cloth is a normal good for Farooq, and it may be a ‘superior good’ for Abdullah Zhaghazai
62
because it helps him uplift his spirituality by adopting zuhd. The point here is that within
neoclassical economics, there is no criterion to evaluate the ‘normality’ or ‘abnormality’ of goods
and activities beyond ‘human desires; i.e. it says that the value of goods and activities comes from
the wants of individuals. If a society agrees to accept wearing string biking as ‘normal’ practice, it
will become a normal good while hijab and naqab will be regarded as ‘inferior’ goods. If
prostitution and homosexuality are viewed as acceptable by a capitalist society, it becomes a
‘normal good’ according to neoclassical economics. This fact is a perfect example of the
marginalist theory of value we discussed in the last chapter. According to that theory, the value of
a commodity or an activity lies in the eyes of the beholder. The answer to the question whether a
commodity is normal or inferior varies from individual to individual and one capitalist society to
another in the marginalist or neoclassical economic perspective.
Note that it is not a logical necessity—the opposite of which involves a contradiction—to
assume that demand for some commodities must increase with increase in the income of an
individual, as is assumed by economics. This assumption holds for an individual who lives in this
world in order to maximize utility. A person not committed to utility maximization will not
follow this general pattern of increasing demand with increasing income. For example, it is
possible that Farooq may not wish to improve his standard of living at all as he becomes richer
because he and his family have adopted faqr. He will give away all excess income, say, for the
cause of Jihad, or he may give khairat (charity) to a Madrasah. Despite the fact that Hadrat
Usman-e-Ghani (RA) was quite a wealthy person, he lived a life of faqr and zuhd. His riches did
not appear in the form of better housing equipments or clothing; rather they took the form of
spending in Ghazawat, helping needy and poor Muslims etc. The point to note is that there is no
logically necessary relationship between increasing demand for commodities and individuals’
income. It depends upon the objectives which individuals pursue in their lives.
If we do assume that there is a positive relationship between the demand for a commodity
and income, as it is the case for Gates, the question arises: ‘how can this effect be studied on a
demand curve drawn in a price-commodity space?’ First note that the demand curves given in
figure 3.1 and 3.2 can be plotted keeping income of the capitalist consumer constant. To ensure
that demand decreases as price of the commodity increases, we must keep income fixed when
price rises. If income of the consumer is also allowed to increase when price is increased, there
can be no guarantee that demand will decrease in response to increase in price for normal goods.
This is because increasing price and income will have opposite effects on the demand for a
commodity—demand will decrease due to increased price while it will increase due to increase in
income. So, income must remain fixed at all points of a demand curve, such as A, B, C and D of
figure 3.1. This fact is shown in figure 3.3 where the demand curve DxO (1000) is drawn for
income Rs 1,000; i.e. the capitalist consumer is ready to purchase these amounts of commodity x
when his income is Rs 1,000 per month. This point is key to understanding the effect of income
on the demand curve.
If income is held fixed along a demand curve, what happens to the demand curve when
income goes up? One way of analyzing the effect of income on demand could be to use an
income-commodity space, such as in figure 3.4. This diagram plots demand for x against the
income of the consumer, M. If x is a normal good in a capitalist society, say chicken, then
increasing income from Rs 1,000 to Rs 1,500 will increase the demand from 4 to 8 kgs per
month.
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Figure 3.3: Income and the demand curve in price-commodity space
Dx1 (M = 1500)
Price
DxO (M = 1000)
A A1
40
B B1
30
C C1
20
D
10
0 4 6 8 10 12 x
Though such a graph gives some additional information, it is not very useful for
economists’ purpose, as will be clear in the third section of this chapter. Economists want to study
the effect of income on demand in a price-commodity space. But how can this be done? Consider
figure 3.3 again. Point A gives us the information that when Nomi’s income is Rs 1,000, he is
willing to purchase 4 kgs of x at a price Rs 40/kgs. What if his income goes up to Rs 1,500 while
the price of x remains the same, Rs 40? Since his purchasing power has increased and x is assumed
to be a normal good, he will increase his demand for x and start purchasing, say, 8 kgs as suggested
by figure 3.4. Where will this point be located in figure 3.3? If you are considering point C, then
you are wrong because this point does indicate 8 units of x, but at a price of Rs 20 per kg.
Figure 3.4: Income and Demand in income-commodity space
B
xb = 8
A
xa = 4
0 M
Ma = 1000 Ma = 1500
64
Remember that price is held fixed at Rs 40 per kg when income is increased. So, the point
corresponding to 8 units of x at price Rs 40 is A1, exactly to the right of point A. According to this
point, Nomi is willing to purchase 8 kgs at the price of Rs 40 when his income has increased to
Rs 1500. Now ask ‘how much x will he purchase if price is Rs 30 per kg while income is
increased to Rs 1,500?’ When his income was Rs 1,000, he purchased 6 kgs at price Rs 30. But
after increase in his income, he will increase his demand and will purchase, say, 10 kgs. This
gives us point B1. We can repeat the same process for all points on the demand curve. If we join
all these points, we obtain another demand curve Dx1 (1500) corresponding to income level Rs
1,500. This demand curve records information about Nomi’s purchasing decision of x at different
price levels when his income is assumed to be Rs 1,500 instead of Rs 1,000 per month. Thus, we
find that if the income of a capitalist consumer increases, then the whole demand curve shifts out
right wards if x is a normal good indicating that demand for x has increased at all price levels due
to the increase in income.
Another way to understand this shifting is to consider the case of two consumers, one
Nomi with income level Rs 1,000 and another Moni (another capitalist consumer) with Rs 1,500.
The person having higher income level will demand more units of x no matter what its price is.
For example, at price Rs 40, Nomi is willing to purchase 4 kgs while Moni is ready to buy 8 kgs
because his income is greater than that of Nomi. The same goes for all price levels. Visualizing
figure 3.3 from this angle, demand curve DxO (1000) stands for Nomi while Dx1 (1500) for Moni.
The larger the income of a capitalist consumer, the farther will be the demand curve from the
origin for normal goods. This is what is meant by the shifting of the demand curve.
The demand for all goods does not rise due to increase in income as explained above. If x
is an ‘inferior’ commodity, then its demand will decrease due to increase in income. This means
that the demand curve will actually shift inwards and towards the left and not outwards for
inferior commodities indicating the fact that demand has decreased for all price levels.
Figure 3.5: Income and Demand for ‘Inferior’ Goods
Dxo (1000)
Price
Dx1 (1500)
B A
20
0 6 10 xinferior
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This is shown in figure 3.5 which shows that as income increases from Rs 1,000 to 1,500,
demand for x falls at all price levels. One such price level is shown in the diagram.
Finally, note that it is merely conventional that the relationship between demand for a
commodity and its own price drawn in a price-commodity space is called a demand curve. In fact
the relationship between demand and income when drawn in income-commodity space such as in
figure 3.4 could also be termed as the demand curve—and there will be no effect of changing this
terminology technically. But as we will see, such a graph is useless for analyzing the behavior of
capitalist markets.
Related Goods’ Prices and Demand
We can also study the effects of changes in the price of one commodity on the demand
for another. This is called the cross price effect; i.e. what happens to the demand for x if the price
of y changes. We have said above in expression (3.1) that prices of related goods can also affect
demand for a commodity. The direction of the relationship between demand for commodity x and
price of commodity y depends upon the nature of the relationship between these two
commodities; i.e. whether they are substitutes or complements to each other. Substitutes are
goods that can be used in place of each other because they serve more or less the same purpose in
the eyes of a capitalist consumer, such as beef and chicken for households or oil and CNG for
automobile users. Technically speaking, two goods are said to be substitutes if demand for one
increases due to increase in the price of another commodity. For example, increase in the price of
petrol has increased the demand for CNG and LPG gases over the last few years in Pakistan.
Thus, we have:
For Substitute goods → = >0 (3.8)
Change in the Price of y ∆Py
In other words, the cross price effect is positive in the case of substitute goods.
Two goods are said to be complementary to each other if they are used more or less
together, such as mobile phones and mobile chip connections or jam and bread. In case of
complementary goods, cross price effect is negative indicating the fact that demand for one
commodity increases when price of another decreases. For instance, a dramatic fall in mobile
connection charges from Rs 3,000 to almost Rs 200 and mobile call service charges from Rs 12 to
Rs 2 per minute has led to a revolutionary increase in the demand for mobile phones over the last
decade in Pakistan. Thus we have the relation:
For Complementary goods → = <0 (3.9)
Change in the Price of y ∆Py
The effects of changes in price of commodity y on the demand for x can also be studied in a price-
commodity space much the same as the effect of income on demand. If two goods are substitutes,
then increase in the price of y will increase the demand for x and the demand curve will shift
outward as drawn in figure 3.6. Note very carefully that we have price of x, Px, on the vertical
axis and not price of y. Secondly, the level of income is held fixed along both demand curves at
Mo level (say Rs 1,000 per month). However, the price of y, Py, is different for both curves. When
Py = Pyo, say Rs 10, per kg we have demand curve DxO (Mo, Pyo) which shows demand for
commodity x at different prices of x when the income of the consumer and the price of y are held
66
fixed at Mo and Pyo levels respectively. When Py increases to Rs Py1, say Rs 15, the demand curve
shifts to Dx1 (Mo, Py1) reflecting the consumer’s willingness to purchase x at different prices of x
when income and price of y remains fixed at Mo and Py1 levels. Again, it is important to note that
income and related goods prices remain fixed along any single demand curve.
Figure 3.6: Effect of increase in price of a substitute on demand curve
Price
A B
Po
DxO (Mo, Pyo) Dx1 (Mo, Py1)
0 xo x1 x
On the other hand, if two goods are complements, then increase in the price of y will
decrease the demand for x and the demand curve will shift inward (try to draw a diagram yourself
for this case). Read carefully FYI Box 3.2 to avoid an important conceptual mistake.
FYI: B O X 3.2
A Precautionary Note on the Law of Demand
Suppose that you want to test the law of demand for, say, milk whether or not a rise in
price of milk reduces its quantity demanded. How would you do this? You might collect the data
on the price of milk over time and the quantity demanded for it. You will observe that the money
price of milk has been rising since August 1947 and its consumption is also increasing. Does this
observation refute the law of demand (or that individuals maximize utility subject to income
constraint)? The answer is no, because the data and assumptions are not realistic. A careful
statement of the law of demand says that it is the changes in relative prices, not absolute money
prices, which produce law of demand. In addition to that, the income of the individual as well as
prices of related goods are also held constant. If you want to test any hypothesis in the real world,
you must take into account its assumptions because assumptions are the conditions under which
that law or hypothesis is true.
Taste and Demand
The only remaining factor in the expression (3.1) is taste denoted by T. Now it should be
a straight forward matter to see how changes in consumer taste towards a commodity can affect
its demand. If it is very cold weather, Nomi might prefer to consume more dry fruits than he does
67
in summer even if their prices and his income remain more or less the same. Alternatively, if it is
hot summer day, he might go to an ice cream parlor or have Lassi. The effect of changes in taste
on the demand curve is much the same as that of changes in income and related goods prices. The
demand curve will shift outward if taste becomes more favorable for a commodity and vice versa.
Remember that a single demand curve is drawn keeping income, prices of related goods
and taste constant. Thus, a correct statement of the ‘law of demand’ is as follows, ‘own price and
demand for a commodity are negatively related keeping other things constant’. These ‘other
things’ include prices of related goods, income and taste of a capitalist consumer within capitalist
society.
Taste and Advertisement
Economists pretend that the taste of an individual is innate or inborn. According to this
idea, all individuals are born with infinitely insatiable desires and infinite appetite to fulfill these
desires. The reason behind economists making this absurd assumption is explored in chapter 7
and 8. But note here that taste or preferences of individuals do not exist independent of the values
of the society he is born into. One of the major factors that shape the taste of individuals in
capitalist societies is advertisement which is a tool to create and maintain new and higher levels
of desire. Firms such as Pepsi and Coca Cola spend billion of dollars per month for this objective.
When Pepsi or Coca Cola advertises its product, it is not providing information to customers as
their products are already well known even in Sindh villages, rather they try to create new tastes
and enhance consumerism within society (see chapter 9 for detailed discussion on it). This fact is
revealed by the attractive types of slogans used by these companies such as ‘dil hay to mango
aur’ and ‘khana mangay coca cola’, etc. The role of advertisement in the market will be discussed
in Application Box 3.4 below.
3.1.2: From Individual to Market Demand

Economists are interested in analyzing individual behavior so as to know and shape the
collective behavior of all individuals in capitalist society. Thus John Hicks; a Nobel prize
winning economist says,
“Economics is not, in the end, much interested in the behavior of single individuals. Its
concern is with the behavior of groups. A study of individual demand is only a means to
the study of market demand”.
One of the fundamental objectives of economics is to study the behavior of a capitalist society;
i.e. to uncover the regularities that ought to be working behind its processes so that appropriate
policies can be derived in order to keep it working efficiently. It is believed by neoclassical
economists that the behavior in capitalist society is reflected in an aggregation of the behavior of
its members. If we convert this into a mathematical equation, it can be stated as:
Behavior of America = Behavior of Mr. Gates + Behaviour of Mrs. Gates + … + Behavior of all
American citizens
In general,
Behavior of capitalist society = Sum of the behavior of all capitalist Individuals
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In other words, if one is interested to know how capitalist society should operate, he must know
how a capitalist individual must behave in a capitalist society. Whatever has been said about
demand so far holds for a single capitalist consumer—how the consumption decision of Nomi
responds to changes in prices and income etc. Given this consumption behavior of a capitalist,
rational individual; the next problem is to find the consumption behavior of capitalist society as
reflected in the market. If we accept the neoclassical belief that market behavior ought to be the sum
of individual behavior, then market demand for a commodity will simply be the sum of all
individual consumers’ demand for a commodity. Let us begin with a two-consumer-one commodity
model, a ‘2×1’ model (two consumers, say Nomi and Moni, and one commodity, say x).
Consider table 3.2 which shows the demand decision of Nomi and Moni for commodity
x at different price levels. At price Rs 10, Moni is willing to purchase two units of x. On the other
hand, Nomi opts not to purchase any amount of x at this price, may be because he is poor. These
differences in demand can result either from the differences in the income of the two individuals
or differences in their taste. Adding the demand for x of the two individuals, the market demand
at price Rs 10 is, thus, two units. Similarly, market demand at price Rs 8 is four units. When x is
offered at Rs 6, Moni chooses to buy 6 units while Nomi buys 3 units. Adding their demands at
price Rs 6 gives 9 units of x. The same holds at point D and E. Thus we find that market demand
is merely the sum of all individuals’ demand at a particular price.
Table 3.2: Deriving Market Demand from Individuals’ Demand
Price of x Amount of x (kg) Amount of x (kg) Market

(Rs) Demanded by Moni Demanded by Nomi Demand (Kg)
A 10 2 + 0 = 2
B 8 4 + 0 = 4
C 6 6 + 3 = 9
D 4 8 + 6 = 14
E 2 10 + 9 = 19
Let us represent the demand functions of each individual for x as:

x M = f m (Px , Py , M M )
(3.10)
xN = f n
(P , P , M )
x y N
(3.11)
Note two things: both individuals are assumed to face the same prices at a time and each person’s
demand depends on his own income and taste and not that of the other. The total demand for x is
then given by the sum of the amounts demanded by the two individuals. Mathematically,
( )
Market Demand for x = xM + xN = f m Px , Py , M M + f n Px , Py , M N ( )
(
Market Demand for x = F Px , Py , M M , M N ) (3.12)
where “F” shows the market demand function for x. Note that the market demand depends on the
income levels of both the individuals.
This idea is shown graphically in figure 3.7 segmented into three panels. The first two panels
draw the demand curves for commodity x of the two consumers. The market demand curve for x
can be obtained by adding these demand curves horizontally. The panel (c) shows the market
demand for x at different price levels. For example, at price Ps and above, market demand is zero
69
since neither Nomi nor Moni is willing to purchase any amount of x at these prices. Now let’s pick
the price level P1 (Rs 10) and see how much of x each individual is willing to purchase at this price.
From Table 3.2, we can see that Moni is willing to buy 2 kgs of x while Nomi is not ready to
purchase any amount at this price. Point A is one point on the market demand curve corresponding
to point a of panel (a). The same holds at point B. The slope of the market demand curve will be
equal to that of Moni’s demand curve above the price where Nomi enters the market, P2. This is so
because above this price level, Nomi does not purchase any amount of x and therefore the market
demand is equal to Moni’s demand in this price region. Now think of price P3 and repeat the same
process. At this price level, Nomi also participates in the market by purchasing 3 kgs of x. The
market demand is 9 (= 6 + 3). This gives us another point C on the market demand curve which is
a horizontal summation of points cm and cn. Repeating this process at all prices and adding the
demand curve of all individuals horizontally will give us the market demand curve, DM.
Figure 3.7: Deriving the Market Demand Curve
Px Px Px
(a) Moni (b) Nomi (c) Market
Ps Ps
a A
P1 (10) P1 P1
2
bq bf B
P2 (8) P2 P2
4 2 4
cq cf C
P3 (6) P3 P3
6 3 6 3 DM
DN
0 2 4 6 0 3 0 2 4 6 9M
xM xN x + xN
This result can easily be generalized to n-individuals in the capitalist economy. The key to derive
the market demand curve is that we add horizontally the demand for a commodity by all
individuals at any given price level. The general formulation for the market demand function for x
turns out to be:
M
Market Demand for x = D x = F (Px, Py, {Mi})
= f m (Px, Py, MM) + f n (Px, Py, MN)
n
D M
x = ∑
i
f i (Px, Py, {Mi}) (3.13)
Note that there is a kink in the market demand curve at the price where Nomi enters the
market, P2 in figure 3.7. With two individuals entering the market at two different price levels,
such as Ps and P2, we have one kink in the market demand curve, such as at point B. Using this
70
logic, if we have three individuals who enter the market at three different price levels, we will
have two kinks in the market demand curve. If there are n-individuals entering the market with
very small differences in the market price, the kinks will increase in numbers and move closer to
each other and we will, approximately, have a smooth market demand curve, just like the one
drawn in panel (c) of figure 3.8. Adding up individual demand curves to produce a smooth
market demand curve is quite unrealistic as several neoclassical and orthodox economists have
noted. Adding up individual demand curves to yield a relatively smooth market demand curve
depends on several unviable—not merely unrealistic—assumptions about tastes, relations
between tastes and income and patterns of income distribution. This has led Hal Varian, whose
book Microeconomic Analysis is compulsory reading on most American M.S Economics
programs, to the conclusion that “unfortunately the aggregate demand curve posses (es) no
interesting properties … The neoclassical theory of consumer behavior places no restrictions on
aggregate behavior in general”.
Figure 3.8: The smoothness of market demand curve emerging by increasing the number of consumers
Px (a) Market demand (b) Market demand (c) Market demand
with three consumers with four consumers with n-consumers
Ps a Ps a
P1 b
P1
b
P2
c
c
P2 d
P3
DM
0 xa + xb + xc xa + xb + xc + xd ∑xi
It would complicate matters a great deal if we were to show why a smooth market
demand curve cannot be derived without making these unviable assumptions (wait for chapter 8).
But an important point to note is that economics is not primarily concerned with describing how
existing capitalist societies (including markets) actually function. Rather, it is essentially a moral
theory prescribing how capitalist societies and markets ought to function. The smooth individual
demand curve shows how a rational capitalist consumer ought to behave. All capitalist consumers
ought to behave in this same way and you are taught to accept as optimal the social outcome of
everyone behaving in this rational way. Allowing everyone to behave in this rational way is an
end in itself. Saying that when individuals are induced to act rationally it cannot be shown that
social utility will be maximized demonstrates the ultimate irrationality of capitalist rationality.
Society cannot be organized to achieve capitalist ends for these ends are inherently unrealizable.
The capitalist organization of production and exchange necessarily constrains the maximization
of consumption/welfare/freedom. No branch of capitalist epistemology—philosophy,
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jurisprudence, sociology, political science or economics—has been able to grapple effectively

with this paradox.
3.2: SUPPLY
Having discussed the idea of demand, let us move on to the other side of the market:
supply. Supply is defined as the amount of output that firms or individuals are willing to sell at a
positive price. Supply can also be modeled in the form of a supply function, such as:
Supply of x (Q xs ) = f (Own Price of the good [Px ], Input Prices [W ], Technology [A])
or Q xD = f (Px ,W , A) (3.14)
This function says that the sellers’ decision to sell a particular amount of output depends upon the
own price of the commodity that they are selling, prices of inputs and technology. Let us briefly
discuss the relationship of supply with each of these factors one by one.
Own Price and Supply
The relationship between the own price of a commodity and its supply is expressed by
the so called law of supply. This law says that quantity supplied will be larger at higher market
prices and smaller at lower market prices, other things held the same. To demonstrate this idea,
consider figure 3.3 which illustrates the meaning of this law. You can see that as the price of x is
increasing, so is the amount supplied. The plot of this relationship in price-commodity space is
called supply curve.
Figure 3.9: The Supply Curve

Price
Sx
D
40
C
30
B
20
A
10
0 4 6 8 10 xS
4 6 8 10
72
The logic behind the positively sloping supply curve cannot be completely understood without
analyzing production and cost structure of a capitalist firm. So you have to wait till chapters 10 and
11 to understand its justification. Loosely speaking, the supply curve is positively sloped due to the
assumption of diminishing returns in the production process which results in higher cost of
production as output increses. To consider a rough example, suppose a car manufacturing company
produces 100 cars per month at a cost of Rs 100,000/car. Suddenly, the demand for cars increases to
500 cars per month. In order to produce 500 cars, more factors of production or inputs must be
purchased. And it is possible that the cost of purchasing additional inputs may increase when their
demand increases in the market. Higher cost means that the firm can no longer produce a car for Rs
100,000 and hence a higher market price is needed to induce the firm to produce more cars. This
justifies the law of supply; i.e. a higher price is required to produce higher output by capitalist firms.
Remember that this law does not usually hold in production of most goods in capitalist markets.
Most of the times, producers are willing to sell more output at the same price, or even at lower
prices. When we reach the theory firm in this book, we will discuss these matters in detail. At this
moment, note that the slope of the supply curve is defined as:
Change in the supply of x
Inverse of slope of Supply curve =
Change in the Price of x
∆Q xS
Inverse of slope of supply curve = >0 (3.15)
∆Px
Another way to make some intuitive sense of the positively sloped supply curve is to
think of an exchange economy. This is a type of economy where goods already exist in the hands
of people and production is no longer taking place. Nomi happens to posses some goods, may be
he has inherited them, and does not face the problem of producing them. Suppose that the only
thing Nomi inherits from his father is wheat. He needs some other goods as well, such as
clothing, housing etc. Now in order to consume goods other than wheat, he needs to sell some
amount of wheat for money so that he can purchase other goods. Thus, the only decision he has to
make is how much of wheat to consume himself and how much of it to sell in the market in order
to purchase other goods. Assume that the market price of wheat is Rs 10/kg while the price of
chicken is Rs 20/kg. This means that for every one kg wheat sold in the market, Nomi can earn
Rs 10. These Rs 10 can then be used to purchase half a kg of chicken (because 1 kg chicken costs
Rs 20). In other words, 1 kg of wheat can be exchanged for half a kg of chicken in the market at
these prices. Now assume that the price of wheat increases to Rs 20/kg. This means that by
selling one kg of wheat in the market, Nomi can now earn Rs 20 and, hence, can purchase one kg
of chicken. Alternatively, after increase in price of wheat, Nomi can exchange 1 kg wheat with 1
kg chicken. Thus, after a rise in the price of wheat, its exchange value increases which mean that
more units of other goods can be purchase by selling one unit of wheat. According to neoclassical
economics, if Nomi is an economic-man (one who maximizes utility / profit), then he should sell
more units of wheat at higher price levels because that will allow him to consume larger amounts
of other goods. However, if Nomi is not an economic-man, then there is no guarantee that he will
exchange more wheat for chicken even if its price keeps increasing in the market. In general, the
law of supply is not a universal law that holds for all individuals and all societies and at all times
it operates only in capitalist markets.
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Input Prices and Supply
Just as the position of the demand curve changes—i.e. the demand curve shifts—when a
factor (such as income) other than the own price of a commodity changes, similarly the supply
curve also shifts out or in due to changes in inputs prices and technology. For example, if prices
of inputs increase from Wo to W1, then the cost of producing the same level of output increases. If
the market price at which that commodity is sold remains unchanged, firms will produce less
amount of that commodity and, hence, supply will decrease. The effect of such an increase in
input prices will be to shift the supply curve inward as shown in figure 3.10. Much has been said
on the meaning of ‘shifting’ in our discussion on demand, read that section again.
Algebraically, this relationship is shown as:
∆Q xS
<0 (3.16)
∆W
which says that there is an inverse relationship between input prices and supply of a commodity.
Technology and Supply
Another factor that can shift the supply curve is technology. More will be said on the
issue of technology in chapter 9; here it is sufficient to note that in economics technology is
conventionally defined as ‘the method of producing output from inputs’ or ‘a way of converting
inputs into output’. Not only inputs but also a specific method is required to produce something.
You can think of inputs as ingredients of a food-recipe while technology as its ‘method’ of
cooking; i.e. which ingredient to use in what combination and proportions. If a new technique
allows a firm, say Microsoft, to produce more output with the same amount of inputs, then
economists says that technology has improved.
Figure 3.10: The impact of change in input prices on Supply
Price Sx (W1)
Sx (Wo)
B A
30
0
4 8 x
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The effect of improved technology is to lower the cost of production and, hence, to increase
supply. So, there is a positive relationship between supply and technology “improvement”.
∆Q xS
>0 (3.17)
∆A
The effect of improvement in technology is to shift the supply curve outward. Just reverse the
direction of the arrow in figure 3.10 to see this effect.
Other Determinants of Supply
One can think of a number of other factors that can affect the supply of a commodity.
Some of them are:
i. Prices of Related Goods: If production of two goods requires the same type of resources,
then a change in the price of one commodity can cause a shift in the supply curve of
another related commodity. For example, consider the production of wheat and grapes both
of which require a particular piece of land for their production. Once a piece of land has
been used for cultivating wheat, it cannot be used for producing grapes at the same time.
Think of Carter who inherits two acres land from his father which he uses for producing
wheat initially. Now assume that the price of wine increases in the US market because most
people have become drunkards in America. The production of wine requires grapes as
ingredients, but grapes can be produced in larger quantity only if land reserved for
producing wheat is diverted to the production of grapes. Therefore, Carter as a capitalist
farmer will decide to produce more grapes than wheat in order to maximize profit. The
supply of wheat will fall, hence shifting its supply curve inward. Note that if the farmer is
not an ‘economic-man’ and does not organize production for maximizing profit, then
production of wheat will not fall no matter how high the price of wine goes up in the
market because the farmer will continue to produce wheat on his land to sustain his society.
See Application Box 3.1 to see the result of capitalist response to price changes in the
eighteenth century.
A P P L I C A T I O N B O X 3.1
Famine in France During the French Revolution
Several authors have noted that a major cause of the French revolution (which occurred in 1789)
was the famine experienced by the landless rural poor. The success of French colonialism during
the eighteenth century led to the inflow of immense quantities of gold and silver into France.
This wealth was used by a new class of capitalist farmer to acquire large landholdings from the
decaying nobility and to dispossess the peasants. At about the same time there was a dramatic
increase in the demand for wine in France—mainly for domestic consumption but also for
export—leading the capitalist farmers to drastically reduce the production of wheat and increase
the production of grapes. The production of wheat declined so catastrophically that in the 1780s,
bread became a luxury commodity and there was wide spread famine and malnutrition
throughout rural France. This was a major cause of the peasant uprisings and revolts which
played a crucial part in the French revolution.
75
ii. Expectations: Supplier’s expectation about future conditions of the market relating
to their goods can also shift the supply curve. For example, suppose that suppliers
of LPG gas are anticipating that the government is going to enact a law according to
which LPG prices will be fixed at some higher level. If they are profit-maximisers,
they will withhold LPG gas today in order to sell it in the future at the anticipated
higher price. Therefore, the supply curve will shift inward today. Application Box
3.2 shows the same type of mentality on the part of fruit-suppliers in Pakistan
before the month of Ramadan.
Fruit Supply before Ramadan
Ramadan is a month reserved exclusively for Ibadaah and earning reward from Allah Almighty.
But the devilish economic-man sees it as a potential source of profit-maximization. It is known
that a week or two before Ramadan, many farm owners withhold the supply of fruits from
markets so that when demand for fruits increases during Ramadan, they can sell fruits at higher
prices. Remember that such a price increase of fruits is not a ‘natural’ outcome; it is artificially
created by the lust of suppliers for more profit. If this evil desire is removed from individuals by
Tazkia, prices will not rise. Economic theory accepts hoarding as natural for it is a capitalistically
rational response to anticipated price changes. If economic-man does not hoard as a response to
expected price raise he will be behaving irrationally from the point of view of economic theory.
iii. Discoveries: The supply curve of natural resources shifts to the right if new resources are
discovered because this is expected to lower the cost of production.
iv. Weather: Because of dry weather or flood, supply curve of, say, wheat will shift to the left.
Similarly, a good harvest of wheat can shift its curve outwards.
One can, easily, think of many other factors that can affect the supply of a commodity and add
them to this list. We now briefly discuss the concept of market supply.
3.2.2: From Individual to Market Supply
Section 3.1.2 gave a detailed description of how to derive the market demand by adding
individual demand curves. We also saw that it is in fact impossible to derive the market demand
curve in this way in real capitalist markets (or indeed justify such a derivation logically) and that
the concept of the market demand curve is an ideological devise to illustrate capitalist rationality.
The same procedure can be applied to obtain the market supply curve which shows the supply
of a commodity made by all firms at different price levels. This is illustrated in Table 3.4 which
presents the supply decision of two firms at different price levels. The resulting diagram is shown
in figure 3.11 that draws the sum of supply by the two firms. Note again that we have one kink in
the market supply curve with two sellers.
76
Table 3.4: Deriving Market Supply from Individual Firms’s Supply Function
Price of x Amount of x Amount of x Market Supply
Supplied by Coco Supplied by
Cola Pepsi Cola
A 5 0 + 0 = 0
B 10 4 + 0 = 4
C 20 6 + 2 = 8
D 30 8 + 4 = 12
E 40 10 + 6 = 16
As the number of firms are increased, kinks tend to increase and become closer and closer to each
other. If there are many sellers, we will have a smooth market supply curve. Mathematically,
Market Supply of x = xc + xp = f (Px , W , A) + f (Px , W , A)
c p
Market Supply of x = F(Px ,W , A,) (3.18)

where “F” shows the market supply function of x.
Figure 3.11: Market supply with two firms
Price
Sc + Sp
8 4
30
D
6 2
20
C
4
10 B
5
A
0 4 6 8 12 xM
A lot has so far been said about demand and supply, it is now time to put the ‘two-blades of
the scissors’—demand and supply—together to understand how markets ‘ought’ to work according
to economic theory.
77
3.3: THE MARKET AND EQUILIBRIUM
We have outlined the behavior of two agents operating in the market—i.e. the
consumption behavior of consumers and production behavior of firms. This enables us to
understand how markets ought to work and how, as a result of this process, prices ought to be
determined according to economic theory. Consider figure 3.12.
Think of an auction where individuals have come with their belongings so as to exchange
them with that of others. The problem for the auctioneer is to determine prices of all goods that
individuals hold so that they can be exchanged. Obviously, exchange of goods cannot take place
without knowing the rate at which goods can be exchanged. To begin with, suppose that the
auctioneer announces a price of Rs 15 (= Po) for the auction to start for good x. He asks
participants to tell him who is willing to sell how many units and who is willing to demand how
many units at this price. It so happens that the amount demanders are willing to purchase turns
out to be exactly the same as the amount sellers are willing to sell at this price. Let it be 8 (may be
8 hundred or thousand etc.) units denoted by xo in figure 3.12. Point e where demand and supply
curves intersect is said to be the equilibrium point. But its meaning can be fully understood only
when we see how this equilibrium point is reached from a disequilibrium position.
Figure 3.12: Market Equilibrium
Price Do So
e
Po = 15
15 = Po
0 xo = 8 x
Market with Excess Demand
Consider figure 3.13 now. Suppose that the auctioneer announces a price Rs 10 for the
auction to start. At this price, demand is 14 while supply is 6 units. In other words, demand for
this commodity is greater than its supply at this price. This situation is known as excess-demand
or shortage in the market. How should this gap between demand and supply be filled? What
should the auctioneer do to eliminate excess-demand? Economists believe that this situation cannot
78
persist for long because it leaves some demanders unsatisfied. This is because at this price, people
are ready to purchase this commodity but the only problem is that there is nothing to purchase.
Figure 3.13: Market with excess demand
Price Do So
15
10
Excess
Excess
Demand
demand
0 6 14 x
Economically rational buyers will be willing to pay a higher price for this commodity. Also
profit-maximizing suppliers can ask for a higher price for this commodity as they know that they
can sell this commodity at a higher price without losing their customers. The auctioneer therefore
raises the price of this commodity from Rs 10 towards Rs 15. Does this resolve the problem? Yes,
because when the price is increased, rational consumers reduce their purchases, quantity
demanded falls. On the other hand, due to increase in price, quantity supplied increases because
rational firms are profit maximizers. Increased price stimulates more supply simply because
selling one unit of a commodity at a higher price means higher profit. Since demand is decreasing
while supply is increasing after increase in price, the gap between demand and supply will
decrease. Where should this process of increase in price stop? Obviously, at point where demand
is equal to supply. The process is explained in figure 3.14.
Figure 3.14: Process of equating demand and

supply in case of excess demand
Excess Price
Demand until D = S
S
Market with Excess Supply
Now think of the opposite possibility in figure 3.15. Obviously, there is no way that the
auctioneer can know in advance at which price the problem of excess demand will be eliminated.
79
Suppose that in order to resolve the situation of excess demand in figure 3.13, he announces a
new price, say, Rs 20 per unit. But at this price the problem of excess-supply or surplus emerges.
To see this, note that at this price, quantity supplied is 10 units while demand is only 4 units. This
means that supply is greater than demand at this price. Again, this situation cannot prevail
according to economic theory for very long because it leaves sellers with goods piling up on their
shelves without anyone to purchase them. The only way firms can sell their commodities is by
accepting a lower price for their commodities. Reducing price, say towards Rs 15, is expected to
induce more customers to purchase this commodity [because they are utility maximizers].
Figure 3.15: Market with excess supply
Excess
Px Supply So
Do
20
15
0 4 10 x
On the other hand, some sellers refuse to sell their goods if offered a price of Rs 15 and leave the
market: quantity supplied should fall. This is shown in figure 3.16.

supply in case of excess supply
D
Excess Price
Supply
until D = S
Market in Equilibrium
Thus we see that:

i) in the case of excess demand price is expected to increase, which as a result, is expected
to eliminates excess demand from the market, and
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ii) in case of excess supply price is expected to decrease, which is expected to eliminate
excess supply.
In both the situations, the direction of change in price ensures that excess demand and excess
supply is eliminated from the market so that demand equals supply. Figure 3.12 shows this end
point of the auctioneering process: price will stop changing where demand is equal to supply, as
at point e where demand and supply curves intersect. This is equilibrium. Equilibrium is defined
as a ‘position where there is no further tendency for change’. Point e is called the equilibrium
point because demand and supply are expected not to change from this point, once attained, until
something else happens (to be discussed below). Price Po is said to be the equilibrium price
because there is no tendency for price to change from this level. At this price level, demanders are
expected to be willing to purchase exactly what firms are expected to be willing to sell: price will
neither increase nor decrease because demand is equal to supply. Similarly, quantity xo is said to
be the equilibrium quantity sold because neither consumers nor sellers will want to revise their
purchase or sale decisions. This expected tendency of price to increase or decrease in the case of
excess demand and excess supply until the market clears is called the market or price
mechanism.
3.4: CHANGES IN EQUILIBRIUM: HOW MARKETS ALLOCATE RESOURCES?
The previous section demonstrated that equilibrium in the market is determined where
demand and supply are equalized. Once such an equilibrium point is established, nothing can
change this point until the factors that determined this point undergo some change. What factors
are responsible for the existence of the equilibrium? Obviously, it was determined by ‘demand
and supply’. As long as the position of the demand and the supply curves remain the same as in
figure 3.12, equilibrium price and quantity will also remain unchanged. This equilibrium point
can change only if either demand or supply curves or both curves change their positions. Let us
first analyze how changes in demand can affect the equilibrium price and quantity sold.
3.4.1: Changes in Demand
What factors can cause the position of the demand curve to change? To see this, consider
the demand function (3.1) of commodity x again:
Q xD = f (Px , Py , M ,T ( A)) (3.1)
We discussed in section (3.1.1) that the demand curve will shift either outwards or inwards if any
factor other than the own price (Px) of a commodity undergoes some change. For example, if the
income of an individual increases, then demand for a normal good will increase and the demand
curve will shift outward (see figure 3.3). Similarly, changes in related goods prices and taste can
also shift the demand curve. In other words, the position of the demand curve changes due to
changes in these factors. Demand can change in two directions due to changes in these variables:
it can increase as well as decrease. Let us consider these positions one by one.
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Increase in Demand
Consider figure 3.17a where initial price and quantity sold are Po (say Rs 5) and xo,
determined by the intersection of the demand curve Do and the supply curve So. Now assume that
demand for this commodity increases after increase in the consumer’s income. As a result, the
demand curve shifts outward to D1 as shown in this diagram.
Figure 3.17a: Effect of increase in demand on market
D1
Price
So
Do
g
7 = P1
e
f
5 = Po
Excess
Demand
0 xo x1 x
Figure 3.17b: Effect of increase in demand on market
D1
Price
So
g
7 = P1
e
f
5 = Po
Excess
Demand
0 xo x1 x
82
After shift in demand curve, Po is not the equilibrium price because demand is now greater than
supply at this price. To see this clearly, look at figure 3.17b which plots the same diagram
omitting the demand curve Do.
Remember that once the demand curve has shifted out, the original demand curve is not
applicable and the relevant demand curve is the new one, here D1. We can clearly see that on this
new demand curve, quantity demanded is xd whereas quantity supplied is the same xo. The
difference between xd and xo or the distance ef measures excess demand in the market at this price
which is very similar to the one drawn in figure 3.13. The same process of increase in price as
outlined in figure 3.14 will begin once excess demand appears in the market and the new
equilibrium is attained at point g in figure 3.1.7a. Price will stop increasing when demand and
supply are equal at P1 (= Rs 7). The process is shown by figure 3.18.

supply after increase in demand
D
Excess
If D Demand at Price until D = S
initial price
S
Comparing the old and new equilibrium points e and g, we can see that market price has
increased to P1 while quantity sold has increased to x1. Thus, economists conclude the following:
Proposition 3.1: If demand for a commodity increases, market price and quantity sold should
increase, given standard demand and supply curves
We will say more about this proposition while evaluating capitalist government price
control policies. Here, see Application Box 3.3 which highlights that if the logic of this
proposition is followed, then it involves some perplexing implications and moral dilemmas when
evaluated with respect to the well accepted moral values of all non-capitalist societies. Also study
Application Box 3.4 to see the role of advertisement within the framework of market equilibrium
(the box notionally shows the effects of advertisement on market price, the role of advertisement
comes into play in imperfectly competitive markets, see chapter 14).
83
Are Increases in Prices Due to the Azad Kashmir Earthquake Justified?
Let us agree with whatever is stated in proposition 3.1. Assume that the market for medicines (or
tents) is characterized by a negatively sloped demand curve and positively sloped supply curve as
drawn below. Now consider the situation after the Azad Kashmir earth quack struck on 8th
October 2005. This immediately and heavily increased the demand for many basic necessities in
those areas including medicines and tents (for shelter). The effect is to shift the demand curve
outwards. The logic of the market mechanism as expressed in proposition 3.1 requires prices of
medicines (or tents) to increase from Rs 100 to Rs 200 in this situation. Viewed from the Islamic
perspective however, the practice
of increasing prices in this Pm
situation is callous hard So
heartedness and exploitation of g
people. However, if medicine 200=P1
companies or tent sellers increase
prices of their products, capitalist
ethics regards this increase in
100=Po e
price as ‘just’ and ‘fair’.
Capitalist ethics sees nothing
wrong about this practice and
considers it to be the right of D1
producers to increase prices in Do
such situations.
0 mo m1 m
Remember that the logic of the market mechanism works only when we assume that individuals
are ‘economic-men’ (one who seeks to maximize utility / profit). Raising prices after the earth
quake is just and fair if men are economic men and act “rationally”. However, if Pakistanis are
not economic men, they will not raise the price of medicines instead they will reduce their prices.
When Madina was hit by a famine and the trading stock containing food-stuff of Hadrat Usman
(RA) reached the city, some Jews tried to offer him four times the price of his food-grain. But
Hazrat Usman (RA) refused to sell it to anyone and distributed it free. Similarly, during the earth
quake, thousands of individuals donated all their many belongings to the victims without even
thinking of the opportunity to make profit. It is important to note that the market mechanism is
not something impersonal like the gravitational force that can exist without human motives;
rather it is guided by the spiritual condition of an individual. Only utility and profit maximizing
individuals respond to the market mechanism. Pious Muslims make price decision on the basis of
quite different considerations, the most important of which is the desire to serve and obey Allah.
84
APPLICATION BOX 3.4

Role of Advertisement in the Market
Consider this figure where demand and supply curves are intersecting at point e with price of Rs
10 prevailing in the market and quantity sold equal to 1,000/month. Note that the supply curve is
drawn very flat (for reasons, wait
till chapter 5 and 11). Assume
that the board of directors of the Pm
company are not happy with the
current performance of the
company and ask the marketing So
department to do something in g
order to improve sales. They set 12 =P1
them the targeted sale level of 10 =Po
1500/per month. The only way e
the targeted sale can be attained
is by increasing the demand from D1
Do to D1 via advertisement. The
advertisement department devises Do
an attractive advertisement
0 1000 1500 m
campaign to befool the people
into belief that ‘this product will make a real difference in their lives’. That is how advertisement
is used to manipulate markets. Once demand increase to D1, the company cannot sit idle, rather it
will have to be active in order to maintain this high level of demand because, otherwise, some
other competitor of this company will snatch away its customers. This explains why companies
participate in advertisement-wars against each other in capitalist markets. The proportion of
advertisement expenditures in total expenditure of firm always keeps on increasing.
Another way to see the contribution of advertisement is to recognize its role in maintaining a
particular high price level. For example, if the company wants to maintain a price of Rs 12/unit
for its product, then demand must be at D1, otherwise price will decrease.
Fall in Demand
Here the demand curve shifts inward. Consider the market for chickens, as shown in
figure 3.19. Do and So are initial demand and supply curves respectively which intersect at point
e. This means that Rs 90/kg is the market price of chicken at which co (say 2 tons/day) chicken is
sold in Karachi. Now assume that rumors of ‘bird-flue virus epidemic hitting poultry chickens’
spreads throughout the city. This drastically decreases the demand for chicken in the city from Do
to D1. After fall in demand, Po is no longer the equilibrium price because quantity supplied is now
greater than quantity demanded (to see this clearly, draw this diagram on a page with pencil and
omit demand curve Do as we did it in figure 3.17b. Once you omit Do, the diagram will be very
similar to figure 3.15). In other words, there is now excess supply at this price in the market
equal to distance he. Again, the market mechanism in case of excess supply as outlined in figure
3.16 set in to equilibrate demand and supply at point k. At this point, the price of chicken has
gone down to P1 (Rs 50/kg) whereas quantity sold has also decreased to c1. Comparing the old
and new equilibrium points, we can derive proposition 3.2:
85
Figure 3.19: Effect of fall in demand on market

Excess
Price Supply So
90 = P0 e
h
50 = P1 k
Do
D1
0 c1 co Chicken
Proposition 3.2: If demand for a commodity falls, market price and quantity sold both decrease,
given standard demand and supply curves
3.4.2: Changes in Supply
As changes in demand can affect market outcomes, so can changes in supply. Let us now
take its changes one by one.
Increase in Supply
Consider figure 3.20 where again demand and supply curves intersect at point e initially.
This time, it is the supply curve that shifts to the right from So to S1, say due to a fall in input
prices or improved technology. As a result, there will be excess supply equal to em at the initial
equilibrium price Po (again to see this clearly, draw this diagram on a page and omit the supply
curve So. The resulting diagram will be very similar to figure 3.15).
Once again, the market mechanism (figure 3.16) will set in to equilibrate demand and
supply and new equilibrium is attained at point n where demand and supply curves intersect. The
process is shown in figure 3.21 and the effects of increase in supply on market outcome are
summarized in Proposition 3.3. Also see Application Box 3.5.
86
Figure 3.20: Effect of increase in supply on market
Price So
Excess
Supply S1
30 = P0 e m
20 = P1 n
Do
0 xo x1 x

supply after increase in supply
Excess
If S Supply at Price until D = S
initial price
S
Proposition 3.3: If supply of a commodity increases, market price falls while quantity
sold increase, given standard demand and supply curves
87
Constant Fall in IT Products’ Prices
It has been observed that prices of Pit So
computer related products; such as
Do S1
processors, motherboard, RAM,
monitor; have been decreasing
constantly over time. This can be P0 e S2
explained in the light of
Proposition 3.3 using standard
demand-supply diagram. Suppose P1 a
that the diagram here shows the
market for IT products with Do and P2 b
So initial demand and supply
curves. Over time, computer
technology has been constantly
improving which means that the
ITo IT1 IT2 IT
supply curve is shifting rightward
over time. As a result, prices are
decreasing from Po to P1 to P2 and so on.
Fall in Supply
The last possibility is that the supply curve shifts inward reflecting a fall in supply. This
case is shown in figure 3.22. Proposition 3.4 summarizes the outcome of fall in supply on the
market (work out the explanation of this diagram yourself).
Figure 3.22: Effect of fall in supply on market
Px S1
So
40 = P1 z
y e
30 = Po
Excess Do
Demand
0 x1 xo x
88
Proposition 3.4: If supply of a commodity falls, market price increases while quantity sold
decreases, given standard demand and supply curves
Read Application Box 3.6 to see this proposition in practice.
Understanding The 2006 Sugar Crises
Let us explore the sugar crises that hit Pakistan in early 2006. To analyze this situation, we
develop a basic demand-supply model. The standard negatively sloped demand curve and
positively sloped supply curve of the
sugar market are used to model this PSug Ss1
situation. Their intersection determines
the equilibrium price of sugar at Rs 40 B Sso
25/kg at which, say, 1 million kg of
sugar is sold per month. Now suppose
that the supply of sugar decreases 25 A
because of hoarding made possible by
the corruption of sugar seths (mill
owners) who are duly supported by the
Musharraf government. The supply- DS
curve shifts backwards, as shown by the
0 0.8 1 Sugar
dotted line. Such a situation will have an
adverse effect on consumers as the
“equilibrium” price of sugar rises to, say, Rs 40/kg while quantity sold is 0.8 million per month.
Consumers are purchasing less sugar at a higher price. We will see in chapter 5 on elasticity that
this situation will make sugar seths better off by increasing their profit margin.
We can compactly summarize the results obtained in this section in Table 3.5.
Table 3.5: Summary of Demand-Supply Results

If Market price Quantity sold
1 Demand increases Increases Increases
2 Demand decreases Decreases Decreases
3 Supply increases Decreases Increases
4 Supply decreases Increases Decreases
The procedure to analyze any given situation within the ideal—not actual—capitalist market can
be outlined as follows:
1. Draw the standard demand-and-supply curves and identify an initial equilibrium price and
quantity sold at the point of their intersection
2. Given the situation to be analyzed, determine:
89
a) which side of the market (demand or supply) will be affected by the given situation, and
b) in which direction (i.e. whether demand or supply will increase or decrease)
3. Once you have shifted the curve in the appropriate direction, identify the problem (of excess
demand or excess supply) at initial market price
4. Follow the logic of the price mechanism to determine new equilibrium point (i.e. price
increases in case of excess demand and price falls in case of excess supply)
5. Compare old and new equilibrium prices and quantity sold.
3.4.3: Simultaneous Changes in Demand and Supply
We have so far analyzed the situations in which only one of the two curves changed at a
time, i.e. either the demand or supply increased or decreased. We can extend this demand-supply
framework to model the situations when both demand and supply change at a time. No major
change is brought about by this extension except that now both the curves will shift at a time.
Here we discuss one of the many possible combinations.
Increase in Demand and Fall in Supply
Consider figure 3.23 where initial demand and supply curves of chicken intersect at point
e with market price Po and quantity sold co. Now suppose that it is the peak wedding-season in
Karachi which runs usually from November till February. During this season, demand for chicken
increases due to its large consumption in marriage and Valima ceremonies. This means that the
demand curve shifts outward to D1. Further assume that bird-flue virus also hits the country
during the same season and a lot of chickens are immediately disposed off which shifts the supply
curve inward to S1.
Figure 3.23: Effect of simultaneous changes on market (I)
S1
Pc
g So
160 = P2
f
120 = P1
90 = Po e
D1
Do
0 c1 co xc
90
If you delete the initial demand and supply curves Do and So, you can clearly see that now there is
excess demand at the initial price. To determine the new equilibrium point, just see where the
new demand and supply curves are intersecting i.e at point g. At this point, price has increased to
P1 while quantity sold is the same. Why is it that quantity sold remains the same? To see the
reason, look at table 3.5 again. According to this table, if demand increases and supply falls, the
market price will increase for both the reasons, as indicated by the two arrows. So, the effect of
both changes on price is on the same direction. However, the effect on quantity sold of these two
changes is in opposite direction, as shown by the table. To see this in the graph, note that if
supply had not decreased after increase in demand, then the new equilibrium would have been at
point f with P1 price and c1 quantity sold. But reduction in supply pulls quantity sold back
towards co. The diagram is drawn such that demand and supply curves are shifted in equal
amount so that rise in quantity sold due to increased demand is exactly off set by fall in quantity
sold due to reduction in supply.
However, there is no reason to assume that both the curves will shift in equal proportion.
If the demand curve shifts out by more than the inward shifting supply curve, then price as well
as quantity sold will rise, as drawn in figure 3.24. You can think of a number of combinations
regarding simultaneous increase or decrease in demand and supply (we leave this as practice).
Figure 3.24: Effect of simultaneous changes on market (II)
Px S1
So
140 = P3 g
90 = Po e
D1
Do
0 xo x1 xc
3.5: WHY ECONOMISTS INSIST ON EQUILIBRIUM?
When one draws the market demand and supply curves for any real world market for a
commodity—onion or computer hardware or motor cycles—they would look like the one in
figure 3.25. The market demand curves shown in economics textbooks not only don’t exist, but
91
also they cannot exist. Adding up “well behaved” individual demand and supply curves never
yields “well behaved” market curves for the reasons we will discuss in detail in the course of
book (see chapters 8, 11, 12 and 13). Some of those reasons include the facts that every change in
price affects income distribution, consumers have different tastes (Motorcycles may be a normal
good for Nomi but an inferior good for Farooq and a luxury good for Abul Bashar), most
producers face constant returns to input, some firms enjoy increasing returns to scale, all
commodity markets are integrated through finance etc. Market supply and demand cannot behave
properly. Why then do economic text books continue to pretend that both market supply and
demand slope smoothly: one upward and the other downward?
Figure 3.25: Real world market demand and supply curves
Px
Do
So
0 x
They do this for ideological reasons. They want you to believe that capitalism is a
rational system. It is not a rational system at all. From the time of Adam Smith apologists for
capitalism have argued that when one person (the butcher and the baker according to Smith)
seeks to maximize his utility / profit, social utility / profit is automatically and necessarily
maximized—the invisible hand argument. Capitalism is, in this view, a naturally benevolent
system and it is rational to allow the butcher to pursue his self interest and not to interfere with
his production and pricing decision.
This is nonsense. The capitalist butcher is greedy (accumulative) and jealous
(competitive). He exploits his customers, his employees and all those who are in his supply chain
whenever he is able to do so. Capitalist society or civil society is inherently conflicting and as
Figure 3.25 shows there are many possible equilibrium outcomes in the market, each benefiting
one set of individuals at the expense of other individuals. There is no unique equilibrium price or
equilibrium quantity demanded and supplied.
But Samuelson and Mankiw cannot admit this, for admitting this is accepting that
capitalism is not a rational system. When individuals are led to maximize their own utility and
profit, social utility and profit is not maximized. That is why capitalist state must step into limit
capitalist exploitation and capitalist injustice. Figure 3.25 shows that capitalism is an inherently
92
unstable, vicious, crises prone system in which every equilibrium level is constantly being
undermined by continuing conflict and struggle among greedy (accumulative) and jealous
(competitive) individuals. Equilibriums are produced either by chance or by force and prices have
a tendency to move away from—not towards—these arbitrary equilibrium points. If you ever
study mathematical chaos theory, you will understand how this happens (of course not a part of
this textbook).
Economics pretends that this does not happen because it is capitalism’s ideology. Its main
concern is to justify capitalist order not to explain how real world capitalist markets actually
function. In other words, the major objective of economics is to prescribe how real world should
be forced to function.
93
Key Concepts
Change in demand is the shift in demand curve for a good brought about by changes in prices of
related goods or income of the individual
Change in quantity demanded is the movement along the demand curve due to change in the
own-price of a commodity. This is different from change in demand
Complements are goods that are used together
Cross price effect is change in the demand for one good, say x, due to change in the price of
another good, say y
Demand curve shows the amount of a particular commodity, say x, a consumer is ready to
purchase at different prices
Demand function shows the relation between consumption of a commodity and all factors that
can change its demand, the prices of all goods and income of a consumer
Demand refer to the amount of a commodity that a consumer is willing and able to purchase
Determinants of demand are factors that affect a consumer’s decision of ‘how much amount of
a commodity to purchase’ with his income
Equilibrium is the position where there is no further tendency for change. In the context of
market, it refers to the situation when demand is equal to supply
Equilibrium price is the price where demand is equal to supply
Excess-demand refers to the situation when demand is greater than supply at some positive price
level
Excess-supply refers to the situation when supply is greater than demand at some positive price
level
Inferior goods are goods for which there is negative relationship between income and demand
Inverse demand curve shows quantity demanded of a commodity as a function of its price
Law of demand says that other things held constant, there is inverse relationship between
demand and price of a commodity
Law of supply says that other things held constant, there is positive relationship between supply
and price of a commodity
Market demand is the sum of all individuals’ demand at a particular price. Graphically, it is the
horizontal summation of individuals’ demand curves at all price levels
Market or price mechanism is the tendency for price to change until market clears
Market supply is the sum of supply by all individual firms at different price levels
Normal goods are goods for which there is positive relationship between income and demand
Own price is the price of a commodity in some monetary terms
Substitutes are goods that can be used in place of each other because they serve more or less the
same purpose in the eyes of a consumer
Supply function simply says that sellers’ decision to sell a particular amount of output depends
upon the own price of commodity that they are selling, prices of inputs and technology
Supply is the amount of output that individuals are willing to sell at positive price
94
Chapter Summary
• “It is a question of demand and supply”. This is the standard answer economics gives to all
questions
• Economists believe that the most significant factor influencing the demand for a commodity
is its own price. Other determining factors include price of related goods, income and taste. In
capitalist society tastes are very significantly affected by advertisement. Expectation about
changes in prices and income also influence demand. Demand also responds to changes in
laws and institutions
• The theory of demand applies only to capitalist societies. The “rational consumer” first
appeared in a large number in sixteenth century Europe
• The Law of Demand holds that in capitalist society, other things remaining unchanged, the
demand for a normal good rises as its price falls
• Since quantity demanded is hypothesized by economic theory to be a function of price the
slope of the inverse of the demand curve is estimated
• The ‘normality’ or ‘inferiority’ of a good is not determined by any intrinsic characteristic of
that good. It mostly reflects the desires / tastes of capitalist consumers
• Demand for a good increases when the price of substitute goods increase and the demand for
a good decreases when the price of its compliment good increases
• Advertising increases demand and creates a taste for new products. It is a means for
stimulating desires
• Economics assumes that adding up the preferences of individuals within capitalist society
yields total social preferences. This is the market demand curve. The market demand curve is
expected to be smooth and not kinked because an infinite number of consumers are expected
to enter the market as price changes minutely
• Unreliable—not merely unrealistic—assumptions have to be made to derive the smooth
downward sloping market demand from individual demand curves. The market demand
curves neither in theory nor in real life have the characteristics identified by economic theory
as recognized by Varian. Economists pretend that the market demand curve has this shape
because they want to show that capitalism is a rational system. The true shape of the market
demand curve—in theory and in real life—shows that capitalism is not a rational system
• The supply function postulates that supply is determined by price, costs of inputs and
technology. The Law of Supply holds that other things remaining the same quantity supplied
will rise with price
• The supply curve is supposed to be upward sloping because of the assumed operation of the
‘law’ of diminishing returns which states that costs increase as production increases
• The Law of Supply applies only to capitalist markets
• Supply falls when input prices rise and the supply curve shifts inwards. If technology
“improves” supply increases. In capitalist society supply is also affected by changes in the
price of related goods
• Normally individual supply curves are horizontal or downward sloping for costs fall with
increased production. The “laws” of diminishing returns does not operate
95
• Economics believes that disequilibrium conditions cannot persist for long because utility
maximizing consumers and profit maximizing firms respond rationally to price signals
• The market mechanism is the process of price adjustment in response to excess demand and
excess supply
• Increase (decrease) in demand raises (lowers) equilibrium price and output. Increases
(decrease) in supply lowers (raises) equilibrium prices
• Market demand and market supply curves cannot have the shape economics says they have
because adding up individual demand and supply curves “distorts” the shape of market
demand and supply curves. This is because individuals have different incomes, different
tastes and income distribution keeps changing. Most firms face constant returns and because
all product and factor markets are integrated and there are no fixed “factors of production” in
the short run
• Economists insist that adding up individual demand and supply curves yield “well behaved”
market demand and supply curves for ideological reasons. Adam Smith developed the
ideology that capitalism is a rational system in that when individuals do—and are allowed
to—maximize utility and profit total social utility and profits are automatically,
unintentionally and necessarily maximized
• This is nonsense: since the capitalist individual is greedy (accumulative) and jealous
(competitive) capitalist society is conflictive and exploitative. There is no single unique
equilibrium in the market but there are several possible equilibriums (Figure 3.25) and every
individual and firm is struggling to reach and maintain the equilibrium which benefits him
most. Social utility / profit cannot be maximized in capitalist markets because capitalist
individuals maximize their own utility and profits by exploiting other individuals
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Review Questions
1. What, according to economic theory, are the determinants of demand?

2. What determines taste in a capitalist society?
3. Why does the theory of demand apply only to capitalist economies?
4. State and explain the demand function and the Law of Demand.
5. Using the following data draw a demand curve. What does it show?
Price of x (Rs) Amount of x Demanded
10 10
8 15
6 20
4 25
6. How is the slope of the demand curve measured? Calculate the slope of demand curve for
above data.
7. What is a normal good in capitalist society and what are ‘inferior’ goods? What
determines whether a good is considered ‘normal’ or ‘inferior’ in capitalist society?
8. What goods were regarded as inferior by Hazrat Usman?
9. What is the effect on the demand for Coke when the price of Pepsi goes up and what is
the effect on the demand for fountain pens when the price of ink goes up in capitalist
society? Illustrate your answer using two diagrams.
10. What is the social purpose of advertisements?
11. What is the market demand curve? What assumption has to be made to derive the market
demand curve from the demand curves of individual capitalist consumers?
12. Why is the market demand curve kinked in Figure 3.7 and smooth in Figure 3.8?
13. State and explain the supply function and the Law of Supply.
14. How is the inverse of the slope of the supply curve measured?
15. Why does the Law of Supply apply only to capitalist markets?
16. Analyze the impact of changes in input prices and “improvements” of technology on
supply. What is the meaning of technological “improvement”?
17. Analyze the impact of factors other than prices and input costs on supply.
18. Why is this market supply curve kinked with two firms? When can the kinks disappear?
19. What is the meaning of excess demand and excess supply?
20. Define equilibrium. Why according to economic theory do markets tend to move towards
equilibrium levels of output and price?
21. What is the “price mechanism”?
22. Using a diagram each, show the impact of (a) increase in demand (b) reduction in supply
on equilibrium price and quantity.
97
23. Was it justified to raise the price of food after the earthquake in Azad Kashmir? Would
Hazrat Usman have done this?
24. Why does the ratio of advertisement expenditure to total expenditure keep on rising in
capitalist societies?
25. Why can market demand and supply curves never have the shapes economic textbooks
say they ought to have? Why do market demand and supply curves never “behave
properly”?
26. Why do economists pretend that market demand and supply curves are “well behaved”?
98
4
Chapter
MARKETS AND
PRICE CONTROLS
Chapter 4: Market and Price Controls
The previous chapter discussed how market mechanism operates if left free from all
interventions. But markets can move freely only if no private agent has any sort of market power;
though ironically capitalism systemically concentrates power in the hands of a few. In this
chapter, we see how governments can use their coercive powers to intervene in the market.
Economic justification of state intervention is based on the view that sometimes it is not in the
interest of capitalist society to let the market mechanism determine price and output levels. In
such cases, it is the capitalist government which is supposed to control markets so that capitalist
objectives are realized. We explained in chapter one that one of the major objectives of
microeconomics is to provide the capitalist state with tools to govern civil (or market) society.
This chapter will show you how the demand-supply model tells government what it should do
and what it should not do.
The capitalist government can intervene in the market in many ways:
• by limiting entry to the market; e.g. no private firm may be allowed to supply water at the
national level
• by limiting exit from the market; e.g. many airports at remote locations, such as at Gilgit,
are going in loss but government wants them to continue operating
• by controlling quantities sold or purchased, e.g. imposing quotas on purchase of imported
goods
• by controlling prices of goods, e.g. mandating price-ceilings and price floors.
The standard demand-supply model can be used to analyze all of these situations. In this chapter,
we will examine the effects of only price controlling policies by capitalist governments on market
outcomes. Let us discuss price ceiling first.
4.1: PRICE-CEILING
Some goods are so essential to life that it becomes difficult to leave their price
determination at the market mechanism even in capitalist society. Suppose, for example, that the
market price of atta (flour) after hoarding becomes Rs 50/kg and the capitalist government feels
that this price is too high for consumers to buy atta. So it decides to control its price through a
policy of price-ceiling. The price ceiling fixes the maximum price of a commodity that can be
legally charged by sellers. Such a price is necessarily set below its current market equilibrium
price. To see how it works, consider figure 4.1 which reproduces the sugar market example from
Application Box 3.6. In this diagram, the price of sugar rises from Rs 25 to Rs 50 / Kilo after
reduction in its supply due to hoarding by sugar mill seths (the initial supply curve Sso is drawn
small because it has no role to play after the shift in the supply curve to Ss1). However, the
government feels this price to be too high. So it opts to ceil the sugar price, say, at its initial price
of Rs 25, Pmax. This is the maximum price that can be charged after the imposition of this ceiling
and no firm can legally charge any price higher than this maximum price set by the government.
Since the objective of government to ceil the price of sugar is to keep its price at a level at which
it can be affordable to most consumers, therefore it is set below the current equilibrium price.
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What will be the effect of this price-control over demand and supply? To see this, note
that at price Rs 25 = Pmax, supply of sugar is 0.3 thousand tons while its demand is 1 thousand
tons. Clearly, there is excess-demand or shortage of sugar in the market. This shortage develops
because once price is reduced from Rs 50 (where demand and supply are equal) to Rs 25, quantity
demanded increases as more consumers enter the market (recall the negative relationship between
price and demand from chapter 3). On the other hand, a fall in price causes profit-maximizing
sellers to reduce quantity sold (recall the positive relationship between price and supply from
chapter 3). Thus, the immediate effect of the imposition of price ceiling is to produce excess-
demand in the market. However, Application Box 4.1 shows that this effect is specific only to a
capitalist society—a society formed by economic-men.
Figure 4.1: Effects of Price Ceiling
PSug Ss1
Market price
is too high, so
50 B
Sso
C A Price
25 = Pmax
Ceiling
Shortage
DS
0 0.3 0.8 1 Sugar
Rent Control after 9/11
Suppose that the Taliban launch a successful counter attack on the ongoing American
terrorism against Muslims. In frustration, the American government deports all Muslims from
America. Because many of those deported from America do not have permanent residences in
Pakistan and yet they are rich, they prefer to spend their lives in Islamabad living on rent. This
raises the demand for rental houses in Islamabad. The market for rental houses in Islamabad is
shown in the diagram below. Note that the supply curve is drawn vertical here because the number
of houses available for rent is fixed in the short-run and, therefore, it is very difficult to increase its
supply even if its price is high. So, say 20000 houses are available for rent. The initial demand
curve is Do and the initial market rental rate for an average house is, say, Rs 4000/month. After
increase in demand for rental houses due to immigrants from the US, the demand curve shifts to
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D1. There will be excess

demand for rental houses Prh So
equal to 10000 (= 30000 -
20000) at the initial rent. So,
rents will increase as c
immigrants compete for 8000
rental houses with existing
residents by offering higher
rents to house owners; and b
4000 = Pmax
at the new equilibrium, rent a
is say Rs 8000/month in this
market (see point c). D1
Do
Suppose that the
government is concerned 0 20000 30000 RH
about this rent rise and
considers it unsatisfactory because it creates problems for local rental-residents in Islamabad. So,
the P.M. decides to fix rental rates at this initial level of Rs 4000. He places price ceiling on
rents. The effect of this policy will be to create shortage in the market for rental houses as more
houses are demanded (30,000) by people at this maximum price than are available (20,000). By
trying to overcome one market problem (i.e. high rents), the capitalist government has created
another (i.e. excess-demand).
Let us now assume that Pakistan is an Islamic-Jihadi state. The outcome of the attack on
the market for rental-houses after immigrants reach Pakistan can be understood in the light of
Muwakhat-e-Madina between the Muhajireens of Makkah and Ansars of Madina after the event
of Hijra. There developed no rental-house market whatsoever. The reason for the absence of
‘rent’ in that society was the fact that the Ansars were not ‘suppliers’ and they did not see the
Muhajireens as their ‘demanders’—i.e. their relationship was not based on utility / profit
maximization. Instead, the Ansars accommodated their Muslim brothers by sharing their houses
and belongings with them. It is the underlying spirit of ‘demand and supply’ that causes rental
rates to increase in such situations. A society that is not committed to the objectives of utility and
profit maximization will not face the problem of excess demand. No state policy is required to
cope with the issue of high rent rates in non-capitalist society.
Non-Price Rationing
The immediate result of price-ceiling is excess demand—capitalist demanders want more

than suppliers are willing to provide. Such a situation is not sustainable in a world of utility /
profit maximizing agents because demanders cannot live without increasing consumption while
producers cannot miss out on profit making possibilities. If price is not fixed below current
market equilibrium, say, in the rental markets, then the problem of excess-demand will be
removed by increase in rents as the market reaches a new equilibrium point, c (figure in Box 4.1).
With price-ceiling, house owners do not enjoy the option of (legally) charging rents above Rs
4000 = Pmax and excess demand cannot be translated into higher rents. Price cannot play its role
103
of rationing demand to equal the amount supplied, and therefore the rental house market cannot
clear. When price is not allowed to ration demand and make it equal to the quantity supplied in
the market, this does not mean that the problem of scarcity has been solved in capitalist society.
Removing the option of competition for rupees switches competition to channels other than price.
Non price rationing is the use of mechanisms other than price to ration or equate the demand for
something with its available supply. Such rationing may be intentional or an unintended response
to excess-demand.
1. Long queues: One response to the problem of excess-demand that can be predicted in case of
price-ceiling is waiting time in long-queues. For example, suppose that a one-day cricket
match is planned between Pakistan and India at the National Stadium, Karachi. The number
of seats available is fixed, say 40,000. However, the demand for tickets is higher than the
available seats, so there is excess-demand. One way of solving this problem could be to
charge a high price for a ticket which will reduce demand. Since such an increase in price is
not allowed, people have to wait in long queues to obtain a ticket. But how does this reduce
the pressure of excess-demand? Obviously, the waiting time and effort required to obtain
tickets in these long queues discourage many people from purchasing tickets and, hence,
some demanders go out of the market. This will help reduce the gap between demand and
supply (see Application Box 4.2).
Long Queues at Utility Stores
After the sugar crises of 2006 the government tried to reduce public frustration by
providing sugar at lower controlled-rates, in specific utility stores. People rushed towards these
outlets in order to purchase cheap sugar. This resulted in sugar sacks going empty very shortly,
thus creating excess demand. People turned up many hours before the utility stores opening time
waiting in long queues.
2. First-Come-First-Served and Lottery: Another way to cope with the problem of excess-
demand is to introduce the device of first-come-first-served. You can often see
advertisements saying: ‘this offer is for a limited time period’ or ‘only a few seats are
available, so be quick to apply’. Another way is to draw a lottery. For example, when the
government announces a new residential-scheme, such as Taisar Town in Karachi, the
applicants are usually far larger than the available plots; sometimes there are 10,000
applicants per plot. In order to allocate these plots among these potential buyers, government
uses the institution of lottery.
Where does this excess-demand develop in case of residential plots? If you think that
it arises because so many people are homeless in Karachi, then you are wrong. Rather, it
arises merely due to the lust for making-profit. It is observed that almost 90% of the
applicants for these plots are those who already posses their personal residence and merely
want to invest their savings in some lucrative project. Thus, the probability of getting a house
in the lottery scheme by the remaining people who do not possess a house and really need it
104
diminishes by a great deal. And this possibility further decreases after the lottery is drawn. To
see this, suppose that originally, the price of a 120 yards plot is Rs 100,000 payable in
installments. Once the lottery is announced and most of the plots are won by the speculators,
the prices of the plots go up sky high, such as to Rs 500,000/120 yards plot which makes it
impossible for a poor and needy person to purchase that plot in the second round. Money
keeps moving among the few. It is the lust for maximizing-profit which is responsible for the
extreme hunger and homelessness in major parts of the world. On the other hand, if society is
non-capitalist, providing personal home at affordable prices will no longer be a problem
because in such a society, land prices will not increase by much overtime due to the absence
of ‘demand for plots for speculation and profiteering’. People will own houses mainly for the
purpose of ‘personal residence’ and not for ‘investment’ as in capitalist societies.
3. Quota or Quantity Restrictions and Holidays: Sometimes, the capitalist government may
decide to restrict the amount of the commodity that people can purchase at any time to
dampen the pressure of excess-demand. For example, if petrol prices are reduced to Rs
40/liter, it may create excess-demand. Government can then issue several coupons labeled
with certain amount of oil that one can use per day; e.g. the government may announce that
you can have only 4 liters/day. Holidays are another means to control excess-demand for a
commodity. For example, the sale of mutton is not allowed on Tuesday and Wednesday
throughout Karachi so that some of its demand may be reduced. During summers 2009 and
2010, all large markets of Karachi; such as Tariq Road, Sadar, Clifton, etc. were forced to
shut-down by 8:00 P.M. The objective of this time restriction was to deal with the problem of
electricity shortage in Karachi city which arose due to the corruption ridden privatization of
KESC. However, this involved loss to sellers due to fall in their sales. Again, the problem of
short-supply of electricity arises due to the existence of capitalist living styles in which
people go for shopping late at night. If this practice is abandoned by the public (as is the case
in the country-side), then markets will automatically shut down before Maghrib Prayer and,
hence, neither state enforcement will be required in this case nor will it result in sellers’ loss.
4. Quality Compromise: In some cases, non-price rationing can develop in the form of reduced
quality of the services offered at controlled prices. For example, in the case of rental housing,
most of the services provided by the house-owner are not explicitly written into the contract.
The house owner may agree to provide hot water during winter, but does not state the
temperature to be maintained. Help in changing over the utilities from one tenant to the next
may be provided or withheld. House owners may reduce the frequency and expense of house
maintenance—i.e. the apartment would not be repainted between tenants, cleaning would not
be done, major repairs would be put-off. This under-maintenance of the house will gradually
reduce the market value of the rent-controlled house to the level of the price ceiling. Thus the
quality of life in a rent-controlled house can drop substantially. Read Application Box 4.3 to
see how price-controls will affect the quality of Bakra-Mandi during Eid-ul-Adha.
105
Price-Control in Bakra-Mandi
Bakra-Eid is one of the two major religious events of Muslims. People buy sacrificial
animals in order to present them as a token of their submission to the will of Allah Almighty. But
the lure of profit-maximization turns this event into a market phenomenon. Prices of animals,
especially of goats, keep on rising every year making it difficult for people to participate in this
religious event. One response to this phenomenon is the participation in ‘combined-sacrificial
animals’, such as that of the
cow. Let this diagram Pg
Sg
represent Bakra-Mandi where Dg
the price of an average goat is
Rs 300/kg (which means that
a 30 kg goat costs around Rs 300 a
9,000) and 1.5 million (15
lacks) goats are sold to the
public. Frustrated by this c b Price
200 = Pmax
high price, people want the Ceiling
government to force sellers to
sell goats, say, at Rs 200/kg.
Technically speaking, the
public is asking for a price 0 10 15 20 Goats
ceiling. But how will it affect
the goat-market if sellers are profit-maximizers? Clearly, it will create excess-demand equal to
the distance cb (= 20 units demanded – 10 units offered for sale). Excess demand develops
because as price is reduced to Rs 200/kg, quantity demanded increases as some new customers
enter this market while quantity supplied falls as some sellers refuse to sell healthy goats at this
price.
One non-price rationing response to this excess demand will be that sellers might bring
only small-sized or unhealthy goats (tedi bakra) for sale in the market and withhold the healthy
ones. Pakistan Navi normally offers such controlled-price animals for their employees on the
basis of their weights. However, if you visit these controlled-price markets, you will find largely
small-sized and low quality animals for sale.
5. Political Influence: Influence, connections and politics can sometimes also help solve the
problem of excess-demand. For example, to get admission at NED University, students do
not and cannot outbid the other applicant by paying higher tuition fees. Even to be considered
at all for admission, you must have superb grades at intermediate level. But grades are not the
only instruments with which some people actually compete. Entrance to such universities are
sometimes sold by politicians or provided with greater ease to their families and friends.
Political influence is sometimes also excreted on the basis of race, national origin or physical
beauty of participants to qualify for a particular post.
106
Remember that these are but only a few ways of allocating resources in case of excess-demand.
Their exact form cannot be predicted. It may vary from case to case. However, if the price is held
fixed, there must develop some device to reduce the gap between demand and supply, if the
people are not willing to do it themselves, in capitalist society irrespective of whether that device
is intended or unintended. See Application Box 4.4 for an interesting example of this case.
Handling Food Shortage at Marriage Ceremonies
Many times, the actual number of guests in a party exceed the expected or invited guests.
Suppose that you have arranged dinner for 200-expected guests at a marriage ceremony.
However, 250 guests turn up which results in food-shortage. It is difficult to provide additional
food at the spot. One way of overcoming this problem could be to convert this event into a
market-exchange by asking guests to pay some price for food which will reduce demand as some
guests will refuse to pay anything and will leave the hall (to never come again to any of your
future events!). But social norms do not allow such a practice. Another standard way of resolving
food-shortage at these events is to ask your close-relatives not to have food at the hall because
this problem has occurred on the promise that they will be served later at the home. Another way
is to slow-down the supply of food; i.e. to reduce the frequency and hence increase time interval
of providing additional food at tables after its initial service. Many people leave and refuse to
wait. This reduces some pressure on excess demand for food.
4.1.1: Black-Markets
Another aspect of price-ceiling that deserves government attention so as to make this

policy work effectively is black-marketing; i.e. the practice of selling a commodity above its
legal price. This phenomenon is present in almost all capitalist societies—societies that are
composed of utility and profit maximizing individuals. To understand how black-markets work,
let us go back to the demand curve again as drawn in figure 4.3 (we discussed this in chapter 3).
Any point on this demand curve can be read in two equivalent ways. Consider point A on this
curve. One way to read this point is to say that the ‘consumer is willing to purchase 4 units at a
price of Rs 9/unit; i.e. at Rs 9/unit, he is ready to purchase 4 units’. However, we can also
interpret it as the ‘consumer is willing to pay 9 rupees per unit for 4 units’; i.e. for 4 units, he is
ready to pay 9 rupees per unit’. In other words, the height of the demand curve at any quantity
measures ‘how much the consumer is willing to pay for that number of units’. For example, for 7
units, the consumer is willing to pay Rs 6/unit (point B). This point is the key to understanding
how black-markets work.
Now consider figure 4.4 which redraws the market for sugar from figure 4.1. At the
controlled-price Rs 25/kg, consumers want to purchase 1 thousand tons of sugar in total. On the
other hand, sellers are offering only 0.3 thousand tons of sugar. Hence, the maximum sugar that
consumers have available is 0.3 thousand kg which means that some consumers must go without
any sugar or have less than what they want to consume (because demand is greater than supply).
107
Figure 4.3: Interpreting demand curve

9 Rs/unit for 4 units
Px
A
9
6 Rs/unit for 7 units
B
6
Dx
0 4 7 x
Now ask yourself: how much can consumers be willing to pay for this much sugar? To see this,
read-off the price at the demand curve against 0.3 thousand ton quantity at point D which is Rs
65/kg (the height of the demand curve at quantity 0.3). This point says that there are some utility-
maximizing consumers who are willing to pay Rs 65/kg for sugar. Such individuals get frustrated
waiting in long queues for sugar and eventually getting nothing! Therefore, some sellers may sell
some sugar to such individuals outside the market at this high price in order to make additional
profits. This creates a black-market for sugar where it is sold above its controlled-price. Thus, Rs
65/kg is the black-market price of sugar. Note that it is not necessary for sellers to charge exactly
Rs 65/kg. Any price between Rs 25/kg to 65/kg will work. Rs 65/kg is the maximum black-
market price that they can charge. Also note that black-market price is even greater than the
equilibrium price of sugar, Rs 50/kg.
The black-market phenomenon illustrates another problem that develops due to price-
controls. If the capitalist government wants to make this policy effective, it must ensure that the
black-market does not develop for the commodity whose price is to be kept under control,
because otherwise it will be a self-defeating exercise. Clearly, the objective of the government is
to benefit the consumers. However, if sugar is sold in the black-market at even higher than
equilibrium prices, then the policy will actually make some consumers worse off. This means that
price-ceiling can work effectively only if (1) the product is actually sold out at the controlled-
price and (2) black-markets do not develop. Both these conditions require the government to
spend a large amount of money for monitoring the effects of price-control. The administrative
problems faced by the government of Punjab in providing ‘2-rupee roti’ to the public is an
example of difficulties associated with the policy of price-ceiling.
108
Figure 4.4: Demand In the Sugar Market
Some consumers are

ready to pay this price
PSug
D
65 = Pblack
50
C A Price
25 = Pmax
Ceiling
Ss1
DS
0 0.3 0.8 1 Sugar
4.1.2: Objectives of Price-Ceiling

If price ceiling carries so many rationing-problems with it, then why do the governments
of almost all capitalist countries practice such control over prices in case of many commodities?
There are several reasons for this, we discuss some of them below.
Consumer Affordability
As outlined above, the government may set the price of a commodity below its current
market equilibrium price in order to make it accessible for most consumers (as is the case for ‘2-
rupee roti’). Much has been said about this already.
Price Stability
The prices of some commodities are subject to large variations if left to the forces of
demand and supply and government, therefore, may wish to smooth out these variations by fixing
its price in the interest of both consumers and producers. For example, agricultural products are
subject to unplanned variations in supply; due to weather conditions, diseases, etc. output can be
greater or less than that which farmers planned to produce. To see how this works, consider
figure 4.5 which shows market for wheat, one major agricultural product.
109
Figure 4.5: Output Fluctuations in the Wheat Market
Pwh Sw1
Swo
12000 B
Sw2
8000 A
6000 C
Dw
0 15 25 30 Wheat
In this diagram, Swo is the planned quantity of wheat by the farmers at the beginning of the year.
Farmers would be happy to produce, say, 25 million tons of wheat at Rs 8000 per ton. Suppose
dry weather or some disaster hits the country and supply decreases to Sw1. This raises the price of
wheat to Rs 1200 per ton. Such a high price might suit farmers but causes distress or even famine
among consumers. On the other hand, if the actual supply is Sw2 due to extra ordinarily good
weather, then consumers might be delighted to have a price of Rs 6000 per ton but this will leave
farmers in an undesirable situation, as some may not be able to cover the cost of their production
at this price. One might argue that it would be necessary for the government to try stabilizing
prices and incomes. But how can a capitalist government do this? One way to achieve this end is
to create a government agency. Suppose that this year, we have the situation shown by the Sw2
supply and with quantity supplied equal to 30 million tons. The agency can purchase the extra 5
millions and store it which will drive price up to Rs 8000/ton. If supply is Sw1 in the subsequent
year, the agency can then release 5 million tons from its store so that price can be maintained
around the market equilibrium price, Rs 8000/tons.
Neoclassical economists emphasize that this policy is not easy to implement because it is
difficult to determine the ‘correct’ market price of a product and decide how much of a
commodity to purchase or release in any one year. The example shows that if the capitalist-state
is committed to stabilize the price of a commodity at or around some desired level, then it must
control quantity supplied in order to address the problem of excess-demand.
Maintaining Competitive Prices
Another reason for fixing prices could be to avoid increase in prices that result from
artificial reduction in supply. Consider for example fruit prices during the month of Ramadan. Let
us assume that the price of an average quality banana is Rs 15 per dozen one month before
Ramadan. In order to increase profit margins during Ramadan, the capitalist-banana producers—
those who produce banana for the objective of maximizing-profit and not for fulfilling their
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religious obligations—withhold its supply from the market for a week or two so that market
prices may increase to, say, Rs 25/dozen. The situation will look very similar to figure 4.1. Once
prices have increased, they bring the withheld quantity of bananas to the market so that its price
remains at Rs 25/dozen. Very often you can see price-controlling authorities announcing that
prices of fruit items will be regulated during the month of Ramadan. One way to regulate prices is
to set them at their current market level. Apparently, this will destroy the incentive for suppliers
to make additional profit by reducing their supply. However, capitalist-producers may offer
bribes to capitalist-state-officials in order to make such policy measures ineffective; a
phenomenon present in all capitalist societies.
Another situation when government wants to control prices around their market or
competitive price levels is during wartimes and disasters. It is likely that profit-maximizing
producers may charge higher prices for their products when people are in dare need of them,
when the country is involved in wars and there is shortage of a commodity or after a disaster has
hit a region.
Income Redistribution
Another objective of instituting price-ceiling is to control the incomes earned by one

segment of society or redistribute it from one segment to another. The European Union’s
Common Agricultural Policy is specifically designed to meet this end as is the Japanese
subsiderization of domestic food production. The incomes earned by individuals in a capitalist
society depend upon the prices of commodities and services they offer for sale. For example, if
Farooq rents-out a house, then his income will depend upon the rental-rate; i.e. the higher the
rental-rate, the higher will be his income, and vice versa. Similarly, the income earned by the
KFC franchiser depends upon how high the price of the KFC burger is. If people abandon
consumerism—the practice of finding meaning and value in more and more consumption of
branded and famous goods—the price of a KFC burger may go down suddenly to, 40 paisa and
its franchiser will find it difficult to run such well-furnished outlets as his revenue will fall
dramatically. Therefore, when government puts price-ceiling on some commodity, e.g. on rental-
rates, then this will lower the incomes of house-owners in favor of tenants. Standard
microeconomic tools can be used to analyze this situation, but this will involve some additional
concepts which will be introduced later when we study input markets.
4.2: PRICE-FLOOR
As price-ceiling is aimed at benefiting consumers, price-floor is designed to help

producers. Price-floor is the minimum price that must legally be offered for a commodity. This
minimum price is set above the equilibrium market price of a commodity and any transaction of
that commodity below this minimum price is illegal. The European Union, Japan, South Korea
and the USA use price floors for almost all locally produced agricultural communities. To see
how this works, consider figure 4.6 which shows markets for cotton. If the market is left alone, it
reaches an equilibrium price of, say, Rs 10/cotton bushel at which 100 units are exchanged as
shown at point e. Suppose that cotton producers persuade the government to increase this price
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because this price is too low to cover their cost of production. The government imposes a price of,
say, Rs 14/cotton bushel above the current market equilibrium price. Since no transaction can take
place below this price, therefore this is the minimum price for cotton, and is called price-floor.
Note that such a price-floor will create excess-supply of the commodity in the market. At
this controlled-price, quantity supplied (120) exceeds quantity demanded (80). In an uncontrolled
market, forces of demand and supply tend to move price down towards the equilibrium price and
hence eliminate surplus. But once price is set above the current equilibrium level, it can no longer
fall below this controlled level. This means that the price floor will cause producers to produce
more than what buyers are willing to purchase. Farmers may be happy to receive a relatively high
price, but will not be happy about their unsold production. Usually, capitalist government steps in to
buy the surplus agricultural production. European Union and American governments destroy
millions tons of agricultural commodities every year to keep their prices high.
Figure 4.6: Price Floor for Cotton
Pcot
a b Price
14 = Pmin
Floor
10 = Pe 50 e Market price
is too low, so
Sc Dc
0 80 100 120 Cotton
As we saw above the shortages developed due to price-ceiling can lead to some
‘undesirable’ rationing mechanism (we discuss in next section why economists regard them to be
‘undesirable’). Similarly, surpluses develop after price-floor which requires some rationing-
mechanism to handle excess supply. Clearly, if production is undertaken for profit-maximization,
we can see that some sellers will be unable to sell their products at controlled-price in case of
price floor fixing as producers have produced more than what demanders want to purchase. In
this scenario, sellers will have to finance rising inventories. This is a very serious problem of
production facing mature capitalist economies. See Application Box 4.5 which discusses the
heatedly debated case of price floor fixing in economics. Also see FYI Box 4.1 to note a
terminological confusion.
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The Minimum Wage Law Controversy
One of the best examples of price-floor fixing is the imposition of minimum wage law in
many social democratic capitalist countries. This law dictates a minimum wage that must be paid
to labor by an employer. For example in Pakistan, currently the minimum legal wage is Rs
6,000/month. To see how it works, first note that labor services are treated as a commodity like
any other commodity, such as potatoes. In other words, you can represent the labor-market by
demand for and supply of labor. The demand for labor is made by firms while its supply comes
from workers. The demand curve for labor is drawn negatively sloped because there is assumed
to be a negative relationship between demand for labor and its price; i.e. the wage rate. As wage
rate decreases, firms
demand more labor, and Wage
vice versa. On the other
hand, labor-supply is Unemployment
assumed to increase as wage Minimum
125 = wmin
rate goes up (see chapter 15 b c wage rate
for detailed discussion on
labor demand and supply). a
100 = wa
This is shown in this
diagram. If the government
does not interfere in this
market, current market SL DL
equilibrium wage rate is
adjusted to that level where 0 Lb La Lc Labor
labor supply equals its
demand. Here it is at point a where wage rate is, say Rs 100/day and La workers get jobs.
However, suppose the government feels that this wage rate is too low for a person to
live, so it decides to impose a minimum wage of Rs 125/day above the market equilibrium wage.
The result of this policy is that labor supply (Lc) exceeds labor demand (Lb) at this wage rate.
Clearly, the number of individuals who get job is Lb, the amount of labor that firms want to hire,
while the remaining (Lb – Lc) go without jobs. So, minimum wage law creates unemployment in
capitalist labor markets. Thus, although minimum wage rates increase the incomes of those who
have jobs, but they also lower the incomes of those workers who cannot find jobs or who have
been laid-off by firms after increase in wage rate (La – Lb workers have lost their jobs after this
wage rate policy). There is a heated political debate on the issue of minimum wage law among
capitalist economists. Advocates of this policy point out that unskilled labor will not be able even
to live without such laws because their market wage would be too low. Opponents believe that
minimum wage law is not the best way to fight poverty because it creates unemployment.
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FYI: B O X 4.1
Note on Terminologies
Students sometimes confuse price-floor and price-ceiling because of their position of
placement with respect to the market equilibrium level. For example, students tend to reason like
this: ‘since floor is below our feet and ceiling is above our head, therefore price floor should be
below equilibrium while price-ceiling should be above’. Note that this interpretation is faulty.
The reason behind price-floor being named so is that it is the minimum price while price-ceiling
is the maximum price. That is why the former is called floor (because it is the minimum level)
while the letter is named ceiling (because it is the maximum level).
4.3: WHY ECONOMISTS PREACH FREE-MARKETS?
We have spent much time understanding the market process in the previous as well as
this chapter. Let us now spend some time trying to understand why economists are in favor of the
free market process and against government intervention in the form of price-controls. This can
be grasped after we understand the role of price—what buyers pay to the seller in exchange for
some commodity—in capitalist economies.
Price as Information, Incentive and Allocative Device
To neoclassical economists, prices of goods give information to market agents

(consumers and sellers). More importantly, they claim that free markets are the best allocators of
resources as they correctly represent consumers’ desires in a capitalist society. For example,
suppose that American citizens want to have more wine. This will increase the demand for wine
in America. If the market is allowed to operate freely, price of wine increases. This increased
price is giving information to agents that the profit-margin in the American wine industry has
increased relative to other industries. Motivated by this high profit, some firms will shift
resources, say, from wheat production to grape production; hence the production or supply of
wine will increase in America. Note that this is exactly what the Americans wanted; i.e. to have
more wine. Taking another example of how prices allocate resources according to consumers’
preferences by providing information to agents, suppose that British society wants to have more
MBAs as compared to IT professionals. How will this desire be signaled to suppliers?
Alternatively, who will decide that more MBAs and less IT professionals should be produced
now? To economists, the answer is the price mechanism. The idea is that the forces of demand
and supply operating in the British labour market will automatically solve this problem. When
demand for MBAs increases in Britain, its price (or salary of an MBA) will increase. On the other
hand, because demand for IT professionals has decreased, their salary levels would fall. This
increase in price or salary of MBA will provide incentive to people of Britain to become MBA
professionals instead of IT professionals—students will enter the business schools instead of IT
colleges, more universities will start offering MBA program and some may stop offering IT
programs because it is not profitable now. Thus, supply of MBAs will increase while that of IT
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professionals will fall. In other words, resources from the IT specialists producing industry will
be shifted to the MBA producing industry and more resources will now be allocated to the MBA
producing industry as compared to the IT producing industry—something that the consumers
wanted.
These examples show that prices give information to market agents just like traffic-
signals in a capitalist society—they guide people about which direction they should move in and
when to stop. When a traffic-signal goes red, everyone stops and when it is green every one starts
moving in that direction. Similarly, when the price of a commodity, activity or skill is high in a
capitalist society, market agents see this as an opportunity to make more profit by engaging in the
supply of that particular commodity, activity or skill.
4.3.1: Logic behind Elimination of Price-Controls
With this background in mind, let us see why economists hate government intervention in
the form of price-control.
Distortion in Resource Allocation
One reason why economists consider price-controls a social evil is due to its adverse
effect on the resource-allocation mechanism in a capitalist society. To them, when individuals are
left free to compete with each other, the invisible hand automatically brings supply in line with
demand without the need for any central-planning. Moreover, when government sets a price of a
commodity other than its equilibrium price, say through price-ceiling, then it ‘distorts’ the
allocative processes of the market by providing wrong signals to market agents. For example, in
the case of price-ceiling, there develops excess demand due to the existence of a lower than
market price. This controlled price has created a mismatch between consumers’ and producers’
calculations by giving wrong signals to them. If the market process is allowed to operate freely;
say if consumer desires are left free to play their part in capitalist society, then this excess-
demand will be eliminated automatically by the price-mechanism. Excess demand will push price
upwards, giving producers an incentive to produce more on the one hand, and discouraging some
consumers from participating in this market as the price increases. Similarly, when government
creates a price-floor, through e.g. minimum wage laws, it also ‘distorts’ the resource allocation
mechanism by giving wrong signals to market agents, resulting in excess-supply. Hence the
market mechanism should not be interfered with. Social harmony is assumed to prevail when all
individuals are allowed to pursue their own utility and profit maximization.
Non-Money Competition
There is even a more fundamental reason underlying economists’ opposition to price-

controls in a capitalist society. We discussed in this chapter that when price-controls are applied,
some non-price rationing mechanism develops to handle the problem of excess-demand or
excess-supply. The fundamental problem—the problem which makes price-control an ‘evil’ in
the eyes of the economists—with non-price rationing is that it shifts competition from money-
prices towards other margins. A capitalist society works when the only thing that individuals
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want or value is money. To see this note that in a market economy, all features of a commodity
can be converted into money. Economic rationality requires individuals to convert even the
slightest quality variations in the commodity or service into money by putting a price on it. For
example, suppose you own an extra house to rent. According to the economist’s advice, the rent
that you should charge must take into account all possible factors, such as: the number of rooms,
the size of rooms, services such as electricity, gas connections, condition of wall-color, so on and
so forth. Similarly, if you have two extra fans and tube-lights installed in your house, then this
feature must also be converted into money by adding some additional rupees into the rental. In
brief, each and every feature of a commodity must be priced to make more money because
earning more and more money is the only way that allows individuals to buy the commodities
they desire. When non-price rationing starts, the medium of exchange shifts to a resource other
than money; i.e. people may start using something other than money to buy commodities. For
example, political friendship, influence, nobility status, family or religious ties may become
media of exchange. The value of these resources induces people to invest their time and effort in
acquiring them. And according to economic rationality of maximizing utility / profit, even a
minute of one’s time invested in developing these relations or resources represent economic
waste for capitalist society because these investments create no new capital—they just represent
attempts to invest in redistributing existing wealth. For instance, in non-capitalist societies,
people frequently visit their relatives and spend hours with each other discussing merely family
ties and issues. Social collectivities, such as the family, are considered highly valuable in these
societies because of their important social functions—an individual cannot survive in non-
capitalist societies without playing his / her role in these collectivities. On the other hand, from an
economic point of view, time and efforts devoted to all such collectivities is merely a waste as it
does not produce capital. An economist would be happy to see you investing this time and effort
in the labor-market earning some additional money. Economic rationality can see any good in
developing such non-market relationships only to the extent they can be brought under the
discipline of market rationality to accumulate what economists call human capital—skills
acquired by an individual through training, education and social-habituation that allow him to
generate more capital by working efficiently in the market. Read Application Box 4.6 to see how
production was organized prior to capitalist societies.
The Organization of Production in Medieval Europe
Production was seen to be a religious—not an economic—activity in medieval Europe.
Agricultural production was organized around a manor and relations between the lord and the
tillers who occupied the land were determined by the ecclesiastical and canon laws formulated by
the Church. Almost all families resident in a manorial settlement were related with each other
and wage labour was unknown.
Production was undertaken primarily for meeting the needs of the community. Prices did not
vary over centuries. Manorial communities were mainly self-sufficient. There was comparatively
little difference in the life style of the peasants and the lords and the lords and serfs had mutual
social obligations determined by custom and religion.
Even in the market towns of medieval Europe crafts were controlled by religious orders—every
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trade had a patron saint. The Church and the town authorities were committed to maintaining a
system of just prices which were determined in accordance with the social commitments to
satisfy traditionally recognized needs and not on the basis of supply and demands. All interest
based transactions were illegal and Jews were punished when found guilty of lending money on
interest. Consumption and production levels remained normally stable varying only in times of
drought, floods, epidemics and prolonged wars.
Economists advocate free-markets because when the market is left free, rationing through
price-competition makes money the only thing that people value while developing relations with
other; and this is exactly what capitalist society wants—inducing its citizens to care only for
money leaving all other identities, such as religious or family identities, aside. According to
economics, the ideal society is one where people are competing only for money and this ideal is
ensured and becomes socially dominant when resource allocation is left to price or market
mechanism. For example; consider again the rental-house market of Islamabad from Application
Box 4.1. Since the number of houses available for rent are fewer after the arrival of emigrants,
then who should get these houses? The economic answer is: whosoever is willing and able to pay
the price; i.e. no characteristic, such as Taqwa of the tenant, other than money price should be
considered while renting ones house and anyone not able to pay the money-price should receive
this strong message from the market: if you want to have what you want, do something to have
more money because only money can buy what you want! Economists idealize free markets
because all features other than the amount of money-possessed by an individual are regarded
meaningless in market relations that are created among demanders and suppliers. The market
does not care who the consumer or producer—Muslim, Kafir, munafiq, muttaqi, fasiq, murtad—
is. The only feature required to successfully develop market relations in market or capitalist
society is the amount of money you possess—and this is the only barometer that market-
mechanism uses to measure and score success. Therefore, the more market-mechanism is free and
unhampered by price-controls, the lesser individuals will be worrying about other things than
money. Thus, it is not only the competition among individuals that economists love to see in a
capitalist society; rather it is competition on a specific margin; i.e. competition for more and more
and more money. So, the description of a market or capitalist society merely by the phrase of
‘competitive-society’ is not comprehensive. Its correct description is a ‘money-oriented-
competitive-society’ because this expresses the nature and the objective of competition nurtured
in this society.
4.3.2: Does Economics Discourage State Intervention?
Real world capitalism does not of course function in the manner economics says it
should. In mature capitalist markets, all prices are administered prices determined by oligopolistic
collision (discussed in Chapter 14) among firms with different levels of market power each
committed to maximizing its own profits. There is no ‘invisible hand’ in mature capitalist
markets. Therefore there is no likelihood that prices produced through negotiation among a small
number of market dominant firms and imposed upon all other consumers and producers are prices
which lead to an allocation of resources that maximizes utility and profit in general. The capitalist
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state therefore has to act in the market as the representative of capital in general. It must ask: are
the administered prices the ‘right’ prices? Do they enable the allocation of resources in a manner
which facilitates the maximization of capital accumulation throughout the capitalist economy? If
not, then the capitalist government must take action to induce the market leading firms to move
existing prices towards ‘optimum’ prices; i.e. prices which permit maximization of the rate of
capital accumulation throughout the capitalist economy. Economics provides capitalist state
policy makers with tools which enable them to:
• Estimate ‘optimum’ prices—prices which economic theory says would automatically
emerge if there was perfect competition in all product and input markets
• Assess the extent to which existing administered process deviates from these ‘optimum’
prices
• Develop and operate policies which induce / force market leader-firms to accept these
optimum price
As capitalism matures markets become more and more monopolistic / oligopolistic—a necessary
and unavoidable consequence of capital accumulation. Therefore the need for effective state
regulation increases as capitalist markets expand, deepen and become socially dominant. Strong
capitalist-markets need stronger and stronger capitalist states. This is the reason why the state
expenditures to GDP ratio has kept on rising throughout capitalisms’ history, especially in
America, Britain, Germany, France, China, India and other “advanced” and “advancing”
capitalist countries.
Economics pretends that it is discouraging state intervention in the market. This is a false
claim. In reality economics seeks to teach the government to behave like a capitalist individual.
This is necessary because (as we shall see in chapters 8, 12, 13, 15 and 16) capitalism is an
irrational system. When individual firms seek to maximize their own profit, this cannot
automatically result in the maximization of total social profits. When the state acts like a capitalist
individual it tries to impose a (non-existing) capitalist rationality on irrationally functioning
markets. That it can never do so—as so many economists have been forced to recognize—is due
to the fact that capitalism is inherently an irrational and self-contradictory way of life; i.e. it can
never achieve the ends it sets itself—the achievement and fulfillment of freedom or infinite
wants. We will return to this issue in several later chapters.
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Key Concepts
Price ceiling is the maximum price of a commodity that can be legally charged for that
commodity. Such a price is set below its equilibrium price.
Non price rationing is the use of mechanism other than price to ration or equate the demand for
something with its available supply
Black-market is the practice of selling a commodity above its legal price
Price-floor is the minimum price that must legally be offered for a commodity. This minimum
price is set above the equilibrium or market price of a commodity
Self-interest is an economic hypothesis about human behavior which says that while doing
something, an individual must always look for his own objectives or desires; i.e. each activity
should be motivated by the expectation of fulfilling one’s own desire
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Chapter Summary
• There are no “free markets” in the modern capitalist world, for necessarily some market
participants have more power to move the markets than others
• Capitalist governments seek to influence market outcomes if market functioning impedes the
achievement of capitalist objectives
• Capitalist governments may impose price ceilings to ensure that prices of essential goods–––
atta, dal, urban transport–––does not rise so high that a portion of the capitalist working class
starves to death
• The price ceilings set by the capitalist government is necessarily below the market price. It
creates excess demand in capitalist markets where firms seek profit maximization and
consumers seek utility maximization
• Price ceilings do not create excess demand in non capitalist market. When the Muhajareen
came to Madina after Hijra, rents did not rise because Ansars owning houses were not profit
maximisers and the Mahajareen were not utility maximizers
• Rationing can be used to equate demand and supply. Rationing can be instituted through first
come first served arguments or the use of lottery
• In capitalist society excess demand emerges often as a consequence of speculative
behavior—buying something one does not need with the aim of selling it at a higher price
later
• Excess demand also emerges due to the extravagant living style, a typical characteristic of
capitalist society. Rationing is a response which reduces demand to cope with supply
shortages
• Non price rationing may also take the form of reduction in the quality of services provided to
customers. Rationing can also allocate scarce supply to selected customers on grounds of
political preferences
• Black marketing is the selling of a good above its legally fixed price
• Administrative costs of implementing price controls and presenting the operation of black
markets may be prohibitively high
• Price controls may be instituted to prevent unplanned variations in price again mainly of
essential consumer goods
• In order to keep prices stable capitalist governments buy essential goods in times of surplus
production, stock this production and sell it in years of relative scarcity. The buying and
selling necessarily is based on a “target” price that the government wants to keep unchanged
relatively stable. Price controls are also enacted to offset tendencies for hoarding
• Price controls have an impact on income distribution. If prices of agricultural goods are kept
high–––as through the Consumer Agricultural Policy of the European Union (EU)–––this
increases the relative income of farmers
• Price flours have been established by the EU to provide income support for European farmers
• Maintenance of price floor generates surplus production and increases the cost of financing
inventories. Such “over production” due to price floors has become permanent in European,
American and Japanese agricultural markets. It is usually the capitalist government which has
to bear the cost using tax payer’s money
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• Microeconomics argues that markets should be left uncontrolled because freely determined
(equilibrium) prices give the best estimates of consumer preferences and signal what profit
maximizing producers should do to benefit from satisfying these preferences
• Microeconomists say that controlling prices “distorts” the information they provide to
capitalist consumers and producers about individual preferences
• Price controls necessitate rationing and this shifts competition from money to non-money
margins. Non monetary competition violates capitalist rationality–––it takes some
commodities outside the circuit of capital. Non monetary competition recognizes non
capitalist transactions–––e.g. religions activities and family associations––as repositories of
values
• Free markets are a myth. In real world capitalism almost all markets function as oligopolistic
and almost all prices are administered. There is no invisible hand in mature capitalist markets
• Therefore state control of capitalist markets is normal and inheritable in capitalist order. It is
exercised to ensure that ‘optimum prices’ are generated in the market–––prices which permit
the maximization of aggregate profit and welfare
• The need for state regulation increases as capitalist markets mature and become more
monopolistically and oligopolistically structured
• State regulation is rarely successful for capitalism is inherently an irrational and conflict
ridden system
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Review Questions
1. Why cannot capitalist markets ever be free?
2. Why do capitalist governments seek to control markets?
3. Why is price control often unnecessary in non-capitalist societies?
4. What is the cause of excess demand in the urban housing markets of Pakistan?
5. Evaluate the economic impact of different forms of rationing.
6. What determines the maximum price that black marketers can charge in a price controlled
market?
7. Why are governments sometimes reluctant to institute price controls for essential goods?
8. Why are attempts by capitalist governments to stabilize commodity prices so rarely
successful in Pakistan?
9. What is the impact of price control on income distribution pattern?
10. With the help of a diagram show the impact of (a) a price ceiling and (b) a price floor on
market supply and demand.
11. What are the costs that governments must bear when they impose price floors or price
ceilings?
12. Should the minimum wage be fixed by law? Why has such legislation been so infective in
Pakistan?
13. What is the “signaling” function of freely determined prices in capitalist markets?
14. What is the meaning of “price distortion”?
15. Why are microeconomists apprehensive of non monetary competition–––which price controls
and rationing entails?
16. Why in capitalist societies must all activities be expressed as money values?
17. “The economists’ preference for free markets demonstrates that economics is not a positive
science but an ideology” Discuss.
18. Why does the need for state regulation increase as capitalist markets mature?
19. What is the purpose of market regulation by the state in capitalist order? Why do strong
markets need strong states and why is state intervention usually unsuccessful.
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5
Chapter
ELASTICITY
In chapter 3 our demand-supply analysis has been qualitative, i.e. in terms of the
direction of changes in quantity demanded in response to changes in prices, income and other
variables in capitalist markets. We will now extend the model to show how to derive quantitative
results; i.e. the amount or magnitude of changes in demand and supply consequent upon changes
in prices and incomes. But before moving on to this issue, let us develop the concept widely used
by economists to desire these quantitative results.
5.1: SLOPE AND ELASTICITY
Elasticity is a measure of responsiveness. It states a quantitative relationship between

independent and dependent variables, such as quantity demanded and price. It answers the
question ‘by how much will the dependent variable (say quantity demanded) change due to one
unit change in an independent variable (say price)’. In other words, it measures the
responsiveness of the dependent variable to changes in the independent variable. Of course, as we
saw in chapter 3 the slope of the demand curve also measures the same relationship. Consider the
demand curve in figure 5.1. This shows quantity demanded of mangoes as a function of its own
price in a capitalist market. The slope of this demand curve is written as the ratio of change in
quantity demanded, ΔQm, to change in price, ΔPm.
∆Qm
Inverse of demand curve slope = <0 (5.1)
∆Pm
Figure 5.1: Typical demand curve
Pm
Dm
0 Qm
First note, that the expression (5.1) above is the inverse of the slope of the demand curve (see
chapter 3). Usually, the slope is defined as change in the variable on the vertical axis divided by
the change in the variable on the horizontal axis; here it is ΔPm/ΔQm. But in case of the demand
curve, we invert this rule (the reason will be clear when we analyze the firm’s ‘cost behavior’ in
chapter 11). We can see that this expression is a measure of responsiveness; it shows what
happens to quantity demanded as price changes. When slope can also give a measure of
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responsiveness, why do economists use elasticity, instead of the concept of the slope, as a basis
for their numeric analysis? What is the difference between slope and elasticity?
Why not Slope?
Actually, there are two conceptual problems in working with the slope. First, the value of
the slope of a demand curve depends upon the units in which we measure quantity and price. The
relationship between demand and price given by slope is not simply a number, but a number plus
some dimensional units. To grasp this point, suppose that we measure mangoes in kilo grams and
their price in rupees. Then the slope is measured in kgs per rupee. For example, if a one rupee per
kg increase in the price of mango decreases its quantity demanded by 2 kgs, the slope is defined
as two kgs per rupee:
∆Qm 2 kg kg
=− = −2
∆Pm 1 Rs Rs
However, measuring mangoes in quarters rather than kgs will make the slope four times larger
(since a kg contains 4 quarters and the numerator will increase by 4 times) as:
∆Qm 8 quarters quarters

=− = −8
∆Pm 1 Rs Rs
Similarly, measuring price in dollars instead of rupees will also change the value of the slope. The
point to note here is that the value of the slope keeps on changing as we change the units of
measurement. The second problem with the slope arises when we compare the slopes of two
differently measured commodities and this problem is even more serious. Suppose we have two
commodities; milk and mangoes and have estimated their slopes. The results are summarized in
table 5.1:
Table 5.1: Slopes of demand curves for two commodities

If price increases by Then quantity decreases by Slope
4 kgs
Mango 1 rupee 4 kgs −
1 Rs
2 Gallons
Milk 1 rupee 2 gallons −
1 Rs
This says that a one rupee increase in the price of mangoes decreases its demand by four kgs
while a similar increase in the price of milk decreases its demand by two gallons. Now ask
yourself the question: what can we infer from this data about the responsiveness of the two
commodities to changes in their prices? Does price have more effect on the demand for mangoes or
on the demand for milk? Nothing can be said about this question since both the goods are measured
in different units and kgs cannot be compared with gallons. For a meaningful comparison of
responsiveness using the slope, we need to convert the unit of either of the two commodities into
that of the other to make them comparable; i.e. either convert kgs into gallons or gallons into kgs.
But all this conversion is not only messy but also makes remembering the estimates extensively
difficult.
126
Meaning of Elasticity
If you look carefully into the nature of these two problems, you can observe that it is the
dimension or unit of measure which is the source of difficulties here. So, to avoid these problems,
it is necessary to drop the unit of measurement from the calculation of slope; i.e. we need a unit-
free measure of responsiveness. Recall that the slope measures the rate of change in a dependent
variable due to change in an independent variable. We can remove this unit of measurement using
simple algebra by converting the rate of change into proportional or percentage rate of change.
To achieve this objective, recall from your elementary mathematics course that division of a
change in a variable divided by the initial level of that variable turns its change into percentage
or proportionate change. For example, if the price of a commodity changes from Rs 10 to Rs 15,
then change in price, ΔP, equals Rs 5 (= 15 - 10) while percentage and proportionate change is
calculated as:
∆P FP − IP 15 − 10 5
%∆P = = = = = 0.5 = 50%
P IP 10 10
where FP = final price while IP = initial price.
So, in order to convert the rate of change (slope) into a percentage or proportionate rate of change
(elasticity), just divide the numerator of (5.1) by initial quantity, Q, and the denominator by initial
price, P and multiply both by 100. Thus, we get an expression of elasticity,
∆Q
× 100
%∆Q Q ∆Q P
Elasticity = = = × (5.2)
%∆P ∆P ∆P Q
× 100
P
since 100s cancel out both in numerator and denominator. This is the expression for what
economists call elasticity. Note that this gives us percentage change in the dependent variable,
here quantity demanded, due to percentage change in the independent variable, here price. How
does this conversion solve the two problems associated with slope due to unit of measurement?
To see this, consider again the mango example. If mango is measured in kgs and its price in
rupees, then elasticity is defined as:
%∆Qm ∆Qm kgs Pm Rs
Elasticity = = ×
%∆Pm ∆Pm Rs Qm kgs
Note that the units of measurement cancel out both in the numerator and in the denominator.
Suppose that when the price of mangoes increases from Rs 10 (IP) to Rs 15 (FP), its quantity
demanded decreases from 10 kgs (IQ) to 6 kgs (FQ). Elasticity can be measured as:
Elasticity =
%∆Qm ∆Qm Pm
= × =
(6 − 10)kgs × 10 Rs = − 4kgs × 10 Rs
%∆Pm ∆Pm Qm (15 − 10 ) Rs 10 kgs 5 Rs 10 kgs
%∆Qm 40 4
or Elasticity = =− = − = −0.8
%∆Pm 50 5
What does this number tell us? It says that a one percent increase in the price of mangoes
decreases its demand by 0.8 percent (the negative sign indicates negative relation between price
127
and demand). Further, it is a unit-free measure of responsiveness because percentage change in a

variable is a unit free measure of responsiveness, a 10 percentage increase in price is the same
percentage increase whether price is measured in rupees or dollars. Thus elasticity differs from
slope in that the former is a percentage and proportionate rate of change while the later is simply
the rate of change. Before we move ahead, let us see how useful the concept of elasticity is in
comparing the effects of price on different commodities. Consider the milk-mango example again
and note down data given in table 5.2.
Table 5.2: Comparing Elasticity of demand of two commodities

If price increases by Then quantity decreases by Elasticity
%∆Qm 4
Mango 1 percent 4 percent =−
%∆Pm 1
%∆Qm 2
Milk 1 percent 2 percent =−
%∆Pm 1
These numbers say that one percent increase in the price of mangoes decreases its demand by
four percent while a similar increase in the price of milk decreases its demand by two percents.
Now we can answer the question: which commodity is more responsive to changes in its price.
Obviously, demand for mangoes is more responsive to changes in its own price than is demand
for milk. Changes in the price of mangoes create more effect on the demand for mangoes than do
changes in the price of milk on its demand. Here is another example. Suppose a teacher asks you
this question: ‘last year, my height increased by 2 inches while my weight increased by 5 kgs,
which one increased by more: height or weight?’ Obviously, the two numbers are not comparable
as they are measured in two different units. However, if he poses his question as: ‘last year, my
height increased by 2 percents while my weight increased by 5 percents, which one increased by
more: height or weight?’ then the correct answer is obviously weight.
Let us generalize what we have so far stated. Elasticity, like slope, can be defined
between any two variables, and not just between price and demand. In general, elasticity
measures percentage change in a dependent variable (say y) due to percentage change in an
independent variable (say x).
%∆y Percentage Change in y
Elasticity = Percentage Rate of Change = = (5.3)
%∆x Percentage Change in x
whereas slope is:
∆y Change in y
Slope = Rate of Change = = (5.4)
∆x Change in x
Keep this fundamental difference in mind. With this generalization, let’s apply the concept of
elasticity to demand.
128
The Elasticity of Demand
We learnt above that elasticity can be defined between any pair of variables. We can also
study the effect of changes in income on demand, as income is also one of the determinants of
demand. Similarly, nothing prevents us from studying the effect of changes in the price of other
goods on demand for a commodity. Generally speaking, elasticity of demand shows what
happens to quantity demanded when the variables which affect demand undergo some change,
that are the price of the good in question, price of related goods and income. Therefore, we can
have elasticity of demand with respect to changes in these three independent variables. Let’s take
them one by one.
5.2: PRICE ELASTICITY OF DEMAND
The price (sometimes called ‘own price’) elasticity of demand shows percentage change
in quantity demanded of a commodity, say x, due to percentage change in its own price:
%∆Q x ∆Q x Px
η xp = = × (5.5)
%∆Px ∆Px Qx
where the symbol η means ‘demand elasticity’ and subscript xp reveals that the relation is
expressed between quantity and price. This is the elasticity of demand with respect to price. To
further explore this relationship, expend it using the definitions of percentage changes as:
∆Q x
× 100
%∆Q x Qx  ∆Q x  P 
η xp = = =  ×  x 
∆Px  Q 
%∆Px
× 100 ∆ Px 
  x 
Px slope Something else
Hence, elasticity can be expressed as the slope of the demand curve multiplied by something else
[ratio of price to quantity (P/Q)]. It is important to note that the sign of price elasticity of demand
is usually expected to be negative. To see this, recall that the slope of the demand curve is
expected to be negative, so the first term in this expression is negative. What about the second
term (P/Q)? Since price of a commodity cannot take negative values and, similarly, demand for a
commodity can also not be negative (otherwise it would not be demand), therefore the ratio (P/Q)
must be non-negative. Hence the multiplication of a negative number by a non-negative number
gives a non-positive result. To take an example, review the calculations of elasticity that we
performed above in our mango example. Our answer was -0.80 (with negative sign). However,
instead of computing elasticities in negative numbers, like -2 or -3, it is more convenient to refer
elasticities in absolute values; that is; we will express price elasticity of demand as a positive
number, like 2 or 3 ignoring the negative sign. We do this because it is not easy for students to
work with negative values (is elasticity -2 greater or lesser than –3?). Throughout our discussion
in this chapter, we will make comparison in terms of absolute values. Thus, a price elasticity of
demand -3 is grater than -2 because the number 3 is greater than 2 in absolute value.
129
Point Elasticity
Price elasticity of demand can be measured in two basic forms depending upon the
available data. One, at a specific point on the demand curve, (called point elasticity of demand).
Suppose that we have enough observations about the purchase of a commodity to estimate its
demand function and, thus, its slope, ΔQ/ΔP. To estimate point elasticity, we multiply the slope
term by the ratio P/Q. Point elasticity gives us the rate at which the quantity demanded changes
as price changes, both in percentage terms. Consider figure 9.1. The elasticity at point A is given
by the expression (5.5). For example, suppose that the initial price of mangoes is Rs 10 per kg
and initial quantity sold is 100 kgs. The slope of the demand curve for mangoes is estimated to
be, say, -5 kg/Rs. Then the elasticity is
10
η xp = −5 × = −0.50
100
which says that a one percent increase in the price of mangoes causes its demand to fall by half,
0.5, percent (the negative sign indicates merely the negative relationship between price and
quantity demanded). It is clear from this discussion that in order to calculate point elasticity of
demand, the slope of the demand curve must be known, say, from some published sources or that
we have available past data to estimate the slope.
Arc Elasticity
Often we have data only at two, or slightly more, different prices rather than having
complete data that allows us to estimate a complete demand function for a commodity. In this
case, the point elasticity would not work, as we have discrete changes in price. To handle this
situation, we use the concept of arc elasticity. It is the elasticity measured between two distinct
points on a demand curve. Suppose that the price of mangoes has increased from Rs 10 to 12 per
kg and the quantity consumed decreased from 100 to 90 kgs. But measuring elasticity between
two points creates little confusion because changes in the direction of measurement will change
the value of price elasticity of demand. For example, measuring elasticity from A to B and from B
to A gives different values of price elasticity. This is so because percentage change in a variable
keeps changing with changes in the direction of measurement. If a number increases from 1 to 2,
we can note a 100-percentage increase in its value, but a decrease from 2 to 1 entails only a 50-
percent fall in it. Similarly, moving from point A to B in figure 5.2 means a 10-percent decrease
in quantity demand [(90- 100)/100] but the movement from B to A implies a rise of about 11.1-
percent [(100- 90)/90]. This suggests that the value of price elasticity of demand will differ
between A to B and B to A. Let’s work out the calculation using the given numbers in figure 5.2.
From points A to B:
90 − 100 10  − 10  10   10 
η xp = × =   = −5 ×   = −0.50
12 − 10 100  2  100   100 
and from B to A we have:
100 − 90 12  10  12   12 
η xp = × =   = −5 ×   = −0.67
10 − 12 90  − 2  90   90 
130
Figure 5.2: Arc elasticity of demand
Pm
B
12
1) An 18%
increase in A
price… 10
0 90 100 Qm
2) leads to an 11% fall in quantity demanded
We can see that the two estimates of elasticity differ even in the first digit. How could this
discrepancy be corrected? If you closely observe at above calculations, you would see that the
slope term remains the same in both the cases (i.e. -5) but the problem arises due to second factor
(i.e. P/Q ratio). Which of the values of price and quantity to use here, Pa-Pb or final Qa or Qb? Since
both, initial as well as final, values of price and quantity affect elasticity, we use the average of
initial and final prices for better estimation. Denoting final price and quantity by FP and FQ while
initial price and quantity by IP and IQ respectively, we have
∆Q (IP + FP ) 2
η xp = ×
∆P (IQ + FQ ) 2
or after canceling out 2, we can write it as
∆Q IP + FP
η xp = × (5.6)
∆P IQ + FQ
which is simply the slope of the demand curve multiplied by the average ratio of price to quantity.
Consider the above example again. Using (5.6), the elasticity is
90 − 100 10 + 12 − 10 × 22
η xp = × = = −0.58
12 − 10 100 + 90 2 × 190
Note that the answer lies between our two early estimates of elasticities. Alternatively, we can
calculate percentage change in each variable separately, and then elasticity is just the ratio of
these changes.
%∆Q
η xp =
%∆P
Continuing with our previous example, we calculate the percentage change in each variable
separately as
131
∆Q
× 100 90 − 100 × 100 − 10
IQ + FQ
η xp = = 100 + 90 = 190 = −0.58
∆P 12 − 10 2
× 100 × 100
IP + FP 10 + 12 22
Which is exactly the same. The numbers indicated in figure 5.2 are calculated using the average
percentage formula as discussed in Application Box 5.1.
Using Elasticities
Calculating Final Quantity
One of the advantages of using elasticity is that given the elasticity of some commodity, we can
estimate how much the relevant variable would change after a price change. Rearrange (5.5) to
obtain
%∆Q = η xp × %∆P
which simply states that if we know the price elasticity and percentage change in price and, the
estimated change in quantity demanded will be their product. Suppose we know that the elasticity
of, say, beef is -0.58. The price regulatory authorities announce that the price of beef will be set
10 percent higher next month. With this information at hand, ηxp = -0.58 and %ΔP = 10, we can
estimate that the consumption of beef will fall by -0.58 × 10 = -5.8%. Suppose that the
consumption of beef is 100 kgs this month. What will be the new quantity demanded next
month? One way to calculate this new quantity is to subtract 5.8 (which is 5.8 percent of 100)
from 100, this gives 94.42 kgs. However, a better estimate can be obtained using the percentage
change in quantity as
∆Q
%∆Q = (5.1.1)
(IQ + FQ ) 2
Note that (5.1.1) includes the average of quantity in the denominator, rather than just the initial
value of quantity. Solve this for final quantity, FQ, using simple algebra as:
%∆Q(IQ + FQ ) = 2∆Q or %∆Q(IQ + FQ ) = 2(FQ − IQ )
or FQ(2 − %∆Q ) = (2 + %∆Q )IQ
or FQ =
(2 + %∆Q ) × IQ (5.1.2)
(2 − %∆Q )
The equation (5.1.2) shows final quantity as a function of percentage change in the variable and
initial quantity. Now plugging the given values in example, we get
FQ =
(2 − 0.058) × 100 = 194.4 = 94.46 Kgs
(2 + 0.058) 2.058
The numerator contains negative sign because percentage change in quantity demanded was
negative in our example and similar goes for denominator. Note the difference in the results
derived by both methods. The average definition of percentage change gives the more precise
calculation. This will become more obvious shortly.
132
Calculating Final Price

Equation (5.5) can also be used to calculate price changes due to a given change in quantity as:
%∆Q
%∆P =
η xp
Suppose, as an example, that due to heavy rains in country, the wheat harvest is badly affected.
Some of the wheat suppliers looking at this situation withhold the supply of wheat by 10 percent.
If the price elasticity of wheat is -0.2, how much the equilibrium price is affected? Plugging
these values in the preceding formula
− 10
%∆P = = 50
− 0.2
The price will increase by 50 percent. If the initial price of wheat is 10 Rs/kg, then the final price
can be calculated using average percentage formula:
∆P
% ∆P = (5.1.3)
(IP + FP ) 2
2 + %∆P 2 + 0.50
or FP = × IP = × 10
2 − %∆P 2 − 0.50
2.50
FP = × 10 = 16.66 Rs / kg
1.50
which is again greater than the final price given by the simple percentage rule: 1.5 × 10 = 15
Rs/kg. It is always recommended to use the exact formula (5.1.2) when changes are greater than
10 percent.
5.2.1: Classifying Price Elasticity of Demand
Quantity demanded of different commodities can respond to changes in their own prices
by different proportions. You can think of change in price as a force while change in quantity
demanded as the resultant effect due to that force. With this idea and the formula of price
elasticity in mind,
%∆Q
η xp =
%∆P
We can think of five possible outcomes about the value of price elasticity around ‘1’ (the
convenience of setting one as bench mark will be clear shortly).
1. η xp < 1 → Looking at the above expression, it is clear to see that price elasticity will be less
than one (in absolute value) if percentage change in quantity demanded is less than
percentage change in price (numerator is smaller than denominator). Commodities which
have price-elasticity less than one are said to have price-inelastic demand. An inelastic
demand curve is one for which the quantity demanded is not very responsive to changes in
price. Increasing price by one percent will decrease quantity demanded by less than one
percent in this case. In capitalist societies necessities such as food and health care services
133
have low elasticities. In Britain for example the demand for beer is very price inelastic.
Increasing prices to higher levels has not reduced the consumption of beer in England. Even
if the prices of these commodities increase by 50%, their demand will not decrease by 50%.
Thus, demand for beer in capitalist societies will be called price-inelastic and it will be
treated as necessary good.
2. η xp > 1 → The above expression shows that price elasticity will be greater than one (in
absolute value) if percentage change in quantity demanded is greater than percentage change
in price, called price-elastic demand. For price-elastic demand, quantity demanded responds
very much to changes in prices. Goods in this category are said to be luxury goods.
3. η xp = 1 → When percentage change in quantity demanded is equal to percentage change in price,
it is called unitary price elastic demand. This has elasticity of exactly one.
4. η xp = 0 → It could be the case when quantity demanded does not change at all in response to
changes in price, called perfectly inelastic demand. This will have a value of elasticity equal
to zero since numerator is zero. Graphically, the demand curves will look like vertical lines at
given quantity, as shown the figure 5.3 below. Demand for pork is perfectly inelastic in the
city of Qum (lran) as it is not demanded at all, no matter what its price.
5. η xp = ∞ → Finally, price elasticity can take a value of infinity when quantity demanded
changes infinitely even for very small changes in price, called perfectly elastic demand. Of
course, elasticity will be equal to infinity, ∞, in this case and demand curves will be flat
horizontal lines at given price, as shown in figure 5.3 below.
Figure 5.3: Perfectly inelastic and perfectly elastic demand
Pm ηxp = 0
ηxp = ∞
0 Qm
Note an important graphical property here that when price elasticity is zero, the demand
curve is vertical while it is horizontal when elasticity is infinity. This means that as elasticity
increases in absolute value from zero to infinity, the demand curve becomes flatter and flatter.
However, it is false to conclude from this that flatter demand curve has greater elasticity than
steeper one because steepness or flatness of a curve shows its slope and not elasticity. We will
explain this issue in section 5.2.4.
134
5.2.2: Determinants of Own Price Elasticity
A question must be teasing your mind: what makes some of the goods to be more
responsive to price changes than others. In general, the price elasticity of demand for a good
depends on the following factors.
Availability of Substitutes
It is easy to see that goods that have readily available substitutes tend to have more elastic
demand than those that have no close substitutes. Consider the case of beef and chicken. Since
both are similar, any increase in the price of, say, beef will cause its demand to fall by a great deal
in favor of chicken. However, the increase in price of flour will hardly change its demand because
it has few close substitutes in the market.
Degree of Necessity
Another factor that affects price elasticity of demand for a good is the common use to
which we put that commodity. The more intensive the demand for a good, such as beer in mature
capitalist societies, the less elastic demand it has.
Time Factor
The amount of time available to a consumer to adjust his behavior to changes in price
plays a key role in determining the price elasticity of demand. Suppose that the price of gas goes
up. After one or two gas bills, most consumers will recognize that the price has increased and will
start to cut back in their usage of gas. But in the short run, they can’t do much.
Figure 5.4: More and Less Elastic Demand Curves
Pm
DL
DS
0 Qm
However, if the price increase is expected to be permanent, a further response may occur. People
may start using coal. But changing cooking equipment will, of course, take some time. This
135
suggests that long run elasticities are much larger than short run elasticities which imply that,
normally, long run demand curves are flatter than the short run ones as depicted in figure 5.4. But
remember that it is not always the flatness or steepness of demand curves that reveals price
elasticity. Something else also matters, as we discus below. Thus, price elasticity of demand
becomes large in absolute value as more time is available to make changes in one’s consumption
patterns. This occurs partly because some consumers are slow to notice price changes, partly
because of habits and social customs regarding consumption patterns, and partly because of
the nature of the commodity whose price has changed.
Budget Share of a Commodity
Finally, the amount of income spent on a particular commodity also affects its price
elasticity. To understand this first note that by definition, the budget share of a commodity, of say
X, denoted by Kx, is the proportion of total income spent on that good. Algebraically,
Px Q
Kx = (5.7)
M
Where M = income. For example, suppose that the price of, say flour, is 15 Rs/kg while the
income of a person is Rs 1,000/month. If the consumer is purchasing 20 kg of flour per month,
then his budget share of flour is:
Rs kg Rs
15 × 20 300
PF F kg month month = 0.30 = 30%
KF = = =
M Rs Rs
1000 1000
month month
Multiplying this figure by 100 will give share in percent terms. The budget share of flour for this
consumer is 30%, i.e. he spends 30% of his income on the purchase of flour. The larger the
budget share of a commodity; the larger will be its price elasticity of demand, and vice versa.
This is so because when budget share of a commodity is large, an increase in its price means a
large increase in its budget share if the consumer does not reduce its quantity demanded. For
example, if the price of flour increases to Rs 20/kg while quantity demanded remains the same,
then its budget share will be:
Rs kg
20 × 20
PF F kg month
KF = = = 0.40 = 40%
M Rs
1000
month
The budget share of flour thus rises to 40% which means that if the consumer does not adjust his
consumption he will have to reduce consumption of some other commodities very significantly in
order to keep his expenditures within his budget (Rs 1,000). However, consider the example of
match which dictates a trivial budget share, if its price is Rs 1 and the consumer uses 2 matches
per month, then:
136
Rs units
×21
P ×m
Km = m = unit month = 0.002 = 0.2%
M Rs
1000
month
Now if the price of match increases to Rs 2, it will not have a significant impact on amount spent
on matches and hence on consumer expenditures (Km will increase to 0.4% which is a trivial
increase). This small increase in match budget share will not force the consumer to adjust
quantities demanded of other commodities significantly, therefore he will ignore such an increase
in price and keep consuming the same amount of match as he did previously.
5.2.3: Price Elasticity and Revenue (Expenditure) Changes
The concept of elasticity has great practical application in capitalist markets due to its
close relationship with price and revenue (or equivalently expenditure). Revenue from (or
expenditure on) a good is defined as price of that good times quantity sold (purchased), that is
Expenditures = Revenue = P × Q (5.8)
A capitalist seller will be interested primarily in increasing his revenue (rather than in increasing
price) since he wants more and more money for its own sake. For example, suppose Badmash is a
charas (drugs) seller who offers a price of Rs 2,000/kg for charas, a price much higher than its
market price of, say, Rs 1,000/kg. After a whole day of hard work, he is able to convince only
charcee that he has some special type of charas to sell and sells him one kg. When Badmash
calculates his sales of the day, it turns out to be Rs 2,000 (= 2000 Rs/kg × 1 kg). Suppose that
there is another charas merchant sitting next to him who is offering a price Rs 1,000/kg and is
able to sell 20 kg on that day. His revenue or sales will be Rs 20,000 (= 1000 Rs/kg × 20 kg),
much higher than Basdmash’s (neglect the element of cost for the sake of argument). So, it is not
price that matters, rather it is sales or revenue (P × Q) that is important for a seller. But how does
elasticity come into play here?
To grasp this point, think of the ideal case in which quantity sold increases with increase
in price. Suppose that if price of charas increases from 1000 Rs/kg to 1500 Rs/kg, quantity sold
goes up from 20 to 30 kgs, then revenue will increase from Rs 20,000 (= 1000 Rs/kg × 20 kg) to
Rs 45,000 (= 1500 Rs/kg × 30 kg). Will the seller have to think what price to charge in this case?
No, because if quantity sold keeps increasing with increase in price, he will keep on increasing
price until it reaches infinity, and so does his revenue. Even if quantity sold remains the same
after increasing price, the seller will charge a higher and higher price. But things are not so
simple. Quantity sold does not increase with increase in price. In fact, when price of a commodity
increases, then in capitalist markets its quantity demanded is expected to decrease, so revenue can
either increase or decrease. For example, consider table 5.3 which shows the effect of increase in
price from Rs 20/kg to Rs 30/kg on revenue. Note that if quantity sold decreases to 25 kgs, revenue
increases (see case 2); if it falls to 20 kgs, revenue is the same (case 3); and if it falls to 15 kgs,
revenue actually falls (case 4). What is going on here? Facing this situation as a seller, the capitalist
producer will ask the question: ‘what will happen to the revenue after I change the price of my
commodity? The answer to this question depends on how responsive demand is to changes in
price; that is on price elasticity of demand. Let us explore this link.
137
Table 5.3: Revenue Responsiveness to Price

(1) (2) (3) = (1) × (2)
Case If price is and Quantity sold is Then sales is
1 20 Rs/kg 30 kg Rs 600
2 30 Rs/kg 25 kg Rs 750
3 30 Rs/kg 20 kg Rs 600
4 30 Rs/kg 15 kg Rs 450
For this purpose, it will be easier to work with expression (5.8) giving total revenue in
percentage terms. We convert change in revenue into percentage terms writing it as:
%∆R = %∆P + %∆Q (5.9)
This simply says that percentage change in revenue is equal to the sum of the percentage changes
in price and the percentage change in quantity. First note that the derivation of this expression
from (5.8) makes use of the mathematical fact that the percentage change of the product of two
variables is approximately equal to the sum of their percentage changes, that is:
%∆ (a × b) ≈ %∆a + %∆b
The advantage of expression (5.9) is that movement of revenue due to changes in price and
quantity sold can be studied by looking at percentage changes in price and quantities directly. To
understand this, we take three cases here. But first recall the formula of price-elasticity of
demand:
%∆Q
η xp =
%∆P
Case A: ηxp = 1: Price elasticity equal to one means %ΔQ = %ΔP according to the definition of
price elasticity. Consider a one percent increase in price first. If there is no change in quantity
demanded, then revenue will increase by one percent according to expression (5.9). However, if
price elasticity equals one, it means that quantity demanded will also fall by one percent. Since
percentage increase in price is exactly equal to the percentage decline in quantity, the net effect
on revenue of their sum is zero %∆R = %∆P + %∆Q
%∆R = 1% increase + 1% decrease = 0
The positive effect on revenue via one percent price increase is exactly off-set by the negative
effect on revenue due to fall in quantity demanded by one percent, and revenue will remain
unchanged. Thus it is easy to see now that for unitary-elastic goods, price leaves revenue
unchanged because percentage increase in price is equal to the percentage decline in quantity
demanded, and the two effects offset each other completely. Hence, goods for which elasticity is
equal to 1, price and revenue are unrelated.
Case B: ηxp > 1: According to the definition of price elasticity, price elasticity greater than one
means %ΔQ > %ΔP. This means that the demand drops a lot when price increases. Consider a
one percent increase in price first. If quantity sold does not change, revenue will increase by one
percent. However, for price elastic goods, the quantity demanded falls by more than one percent,
say by two percent. Since percentage increase in price (one percent) is less than percentage
decline in quantity (two percent), the net effect of their sum is decrease in revenue [as is apparent
from expression (5.9); that the positive effect on revenue via price increase is less than the
negative effect due to fall in quantity demanded, the net effect of their sum is negative]. The
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reverse will hold if price is decreased by one percent. In this case, quantity demanded will
increase by more than one percent and hence revenue will increase [because the negative effect
on revenue via price fall is less than the positive effect due to rise in quantity demanded, the net
effect of their sum is positive]. The important thing to note is that when price elasticity is greater
than one, increasing price reduces total revenue and vice versa. So, we get a useful relationship:
Goods for which elasticity is greater than 1, price and revenue are negatively related.
Case C: ηxp < 1: Now it is easy to work on this case. When a good has price-inelastic demand,
quantity demanded drops only a little when the price increases which implies that the revenue will
increase. This is exactly opposite of the price elastic goods demand case. A one percent increase in
price causes, say, a half percent drop in quantity, and thus a half percent increase in revenue. This
can directly be verified by expression (5.9). Therefore, we conclude that: Goods for which elasticity
is less than 1, price and revenue are positively related. Table 5.4 summarizes all these
relationships. Application Box 5.2 shows a useful way to apply these relationships.
Table 5.4: Relationship between Price Changes, Price Elasticities and Revenue
Type of good Price elasticity* Price change Total Revenue /
ηxp Expenditures
+ 0
Unitary ηxp = 1
- 0
+ -
Price elastic ηxp > 1
- +
+ +
Price inelastic 0 < ηxp < 1
- -
* Price elasticity is expressed in absolute values
Using Elasticities
Bus Fare Increase
Often we have data only of changes in prices and revenue from which we have to calculate
elasticity. This application shows a useful method to analyze such data. Bus owners raise the fare
of buses to increase their revenue. But is there any guarantee that increasing the fare will always
increase revenue? Suppose that the fare is increased from 4 to 5 Rs / ride. Two months later, the
revenue increases by 20 percent. What can we infer about the original price elasticity of demand
for bus services from this information? First note that the percentage change in revenue can be
written as
FP × FQ − IP × IQ
%∆R = %∆(PQ ) = (5.2.1)
IP × IQ
Note that the final quantity FQ by definition also equals initial quantity plus some change (FQ =
IQ + ΔQ), so we can write the above as:
FP(IQ + ∆Q ) − IP × IQ
%∆R = %∆(PQ ) =
IP × IQ
Substituting the given values of final price (Rs 5), initial price (Rs 4) and the fact that revenue
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increased by 20 percent, we obtain:

5(IQ + ∆Q ) − 4 IQ
%∆R = = 0.20 (5.2.2)
4 IQ
Note that ΔQ < 0 is the fall in ridership. A little algebra shows that (5.2.2) reduces to
IQ + 5∆Q
= 0.20
4 IQ
Solving for the percentage quantity term as
5∆Q = 0.8 IQ − IQ
∆Q − 0.2
%∆Q = = − 0.04 = −4% (5.2.3)
IQ 5
We already know that
∆P 5 − 4
% ∆P = = = 0.25 = 25% (5.2.4)
IP 4
Equations (5.2.3) and (5.2.4) tell us that
% ∆Q − 0.04
η xp = = = −0.16
% ∆P 0.25
The demand for Bus rides turns out to be highly inelastic in response to changes in fare. The fact
that revenue increased after price increase is consistent with this result. Thus, it is always
profitable for bus owners to increase the fare because that will raise their revenue.
Elasticity of a Straight Line and Total Revenue Curve
We now discuss price elasticity of an important type of demand curve that is normally
encountered in most of the economic text books. This is called a linear demand curve. Usually,
in most economic examples, we work with linear or straight line demand curves as an
approximation of real world data. We know that an important property of the straight line demand
curve is that its slope remains constant along all points. What about its elasticity at different
points? The elasticity of the demand curve is different at each and every point on a straight line
demand curve. To understand the reason why this is the case, note that elasticity consists of two
terms, (a) the slope and (b) the P/Q ratio (what we termed as ‘something else’ above). Even if the
slope term remains constant, the P/Q ratio keeps changing as we move along the demand curve.
To see this, recall the definition of price elasticity given by (5.5)
∆Q P
η xp = × (5.5)
∆P Q
Consider figure 5.5. Suppose that the slope of this demand curve is -1, a constant number. We see
that at point A, the value of quantity demanded, Q, is zero, and hence P/Q is equal to infinity which
implies that the elasticity [given by equation (5.5)] also equals infinity:
∆Q P P
At point A η xp = × = −1 × = −∞
∆P Q 0
Similarly at point B, the value of P is zero which means that P/Q, and hence elasticity, is equal to
zero. Now consider the mid point B. At this point, value of P and Q must be equal since it is a
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mid point. With slope equal to one and P = Q, the ratio P/Q will also be equal to one and, hence,
the elasticity must be one.
∆Q P
At point B η xp = × = −1 × 1 = −1
∆P Q
Figure 5.5: Elasticity of linear demand schedules
P η=∞
A
η>1
Pd η=1
DB
Pb
η<1
η=0
0 qd qb C Q
Next consider movement from point A to B. As we do so, the value of P is falling while that of Q
is increasing. Clearly, the ratio P/Q is decreasing all the times (since the numerator is decreasing
while the denominator is increasing). With constant value of the slope, ever decreasing P/Q ratio
implies a decreasing value for the elasticity of demand (in absolute terms). To find the exact
range of elasticity between points A and B, take any point on the linear demand curve between
these points, such as D. At such a point, the value of P must be greater than the value of Q
(because point D is to the left of B which is the mid point). The P/Q ratio must be greater than
one at this point. Hence elasticity will be:
∆Q P
B/w points A and B η xp = × = −1 × greater than 1 > −1
∆P Q
So we can conclude that the elasticity will be greater than one not only at point D but also at all
points above point B (since P/Q ratio will be greater than 1 in this region). Finally, obviously
price elasticity will be less than one between points B and C (since P/Q ratio will be less than 1 in
this region).
The important thing to note about this result is that the slope is constant along all points
on this demand curve (since it is a straight line), however elasticity is not constant. As a general
principle, the elasticity of a negatively sloped straight line demand curve varies from infinity at
vertical intercept to zero at horizontal intercept. This is an important result to remember because
most of the times, students confuse the slope of demand curve with its elasticity. Elasticity is not
merely slope, it is slope multiplied by average price.
% ∆Q x  ∆Q x   Px 
η xp = = ×   (5.10)
% ∆Px  ∆Px  Q 
x 


slope Average Pr ice
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Remember that flatness or steepness shows only the slope of the demand curve and does not imply
anything about its elasticity; the P/Q ratio also makes its contribution in determining the value of
price elasticity.
Next we have to derive the total revenue curve from this demand curve. For this purpose,
first note that the rectangular area below any point on the demand curve gives total revenue at
that point. For example, consider point A in figure 5.6 with coordinates [(Q,P) = (10,20).
Figure 5.6: Relation between total revenue and demand curve
A
20 = C
Ra = 20 × 10
= 200
B
10 = D
Rb = 20 × 10 DO
= 300
E F
0 10 30 Q
The area of the rectangle below this point AC0E measures total revenue, as total revenue equals
price times quantity. To see this, note that the area of any rectangle is given by its height
multiplied by its base. The height of the rectangle AC0E is given by the distance 0C while its base
equals 0E. Multiplying both give the area of the rectangle AC0E.
Area of rectangle AC0E = Height × Base = 0C × 0E
The height 0C measures the price of this commodity at point A while the base 0E measure
quantity demanded. Thus, the area of the rectangle also equals:
Area of rectangle AC0E = Height × Base = 0C × 0E = P × Q = Revenue
Since the product of price and quantity equals revenue, therefore the area of the rectangle below
any point on the demand curve gives revenue at that point. Revenue at point A equals Ra = Rs
20/kg × 10 kg = Rs 200. Similarly, revenue at point B is given by the area BD0F = Rb = Rs 10/kg
× 30 kg = Rs 300. Thus, each point on a demand curve measures total revenue. We are now in a
position to derive total revenue curve by combining these two results. Consider figure 5.7 below.
The top panel plots a straight line demand curve while the bottom panel shows total revenue
against quantity demanded. We have summarized our results in table 5.5. Take point A first.
Since we know that total revenue by definition is R = P × Q, and Q = 0 at point A, therefore
revenue must be zero at this point. The same goes at point C because P = 0 at that point. So we
obtain points a and c (in the bottom penel) on the total revenue curve. Next think of the range of
the demand curve from A to B. In this range, price elasticity of demand is greater than one (see
figure 5.5).
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Figure 5.7: Deriving total revenue from the demand sSchedules.
P
A
Po
B
0 Q C Q
TR
a
0 q c Q
Recall that when price elasticity is greater than one, price and revenue are negatively related (see
the discussion in previous section). Therefore, decreasing price in this range from A to Pb will
increase total revenue and hence the total revenue curve must be rising in this range. This can be
seen from the fact that the total revenue curve is rising in this range of output 0-to-qb (in the
bottom penel). Similarly, in the price range Pb-to-0 (or equivalently quantity range qb-to-C) on the
demand curve, price elasticity is less than one and hence price and revenue must be positively
related in this range. Therefore, if price is reduced from Pb-to-0, revenue will decrease, as shown
by the decreasing phase of the total revenue curve in output range qb-to-C. Finally, note that if the
total revenue curve is increasing in the output range 0-to-qb and decreasing in range qb-to-C, then
it must be at its maximum at qb (or point B on the demand curve). At this point, price elasticity is
one which means that changes in price at this point will leave total revenue unchanged. Thus, we
obtain an inverse U-shaped total revenue curve. Keep this shape in mind as it will be used in our
discussion on monopoly (chapter 13). Here, Application Box 5.3 provides a useful application of
this important concept.
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Table 5.5: Demand and Total Revenue: A Summary

At (or b/w) Price Which If price TR = P × Q Revenue-
Point(s) on elasticity is implies that curve
demand curve
Zero (because is at zero on
A Infinite - -
Q = 0) output axis
Zero (because is at zero on
C Zero - -
P = 0) output axis
Price and
Rises b/w
Greater revenue are Decreases in Revenue
A-B output range
than one negatively this range increases
0-to-qb
related
Price and
Falls b/w
Less than revenue are Decreases in Revenue
B-C output range
one positively this range decreases
qb-to-C
related
Price and
Decreases or Revenue is at its
B One revenue are
increases unchanged maximum
unrelated
Using Elasticities to Understand the 2006 Sugar Crises
Let us now explore the 2006 sugar crises discussed in previous chapter in terms of
elasticities. To analyze this situation, we develop a basic demand-supply model. The demand for
sugar is expected to be price-inelastic because it has no close substitutes and it falls in the
category of necessities. That is why the demand curve in the diagram below is drawn rather
steep. On other hand, we have drawn a “normal” positively sloped supply curve of sugar. Their
intersection determines a price of sugar at Rs 25/kg at which, say, 1 million kg of sugar is sold
per month. This means that the revenue of the sugar seths amounts to Rs 25 million per month (=
25 Rs/kg × 1 million kg). Now suppose that the supply of sugar decreases because of hoarding
made possible by the corruption of the Musharraf government. The supply-curve shifts
backward, as shown by the dotted line. Such a situation will have an adverse effect on consumers
as the “equilibrium” price of sugar rises to Rs 40/kg while quantity sold is 0.8 million per month.
Consumers are purchasing less sugar at a higher price. But how would this situation affect the
sugar seths in Musharraf government? To see this, note that at the new price, the revenue of the
 3.2 − 2.5 
seths is Rs 3.2 millions (= Rs 40/kg × 0.8 million kg). They have enjoyed a 28%  = 
 2.5 
per month increase in their revenue. They put more and more pressure on Musharraf to let them
continue hoarding.
To confirm this result, we find that price elasticity of demand (using arc elasticity expression)
turns out to be -0.48 (less than one in absolute value). It is for this reason that the sugar seths
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originated this artificial shortage by hoarding sugar in their godowns. Since many sugar mills are
owned by ministers and government supporters no serious effort was made by price regulatory
authorities to uncover the causes of the sugar shortage (Also see analytical problem 5 at the end
of this chapter).
Psugar Ss
40 B Sso
1) A 46%
increase in 25 A
price…
DS
0 0.8 1 Qsugar
2) leads to a 22% fall in quantity demanded
5.2.4: Geometric Interpretation of Price Elasticity
While classifying elasticity of demand, we said that a flat curve has a lower price
elasticity of demand as compared to steeper one. But this assertion does not describe the general
relationship between the curvature of a demand curve and its price elasticity. In fact, it is true for
a specific case—true only when the two demand curves cross each other at some point in P-Q
space. There exists a general geometric way to illustrate price elasticity of straight line demand
curves. Here we discuss the procedure in brief. Consider figure 5.8 where the demand schedule
has a vertical (or price) intercept A. The elasticity at point B, (or any other point) can be obtained
by comparing the height of the intercept and the price level from the origin. To understand this,
note the triangle AP0B formed by the price-axis, the quantity axis and the demand curve D. Recall
the definition of price elasticity from (5.5):
∆Q P
η xp = × (5.5)
∆P Q
We need two factors, the P/Q ratio and the slope to estimate elasticity. Note that the price P is the
vertical line segment 0P0 and, quantity Q is the distance 0Q0. Geometrically, the distance 0Q0 is
exactly the same as the distance P0B. Therefore, we can state that the P/Q ratio is the ratio of the
distances 0Po and Po B or:
P 0 Po
=
Q Po B
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Now consider the slope term. The slope of the inverse demand curve D is given by change in
quantity ΔQ = P0B divided by change in price ΔP = AP0 or the ratio P0B/AP0. Plugging these
values in the elasticity formula (5.5) we have:
0 Pο Pο B
η xp =
Pο B APο
0 Pο Height H N
or η xp = = (5.11)
APο Height H D
Figure 5.8: Geometric estimation of price elasticity
Pm
A
HD
B
Po
HN D
0 Qo Qm
This ratio gives the price elasticity of demand at point B. The distance P0B appears both in the
numerator and in the denominator, hence it cancels out. This is a strong result: Pick up any point
along a demand curve, and the elasticity is given by the distance from the origin to price at that
point divided by the distance of the vertical intercept to the price at the desired point; i.e. the ratio
of the heights HN to HD (N and D denote heights to be placed in the numerator and the
denominator respectively). Let us apply this geometric interpretation to see how useful it is.
Elasticity of Two Straight Line Demand Curves
Consider the left panel of figure 5.9 which has two demand curves, D and D1 with the
same slope but different intercepts A and A1 respectively. Apparently, one might think that their
elasticity should be the same. Let us compare their elasticity at price level Po. The corresponding
quantities demanded on both the curves are Q and Q1 or points B and C (because the distance 0Q
is the same as PoB). According to our above equation (5.11), the elasticity of demand curve D at
price Po is equal to the ratio
0 Po
η xp = (5.12)
APo
While that of D1 at the same price is
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0 Po
η xp = (5.13)
A1 Po
Since A1 > A, the denominator of (5.13) is greater than that of (5.12) and, thus, the elasticity of the
demand curve D1 is less than that of D at price Po. In general, for two straight line demand curves
of the same slope, the one farther from the origin is less elastic than the one closer from the
origin for any given price level. The reason in terms of equation (5.5) is that, with constant slopes
of both the curves (ΔQ/ΔP), for any given value of P the corresponding Q value is greater for the
demand curve that lies farther from the origin, hence, P/Q as well as elasticity is smaller.
Elasticity of Two Pivoting Lines
Now consider the right hand panel of figure 5.9. We see that both the curves have similar
vertical intercepts while their slopes are different (this is exactly the opposite of the previous
case). What about their elasticity? Apparently a surprising result, their elasticity is the same for
any given price. To understand the reason for this, consider their elasticity at price P1. Note that
by (5.11), the elasticity of the demand curve D at point B1 is:
0 P1
η xp =
A P1
Figure 5.9: Slopes and Elasticities of Straight Line Demand Schedules
P P
A1 A
Po P1
B C D1 B1 C1 D1
D
D
0 Qo Q1 Q 0 Qo Q1 Q
By the same token, the elasticity of D1 at point C1 is:

0 P1
η xp =
A P1
The two are the same. What is going on here? The geometric reason for this result is that the
difference corresponding to the quantity demanded at P1 (P1B1 and P1C1) appears in both the
numerator and the denominator and thus cancels out. Alternatively speaking, if the slope of a
straight line D is twice as steep as D1, this means that the quantity demanded Q is half at this
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demand curve at P1. Therefore, the steeper slope (a smaller ΔQ for the same ΔP) is exactly offset by
the smaller quantity demanded (a smaller Q for the same P). Carefully note here that though the
demand curve D1 has greater slope than D (as it is steeper), however the elasticity of both is the
same at each price level. This confirms the fact that steepness or flatness of a demand curve shows
its slope which is of course not the sole determinant of its elasticity.
Elasticity of Two Intersecting Lines
As a general rule, price elasticity of two intersecting lines can be compared at the point
where they intersect just by comparing their slopes. The steeper line has less elasticity. Note that
at the intersection point, P/Q ratio will be the same for both the curves. Therefore, it is only the
slope term, ΔQ/ΔP, which determines the elasticity at that point. We know that the slope of the
steeper demand curve is lower (because ΔQ/ΔP is the reciprocal of the slope of the demand curve
ΔP/ΔQ which is higher for the steeper demand curve) than that of a flatter one, hence, it has
lower elasticity. Flatter demand curve means higher elastic demand only if the P/Q ratio is the
same in both cases.
5.3: INCOME ELASTICITY OF DEMAND
So far, we have considered only own price changes. Recall that while deriving the
consumer demand curve, we held income constant and then verified the effects of changes in
price on quantity demanded. However, income can also change. Similar to the price elasticity of
demand, income elasticity of demand is used to describe how demand (not the quantity
demanded) responds to changes in income. It is given by
∆Q x
% ∆Q x Q ∆Q x M
η xm = = x = × (5.14)
% ∆M ∆M ∆M Q x
M
where the subscript ‘xm’ indicates ‘elasticity of demand for x with respect to income’. Income
elasticities are classified into two broader groups. In capitalist economies an inferior good is one for
which there is a negative relationship between income and demand For this sort of good, income
elasticity in capitalist society on the other hand is negative. “A normal” good in capitalist society is
one for which an increase in income leads to an increase in demand; for this sort of good, income
elasticity is positive. Economists further classify “normal” goods into necessities, if income elasticity
is less than one, and luxuries or superior, if income elasticity is greater than one.
In non capitalist societies consumption does not normally rise with income because income is
basically not considered a source of increasing worldly comforts. What rises in these societies is
expenditure on charity and on jihad. Thus in response to the inflow of wealth from South America
there was an explosive growth in the building of churches and cathedrals in Spain in the sixteenth
century. At the time of the Prophet (S.A.W) the conquest of Khyber led to a major increase in the
wealth of the Muslim community but this did not lead to an increase in consumption—it is this which
explains the total absence of inflation in that Nabawi period and the period of the Khilafat-e-Rashida.
148
It was normal for men possessing great wealth to lead lives of extreme poverty. Sayidna Usman (RA),
despite being a successful merchant and wealthy person, at the time of his appointment as caliph
moved into a small Hujrah in the Prophet’s mosque and lived there for the next 12 years and
historians accept that the shirt in which he aliened Shahadat was the only shirt he possessed at that
time. In non-capitalist society production and trade is not undertaken for maximization of utility and
profit. Production and trade are religious not economic produce and men participate in them to earn
God’s favor. In non capitalist societies men are not “rational”—i.e. they are not self-interested utility
and profit maximizers. Economic concepts such as income elasticity of demand do not provide any
adequate basis for understanding production, consumption and trade in non capitalist societies.
Now consider how the variations in income elasticities across different commodities in
capitalist societies can be explained. In general, the distinction between “necessities” and
“luxuries” help explain differences in income elasticities. The more “basic” a commodity is in the
consumption of a consumer, the lower is its income elasticity in capitalist society. However, it
should also be noted that income elasticity for any commodity varies with the level of the
consumer’s income in capitalist society. When income is low, consumer will end up consuming
only food stuff and a little of other goods, such as cosmetics. However, as income increases, the
consumer in capitalist society starts spending more of his budget on goods other than
“necessities”, so the income elasticity of necessities falls for higher income levels. The demand
for “necessities” will not increase by much for increments in income at higher income levels than
it does at lower levels of income because necessities are consumed in more or less fixed amounts.
That is why it is said that ‘there is a difference between necessities and wants’: the former refers
to basket of goods that makes life possible on this earth whereas the letter amounts to those goods
that add nothing to the achievement of our objective of salvation in life-here-after.
“Necessities” keep on increasing in capitalist society, more and more luxuries—
refrigerators, video cameras, mobile phones, microwave ovens—have become “necessities” even
for the “poorest” people in America. It is only in non capitalist societies that necessities can be
defined in physical terms (called intakes). In capitalist society, characterized by ever increasing
scarcity, all luxuries—including even shares and bonds—are potential necessities.
Calculation of income elasticity of demand is exactly the same as that for price elasticity
of demand. For example, suppose that the income elasticity of demand for fast-food business in
Clifton, Karachi city is 1.5; i.e. one percent increase in income of individuals in Clifton leads to
1.5 percent increase in fast-food sales. If incomes of people living in Clifton increase by 5% (on
average) per year, then at what rate will demand for fast-food business increase? From expression
(5.14) we note that
% ∆Q x
η xm = → % ∆Q x = η xm × % ∆M
% ∆M
Plugging in the given values we obtain:
% ∆Q x = 1.5 × 5 / year = 7.5 / year
The explanation for such a large increase in fast-food demand in areas like Clifton is the effects
of westernization on people’s living styles. Three factors contribute in this trend: firstly growing
participation of women in the job markets. Families where women play a dignified role of ‘house-
wife’ have less frequency to visit fast-food restaurants than families where females are working in
offices. Secondly, increasing demand to ‘make most of this worldly life in terms of utility
149
maximization’ leads individuals to adopt pleasure intermingling eating habits. People living in
Pirbaba who are not exposed to enlightened moderation and the capitalist way of life have no
preference for fast-food. Finally, advertisement by fast food restaurants, such as KFC and
McDonald, distorts public preferences by portraying appearance at these restaurants as a symbol
of status and a ‘higher standard of living’.
5.4: CROSS PRICE ELASTICITY OF DEMAND
The concept of the cross price elasticity of demand addresses the question: what happens
to the demand (and not the quantity demanded) for good x, Qx, when the price of good y, Py,
changes, given by:
∆Q x
% ∆Q x Q ∆Q x Py
η xy = = x = × (5.15)
% ∆Py ∆Py ∆Py Q x
Py
where the subscript ‘xy’ now indicates elasticity of demand for x with respect to price of y.
Calculation of cross price elasticity is the same as that of own price and income elasticities (see
analytical problem 3 at the end of this chapter). Its value can vary from minus infinity to plus
infinity. Two goods are classified as substitutes if cross price elasticity is positive, that is an
increase in price of one good increases the demand for another. Consider for example beef and
chicken. A small increase in price of beef causes people to purchase more chicken (and hence a
positive effect). As another example, a large rise in the price of cars would lead to a rise in demand
for public transport because some people will shift from cars to public transportation. Goods are
complements if cross price elasticity is negative; that is an increase in price of one good decreases
the demand for another. For example, the increase in oil price causes the demand for cars to fall
(and hence a negative effect).
Higher values of cross price elasticity suggest stronger relationship between two goods,
whether that of substitutability or complementarity. For example, if cross price elasticity between x
and y is two, ηxy = 2, while for x and z it is three, ηxz = 3, then x and z are closer substitutes for
each other than are x and y.
5.5: SUPPLY ELASTICITIES
The concept of elasticity is not limited to demand. Economists refer to supply elasticity
as the response of quantity supplied to changes in any of its determinants, such as its own price.
More precisely, price elasticity of supply is the percentage change in quantity supplied due to
percentage change in price, that is:
% ∆Q xS ∆Q xS Px
ε xp = = × (5.16)
% ∆PX ∆Px Q xS
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Since “normal” supply curves in neoclassical analysis have positive slopes, the price elasticity of
supply, εxp, is a positive number. Price elasticity of supply can also be classified into five
categories around its value ‘1’, just like demand elasticity. When supply of a commodity is fixed,
such as the amount of wheat in a given year, supply elasticity is zero (a vertical supply curve). At
other extreme, a horizontal supply curve displays an infinitely large response of quantity to price
changes. In between these two extremes, the supply is called elastic or inelastic depending upon
whether the percentage change in quantity supplied is larger or smaller than the percentage
change in price. The supply elasticity ranges from zero to plus infinity.
One of the major determinants of supply elasticity in capitalist societies is the ease with
which production can be changed in an industry after a price change. If the price of some product
increases, how much more can a firm produce of that good depends upon how easy it is for
producers to shift from the production of other commodities to the one whose price has changed.
If the prices of land rise suddenly, nobody can sell more land than what is available in fixed
amount by nature. Another factor that affects supply elasticity is the duration of time. A given
price change tends to have larger effects on quantity supplied as the time available to respond for
suppliers increases. Suppose that the price of wheat increases this year. Capitalist farmers may
increase the supply of wheat from their go downs, but they can’t produce more wheat immediately.
However, if price increase persists in the next year, capitalist farmers can respond by cultivating
more wheat and perhaps less cotton. The behavior of cost as output increases also affects the supply
elasticity. This issue will be dealt in detail when we study cost curves and the theory of production.
Suppose that the cost of producing any amount of output is fixed, then an increase in output price
will stimulate capitalist producers, to increase their production by a great deal. However, if the cost
of producing a unit of output also rises with the rise in output, then the increase in production will
be dampened by the increase in the cost of production because profits will not rise for capitalist
producers. In this latter case, supply will tend to be inelastic
5.6: ELASTICITY AND CAPITALIST POLICY
Table 5.6 comprehensively summarizes all that is explained in this chapter. Here we
discuss how we can use information on many types of elasticities to determine the outcome of any
given change in market. Application Box 5.4 consolidates this understanding by discussing an
example.
Calculating Combing Effects
We can combine several pieces of analysis to illustrate the application of elasticity

concepts in capitalist societies. Consider railway ticket sale on Eid season at, say, Karachi Cant
station. The seats available in trains for passengers are fixed in number, irrespective of its demand
which means that the supply curve is perfectly inelastic in figure 5.10. The demand for tickets is
drawn negatively sloped. The intersection of demand and supply gives the equilibrium price of
tickets, say Rs PR. Suppose the demand for tickets increases, say, due to 20% extra income given
by the government as an Eid-bonus (paid before Eid).
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Table 5.6: Summarizing Elasticity Concepts

Terminology Symbol Numerical Value Definition
Price Elasticity of η xp Negative %ΔQ due to %ΔP
Demand
Unitary price elastic Equal to 1 (in absolute %ΔQ = %ΔP
term)
Elastic Greater than 1 (in %ΔQ > %ΔP
absolute term)
Inelastic Less than 1 (in absolute %ΔQ < %ΔP
term)
Perfectly inelastic Zero %ΔQ = 0 due to any %ΔP
Perfectly elastic Infinity %ΔQ = ∞ due to small %ΔP
Income Elasticity of η xm %ΔQ due to %ΔM
Demand
Inferior Negative %ΔQ < 0 when %ΔM > 0
Normal Positive %ΔQ > 0 when %ΔM > 0
Income elastic Greater than 1 %ΔQ > %ΔM
Income inelastic Less than 1 %ΔQ < %ΔM
Cross Price Elasticity of η xy %ΔQx due to %ΔPy
demand
Substitutes Positive %ΔQx > 0 when %ΔPy > 0
Complements Negative %ΔQx < 0 when %ΔPy > 0
Supply Elasticity ε xp Positive %ΔQs due to %ΔP
Adapted from Lipsey
If the income elasticity of demand for tickets is 1.5 and price elasticity of demand for tickets is -
1.2, by what percent Pakistan Railway (let it be recently privatized) can increase prices and yet
sell all the tickets? To answer this question, first think about the question: ‘what happens to
demand when income increases’ in capitalist societies. We know that increase in demand due to
increased income will shift the demand curve outward in typical capitalist societies. But by how
much? To determine this, use the definition of income elasticity of demand (5.14):
% ∆QR
η xm =
% ∆M
Solving it for quantity demanded % ∆Q R = η xm × % ∆M
Plugging in the given values we get,
% ∆Q R = 1.5 × 20 = 30%
So, demand increases by 30%, and hence the curve shifts rightwards by 30%. This means that
there will be 30% excess demand for tickets at the old price PR. Next ask the question: ‘by how
much the newly privatized Pakistan Railway may increase prices in order to eliminate this 30%
extra demand’. For this purpose, use the expression of price-elasticity of demand to determine
price change:
152
% ∆Q R % ∆Q R
η xp = or % ∆PR =
% ∆PR η xp
Plugging in the given values, we get:
− 30
% ∆PR = = 25
− 1.2
The negative sign before ‘30’ indicates that demand has to fall by this much amount in order to
clear the market. Thus, new price will be 25% greater than initial price, PR + 25%.
Figure 5.10: Considering combing effects of elasticities

PR
So
e1
PR + 25% 30% shift in
demand curve
C
PR
e
D1
0 QR QR +30% QR
Suppose Pakistan Railway is not a capitalist firm—not committed to profit maximization.

It will then not raise price of tickets when demand rises. It will ration tickets on the basis of some
criteria—e.g. give tickets to people going to destination not served by road transport
preferentially. It is only the commitment to profit maximization which leads Pakistan Railway to
increase price and there is nothing natural or inescapable about this capitalist response to demand.
Nationalized companies do not normally raise price in response to demand. The normal response
of non-capitalist societies is to ration goods in short supply on the basis of a criterion of justice—
not to raise price. The identification of criteria of justice when rationing becomes necessary is one
of the functions of the Khalifah in an Islamic bazzar according to Hanafi Fiqh. Application Box
5.4 applies the combining effects of elasticities on minimum wage law controversy example.
153
Using Elasticities
Combining Effects & The Minimum Wage Law Controversy Revisited
You learnt about ‘minimum wage law’ controversy in chapter 4 (see Application Box 4.5). Let us
analyze this issue again in the light of tools developed in this chapter. Opponents of minimum-
wage-law contend that minimum wage laws in capitalist societies will lower wages as demand for
unskilled workers is price-elastic. To understand this logic, consider the left panel below. Here,
demand curve for unskilled labor is drawn as being relatively elastic while supply curve is drawn
positively sloped. The initial wage rate is, say, wa = Rs 100/day and La = 20,000 workers get jobs at
this wage rate in Faisalabad. The total earnings of workers is given by wa × La = Rs 100/day ×
20,000 = Rs 2,000,000/day (or Rs 2 millions). Now suppose that government imposes minimum
wage law and sets wage at wm = Rs 125/day. This lead profit-maximizing capitalist firms to reduce its
demand for labor and only Lm = 14,000 workers are employed (as explained in chapter 3). The
incomes received by workers after minimum wage legislation is given by wa × La = Rs 125/day ×
14,000 = Rs 1,750,000/day (or Rs 1.75 millions). Income received by workers has decreased from Rs
2 millions/day to Rs 1.75 millions/day. This result can be confirmed by the fact that elasticity of
demand for workers with respect to wage rate is:
% ∆L ∆L La + Lm 14000 − 20000 100 + 125
η lw = = × = × = −1.59
% ∆w ∆w wa + wm 125 − 100 20000 + 14000
Thus, price elasticity of demand for labor is greater than one (in absolute value) and this confirms
the fact that increasing wage rates will decrease the total wage bill received by the workers provided
firms are profit maximisers. However, if price elasticity of demand for labor is assumed to be less
than one (inelastic demand), then minimum wage law will lead to an increase in workers’ total wage
bill, as shown in the right hand panel. For this case, the total wage bill received by workers
increases to Rs 2.125 millions/day while elasticity of demand for labor turns out to be:
% ∆L ∆L Le + Lm 17000 − 20000 100 + 125
η lw = = × = × = −0.73
% ∆w ∆w we + wm 125 − 100 20000 + 17000
wage wage
So So
U = 61.6%
m c
wm=125 b wm = 125
m
wa =100 a we = 100 e
Do
DO
0 Lm La Lb L 0 Lm Le Lc L
14000 20000 ? 17000 20000 ?
154
Whether wages received by the workers increase or decrease crucially depend upon the wage
elasticity of demand for labor in capitalist society where the firms employing labour are profit
maximizers.
We can further extend this analysis to study the effects of minimum-wage-law on unemployment in
a capitalist economy. Consider the left hand panel again where demand elasticity is -1.59. Suppose
that elasticity of labor supply with respect to wage is 1.3 (an elastic supply curve). How much
unemployment will be generated due to increase in wage from wa to wm in capitalist society? To see
this, recall from chapter 4 that unemployment in this case will be equal to the distance mb (the
difference between supply of and demand for labor at wage wm). Part of this unemployment is
generated by the fact that demand for labor has decreased, from La to Lm, while part of it arises
because supply of labor increases from La to Lb as wage rate increases. Unemployment will be equal
to the sum of these two changes (in absolute value) as:
Unemployment = mb = Fall in demand for labor due to wage increase +
Increase in supply of labor due to wage increase
We need to find these two changes. For this, first note that wage has increased by 22% as:
∆w 125 − 100
% ∆w = = = 0.22 = 22%
(wa + wm ) 2 (100 + 125) 2
The fall in demand for labor can be calculated using definition of elasticity of labor demand:
% ∆LD
η lw =
% ∆w
Solving it for quantity demanded gives % ∆LD = % ∆w ×ηlw
Plugging in the given values we get,
% ∆LD = 22 × −1.6 = −35.2
So, demand decreases by 35.2% (movement from a to m). Similarly, increase the labor supply can
also be calculated using wage elasticity of labor supply as:
% ∆LS
ε lw = ⇒ % ∆LS = % ∆w × ε lw
% ∆w
Plugging in the given values we obtain,
% ∆LS = 22 × 1.2 = 26.4
This means that increase in wage rate brings forward 26.4% additional workers into the market
(movement from a to b). Total unemployment can now be obtained by adding these two numbers
together (in absolute terms):
U = % ∆LS + % ∆LD = 26.4 + − 35.2 = 61.6
Thus, unemployment of unskilled workers increases by 61.6%, a number quite large due to the fact
that we assumed very large values of wage elasticities and changes in wage rate. As a matter of
exercise, now apply the same procedure on the right hand penel numbers assuming ε lw = 0.8 . Also
determine the final values of labor supply (with ‘?’ mark in the diagram) at wage wm for both cases.
Note carefully that all of the above analysis depends crucially on two presumptions:
• Firms are capitalist firms—maximizing profits
• Workers are capitalist work force—responding with more effort to higher wages
In non capitalist societies—medieval Europe or the Usmania Khilafat for example—wages are
155
determined on the basis of an anticipation of a first wage. Since neither firms nor workers are
capitalist—they are concerned neither with profit nor with utility maximization—a rise in the just
wage (determined essentially by the rate of growth of population and changes in the total costs of
production through out the economy) does not lead to unemployment. Non-capitalist producers do
not reduce the demand for labour nor do non-capitalist workers increase the supply of labour when
the just wage rises. Phyllis Deane has shown that both unemployment and wage inflation were
unknown in Christian Europe and it was the emergence of capitalist economics which made
inflation and unemployment a permanent threat to the economic life of modern Europe. The concept
of elasticity is therefore useless for analyzing production, consumption and employment in non-
capitalist societies. It is only when men are “rationally”—when they seek profit and utility
maximization as ends in themselves—that inflation and unemployment become permanent threats
to society.
The discussion in this section (including in the application box) shows some of the uses
to which the concept of elasticity can be put both for justifying capitalist behavior and for
developing policies for strengthening capitalist rule. Broadly speaking capitalist rule requires
perfect demand elasticity—that is why the demand curve is shown as infinitely elastic in the
perfectly competitive model (see chapter 13). Capitalism’s only conception of value (chapter 2) is
price alone which must at least “in the last instance” determine choice. Capitalism also seeks to
increase the price responsiveness of production (supply but since capitalism can survive only in
conditions for perpetual, never ending scarcity, an infinity power elastic supply curve cannot be
assumed so economic theory presumes the existence of a “normal” upward slipping supply curve
(that such a curve cannot exist at the aggregate level, as shown by Sraffa is another matter and we
will discuss this in chapter 13).
Estimations of elasticity thus enable capitalist policy makers to identify constraints on
rational utility and profit maximizing behavior as well as for deriving policies which can reduce
these constraints. If the price elasticity of beef is low this may be because this is the only meat
available. There is therefore scope for taxing the consumption of beef and using the money raised
to subsidize pork production (which as research in Belgium has shown is a much more cost
effective industry in the long run). The price and income and cross price elasticity of demand for
pork in Pakistan is almost zero today. But so it was in Israel in 1949 which according to FAO
statistics now consumes about 370,000 tons of pork annually. Cannot a modern ruler, like
Musharraf, persuade an enlightened moderate scholar to issue a fatwa to the effect that it is only
unhygienically produced pork that is haram? After all “non alcoholic” beer has been “hallalised”
(made permissible) in many Gulf states. Such policies will increase the price elasticity of beef in
the long run and enhance both utility and profit maximization.
Of course utility calculations are useless if people refuse to act rationally. If instead of
listening to the enlightened moderate scholar “halalising” pork people make a fun of his views,
choices will not be widened and utility and profit maximization will not be facilitated in the long
run. What is the point of estimating elasticities in these circumstances? Elasticity concepts are
useful for legitimizing and facilitating capitalist rule. They are useless for every other purpose.
156
Key Concepts
Arc price elasticity reflects the change between two points along a demand curve
Budget share is the proportion of income that is spent on a particular commodity
Complements are the goods which share negative cross price elasticity
Cross price elasticity shows relation between quantity demanded of one commodity and price of
another. It measures the proportional rate of change in quantity demanded of one good due to
proportional change in price of another good
Elasticity is a pure algebraically signed and unit-free measure of responsiveness between two
variables. It measures percentage rate of change in the dependent variable due to change in the
independent variable
Elasticity of demand shows what happens to demand for a commodity when the variables which
affect demand undergo some change, that are the price of the good in question, price of related
goods and income
Income elastic demand is greater than 1. The demand changes by more than the change in
income in percentage terms
Income elasticity of demand shows percentage change in demand due to percentage change in
income
Income inelastic demand is less than 1. The demand changes by less than the change in income
in percentage terms
Inferior good has a negative relationship between income and its demand. It displays negative
income elasticity
Linear demand curve is one for which the slope is constant at all points while elasticity varies
from zero to infinity
Luxuries are the goods which have income elasticity greater than 1
Necessities are the goods which have income elasticity less than 1
Normal good is one for which an increase in income leads to an increase in demand. It has
positive income elasticity
Point elasticity measures elasticity at a specific point on a demand curve
Price elastic demand is greater than 1 in absolute value. The quantity demanded changes more
than the change in price in percentage terms
Price elasticity of demand shows the percentage change in quantity demanded due to percentage
change in price
Price elasticity of supply is the percentage change in quantity supplied due to percentage change
in price
Price inelastic demand is less than 1 in absolute value. The quantity demanded changes less than
the change in price in percentage terms
Slope measures the rate of change in the dependent variable due to change in the independent
variable
Substitutes are the goods which posses positive cross price elasticity
Unitary price elastic demand is equal to 1 in absolute value. Change in quantity demanded and
price are equal in percentage terms
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Chapter Summary
• The inverse of the demand curve slope is measured as ∆Q / ∆P < 0

• Slope should not usually be used to measure responsiveness of quantity demanded to changes
in price or income because
o Slope has to be measured in specific units and not as a pure number
o It makes the comparison of responsiveness of commodities measured in different
units difficult
• Price elasticity of demand is measured as %∆Q/%∆P
• Elasticity may be measured at a point on the demand curve. To calculate point elasticity we
must have sufficient data to estimate the slope of the demand curve. In principle this requires
information on quantity demanded at every (possible or actual) price in the market. This is
usually not available and we have information about quantity demanded at only a few prices.
• Arc elasticity of the demand curve is measured as
∆Q IP + FP
η xp = ×
∆P IQ + FQ
Where IP and IQ are initial price and quantity demanded and FP and FQ are final price and
quantity.
• When quantity demanded changes less than proportionality to change in price (ηxp < 1) the
demand is said to be inelastic (in mature capitalist societies demand for alcohol is price
inelastic). When ηxp > 1 demand is price elastic. If ηxp = 0 price is perfectly inelastic. When
ηxp = 1 demand is said to have unit price elasticity. When ηxp = ∝ elasticity of demand is said
to be infinite
• Price elasticity is affected by the price of substitutes. Necessities are less elastic than
luxurious—a prayer rug is a luxury in mature capitalist societies, a necessity in non-capitalist
ones. Elasticity increases over time. Other factors which influence prices elasticity are
availability of substitutes and the share of the expenditure on a commodity in the budget of
the consumer.
• Sellers are primarily interested in change in net revenue. When ηxp = 1 change in price
exactly cancels out change in quantity demanded. With elasticity > 1, price and quantity are
negatively related and with ηxp < 1, there exists a positive relationship between price and
revenue.
• While the slope of the linear demand schedule remains constant its elasticity changes at every
point since P/Q ratio keeps changing. Figure 4.5 shows that with slope of the linear demand
schedule equal to 1, ηxp > 1 for all points above the mid point of the schedule and ηxp < 1 for
all points below the mid point of the demand schedule
• The elasticity of a demand schedule with constant slope varies between infinity and zero.
This shows that the flatness or steepness of a demand curve is only one determinant of its
elasticity. The other determinant is the P/Q ratio
• The rectangular area below any point on the demand curve gives the total revenue at that
point
• At every point on a straight line demand curve elasticity is given by the distance from the
origin to price at that point divided by the distance of the vertical intercept to the price at the
158
desired point. For the straight line demand curves with the same slope the one further from
the origin has lower elasticity than one nearer the origin at any given price
• The elasticity of straight line demand curves with different slopes but the same vertical
intercept is equal at every price level
• Flatter straight line demand curves have higher elasticities than steeping ones at their
intersection point—i.e. at the point where P/Q is the same in both cases
• Income elasticity of demand is estimated by ηxm = ∆Qx/∆M × M/Q
where ηxm is income elasticity of demand
• The concept of income elasticity of demand is applicable to consumer behavior only in
capitalist societies. In non-capitalist societies demand does not normally rise with income.
That is why inflation is a very rare phenomena in non-capitalist societies
• In capitalist society goods are classified as (a) inferior if ηxm < 0, (b) necessities if ηxm < 1 (c)
luxuries if ηxm > 1. “Necessities” are defined by an individual’s orientation of the society in
which he lives. All luxuries are potential necessities in capitalist society (because of the
condition of perpetual scarcity). In non-capitalist society only necessities are defined on the
basis of physical needs
• Cross price elasticity of demand is measured by ηxy = ∆Qx/∆Py × Py/Qx
Where ηxy indicates the elasticity of demand for commodity x with respect to change in the price
of good y. The value of this ratio can vary form minus infinity to plus infinity.
• Goods are (a) substitutes where ηxy > 0 = (b) complements when ηxy < 0.
% ∆Q xS ∆Q xS Px
• Price elasticity of supply is measured as ε xp = = ×
% ∆PX ∆Px Q xS
• The neoclassical assumption is that the “normal” supply curve is upward sloping i.e. the
quantitative estimate of εxp is expected to be positive. This “normal” supply schedule is
unlikely to exist in non-capitalist societies and this shape of (especially the aggregate) supply
curve has been disputed even by analysts of capitalist production
• Supply elasticity ranges from zero to plus infinity. Speed at which production can be
increased or decreased in response to price signals is likely to vary over time. Cost is another
determinant of supply elasticity. If costs of production rises as much as price, capitalist
producers will have no incentive to expand production and εxp = 0
• The elasticity concepts cannot be used to analyze production, consumption and
unemployment in non-capitalist societies—i.e. societies in which men do not seek profit and
utility maximization. The typical response of producing to changes in supply in such societies
is rationing, not price increases. Unemployment and inflation are the products of capitalist
rationality. They are virtually unknown in non capitalist societies
159
Review Questions
1. Why is the slope not used by economists to measure the responsiveness of quantity demanded
to changes in price and income?
2. How is elasticity measured? What is the difference between slope and elasticity?
3. How is price elasticity of demand measured? Why is price elasticity of demand usually
expected to be a negative number?
4. What is point elasticity and how is it measured?
5. Why is demand for beer inelastic in mature capitalist societies?
6. Why are flatter demand curves not always more elastic than steeper ones?
7. What factors determine the price elasticity of demand for a particular commodity?
8. Show why price and revenue are unrelated in the case of goods where the price elasticity of
demand is unity.
9. Show why price and revenue are negatively related where price elasticity of demand is
greater than one and that price and revenue are positively related when demand elasticity is
lower than unity.
10. A company produces a model of car of which 16000 cars/year are sold out. Suppose that cross
price elasticity of demand for cars with respect to petrol is -0.5. If price of car remains same,
but the price of petrol increases from Rs 40 to 50 per liter, calculate change (not percentage
change) in the demand for this car.
11. Assume that 100 plates of Biryani are demanded at the moment in your institute’s cafeteria at
a price Rs 20 per plat. If the price of Biryani increases to Rs 25 and its demand decreases to
90 plates, then:
a. Calculate the value of price elasticity of demand for Biryani from the given data
on price and quantity
b. Calculate the total expenditures on Biryani at new price, both before and after
price change?
c. How can you conclude your answer in (a) about price elasticity of Biryani by
comparing the information on total expenditures data in (b)?
d. What general relationship between price, demand elasticity and expenditures can
you confirm from this example?
12. Suppose that you are called by Pakistan’s ‘drugs usage controlling authority’ in a meeting.
The agenda of the meeting is to devise an effective policy to reduce crimes committed by
drugs addicted people. One of the members suggests putting a ban on the sale of drugs.
However, another member, who is economist, argues that this will not reduce drugs related
crimes, rather increase them. He gives his explanation in the following quote:
‘As the demand curve for drugs is expected to be price inelastic, ban on the sale of drugs
will shift supply curve to the left which means that expenditures of addicted people will
increase. This will force them to commit more crimes in order to fulfill their demand’
Using an appropriate diagram, explain the logic of this argument to other members as they
could not understand it.
13. Why does the elasticity of straight line demand curves keep changing at every point?
14. Show why the elasticity of a linear demand curve with constant slope varies between infinity
and zero. Illustrate your answer with a diagram
160
15. How did Musharraf’s sugar seths benefit from the inelasticity of demand in the sugar market
in 2006?
16. What can you say about Syedna Usman Ghani’s income elasticity of demand?
17. What are “necessities” in (a) non-capitalist and (b) capitalist societies?
18. Why is the income elasticity of junk food high in Clifton but almost zero in Pirbaba? Should
income elasticity of demand be raised in Pirbaba? How can it be raised and who will gain
from this increase?
19. What is cross price elasticity of demand and how is it measured?
20. What is the price elasticity of supply and what is its range?
21. What according to neoclassical theory are the determinants of the elasticity of supply?
22. Suppose there is a prolonged draughts and production of wheat falls drastically. What would
happen to its price in (a) a capitalist market and in (b) an Islamic bazzar?
23. Suppose that the demand for a commodity is perfectly inelastic. Currently 100 units are sold at
a price Rs 5/unit. If the price is raised to Rs 6, how many units will be sold?
24. ‘A good harvest of wheat will generally lower the income of farmers because its demand is
price inelastic’. Explain this statement using a demand-supply diagram.
25. Can the concept of elasticity be used for an analysis of production and employment in non-
161
162
PART THREE
Behind Markets
Consumer and Firm

Behaviours
Chapter 6: Preferences and Utility

Chapter 7: Budget Set, Choice and Demand
Chapter 8: Changes in Demand: A Comparative Static Analysis
Chapter 9: Firm and Production in Capitalist Society
Chapter 10: Neoclassical Theory of Production
Chapter 11: Neoclassical Theory of Cost
6
Chapter
PREFERENCES
AND UTILITY
The previous three chapters show how prices of goods and services are determined within
the neoclassical demand supply model. But one must raise an important question at this stage.
Where do demand and supply come from? And is the demand and supply analytical model
applicable to all societies? If yes, what is the justification for this claim? If not, what are the
characteristic features of the society to which demand and supply analysis is applicable?
Answering these questions requires us to understand the source of demand and supply, the
motives of demanders and suppliers, and the scope, the range of applicability, of these theories.
Let’s begin by looking at the motives of the ‘demanders’—the consumers. Neoclassical
economists analyze consumer behavior in order to justify the negatively sloped individual and
aggregate (market) demand curve. Before we begin with the formal neoclassical analysis it is
necessary to explain what lies behind this formal theory—philosophers would call this the
metaphysics of the neoclassical theory of consumer behavior.
6.1: WHO IS CONSUMER?
The economic theory of consumer behavior is founded on the Enlightenment doctrine

known as possessive individualism. This doctrine holds that:
• Every person is committed to the promotion of his own interest
• This (self) interest is the maximization of the freedom of the individual; i.e. the ability of the
individual to himself determine what is good for him. He is not obliged to accept or reject
something as good on the basis of some other authority. Man is “autonomous”, as Kant puts
it, and he does not accept any authority’s right to tell him ‘what he ought to do’.
This is the essence of the conception of ‘home economicus’—economic man—which underlies
all economic theory. Abdullah Zhaghazai will be a “homo economicus” only if:
• he is self interested. His own well being—and not that of Munira his daughter, Aleemullah,
his employee, the Zhaghazai tribe, Pakistan or the Muslim Ummah—is his primary concern
and its promotion his main motivation
• he defines his interest himself and does not accept any one else’s authority—that of his tribal
chief, his Peer, his community customs, the Quran and Hadith—to define his self-interest
• he regards this capacity to choose—to himself determine what is good—as primary; i.e. more
important than any particular choice that he makes. What is really important for him is that he
has the money so that Abdullah can either (a) buy a car or (b) finance the construction of a
mosque or (c) choose the choice to do either (a) or (b) or both (a) and (b) or to buy a car in
2010 and finance the mosque in 2011. For Abdullah to be a consumer, it is primarily
important for him that he has the right to do whatever he likes and nobody (neither his family,
nor his tribe nor God) has the right to tell him what he should like or dislike in his life
The above is not entirely possible for Abdullah and there are important constraints on
Abdullah’s right to choose (not a particular thing but choice itself). First if Abdullah is a homo
economicus he must accept Munira and Aleemullah as homo economicuses too. This is because
Abdullah cannot flourish in a non-capitalist society—in a society of Muslims or Christians or
Red Indians or other non-homo economicuses. But recognizing Munira as a homo economicus
167
is problematic. 1 If Aleemullah has the right to choose just like Abdullah has, then Abdullah
cannot choose anything which restricts Aleemullah’s right to go his way. Abdullah cannot
choose for example to ban the production of whisky for Aleemullah may want to drink it. Thus
Abdullah can choose not to drink whisky but he cannot choose to ban its production, no matter
how much utility he derives from such banning. Thus recognizing Aleemullah as a homo
economicus requires that only those types of utility maximizing activities should be recognized
as legitimate which do not impede aggregate utility maximization (i.e. the sum of the utility of
all consumers).
This means that “utility” has to be defined in a particular and specific way. Aggregate
utility is necessarily utilities derived from the expansion of everyone’s choices. Since aggregate
utility is the sum of all individuals’ utility, the component of individual utility derived from acts
which reduce or constraint aggregate utility must be factored out before the aggregation of
personal utility takes place. To understand this idea, suppose Abdullah derives utility from the
following three:
a) eating coconuts—this yields 1 util (util is a measure of utility)
b) playing football—this yields 2 utils
c) preventing Aleemullah’s drinking of whisky—this yields 3 utils
Here while (a) and (b) do not restrict aggregate utility (i.e. do not restrict the expansion of
Aleemullah’s choices), however (c) does impede aggregate utility. Thus while (a) and (b) may be
“added up”, (c) must be “netted out” while calculating aggregate utility.
In aggregate utility calculation Abdullah’s net utility is zero according to our example (1
util ‘from coconuts, 2 from football and minus 3 from banning whisky). He contributes nothing to
aggregate utility and is therefore not a homo economicus. Thus, the ‘right to choose anything’
rules out the right to choose banning whisky, for this specific choice impedes choice in general.
This ‘choice in general’ can only be measured in Rupees and Dollars and Euros. For it is
Rupees and Dollars and Euros alone which confer the right to choose in general on Abdullah.
That is why the utility (or welfare) function aggregates are expressed in Rupees or Dollars in
economics. Anything which cannot be so expressed—mother’s love for example—cannot be
incorporated in individual utility functions (the concept of the utility function will be explained in
detail later). This is another proof of the essentially normative character of economic analysis.
There is no such thing as positive economics because economic analysis illuminates the process
of “the production of dollars by means of dollars” assuming that dollars can measure everything
worth measuring and we want everything—i.e. more and more dollars. If Abdullah is willing to
do something that cannot be measured in rupees (e.g. to love his mother, to honor his tribal
customs, to serve God), economics cannot tell him how to use resources efficiently for such
purposes. This is because in such a case Abdullah’s net contribution to aggregate utility is zero or
negative. He must be “netted out”—sent to Guantanamo Bay or shot, declared insane or
fundamentalist—until he agrees to become “homo economicus” and internalizes capitalist
rationality.
Economic theory pretends that as “homo economicus” Abdullah leads a dual life. In his
private life Abdullah is supposedly free to choose anything depending upon his desires—praying
five times a day or playing football. In his public life he must submit to the market (and to the
1
That is why Sartre said “hell is other people”
168
capitalist state which guarantees its existence). The market will reward or punish Abdullah on the
basis of the exchange value of his activities. For example, praying five times a day commands no
exchange value and there can be no market rewards for this activity as there can be for playing
football depending on the value of football player. The market and the capitalist state basically lie
when they claim that they are neutral in terms of the type of private life Abdullah chooses. By
valuing all of Abdullah’s activities in terms of their exchange value they are forcing Abdullah to
prefer the life of a footballer. That is why capitalist norms—lust, greed and jealousy—flourish in
the private lives of most people in capitalist society.
Economic theory holds that it is rational to be lustfull, greed and jealous. It calls jealousy
‘competition’ and greed ‘accumulation’. The rational individual is necessarily accumulative and
competitive. He is necessarily committed to the maximization of his well being and this “well
being” is necessarily measured in terms of the (appropriately discounted) exchange value of the
goods and services he consumes during his life. If Abdullah does not seek maximization of his
“well being” he is an irrational, insane, unenlightened savage. If Pakistani society values
Abdullah’s activities on basis other than their exchange value, Pakistan is an uncivil society and a
failed state.
Abdullah’s conception of himself as a consumer, his commitment to maximization of his
consumption during his life, is based upon the Enlightenment conception of self interest. A self-
interested person is one who seeks to maximize his consumption during this life. If Abdullah
regards his self-interest in obeying God’s commands so that he reaches heaven, the market can
provide no valuation calculus for evaluating the progress he is making for the achievement of this
objective and the realization of this type of self-interest. The only conception of self interest that
economics recognizes as rational and that the market can value is the one which is expressed in
the unconditional commitment to the maximization of consumption in this life.
6.2: CONSUMER BEHAVIOR AND THE THEORY OF CHOICE
Economics studies consumer behavior within the context of the theory of choice. Choice
is necessary due to the existence of scarcity. If there are many more coconuts growing in
Maldives than people want to eat, Abul Bashr can have as many as he likes. If American Fruit
Enterprises buys all the coconut trees in Maldives, Abul Bashar will have to purchase coconuts
from the wages American Slave Holdings pay him as their workers. Moreover, since American
Seafood Inc. has bought up all of Maldive’s fishing, so Abul Bashar has to decide how much to
spend on fish and how much on coconuts—he is free to decide how much he will spend on fish
and how much on coconuts given his income. He is not free to spend nothing on them, for in that
case he will starve. He is free to work for American Slave Inc, or American Sea Foods or
American Fruit, given his skills. He is not free to work for none of these corporations for there is
no other employment. He is also not free to prevent the development of capitalist property in the
Maldives, for if he does so, he will be shot as were the 80 million Red Indians who opposed the
development of capitalism in America.
The two determinants of Abul Bashar’s “free choice” are:
a) his tastes—he may like fish more than coconuts
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b) his income—fish may be so expensive that he cannot buy any of it

Due to the miserable wages paid by American Slave Holdings, Economic theory assumes that
Abul Bashar’s tastes are independent of his income and are not determined by his place in time
and space. He is assumed to have ‘this taste’ because he has it; i.e. his tastes are predetermined
and fixed. So are Rahiman’s (his wife) tastes—she may like coconuts more than fish for no other
reason but that she likes coconuts more than fish.
Figure 6.1: The economic conception of society
Maldive =
Choices of
Fixed taste of Abul Bashar Prices of goods, Abul Bashar’s Choices Abdul Bashar +
income and Choices of
Fixed taste of Raheeman Basharians Choices
opportunities of Raheeman +
Fixed taste of Mubashir consumers Mubashir’s Choices
Choices of
Mubashir
It is this assumed independence of individual tastes which allows economists to add them all up
to obtain ‘aggregate or social utility’ (to be discussed in chapter 8 in details). Maldivian society is
seen merely the sum of the tastes of all Moldavians. This economic conception of society is
shown in Figure 6.1.
In the economists vision of society, Abul Bashar as consumer is sovereign (so too are
Raheeman and Mubashir, their son) precisely because it is his own choices—given his income—
that will determine the production and distribution of value in Maldivian society. This consumer
sovereignty would vanish if we recognize that Abul Bashar’s choices are determined by the
family he comes from, the people he works with, the sufi order be belongs to and the income he
has. In this case he would not be sovereign as a consumer as his tastes would be determined by
his relationships.
The economic theory of consumer behavior as outlined below claims that it is universally
applicable—in Maldives and Congo and Sweden and Cuba and the Taliban’s Afghanistan, in BC
5000, AD 1, AD 2007 and AD 100,000. All consumers are and ought to be sovereign. They have
and ought to have predetermined ‘given’ tastes entirely un-influential by their social
relationships. They all pursue and ought to procure the over-riding objective of maximizing
consumption in this life.
It is not difficult to see the underlying misconception behind this presumption of ‘given
innate taste’ even within capitalist society. In a capitalist society, wants of consumers do not exist
independently of the products created by firms for maximizing their profits. Not only do firms
determine the range of market goods from which consumers must choose, they keep on
persuading consumers, through advertisement and promotion drives, to choose that which is
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being produced today and reject that which was being produced yesterday. Therefore, capitalist
society (civil society) is fundamentally a want-creating, and not a want-satisfying, mechanism.
An unchanging pattern of wants is the hall mark of non-capitalist societies, such as religious ones.
Tastes haven’t changed much in Pirbaba since the times of Abdullah’s great grandfather.
Contentment (Qana’at) and unchanging taste pattern are not compatible with the capitalist project
of utility and profit maximization because a society exhibiting such traits would not absorb the
rapid growth in the flow of goods coming on to the markets. Hence, the part of national income
devoted to create new wants always keeps increasing in capitalist societies. Manufacturers strive
to create an atmosphere which simultaneously glorifies the ‘pace-setters’ and ridicules the fashion
laggards. Women’s fashions are merely a familiar case in point. The art and fashion industries are
the perfect examples of activities dedicated to using up resources not to produce satisfaction, but
to create dissatisfaction with what people posses—to create a sense of ‘out datedness’ in
otherwise perfectly satisfactory goods. Infinite wants have somehow to be created to sustain this
rising industrial capacity.
6.3: MODELING CONSUMER PREFERENCES
This section presents the formal economic model of consumer preferences. Remember
that this model is based on assumptions about individual motivation and behavior and the
relationship between the individual and society outlined in sections 6.1 and 6.2.
Satisfying consumer preferences is said to be the ultimate goal of a capitalist society, (this
is not true as explained in sec 6.2). To analyze consumer preferences, we need to analyze consumer
behavior, the way a consumer reacts under different economic settings. Before we start, it will be
useful to learn how economic goods are perceived by “homo-economicus”. There are innumerable
commodities that Bush wants to use. We need some way to reduce the complexity to handle
consumer choice. Let’s pick fish and coconut. The reason to start with two goods is that we can use
a two dimensional graph. Consider a point showing the quantity (4, 3) as point A in figure 6.2.
Figure 6.2: Consumption bundles
Coconut
B
5
4
3 A
0 1 2 3 4 5 Fish
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The first number represents the quantity on the horizontal axis, 4 units of fish, and the second
entry shows the quantity on the vertical axis, 3 units of coconut. Such a pair of non-negative
numbers shows a consumption bundle or basket of commodities. Point B also represents a
consumption basket. The smallest consumption bundle can be, of course, (0, 0) which is the
origin of the graph. Negative quantities do not appear for nobody can consume -1 unit of
anything. We can think of a number of such pairs between two commodities and compare them in
two general relationships which are as follows.
The Strict Preference Relation
Consider the following choice situation:

A B
3 fish 7 fish
4 coconut 5 coconut
Suppose Farooq is offered a choice between bundles A and B each Friday. If he chooses bundle A,
we say that Farooq prefers A to B, denoted by,
APB spoken as “A is strictly preferred to B”
If A P B to Farooq on a certain Friday, then B P A is not true at the same time because that is
inconsistent behavior. Note that we stay nothing about why he prefers A to B because, as noted
above, economists deal with given consumer preferences. All that is important is the fact that he
makes a consistent choice between a pair of commodities.
The Indifference Relation
But suppose that sometimes Farooq chooses A sometimes he chooses B. Farooq may then
be said to be indifferent between the two bundles. Hence,
AIB “A is indifferent to B”
By indifference, we mean that Farooq doesn’t care whether he consumes A or B; i.e. he will be
equally happy with both of them. We can say that Farooq will be ready to receive any bundle if a
coin is tossed to decide which bundle he receives. Note that if A is considered indifferent to B then
this must mean that B is also considered indifferent to A. Also both A P B and A I B cannot be true
at the same time. This is because if A P B, then B cannot be equal to A at the same time—Farooq
prefers bundle A to bundle B, he cannot at the same time be indifferent between them.
Based on this information, we can conclude that if we consider a pair of different
consumption bundles A and B, a consumer can have three possible reactions to these pairs:
A P B: A is preferred to B
or B P A : B is preferred to A
or AIB: A is regarded as indifferent to B
Equipped with this information, we can model consumer preferences as understood by economic
theory.
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6.3.1: Assumptions about Consumer Preferences: Rationality Conditions
Economics analyzes the behavior of only “rational” consumers and in its view, as we
have seen above Abdullah Zaghazai is irrational. The question is: ‘who is a rational consumer?’
The following four assumptions define the minimum conditions underlying the economic
conception of consumer rationality. The rational individual must posses these characteristics.
A. Completeness or Comparability
This assumption says that the consumer is fully aware of his tastes and can always
compare and rank all commodity bundles. Technically speaking, given any two bundles A and B,
the consumer must be able to decide whether he prefers A to B or is indifferent between them,
that is, one of the following statements must be true:
APB or BPA or AIB
Economists cannot say anything about the consumption behavior of an individual if he is unaware
of his taste. If Farooq cannot compare commodity bundles in terms of preference or indifference,
then economists can’t say what Farooq will choose to do. Completeness of preferences is a strong
assumption, as it requires complete information of all the relevant outcomes of an action. In the
real world, Farooq usually faces uncertainties and has to take risks. Economists simply rule out
the possibility of uncertainty in their formal analyses of consumer behavior. This implies the
existence of an all-wise and all-knowing consumer (see Box 6.2 at the end after reading this
chapter)—the consumer is not only sovereign, he is also God.
B. Transitivity
By transitivity, economists mean that given any three commodity bundles, A, B and C
if A P B and B P C then A P C. This idea is very similar to the mathematical notation: if A > B
and B > C, then A > C. Transitivity is not a pure statement of logic, however it is a hypothesis
which presumes that individual’s choices are consistent. Consider a person who prefers ice cream
(I) to burgers (B) and burgers to fish (F), but then also says that he prefers fish to ice cream. Is his
choice pattern rational? Not according to the economists. Look at table 6.1 which ranks Farooq’s
preferences. His first statement places ice-cream above burger and his second statement places
burgers above fish. Therefore, ice-cream must precede fish in ordering. But his third statement, in
contrast, puts fish ahead of ice-cream, and his preference ranking becomes in-determinant.
Table 6.1: Ranking Preferences.
Statements Ranking
i. I i. I
1. I P B implies
ii. B ii. B
Imply IPF
i. B iii. F
2. B P F implies
ii. F
i. F Not possible due to contradiction
3. F P I implies Implies FPB
ii. I with statement 2
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Therefore, we say that consistent choices can take place only if preferences satisfy the transitivity
axiom. Otherwise economic theory will not be able to identify choice patterns.
C. Greed
It is not possible to rank preferences of an individual for different commodities without
answering the question, ‘what is consumption for?’ This purpose of consumption is given a
technical name by economists non-satiation. Economics presumes that the consumer always
prefers more of all goods; he prefers more of any bundle to less of that bundle, called ‘more is
better’ because it is more. If bundle A contains one unit more of at least one commodity than
bundle B, then bundle A must be preferred to bundle B by the rational consumer. Thus, a
consumer prefers bundle (3x, 2y) to bundle (2x, 2y) because the first bundle contains at least one
unit more of commodity x. Unlike the first two assumptions, this assumption is not a technical
one. Rather, it expresses the psychological and spiritual state of the consumer. According to this
assumption, a rational consumer is “naturally” greedy and it is exactly this bizarre impulse that
constitutes the rationality of the consumer. The rational individual is one who is greedy. Greed
is the essence and the most important constituent of his rationality.
This choice of greed as a standard of rationality is not an arbitrary one. Recall that
economics begins with an unjustified presumption that wants are (and should be) infinite and,
hence, it is always impossible to satisfy all of them. Therefore, a rational individual is one who
always wants more; that is he must be greedy. Moreover the attainment of economic efficiency is
guaranteed when society is dominated by greed. People committed with the desire to keep on
increasing their consumption or standard of living will exert them for enhancing efficiency.
Contented people, like Abdullah’s sufi sheikh, will not worry about efficiency for very much
because the ideal of religious rationality is Zuhd, Faqr and Qana’at. The absence of contentment
(qana’at) is a necessary condition for consumer rationality to hold.
D. Independence
Almost all microeconomics textbooks leave an important condition for rationality; i.e. of
independence. The axiom is concerned with the relation between ‘the one’ and ‘many’. As we
saw in chapter 3 that economists study individual demand behavior in order to obtain market
demand curves. The market demand is obtained by summing up the demand curves of various
individuals. But this summation of individual demand curves is possible only if the demand
functions of all individuals are independent of each other. This means that one of the rationality
conditions is to assume the absence of interdependence between the preferences of individual
agents. Alternatively stated, the independence assumption says that a rational consumer is one
who seeks to promote only and only his own self-interest irrespective of the concerns for others.
His choice pattern should be independent of what others think or do in the society. While
considering what to do in his life, Farooq should pay no attention to what his parents expects him
to do. Neither should Farooq try to imitate what his peer has been doing throughout his life.
Instead Farooq should consider himself an autonomous and self-determined being. He should
recognize others but only in the capacity of another isolated self-interested selves incapable of
evaluating the quality of desires and feelings held by the others in society.
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6.3.2: From Assumptions to Indifference Curves
These four assumptions form the basis of consumer behavior analyses. Thus a rational
consumer is one (a) who is happy to be greedy and (b) makes logically consistent choices based
on his greed. There is one more technical assumption that we will add later. Now consider figure
6.3 where we have shown two axes representing a consumer’s consumption of the two
commodities x and y.
Figure 6.3: Representation of preference relations
y
A
5
II
B I
4
3
U
III
2 D
IV
C
1
0 1 2 3 4 5 x
Given our assumptions, we know that the consumer can indicate either preference or indifference
between all commodity baskets. This information can be used to rank all of the consumer’s choices.
Let’s pick a certain consumption bundle, say U (3x, 3y) and find the bundles that are preferred to
and are considered indifferent to it by the consumer. We have divided the diagram into four
quadrants around point U. Any point in the first quadrant will be preferred to bundle U as it contains
more of both goods (recall ‘more is better because it is more’).
Similarly, any point in the third quadrant will be less preferred than U because it consists of
less of both the goods; e.g. C (1x, 1y) in this region. So we can say that any curve that is passing
through point U and representing those bundles which are considered indifferent to each other
cannot enter the first or the third quadrant of this diagram because all bundles in quadrant I are
preferred to U while all bundles in region III are considered to be worse than U. Now we are left
with quadrants II and IV. It is possible that all points that fall in these quadrants might be
considered to be indifferent to U. Why? Consider point B which consists of more y but less x than
bundle U. The reduction in x decreases utility; however the increase in y raises it. It is reasonable
to assume that both of these effects, negative and positive, might offset each other and the
consumer obtains the same utility as at point U. The same reasoning applies for point D in the
quadrant. Through this procedure we have located some points which contain all those bundles
which may be considered to be indifferent to U; these points yield the same utility as it. If we join
such bundles that are considered by the consumer to be indifferent to each other by a curve, then
this curve must pass through quadrants II and IV. Such a curve is drawn in figure 6.4 (forget
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about its exact shape for the moment, which we discuss shortly). This curve is called the
indifference curve, (labeled I0). It shows all combinations of two goods that are considered
indifferent to each other; because they yield equal utility to a consumer. The utility level is
constant at all points of the curve passing through points B, U and D.
Figure 6.4: An indifference curve
y
A
5
B
4
3 I1
U
D
2
1 Io
0 1 2 3 4 5 x
The Indifference Map
Note that there was nothing special about point U to begin with. We could start with
point A instead and could derive all the points that could be considered indifferent with it and the
resulting curve would be I1 as shown in figure 6.4. Because of the assumption of greed
economists assert that bundles on the indifferent curves farther from the origin must be preferred
to the bundles on curves closer to the origin as the former contain more of at least one good.
Figure 6.5: The indifference map

y
2 I3
1 I2
I1
Io
0 1 2 3 4 5 x
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The bundle A on I1 is preferred to all bundles on I0 due to the implications of the transitivity
assumption: (if A P U, and U I B and D, then A P B and D).
Look at figure 6.5 which shows a number of indifference curves. As we move up and to
the right in this figure, we are reaching indifference curves containing more preferred
consumption bundles. Such a graph is known as an indifference map. It shows a set of
indifference curves representing the utility a consumer can obtain from all possible consumption
options. It is possible to construct an infinite number of such indifference curves given the taste
of a consumer. Let us discuss some of the vital properties of indifference curves.
Property 1: Indifference curves are negatively sloped
The assumption of greed implies that indifference curves must be negatively sloped.
Upward sloping indifference curves will violate this assumption. To see this, consider figure 6.6
where bundles A and B lie on a positively sloped indifference curve. Can these two bundles be
considered as indifferent by the consumer?
Figure 6.6: Slope of the indifference curve
B
3
A
2
0 1 2 3 4 x
Obviously not, because bundle B contains more amounts of both commodities than
bundle A. Bundle A could be considered indifferent to B only if we rule out the assumption of
universal greed (non-satiation). This of course is never allowed by economics. Therefore, the
relation between A and B is of preference, and not of indifference. Bundles that could be
considered to be indifferent to each other must fall on a negatively sloped curve (recall quadrants
II and IV of figure 6.3). The negative slope of the indifference curve conveys the idea of
commodity substitution—the smaller quantity of one good is compensated by a larger quantity of
another to keep utility constant.
Property 2: Indifference curves can’t intersect
To see why this is so look at figure 6.7 where this situation is depicted. This case is
unfeasible according to the assumptions underlying consumer preference theory. Bundle A is on
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both the curves. By definition, the consumer considers bundle A to be indifferent to B as they fall
on the same indifference curve I0. So, we get the information:
From indifference curve I0 AIB
Figure 6.7: why can’t indifference curve intersect
C
B
A
I1
Io
0
x
But, bundle A and C can also be considered indifferent to each other because they fall on the
same indifference curve I1. So,
From indifference curve I1 AIC
These two statements imply that B I C by the assumption of transitivity. But we can see that this
is a violation of the assumption of greed because bundle C contains more commodities than
bundle B, so it must be preferred to B. If the two indifference curves were distinct from each
other, then B cannot be equal to C, but we have shown that they are the same. Nothing
distinguishes the two curves if point A lies on both of them. The underlying assumption of
universal greed and transitivity necessitate that indifferent curves cannot intersect. There can be
one and only one indifference curve passing through any point.
Property 3: Higher Indifference curve shows preferred bundles
This property is a straight forward implication of the assumption of greed, as explained in

figure 6.4 above. Due to this assumption, all bundles that fall on an indifference curve farther
from the origin are preferred to those bundles that fall on an indifference curves closer to the
origin.
So far we have been able to locate the position of indifference curves. However, its exact
shape not has been determined. Even if we know that bundles that are considered to be indifferent
to each other, such as A and B, must be joined by a negatively sloped curve, nothing rules out any
of the shapes of indifference curves shown in the left and right panels of figure 6.8. Economists
impose another assumption on the taste of the consumer to give a precise shape to the
indifference curve. This assumption implies convexity. The importance of this assumption will be
revealed in chapter 6 when we discuss the idea of consumer equilibrium. Let us understand its
meaning and implication for the shape of the indifference curve at this stage.
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Figure 6.8: Shape of indifference curve?
y y
A A
A A
B
B
B
B
0 0
x x
E. Convexity
Convexity is a mathematical property of a function. In consumer behavior theory, it

means that a weighted average sum of any two bundles of commodities, say bundles A and B, is
preferred to those bundles themselves. To understand this idea, let us first understand the concept
of ‘weighted-average’. Suppose you teach two classes, class a and b, each comprising of 20
students. Further assume that each class contains 10 boy (B) and 10 girl (G) students. Suppose
you want to develop a new class of 20 students containing 50% students from class a and 50%
students from class b. This means that you will pick up 10 students from class a (5 boys and 5
girls) and 10 from class B (5 boys and 5 girls). The new class, say class c, thus created will be a
weighted-average representative of classes a and b. The representation of each class in the new
class in this case is 50%. Similarly, we can construct any new class out of the two classes with
different proportions of representation. Table 6.1 shows some examples:
Table 6.1: Proportionate Representation

Actual Class a = (10 Ba, 10 Ga)
Actual Class b = (10 Bb, 10 Gb)
New class with 50% representation of each class c = (5 Ba, 5 Ga, 5 Bb, 5 Gb)
= (5 Ba, 5 Bb, 5 Ga, 5 Gb)
New class with 80% representation of class a and 20% d = (8 Ba, 8 Ga, 2 Bb, 2 Gb)
of b = (8 Ba, 2 Bb, 8 Ga, 2 Gb)
New class with 20% representation of class a and 80% e = (2 Ba, 2 Ga, 8 Bb, 8 Gb)
of b = (2 Ba, 8 Bb, 2 Ga, 8 Gb)
Thus, each class, c, d and e, is a weighted-average sum of the classes a and b with different
proportions. With this understanding of weighted-average, consider bundles A (2x, 4y) and B (4x,
2y) in the left panel of figure 5.9. We can construct a new bundle, say C, by taking some amount
of x and y from bundle A and some amount from bundle B. That bundle will be a weighted-
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average of bundle A and B. Suppose we take 50% of x and y from bundle A and 50% from B.
Such a bundle will contain 3x and 3y as:
Bundle C = [(0.50 × 2xa + 0.50 × 4xb), (0.50 × 4ya + 0.50 × 2yb)]
Bundle C = [(1xa + 2xb), (2ya + 1yb)] = (3x, 3y)
Figure 6.9: Representing proportionate bundles
y
y
4 A A
4
D = (0.75×xa, 0.25×xb,
3.5 0.75×ya, 0.25×yb)
3 C = (0.5×xa, 0.5×xb,
0.5×ya, 0.5×yb)
2 B B
2
0 2 3 4 x 0 2 2.5 4 x
This bundle falls exactly in between the two bundles A and B. Similarly, we can construct another
weighted average bundle; say D, with 75% weight of A and 25% of B as:
Bundle D = [(0.75 × 2xa + 0.25 × 4xb), (0.75 × 4ya + 0.25 × 2yb)]
Bundle D = [(1.5xa + 0.5xb), (3ya + 0.5yb)] = (2.5x, 3.5y)
and this falls closer to bundle A (see the right hand panel) because the weight of bundle A was
assumed to be greater (75%) than B (25%) in this bundle. But it is important to note that both
bundles C and D fall on the straight line joining bundles A and B in both diagrams. This is a
general result; the weighted average of any two bundles, say A and B, will fall exactly on the line
segment joining those two bundles. The exact location of that weighted average bundle on the
line segment AB depends upon the weights assigned to each bundle. If bundle A is given greater
weight than B, the new bundle will fall closer to A on the line segment AB.
You might be tempted to ask, why are we doing all these messy calculations for
developing weighted average bundles? “Let us go back to the assumption of indifference curve
convexity. It says that a weighted average sum of any two bundles, say bundles A and B, is
preferred to those bundles themselves. Then according to this assumption, bundle C and D, will
be preferred to both bundles A and B. And not only bundles C and D, but all bundles on the line
segment AB must be preferred to both A and B because the line segment AB represents all
weighted average bundles of A and B. This is exactly what the assumption of convexity means.
Intuitively, what the assumption of convexity says is that people have a taste for variety in their
consumption. That is, instead of having ‘4 units of coconut and 1 of fish’ or ‘1 of coconut and 4
of fish’, the individual will prefer to have a mixture of them, say (3, 3), and that mixture would be
preferred to either extreme bundles, generally speaking, we assume that balanced bundles are
preferred to the bundles that are heavily inclined towards one commodity, such as bundles A and B.
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Property 4: Indifference curves are convex to the origin
The assumption of convexity helps economists derive the exact shape of the indifference
curve. If A and B are considered to be indifferent to each other, the problem is to find another
point that is indifferent to A and B so that a curve joining A and B could be obtained. To see what
such a curve would look like, consider the left panel of figure 6.10. Draw a ray such as OR from
the origin crossing the line segment AB at some point such as C.
Figure 6.10: Convexity of IC

y y
A A
R R
D
C D
C E
B B
0 x 0 x
In order to find another bundle that is considered indifferent to A and B, ask the question: on ‘which
side of the line segment AB will that point fall on ray OR”? First, think of a point like D on ray OR
to the right of the line segment AB (see left hand panel). This bundle cannot be considered as
indifferent to A and B. To prove this, note that bundle C on the line segment AB is a weighted
average bundle of A and B. By the convexity assumption we know that C P A and B. Further we
also know that D P C due to the greed assumption. Therefore, transitivity of preferences implies
that D P A.
An indifference curve joining A and B cannot pass from any point to the right of the line
joining bundles A and B, as shown in the left hand panel of Fig 6.10. For a similar reason, a point
considered to be indifferent to A and B cannot be on the line segment AB. This is so because the
line segment AB shows the weighted average bundles of A and B, and by the convexity
assumption all weighted average bundles of A and B are supposed to be preferred to A and B
themselves. Now we are left with the region to the left of line segment AB as the only available
area to find an indifferent bundle. This means that any point considered as indifferent to A and B
must be to the left of the line segment AB as this does not violate any of the economist is
assumption about consumer preferences. For example, consider a point like E to the left of the
line segment AB in the right hand panel of this diagram. Such a point can be accepted as
indifferent to A and B because you can clearly see that C P E (on the basis if the greed
assumption) and also C P A (on the basis of the assumption that weighted averages of two bundles
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are proffered). Thus we conclude that an indifference curve joining points A and B must be convex
to the origin. We will see in the next chapter that the assumption of convexity of indifference curves
will ensure that there exists a unique solution to the consumer choice problem.
Convexity and the Slope of the Indifference Curve
Now we have derived the exact shape of the indifference curve. Let us understand the
geometry of its shape. Algebraically, the average slope of an indifference curve between any two
points is given by the change in the quantity of good y divided by change in the quantity of good x,
and it is negative:
∆y
<0 (6.1)
∆x
This is the standard way of writing the slope, the rise over the run, meaning change in the
variable on the vertical axis divided by the change in the variable on the horizontal one. Note that
the slope term is negative because indifference curves are negatively sloped. However, since the
indifference curve is a ‘curve’ and not a ‘straight line’, its slope changes between any two given
points. Therefore, the exact slope of the indifference curve at any point is given by the slope of
the line tangent at that point. We have shown such tangents at Z and U (the dashed lines) in
figure 6.11. Note that the slope (the tangent) of the indifference curve becomes flatter as we
move down from left to right (compare the tangent at point Z and U). This means that the slope of
the indifference curve gets shallower (less steep) as we move down from left to right.
Figure 6.11: Slope of the indifference curve

y
Io
0 x
Indifference Curve as Representative of Taste
What does the slope of the indifference curve mean? Consider two individuals Farooq
and Nomi, with their distinct indifference curves. We try to compare the preferences of two
individuals at point Z in figure 6.12. If we take some x away from Farooq, say ΔxF (= 1) unit, we
need to give him ΔyF (1 unit) y to keep him on the same indifference curve IF. But taking the
same amount of x from Nomi requires much more y (2 units) to compensate him, as his
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indifference curve has a steeper slope at point Z. We can say that Farooq will be willing to
sacrifice 1 unit of x to get 1 additional unit of y, or alternatively, he will forgo 1 unit of y for one
additional unit of x. Thus, we see that for Farooq, the value of ΔxF (1 unit of) x is ΔyF (1 unit of) y
while for Nomi, it is ΔyN (2 unit of) y. So, the value of the slope of the indifference curve of
Farooq is:
 ∆y 
F
1
  = − = −1
 ∆x  1
And that of Nomi it is:
 ∆y 
N
2
  = − = −2
 ∆x  1
where the negative sign shows that increase in one commodity must be off-set by fall in another
commodity in order to keep utility constant on both bundles.
Figure 6.12: Meaning of the slope of IC
y y
Farooq Nomi
∆yN =
∆y =1
F
Z Z
∆x IF ∆x N
IN
F
= =1
0 x 0 x
What do the numbers 1 and 2 measure? Remember that the slope of the indifference curve measures
the utility yielded by one commodity in terms of another. It is a relative concept. It measures the
utility yielded by x in terms of that of the utility lost by not consuming one unit of y. So,
For Farooq at point Z → 1 x = 1 unit of y
For Nomi at point Z → 1 x = 2 units of y
Furthermore, it is the rate at which the consumer is willing to substitute the good on the vertical
axis with the additional unit of the good on the horizontal axis so that his utility level remains
constant. For example:
For Farooq at point Z → Rate of exchange of y for one extra unit of x is 1
For Nomi at point Z → Rate of exchange of y for one extra unit of x is 2
This rate of substitution between x and y, or any commodities, at constant utility level is
called the marginal rate of substitution (MRS). With this added information, we can define the
slope of indifference curve algebraically as:
 ∆y 
MRS xy = − −  (6.2)
 ∆x 
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Note that MRS is defined as the negative of the slope of the indifference curve. Since the
slope of the indifference curve is itself negative, therefore MRS is a positive number. Also note
that this trade-off between two goods is supposed to be voluntary, the consumer is not forced to
accept it. He himself makes utility evaluations of different commodity bundles and then decides
at what rate he should exchange the two goods. In other words, the slope of the indifference curve
is expected to show voluntary exchanges that an individual is willing to make. Recall that at the
start of this chapter, we defined the taste of an individual as all hypothetical exchanges that he is
willing to make. Thus the indifference curve is a representative of consumer taste. The steeper
indifference curve implies a stronger taste for the good on the horizontal axis (because with a
steep indifference curve, Nomi is willing to sacrifice many units of y for one additional unit of x),
while a flatter indifference curve shows a stronger taste for the commodity on the vertical axis (e.g.
1y = 1x for Farooq with flatter indifference curve while 1y = ½ x for Nomi with the steeper one).
Diminishing Marginal Rate of Substitution (DMRS)
Look at figure 6.13 below and move from point A to B. As we do so, we are adding more
x to the consumption and reducing y. From A to B, the consumer is willing to substitute one unit
of x at a sacrifice of two units of y. But at C, the consumer is willing to substitute one unit of x by
giving up only ½ y. Note that the substitution ratio at C is smaller than at A. Thus, starting from
point A and moving to B, we find that the consumer is willing to sacrifice many more units of y (2
units) for x than he is willing to do when he moves from point C to D. Thus, as more and more of
x is added to his consumption, he is expected to be willing to give up lesser amount of y for an
additional unit of x and hence the value of MRS decreases. Economic rationality requires that we
expect the consumer to give up fewer amount of another good as more of one is consumed
whatever the goods that are being consumed. Suppose Farooq is spending money on going to haj
(x) and on buying footballs (y).
Figure 6.13: Marginal Rate of Substitution
y
MRS = 2
A
∆y=2
B
MRS = ½
C
∆y=½ D
Io
x
∆x=1 ∆x=1
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The utility yielded by buying footballs will increase as the number of haj performed by Farooq
increase—if he has gone for haj 20 times he will enjoy spending money by buying footballs
(rather than Ahram) than if he had never been to haj. Economic rationality assumes that Farooq’s
love for haj will necessarily decline as he performs it again and again. This tendency of
decreasing rate of substitution between x and y is called diminishing marginal rate of
substitution. This means that Farooq is greedy as such, not greedy for any particular commodity.
He wants more of all things not of a particular thing. Competition is the capitalist way of life, not
just a means for getting on a particular thing.
Summarizing the above discussion, we can say that the slope of the indifference curve
measures the consumer’s rate of substitution (MRS) between two goods. When indifference
curves are expected to be convex the slope of the indifference curve diminishes which implies
diminishing marginal rate of substitution between commodities that are being consumed.
It is important to realize that indifference curves do not exist—they cannot be directly
observed. All that we can observe in the market are specific prices and specific amounts of
commodities purchased. How much utility is yielded by the consumption of any particular bundle
of commodities is neither observable nor measurable. Economics assumes that rational consumers
ought to behave in the way that indifference curves portray him to behave—this is another proof
of the necessarily normative character of economic analyses. Abdullah is accepted as rational
only if he seeks to maximize utility generally. The diminishing marginal rate of substitution
assumption implies that Abdullah must derive utility from consumption as such—not from the
consumption of a particular commodity. Abdullah is irrational if he derives “utility” only from
spending on haj and never plays football at all. If he derives “utility” only from going to haj,
utility collapses and going to haj becomes an end in itself. Economic theory insists that a person
is rational only if he regards utility maximization (maximization of his ability to consume
everything; i.e. freedom) alone as an end itself. Everything else is a means for achieving this
supreme, over arching, dominant end in itself. Utility thus has a specific meaning. Utility is
maximized only when we seek to be free—to consume more and more of everything. If Abdullah
goes for haj to express his freedom, it shows that he can consume anything he wants to consume.
We can legitimately say that he derives utility from performing haj as he does from consuming
other commodities. If he goes for haj because God commands him to, he is “harmoniously”
rejecting freedom and it would be nonsensical to speak of his “utility” in circumstance where
Abdullah seeks ma’arifat. We simply would not know what to put on the y-axis. It would be
meaningless to speak of his “indifference curve”, its “convexity” and the marginal rate of
substitution.
6.4: TASTE FOR SPECIAL COMMODITIES: EXAMPLE OF IC
In this section, we use indifference curve maps to illustrate the taste for different kinds of
commodities in order to consolidate the understanding about indifference curve. Let’s first define
a general way of constructing an indifference curve for the capitalistically rational consumer.
1. Make a point on a graph paper, say (xo, yo) along two axis showing different amounts of
commodities x and y.
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2. Now think what would happen if you give a little more of x, say Δx to the consumer to take
him to the point (xo + Δx, y).
3. Now ask how the consumption of y should be changed to make the consumer indifferent
between the old and new situation, that is (xo, yo) and (xo + Δx, yo + Δy).
4. After you have determined this movement, you have drawn a point of an indifference curve.
Now let us consider different types of consumer goods in capitalist society.
An Economic Bad
Economic theory does not regard that all goods are not “good”, some of them are bads. A
good is bad for a consumer if it reduces his utility. Suppose that a consumer does not like
cigarettes and there is a trade-off between cigarettes and fish. How can we represent his taste for
such a commodity? Suppose we start at point (5, 0); 5 units of fish and 0 units of cigarettes, in
figure 6.14 (point A). What if we increase the amount of cigarette by one unit holding the amount
of fish at 5 units, bundle B? Since each additional unit of cigarette will decrease the consumer’s
utility the bundle B will be worse than A because it contains more units of cigarette which is a bad
commodity. What do we have to do to put our consumer on the same indifference curve; that is to
keep his utility constant? Because additional cigarettes reduce his utility level, we have to give
him some extra fish to compensate him for additional cigarettes, such as bundle C (6, 1) which
contains one unit more of both the goods as compared to bundle A (5, 0). This suggests that the
indifference curve will slope upward as depicted in this figure 6.14.
Figure 6.14: IC for an economic bad
Cigarett
Io I1
B C
1
A
0 5 6 Fish
A Useless Good
A good is classified as neutral or useless if it does not increase the utility if the
consumer. Suppose that Farooq is neutral about the consumption of Pepsi. This means that adding
Pepsi into his consumption basket does not increase his satisfaction. Only by consuming
additional, fish can his utility increase. In this situation, his indifference curves will be vertical
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lines because Farooq only drives utility from fish and the number of Pepsi drinks he consumes
make no difference to him. These curves are drawn in figure 6.15 (the arrows are indicating the
direction of preferences). The more fish Farooq has the greater his utility but adding Pepsi makes
no difference to. For example, the vertical line Io represents the utility level I0 as long as he has 5
units of fish no matter how many Pepsis he consumes. Extra utility derived from an additional
unit of a neutral good is always zero.
Figure 6.15: IC for neutral good

Pepsi Io I1 I2
0 5 10 Fish
Perfect Substitutes
Convex indifference curves were drawn on the assumption that consumers have taste for
variety in consumption bundles. What if the two goods are perfect substitutes, goods that yield
equal utility to a consumer and he does not care how much he has of one commodity or the other?
Consider a choice between two types of pens, Picasso and Piano. Figure 6.16 shows this situation.
Figure 6.16: IC for perfect substitute
Picasso
Io I1
5
0 5 Piano
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Suppose we start with a particular bundle (5, 5). Then any other bundle that contains 10 pens in it is
just as good as this bundle. Because the consumer does not care which pen he has, he is always
willing to trade one Picasso pen with only one pen of Piano, Thus, MRS along this indifference
curve is 1 at all points. The indifference curves are straight parallel lines for such goods.
However, the one-to-one exchange rate is the simplest of the cases of perfect substitutes;
it is not a general one. The important fact about perfect substitutes is that the indifference curves
have constant slope, the slope can be more or less one, say 3. In that case, one commodity is
substituted for three units of another good.
Perfect Complements
Goods are said to be perfect complements if they are always used together in some fixed
proportion. The famous example is that of a right and left shoe. The consumer always uses a pair of
shoes. Having only one out of a pair of shoes does not increase the utility level of the3 consumer.
Again, start with some point, say (2, 2). Now add one more right shoe to the consumption bundle.
This will not increase the utility of the consumer and will leave him indifferent with the original
bundle. It is only the extra pair of shoes that will increase the utility of the consumer and put him
on a higher indifference curve. Thus, the indifference curve is L-shaped in figure 6.17 centered at
45o line coming from the origin. Remember that the important thing about perfect complements is
that they are used in a fixed proportion, but that proportion is necessarily is one-to-one. As an
example, suppose that a consumer always uses two teaspoons of sugar in a cup of tea and does
not use it for any other purpose. In this situation, the corner of the L shaped indifference curve
will occur at (2 teaspoon sugar, 1 tea cup), (4 teaspoon sugar, 2 cups of tea) and so on.
Figure 6.17: IC for perfect complement
Left Shoe 45o
I2
I1
2 Io
0 2 3 Right Shoe
Recall that indifference curve maps reflect consumer’s preferences about the goods they
choose, in the market; such maps provide us with the first building block for analyzing consumer
behavior through their choices. The next sector, opportunities, will be taken up in the next
chapter. Note that goods are differentiated only in terms of the contribution they make to utility
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(negative, zero, prehorticuate) i.e. to the capacity of the consumer to consume anything and
everything. All other qualities of goods are disregarded.
6.5: THE UTILITY FUNCTION
Economists use utility as a measure of consumer welfare or well-being. A person’s

preferences are summarized by a utility function. Preferences are always represented in utility
functions because the capitalist consumer seeks the fulfillment not of a particular preference but of
preference in general—i.e. utility. The utility function shows information given by the preference
relation. It represents an individual’s taste or preferences regarding the consumption of various
bundles of goods. A utility function U(A) is a way of arbitrarily assigning a number such as 2.6 or
5 to every bundle of commodities. The number of more preferred bundles is larger, and higher A
number means a more preferred bundle. That is, we say that if a bundle A(x1, y1) is preferred to
bundle B(x2, y2), this means that the utility obtained from bundle U(A) is greater than that from
U(B). Symbolically, we state it as: (x1, y1) > (x2, y2) if U(x1, y1) > U(x2, y2). Let’s see how
indifference curves are generated from a utility function.
6.5.1: Indifference Curves and Utility Functions
A question must be teasing you: what does it mean that a utility function assigns an
arbitrary number to each indifference curve? Consider the utility function,
U = f (x , y ) (6.3)
Where x and y are the quantities of consumerables x and y. This function says that the utility the
consumer derives depends upon the consumption of these two goods. To simplify the nature of
analysis, we have assumed that the consumer has only two goods to consume, this restriction
allows a geometric presentation of the results. Nomi is always willing to give up some amount of
one commodity to get an additional amount of the other. We know that the maximum amount he
is willing to give up of one good, say y, to get one extra unit of x is that amount which leaves him
indifferent between the old and new situation because his utility remains the same. That is how
trade-offs were described, and this shows an indifference curve (recall the concept of MRS). If all
combinations of two goods along an indifference curve are regarded as being indifferent to each
other by the consumer it is assumed that this is so because they give equal utility. Therefore, to
covert the utility function (6.3) into an indifference curve equation, we have to hold the utility
level, U, constant in (6.3) as
U = f (x , y ) (6.4)
and then find out all combinations of x and y which give that constant level of utility. See
Application Box 6.1 to understand this idea.
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Generating Indifference Curves
Consider a simple utility function:
U=x×y (6.1.1)
This is a mathematical form of the utility function (6.3). It says that utility attained from any
bundle of x and y is the product of the amounts of x and y consumed. For example, a bundle (2x,
3y) will give a utility equal to 2 × 3 = 6 utils. Note that the bundle containing more units of x and
y will give higher “utility” level according to this function, e.g. the bundle (3x, 3y) produces U =
3 × 3 = 9 utils. Thus, this function attaches a number to each consumption bundle. Some of these
numbers are shown in this table.
Bundle U=x×y
(2x, 3y) 6 utils
(3x, 3y) 9 utils
(3x, 4y) 12 utils
(4x, 2y) 8 utils
However, there is nothing special about function (6.1.1) to begin with. This function can take
some other mathematical form as well. One of its example is:
U = x× y (6.1.2)
Note that this function will assign a different number to each consumption bundle as compared to
function (6.1.1) as shown in below table.
Bundle U = x× y
(2x, 3y) 2.45 utils
(3x, 3y) 3 utils
(3x, 4y) 3.46 utils
(4x, 2y) 2.82 utils
The point here to note is that the exact mathematical form of such a function does not matter and
like the numbers assigned to x and y is chosen arbitrarily. Such transformations of utility
functions are nothing but a redrawing of indifference curves. It makes no difference whether we
label an indifference curve by 10 or by 100 utils because these numbers are arbitrarily used to
reveal the (necessarily subjective) ranking of different bundles, not the intensity of their demand.
What matters are the fact that the function must assign a specific number to each consumption
bundle and a higher number is attached to preferred bundle containing at least one more unit of a
commodity.
To generate indifference curves from such utility functions, recall that the indifference curve
shows all combinations of x and y where utility level is expected to be constant. Thus, in function
(6.1.1), we fix utility level at some arbitrary level, say 100 “utils” to obtain:
100 = x × y (6.1.3)
In this function, x and y take only those values for which utility remains at 100 “utils”. Note that
the function shows one equation with two unknowns x and y. For solution, we solve the function
for one independent variable in terms of another, that is:
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100
x= (6.1.4)
y
In this solution, x always adjusts to any value of y so as to keep the function equal to 100. The
following table gives some x-y values associated with 100 utility level.
∆y
U = x × y = 100 x Y MRS = −
∆x
100 4 25 -
100 5 20 5
100 8 12.5 2.5
100 12.5 8 1
100 20 5 0.4
100 25 4 0.2
If you join all those values of x and y for which the utility is 100, you will get an indifference
curve like the one in the figure below.
Note that MRS is decreasing along this indifference curve illustrating that the consumer prefers
more utility as such and not any particular commodity. So, for any mathematical function to be
used as a utility function, it must posses the property that MRS decreases along the indifference
curve generated from that function. Thus, (6.1.4) is a valid equation for indifference curve and
labels it as U = 100.
30
y
25
20
15
10
5
U = 100
0
0 5 10 15 20 25 30
x
Further note that increasing the level of utility from 100 to, say, 110 will generate a higher
indifference curves because either x or y will take a larger value to make 110 “utils” than they
191
took to make 100 “utils”. For example, the following table keeps the values of x at the same level
as in the above table but the values of y are different:
∆y
U = x × y = 110 x Y MRS = −
∆x
110 4 27.5 -
110 5 22 5.5
110 8 13.75 2.8
110 12.5 8.8 1.1
110 20 5.5 0.4
110 25 4.4 0.2
Joining these points will give an indifference curve of 110 “utils” and this curve will be higher
than that of the 100 util level. Both curves will depict diminishing MRS since both curves
assume that the consumer wants more utility not just more of a particular commodity.
The exact mathematical form of the utility function (6.3) depends on the function that is
arbitrarily chosen to represent consumer preferences. Economic theory postulates that such a
function must have certain well defined mathematical properties; three of them are explained in
Application Box 6.1. Some of these are reflect in the concept marginal utility in which we now turn.
Marginal Utility
As Nomi consumes more of a commodity, say x economics assumes that his utility level
keeps changing. This rate of change in total utility due to change in the consumption of one more
unit of x is called marginal utility of x. It is the extra utility derived from the consumption of one
extra unit of x. Algebraically, the marginal utility of x can be denoted as:
∆U Change in Utility
MU x = = (6.5)
∆x Change in x
Consider figure 6.18. Suppose that x and y are the only two commodities available for
consumption and that their utility can be represented by a utility function, U(x, y). Further assume
that initially Nomi is at point P in this diagram which has xp amount of x and yp amount of y. This
consumption bundle will provide a certain level of utility to Nomi, say U(P) = U(xp, yp) = Up. The
exact value of Up depends upon the particular mathematical function chosen by the economist
(see box 6.1 again if you are unable to understand this point). All bundles lying on the
indifference curve IP provide equal utility to Nomi (i.e. Up). Now consider what happens when
Nomi consumes one additional unit of x, call it Δx. Given the amount of y = yp, the new bundle
will be R (xp + Δx, yp). The additional unit of x is expected to take Nomi to a higher indifference
curve at point R. The utility level is also expected to increase while moving from point P to R
because the bundle R contains more units of x and hence falls on a higher indifference curve than
bundle P. How can we ensure that utility has increased, and not decreased, from point P to R?
Recall the assumption of greed (more is better’).
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Figure 6.18: Marginal Utility
y
∆U
MU x =
∆x
∆x
yp R (xp + Δx, yp)
IR = U(xp + Δx, yp)

∆U
IP = U(xp, yp)
0 xp xp + Δx x
This assumption ensures that an additional unit of any commodity will increase the utility
level of Nomi (who wants utility not any particular commodity). So, the bundle R gives a utility
U(R) = U(xp + Δx, yp) = UR. Thus, the indifference curve IR is labeled with this utility level. Now
the change in utility from P to R, denoted by ΔU, can be defined as the difference between utility
levels of the two bundles R and P:
∆U = U R − U P
or ∆U = U (x P + ∆x , y P ) − U (x P , y P ) (6.6)
To obtain the expression for change in utility due to change in x; that is the marginal utility of x,
divide equation (6.6) by Δx:
∆U U (x P + ∆x , y P ) − U (x P , y P )
MU x = = (6.7)
∆x ∆x
If more of x is always preferred to less of x (more is better), then marginal utility from each unit
of x will always be positive; that is each additional unit of x will give positive satisfaction to
Nomi and will not harm him. As a numeric example, let bundle P(xp, yp) = (1x, 2y) and assume
that it provides a utility of 20 “utils”. Suppose we add two additional units of x into Nomi’s
consumption bundle. The new bundle will be R(xp + Δx, yp) = (2x + 2x, 2y) = (4x, 2y). Assume
that now the utility from this bundle is 30 “utils”. The marginal utility from these two extra units
of x can then be calculated using (6.7) as:
∆U 30 − 20
MU x = = = 5 utils
∆x 4−2
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This says that each extra unit of x adds 5 “utils” to Nomi’s utility at point P. The definition of
marginal utility in (6.7) implies that we can also calculate change in utility resulting from the
change in the consumption of any commodity, say x, as:
∆U x = MU x × ∆x (6.8)
For example, if we know that MUx = 5 “utils” and 2 units of x are added in the consumption
bundle of Farooq, then change in his utility level will be 10 utils (= 5 × 2).
The calculation of marginal utility depends upon the particular utility function that we
assume will represent consumer preference ordering. The method for calculating marginal utility
from any utility function uses calculus. We cannot calculate marginal utility from consumer
preferences since preferences show only the way a consumer ranks different bundles of
commodities.
Finally, note that the amount of y is held fixed while calculating the marginal utility of x.
The marginal utility of y can also be expressed in a similar way keeping x constant as:
∆U U (x P , y P + ∆y ) − U (x P , y P )
MU y = =
∆y ∆y
MRS as the Ratio of Marginal Utilities
We have discussed the idea of MRS. Another explanation of MRS can also be obtained
applying the idea of marginal utility. Figure 6.19 plots the indifference map of Farooq. Consider
removing a very small amount of y, say Δy, at point S down to M. The reduction in y keeping the
amount of x constant will put Farooq on a lower indifference curve and, hence, his utility level is
expected to decrease which can be shown as:
− ∆U y = MU y × ∆y (6.9)
The negative sign indicates the fact that the utility level has decreased while moving from S to M.
To put Farooq on the original indifference curve, we need to give him some extra amount of x,
say Δx, for the reduced y. This is shown in the move from point M to Z. This time the utility level
will increase because more x is added to Farooq’s consumption. This increment to utility can be
expressed in the same way as for change from S to M.
∆U x = MU x × ∆x (6.10)
Since S and Z lie on the same indifference curve, both bundles represent the same level of utility.
This means that the reduction in utility going from S to M is exactly equal to the increase in utility
going from M to Z. There is no change in Farooq’s utility level from S to Z as the negative and
positive effects sum to zero. If both changes are equal, then,
∆U x = −∆U y
or MU x × ∆x = − MU y × ∆y
Solving this equation for the slope term Δy / Δx gives:
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∆y MU x
=− (6.10)
∆x MU y
Figure 6.19: Difference b/w MRS and Marginal Utility
y
S
-∆y
M Z
I1
∆x
Io
0 x
The negative sign behind the slope term shows that indifference curves are expected to slope
negatively. Remember that MRS is defined as minus the slope of the tangent (Δy / Δx) at any point
on the indifference curve. Thus multiplying the slope term by minus we have,
∆y MU x
MRS xy = − = (6.11)
∆x MU y
Note carefully that marginal utility of x is in the numerator while marginal utility of y is in the
denominator in this expression. The marginal rate of substitution is the ratio of the marginal
utilities of the goods on the horizontal and vertical axes. We can say that MRS measures the
marginal utility of the commodity on the horizontal axis in terms of the one on the vertical axis. If
this ratio is 3 for Farooq, it means that he is ready to give up 3 units of y to obtain 1 unit of x. In
other words, extra utility from one extra unit of x is three times the extra utility from one extra
unit of y. Remember that it is a relative concept. The interesting thing about MRS is that it can be
measured by observing a person’s actual behavior as revealed by his willingness to exchange two
goods. What cannot be directly measured is the utility the consumer derives from this exchange.
Difference between Marginal Utility and MRS
A common misperception is that marginal utilities and MRS are two names for the same
concept. To see the difference between marginal utility and MRS graphically, consider figure
6.18 again. As we reduce the amount of y from Z to M, the utility level changes and this change in
utility is called marginal utility. However, MRS is measured along movements from Z to S. What
is the difference? Remember that marginal utility is measured by the shift from one indifference
curve to another changing utility from one level to another; it is a change in utility. On the other
hand, MRS is measured along the same indifference curve keeping the utility level constant as
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shown in figures 6.12 and 6.13. Also see appendix to this chapter to note some other technical
differences.
FYI: B O X 6.2
The All Knowing godly Consumer
We made a comment that assumption 1 (of completeness) about consumer behavior
implies an all-wise and all-knowing consumer. Now it is time to explain this statement. This
assumption seems sensible in a two-commodity model but becomes ridicules when we consider a
typical market situation. To see this, let us consider a real world example. Suppose you are
standing in a super market which contains 1,000 different commodities. Further assume that you
have to decide whether or not to buy but one unit of each commodity. How many bundles do you
have to consider? In standard two-goods model, only 4 bundles are to be ranked: i- (0x, 0y); ii-
(0x, 1y); iii- (1x, 0y); iv- (1x, 1y). In general, the number of combinations to be considered in a
given choice situation equals:
Number of units being considered + 1, raised to the power of how many goods are
available
In our example, the consumer has to consider 1 unit of each commodity. Hence the number of
units to be considered is 1 + 1 = 2; i.e. 0 and 1.
• If there are only two goods, then total combinations will be 22 = 4 combinations
• If there are three goods, then total combinations will be 23 = 8 combinations
• If there are four goods, then total combinations will be 24 = 16 combinations
So, how many combinations in a 1,000 good super market will you have to consider? It is:
21000, or roughly 10300
How big do you think this number might be? Spelling it out in full, it is:
10,720, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
000, 000, 000, 000, 000 combinations!
To have an idea of how big this number is, think about the question ‘how big a brain would you
need to remember these combinations?’ Let us pretend that each neurone of your brain could
remember the utility of 100,000,000,000 (100 billion) combinations. Your ‘grey matter’ weighs
about one kilo: 100,000,000,000 (100 billion) neurones, each weighing 1/100,000,000 grams.
Here is a quick quiz for you: what would be the weight of so big a brain?
(1) More than your brain?
(2) More than your weight?
(3) More than our elephant?
(4) More than the earth?
(5) More than the Sun?
The correct answer is: 10224 times as much as the entire known universe! But this is not enough.
Now think about the question: If you could recall utility of each combination in
1/10,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000, 000,000,
000,000,000,000,000,000,000,000,000,000,000,000,000,000th of a second, how long would it
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take you to remember the combination with maximum utility? The answer is 10200 seconds: 10180
times the speculated age of the known universe!
What is going on here? The problem arises due to the ‘curse of dimensionality’ according to
which the number of combinations grows exponentially as more options are considered. The
point here to make is that it is practically impossible for a consumer to consider even a tiny
fraction of options available and the utility they would yield in effectively finite time.
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Key Concepts
Bads are the goods which give negative marginal utility to a consumer.
Concavity is the property of a set which says that a set is concave if a line joining any two points
in that set remains entirely below that set
Consumption bundle is the quantities of each consumption commodities that a consumer has
available for his consumption. It is shown by a point in a commodity space representing some
commodities
Convexity is the property of indifference curve which says a weighted average sum of any two
bundles, say bundles A and B, is preferred to those bundles themselves. Mathematically,
convexity is the property of a function which says that a function is convex if a line joining any
two points of that function remains entirely above that function
Diminishing marginal rate of substitution (DMRS) is the tendency of MRS to decline. The
more x one has and less of y, the less is the relative value placed on the extra unit of x compared
to that placed on y. DMRS comes from the assumption about people behavior that they have a
taste for variety in their consumption
Indifference curve represents all combinations between two goods that give equal satisfaction or
utility to a consumer
Indifference map shows a family of indifference curves representing the utility an individual can
obtain from all possible consumption options
Marginal rate of substitution (MRS) measures the rate at which the extra unit of x is substituted
with y to keep utility constant
Marginal utility is the rate of change in utility due to change in the consumption of a
commodity. Marginal utility is usually assumed to decline as more of a commodity is consumed,
other things held constant
Neutral goods are those which have zero marginal utility to a consumer
Non-satiation is a claim about consumer psyche which says that a consumer is always greedy;
i.e. he prefers more goods to less
Perfect complements are the goods that are used in specific combination with each other.
Perfect substitutes are those commodities that have equal value to a consumer and he ranks them
same in order in terms of taste
Rationality is a hypothesis about consumers by which they can make logical and consistent
choices based on universal greed
Tastes are all the hypothetical exchanges that an individual is willing to make at various terms of
trade
Transitivity is an assumption about consumer taste which says that given any triple of
commodity bundles, A, B and C if A P B and B P C then A P C
Utility function is a way of assigning a number to every possible consumption bundle such that
more preferred bundles get larger numbers than the less preferred ones
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Chapter Summary
• Economic analysis of consumer behavior presupposes that every individual is self interested.
This self-interest is the maximization of freedom. Such an individual is “homo-economicus”
• “Homo economicus” is committed to maximizing aggregate utility. Maximizing personal
utility in a way which reduces aggregate utility—i.e. everyone’s right to choose anything they
wish to choose—is considered illegitimate
• If personal utility is derived from an act which restricts aggregate utility—everyone’s right to
choose—it is regarded as “disutility” and netted out from aggregate utility calculations.
Utility is measurable only in Rupees because Rupees alone can be a measure of choice in
general, though Rupees cannot measure many specific choices such as mothers’ love
• Since the market values all acts in terms of their contribution to aggregate utility, it creates a
powerful incentive for individuals to choose private lives which increase their ability to
promote capital accumulation. That is why capitalist norms—greed, lust and jealousy—
flourish in capitalist society
• The only conception of self-interest that can be assigned value by the market is that expressed
by the commitment to maximize a (discounted) flow of consumerables over a definite time
period. The market cannot evaluate any other conception of self-interest and well being
• The consumer must choose, says economic theory, because resources are scarce. Choice is
determined by (a) tastes and (b) income. Economic theory does not specify any determinant
of tastes. This allows economists to aggregate individual tastes
• The concept of consumer sovereignty is also grounded on the assumption of the
independence of individual choices. In capitalist society consumer sovereignty is undermined
by the corporations’ quest for want creation
• Consumers must choose consistently. If they prefer A to B they are expected not to prefer B
to A at the same time. Consistency also implies that if someone is indifferent between two
commodity bundles (because they yield the same utility) he cannot prefer one bundle to
another
• Economics analyses the behavior (only) of rational consumers. ‘Rational’ consumers fulfill
the conditions of:
a) Completeness; i.e. the consumer must have the full information to be able to rank his
preferences
b) transitivity; i.e. consistency
c) greed; i.e. the consumer always prefers more to less, and
d) independence, i.e. the consumer taste is unaffected by the behavior of others
• An indifference curve shows all combinations of two consumerables which yield the same
utility for a consumer. An indifference curve farther away from the origin yields higher utility
• Indifference curves slope downwards because the consumer is expected to prefer more to
less. Upward sloping indifference curves could imply that the same utility is yielded by a
bundle with more of both commodities. Indifference curves cannot intersect because utility
yielded by points on different indifference curves is different. There can be only one
indifference curve passing though one point
• Indifference curves are assumed to be convex to the origin. This implies that the weighted
average of two commodity bundles is necessarily preferred to each of these bundles
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• The assumption of convexity implies that

o people do not want particular commodity as such
o they consume a commodity to obtain utility
o since utility is assumed to decrease as more of a commodity is consumed people
prefer to “balance” the consumption of different commodities so as to maximize
utility
• MRS is the rate of substitution of the consumption of commodity x for commodity y at a
constant utility level i.e. on the same indifference curve. MRS is the negative of the slope of
the indifference curve. Since the slope of the indifference curve is negative. MRS is positive
• The slope of the indifference curve and its negative MRS is assumed to show the voluntary
exchanges that consumers make. The indifference curve reflects the tastes of an individual
• Economics expects that MRS decreases as we move down and to the right on an indifference
curve. The consumer is willing to give up less and less of y as his consumption of x increases;
without reference to the nature of x and y. MRS is expected to diminish because the consumer
wants more of all. He is essentially greedy, not greedy for any particular thing
• If more of something is always preferred, say going to haj, over more of something else, say
playing football, then the former becomes an end in itself and utility collapses in the sense
that utility maximization can no longer be regarded as an end in itself. Utility is maximized
only when one seeks freedom
• Indifference curves have constant slopes for perfect substitutes and are L-shaped for perfect
complements. Goods are differentiated only in terms of the contribution they make to
utility—i.e. the ability of the consumer to consume everything (the preference for preference
itself). Every other quality of the good is disregarded
• The utility function represents the taste of a consumer. It shows how consuming different
bundles of commodities allows a consumer to express his preference for preference itself—
i.e. utility
• Marginal utility is the rate of change in total utility consequent upon increasing the
consumption of one commodity holding the other constant
• MRS can be defined as the ratio of the marginal utility of the two goods on the x and y axes.
MRS measures the MU of the good on the horizontal axis in terms of the MU of the good on
the vertical axis. MU is measured by the shift from one indifference curve to another while
MRS is measured along the same indifference curve
• Empirical studies have shown that even in mature capitalist countries consumers do not
maximize utility and consumer decisions are not based on utility calculations. Indifference
curves, marginal utility and MRS are ideological concepts
• Utilitarianism is the ideology underlying consumer behavior theory. Utilitarianism says that
all acts and rules should be assessed in terms of the consequences they produce with respect
to the maximization of total consumption over a given time period. Utilitarian moral agents
seek the maximization of total consumption irrespective of the wishes of those whose
consumption is maximized. The commitment to the maximization of aggregate consumption
is an expression of the commitment to prefer preference in general (freedom) over all specific
preferences. Hence the commitment to the maximization of aggregate consumption once
again illustrates the normative framework within which the positive analysis of consumer
behavior is necessarily situated
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• Only a neutral world agent (the economist) can judge all acts and rules in terms of their
impact on aggregate consumption. Therefore only the world agent has the right to evaluate
acts and rules and make policies
• If a consumer does not accept maximization of aggregate welfare / profit as an end in itself
and refuses to accept the authority of the World Agent who judges acts and rules and makes
policies on this basis, such a consumer becomes a danger for capitalism
• Economics deals with this danger by:
o showing how the ideal / prefect capitalist economy and society should function
o developing policies for moving actually existing systems of consumption, production
and exchange towards ideal capitalist systems of consumption, production and
exchange
o thereby ensuring that people who refuse to accept capitalist rationality, norms and
practices starve to death like the eighty million Red Indians of North America.
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Review Questions
1. What is possessive individualism? And what are the characteristics of “homo economicus”?
2. What are the necessary constraints within which “homo-economicus” maximizes his personal
utility?
3. Why can aggregate utility not be derived from supporting the Taliban?
4. Why can utility and welfare be measured only in Rupees?
5. How does the market affect the private life of individuals in capitalist society?
6. Why can “well being” not be anything other than maximization of consumption?
7. What is the relationship between choice and scarcity?
8. What is Abul Bashr free to do and what is he not free to do in a capitalist economy?
9. What is the meaning of consumer sovereignty? Why and how is consumer sovereignty
undermined in a capitalist market?
10. What is transitivity? Is it a requirement of logic?
11. “Greed is the core constituent of rationality”. Comment.
12. “Greed guarantees the prioritization of efficiency as a social objective. Why?
13. What does the indifference curves show and what is an ‘indifference map’.
14. Why must indifference curves be negatively sloped? Why can they not interact?
15. Why are indifference curves assumed to be convex to the origin?
16. Show why concave to the origin indifference curves violates the assumption of transitivity
and greed? Give a numerical example.
17. Why cannot indifference curves be drawn as a straight line with a constant slope joining two
points (for normal goods)?
18. Why does the slope of indifference curve change at every point?
19. Why does the indifference curve become flatter as we move to the right?
20. What is MRS and how is it measured?
21. What is the assumption underlying the expectation that MRS decreases as we move to the
right of an indifference curve?
22. What do you think will happen to MRS if the commodity on the x axis is expenditure on haj
and the commodity on the y axis is whisky?
23. Why and how does the assumption of universal greed lead to the expectation of diminishing
MRS.
24. “Indifference curves do not exist”. Comment.
25. Why can utility not be derived from acts which reject freedom, such as obeying God?
26. What are economic “bads”? What are economically “useless” goods? Draw indifference
curves for “bads” and “useless” goods.
27. Draw indifference curves for perfect substitutes and perfect compliments.
28. What is a utility function?
29. What is marginal utility? How is marginal utility calculated?
30. What is the difference between MU and MRS?
31. Why is it impossible for all consumers in a typical capitalist market to estimate MRS?
Illustrate assuming that there are 30 items in the market.
32. “Consumer behavior theory shows that economics is essentially an ideology”. Do you agree?
33. What are the main features of utilitarianism?
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34. Is it “rational” to accept maximization of aggregate consumption as an end in itself for all
consumers for all times?
35. Who has the right to judge acts and rules and make policies according to utilitarianism?
36. How according to utilitarian ideology should a rational consumer express his preferences?
37. If economic theory does not describe how a consumer behaves in a typical capitalist market,
where lies its usefulness?
203
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7
Chapter
BUDGET SET, CHOICE
AND DEMAND
Recall the ideal capitalist vision of individual choice as stated at the beginning of chapter
6: consumer choices should be determined by autonomous tastes with given resources and
unlimited wants. We analyzed tastes in the previous chapter. In this chapter, we first look at
resource constrain and then go on to see how actual choices are supposed to be made in the
market. Section 1 discusses the idea of consumer opportunities. Section 2 explains choice
decision of an ideal capitalist consumer. Section 3 assesses the concept of demand.
7.1: THE BUDGET SET
Two additional assumptions are required to explore consumer choice. First, apart from
the assumption of ‘given innate taste’, economics also presumes ‘given initial resources for all
individuals in society’. According to this assumption, all individuals living in a society enter the
market with initial resources they happen to posses. In other words, capitalist society begins with
a given distribution of resources among its citizens. The question ‘what determines this initial
resource distribution or what should this initial resource distribution be is not addressed by
economic theory. This is important presumption that we will explore in greater detail in chapters
15 and 16.
Secondly, the consumer is supposed to know the prices of all goods in the market. He is
supposed to behave as a price-taker—one who has no control over market prices and accepts
them as given by the market before taking his decision to purchase commodities. This idea will
become clear as we proceed further in this chapter.
Suppose again that there are only two goods, x and y. The consumer, as presumed, has
some income, denoted by M, to spend on these goods. Further, he also knows the prices of each
commodity, Px of x and Py of y. We will assume that buying these commodities is the only
possible use of his income, so he will spend all his income on their purchase. We further assume
that our consumer will spend all his income in the current time period; he will neither save nor
borrow. This implies that total income must be equal to total expenditure.
Total Income (M) = Total Expenditures (TE) (7.1)
Since the available income must be spent either on x or on y, total expenditure is equal to the sum
of expenditure on x and y:
TE = Expenditures on x + Expenditures on y (7.2)
By definition, expenditure on x are given by the price of x times the amount of x purchased, that
is Px × x (this idea has already been discussed in chapter 4). Similarly, Py × y is the expenditures
on y. We have:
TE = Px × x + Py × y (7.3)
Substituting TE from (7.3) into (7.1) we get:
M = Px × x + Py × y (7.4)
This is the algebraic statement of the consumer budget constraint. Let us see what this budget
constraint looks like when we draw it in the (x, y) commodity-plan. It is drawn in figure 7.1. Let us
understand how this line is drawn. Consider the following data.
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M = Rs 100 Px = Rs 1 Py = Rs 2
This says that the consumer has an income of Rs 100 (M = 100) to spend on commodities x and y.
The price of one unit of x is Rs 1 while that of y is Rs 2. First assume that he does not purchase
any amount of x. In this case, all his income will be spent on y and the maximum units of y he can
purchase are given by his income divided by the price of y:
M 100
y max = = = 50 units
Py 2
This is the vertical intercept of this line, Z. Similarly, if he does not purchase any amount of y and
spends all his income on x then:
M 100
x max = = = 100 Units
Px 1
Figure 7.1: The Budget Line

y
M Z
y max = = 50
Py
A D
40
30 B
C
S
0 S
0 20 40 M x
x max = = 100
Px
This is the horizontal intercept of this line, (S). Thus we see that the vertical and the horizontal
intercepts of this line measure how much the consumer can afford if he spends all his income
only on one commodity. Joining these two points, Z and S, by a straight line gives us a line ZS
called budget line. This budget line ZS shows all possible bundles that can be purchased at given
prices and income. To see this point, consider point A. If the consumer purchases 20 units of x,
this means that the maximum units of y he can purchase are 40. Why? This is so because since Px
= Rs 1, purchasing 20 units of x means that expenditure on x is:
Expx = 1 × 20 = Rs 20
This leaves the consumer with Rs 80 to spend on y out of his total income of Rs 100. Since Py =
 80 
Rs 2, he can purchase 40 units with these Rs 80  = Rs  . Thus, (20x, 40y) is another maximum
 2
affordable consumerable bundle given the income of the consumer (Rs 100) and prices of x (Rs 1)
and y (Rs 2). The same logic applies at point B (40x, 30y). Thus, all points on this budget line
represent maximum affordable bundles. To fully understand this point consider bundle C (20x, 30y)
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inside the budget line ZS. This bundle will leave some of the consumers income as his expenditure
will be less than his income:
At point C → Rs 1 × 20 + Rs 2 × 30 < 100
This shows that though bundle C is affordable, but it is not the maximum affordable bundle. Finally,
bundle D (40x, 40y) is not affordable as it costs more than the income that the consumer has. Thus
we conclude that:
• All points on this budget line are maximum affordable bundles for the consumer and
exhaust his income
• All points below this line are affordable but do not exhaust his income
• All points above this line are not affordable as they cost more than the income
Note that the budget constraint requires that the expenditures on the two goods must not be
greater than the amount of income the consumer has to spend. The affordable consumption
bundles of x and y are those that don’t cost any more than his income, M. This set of all
affordable consumption bundles (all bundles on and below the budget line) is called the budget
set of the consumer. On the other hand, the budget line shows only those bundles that are both
affordable and fully utilize the consumer’s resources.
Slope of Budget Line
The slope of the budget line is its key feature, as it will be revealed shortly. One way of
looking at the slope is to study the changes in quantities of the two goods consumed while
moving from one point to another on a budget line. For example, think of moving from point A to
B on budget line ZS in figure 7.1. The slope of budget line is given by the ratio:
∆y
<0
∆x
and it must be negative, as indicated by the negative slope of budget line. Note that change in y
from point A to B equals:
∆y = 40 units − 30 units = 10 units
while change in x is equal to:
∆x = 20 units − 40 units = −20 units
Dividing them we obtain:
∆y 10 1
=− =− (7.5)
∆x 20 2
The value of the slope of this budget line is ½, where minus sign indicates the negative slope of
the budget line. The budget line has a negative slope because Δx and Δy must always move in
opposite direction in order to keep expenditures constant: an additional unit of x could be
purchased only when some amount of y is forgone. Thus the slope of the budget line shows a
trade off between the two commodities x and y.
One important aspect of this value of the slope of budget line is that it equals the ratio of
the price of x to the price of y:
∆y P 1
=− x =−
∆x Py 2
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Recall that the price of x was Rs 1 while the price of y was Rs 2. No matter what prices you
assume, the slope of the budget line will always equal their ratio. This is a general result that
holds for any budget line for any given prices of x and y. Let us derive this result graphically.
Look at point A in figure 7.2 with xa amount of x and ya amount of y. Now consider a move from
point A to B on this budget line. Since both these points are on the same budget line, each must
satisfy the budget equation:
Px × xa + Py × ya = M (a)
Px × xb + Py × yb = M (b)
That is, at both these points, (xa, ya) and (xb, yb), expenditures are the same (equal to the
consumer’s income) because both bundles are on the same budget line. Subtracting equation (a)
from (b) we get:
(Px x b + Py y b ) − (Px x a + Py y a ) = M − M
collecting terms: Px ( x b − x a ) + Py ( y b − y a ) = M − M
The bracketed terms denote changes in the amount of x and y respectively while moving from
point A to B. Denoting these changes by Δx and Δy respectively, we get:
Px × ∆x + Py × ∆y = 0
Figure 7.2: Slope of the Budget Line and the Price Ratio.
y
A (xa , ya)
ya
B (xb , yb)
yb
0
S
xa xb x
This equation says that the total value of change in expenditure must be zero (remember that the
total expenditure on a budget line is constant since income is fixed, so total expenditures cannot
change while moving from A to B and remains equal to M). We want to solve for the slope term
of the budget line which is Δy/Δx. With slight rearrangement we get:
∆y P
=− x (7.6)
∆x Py
which is exactly what we wanted. Algebraically, the value of the slope of the budget line is equal
to the price ratio. In terms of our numerical values with Px = 1 and Py = 2, the slope of budget line
was ½. What is the meaning of this number, ½? Look at the following table.
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Table 7-1 Trade off between goods

If Px = 1 Rs and 1 unit of x = ½ unit of y
Py = 2 Rs, then 1 unit of y = 2 units of x
With given prices of x and y, if the consumer wants to add one more unit of x to his consumption,
he must sacrifice ½ a unit of y (because the price of y is Rs 2, reducing its consumption by ½ unit
will release one rupee which can be used to purchase one unit of x as its price is assumed to be Rs
1). Similarly the market value of one unit of y is 2 units of x. Remember that the slope of the
budget line shows the rate at which the consumer can substitute one unit of x with y, or rate at
which the market allows substitution of one good for another. Thus we find that the consumer can
substitute 1 unit of x for ½ of y at these prices. This is the relative price of x—relative price is the
price of a commodity (say x) in terms of another commodity (y). Similarly, the consumer can
substitute 1 unit of y with 2 of x. This is the relative price of y given by the inverse of the
expression (7.6): Py / Px = 2, to consume one more unit of y; the consumer must sacrifice 2 units
of x. But usually, the slope of the budget line is measured for the commodity on the horizontal
axis. It is for this reason that economists say that the slope of the budget line measures the
opportunity cost of consuming either of the two commodities. In order to consume more of x, you
have to give up some amount of y. it is easy to see how this conception of the budget, constraint is
based on the presumption of universal scarcity.
Remember that there is a difference between the nominal price and relative price. The
nominal price of a commodity is what a consumer pays to purchase it in monetary terms, say Rs 1
is the nominal price of x. But the relative price of a commodity is the number of units of other
good(s) the consumer has to forgo to purchase one unit of that commodity, e.g. ½ y is the relative
price of x. The slope of the budget line measures the relative, not the nominal price of the good on
the horizontal axis, here x.
7.2: CONSUMER CHOICE
We can now put together our representation of taste and opportunities. The economic
problem of choice is that the consumer wants to choose the bundle yielding the highest level of
utility he can afford.
What Does Consumer Want to Do?
Consumer behavior theory is built on the assumption that capitalist consumers make the
most of their opportunities to satisfy their unlimited wants in the light of their arbitrary
preferences. The consumer can never achieve a point of ‘maximum utility’ because his wants are
infinite. The consumer choice problem is not of maximizing utility / freedom in general, but of
maximizing utility given specific resource reflected in his budge line. To understand this idea,
recall that we have shown that higher indifference curves contain bundles that are preferred to
those contained by lower indifference curves because they yield higher levels of utility.
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Preferences in economic theory are represented by a utility function written as U(x, y). This
allows us to reformulate the consumer problem. Rather than saying that a consumer is trying to
attain the highest indifference curve, we can say that he is trying to attain highest level of utility;
i.e. to his maximize utility. If the consumer choice problem is to maximize utility, then the
consumer is concerned to find the highest indifference curve since it yields the highest utility.
Since consumer is greedy, therefore the highest indifference curve will never be attained because
there will always be a bundle yielding even more utility (he can always wish for more). Thus, the
desire to maximize utility / freedom itself is infinite and never satiable.
However the consumer has limited resources given the assumption of scarcity, as he is
not Abul Bashar who can pick as many coconuts as he wants—but picks only one per day
because his peer has told him to fill only one third of his stomach. To see why the conventional
consumer choice problem will not be applicable to a person like Abul Bashar, we can say, in
terms of figure 7.1, that:
• Income is not a constraint on Abul Bashar’s consumption. He can pick as many coconuts as
he wants
• His consumption is however limited by:
o his own inclinations. He does not want to raise his living standard. He wants to live a life
of Zuhd and faqr
o his traditions and society. He lives in a Muslim community which values sabr and
qana’at and abhors greed, lust, jealousy, accumulation and competition
o The Shariah which outlaws alcohol, the wearing of silk and jewelry, gambling, interest
bearing transactions and widely distributes Abul Bashar’s wealth at the time of his death
making accumulation somewhat pointless.
o Moreover Mubashir—Abul Bashar’s son—is a member of the Dawat-e-Islami and
probably gives away most of what he inherits. Moreover Bashir, Abul Bashar’s other son,
has already left the Maldives to enroll as a mujahid in the Chechnya jihad and Abul
Bashar’s Youngest daughter is Abdullah Zhagliazai’s wife. In these circumstances who
can convince Abul Bashar to be concerned about maximizing utility?
Figure 7.3 summarizes the factors that affect upon a consumer’s choice. Contrast this with the
mind set and social environment of Mr. Bill Gates. Mr. Gates is demonically greedy, lustful,
jealous, competitive and accumulative. He lives in America founded on the dead bodies of eighty
million Red Indian and practicing loot and plunder on a global scale for the last two hundred
years. Promoting lust, geed, jealousy, competition and accumulation is America’s national
mission. Moreover the vague recollection of Christian teachings which Mr. Gates has inherited
has no Shariah contents at all. Saint Augustine subordinated cannon law and ecclesiastical law to
Roman law in the fourth century and today even a lesbian can head the Evangelical congregation
that Mr. Gates attends.
Most importantly Mr. Gates subscribes to the Enlightenment conception of truth—all
other conceptions of truth are mythic in his eyes. The Enlightenment conception of truth is
embodied in the natural sciences and the social sciences (see Table 7.2). The natural sciences tell
Mr. Gates how to exploit nature for accumulation of capital and for the subordination of all
natural forces to Mr. Gates arbitrarily determined desires. Social sciences teach him how to
organize society so that domination of nature becomes a means for the efficient accumulation of
capital/resources.
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Figure 7.3: Constraints on consumer’s consumption pattern
Physical limits, e.g.

physical laws
Abul Bashar
Legal limits, e.g.

Social limits, e.g.
Shariah laws
traditions
Internal Constraints
Thus, the knowledge systems, to which Mr Gates is exposed to from his childhood, are applicable
to facilitating utility / profit maximization and maximization of the rate of accumulation. Their
purpose is to eliminate all personal, social and legal constraints on utility / profit maximization
and from the maximization of capital accumulation. It is therefore “natural” for subjects of
capitalist order such as Mr. Gates to seek utility maximization.
Table 7-2: Objectives of Enlightenment Knowledge Systems

Discipline Objective
To discover regularities in the universe in order to allow man’s control
Natural Sciences over it so that he can use them for the accumulation of capital and
fulfillment of his desires
Give a framework of social arrangements which ensures maximization
Social Sciences
of freedom (utility / profit) for all individuals
In mature capitalist societies, the constraint of finite income is the single most important
constraint that an individual faces. Mr. Gates is a rational consumer who is universally greedy; he
is always feeling ‘dissatisfied’ even if he becomes the richest man in the world. The moment Mr.
Gates ceases to wish for more, he ceases to be ‘rational’ and disqualifies him as ‘human’ being.
The limits of a citizen’s freedom are defined principally by the amount of income he has in
capitalist society. Mr. Gates can exercise more freedom (i.e. satisfy more wants) than Hobo
Rasters because he has more income. Income is the major constraints on consumption and the
consumer has to maximize utility such that he does not violate this income constraints. In our two
commodity model, this means that though the consumer desires to purchase the combination of x
and y from which he derives the highest level of utility, his income is limited and he cannot
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purchase unlimited amounts of the two goods. His problem can, thus, be stated as of
maximization of utility subject to this budget (income) constraint. Formally, his utility-
maximization problem is written as:
Maximize U (x, y)
By choosing optimal amounts of x and y
Subject to the constraint: Px x + Py y = M
This expression is a compact way of stating the consumer’s choice problem. It tells (a) what is the
objective of the consumer—maximize utility; (b) what is the consumer choosing—a consumption
bundle of commodities and (c) what are the constraints the consumer faces—the budget set. More
precisely, the capitalist consumer wants to maximize his utility by choosing quantities of x and y
such that those quantities are affordable with his limited income. For example, bundle D in
figure 7.1 will give higher utility than bundles A and B; however this bundle is not affordable
with given income and prices. The consumer can choose a bundle on or below his budget line not
above it.
Before going onto the graphical analysis of the solution of the consumer choice problem,
we can infer one important result; i.e. where his selected bundle will fall. It must lie on the budget
line, and not below it. Why? Consider for example the bundle C in figure 7.1 which falls inside
the budget line. This cannot be the utility maximizing bundle because the assumption of greed
implies that any bundle on the line segment AB of the budget line is preferred to the bundle C as it
contains more of both the goods. Therefore, we can safely ignore all bundles below the boundary
of budget line and say that the capitalist consumer always picks a bundle on the boundary,
indicated by the budget line.
7.2.1: Consumer Equilibrium
Now we are ready to describe the solution to the consumer choice problem. The consumer is free
to move anywhere along the budget line ZS. Positions to the right and above ZS are not affordable
because they require more than the current income of the consumer. We impose the indifference
map of the consumer on this budget line in figure 7.4. We saw in the last chapter that choice is
determined by two factors: taste and opportunities. The indifference map shows the taste of the
capitalist consumer while the budget line shows his opportunities. What will be the choice? Start
moving form the left-hand corner of the budget line to the right-hand corner. The consumer is
moving to higher and higher indifference curves. Where should we the consumer? Surely, at the
point where he reaches the highest possible indifference curve that just kisses the budget line.
Here it is at point E in the right panel of figure 7.4. At this point, the budget line just touches, and
does not cross, the indifference curve. This point of tangency is on the highest attainable
indifference curve, I2, and provides the highest possible utility to the consumer. All bundles on I3
have higher utility than I2, but they are not affordable. Thus, the consumer attains equilibrium at
the point where his budget line is tangent to the highest indifference curve.
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Figure 7.4: Locating Consumer Equilibrium
y y
Z
Z
P
M P
E
y*
I3
I2
N
I1 I1
Io Io
R
0 x S
S 0 x* x
Why Tangency?
At the point of consumer equilibrium, the indifference curve must be tangent to the
budget line. But what about bundle P lying on the indifference curve I1 (look at the left panel of
figure 7.4)? This bundle is also affordable as it lies on his budget line. Why does the consumer
reject it in favor of bundle E? The reason is that this bundle does not maximize the utility of the
consumer. To see why, note that all bundles on the budget line between points P and R are
affordable. Further, recall the fact that the weighted average bundles of any two bundles which
fall on the line joining those two bundles are necessarily preferred to those two bundles
(assumption of convexity). This means that any bundle on the line segment PR of budget line will
be preferred to P and R because that bundle will be a weighted average of P and R (the line
joining P and R will be this budget line). Since these bundles are preferred to P and are also
affordable, the consumer will select that bundle which is a weighted average of P and R. But note
that any bundle on the line segment PR will be on a higher indifference curve, such as bundle N.
Since a higher indifference curve shows higher level of utility, so consumers’ utility is not
maximum at bundle P because it is possible for him to increase his utility by moving to a bundle
like N. If utility were maximum at P, it could not be increased at all. If you look at bundle N, you
will see that this also does not maximize the utility of the consumer because any bundle on the
line segment NM will be on a higher indifference curve (due to convexity assumption as
explained above). As long as there is a line segment above the indifference curve, the consumer can
increase his utility by choosing a bundle on that line segment. Now look at point E in the right hand
panel. At this point, there is no preferred bundle available to our consumer. So, this is the bundle
that maximizes his utility. Note that such a utility maximizing bundle falls on the point of tangency
between indifference curve and budget line. The convexity assumption thus ensures that the
consumption of a good is a means for the maximization of utility. It is not an end in itself nor a
means for any other purpose. The preference for preference itself (utility maximization) is the sole
purpose of consumption.
215
Recall from chapter 5 that the slope of the indifference curve at any point is given by the
tangent at that point. One such tangent is drawn at point P on indifference curve I1 in the right
hand panel. Since this tangent is steeper than the budget line, it means that the slope of the
indifference curve is greater than the slope of the budget line at point P:
At P The tangent of the indifference curve is steeper than Budget line
Therefore, The slope of the indifference curve > this slope of the budget line
However, if you draw a tangent on indifference curve I2 at point E; that tangent will fall exactly
on budget line. This means that at the point of tangency, point E, we have the condition:
The slope of the indifference curve = the slope of the budget line
Tangency implies that slopes of the indifference curve and the budget line are exactly equal.
Meaning of Tangency
What is the economic meaning of equating slopes? To understand this important idea,
recall the definitions of MRS and the commodity price ratio:
Slope of Indifference curve → MRS measures the rate at which a consumer is willing to
substitute two goods
Slope of budget line → measures the rate at which a consumer can substitute two
goods
Consider a simple numerical example to understand the idea. Continuing with our
previous data, suppose that Px = Rs 1 and Py = Rs 2 while consumer’s income is M = Rs 100. This
gives us a budget line with a slope of - ½ [as shown above, see equation (7.5)]. This means that
the consumer can buy one unit of x in place of ½ a unit of y. Alternatively, he can substitute ½ a
unit of y for one unit of x as the price of y is double than that of x.
Now consider point P in figure 7.5 where the indifference curve is crossing the budget
line. The tangent of the indifference curve at point P is steeper than the budget line which implies
a greater MRS than the price ratio (recall that the slope of the indifference curve shows MRS).
Say, MRS is 1 (or any number greater than ½, the slope of the budget line) at P. This means that
the consumer is willing to substitute one unit of x with one unit of y, or in other words the utility
of one unit of x is equal to the utility one unit of y in his eyes. Point P is not his optimum since
MRS is greater than price ratio:
Px
MRS xy >
Py
The consumer can do better by reallocating his expenditure on x and y. Because he is expecting
utility derived from consumption of x to be higher than the market does (the price of one unit of x
is equal to ½ units of y in the market while 1x = one y to consumer), it is in his interest to
consume more x and less y. Why? Suppose that he reduces his consumption of y by one unit. This
will save Rs 2 (as Py = Rs 2). He can purchase two units of x from these Rs 2 (as Px = Rs 1). But
how many x were needed to compensate the reduction in the consumption of y by one unit?
Clearly, he needed only one x to compensate for one unit of y (as MRS = 1). Since the consumer
can purchase two units of x in place of one y, the one extra unit of x will put him on a higher
216
indifference curve. This reallocation of expenditure from y to x will be of benefit for the
consumer as long as his MRS is greater than the commodity price ratio and he will stop only
where both are equal, (at point E).
Figure 7.5: MRS and the Commodity Price Rates.

y
Slope of IC =
MRS = 1
50
y* E Slope of budget
line = - ½
0 x* 100 x
The equating of the slopes implies that the consumer should consume a commodity up to the
point where his personal evaluation of a commodity is equal to that of the market. It reflects the
idea that the consumer’s rate of exchange between x and y is equal to the market rate of exchange
between the two goods. Recall that the slope of the indifference curve shows consumer’s rate of
evaluation between two goods, while the slope of the budget line shows the market rate of
exchange between the two goods. Equilibrium occurs when the two rates are equal. Tangency
means that the consumer will be in equilibrium when:
 The rate at which he is willing   The rate at which he can 

  =   (7.7-a)
 to substitute two goods   substitute two goods 
or Value of both goods in his eyes = Value of both goods in the market (7.7-b)
Thus, the equilibrium condition can be stated as:

Px
MRS xy = − (7.8)
Py
Since MRS is also equal to the ratio of marginal utilities, the equilibrium condition becomes:
MU x P
MRS xy = =− x (7.9)
MU y Py
Finally, look at the equilibrium quantities of x and y, x* and y* at point E. This bundle
provides the maximum utility to the consumer as it lies on the highest attainable indifference curve.
With given income and prices, point E is the demand point of the consumer where he opts to
purchase x* and y* quantities of the two goods x and y. These are the solution values of x and y in
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his maximization problem. The bundle (x*, y*) is therefore called the optimum bundle (the bundle
that maximizes utility).
From Two-Goods to Infinity
If the model of choice between two goods is extended to choice among three or more
goods, then the two dimensional graph will no longer be useful. Mathematical techniques allow
economists to extend their model of two-goods to any number of goods (see appendix to this
chapter). However, the basic idea underlying equilibrium analysis of consumer behavior remains
unchanged, no matter how many goods are considered. For example, suppose there are three goods,
x, y and z with prices Px, Py and Pz respectively. The equilibrium quantities of three goods will be
given at the point where the following three conditions are satisfied:
MU x P
MRS xy = =− x (7.10-a)
MU y Py
MU x P
MRS xz = =− x (7.10-b)
MU z Pz
MU y Py
MRS yz = =− (7.10-c)
MU z Pz
The same conditions must hold even if there were an infinite number of commodities.
Consumer Sovereignty
Equilibrium is a centrally important concept in economic theory. Our discussion of

consumer behavior provides one illustration of its importance. It shows that in equilibrium the
personal valuation of the consumer are subjected to the discipline of the market. He can only
maximize his utility by accepting the market valuation of x and y. If he refuses to accept the
market valuation—if he refuse to move from point P in Figure 7.5—he will never maximize
utility. If he is a capitalist consumer and committed to utility maximization as an end in itself
(remember Abdullah Zhaghazai and Abul Bashar are not so committed, they are not capitalist
consumers) he must accept the relative prices of x and y set (independent of his preferences) by
the market. Market-evaluation rules capitalist society. All personal preferences are subject to the
evaluation of the market. It is this necessary social dominance of the market which ensures that in
equilibrium both profits and welfare (aggregate consumption) are maximized. But we will be able
to show why this is so only after we have looked at the theory of costs and production.
Economists begin their model of consumer behavior with the presumption of ‘given
innate taste’ of individuals. The objective behind this assumption is to pretend that since it is the
capitalist individual himself who ‘makes free decisions’ in the light of his own taste, therefore he
is himself master, and hence responsible, for his own life. But the solution to the utility
maximization problem through reconciling preferences with market determined price ratios does
not allow us to reach this conclusion. It was stated above that an individual is in equilibrium—a
position where he will not be willing to change his decision—when his personal evaluation of all
goods or activities is inline with the market [conditions (7.7a) and (7.7b)]. In other words, he
must place as much value on all goods and services as the market demands that he should. If this
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does not hold; i.e. if his taste and preferences are not inline with market valuations, he is in
disequilibrium—a position he is supposed to leave sooner or later if he is a rational individual
(i.e. one committed to utility maximization as an end in itself). This logic of utility maximization
has two noteworthy implications:
i. Any choice or objective that is not valued by the market is an irrational one and, therefore, must
be ruled out be a rational individual. Thus, if Aleemullah chooses to be a Muhaddis, [a person
who holds mastery over the interpretation of the Sayings of Prophet (SAAW)], a Mujahid or a
Da’i (preacher of Islam), he is making an irrational choice. These choices are not valued and
allowed by the market because they do not contribute to the objective of maximization of utility
/ profit / freedom / capital. Thus, an individual is not free to choose whatever he wants to
choose; rather he is disciplined and expected to choose from whatever the market offers him to
choose.
ii. Equilibrium means that an individual must adjust his taste in any given choice situation as
market requires him to do. His choices should be consistent with those allowed by the market.
In other words, it is the market which determines the objectives set by the individuals for
themselves. Choices made by rational (utility maximizing) individuals are not independent
pursuit of their own self-defined objectives; rather they are expressions of submission to the
discipline of market. Since the rational consumer cannot affect prices of goods (opportunities
offered by the market) and is merely a price-taker, therefore, all utility maximizing individuals
are equal in their powerlessness before the anonymous and impersonal market: Sovereignty
belongs to the market not to the consumer.
Freedom = Income
The link between maximization of freedom and accumulation of capital has been
explained at several places in this book. But this link becomes clear in the context of consumer
equilibrium. Note that the solution to the utility maximization problem (tangency point) says that
‘the level of utility a consumer can attain depends upon the position of his budget line’: the higher
the budget line, the higher the indifference curve and hence utility level the consumer can attain.
How far away the budget line will be located from the origin depends upon the level of the
consumer income. To see this clearly, note that the vertical and horizontal intercepts of the budget
line are given by:
M M
y max = and x max =
Py Px
With given prices of x and y, the larger the income of the consumer, the farther away will be the
intercepts of the budget line from the origin. This situation is shown in figure 7.6 where the
equilibrium points of Farooq are shown at two different levels of income, Mo and M1 where M1
(say Rs 200) > Mo (say Rs 100). Note that in order to attain a higher level of utility or to satisfy
more wants (i.e. to increase his freedom); he must enjoy higher levels of income. That is the only
way freedom (maximization of utility) can be realized. The theory of consumer behavior shows
that if an individual wants to maximize his utility there is one and only one rational preference
that he must pursue: and that is the preference for higher income through participation is the
accumulation of capital.
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Figure 7.6: Freedom is a function of income

y
M1
Py
Mo
B
Py
A I1
Io
0 Mo M1 x
Px Px
Thus we have the fundamental relation:
Maximization of Freedom = Maximization of Utility = Maximization of Income

It is for this fundamental reason that we see individuals living in a capitalist society committed to
‘higher levels of income’, ‘higher standards of living’ and ‘better quality of life’ phobias.
7.2.2: Assumption of Convexity and Uniqueness of Equilibrium
We have derived the result that the tangency between the indifference curve and the budget line is
the necessary condition for identifying the optimum bundle which maximizes utility. But the
important question to ask is: whether a tangency condition is always sufficient for a commodity
bundle to be optimal in this sense? Look at figure 7.7 where three bundles satisfy the tangency
condition. Bundle A is not optimal because there are other bundles which lie on a higher
indifference curve such as bundles B and C (remember that the optimal bundle is one which is on
the highest indifference curve). Both bundles B and C are optimal bundles as they fall on the
highest possible indifference curve and they satisfy the tangency condition as well. What caused
this type of situation to occur? Obviously, it is the non-convex shape of the indifference curve.
Recall that in chapter 5 while discussing convexity of indifference curves, we said that this
assumption plays a crucial role in determining a unique solution to the consumer choice problem.
In the case of convex preferences, any point that satisfies tangency condition must be an optimal
point. And since convex indifference curves do not have any flat spots in them, there is one and
only one optimal bundle which maximizes consumer utility. Convex indifference curves are
bowed towards the origin and must curve away from the budget line on that bow; they can’t bend
back to touch the budget line again. Thus, we learn an important principle: when indifference
curves are strictly convex, the tangency condition shows the only one point at which utility is
maximized (that is what we mean by a unique solution to the consumer choice problem). Such a
solution is called an interior solution, the one in which quantities of both goods are consumed in
220
positive amounts. The importance of the unique solution of the consumer choice problem will
become evident when we consider the demand function later in the next chapter. Thus far, just
keep in mind the condition for his unique solution.
Figure 7.7: Non Convex Indifference Curves and Multiple Equilibriums

y
A
C
I1
Io
0 x
Consumer Optimum with Concave Preferences
The above argument is made clearer by considering what happens when preferences are
non-convex. With non-convex preferences, the tangency condition does not show the optimum,
instead it shows the minimum. To understand this, look at figure 7.8 where we have presented
concave preferences. We can see that MRS increases along these indifference curves as x is
substituted for y (tangent becomes steeper as we move along the indifference curve). Consider
point A first where the indifference curve is tangent to the budget line. This point is the worst
bundle because it lies on the lowest indifference curve, Io and the consumer can do better by
choosing point S lying on a higher indifference curve I1. But even bundle S is not the best the
consumer can choose. To see this, look at the place where indifference curve I1 hits the vertical
axis, at point K below point Z on the budget line. Since Z has more of y than does K, so Z P K.
Since K I S (from I1), then, by transitivity, Z P S. So, point Z is the equilibrium point of the
consumer with zero amount of x.
In general, with non-convex (increasing MRS along an indifference curve) but non-
satiated preferences (more is better), consumer equilibrium must be where the budget line
intersects one of the axis. Such a solution is called corner solution showing the fact that the
consumer always specializes in the consumption of one commodity and does not consume both
the goods. This result states an important principle: the maximum-utility point occurs at the
convex region of the indifference curve, tangency in the concave region implies minimum point
rather than maximum. The importance of convexity assumption will become further clear when
we discuss the idea of demand curve in chapter 8.
221
Figure 7.8: Concave Indifference Curves and Consumer Choice

y
I2
A I1
Io
S
0 x
7.2.3: Equi-Marginal Principle: Restating Consumer Equilibrium

Consumer equilibrium or optimum consumer choice described above can be restated in a
more interpretable way. As slight rearrangement of the equilibrium condition (7.9) gives:
MU x MU y
= (7.11)
Px Py
This condition simply states that to maximize utility, the consumer must spend his income in such
a way that the marginal utility of the last rupee spent on each good is the same. What does this
mean? First, note that this statement of the equilibrium condition makes sense only when we
assume that utility is measurable in terms of cardinal numbers (one, two, three rupees).
Understanding equation (7.11) requires us to introduce another concept known in economics as
the law of diminishing marginal utility which says that the marginal utility derived from any
commodity tends to decrease as more of that commodity is consumed, other things held constant.
This is to say that as the consumption of a certain commodity increases, the extra unit of that
commodityyeilds lower utility. As we have seen this idea is also behind the assumption that
normal indifference curves are convex. Consider table 7.3. Note that as units of Pepsi consumed
increase from 1 to 2, the total utility that the consumer obtains increases from 10 to 18 utils. The
marginal utility of this unit—extra utility derived from this extra unit of Pepsi—is obtained by
subtracting utility of the previous unit from the last one; e.g. 18 – 10 = 8. We can see that as
consumption of Pepsi increases, total utility is increasing. However, marginal utility of each extra
unit is decreasing in this table. This is exactly what is meant by the tendency of diminishing
marginal utility. This behavior is supposed to hold for all commodities. Now we pose the
important question: How can a consumer maximize his utility with decreasing marginal utility?
There are two things that a consumer must do to achieve this objective. First, he can do this by
spending his income on different commodities rather than purchasing only one commodity.
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Table 7.3: Total and Marginal Utility

Units of Pepsi Total Utility Marginal Utility
1 10 -
2 18 8
3 24 6
4 28 4
5 30 2
To see the look at table 7.4 where decreasing marginal utilities of two goods, Pepsi and burger,
are recorded. Suppose that the consumer has only Rs. 50 to spend; i.e. M = Rs 50 while each unit
of burger costs Rs.10 (Pb = 10) and each can of Pepsi costs Rs. 5 (Pp = 5). You can afford to buy
5 burgers if you spend all your income on it (50/10) and similarly 10 cans of Pepsi (50/5) if all
income is devoted to Pepsi. If you spend all your income on burger and purchase five units, you
will obtain 100 utils utility (= 28 + 24 + 20 + 16 + 12; i.e. sum of the marginal utilities of all units
of burger). Similarly, if you purchase only Pepsi, your total utility will be 85 utils. Obviously, you
are better off by spending all your income on burgers than Pepsi if given a choice between either
of them.
Table 7.4: Deriving equi-marginal principle
Units Marginal Utility Marginal Utility
from burger from Pepsi
1 28 16
2 24 14
3 20 12
4 16 10
5 12 8
6 7
7 6
8 5
9 4
10 3
100 utils 85 utils
However, your total utility will be greater if you buy 3 burgers and 4 cans of Pepsi as the sum of
their marginal utilities is 124 (= 28 + 24 + 20 + 16 + 14 + 12 + 10). But a question arises: How
did we find this bundle? The key to find the optimal bundle of a utility maximizing consumer is to
assume that he compares the marginal utilities from the purchase of the additional units of two
commodities, and purchases that combination which gives him the higher marginal utility. To see
how this is done, first note that for a valid comparison between Pepsi and burger, we must
compare two units of Pepsi with one unit of burger because the price of the burger (Rs. 10) is
twice the cost of Pepsi (Rs. 5). The utility gained from one burger should be compared with the
utility from two cans of Pepsi because you have paid exactly twice as much for the burger as you
did for Pepsi. Now think about spending Rs. 10 out of your total Rs. 50. Which commodity
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should you purchase first? If you purchase 1st unit of the burger, your utility will be 28 utils, but
you can purchase two units of Pepsi with Rs. 10 (its price is Rs. 5) and you will gain 30 utils (16
+ 14). Surely, you should purchase two units of Pepsi and not the burger. After purchasing two
units of Pepsi, you should spend the next ten rupees on purchasing the first burger because that
will add 28 utils to your utility which is greater than the sum of marginal utilities of the 3rd and 4th
cans of Pepsi, (22 utils = 12 + 10). Which one to purchase next? Again, one burger because 24
utils is still greater than 22 utils. 20 rupees are still left with you. Now you should spend the next
ten rupees on Pepsi because the joint marginal utilities of the 3rd and 4th cans of Pepsi (22) are
greater than that of the 3rd burger (20). Finally, the last ten rupees should be devoted to burger for
the same reason. You have spent all your Rs. 50 in an optimal way. Note that no other way of
spending your income will give you higher utility than this bundle (try to work this out).
What is the lesson to be drawn from this numerical example? Diminishing marginal
utility forces capitalist consumers to use their resources for purchasing a variety of goods. But
what is its rule? Would you expect that the last pencil you are buying brings you the same
marginal utility, as does the last pair of shoes? Not at all, simply because shoes cost you much
more per unit than the pencil. The rule would be: if good A costs twice as much as good B, then
buy good A only when its marginal utility is at least as great as good B’s marginal utility. This is
exactly what you did when you bought burgers and pepsi. Since the price of the burger was
double that of Pepsi, the last unit of burger is bringing you twice as much marginal utility (20) as
the last unit of Pepsi (10). This is the consumer equilibrium condition which can be written in the
following way:
 Marginal utility of the last  MU b Marginal utility of burger 20 Utils 2 Utils

  = = = =
 rupee spent on burger  Pb Price of burger 10 Rs Rs
Since the last unit of burger was purchased with Rs. 10, and it brings you a utility of 20 utils, this
means that the last rupee spent on burger adds 2 utils to your utility. Similarly,
 Marginal utility of the last  MU p Marginal utility of Pepsi 10 Utils 2 Utils

  = = = =
 rupee spent on Pepsi  Pp Price of Pepsi 5 Rs Rs
i.e. the last unit of Pepsi was purchased with Rs. 5, and it brings you a utility of 10 utils, this
means that the last rupee spent on Pepsi also adds 2 util. Note that the marginal utility of the last
rupee spent on each good is the same, 2 utils. So our general equilibrium formula will be:
MU 1 MU 2 MU 3 MU n
MU Income = = = = ... = (7.12)
P1 P2 P3 Pn
This is what is meant by the law of equi-marginal utility as stated above: “A consumer having a
fixed income and facing given market prices of goods will capitalist maximize utility when the
marginal utility of the last rupee spent on each good is exactly the same”. Alternatively, when the
ratio of marginal utility of a good to its price is equal to the ratio of marginal utility of another
good to that goods price, capitalist consumer attains equilibrium—a position he will not change
because he can’t maximize utility by any other pattern of consumption.
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Why Must this Condition Hold?
Understanding the mechanism how that equilibrium is attained when we start from a
disequilibrium condition tells us a great deal about economics. Suppose that Pepsi gives Nomi
more marginal utility per rupee than burger; i.e:
MU b MU b
<
Pb Pb
What would Nomi do? He can increase his utility by taking money away from burger and
spending more on Pepsi. As he starts spending more on Pepsi, its marginal utility will fall, while
that of burger will increase (because its consumption is decreasing). How long should he continue
substituting Pepsi for burgers? Simply, until the law of diminishing marginal utility drives the
marginal utility of Pepsi per rupee down to the equality level with that of burger. In the next
chapter, we will see how this principle is used to derive the demand curve for a commodity. See
application box 7.1 to gain further insight of this rather difficult principle.
Deciding Study Hours
We can apply the concept of equi-marginal utility to a wide range of optimization problems in
capitalist societies. Every student faces a problem when studying for final exams deciding how
much time to allocate capitalist to each subject, especially when all the studies have to come
during last few weeks before the exams. Obviously, the amount of time spent on each subject
will depend on how well the student understands the subject he is already doing in that cource.
Let us suppose that he has to appear in two exams, economics and mathematics. He has a number
of hours available for studying and he wants to maximize his total score in the exams.
Assume that the student has a rough idea about the technology that transforms the time allocated
to a subject into marks; that is he knows the expected effects of different amounts of study time
on the marks. For example, he is doing well in economics and knows that 3 hours spent studying
this subject will surely bring 80 out of 100 marks. The following Table shows the relevant
information on studying and marks. Column (3) shows the effect of each hour of studying
mathematics on the final exams, that is the marginal marks. For example, devoting one extra
hour to the study of mathematics after the first hour will add 10 marks to the total score in
mathematics, and so on. As he devotes more and more hours studying mathematics, expected
increase in marks becomes less and less likely (because it becomes difficult to obtain extra marks
as he approach as the maximum 100).this also applies to marks in economics.
Suppose that the student has only five hours a day for studying both these subjects. How should
he allocate these hours studying these two subjects? If he wants to maximize the sum of total
score in both these subjects, then he should spend three hours on studying economics and two on
mathematics because the marginal contribution of the last hour spent on each subject is 10 marks
with this distribution. This becomes clearer if, for example, you assume that one additional hour
is available for study. Then where should the student devote this extra hour? Clearly to
mathematics because that will add 8 marks to his total score while giving the same hour to
economics will add only 4 marks.
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(1) (2) (3) (4) (5)

Study Marks in Changes in Marks in Changes in
Hours Mathematics Marks Economics Marks
1 50 - 55 -
2 60 10 70 15
3 68 8 80 10
4 73 5 84 4
5 74 1 85 1
You might be tempted to think that we cannot tell the exact relationship between time devoted to
study and the results of the exams. Although it is true, still the equi-marginal principle suggests
the optimal allocation of time in the simple way as: if an additional hour devoted to the study of
economics is more productive than studying mathematics, then reallocation of time away from
mathematics and towards economics is suggested. This is the central idea behind equi-marginal
principle.
The equi marginal principle applies only when we are concerned about the consequences of
actions—that is why it is so useful for utilitarian analysis as they are essentially consequentiality
(see Chap 5). In this example the consequences of taking the two exams is the production of
marks. The student is primarily interested in getting marks which in capitalist society are a means
for acquiring utility / profits. Marks can substitute for utils because studying economics and
mathematics are not ends in themselves—they are means for acquiring marks if a student is
really interested in understanding economics and mathematics marks will become completely
irrelevant to this decision about how to allocate time / between mathematics and economics.
Suppose he wants to understand both—then he will allocate more time to the subject he finds
difficult to understand. The marks he obtains will become quite irrelevant to his allocation of
time between the subject.
Here we learn one of the most fundamental principles of economics theory: prices are not
arbitrary numbers, but they are supposed to reflect how people value things at the margin. It is
assumed that at this equilibrium point, MRS is equal to the price ratio. The price ratio measures
marginal rate of substitution. This means that we have a way to value possible changes in
consumption. If we observe one choice at one set of prices, we get the MRS at that consumption
point. If prices change and we observe another choice, we get another MRS at that point. That is
what economists mean by the statement that ‘prices are a measure of valuing goods’.
The important thing to understand is that MRS is a conceptual phenomenon. It does not
exist in the real world in the same sense as prices exist. We can observe prices and calculate what
happens to quantity demanded when prices fall. We can never observe MRS and therefore can
never verify or refute the existence of the equi marginal principle as a determinant of consumer
behavior. Economics is simply saying that what people ought to do is the maximization of utility
(the preference for preference itself). Economics cannot answer the question ‘why should people
seek utility maximization as an end in itself’. Because it cannot answer this question, economics
is essentially normative and ideological. Its positive analysis requires that its normative
presumptions be accepted as valid. That is why while the equi marginal principle can be used to
understand how a student allocates time when studying for exams, it cannot be used to understand
student behavior not looking for marks (See Application Box 7.1).
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Why Alternative Approaches?
Historically speaking, the equi-marginal utility approach (also known as the cardinal
utility function) of analyzing consumer behavior predates the indifference approach, which was
discussed earlier in this chapter. However, the critical assumption underlying the marginal utility
approach was that utility could be measured in terms of cardinal numbers. The cardinal utility
function asserts that the order of preferences is determined by the relative size of the utility
numbers assigned to each bundle of consumption. The cardinal utility function says that utility
can be measured in cardinal numbers (one, two, three ), it requires information about utility
differences as well as the preference ordering their difference represent. Thus if U(x), = 10, U(y)
= 11 and U (z) = 13 we can say that z is preferred to y by more than y is preferred to x because the
utility difference between z and y is greater (2 = 13 - 11) than that between y and x (1 = 11 - 10).
But the problem with this approach was the way how to measure utility. How can in principle we
calculate the “amount” of utility associated with the consumption of a commodity? How can we
measure the utility derived by the consumption of, say, bread? Is Farooq’s utility the same as that
of Nomi? These difficulties because utility does not exist therefore it cannot be observed? Due to
these conceptual difficulties, economists stopped thinking that utility is a cardinal measure of well
being. Gradually, it was realized that all that matters about utility is the fact that one bundle has a
higher utility than another, but how much higher does not matter at all. This lead to the idea of the
ordinal utility function which says that the numbers attached to consumption bundles give only
the ranking of preferences; it has little to do with the numerical utility differences in those bundles
(the idea is also known as the indifference approach). Thus if A P B, we conclude that the utility
of A [U(A)] is greater than that of B, but we don’t calculate by how much it is more, that is why it
is called ordinal, meaning it gives only the order of the preferences (first, second, third…). This
move from the cardinal to the ordinal conception of utility does not eliminate the problems which
course from the fact that utility cannot be directly observed.
Do not confuse the two ideas, as they are different. The cardinal utility function makes
sense only if the increments to marginal utility are measurable. This additional information is no
more required to study consumer behavior with an ordinal utility function. Remember that the
numbers attached to indifference curves (first, second …) serve only to order the curves and not
to attach weights to them. They don’t mean that the first indifference curve is two times preferred
to the second one. Secondly, with the cardinal utility approach, preferences are defined in terms
of utility. When we say that bundle A is preferred to B, it means that bundle A has higher utility
than bundle B:
Cardinal Utility Approach: U ( A) > U (B ) → A P B
But with ordinal approach, we go the other way around. The preferences of a person are taken as
fundamental and primitive (as given) while utility is only a way to describe preferences.
Ordinal Utility Approach: A P B → U ( A) > U (B )
The only property of utility function that is important is that it orders or ranks the bundles of
goods, its magnitude serves only to rank different bundles, and the size of the utility differences
makes no difference.
The most important similarity of the two approaches is that the ordinal utility approach
gives the same results regarding consumer choice problem as does the cardinal utility approach
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without using the assumption of the measurability of utility. This can be seen by comparing the
consumer equilibrium condition of the two approaches for two goods case:
MU x MU y
Consumer Equilibrium in Cardinal Utility Approach = as per (7.11)
Px Py
MU x Px
Consumer Equilibrium in Ordinal Utility Approach = as per (7.9)
MU y Py
Note that both are the same. Since the ordinal utility approach requires less information to derive
this result than the cardinal utility approach, therefore the former method replaced the later over
time. In the next chapter, we will see how the downward sloping demand curve can also be
derived using both approaches.
Both approaches give the same results because both are grounded on utilitarian ideology.
The ordinal approach puts the emphases on preference and pretends that utility is a means for
ranking them, but this is a dangerous half-truth. Utility is the only means for evaluating
preferences according to the ordinal approach. Hence utility is the essence of preference—the one
and only thing which all preferences generate and the one and only measure on the basis of which
they can be ranked. Utility as we have seen is the preference for preference itself, it is nothing
else. If Abdullah’s preferences reject the preference for preference itself, his preference can
neither be measured (cardinally) nor ranked (ordinally) on the basis of utility.
7.3: EXPLAINING CHOICE FOR SPECIAL TASTES
In chapter 5, we used the concept of preferences to illustrate the taste of an individual for
certain types of commodities. In this section, we add the notion of the budget set to determine the
choice for them given his taste.
A Useless Good
We noted in the last chapter that the taste for a neutral commodity is illustrated by
vertical indifference curves as reproduced here in figure 7.9. We have also depicted the standard
budget line ZS. We can easily determine the choice under this situation for capitalist consumer.
First note that since indifference curves are vertical lines, there is no point at which the slope of
the indifference curve and the budget line will be equal, so the tangency solution is not possible.
Because indifference curves originate from the horizontal axis, the equilibrium will be where the
highest indifference curve hits the budget line at point S at the horizontal axis. Thus, in case of
neutral goods, the consumer does not consume any amount of the useless commodity, here (Pepsi
for Farooq) consumer, and devotes all his resources to the consumption of bread. It is quite easy to
understand the reason for this outcome: if something is useless, don’t spend anything on it.
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Figure 7.9: The Budget Line and Useless Good.

Pepsi
Io I1 I2 I3
Z
S
0 5 10 Bread
An Economic Bad
Recall that an economic bad was defined as the commodity for which “more is bad, not
good” and its taste is represented by positively sloped indifference curves, (see figure 7.10).
Again, it can easily be shown that point S is the equilibrium point because Farooq does not want
to have any amount of cigarettes.
Figure 7.10: Budget Line and “Bads”

Cigarette
Z
Io I1 I2
0 S Bread
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Perfect Substitutes
The taste for perfect substitutes is shown in figure 7.11 (the thicker lines are the
indifference curves with MRS = 1). We can have three possible situations with regard to the
budget constraint:
i. Price of Piano > Price of Picasso pens

ii. Price of Piano < Price of Picasso pens
iii. Price of Piano = Price of Picasso pens
PPiano
Recall that the slope of the budget line equals the price ratio, here it is: − . Now if we
PPicasso
consider the first case, Ppiano > Ppicasso, the ratio will be greater than one and the budget line will be
steeper than the indifference curve because the slope of the indifference curve was assumed to be
one. This situation is depicted in figure 7.11 where the dashed line ZS is the budget line. At this
price ratio, Nomi can afford fewer pianos and more Picassos (b/c Picassos > Picassos). The
equilibrium is at Z. As a rational consumer, he should buy only Picassos because one piano pen
costs more than one Picassos (relative price of piano is greater than 1) but he gives equal value to
both of the pens. Therefore, he will specialize in his consumption and buy only the cheaper pen
Picasso.
Figure 7.11: The Budget Line and Perfect Substitutes.

Picasso
Z
Io I1
0 S Piano
Now, following this reasoning, we can easily see that if we had the second case, Ppiano <
Ppicasso, then Nomi will choose only Piano. What about the third situation when both the
commodities have equal prices? The slope of the budget line will be one which means that
indifference curves and the budget line will be parallel to each other. It simply means that there is
no unique choice point in this situation, rather Nomi can choose any point on the budget line as
MRS will be equal to the slope of the budget line at all points (draw a diagram to clear your
understanding. In this diagram, indifference curve and the budget line will coincide). This means
that Nomi will not care about which pen he purchases because they cost him the same amount.
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Any amount of both the commodities will satisfy him equally and he can choose any point on the
budget line to attain his equilibrium. So, we can conclude that:
Choose only Picasso if Ppiano > Ppicasso
Choose only Piano if Ppiano < Ppicasso
Choose any combination of the two if Ppiano = Ppicasso
Perfect Complements
Perfect compliments were defined as goods that are always used together in some fixed
proportion. Suppose that Farooq has money to buy only two pairs of shoes. This point occurs at U
on the budget line ZS in figure 7.12. The best possibility for him is to choose point U with equal
amounts of both the shoes, no matter what their individual prices are. Note that the consumer
equilibrium point must lie on the diagonal, here on the 45o line joining all kink points because this
line represents an equal amount of both the shoes at all points along it. More insight on this situation
will be gained when we consider how budget line changes its position in the next chapter.
Figure 7.12: The Budget Line and Perfect Complements
Left Shoe 45o
I2
2 I1
U
Io
0 2 Right shoe
7.3: DEMAND
In the preceding sections, we saw how the consumer choice problem is solved. The point
where this problem is solved, the point of tangency between the indifference curve and the budget
line, is a point on the demand curve. Given market prices for the two goods and his money
income, the tangency point shows what amount of the two goods the consumer is going to
purchase in the market. For example, given an income of Rs 100 and prices of x and y equal to Rs
2 and 1 respectively, Farooq will demand x* amount of commodity x and y* of commodity y as
indicated in figure 7.4. These are the equilibrium values of x and y and are thus called the
solution values for his maximization problem. Observing these values, we can define the demand
function for this consumer. We can observe that Farooq purchases these amounts of x and y and
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economists assume that while doing this he equalizes marginal utilities and price ratios to the
equality revenue condition.
7.3.1: Demand Functions

Having established the demand point of the consumer; think about the factors that can
change this demand point. One can, obviously, say that the factors that can change the
equilibrium or demand point should be those which were responsible for its occurrence. Refresh
how we determined the consumer’s demand point. There were two objects, the indifference curve
(taste) and the budget line (opportunities). So changes in these two factors can alter the demand
point of the consumer. Consider taste first.
Taste Differentials and Demand
Changes in taste over time or differences in taste across individuals can alter the
consumer demand point, as indicated by figure 7.13 which depicts the choice situation under two
different types of taste. Suppose that these are indifference curves of two different individuals
Farooq and Nomi. Farooq is assumed to be more inclined towards commodity x than y, so his
indifference curves are steeper such as IF. Similarly, Nomi is fond of commodity y, therefore his
indifference curves are relatively flat such as IQ (see chapter 5 to recall the concept that steeper
indifference curves show greater taste for the commodity on the X-axis). Let us assume that both
have the same level of income and are facing the same set of prices for the two commodities in
the market. This means that their budget lines look similar, ZS, with identical slope and
intercepts. The rule for calculating the optimum bundle is the same for both; it will be where the
indifference curve is tangent to the budget line.
Figure 7.13: The Impact of Taste on Demand

y
Q
yq
IQ
IE
F
yf
IF
S
0 xq xf x
For Farooq, equilibrium is at point F where he purchases xf and yf amounts of the two
commodities. However, for Nomi, the equilibrium point will be at Q with a demand of xq and yq
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amounts of the two commodities. To understand why the equilibrium point is different for both
consumers, consider indifference curve IF and the point of tangency F. Now think of the question
‘where will tangency move to if we rotate this indifference curve anti-clockwise.’ Clearly, it will
move towards the vertical intercept Z of budget line ZS, such as point Q.
Note the important result that both consumers ended up consuming different amounts of
the two commodities even though they had the same income. This difference occurs due to
differences in their tastes. Since Farooq liked x highly (steeper indifference curve), he purchased
more of it. Similarly, Nomi ended up consuming more y because he was fond of y. Note this very
important principle: the consumer will purchase more of the commodity which he likes more.
The result is highly important for its own sake because it is hoped to represent ‘consumer
sovereignty’ in a market economy by showing that if different individuals having similar income
levels are making different choices, then this difference is solely due to differences in their tastes.
But there is another more important reason for this result to be crucial: it pretends that the theory
of consumer behavior allows us to capture differences in individuals’ taste in order to understand
capitalist society—i.e. the theory of consumer choice can be extended to multiple individuals
with heterogeneous taste and is able to explain the variety of choices made by individuals living
in a capitalist society. It is standard practice in economics text books to stress these. But in
estimating the market demand curve economic theory assumes that ‘all individuals have identical
taste’. This is presented either ‘a simplifying tool for analysis’ or defended tactically by saying
that ‘it is difficult to predict changes in demand due to changes in taste’ hoping that students will
never question this assumption. We show in the next chapter that assuming similar tastes for all
individuals is not a matter of simplification, rather of compulsion. It is impossible for economic
theory to allow differences in taste across individuals if it has to achieve its objective
successfully—the objective of deriving the market demand curve. This will be discussed in detail
later in chapter 8.
It is important to understand why this is so. The similarity of tastes assumption applies to
capitalist society as a whole. Every rational capitalist consumer has the same taste in the sense
that he prefers preference itself to every specific preference. This is the precise meaning of utility
maximization. Farooq cannot maximize utility by consuming anything he likes—his consumption
pattern must facilitate total utility maximizations. It is the market, specially the financial market,
which determines the value (i.e. price) of all economic activities and outputs (i.e. commodities) in
terms of their contribution to aggregate utility. It is not consumer choice which directly
determines goods and factor prices but financial market valuations of economic activities and
customers in terms of their expected contribution to aggregate utility / profit maximization and
maximization of the rate of accumulation. Consumer choice is necessarily subject to the
discipline of the markets. Economic theory recognizes this in the sense that it accepts that the
individual consumer has to take both the prices be forefronts and the income as given. In
equilibrium he reconciles his choices with the given price ratio’s and the given budge line. These
price ratios and the budget line are determined by homo economicus, not by an aggregate of
actually existing consumers. The valuations of homo economicus force Farooq to:
• Reject all choices—such as worshiping God as an end in itself—which impede utility
maximization
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• Subordinate his preferences for individual utility maximization to the market valuation, for
these preferences are instruments for the maximization of aggregate utility / profit
The assumption of identical taste in the derivation of market demand is essential because it shows
the optimum tastes that capitalist consumers ought to have. It shows that utility has a very precise
meaning. Farooq does not increase his utility by satisfying himself in any way he likes—by
helping anti-imperialist forces—for the market cannot value this type of satisfaction. Farooq
increases his utility only when he derives satisfaction from preferring preference itself (profit /
capital) for the market can evaluate it. Economic theory says that Farooq is rational only when he
is a subject of capital—i.e. only when he derives satisfaction from the preference of preference as
an end in itself. If he drives satisfaction from the fulfillment of any other preference he is an
insane, irrational and (at least potentially) very dangerous. He deserves to be shot like the 80
million Red Indian whom the Americans slaughtered in the 17th and 18th centuries.
The other determinant of demand is the consumer’s income. Anything that can change
the budget line can affect the consumer demand point. Let us see which factors can change the
budget line, and hence, demand point. Recall that the budget line, as discussed earlier in this
chapter, is determined by the prices and consumer’s income. The budget equation was,
M = Px × x + Py × y (7.4)
There are five variables in this equation: consumer’s income (M), prices of commodities x and y
(Px and Py), quantities of commodities x and y to be chosen by the consumer (x and y). Note that
the quantities of the two goods, x and y, are the endogenous (dependent) variables because the
consumer himself chooses them (see the definition of endogenous and exogenous variables from
the appendix to chapter 1). These two are themselves objects of his choice and cannot affect the
position of the budget line. Now we are left with three variables in the budget equation, prices of
x and y, and the income of the consumer (M). It is changes in these factors that can change the
position of budget line. To see this clearly, recall that the vertical and horizontal intercepts of the
budget line are given respectively by:
M M
y max = and x max =
Py Px
Px
while its slope is given by . If income and prices remain constant, neither the intercepts nor
Py
the slope of the budget line can change. So, any change in these three factors can also change
demand or equilibrium point of the consumer (we will see this in detail in next chapter).
Therefore, we can say that the demand for a commodity depends upon the variables, Px, Py and
M, written as:
x * = f x (Px , Py , M ) (7.13-a)
y * = f y (Px , Py , M ) (7.13-b)
where f x shows the demand function for commodity x and f y shows the demand function for
commodity y. These equations are simply a symbolic way of saying that the choice of x and y
depends on prices of all commodities in the consumption bundle of a consumer and the total
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amount of income that he has available to spend. A single demand function represents the
functional relationship between the quantity demanded of a good and all factors that can influence
its demand, the price of that good, the price of other goods and the size of income. If you compare
equation (7.13) with that of (3.1) in chapter 3, you will see that they are exactly the same. We
introduced this demand function in chapter 3 while this chapter has shown how this demand
function is derived. These demand functions tell us how much of a good will be demanded given
these exogenous variables.
Homogeneity of Degree Zero: A Property of Demand Functions
Economists derive an important property of demand functions, called homogeneity of

degree zero. This property simply states that if all prices and income change by the same
proportion, consumer choices will remain unchanged. To see why, suppose that all variables in
the demand function are multiplied by a positive constant, say, 2, then the two budget equations,
Px × x + Py × y = M
2Px × x + 2Py × y = 2M
are the same because we can obtain the original budget line just by dividing the second equation
by 2. This means that the two budget lines are exactly the same (plot these two budget equations
to convince yourself choosing Px = Rs. 1, Py = Rs. 2 and M = Rs 100). Since the budget lines are
identical, nothing has changed, so the demand point will also not change. More technically, we
can write this result as that for any commodity x:
x * = f x (Px , Py , M ) = f x (λ Px , λ Py , λ M ) for all λ > 0 (7.14)
Hence, we have learnt that the demand functions are homogenous of degree zero in all prices and
income. Changing all prices and income in the same proportion will not change the physical
quantities of goods demanded. The underlying assumption again is about the invariance of talent.
One of the important implications of this property is that money illusion is not a property
of the demand functions. What does this mean? Income and prices are, of course, denoted in
some monetary unit such as rupees. But does it matter which unit we choose? The simple answer
is that according to economic theory designating the monetary units as rupees or dollars will not
affect the result if the right rate of exchange is used. The units in which we measure each
commodity has no effect on the consumer’s decision. Similarly, whether x is measured in pounds
or kilograms or in any other unit of weight, the same budget set and trade-off is available to the
consumer in terms of physical quantities.
Another important implication of this property is that introduction of money in the model
of consumer choice model does not affect results derived without money. In other words, a
money economy is equal to barter exchange economy.
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7.3: CONSUMER THEORY AND UTILITARIANISM
We have seen at several places in the last two chapters that most of the concepts
employed by economists in consumer behavior analysis are unobservable. For example, it is
impossible for the consumer to estimate MRS for goods in a typical capitalist market. Information
processing requirement for doing this are so formidable that no one can base his choices on such
estimation (not even with the help of the latest computer technology). We have also seen that
indifference curves cannot be directly observed. They are assumptions about consumer behavior
and most empirical studies have shown (as psychologist economics emphasizes) that consumers
do not seek utility maximization and do not normally behave as economic theory expects them
to—Abdullah Zhaghazai reacts with horror and repulsion when the World Bank sponsored
Consumer Council of Pakistan informs him about his ‘sovereignty’ as a consumer. Even in
America, where greed and selfishness is greater than at any other time or place in history,
consumer right activists continue to complain about the apathy of the overwhelming majority of
consumers who are basically impulse buyers and care little about their “rights”. Actually existing
capitalism does not function as economists expect it to.
Why then do economists raise such ballyhoo about indifference curves, marginal rates of
substitution, total and marginal utility? This is because economics is essentially an ideology. It’s
positive analysis in functional only if one seeks to realize the norms it sanctions. If these norms
(utility / profit maximization as ends in themselves) are rejected, the positive analysis becomes
useless.
Indifference curves, MRS, utility and marginal utility are ideological concepts. They have
been developed not on the basis of observation of the behavior of actual consumers at a particular
time and place but on the basis of the acceptance of an ideology—the ideology of utilitarianism.
The concepts of the indifference curve, the marginal rates of substitution, the utility function and
marginal utility show how consumer behavior should be modeled if utilitarianism is accepted as
an ideology.
Utilitarianism is one of the two enlightenment ideologies which provide a philosophical
basis for capitalist social sciences. Utilitarianism is the philosophy underlying economics.
Deontology provides the ideological grounding for political science and mainstream sociology.
Utilitarianism was born in the eighteenth century. It’s founder was David Hume, one of Britain’s
most famous atheists of that time and a close friend of Adam Smith. Two other leading
utilitarians—Jeremy Bentham and John Stuart Mill—exerted great influence on the founders of
neoclassical economics; Jevons, Walrus, Manger, Edgeworth and Marshall, all of whom were
utilitarians.
Utilitarian ideology says that all acts and rules should be assessed on the basis of the
consequence they produce in increasing or decreasing total consumption over a defined time
period. Consumption is regarded as the main activity which increases pleasure and reduces pain
and according to utilitarian ideology the moral person seeks to maximize net utility (the excess of
pleasure over pain) for all persons capable of experiencing pleasure and pain. Maximizing
consumption—you can call it utility or welfare for the ‘welfare function’ is identical with the
utility function—is an end in itself. Utilitarian moral agents seek maximization of aggregate
consumption irrespective of the wishes of those whose consumption is being maximized. Thus
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the IMF expert advising the Government of Pakistan ignores Abdullah’s preference for helping
Madrassah as against maximizing the consumption of the people of Pakistan, for maximizing
consumption is an end in itself. Utilitarian ideology does not allow Abdullah to prefer anything
over the maximization of aggregate consumption—for maximizing aggregate consumption is the
preference for preference itself. The IMF specialist is the World Agent who tells Abdullah that he
must prefer preference itself (maximization of aggregate consumption) over all specific
preferences. Utility must be defined as maximization of aggregate consumption, anything which
reduces aggregate consumption is dis-utility and cannot therefore be the subject of rational
choice. Thus the World Agent (the IMF specialist) has the correct preferences and therefore he
should determine both the valuation of all acts and rules and the conception and articulation of
policy. The World Agent is thus a legitimate “second guesser”—he has a right to tell Abdullah
what yields the maximum net pleasure. This is necessarily the act and the rule which facilitates
the maximization of profit for maximization of profit necessarily maximizes value added and
minimizes costs over the long run.
Thus based on utilitarian ideology, consumer preference theory and its conceptual tools
(indifference curves, MRS, the utility function, marginal utility) tell us how Abdullah ought to
behave as a capitalist consumer.
• He should be indifferent to all those combinations of goods he is consuming which yield
the same net pleasure (utility)
• He should prefer more consumption to less consumption for increasing consumption is
the only way to increase welfare (net utility)
• He should not prefer the infinite consumption of any one good, his indifference curve
should be convex to the origin and the marginal utility he derives from the consumption
of any one good should decline as he consumes more of it. He should prefer preference
for itself—i.e. the ability to consume more of all goods—to the preference of any
particular set of goods
• Indifference curves should be additive. We should be able to derive community
indifference curves and Abdullah should accept policies as rational which seek aggregate
profit maximization, for this alone ensures the minimization of costs and the
maximization of net aggregate welfare (consumption)
• Abdullah should accept the legitimate authority of the World Agent (the IMF economist)
who has the expertise to devise policies for the maximization of profit / aggregate
welfare. Abdullah should subordinate his preference to the preference of the all knowing,
perfectly judicious capitalist World Agent
Suppose Abdullah rejects all these ‘oughts’ and ‘shoulds’. He rejects consumption
maximization, both for himself and for Pakistan as an end in itself. He refuses to prefer
preference itself to all specific preferences. He rejects to accept as legitimate the authority of
those who seek to impose the preference for preference itself (profit / welfare maximization) as
criteria for valuing acts and rules. What will the economist do in these circumstances? He can
either pretend that Abdullah is insane, irrational, ignorant or even that Abdullah does not exist.
But doing that is dangerous for Abdullah may prove his existence by obstructing the capitalist
organization of the economy. The economist must therefore force Abdullah to accept capitalist
discipline. The economy must be so organized that Abdullah cannot survive unless he acts as a
capitalist consumer, producer, trader and regulator. That is where policy is needed. As a
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normative discipline economics is concerned to transform all existing systems of consumption,

production and exchange into capitalist economies. Its theories outline what a capitalist economy
is and how it functions. These theoretical descriptions of ideal capitalist consumption, production
and exchange provide the criteria on the basis of which all existing patterns of production,
consumption and exchange can be evaluated in terms of their correspondence with capitalist
ideals. Economics is capitalism’s ideology—it is useful for capitalism not because it shows how
actually existing capitalist markets function but because it spells out the logical implications of a
complete organization of economy and society along capitalist lines. Other capitalist
disciplines—e.g. political science, sociology, psycho analysis, jurisprudence, management—have
proved more effective in transforming actually existing societies into capitalist ones, but the
abstract model of a fully articulated capitalist order is most rigorously presented by economic
theory. That is economics’ great contribution to the emergence and sustenance of capitalism as a
(potentially) universal life world. Therefore, the capitalist theory of consumer preference:
• does not tell us much about Abdullah or Nomi’s actual behavior as a consumer
• nor does it tell us how to induce Abdullah to accept capitalist consumerist norms and
rationalities
• but it does tell us how to organize the markets in such a way that if Abdullah refuses to
accept capitalist norms and rationalities he will starve to death, as did the eighty million
Red Indian in North America during the seventeenth to nineteenth centuries.
In that lies its supreme usefulness to capitalism.
What is Next?
This chapter has explored how preferences and opportunities interact to determine consumer
choices in the market. We also learnt how choices can be shown by demand functions. The next
chapter will show how the demands for goods undergo changes due to changes in opportunities.
It is again necessary to state that consumer choice theory is ideological, not functional. It is
useful for capitalism not because it tells how consumers’ choices are determined in the real world.
As we will see in later chapters it is usually impossible to derive a “well behaved” (i.e. downward
sloping all the way) marks demand curve from individual demand curves. Consumer choice
theory is useful because it shows how ideal consumers ought to behave and thus forms a basis for
developing policies to force consumers to behave in this ideal way. Regulating consumer
behavior in this way facilitates capitalist social dominance.
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Key Concepts
Absolute price is the price of a commodity in some monetary terms

Budget constraint or budget line shows the largest available bundles of two commodities with
given prices and income. Its slope measures the relative price of x
Budget set shows the set of all income feasible consumption bundles
Cardinal utility function contains information about utility differences as well as preference
ordering that it represents
Consumer equilibrium is the consumption bundle that shows a consumer doing the best that he
can do. It is the point where indifference curve is tangent to the budget line reflecting the fact that
subjective valuation of a consumer for a commodity is equal to that of market
Corner solution shows that the consumer purchases zero amount of one of the two commodities
and he specializes in the consumption of other one
Diminsihing marginal utility says that the utility derived from the consumption of a commodity
decreases as more of it is consumed
Equi-marginal principle states that at consumer equilibrium, the ratio of marginal utilities to
prices is equal for all goods consumed. Verbally, it says that marginal utility of the last rupee
spent on one good should be equal to the marginal utility of the last rupee spent on another good
Homogeneity of degree zero is the property of a function which says that if each of the
arguments of a function is multiplied by a positive number, the value of the function remains
unchanged. Demand functions are also homogenous of degree zero in prices and income meaning
doubling all prices and income changes only the units by which we count, not the physical
quantities demanded
Interior solution occurs when consumer opts to consume positive amounts of both the
commodities.
Optimum bundle is that combination of (x,y) which lies on the highest indifference curve. It is
that bundle for which the utility of the consumer is maximum
Ordinal utility function represents a consumer’s taste showing only the order of the preferences,
not the utility differences
Price-taker is a consumer who does not have any control to determine market prices and accepts
them as given information by the market for making his choice decision
Relative price is the price of one good in terms of another. It is the rate at which one must give
up another commodity to obtain one good in terms of specific good.
Unique solution is that which has only one solution value. Consumer utility maximization
problem has a unique solution if indifference curves are strictly convex. The tangency condition
shows the only one point at which utility is maximized
Utility-maximization is a hypothesis about consumer behavior which says that the objective of a
consumer is to maximize utility subject to his income constraint
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Chapter Summary
• Consumer behavior theory assumes that the consumer has (a) given tastes (b) given resources
(income). Capitalist society begins with a given distribution of resources
• The consumer is also assumed to know all prices. He is a “price taker”
• The budget constraint gives the different quantities of x and y that can be purchased given the
prices of x and y and the income of the consumer. Points outside the budget line are not
affordable to the consumer; points inside the budget line leave some of his income unspent
• The slope of the budget line is negative because it shows a trade off between amounts
consumed of the two commodities. The value of the slope of the budget line is equal to the
ratio of the price of the two commodities. The slope of the budget line is constant because
expenditures are fixed and the price ratio of the commodities consumed remains constant
• The budget line shows the opportunity cost of consuming one commodity in terms of not
consuming the other
• Consumer choice theory seeks to show how the consumer can maximize his utility given his
limited resources. His utility function measures the utility he derives from the consumption of
the goods for which he has preference. If scarcity does not exist and men voluntarily limit
their consumption the theory of consumer choice cannot explain consumer behavior
• The consumer whose behavior consumer choice theory can explain must be greedy, jealous
and accumulative. He must accept the Enlightenment conception of truth— i.e. the purpose of
knowing the world is to dominate it and that the pursuit of accumulation is an end in itself
which should be attained through an appropriate organization of individual and social life
• The capitalist consumer chooses that combination of goods which maximizes his utility given
his income. This is the combination of goods shown by the tangency of the budget line
(showing the consumer’s income) and the highest indifference curve (showing his tastes)
• The convexity assumption implies that the consumer will choose that combination of goods
which lies on the highest indifference curve touching the budget line—a combination on the
budget line at every other point will necessarily be on a lower indifference curve
• The consumption of a good is not an end in itself. It is a means for the maximization of
utility—the only end in itself. The maximization of utility as the only ‘end in itself’ reflects
the commitment of the consumer to the preference for preference itself rather than to any
specific preference
• At the point of tangency (i.e. the goods combination the consumer chooses) the slope of the
budget line and the indifference curve are equal. This is the point at which the choice of the
consumer’s substitution of two goods (MRS) equals the market valuation (price ratio) of
these goods. The optimum (utility maximizing) combination of goods to purchase is that at
which the consumer’s valuation equals the market valuation of the purchased goods. In
equilibrium the market valuation of commodities will determine the combination that the
consumer must choose to maximize his utility given his income
• In equilibrium the individual chooses what the market allows him to choose. He cannot
choose what the market is not offering (to be a mujahid for example) and yet act rationally. In
this sense in equilibrium the choices of all individual capitalist consumers are determined by
market valuation. Moreover, the consumer’s ability to maximize his utility depends on his
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income—which in turn depends upon the valuation of the individual’s labor by product
markets
• In capitalist order income is the concrete form of freedom. The greater the income the greater
the individual’s freedom to choose. Freedom is maximization of utility made possible by
higher levels of income. The rational individual’s ultimate choice (‘end it itself’) is for higher
and higher levels of income and wealth through participation in capital accumulation. Every
other choice is a mean for achieving higher levels of income which is the same thing as
maximization of utility and maximization of freedom
• A unique utility maximizing equilibrium point cannot be identified on non-convex
indifference curves. This unique equilibrium point is described as interior solution since
positive amounts of both commodities are consumed
• If indifference curves are concave we have a corner solution showing that there is
consumption of only one good. Maximum utility is achieved only in the convex region of the
concave indifference curve; i.e. at the point the indifference curve touches the axis. This
shows that for utility to be maximized indifference curves (i.e. tastes) must be convex.
• Utility is maximized when the utility derived from the expenditure of the last rupee on each
commodity purchased is the same. This result is based on the theory of diminishing marginal
utility which states that utility decreases as the quantity consumed of a commodity increases.
This is simply a statement of the assumption that indifference curves are convex to the origin.
The law of diminishing marginal utility implies that the consumer purchases more than one
commodity. Resources should be so allocated that the ratio of marginal utility to price is
equalized on expenditure with respect to each commodity. This is the law of equi-marginal
utility
• The law of equi-marginal utility cannot be used to determine the allocation of resources if the
purpose of this allocation is anything other than utility maximization
• MRS cannot be observed as prices can ne and therefore the equi-marginal principle can
neither be validated nor refused. Economics says that this is how people ought to allocate
resources since they ought to maximize utility. Economics cannot justify the view that
everyone ought to maximize utility. It is for this reason that economics is a normative science
• Applications of the equi-marginal utility principle require that utility be measured cardinally.
Indifference curve analysis requires only ordinal measures of utility
• The equi-marginal principle and the indifference curve approach identify the same criteria for
the allocation of scarce resources. This is so because both are based on the same objective of
maximizing utility. Neither of the approaches can be used if the purpose of resource
allocation is some thing other than utility maximization
• The point of tangency between an indifference curve and the budget line is a point on the
capitalist consumer’s demand curve. At this point marginal utilities and the prices of the
purchased goods are assumed to be equalized. We can observe what combination of goods is
purchased in the market at different price levels. We cannot observe whether this equalizes
prices and marginal utility of the purchased goods to specific purchasers
• The demand changes when there is a change in tastes or prices or income. The capitalist
consumer will purchase more of the good he (arbitrarily) likes more. Economists usually
assume that all consumers have similar tastes. This they do, not for simplifying the analysis,
but because without this assumption it is not possible to derive the aggregate market demand
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curve. The aggregate market demand curve reflects the presumption that every rational
capitalist consumer prefers preference itself (capital accumulation) to every other specific
preference. The similarity of taste assumption applies to capitalist society as a whole
• In capitalist society consumer choices which do not contribute to aggregate capital
accumulation (preference for preference itself) cannot be valued on the market. Such choices
are thus not available to individual consumers. Consumers choose only among choices which
contribute to capital accumulation and are valued by (especially financial) markets.
Consumers are not sovereign to choose anything they like
• Utility has a very specific meaning. It is derived only from acts which lead to utility
maximization and can be evaluated on the basis of capital accumulation. Capitalist markets
and capitalist states cannot recognize utility in any other form
• The determinants of the demand function are (a) income, (b) the price of the commodity
being demanded and (c) the price of compliments and substitutes
• Demand functions are assumed to be homogeneous of degree zero—i.e. if all prices and
incomes change by the same proportion, consumer choice will remain unchanged. This
assumption reflects assumptions about tastes being similar. It also assumes that capitalist
consumers do not have money illusion
• Consumer behavior theory is useful because it shows how an ideal capitalist consumer ought
to behave. This provides a basis for developing policies which can force consumers to behave
in this desired way. Consumer choice theory is therefore normative and ideological
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Review Questions
1. What assumptions underlie the theory of consumer choice?

2. What is the budget constraint?
3. What is meant by the “budget set” of a consumer?
4. What is meant by the “relative price” of a commodity?
5. Show that the conception of the budget line is based on the presumption of universal scarcity.
6. What problem does consumer choice theory seek to solve?
7. Define the utility function of a consumer. Why cannot the theory of consumer behavior
explain Abul Bashar’s pattern of consumption? Does Abul Bashar have a utility function?
8. Contrast the characteristics of Abul Bashar and Mr. Bill Grates.
9. Formally state the utility maximization condition. What does it mean?
10. Demonstrate graphically the attainment of equilibrium by a capitalist consumer. Why cannot
he choose to go to (a) a higher indifference curve or remain on (b) a lower indifference
curve?
11. What is the economic meaning of consumer choice being determined at the point of tangency
of the indifference curve and the budget line?
12. “Market valuation determines consumer’s choice in equilibrium”. Do you agree?
13. “Rationality requires that personal preferences be subordinated to market valuation”. Do you
agree?
14. Who is sovereign, the market or the consumer or both or neither?
15. What is the meaning of freedom in capitalist order?
16. With the help of a diagram show that a unique equilibrium position cannot be identified on
non-convex indifference curves.
17. What is “the corner solution”? Illustrate with the help of concave indifference curves. Why is
the corner solution a realistic situation only if we regard capital as the only good that is being
consumed?
18. Describe the theory of diminishing marginal utility with the help of a numerical example.
19. Why can the principle of equi-marginal utility not be empirically validated?
20. Show that application of the equi-marginal principle and the indifference curve approach
yield the same result. Why is this so?
21. Show diagrammatically that in the case of perfect substitutes with equal prices, indifference
curve analysis cannot determine a unique consumer choice solution
22. Why do economists usually assume that tastes are similar?
23. “Consumer preference theory shows actually that consumers cannot be sovereign”. Discuss.
24. What is utility? Can we derive utility from giving zakat?
25. What are the determinants of the demand function?
26. Draw a diagram to illustrate that the demand curve is homogenous of degree-zero.
27. What purpose does consumer choice theory serve?
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8
Chapter
CHANGES IN DEMAND
The concept of consumer equilibrium, discussed in chapter 7, is very important in

economics. Consumer equilibrium is determined by the interaction between the consumer’s taste
and his market opportunities. But the problem is that the taste of a consumer is not observable,
therefore, the point of his equilibrium cannot be identified in actual existing markets. Then, of
what use is this equilibrium in analyzing the behavior of the consumer? In other words, if
equilibrium can never be observed, what can this concept of ‘consumer-equilibrium’ tell us about
consumer behavior? The necessary assumption needed to use the concept of ‘consumer-
equilibrium’ is to keep the taste of not only one consumer but of all consumers constant over a
period of time. As we see in this chapter it is this assumption that allows economists to study the
effects of changes in opportunities on consumer behavior. This can be observed; i.e. some
observable changes in the behavior of the consumer can be noted in response to the changes in his
opportunities. The underlying idea is that if some changes are observed in consumer demand, you
can attribute these changes in demand to changes in market opportunities. This is the general
methodology used by economists. Instead of trying to use the results from a single equilibrium
point, economists are more interested to know how equilibrium changes when variables that
determined the equilibrium undergo some changes. This analytical technique is called
comparative-static-analysis.
It is important to note what this method of analysis rules out of its scope. Suppose John
Hall was a member of the American Republican Party in 2006. In 2007 he became a Muslim and
joined the Black Panthers of Islam. Economics assumes that his tastes and his pattern of
consuming, say, wine will not change as a consequence of John Hall becoming Sheikh Yahya
Hall. This means that if an Islamic revolution—e.g. in Iran in 1979—takes place, patterns of
consumption will not change. This means that Iranies will continue to eat pork and drink whisky,
while consumption of pork and wine will continue to change only in response to changes in prices
and incomes. This means that economists rule out both changes in individual identities and social
change in their comparative static analysis of consumer behaviors.
We discussed in the last chapter that variables that can change the demand point of a
consumer are income and prices of the goods, while his taste is held constant. This chapter
analyzes how changes in these variables affect the demand of a consumer and how economists
derive relations among these effects. But note that none of the variables are expected to change
the taste of a consumer; rather they will change only his budget set. Also recall our definition of
the demand function of a consumer for some commodity, say, x: it was said to be a function of
income, price of x and the price of y. We take changes in these variables one by one and see how
they affect the demand for a commodity. We will show in this chapter the impossibility of
extending this model to more than one consumer without involving contradictions. This illustrates
an important, but often un-mentioned weakness of economics.
8.1: INCOME CHANGES AND DEMAND
As the income of the consumer changes, so does his purchasing power. Suppose that his
income level increases, this means that now he can afford to purchase more of all commodities.
First understand how his budget line will change due to this increase in his income. We discussed in
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the last chapter that increase in income will shift the budget line of the consumer outwards. To see
this again, recall that the vertical and horizontal intercepts of the budget line are given by:
M M
y max = and x max =
Py Px
With given prices of x and y, the larger the income of the consumer, the farther away will be the
intercepts of the budget line from the origin. This situation is again shown in figure 8.1 where
budget lines for two different levels of income, Mo and M1, are shown, where M1 (say Rs 200) > Mo
(say Rs 100). The original budget line shifts out from ZS to RT.
Figure 8.1: Effect of increase in income on budget line

y
M1 R
= 100
Py
Mo Z
= 50
Py
S T
0 Mo M1 x
= 100 = 200
Px Px
As an example, suppose that income has increased from Rs 100 to Rs 200 while the prices of x and y
have remained constant at Rs 1 and Rs 2 respectively. This means that now the consumer can afford to
buy 100 units of y if he spends all his income on y and similarly 200 units of x. The vertical as well as
the horizontal intercepts have shifted by equal proportions, so we see a parallel shift in the budget line.
Since the slope of the budget line is given by the ratio of prices and prices have not changed, therefore
the slope of the new as well as the old budget lines must be the same; i.e.
Px 1
Slope of old and new budget line = =−
Py 2
Now think what happens to the equilibrium point after this shift in the budget line. It is
expected, due to the assumption of more is always better than less, that the quantity of each good
purchased will also change after an increase in income. Why? Recall that the budget equation of
the consumer was defined as,
Px × x + Py × y = M
If the consumer has more income to spend at fixed prices, it is impossible for him to buy the same
amount of the two goods because his expenditures must also increase by the amount of increase
in his income for the budget equation to hold. This means that demand for at least one commodity
must increase for total expenditures and income to remain equal after increase in income. The
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answer to the question ‘where will the equilibrium be on the new budget line’ depends on the
nature of goods in question. Let us explore this a little further.
8.2: NORMAL AND INFERIOR GOODS
Consider point E in the right hand panel of figure 8.2, the initial demand point of Nomi
at budget line ZS with xo and yo amounts of x and y demanded. We have to determine his new
equilibrium or demand point at budget line RT created due to increase in his income. To see
where equilibrium can move, consider points A and B on the triangle AEB at point E. The budget
line RT has now been divided into three segments; RA, AB and BT. Look at point A first. If
equilibrium moves to point A, this means that the demand for y increases to y1 while that of x
remains unchanged. On the other hand, if equilibrium moves to point B, only the demand for x
increases. Recall from chapter 3 that if demand for a commodity increases due to increase in
income, then such a commodity is said to be a normal good in capitalist order. If x and y both are
‘normal’ goods for this capitalist consumer, then demand for both must increase.
Figure 8.2: Determination of new equilibrium point after increase in income (new budget line)
ynormal y
R R
A A
y1
Z Z
y2 F
I2
B B
yo yo
E E
I1 I1
S T S T
0 xo x2 0 xo x1
normal
x x
This implies that the new equilibrium will lie in between points A and B in this case as shown in
the left hand panel of this diagram at point F. Demand for both goods has increased from xo and
yo to x2 and y2 respectively on the new budget line. Thus, we see a positive relationship between
income and demand for these goods. This can be stated as:
If xnormal and ynormal tangency or equilibrium point will lie between AB
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Mathematically, we say that the demand-function of, say, x is increasing in income; that is an
increase in income leads to an increase in demand for x. Algebraically:
∆x normal
>0 (8.1-a)
∆M
The same also holds for y, if it is also a ‘normal’ good:
∆y normal
>0 (8.1-b)
∆M
But the demand for all goods does not increase after an increase in the income of the individual.
Consider the demand for potatoes or second hand shoes as an example. As the capitalist consumer
becomes richer, he may reduce the purchase of these goods, and hence we see a negative
relationship between income and demand for such goods. Recall from chapter 3 that goods with
negative relationship between income and their demand are called ‘inferior goods’ in capitalist
order. Suppose that x is an ‘inferior’ good. In this case, equilibrium will move between RA in the
right panel of figure 8.2 which means that demand for x falls as the income of the consumer
increases. This phenomenon is illustrated in figure 8.3 where x is assumed to be an ‘inferior’
good. Algebraically, it can be stated as:
∆x inferior
<0 (8.2)
∆M
Figure 8.3: Equilibrium after rise in income in case of ‘inferior’ goods

ynormal
G
y3
I2
ICC
E
y0
I1
0 x3 xo xinferior
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If xinferior and ynormal tangency or equilibrium point will lie between RA

Similarly,
If xnormal and yinferior tangency or equilibrium point will lie between BT
Finally, it is straight forward to understand that both x and y cannot be inferior (assuming that
they are the only goods the consumer can buy). We leave the explanation of this proposition to
you. This fact explains the necessary-positive-relation between income of a consumer and
demand for at least some commodities for a consumer—the one who maximizes utility as an end
in itself. This tells us something very important about capitalist society—in such a society the
consumer always wants more; i.e. ‘more’ is always better than less.
8.2.1: Income-Consumption Path and Engel’s Curve
We have shown equilibrium only at two income levels in our previous diagrams, such as
at points E and F in the left hand panel of figure 8.2. However, it is also possible to show
equilibrium at more than two income levels as indicated by points E, F and G in the right hand
panel of figure 8.4. And not only three points, we can trace out equilibrium points at many
possible income levels. If we join all such equilibrium points by a curve, such curve is called the
income-consumption-path (ICP) or income-consumption-curve. This curve shows the position
of the equilibrium point at all income levels; e.g. if the budget line is ZS, then equilibrium will be
at E; if it is RT, equilibrium will be at F and so on for any income level.
Figure 8.4: Income-consumption-path and Engels curve

Income ynormal
P
R Income
consumptio
Z
n curve or
Engel’s
C
G
F
E
0 0 S T Q normal
normal
x x
In this diagram, both goods are ‘normal’ since demand for both of them is increasing due to an
increase in income. This implies that every equilibrium point will be above and to the right of the
previous equilibrium point. If both the goods are ‘normal’, as it is the case here, then the income-
251
consumption-path must be positively sloped. If we now plot this ICP in commodity-income space
placing income at y-axis and demand for xnormal’ on x-axis, the resulting curve is called Engle’s
curve, (named after Ernest Engel), as drawn in the left hand panel of figure 8.4. This curve gives
the same information of consumer equilibrium points at all income levels as ICP but in income-
commodity space. Remember that ICP shows consumer-equilibrium-points in the ‘commodity-
space’; i.e. ICP is drawn with commodities at both axes while the Engel’s curve is drawn with
income on one axis and commodity demand on the other.
Shape of ICP or Engel’s Curve and Flaws in Economic Reasoning
Let us look closely at how the spending of a consumer changes as his income changes.
This analysis will reveal an important pitfall in the economic theory of consumer demand. To
begin with, note that for the ‘normal’-goods case, ICP can take any positively sloped-shape at all;
it needs not necessarily be a well-behaved straight line curve. In standard microeconomics text-
books, economists pretend to allow this possibility in principle. However, we show in the third
section of this chapter that this degree of freedom holds as far as they are analyzing the demand
behavior of only a single consumer. When demand for more than one individual is involved, then
ICP must be a straight line positively sloped curve. To understand the meaning of the shape of the
ICP curve, look at figure 8.5 which depicts four different shapes of ICP curve.
Keep in mind that the shape of the ICP shows the rate at which demand for a commodity
increases as income increases. Consider panel (a) first. This is the case of an inferior good. Recall
that for inferior goods, consumption (demand) falls as income increases —some commodities
may be substitutes for better quality products for the capitalist consumer when he is poor but their
demand disappears as he becomes wealthier. Hence, ICP must be negatively sloped if x is
assumed to be an ‘inferior’ good which shows that as the income of the consumer is increasing,
he is reducing the demand for x. Now consider panel (b) depicting the case of a necessary good.
We discussed in chapter 5 that necessities are goods for which demand remains more or less fixed
or increases marginally as the income of the consumer increases (demand for necessities is
income inelastic). This means that as the consumer becomes wealthier, the share of spending on a
‘necessary’ good decreases in his total expenditures. In terms of panel (b), this means that the
demand for x increases at a decreasing rate as income increases; i.e. each time a smaller
proportion of additional income will be devoted to the purchase of more units of x as it is a
‘necessary’ good. Therefore, ICP takes on an increasing slope shape. In other words, it gets
steeper. On the other hand, demand for luxury goods increases at an increasing rate after a rise in
income; i.e. most of the additional income is spent on luxuries after the consumer has reached a
certain level of affluence. This means that ICP will get flatter as drawn in panel (c).
Thus, there is a particular name that can be associated to x in these three cases. But
consider the final case of panel (d) where ICP is a straight line. Such a shape means that
consumption or demand for x increases at a constant proportion every time income of the
consumer rises. Such a commodity is termed as a representative-commodity by economists—
according to economics, this is a commodity whose consumption pattern represents the most
common consumption behavior in this world and which fits almost all of the cases. The share of
spending on such a ‘representative’ commodity would remain the same in total income even if a
person rose from miserable poverty to unimaginable opulence.
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Figure 8.5: Shape of ICP determine the nature of commodity in question
ynormal ynormal
a) x is Inferior b) x is necessary
ICP
ICP
0 xinferior 0 xnormal
ynormal ynormal
c) x is luxury d) what is x?
ICP
ICP
0 xnormal 0 xnormal
Can you give any example of such a commodity in capitalist society? Think again! Not
surprisingly, there is no commodity in capitalist order whose consumption follows such a uniform
pattern of consumer expenditure. But interestingly enough, it is exactly this non-imaginable
commodity that economists describe as the ‘representative of all’ to model consumption behavior
and all the propositions discussed in chapter 3 assume the existence of this representative
commodity! In fact, there is no commodity in capitalist society except in economics text books to
which this commodity refers. Don’t lose your head; there is more to be surprised at in the coming
sections. Here, read Application Box 8.1 to know the exact nature of this mythical
‘representative’ commodity.
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Application BOX 8.1

The Non-Sense of ‘Representative-Commodity’
We said that consumption of the ‘representative’ commodity remains a constant
proportion of income as income increases. This can be the case only if:
 The consumer’s taste for it remains the same no matter what age-group he belongs to
 The consumer’s taste for it remains the same no matter how much his income increases
 Every additional rupee of income is spent exactly the same way as all previous rupees; i.e.
if out of each one rupee the consumer spends, say, 20 paisa on pizza, 30 paisa on clothing,
10 paisa on bananas and 40 paisa on housing, then this proportion must remain the same no
matter how poor or rich he becomes.
These are absurd statements which can never be true in capitalist society. They simply say that
when, say, Bill Gates earned $100 a week, he spent $10 on pizza (10% of total income). Now that
he earns $100,000,000 a week, he must spend 10% on pizza. Do you know how much does this
amount to? It requires that Mr. Gates must spend $10,000,000 each week on purchasing pizza! If
the price of a typical pizza is assumed to be $10, it means that he must eat 10,000,000 (10
millions) pizzas per week or almost 1,428,571 (more than fourteen lacks) pizzas per day!
Similarly, this proportion must remain the same irrespective of whether he is 25 or 90 years of
age. Does it make any sense? Of course not. As suggested by these conditions, there is simply no
commodity in capitalist society expenditure on which equals the same proportion of a homeless
person as it does of a billionaire. As the age and income of a capitalist consumer rises, his
consumption pattern will change. In reality, a typical consumer is going to have the majority of
his ICP curves like a, b and c, but no curve like d.
You might be tempted to believe that the choice of such a commodity by economists is a
‘scientific-abstraction’ adopted in order to simplify the nature of the analysis. Well most of the
text books on microeconomics, and probably your teachers, will try to satisfy your discontent
with economic analysis by making you belief in this type of scientific dogmatism in the name of
‘simplification’. However, the choice of ‘representative-commodity’ is not a matter of
simplification. It is a matter of compulsion. The major objective of consumer theory is to justify
the negatively sloped market demand curve which, can be derived only in the case of the mythical
representative-commodity. Economic theory fails to justify its desired negatively sloped market
demand curve in case of all goods which are not representative-commodities. But in order to
understand this fact, you need to understand how economists derive the individual demand curve
from its consumer choice model. We now turn to this issue before exposing a fundamental
contradiction in this model.
8.3: OWN PRICE CHANGES AND DEMAND
Let us analyze how changes in the own price of a commodity are going to alter its
demand. You will see that the effect of a price change on the quantity demanded of a commodity
is somewhat more complex than the effect of an income change. This is due to the fact that
changing price does not only change the position of the budget line but also its slope. To see how,
look at figure 8.6 where the initial budget line is ZS and the price of x Px = Rs 1. Now suppose
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that the price of x drops to, say, Px* = Rs 0.50. How will this change the budget line? Since the
price of y and income is the same, the vertical intercept will not change; the consumer can still
afford to purchase the same amount of y as before, 50 units. But after the reduction in the price of
x, the consumer can purchase more units of x, say 200 units; so the horizontal axis moves out
from S to T. You can see that the slope of the budget line has gone shallower after lowering the
price of x.
Figure 8.6: Effect of fall in price on budget line
y New budget line after fall

in Price with slope -0.25
M 100 Z
= = 100
Py 1
Old Budget line
with slope -0.5
S T
0 M 100 M 100 x
= = 50 = = 100
Px 2 Px* 0.5
This can be seen from the fact that the slope of the budget line before change in price was:
Px 1
Slope of old budget line = − = − = −0.5
Py 2
while after decrease in price of x, it is:
Px* 0.50
Slope of new budget line = − =− = −0.25
Py 2
Since Px* < Px , the slope of the initial budget line is steeper than that of the budget line after
price-change. The decrease in price has rotated the budget line anti-clockwise around its y-
intercept showing that now the consumer can purchase some bundles that were previously
unattainable for him. A price increase in x, on the other hand, would rotate the budget line inward
in clockwise direction. What about the new demand point on the budget line ZT? At this moment,
we can say at least one thing for sure, irrespective of the taste of the consumer. Because the new
budget set includes the entire original budget set, if the consumer was initially consuming both
the commodities on budget line ZS, it is certain that he would increase the consumption of at least
one of the commodities. If consumption of both commodities remains the same or decreases, then
the consumer would not be using all his income.
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8.3.1: Price Changes and Demand for ‘Normal’ Goods
Now let us see where will be the equilibrium point on the new budget line, ZT. Assume
that x is a ‘normal’ good—its demand increases with income. To answer this question, first we
need to understand what happens when the price of a commodity changes. Remember that when
the price of a commodity changes, it creates two effects: (1) The substitution effect and (2) The
income effect.
The Substitution Effect
When the price of x, decreases, the rate of exchange between the two commodities, x and
y, also changes. How? Suppose that the price of x goes down. Thus means that now the consumer
has to sacrifice less units of y in order to purchase an additional unit of x. For example, initially,
when the price of x was Rs 1 and the price of y was Rs 2, the consumer could purchase one unit
of x by sacrificing half a unit of y (recall table 6.1 from chapter 6). But suppose that the price of x
has dropped from Rs 1 to 0.50 while the price of y is still the same, Rs 2. How many units of y are
to be sacrificed in order to purchase one unit of x at this new price ratio? Obviously, 0.25 y
because reducing the consumption of y by 0.25 amount will free Rs 0.50 for the purchase of x
(since 1y costs Rs 2, so 0.25y costs Rs 0.50). This can be calculated from the value of the slope of
the budget line and can be seen in Table 8.1:
Px 0.50
− =− = −0.25
Py 2
Table 8.1: Rate of Exchange between x and y at Different Prices

At Old Prices At New Prices
Px = Rs 1 Px = Rs 0.50
Py = Rs 2 Py = Rs 2
Rate of exchange 1x = 0.50y Rate of exchange 1x = 0.25y
1y = 2x 1y = 4x
The reduction in the price of x has made it cheaper in terms of y its relative price has decreased
from 0.50 y to 0.25 y. On the other hand, the relative price of y has increased from 2x to 4x (recall
that the reciprocal of the slope of the budget line gives the relative price of y). So, y has become
expensive in terms of x. Economists expect that the consumer will substitute the cheaper x for the
expensive y. This increase in demand for x due to decrease in exchange rate between the two
goods after a price fall is called the substitution effect. But this is only part of the story.
The Income Effect

The second effect is somewhat more complex. The change in price of a commodity also
changes the real income of the consumer. What is the real income? It is given by nominal
income divided by price:
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Nominal Income M
Real Income = = (8.3)
Price P
It is the purchasing power of nominal income. Suppose that you have Rs 100 in your pocket
while Px is Rs 1. At this price, you can purchase 100 units of x in the market. Suppose that Px
decreases to Rs 0.50. Now, you can afford to purchase 200 units of x with the same Rs 100. This
means that the purchasing power (the amount of x that can be purchased by Rs 100) of your
nominal income (income expressed in monetary units, such as in rupees or rials) has increased.
Thus, decrease in the price of a commodity raises the real income of a consumer. This increase in
real income can be spent on any good, not just the good whose price has changed. But if x is a
‘normal’ good, then at least some of the increase in real income must be spent on x and the quantity
demanded of x will increase due to this income effect. Look at figure 8.7 now.
Figure 8.7: Income and Substitution Effect
Rate of exchange falls Demand for x increases
Px decreases Substitution Effect
Real income increases Demand for x increases
Income Effect
Note that after a reduction in price of x, its demand has increased both due to the substitution effect
(demand for x increased when rate of exchange of x for y decreased) and the income effect (demand
for x increased when real income of the consumer increased). Therefore, the demand for x must
increase if its price decreases. Thus, we have discovered how demand for x will respond to change
in its own price:
∆x D*
<0 (8.4)
∆Px
This is an important result: demand for a commodity is negatively related to its own price—a fall
in price has lead to an increase in demand for x, so both are moving in the opposite direction with
respect to the movement of price change. We can now translate this whole information into a
graph. Figure 8.8 plots the new as well as the old budget lines.
To see where the equilibrium point will move on the new budget line, consider point d
(exactly vertically up to point a) on the new budget line ZT. Ask yourself: can the new
equilibrium point move to point d? Of course not because at point d, the demand for x is
unchanged (xa) while the demand for y has increased. Since price of x has decreased, the demand
for x at the new tangency point should increase on the new budget line, as we just discovered that
there is a negative relationship between demand and price. Therefore d cannot be the new
equilibrium point. Can equilibrium be between Z and d? Clearly not because demand for x will
fall if the equilibrium moves to this region. This means that the new tangency point will be to the
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right of d on the budget line ZT, such as point c in this diagram. You can see that the demand for
x has increased at this point from xa to xc as described by equation (8.4). Thus, c is the equilibrium
point. In fact, there is nothing special about point c; we can have tangency at any point in the
region dT.
Figure 8.8: Determination of new equilibrium after fall in price
y New budget
line
Z Old Budget
line
a
ya
c
I2
I1
S T
0 xa xc x
Price Consumption Curve and Individual Demand Curve
This logic allows us to derive a negatively sloped demand curve for x in case of a single
capitalist consumer. Note that points a and c are the equilibrium points at only two different price
levels. If we join these two points by a curve, we will get the price-consumption-curve (PCC) as
drawn in the upper panel of figure 8.9. This curve is very similar to income-consumption path
with the difference that it shows consumer-utility maximizing points at different price levels
keeping income constant while ICP shows those points at different income levels keeping prices
constant. Suppose that we allow the price of x to change over all possible values. We will observe
equilibrium at all these different price levels and joining all of them will give us the price
consumption curve as in the upper panel of figure 8.9 (forget about the shape of this curve for the
moment, we will discuss this when we look at cross-price effects later in the last section fo this
chapter). We are interested to draw the price-consumption path in the price-quantity-plane. Look
at the lower panel of this diagram. It shows the effects of a fall in price of x on its demand. Note
that price does not appear on any of the axis in the upper panel, while it appears on the vertical
axis of the lower panel. If we join all points of consumer equilibrium at different price levels
drawn in the commodity-plane (as points a and c in the upper panel), we obtain the price-
consumption curve (or path). But when the same equilibrium points are joined in price-
commodity space, we get the demand-curve. To see how, note that the consumer demands xa
amount of x at Px = 1 (or at budget line ZS in the upper panel). This corresponds to point A in the
lower panel. Similarly, he purchases xc amount of x at Px = 0.50 (or at budget line ZT in the upper
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panel) which corresponds to point B in lower panel. When we join these points in the lower panel,
we get a negatively sloped curve, called the demand curve which shows all consumer equilibrium
points at different price levels drawn in a price-commodity plane. It demonstrates the negative
relationship between price and quantity demanded for a commodity. This curve shows how the
consumption decision of a single utility-maximizer consumer will evolve in response to changes in
the price of a commodity. But deriving negatively sloped demand curve for a single consumer is not
the end of the story; rather it is merely the first step towards the goal of the economists. But before
that, let us study the slope of this demand curve.
Figure 8.9: Derivation of individual demand curve
y New budget
line
Old Budget
line
a PCC
ya c
I2
I1
Px = 1 P =.50
0 xa xc x
Price
A
1
0.5 B
(
D M , Py )
0 xa xc x
Slope of Demand Curve: Graphical Analysis of Substitution and Income Effects
Our previous analysis has enabled us to derive a negatively sloped demand curve for a
single consumer. We now translate the verbal discussion of substitution and income effects into a
graph to consolidate this result. This will enable you to see under what conditions the demand
curve can have a negative slope for a single consumer.
To begin with, consider figure 8.8 where the consumer has moved from a to c after a fall
in the price of x. Let us call this movement from a to x the total effect of a price change. We have
seen above that a change in price brings two changes at the same time, therefore, we can think of
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the movement away from a to c as divided into two parts: some movement due to change in the
rate of exchange (substitution effect) and some movement due to change in real income of the
consumer ( income effect). The problem is to separate the total effect or total movement from a to
c into these two movements. This problem can be solved only if we can somehow manage to stop
the two changes (change in the rate of exchange and change in income) occurring at the same
time; that is if we allow only one change to occur at one time and the other later. To do this,
consider figure 8.10 with two solid and one dashed budget lines. The budget line ZS is the initial
budget line drawn at initial income and initial price ratio representing the initial rate of exchange
(ROE) between x and y. We call this the old budget line showing the old income and the old rate
of exchange. When the price of x falls, both the rate of exchange and the income level of the
consumer changes, so ZT is the new budget line drawn at new income and new price ratio
representing the new rate of exchange (ROE) between x and y. So far is so good. Graphically, we
can think of a movement from ZS to ZT broken up into two steps: first a rotation of the budget
line from ZS to MN (the dashed line) such that it becomes parallel to ZT and then a shift from MN
to ZT. The dashed line thus created shows the new exchange rate (or price ratio) but not the new
income level.
Figure 8.10: Visualizing substitution and income effects

y
Old budget line with old income
and old ROE (or prices ratio)
Z
New budget line with new income
and new ROE (or price ratio)
M
New budget line with reduced income
and new ROE (or price ratio)
N T
S
0
At this budget line, the rate of exchange is new but income may be at the initial level (we will see
below how to find with certainty the old income level). To see why income on the budget line
MN is not the new income, note that the only difference between the budget lines MN and ZT is of
income level, the rate of exchange is the same at both (they are parallel to each other and hence
their slopes are equal). Another way to construct a budget line like MN is to reduce the income
level of the consumer from budget line ZT (recall that a fall in income brings a parallel inward
shift in the budget line). So, we can think of MN showing the same rate of exchange as ZT but
shifted inward due to reduced income. Thus, we have found a way to separate change in the rate
of exchange from change in income. For a complete solution of this problem, we need
indifference curves in such a diagram.
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To separate the income effect from the substitution effect, we reduce the income of the
consumer to its initial level. Graphically, we shift the budget line downwards. But how much
shifting is required to bring income to its initial level? To know this, draw an indifference curve
on the old budget line and mark the equilibrium point, such as a in figure 8.11. We shift down the
new budget line ZT such that it passes through this equilibrium point a. The idea behind this is to
give the consumer only that much income so that he can afford the old bundle a at the new rate of
exchange or price ratio. Thus budget line MN uses the new rate of exchange but gives first
enough income to the consumer to purchase the original bundle. By allowing the consumer to
purchase the old consumption bundle a at the new price ratio, we are in principle holding the real
income (purchasing power) of the consumer constant. The tangency on this budget line will tell
us how much of x the consumer would have bought at the new price ratio, if his income had
remained unchanged. We can see that the lower price of x creates a set of affordable preferred
bundles at a with the new budget line MN (this is shown by the fact that indifference curve Io is
crossing the budget line MN).
Figure 8.11: Separating substitution effect from income effect for xnormal
Z I1
Io I2
e
a c
b
S N T
0 xa xb xc x
∆xsub ∆xInc
∆xTot
The consumer can reach a higher indifference curve, I1, by choosing point b which was above the
initial budget line, ZS, and hence was beyond the reach of the consumer at the old price ratio or
rate of exchange. The consumer would have chosen point b if he had faced the new prices at
initial income level. Thus, the move from a to b is the substitution effect. Why is b chosen?
Simply because it lies on a higher indifference curve. We can clearly see that as long as
indifference curves are drawn convex to the origin, any budget line flatter than ZS (such as MN)
cannot be tangent to the indifference curve Io. This is so because tangency means that the slope of
the budget line and indifference curves are equal. Given the three facts that (i) the slope of the
indifference curve decreases, (ii) the budget line MN has a smaller slope than ZS (as it is flatter)
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and (iii) indifference curve Io is tangent to ZS, it cannot be tangent to MN as well. The tangency
point must move to the right of a (the budget line MN with a smaller slope than ZS can be tangent to
an indifference curve with a smaller slope than Io at a). Such a point is b where the consumer wishes
to substitute more x for fewer y because the rate of exchange between x and y has been reduced. The
∆xSub = xb – xz amount increase in the consumption of x can be attributed to the substitution effect:
change in the demand for x purely due to change in the rate of exchange, holding income constant.
Recall that when price of a commodity decreases, the real income of the consumer increases, so we
should take some income away from him to keep his purchasing power constant. On the other hand,
an increase in price implies a fall in real income; the consumer should be given some additional
income to purchase the old consumption bundle. Thus, the substitution effect is separated by
holding the income of the consumer constant such as allowing him to buy the old demand bundle at
the new prices. Note that the direction of change in quantity demanded of x and in its price is
opposite due to the substitution effect—a fall in price has caused the demand to increase.
Therefore, it is said that the substitution effect is negative—it produces a negative effect on
quantity demanded of a commodity with respect to its price change. This can also be confirmed
by looking at diagram 8.7 which shows that decrease in price of x increases its demand due to
the substitution effect.
Thus far, we have explained the increase in demand for x from xa to xb. What about the
rest of the increase in the consumption of x, from xb to xc? As we know that when the price of x
drops, the real income of the consumer increases as now his purchasing power will increase. To
separate the substitution effect, we reduced the income of the consumer to its original level. Now
to find the income effect, we give back this income to the consumer. This result can be viewed as
a shift of the budget line from MN to ZT where the consumer attains point c, at the tangency of
the new budget line with the new indifference curve I2. Because x is a ‘normal’ good, the
tangency must be to the right of point e (just above b) on the budget line ZT to ensure that
increased income has resulted in increase in demand for x. Therefore, ∆xInc = xc – xb amount
increase in the consumption of x is due to the income effect. Thus, we have distinguished the
magnitudes of both the effects. Again, we see a negative relationship between quantity demanded
and price of x due to the income effect. If we put both these effects together, we find that a price
drop causes an increase in quantity demanded for a ‘normal’ good. Remember that with ‘normal’
goods, both the substitution and the income effect of a price change must be negative with respect
to price change—the quantity demanded and price must move in the opposite direction due to
substitution and income effects (see figure 8.7 again). The move from a to c is the total effect of a
price change. Thus, we have shown that the demand curve must be negatively sloped for ‘normal’
goods in case of a single consumer.
• Algebraic treatment of the slope of the demand curve
We have seen that the total effect of a price change can be decomposed into substitution and
income effects which can be written as:
∆xTot ∆x Sub ∆x Inc
= + (8.5)
∆Px ∆Px ∆Px
We have to find the sign of this expression. To determine its sign, note that in terms of figure
8.11, the move from a to b is showing the substitution effect expressed as:
262
∆x sub = xb − x a > 0 (8.6)

that is, change in quantity demanded for x is positive—demand has increased after fall in price
due to the substitution effect. Recall that we assumed that the price of x decreased from Px = Rs 1
to Px* = Rs 0.50, so the change in price is negative, that is:
∆Px = Px* − Px < 0 (8.7)

dividing (8.6) by (8.7) gives:
∆x Sub x − xa
= b* <0 (8.8)
∆Px Px − Px
With the numerator positive and the denominator negative, the expression (8.8) turns out to be
negative. This is an important equation which says that the substitution effect of a price change is
always negative. Let us now pick up the second part of expression (8.5). Since x is assumed to be
a normal good, the change in demand for x should be positive due to the income effect:
∆x Inc = xc − xb > 0
and again the change in the demand for the commodity divided by the change in price is negative
[because ΔPx is negative as shown above by (8.7)]:
∆x Inc x − xb
= c* <0 (8.9)
∆Px Px − Px
Since the numerator is positive while the denominator is negative (Read FYI Box 8.1 to avoid
confusion about the negativity of this income effect). Thus, we have determined the signs of the
two effects in equation (8.5): for normal goods, both substitution and income effect must be
negative and adding two negatives must give a negative result
∆xTot ∆x sub ∆xinc
= +
∆Px ∆Px ∆Px (8.10)
( −) = ( −) + ( −)
which is exactly what economists want to prove: the demand curve of a normal good is negatively
sloped for a single consumer. Read carefully FYI Box 8.2 so that you may not run into another
type of conceptual mistake.
FYI: B O X 8.1
Meaning of Negative Income Effect of Price Change
The statement that the income effect of a price change is negative in case of normal
goods is a potential source of confusion for students. It is so because we have learnt in the
previous section that there is a positive relationship between income and demand for normal
goods, thus income effect should be positive in case of normal goods. However, both statements
are correct. To see this, consider this diagram. The upper diagram refers to what we learnt
previously. The lower diagram shows that the change in demand due to income effect arising out of
price change is negative; i.e. when price falls, income increases and demand increases, hence there is a
negative relationship between price and demand due to income effect. The income effect when viewed
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in terms of the relation between income and demand is positive. But its effect on demand is in the
opposite direction to change in price. That is why it is stated as: ‘the income effect of a price change is
negative with respect to movement of price change for normal goods’.
Demand for xnormal

Income increases increases
Income Effect is positive
Demand for xnormal

Price falls Income increases increases
Income Effect of price change is negative
FYI: B O X 8.2
A Precautionary Note on the Law of Demand
Suppose that you want to test the law of demand for, say, milk; i.e. whether or not a rise
in price of milk reduces its demand. How would you do this? You might collect data on the price
of milk over time and the quantity demanded of it. You will observe that the money price of milk
has been rising since August 1947 and its consumption is also increasing. Does this observation
refute the law of demand or that individuals do not maximize utility subject to the income
constraint? The answer is no, because the data and methodology are not correct. A careful
statement of the law of demand says that it is the changes in relative prices, not absolute money
prices, which produce the law of demand. In addition to that, the income of the individual as well
as prices of related goods are also held constant. If you want to test any hypothesis in the real
world, you must take into account its assumptions because assumptions are the conditions under
which that law or hypothesis is supposed to hold.
8.3.2: Price Changes and Demand for Inferior Goods
A similar type of analysis can also be undertaken to study the effects of price change on
the demand for an ‘inferior’ good. We have seen while discussing the effect of changes in income
on demand that all goods are not ‘normal’. The preceding sub-section has shown that demand
curves for normal goods are necessarily negatively sloped because both substitution and income
effect have the ‘right sign’ for the demand curve—both are negative. Now think what will happen
in the case of an ‘inferior’ good in capitalist society, say second-hand clothing. Recall that the
slope of the demand curve is the sum of two effects, substitution and income effects. We have
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seen that the substitution effect must always be negative as long as the indifference curves are
convex to the origin whether x is a ‘normal’ or an ‘inferior’ good, that is:
∆x Sub
<0
∆Px
But consider the income effect. Suppose that x is ‘inferior’ and its price decreases. This will lead
to an increase in the real income of the consumer. But the increase in income will not increase the
demand for x, second hand clothing, rather it will reduce it because it is assumed to be an
‘inferior’ commodity. This means that demand for inferior good decreases due to income effect
after a fall in its price. So the expression
∆x Inc
>0 (8.11)
∆Px
will be positive because changes in both variables are negative—both have decreased. Thus, we
see that the slope of the demand curve for an inferior good is the sum of the negative substitution
effect and a positive income effect:
∆xTot ∆x sub ∆xinc
= +
∆Px ∆Px ∆Px (8.12)
(?) = ( −) + ( + )
The sign of the total effect depends on the magnitudes of the two effects: it will be the positive if
positive income effect is greater than the negative substitution effect and vice versa. This
discussion suggests that the demand for inferior goods can be positively related to their prices if the
income effect is strong enough to outweigh the substitution effect. Do all ‘inferior’ goods have
positively sloped demand curves? The clear answer is no because it depends on the degree of
income ‘inferiority’ of a commodity. If a commodity is so much income-‘inferior’ that the positive
income effect is greater than the negative substitution effect, it is termed as a Giffen good (named
after Robert Giffen).
Graphical Analysis of Inferior Goods
Let us use indifference curves to graph the case of Giffen goods. Consider the demand
for, say, second-hand clothing. Will the capitalist consumer buy more and more of it as its price
decreases? Perhaps not, because he might want to shift to the purchase of finer clothing and
reduce the demand for second-hand clothing. Look at figure 8.12 to understand this effect. It
shows a fall in the price of second-hand clothing by pivoting the budget line from ZS to ZT.
Again, MN is drawn to let the consumer buy the old bundle at new prices. The move form a to b
is again the substitution effect. You can notice the negative relationship appearing between price
and demand due to the substitution effect. Now think in which direction demand will move due to
the income effect. Begin with giving the income back to the consumer which we had taken form
him to separate the substitution effect from the income effect. This will increase his income to ZT.
Suppose for this consumer, the demand for second-hand clothing is highly income inferior.
Where should he move to find his equilibrium on the new budget line? Surely to the left of point
d (exactly above b) because second-hand clothing is an ‘inferior’ good and therefore a fall in its
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price implies increase in real income and, hence, a fall in its demand due to increased income. So
we are left with region Zd on the budget line ZT where equilibrium can fall. Where will it be in
this region? Consider point e (exactly above a) to the left of d on budget line ZT. With this point,
we have two regions on segment Zd: Ze and ed.
Figure 8.12: Separating substitution effect from income effect for xinferior
y
I2
Z
c
M
e d
a b
S N T
xc xa xb Second hand
clothing
∆xsub
∆xInc
∆xTot
Whether equilibrium will be in region Ze or ed depends on whether the substitution effect or the
income effect is greater. If the negative substitution effect is greater than the positive income
effect, the total effect will be negative [see equation (8.12)] and demand for x will increase when
its price falls. In this case, tangency will be on the region ed. However, if the positive income
effect is greater than the negative substitution effect, the total effect will be positive [again see
equation (8.12)] and demand for x will decrease due to fall in its price. In this case, tangency will
be in the region Ze, as shown in this figure at point c. You can see in this figure that the income
effect is greater than the substitution effect (look at the length of the arrows). What does point c
show? It reflects such a strong income ‘inferiority’ for second-hand clothing that the income
effect surpasses the substitution effect and pushes the consumer back to basket c which contains
less amount of second-hand clothing than his earlier basket of a.
The above analysis has made it clear that it is the magnitude of the two effects which
matters in case of ‘inferior’ goods. It could be the case that the negative substitution effect was
larger than the positive income effect and we might have had equilibrium at some point f,
somewhere in between points d and e. In this case, the demand curve would have been negatively
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sloped. Therefore, we conclude that all Giffen goods must be ‘inferior’ but all ‘inferior’ goods are
not Giffen. ‘Inferior’ goods that have negatively sloped demand curves are called Non-Giffen-
inferior goods. Remember that the actual response of quantity demanded to change in price is from
a to c. Point b is just a hypothetical one and can’t be observed in the real world. However, its
importance lies in terms of policy evaluation is the subject of welfare economics. The fact that the
own-price-substitution effect is negative is one of the very few landmarks economists have made in
the theory of consumer behavior during the whole twentieth century.
We find that consumer choice theory can also justify the possibility of a positive
relationship between price and quantity demanded in case of Giffen goods—there is always a
possibility of positively sloped demand curve even in the case of a single consumer. Economists
dismiss this possibility by holding that examples of Giffen goods are rare in capitalist order.
However, this is merely an empty claim. In reality, most market demand curves are not going to
be negatively sloped as we discuss in the next section. But you must clearly understand the
discussion of this section before moving on to the next one.
8.4: FROM INDIVIDUAL TO MARKET DEMAND: AN UNTOLD STORY ABOUT THE

CONTRADICTIONS OF ECONOMICS
The acid test of economics comes while deriving market demand curve — the curve
representing the consumption decision of the whole of capitalist society—from individual
demand curves. The demand-supply model of price-determination makes sense only when
economists are able to prove that market-demand and supply curves are of the ‘right shape’—the
demand curve is negatively sloped while the supply curve is positively sloped. The negatively
sloped demand curve drawn in chapters 3 and 4 were reflecting the behavior of the whole of
society, and not of any single individual. One of the major objectives of consumer choice theory
is to provide theoretical justification for such demand behavior for capitalist society as a whole;
i.e. economists claim that this behavior is a natural outcome of human self-interestedness—the
tendency of individuals to maximize utility. But what if economists fail to derive a negatively
sloped market demand curve from individual demand curves? This failure means that:
• The economists contention that all people are by their nature freedom / utility maximisers is a
fundamentally flawed presumption about mankind
• Capitalist social choice is not merely a sum of individual preferences
We begin by showing how economists pretend to have derived the negatively sloped market
demand curve from consumer choice theory. Then we explain its underlying problems.
From One to Infinity

Economists hope that they can prove that capitalist society acts like ‘one big consumer’.
This means that when society chooses a particular set of commodities at any given prices and
income, this bundle will necessarily maximize ‘social utility or social welfare — the sum of the
utility of all individuals. To them, social utility or welfare can be obtained by simply adding up
the utilities of all individuals. Since the indifference map represents the utility or welfare level of
a single consumer, therefore, if we add up the indifference maps or preferences and choices of all
individuals living in a capitalist society, we will be able to construct the social indifference
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map—set of indifference curves representing the preferences of all individuals living in that
society. This is shown in the upper part of figure 8.13. The left hand panel shows the preferences
and choices of a single ‘representative’ consumer. Economists argue that since each individual
has preferences and makes choices in a similar way—i.e. he maximizes utility—therefore if we
sum up the preferences and choices of all individuals, we obtain a social indifference map in the
right hand panel which will have similar properties as that of an individual’s indifference map.
Figure 8.13: Economists’ vision of deriving market demand from individual demand
y Individual Indifference y Social Indifference Map
Map and Choice and Choice
Sum of all individuals

tastes and choices
y a y A
c C
I2 I2
I1 I1
0 xa xc x 0 xa xc x
Price Individual Price Social or Market

demand curve demand curve
a A
1 Sum of all individuals
1
demands
c C
0.5 0.5
(
D M , Py ) ∑ D(M , P ) y
0 xa xc x 0 xA xC x
In the same way, as we can derive the individual demand curve from this utility maximization
behavior by changing prices, a similar procedure will allow us to derive negatively sloped market
demand curve by summing up all individual demand curves as shown in the lower panel of Figure
8.13. Economists hope that the market demand curve obeys the same laws that they had derived
for the individual demand curve—i.e. it must necessarily be smooth and negatively sloped. This
statement involves two claims:
• If capitalist society prefers bundle A over B at any price and income level, then this choice
will necessarily maximize the utility of capitalist society and of all individuals living in it,
and
• It is possible to derive a consistent set of social preferences by summing up individuals’
preferences
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Interestingly, it has been proved that both of these claims are impossible to prove. Instead, it has
been proved that this consistent summation from individual to society can not be achieved. The
issue is that if all individuals are allowed to have any taste they want that satisfies conditions of
individual rationality (as discussed in chapter 5), then in general it will not be the case that
collective behavior is rational. More specifically, individual rationality does not imply social
rationality—i.e. if all individuals are maximizing their own welfare, then there is no guarantee
that social welfare will also be maximum! Let us first see why economists are keen to derive
social welfare from individuals’ welfare (note that maximizing ‘welfare’ is simply maximizing
consumption in capitalist society).
Economist’s Vision of Human Being and Society
According to economists, their model of the utility-maximizing-consumer is based on the

core intuition of ‘human being’. This vision of the ‘human’ has already been outlined in chapter 6
(see the description on ‘who is a consumer?’). Maximizing freedom / utility is the only rational
end in itself and all other objectives must be subordinated to this end. And when every one
maximizes his personal utility or seeks his own self-interest, the utility or welfare of the whole of
society is also maximized. This means that the best society will be one where each individual is
left free to pursue his own interest the way he wants to without any intervention by any
authority—even if it is the authority of religion because the human being alone is recognized as
soverign and rational. This is mainstream economics’ vision of ideal society. Economists preach
free markets because free markets are supposed to provide the maximum opportunities to citizens
for maximizing utility / freedom. However, to provide any kind of rational ground for such a free-
market model, economists must be able to show that the desire to maximize utility / freedom is
universal and can be expressed in a negatively sloped market demand curve which is a simple
aggregate of similarly sloped individual demand curves. But we will see why it is impossible to
add up individual demand curves in this way to yield a ‘well behaved’ market demand curve.
Unfortunately, the full proof of this requires advanced mathematical logic; however, its essence
can be visualized graphically.
8.4.1: The Collapse Begins: The Problems of Aggregation
This argument is developed in three stages. In reality these stages are not separate but
occur simultaneously.
The Social Indifference Curve is not Smooth: To begin with, recall that the social indifference
map was said to be the sum of all individuals’ tastes and a negatively sloped market demand
curve could be derived from this map only if it had the same properties as individual indifference
maps (see figure 8.13). However, there is in general no guarantee of the existence of a ‘well-
behaved social indifference map’ when individuals have heterogeneous or diverse tastes.
Look at figure 8.14 which shows the nature of the problem involved in adding up
individuals’ tastes. Concentrate on the left hand panel first which shows the preferences of two
individuals, the solid line representing the preferences of Farooq while the dotted line that of
Nomi. Though the indifference curves of a single consumer cannot intersect, this is possible when
we are considering more than one consumer each having different and distinct tastes. Note from
the left hand panel that in this case, the point of tangency between the indifference curve and the
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budget line for one individual will not necessarily be same for another. Once price changes,
income will also change and the income-effect of the price change may work in opposite
directions for the two consumers (one might consume less of a commodity as its price falls, the
other more). The total effect of the price change on quantity demand will in general be quite
unpredictable when there are many consumers.
Figure 8.14: Direct Summation of two different sets of preferences is impossible
y Preferences of Farooq y
Preferences of Nomi
B
A
Iq Social
C IC
Iq
E
D
IF IF
0 x 0 x
Also remember that the two sets of indifference curves are incomparable because there is
no rule to assign weight to each individual’s indifference curve as each individual ranks and
derives utility from his preferences in his own way. To understand what this means, let us assume
that utility can be measured in some scale or units called utils. Suppose you give Rs 100 to a
beggar and ask him to assign some numerical value to ‘how much utility will he derive out of this
Rs 100’. Suppose he says, ‘20 utils’. Then you see Bill Gates having a KFC burger for Rs 100. On
your asking him, ‘how much utility did he derive from this Rs 100’, suppose he replies, ‘50 utils’.
Now if you are asked the question: ‘which of the two individuals is better-off with Rs 100’, what
would you say? If you think it is Bill Gates because he derives 50 utils as compared to the beggar
who derives 20 utils, then you are wrong. How can you compare the number 20 utils of the beggar
with Bill Gates’ 50? The problem is that numbers like 20 and 50 utils are merely arbitrary numbers
expressing the mental states of two different individuals and there is no guarantee that both of them
use the same barometer to measure the intensity of their wants and satisfaction. It is quite possible
that the number ‘50 utils’ of Bill Gates turns out to be only ‘3 utils’ when measured from the
barometer of the beggar. On the other hand, the intensity of the beggar’s wants may be measured as
’90 utils’ on Gates’ scale. The issue is that the utility derived by one individual from a consumption
bundle cannot be compared with that of another with the same consumption bundle. Numbers
attached to indifference curves are arbitrarily chosen to rank the preferences of individuals (see the
last section of chapter 6 again) and it is not possible to compare these numbers. Technically
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speaking, interpersonal comparison of utility is not possible. This is called impossibility of

interpersonal comparison of utility.
What problem does this issue pose for economists? It means that any ‘social’ indifference
curve derived by summing up ‘well behaved’ individual indifference curves will neither be
smooth (as shown in the right hand panel of figure 8.13) nor will they even show some unique
preference ordering. This aggregate indifference curve can take any shape. Look at the right hand
panel of figure 8.14. According to this diagram, the bundle C is indifferent in terms of A and D,
but D is clearly preferred to A (you should be able to work out that D I B and B P A, so D P A).
Moreover, to Farooq, B and D should be preferred not only to A but also to E [B P A and B I D (to
Farooq) while A I E (for Nomi), so B and D P E as well). On the other hand, Nomi says that
bundle E should be preferred to D and, hence, to B on the ‘social’ indifference map. Clearly, it is
impossible to sum these preferences without assigning some weight to the preferences of each
individual. Now which bundle is preferred to the other depends upon the particular weight it
carries in the social indifference map. Any change in these weights will change the ordering of
these bundles. You can sense the kind of problem when you consider this case. These
complexities increase as the number of consumer preferences to be considered in the social
indifference map keeps on increasing. In general with many consumers, the social indifference
curve will look jagged instead of smooth, as shown by the thick line in figure 8.14.
Change in prices changes distribution of income: Recall from chapter 4 that prices of
commodities also determine the amount of income individuals can earn. In other words, they
determine the distribution of income among individuals. When relative prices of commodities
change, then, according to economics, the distribution of income also changes, and this fact
further complicates the problems at hand. Suppose that you produce bananas. If its price falls,
then the amount of income you receive by selling bananas will also change (it may increase,
decrease or remain the same depending upon the price elasticity of demand for bananas) which
means that your share in total national income can change in any way. Since any change in
relative prices changes the distribution of income, it therefore changes ‘who consumes what’. The
redistribution of income might effectively transfer one banana from someone who gets very little
utility from it to someone who gets a great deal of utility—since what gives great utility to one
may give very little to another as taste is purely a subjective phenomenon. This means that the
‘sum of subjective utilities of all individuals’ will also change as the distribution of income
changes after price change. Since utility is subjective, there is no way to determine whether one
distribution of income produces more or less total utility than any other pattern of income
distribution. Therefore, there are many different ‘social indifference maps’, one for every
distribution of income.
We have learnt above that in order to derive a market demand curve, you have to alter
prices. As long as there is only one consumer, you need not consider the consequences of change
in distribution of income after change in prices. But prices cannot be changed without changing
distribution of income when there are more than one individual. In the analysis of individual
consumer demand, economists can safely assume that ‘taste is independent of income’—it is this
fact which enables economists to draw independent indifference curves and budget lines. But
‘social budget lines’ and ‘social indifference curves’ are interdependent because each different set
of prices will generate a different social indifference curve.
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Result: The possibility that the market demand curve can have any shape. One important
implication of such a social indifference curve is that there is no guarantee of the existence of a
smooth negatively sloped market demand curve. To see that, consider figure 8.15. The budget
line ZS is passing through point E in this diagram. As the price of x falls, budget lines flattens
which means that demand for x must rise in order to make its demand curve negatively sloped.
However, with kinks in ‘social’ indifference curves, it is possible for the slope of the budget
line—the price-ratio of x in terms of y or the rate of exchange—to vary substantially at these
kink-points in the curve without any change in the quantity demanded of x as shown in this
diagram where the price-ratio has fallen from ZS to MN but the equilibrium demand point is
unchanged. This means that the market demand curve derived from this ‘social’ indifference
curve will also be jagged—and not smooth—at these kink points. More importantly, there is
nothing which prevents the possibility of positively sloped market demand curve.
Figure 8.15: Possibility of demand not responding to price changes
y
Z
Demand point
remains the same
even after fall in the
M relative price of x
E
Social
IC
S N
0 xe x
This failure in deriving smooth negatively sloped market demand curve is most bluntly
stated in Varian’s Microeconomic Analysis—a book all academic economists must read in their
Masters or M. Phil / Ph.D. programs:
“Unfortunately…the aggregate demand function will in general possess no interesting
properties…The neoclassical theory of the consumer places no restrictions on aggregate
behavior in general”
Solution: One for All and All for One—the representative consumer
What is the way to deal with this problem? We have seen that economists have failed to
derive negatively sloped market demand curves recognizing that individuals have heterogeneous
tastes and preferences. They derive well behaved market demand curves by subscribing to the
myth of ‘representative consumer’—he has the tastes each consumer ‘ought’ to have. However
the problem remains that altering the distribution of income also changes the measurement of
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‘social’ welfare—the sum of utilities of all individuals. If economists could somehow avoid this
problem—i.e. if they could show that distribution of income did not alter social welfare—they
could be able to derive smooth negatively sloped market demand curves on the basis of the
‘representative’ consumer myth. Over time, they have worked out that at least two conditions are
necessary for market demand curves to at have the ‘right shape’,
a) that each individuals’ tastes remains the same as income changes, so that every additional
rupee of income is spent exactly in the same way as all previous rupees—effectively every
commodity is a ‘representative commodity’
b) that all people living in society must have the same tastes—effectively every individual is a
‘representation consumer’
Let us understand the economic meaning of these conditions. The first statement requires that all
income-consumption-curves must be straight lines, like panel d of figure 8.5 so that all
commodities are neither luxuries nor necessities. Note that ICP for any single consumer can be of
any length because incomes may vary among individuals—the length of ICP will be larger for the
individual having more income because his equilibrium will be farther from the origin and vice
versa—but all curves must be straight lines. In other words, all goods existing in the market must
be representative commodities. We have already seen in Application Box 8.1 that representative
commodities do not exist. Yet economists pretend that increasing the income of the single
consumer by, say, 100% increases his consumption of all commodities by the same factor. The
economic meaning of the second statement is even more extreme. It says that every consumer
must spend the same proportion of each additional rupee of income in the same way—which
means that all individuals must have the same tastes. These conditions imply that individuals are
not allowed to have any taste they desire. In other words, individual indifference curves cannot
take any allowable shape because this does not permit economists to treat society as the sum of
all individuals in it.
Figure 8.17: The only allowable ICs if individual utilities are to be added
to obtain social IC
ICPI
y
ICPI
ICPI
0 x
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Instead, they all must take shapes which generate income consumption curves like those shown in
Figure 8.17 by the lines ICPI, ICPII and ICPIII. These lines meet the two restrictions imposed on
consumers’ tastes. The small dashed lines are budget lines with different relative price ratios. The
idea is that no matter what the price ratio, preferences should be such that they always generate
straight lines income-consumption-curves. Read Application Box 8.2 to see their ridiculous
meaning in practical terms.
All of You Need to be Clones
The absurd practical meaning of the first statement has already been discussed in
Application Box 8.1. Here we consider the second statement. It means that your propensity to use
each extra rupee must be the same as that of Bill Gates! To see the implications of this, let us
imagine that Bill Gates, being a very rich person, spends 10% of his additional income on
purchasing luxurious cars and renovating his drawing room. The assumptions thus requires not
only you but all individuals, even those in abject poverty having no cars and drawing rooms in
their houses, to spend the same proportion of income on cars and drawing rooms. Clearly, this is
an impossible condition to hold in reality. But once these conditions are violated, as they always,
the results derived by consumer choice theory cease to appear.
Though these restrictions are obviously absurd, they seem very ‘scholarly’ when expressed in
mathematical language in advanced microeconomic text books: ‘preferences are assumed to be
homothetic and affine in income’, instead of saying ‘we assume all consumers are identical and
never change their spending habits’. The use of mathematical language by economists to derive
their results makes it difficult for students to see how absurd the assumptions needed to sustain
the aggregation process are because it mesmerizes them by its mathematical ‘elegance’. However,
things are not as elegant as they might seem to be. According to neoclassical economics, if:
• the tendency to consume a commodity is the same for all consumers, and
• the tendency to consume a commodity doesn’t change with income
only then market demand curves will be negatively sloped. In other words, to guarantee that a
market demand curve slopes down like an individual demand curve, all consumers effectively
need to be identical (clones) and have tastes that don’t change with income. This is the solution
economic books impose on their students on the name of ‘intuitively reasonable assumptions’.
Is it a Solution or Contradiction?
Let us consider the meaning of the assumptions about the invariance and similarity of tastes. The
similarity assumption actually amounts to saying that there is only one person in society (or that
society is composed of a multitude of identical individuals)—how else could every one have the
same taste? One of the important senses in which people are differentiated in capitalist societies is
in terms of their consumption preferences; to assume that all have the same preferences is to
assume that there is only one individual in society whose preferences must be followed by all! On
the other hand, the ‘constancy’ assumption says that there is only one commodity—since
otherwise spending patterns would change as income rose. One of the key features of capitalist
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individuality is supposed to be variability—the consumption pattern of youth is supposedly quite

different from the expenditure habits in old age. This statement that ‘taste remains the same’ is to
say that individuals will never change! Thus, the scope of the theory of consumer behavior
effectively boils down to this:
If capitalist society has only one (representative) consumer, and that consumer only
consumes the one (representative) commodity, then individual utility can be added to
obtain social utility, and hence a ‘well behaved’ market demand curve
Pause here for a moment and go back to the economic vision of society. Economics attempted to
prove Adam Smith’s vision according to which a self-interested individual is led by an ‘invisible
hand’ to promote society’s welfare so that if all individuals pursue their own self-interest, social
welfare will necessarily be maximized. Moreover, social welfare is nothing more than the sum of
all individuals’ utilities (consumption). In other words:
• the postulate of self-interested hedonism captures the essence of individual behavior; i.e. each
action is motivated solely by the desire for utility, and by nothing else
• the collective behavior of capitalist society can be derived by summing the behavior of this
self-interested multitude (See figure 7.1 again in chapter 7)
However, to prove these propositions economists they had to aggregate from a single individual
to the sum of all individuals in capitalist society. This means that they had to prove that:
• a ‘social indifference curve’ could be constructed as the simple sum of all individuals’
utilities
• which would accurately capture the preferences of all (heterogeneous) consumers
• and enable economists to show that a capitalist society composed of a multitude of self-
interested, utility-maximizing individuals would give rise to an outcome which maximized
the welfare (consumption) of all individuals
But the two assumptions required to derive these results clearly contradict the case economists are
trying to prove, since they are necessarily violated in actually existing capitalist societies—
apparently consumer theory is of no use to understand capitalist society which is composed of
individuals having heterogeneous preferences as explained in this section. Unfortunately, after
two-centuries of search, economists have ended up showing that it is impossible to go beyond the
one-individual-one-commodity model of society—technically termed as ‘1×1’ (one by one)
model of society. In other words, they have shown that it is impossible to obtain a ‘social’
indifference curve by summing up individuals’ utilities unless we assume that there is only a
single consumer and only a single commodity consumed by all individuals in society—and that
commodity must also be a representative commodity! Read Application Box 8.3 to see how
economists deal with such problem.
Analyzing Class Behavior on the Basis of ‘One for All’ Assumption
Suppose that you opt for a course in psychology, may be because you want to understand
what determines the behavior of people. Assume that there are 30 students in this course. When
your psychology teacher comes to take your first class, he makes the following interesting claim:
‘well students, if you want to understand the behavior of this class during this whole semester,
then I can teach you a magical methodology by which you will be able to explain the behavior of
all your class mates at any time you want by simply summing up their behavior!’
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Oh! You are now waiting to learn this important principle and you request your teacher to
present it immediately. Then he asks you to stand up and apply the following ‘golden-principle’
of economists: ‘the rule is very simple to work with. Just assume that the taste of all individuals
is exactly the same as that of yours and that their taste remains the same through out this
semester. This will allow you to explain what they will do by simply looking at what you will
do’.
What is the teacher asking you to assume? Effectively, he is saying that there is only one student
in this class; and not 30 different students because the rule will explain the behavior of only one
student (yourself) and not that of 30 different individuals if their tastes are not the same as yours.
Is this rule of any use to explain the behavior of the other 29 students? The only sensible reply is
NO. But economists illogically insist that such a non-sensible rule is good enough to understand
the behavior of millions of individuals living in a capitalist society.
The failure of economics to prove the existence of the negatively sloped market demand curves
means that:
a) the economic picture of an individual as fundamentally a self-interested creature is both
fallacious and misleading guide to policy making even in capitalist societies
b) self-interested pursuit of individual welfare does not necessarily maximize the welfare
(consumption) of all
c) capitalist society is conflict ridden—maximizing A’s welfare usually occurs at the cost of B’s
welfare
These facts are exactly the opposite of what economists actually set out to prove initially.
Equilibrium in Question
One of the most important problems arising from this analysis is the possibility that the
market demand curve may intersect with the supply curve at more than one point as shown in
figure 8.18.
Figure 8.18: Non-unique multiple equilibriums
Price
Sx
One possible
shape of market
demand curve
0 Quantity of x
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Even if we assume that the supply curve is positively sloped (which is in fact not the case as we
see in the next section of the book), economic theory cannot rule out the possibility that a market
demand curve may have the shape as drawn here. This possibility strikes at the heart of economic
theory: it undermines one of the fundamental ‘articles of faith’ in economics that ‘everything
leads to equilibrium and, hence, to harmony in capitalist society’. The equilibrium methodology
is adopted to pretend that capitalism is a natural and rational and conflict-less state of human
living (see discussion in the last section of chapter 3), which is in fact not the case as shown even
by economic theory itself. If there are multiple points of intersection between demand and supply,
there will be multiple points where ‘everything happens’ in capitalist society. How can then you
determine which point or state prevails—or should prevail—in practice?
Why Consumer Theory at All? There is even more to surprise
At this point, any reasonable person would abandon the initial theory that individuals
maximize utility and that society can be treated as a simple sum of these utility maximizing
agents in it. Instead, economists actually prefer to accept the two assumptions mentioned above—
that all individuals are identical and never change in their life! Despite its illogical contradictions,
economists insist that their vision of society as well as its theoretical derivation using consumer
choice theory is valid and intuitively reasonable. Thus Gorman a well known economist,
maintains:
“The necessary and sufficient condition quoted above is intuitively reasonable. It says, in
effect, that an extra unit of purchasing power should be spent in the same way no matter
to whom it is given”
These assumptions have become part of the standard advanced economic education (where they
are known as the Sonnenshein-Mantel-Debreu (SMD) conditions, named after three economists
who originally invented them to get around the failure in deriving the negatively sloped market
demand curve). These conditions are normally taught without even discussing how manifestly
unrealistic and absurd they are.
The main reason for this is to defend capitalism as a natural and harmonious state of
human living. All social science disciplines, including economics, try to articulate theoretical
foundations for justifying capitalism. However, two centuries later when the proof came that this
vision is internally inconsistent, the commitment to the vision had become too strong to be
broken. The attitude of the economists was that of the typical scientist: better to search for special
conditions which could let the theory survive—no matter how ridiculous they might be—than to
admit failure. The great irony of this particular critique of economics is that it was developed by
its supporters. Therefore, there is no rejoinder to this criticism by any segment of economists.
Instead, there are only ‘rationalizations’, such as assumptions about representative consumers /
commodities. The uninformed majority of economic professionals in countries like Pakistan
believe that their ‘religion of economics’ bears the ultimate truth that all humanity must choose to
follow in the long run!
Economists make these assumptions because economics is a moral science. It does not
seek to explain how consumers behave in actually existing capitalist societies. Conversely, it lays
down the rules on the basis of which ideal consumers ought to behave in ideal capitalist markets.
The nearest thing we have to an ideal capitalist market is of course the market for capital. The
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representative commodity is capital and the representative consumer is the agent-of-capital. It is

preference for capital is everlastingly maximum. Only irrational—hence non representative—
consumers can prefer other commodities—non representative commodities—to capital (which is
the preference for preference itself see chapter 7). Every one must have the same taste; he must
regard everything as simply a means for the accumulation of capital. This everlasting preference
for capital (i.e. preference for preference itself) provides the standard for measuring choices of all
other (non representative) commodities, hence it must remain invariant, constant—like the ruler
or the scale. Both beggar and Bill Gates must have the same constant preference for capital
accumulation as an end in itself. The beggar does not become a capitalist by acquiring as much
wealth as Bill Gates. The beggar becomes a capitalist by becoming as infinitely and insatiably
greedy (accumulative) and as infinitely and insatiably jealous (competitive) as Bill Gates. We will
see why these assumptions are so crucial to economic theory when we discuss the micro
foundations of macroeconomics in chapter 17.
A lot of ground has been covered in this section. FYI Box 8.2 summarizes the major
points.
FYI: B O X 8.2
Summary of the Untold Story about the Failure of Economics
• The great appeal of economics lies in its apparently coherent picture of a complex system
where:
 Individual preferences generate demand curves
 Profit maximisation generates supply curves (to be discussed in the next part of this
book)
 Intersection of well behaved supply and demand curves determines prices and
outputs
 Markets harmonise in general equilibrium
 Welfare (consumption) of society is maximised by free markets
– The vision of society as the sum total of individuals’ utilities seems valid
• Great weakness of economics
 All steps in the above process have logical flaws
 Firstly, a recap of the economics vision of consumption behaviour
• Consumer’s demand is determined by preferences
 A rational consumer
– Does not let his income affect his tastes
– Always prefers more to less
– Gets less utility out of each additional unit (diminishing marginal utility)
– Can always tell which bundle he prefers
– Is consistent in his preferences
 End result
– Tastes can be represented by indifference maps
– Prices and incomes determine budget
– Interaction of these determines demand curve
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– Fall in price necessarily increases consumer’s welfare

• Adding lots of consumer preferences together entails problems
 Economists pretend to get a downward sloping market demand curve where all consumers
welfare rises as price falls
• However, adding lots of consumers together…
 With one individual
– unambiguous link between preferences (ICs) and demand curve
– Fall in price unambiguously benefits consumer
 With more than one individual, two different incomparable sets of indifference curves exist
– Point of tangency for one won’t be that for the other
– Income effect may work in opposite directions for two consumers (one might consume
less as price falls, the other more)
 Income effects of changing prices
– Change in relative prices changes income distribution
– One-person analysis assumes that prices can be changed without affecting income
– Can’t alter prices without affecting incomes of individuals within the economic
framework
• With two consumers, even if their tastes are identical, we can no longer separate prices from
incomes
 Social budget lines and social indifference curves are interdependent
 Market demand curve can take any shape
• The sources of problems in economic theory lie in the belief that:
 Each person’s utility is unique, and hence subjective, because each individual is
autonomous (self determined). This makes interpersonal comparison of utility impossible
 The price system determines income distribution
 Thus, any change in prices changes income distribution and therefore changes the sum of
subjective utilities of all consumers
• Many outcomes of these dilemmas:
 The belief that an ‘individuals maximize utility’ is false
 Self-interestedness is not socially rational behavior
 Standard individual “law of demand” (that demand rises as price falls) does not apply at
market level
 Multiple equilibriums are possible. The harmony assumption of capitalist order is not
proved
• To guarantee that a market demand curve slopes down like an individual demand curve, consumers
effectively need to be identical and have tastes that don’t change with income
 Conditions to avoid this outcome in effect amount to saying that:
– All consumers are identical; i.e. clones
– All commodities are identical
– the model only works with one (representative) consumer and one (representative)
commodity
279
• Contradicts the very task economists set for themselves

• Capitalist society cannot be treated as merely sum of the preferences of agents living in it
• Yet economists accept it as intuitively reasonable
 Due to their strong commitments to human autonomy / freedom and capitalist order
– Commitment to capitalism as a moral order showing how every one ‘ought to
behave’
• Every individual should have the same taste of preferring capital to every other commodity
 Capital is the only representative commodity and contribution to its accumulation
should provide the standard for evaluating all non representative commodities
• The fact that such a standard cannot be developed or applied unequally shows the
irrationality and internal incoherence of capitalism both as knowledge and practice
Does Capitalism Allow Heterogeneous Taste and Cultures?
There is widely held belief that liberal capitalism allows the maximum range of
individuals’ preferences and ways of life to co-exist in a peaceful state. However, this belief is
false because there is one and only one way of life that capitalism is capable of sustaining—the
life and culture which is based on the principle of ‘ever increasing and never ending accumulation
of capital’. Capitalism can flourish only when all of its citizens behave in a particular way and
subordinate themselves to a particular type of preferences. The same idea is also reinforced by
consumer theory in the sense that equilibrium or harmony prevails in capitalist order only when
all individuals have the same kind of preferences and never change their attitudes. There is only
one representative-individual whose taste or preferences must be followed by all and only his
taste is allowed to dominate everyone living in capitalist society.
Moreover, it has been shown in the context of Social Choice Theory (which is also based
on Consumer Choice Theory) by Arrow (1963) that under certain conditions, an overall social-
ordering of individuals’ preferences possessing any reasonable properties cannot exist. This
negative theorem, called Arrow’s Impossibility Theorem, states that no decision rule based on the
sum of individual preferences can be completely satisfactory to choose among different
alternatives. Any social decision rule that is chosen on the basis of majority voting must be
dominated by the preferences of a single consumer—social choice must be based on the rule of
the dictatorship of the representative consumer (i.e. the capitalist) and his eternal preference for
the representative commodity (i.e. Capital). In other words, social choice theory says that
economists must relinquish either the desire for transitive preferences (the very basis for
rationality) or democracy (the very basis for capitalist society). Sen has shown even a more
perplexing impossibility-dilemma having more disturbing consequences for economic theory.
According to this theorem, the frame work of rational consumer choice does not permit even
minimal liberalism. Sen says, “the society cannot let more than one individual be free to read
what they like, sleep the way they prefer, dress as they care to, etc., irrespective of the
preferences of others in the community”.
Capitalism has internal inconsistencies not because economists have treated it ‘badly’ in
their theory, but because it is an irrational way of life. Its irrationality is clearly manifested in the
very objective it sets for itself—the unachievable task of ‘fulfilling infinite wants’, and hence
infinite accumulation of capital.
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8.4.2: The Possibility of Discontinuous Individual Demand Curve
We have learnt up to this point the difficulties involved in deriving market demand
curves from the utility maximizing behavior of an individual. Here we discuss that even the
demand curve for a single individual can also take an ‘inappropriate shape’ if his preferences do
not take a specific form. To see what lies behind the individual demand curve, recall from chapter
7 that for a unique solution to the utility maximizing problem—or for the demand point to be
unique — the indifference curve of an individual must be convex to the origin. We saw in chapter
7 how non-convexity of indifference curves creates problems in establishing a unique solution to
the problem of utility maximization (see figure 7.8). In this section, we extend that idea to
examine the implication of non-convexity for the shape of the demand curve. This will give you a
better understanding of the reason why economists insist on imposing the assumption of
convexity on consumer preferences or tastes. Most economic text books pretend that this is
merely an extra assumption imposed to simplify the analysis. However, we will see that this
assumption is very important for deriving the desired shape of the individual demand curve.
Non-Convex Preferences and Individual Demand Curve
The left panel of figure 8.19 reproduces from figure 7.8 the situation where the consumer
was making his choice on the basis of concave preferences (see chapter 7). Facing the budget line
ZS, the optimal bundle is at point Z because it is on the highest indifference curve, I1. The result is
a corner solution as discussed earlier. The consumer maximizes his utility by spending all his
income on only one commodity.
Figure 8.19: Non-smooth individual demand curve if preferences are concave
Price Discontinuity in individual

y of x demand curve resulting from
non-convex taste
Z
T
Px*
To get a clue of the problem with such demand curves, try to read this demand curve
closely. It says that there is no uniquely determined or definite quantity demanded at price Px* ;
I2
I1
a
any amount of x could be demanded from zero to x*: either the consumer will not consume any
amount of x or he will suddenly start purchasing a lot of it at a certain price. The smoothness
Dx of
the demand curve has been S lost. Such Ttypes of indeterminacy about the amount of quantity
demanded
0 create problems while discussing
x* thexpossibility
0 of markets.x*
Quantity of x
Now suppose that the price of x starts decreasing from, say Px to Px* and the budget line
pivots from ZS to ZT. Where does equilibrium move? The demand point jumps from Z to T because
now this point is on the highest indifference curve, I2. At this point, the consumer consumes only x.
Note that for all prices below this price level, the consumer will continue to consume increasing
amounts of x. This switching from one commodity to another generates a strange looking demand
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curve as shown in the right hand panel. The demand for x is zero as long as its price is greater than
Px* , therefore the demand curve is on the vertical axis in this price range. However, when its price
is right at Px* , the demand jumps from zero to x* (at the horizontal axis in the right panel
corresponding to point T in the left panel). If price further falls below this level, the quantity
demanded increases and the demand curve is negatively sloped (as the equilibrium keeps on
moving out at the horizontal axis in the left panel). With such taste, we will see jumps in the
equilibrium point of the consumer. Such preferences generate jumps in the demand curve even in
case of a single consumer. Such jumps in demand curves create problems for economic analysis,
especially, when we discuss the existence of competitive markets. Markets simply fail to exist if we
assume that people have non-convex preferences. This situation has some serious negative
implications for the analysis of general equilibrium framework.
Figure 8.20: Dilemma of non-smooth demand curve
Price
So S1
Px* T
One possible
shape of market
demand curve
0 Quantity of x
Figure 8.20 shows the essence of the dilemma associated with this case. You can see that there is
no guarantee that the supply curve will intersect with the demand curve in its negatively sloped
range. Even if the supply curve is assumed to be positively sloped, there will be no unique
equilibrium point. Interestingly, even a shift in the supply curve from So to S1 cannot produce any
effect on the market price of a commodity in this case. It is for this reason that non-convex
preferences are ruled out by economists in consumer choice theory. Strict convexity of
preferences is required to guarantee that:
• the demand curves will not have jumps; that is they will be continuous, and
• they show a unique quantity demanded at every price
8.5: CROSS PRICE EFFECT AND THE SLOPE OF PRICE CONSUMPTION PATH
Let us now briefly examine the last factor remaining in the demand function, the price of
related goods, Py, within the consumer choice framework. Figure 8.9 above showed how we
could derive the price-consumption curve or path by varying the price of the good and
determining the corresponding quantity demanded. Joining all those equilibrium points in the
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commodity-plane gives us the price-consumption curve. We did not say anything regarding its
slope at that point. Here, we discuss the relationship between the shape of PCC and the demand
relationship between the two goods.
The slope of the price-consumption curve is closely related to the nature of the relationship
between the two goods; that is whether the two goods are substitutes or complements can be seen
by its slope. Consider figure 8.21 where we have drawn the PCC as we did in figure 8.9.
Figure 8.21: Shape of PCC and relations between two goods
PCCC
a c
I2
I1
S T
0 x
Note that economists prefer not to name any goods that are placed on the two axes in this
diagram; they pretend that these could be any commodities—however, we saw above that in case
of more than one consumer, both goods must be representative-commodities. A typical price-
consumption curve takes the shape as drawn here. Note that it originates from the vertical
intercept showing that the demand for x is zero when price of x is very high and the consumer is
spending all his income on y. As the price of x starts decreasing, the consumer increases the
demand for it along the price-consumption curve. The important thing to note is that as long as
the price-consumption curve is negatively sloped, the demand for x is increasing while that of y
is decreasing. This indicates that the two goods are substitutes since we see a positive cross-price
effect, i.e. fall in price of x causes the demand for y to decrease in this range of PPC. However,
when the slope of the price-consumption curve becomes positive, the demand for both the goods
are increasing at the same time showing that the two goods are compliments. Remember that the
price-consumption curve drawn in this diagram is just a typical one and its exact shape is
determined by the relationship of the two goods in question.
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Key Concepts
Comparative-static-analysis is analytical technique in which results of two static

equilibrium states are compared with each other
Demand curve shows all consumer equilibrium points as does the price consumption-curve but
drawn in a price-commodity plane. It demonstrates the negative relationship between price and
quantity demanded of a commodity due to negative sign of substitution and income effects
Engels curve represents all points of consumer equilibrium at all positive income levels, but in
income-commodity space as opposed to ICP which is drawn in commodity-space
Giffen good is a commodity which has positive segment of demand curve due to the positive
income effect larger than the negative substitution effect
Income effect is the change in demand due to change in income holding the final price fixed. It
has a negative sign for normal goods and positive for inferior goods with regard to price change
Income-consumption curve (or path) is a curve showing all points of consumer equilibrium at
positive income levels, drawn in the commodity-plane
Interpersonal comparison of utility refers to the idea that in order to obtain social welfare
function by adding up the utilities of more than one individual, one must be able to compare and
rank the utility scales of all individuals (which is impossible because utility is a subjective
phenomenon, known as impossibility of interpersonal comparison of utility)
Market demand curve relates the price of a commodity to the total demand for that commodity
by all individuals in the market. Economists wrongly claim that such a negatively sloped curve
can be obtained by horizontal summation of all individuals’ demand curves
Non-Giffen inferior good is an inferior good but has a negatively sloped demand curve.
Price-consumption curve (or path) is a curve showing all points of consumer equilibrium at all
relative prices
Representative commodity always shows a proportional change in its demand as income of
consumer increases. This holds only if taste of consumer always remains unchanged for a
commodity as income increases
Representative consumer is a mystical consumer in economic theory whose taste is supposed to
be followed by all individuals living in capitalist society; i.e. his taste represents the taste of all
consumers
Social indifference map ranks the sum of all consumers’ preferences in a consistent manner and
is expected to have same properties as individual indifference map
Social utility or welfare is the sum of all individuals’ utilities or welfare living in a capitalist
society
Substitutions effect shows change in demand for a good due to change in its own price keeping
real income constant. It always moves opposite to the price change and, hence, has a negative
sign
Total effect is the observed effect of a price change on the quantity demanded of a commodity. It
is the sum of substitution and income effects.
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Chapter Summary
• Since tastes are unobservable so is the point of consumer equilibrium in actually existing
markets. In order to study the effects of changes in prices and income on demand, economists
have to assume that the taste of all consumers remain constant. Changes in demand are thus
attributable to changes in market opportunities only
• Comparative static analysis involves studying changes in the equilibrium position due to
changes in market opportunities (i.e. prices and incomes). Change in prices and incomes are
not seen as effecting tastes
• Change in income shifts the budget line of the consumer outwards—i.e. to the right of the
diagram. The slope of the budget line is given by the ratio of prices; if prices remains the
same then the slope of the budget line does not change when the budget line shifts outwards
• Since economics assumes that “more is better”, increase in income with prices remaining
unchanged leads to a change in the consumption of both commodities depending on whether
they are ‘normal’ or ‘inferior’ goods. Demand for ‘normal’ goods increases and for ‘inferior
goods’ decreases as income increases in capitalist order
• All commodities in a consumer basket of goods cannot be inferior goods because this violates
the “more is always better” assumption of capitalist order
• The income consumption path (ICP) shows the equilibrium points of the consumption of the
two goods at different income levels. ICP is positively sloped in the case of ‘normal’ goods
• The Engel’s Curve shows increase in the consumption of a single commodity at different
income levels in income-commodity space
• ICP can take any positively sloped shape for ‘normal’ goods. It need not be a ‘well behaved’
straight line curve
• ICP is negatively sloped for ‘inferior’ goods in capitalist order. In the case of ‘necessary’
goods ICP takes an increasing slope shape. In the case of luxuries ICP takes a decreasing
slope shape
• In the case of a ‘representative’ good demand increases at a proportionate rate every time
income increases. Economists assume that most goods are of this character but representative
goods do not exist in capitalist order. However this absurd assumption is necessary for
deriving most of the results of consumer choice theory. The choice of a ‘representative’ good
for consumer behavior analysis is not a matter of simplification. The negatively sloped
market demand cannot be derived without assuming that the good for which it is drawn is a
‘representative’ good
• Changing the price of a good changes both the position and the slope of the budget line.
Demand for the good changes due to this shift in the budget line and due to the change in
relative prices of the goods consumed. The increase in the demand for a commodity due to
decrease in its relative price is known as the substation effect. Increase in demand which is
caused by the increase in the income of a consumer due to the decrease in the price of the
goods he is consuming is known as the income effect of the price change
• In the case of ‘normal’ goods both the substitution and the income effects of price change
move demand in the same direction. As fall in price will lead to an increase in demand for a
‘normal’ good due to both the substitution and the income effect of this full in price
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• The price consumption curve (PCC) shows consumer utility maximizing points at different
price levels keeping income and taste constant
• The demand curve is derived from the price consumption curve by joining all points of
consumer equilibrium at different price levels in the price commodity plane. The demand for
a single utility maximizing consumer is shown to be negatively sloping in the case of
‘normal’ goods. This means that as the price of a good falls, more of it is demanded both
because price fall has led to an increase in the real income of the consumer and because this
good has become cheaper relative to other goods being consumed by the consumer.
• In the case of ‘inferior’ goods the substitution effect of price change (assuming that
indifference curves are convex to the origin) is negative but the income effect of its price
change is positive and whether the demand curve of such a good will have the ‘right’ shape,
i.e. whether it will have a negative slope, will depend on the sum of the substitution and the
income effects
• A ‘Giffen’ good is an ‘inferior’ good in the case of which the positive income effect of a
change in its price outweighs the negative substitution effect. Giffen goods have positively
slope demand curves. All ‘inferior’ are not Giffen goods
• Economists claim that by adding up individual demand curves they can obtain a negatively
shaped demand curve. This is the claim that when an individual behaves rationally—i.e. in a
self-interested manner—maximizing his utility, this leads to the maximization of the utility of
capitalist society as a whole
• If a “well behaved” market demand curve cannot be derived by adding up individual demand
curves this means that either consumers are not behaving “rationally” or that social choice is
not simply an aggregate of individual rational preferences. A consistent set of social
preferences cannot be obtained by simply summing individual preferences
• If adding up individual negatively sloped demand curves can yield a smooth negatively
sloped market demand cure then the lesser the interference with individual choices the better
for the maximization of total social welfare / consumption
• However if we agree that individuals have different tastes, two individuals’ indifference
curves can intersect. The point of the tangency of the budget line and the indifference curve
may not be the same for both individuals. The income effect of price change may work in
opposite direction for the two consumers and the effect of price change on aggregate demand
will be indeterminate. Furthermore indifference curves can’t be added up for there are no
rules for assigning weights to consumer choices. Interpersonal comparison of utility is
impossible. Aggregate (i.e. community) indifference curves cannot show uniquely rational
social preference ordering
• Change in prices also changes the distribution of income among consumers. Utility derived
from different consumption bundles will change as the pattern of income distribution
changes. It is not possible to rank different income distribution patterns in terms of the utility
they generate. There is a different social indifference map for every pattern of income
distribution. Social budget line and social indifference curves are interdependent, and not
independent
• This means that the market demand curve can take any shape. Usually it will be neither
smooth nor downward sloping
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• Well behaved market demand curves are derived on the basis of the myth of the
representative consumer—he has the tastes every consumer “ought” to have. They also have
to ignore the impact of changes in prices on changes in the pattern of income distribution and
hence on the social utility (indifference) map to derive smooth negatively sloped market
demand curves on the basis of the representative consumer myth
• Smooth negatively sloped market demand curves can be derived on the basis of two
assumptions (a) that every consumer has the same taste and (b) that tastes do not change as
income changes. Assumption (b) implies that every commodity is a ‘representative’
commodity while (a) implies that every commodity is a ‘representative’ consumer. They also
imply that all income consumption curves are straight lines
• Economists make these assumptions because economics is a moral science. The
representative commodity is capital and the representative consumer is the capitalist.
• Consumer preference theory says that a ‘well behaved’ market demand curves can be
obtained by adding up individual demand curves if and only if there is one representative
consumer consuming one representative commodity
• It is technically impossible to go beyond the one individual— one commodity one individual
model—to derive a well behaved market demand curve. This means that the self-interested
pursuit of individual welfare does not lead to the maximization of total social welfare
(consumption) and that capitalist society is characterized by conflict
• It is impossible to establish a unique market equilibrium if the market demand curve is not
‘well behaved’. It may intersect with the supply curve at more than one point. This shows that
there is conflict not harmony in capitalist society—non unique equilibrium points benefit
particular consumers not society as a whole
• Markets fail to exist when individuals have non convex preferences. There is no uniquely
determined quantity demanded at the ‘equilibrium’ price in such a situation. There is no
uniquely defined equilibrium point, nor can changes in supply effect price. Convexity is
required to guarantee that demand curves will not have “kinks” or “jumps” and that they
show a unique quantity demanded at every price
• The slope of the price consumption curve (PCC) shows whether the two goods being
consumed are substitutes or complements. It has to be assumed that both goods to are
representative goods. When ICC is negatively sloped the two goods are substitutes and there
is a positive cross price effect. When the slope of PCC is positive both goods are
complements.
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Review Questions
1. Why must economists assume that tastes remain constant in their analysis of consumer
demand?
2. Explain comparative static analysis methodology.
3. How is the slope of the budget line defined?
4. Why do economists expect change in income to lead to change in demand?
5. Is it possible for both goods on the axes of a consumer equilibrium diagram be ‘inferior’?
Why or why not?
6. Define ICP. Illustrate with the help of a diagram.
7. Derive the Engel’s Curve” from your previous diagram. What does it show?
8. What are the normal shapes of ICP?
9. Why do economists assume that all goods are ‘representative’ goods? Can there be any
commodity that falls in this category?
10. Define “the substation effect” and the “income effect” of a change in the price of a good and
illustrate your answer with the help of a diagram.
11. Define and draw a price consumption curve.
12. Why does the demand curve for a “normal” good slope downwards?
13. With the help of a demand curve isolate (a) the substation effect and (b) the income effect of
the increase in the price of a good on its consumption.
14. Will the demand curve of an inferior good always have a negative slope?
15. What is a ‘Giffen’ good. When is an ‘inferior’ good not a ‘Giffen’ good?
16. What is the implication of the claim that negatively sloped individual demand curves can be
added up to yield a similarly negatively sloped market demand curve?
17. What are the implications of accepting difference in tastes and the recognition of the
impossibility of interpersonal comparisons of utility for the derivation of community
indifference curves?
18. What is the impact of price changes on the pattern of income distribution? What are the
implications of taking account of income distribution for the derivation of the market demand
curve?
19. The market demand curve can take any shape in general. Explain.
20. What assumptions or conditions are required to derive “well behaved” market demand
curves?
21. Explain the meaning of ‘representative consumer’.
22. Why do economists assume the existence of the “representative consumer” and the
“representative commodity”?
23. “Consumer theory shows that capitalism is an irrational system”. Discuss
24. Show that the determination of unique market equilibrium depends on the existence of a
“well behaved” market demand curve. Use a diagram to illustrate your answer.
25. Non-unique equilibrium points show that there is conflict not harmony in capitalist society.
Why?
26. “Markets fail to exist when individuals have non convex preferences? Explain.
27. What does the slope of the PCC tell us about the relationship of the two goods being
consumed?
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9
Chapter
FIRM AND PRODUCTION IN
CAPITALIST SOCIETY
Chapter 9: The Firm and Production in Capitalist Society
The model of demand-and-supply is the central conceptual tool of economics for

understanding society in terms of its ‘theory of self-interest’. However, to prove that
representation of society by this model is valid, economists must show that the standard demand
and supply curves can be derived from utility and profit maximizing behavior of economic
agents. We have seen in the last chapter that the demand-half of micro economic analysis is
unsound—economics cannot derive a smooth, negatively sloped market demand curve from its
theory of utility maximizing consumer behavior. In this chapter and in the next part of this book,
we will try to see whether or not the ‘obviously appealing idea that to induce a larger supply of a
commodity, a higher price must be paid’ makes any sense. We will see that there are alternative
propositions which hold that price is set by cost of production which results in horizontal (and
even downward sloping) supply curves! We will show that although the economists’ position
seems superficially attractive, there are logical problems with it. This will confirm the fact that
despite its logical contradictions, the major reason for the survival of economics is the
commitment of Enlightenment social theory to the justification of freedom—the ultimate end of
enlightened moderation and of capitalist order. It is for this reason that understanding economics
as a moral science is so important.
As the consumer is the central figure in demand theory, the firm is the central agent in the
theory of supply. To fully understand the supply decision of a firm, it is necessary to understand
the nature of the firm. We begin this chapter by doing this. We then look at how capitalist
production came into existence and how it affects society. And finally, we turn our attention to a
discussion of the role of technology within capitalist society.
9.1: FIRM: THE AGENT OF PRODUCTION IN CAPITALIST ORDER
Whenever you start analyzing the behavior of any individual, you have to begin by
explicitly stating his objective because his behavior can only be understood in terms of the
ultimate ends he is pursuing. To take a simple example, suppose you want to explain and predict
the expected behavior which a student is going to display during his stay in college. Whatever
you say about what this student is going to do depend upon what you think is the objective of this
student. For instance, if the objective of this student is to have fun, then the following typical
activities related to this objective can be predicted.
• Bunking classes • Sitting in the canteen for long hours
• Playing cards • Not submitting assignments
• Having a long list of friends • And finally, failing in the exams
On the other hand, if he sets himself the objective of ‘getting maximum knowledge’, then the
predictions characterizing his behavior will be exactly the opposite of the above so:
• The behavior of an individual cannot be studied in isolation from his objective, and
• The behavior of one individual resulting from pursuing a particular objective may not
necessarily apply to another person who has some different objective.
In terms of our example, the objective of having fun cannot explain the behavior of the student
who wants maximum knowledge. Similarly the typical activities resulting from having the fun
objective’ do not apply to the knowledge maximizing student.
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Anyone having a little common sense would agree that a ‘research methodology’ which
ignores objectives is fallacious. But it is exactly this methodology which economists tend to use.
Economists analyze the production behavior of the firm which has a specific objective (i.e. profit-
maximization) and then come up with the suggestion that the behavior of firms pursuing this
objective is universally valid and therefore all units of production should be forced to follow this
course of action. When economists pretend that their theory of the firm is ‘universally
applicable’, they actually claim that ‘all ends or objectives of organizing production other than a
specific one (profit-maximization) are irrational and therefore outside the theory of knowledge.
We have seen that economists do this because economics is a moral science. Its
own purpose is to justify capitalist order and the behavior patterns that produce this order.
If production is undertaken for any purpose other than profit maximization (i.e. the
maximization of the rate of accumulation) capitalist order is undetermined. Therefore
economists insist that it is irrational to undertake production for any purpose other than
endless profit maximization. The question ‘profit maximization for what’ cannot be
raised within any branch of capitalist knowledge—science, philosophy, sociology,
psychology or economics.
9.1.1: The Firm

Some economics text books begin the analysis of the firm by defining it as an entity or
organization that undertakes the activity of production—i.e. combining and processing goods,
called inputs, in technological processes to convert them into some other goods, called output.
This definition tries to define the firm in purely technical terms—production activities—by
abstracting from the objective pursued by the producing unit. The definition tends to imply that a
firm derives its nature from its technical function (production activity) and not from any
particular objective that it seeks to pursue. But, as explained above, the behavior of a social agent
cannot be explained without explicating (taking account of) its objective. Similarly, it is impossible
to speak of the ‘activity of production’ without understanding its presupposed objective. There can
be several objectives for productive activity. For example, production can be carried out:
• to fulfill needs of the people in order to earn reward from God
• to serve consumption needs of a particular community.
• to enhance national defense capabilities
• to maximize profit
• to serve some other social objective
In principle, one may organize production to serve any of these objectives. The achievement of
these ends will not, as economists insist, be the unintended consequence of profit maximizing
behavior. Profit may have to be sacrificed for achieving these objectives. For example building a
nuclear capability for jihad may involve producing fewer cars and fridges although producing
cars and fridges may be much more profitable and producing what is most profitable to produce
now is no guarantee that we will be able to develop our nuclear capability even in the future.
According to economics, the only legitimate and rational objective for undertaking
production activity is the maximization of profit. It is the pursuit of this objective—and it alone—
that defines the role of the firm within capitalist society—a firm is an entity that undertakes the
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activity of production or trade for the sake of maximizing profit and for it alone. A production or
trading unit which seeks some other objectives is not a firm. The garden of Fidak owned by the
Prophet (Peace Be Upon Him) and the trading business of Hazrat Usman (RA) were not firms
because their objective was not the maximization of profit but the attainment of Allah’s approval.
Maximization of profit is the only reason why a firm exists in capitalist society.
Economics asserts that the welfare of society will be maximum when all firms are producing
output for the sake of making maximum profit. In other words, when all production activities are
organized on this basis, then society maximizes consumption. As capitalist society matures, all
activities taking place in society are connected to the maximization of profit—accumulation of
capital—in such a way that pursuit of any other objective becomes increasingly difficult. Read
Application Box 9.1 to see how profit-maximization directs social activities.
A p p l i c a t i o n B O X 9.1
Is KFC Serving Society or Maximizing Profit?
KFC has opened an outlet at University Road, Karachi, where most of the waiters are deaf-and-
dumb. Many people believe that KFC is serving an honorable national cause by providing
economic support to one of the marginalized groups of society. The reality is otherwise. What
KFC is trying to do is to win public sympathy in order to increase its profit. That KFC is
maximizing its profit is evident from the fact that it tries to create the impression that ‘if services
at this outlet are a bit slow, more people should visit this outlet so that KFC may not shut it down
due to loss’. The idea of hiring deaf-and-dumb staff seems ethically appealing because it
corresponds to the religious values of Pakistani society. However, remember that profit-
maximizing thinking may sometimes take the form which is consistent with the moral values of a
religious society, such as in this case. In such cases, people tend to confuse profit-maximizing
behavior by tracing it to their own (not the firm’s) social values. But when it takes the form
which goes against well-established social norms, people abuse profit-maximizing behavior, such
as in the case of increasing prices of tents and medicines during the time of the earthquake in
Azad Kashmir. But there is fundamentally nothing wrong about increasing prices during the
earthquake according to economic theory because profit-maximizing behavior requires firms to
increase prices at such times because increase in demand must bring forth increase in market
price. Similarly, when KFC hires deaf-and-dumb staff, it is serving a social objective simply to
maximize profit. If KFC sales increase, other firms, such as McDonalds, will also come up with
deaf-and-dumb serving outlets shortly. If not, then KFC will say ‘bye bye’ to social objectives.
All activities are tied to the maximization of profit in capitalist society.
In a fascinating book The Corporation, an eminent lawyer Joel Bakar has shown firms
such as Microsoft, Coca Cola, Pfizer, Nike and Nestle under philanthropic projects only
when the costs involved can be shown to generate profits somewhere else within these
empires. Microsoft preside free hardware to Harleem schools because software sales thus
generated exceed costs of the hardware handed. Pfizer used to provide free AIDS
treatment in Malaur and Switzerland in the hope that this will lead to a more than
proportionate increase in medicines. When this did not happen, Pfizer abandoned its free
AIDS program.
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The Firm and the Entrepreneur
Note that the firm is more than a cooperating group of producers; it is a group with a
particular organizational structure and a particular set of property rights. For example, it is
possible to think of a ‘Producers’ Cooperative’ in which assets are owned in common—with no
individual having the right to the exclusive use or disposal of any of the equipment, output, cash
reserves, etc. of the cooperative and decisions being taken on a majority voting basis. This
produces co-operative would clearly not be a firm. The essence of the firm is the existence of a
central figure: the owner, employer chief executive manager or entrepreneur—a critically
important character in capitalist society. He is the one who:
• enters into a contract with each of the individuals who supplies productive services
• has the right to profit from production
• has the right to direct the activities of the suppliers of productive services (specially labour)
• can change the membership of the producing group not only by terminating contracts but also
by entering into new contracts
Thus, there is a similarity between the function of a firm and the role that an entrepreneur plays.
Both of them combine resources for producing commodities in order to make profit. This
similarity is not coincidental. The firm simply constitutes the organization used by the
entrepreneur to combine inputs—land, labor and capital—in the production process.
Conventionally, the entrepreneur is defined as a person who undertakes and operates a new
enterprise or business venture to offer a new or existing product or service in a new or existing
market and assumes some accountability for the inherent risks. In the context of the creation of
for-profit enterprises, the entrepreneur is often synonymous with the founder. He is a person who
takes the risks of finding new channels of profitable investments for the sake of further
accumulation of capital. However, as we see below this view of the firm—as held by the classical
economists who saw the entrepreneur as a heroic figure —is not an appropriate description of the
ideal capitalist property form, i.e. the corporation, the distinguishing feature of which is a
separation of ownership from control (this issue is discussed below).
Plant and Industry
This relation between the firm and the entrepreneur brings us to an important distinction
between the firm and the plant. A plant is the physical capital at a particular location used for
producing commodities—i.e. it is the unit of production in a firm. On the other hand, the firm is
the unit of ownership and control. Common examples of plants are factories, offices and farms.
Remember that the plant comprises of only a part of the capital organized by the firm and thus
represents only one of the factors of production; i.e. capital and that too partially. A firm may
have more than one plant, e.g. production facilities of General Motors are scattered across many
countries. Conversely, a single plant can also be part of the capital shared by more than one firm,
e.g. a gas and petrol exploration plant jointly owned by Pakistan Petroleum Limited and OGDCL.
Moreover the growth of E-business shows that firms may exist almost without having a plant—
you may run your E-business from a computer on a table sitting on a chair; and the chair, the
table, the computer and the software will be the only fixed capital (plant) you need to run a Rs
100 billion share trading firm. Finally, an industry is the collection of all firms concerned with a
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particular line of production. Pakistan Economic Survey lists 21 industries; including textile,
transport, chemicals, food manufacturing etc. However, it is difficult to give a rigorous definition
of ‘industry’ because one firm may operate in more than one ‘industry’ at a time.
9.1.2: Legal Forms of the Firm
Firms can be classified in many ways: by size, type of competition or by legal forms. We
begin with this last classification. In a capitalist country, firms exist in three legal forms:
proprietorship, partnership and corporation. As we see below, capitalist production takes place
most efficiently when the firm takes the form of a ‘corporation’—the typical and dominant
property form in capitalism.
Proprietorship
A proprietorship is a firm which is usually owned and managed by a single person—

that is why it is often called sole proprietorship. In this case, the owner is himself the boss who
makes all decisions, receives profits and is responsible for all losses. In many cases, the proprietor
also provides and owns a large share of the assets; including labor, building, land and equipments.
Agricultural production is a typical example of proprietorship. A very large proportion of the total
number of farms in Pakistan can be described as proprietorships. The farmer owns the land, and
farming equipment and uses his own labor to do most of the work. At the end of the production
year, the farmer receives a profit or incurs a loss. Another major commercial activity in Pakistan
for the sole trader is retailing. Note that most of the business forms that are typically organized
under proprietorship are characterized by low capital-intensity—i.e. they require little capital. In
terms of the share of total capital and total employment, sole traders are of limited importance in
mature capitalist countries. Remember not to equate proprietorship with ‘one-man-business’. Sole
proprietorships are indeed owned by one person but the business may employ many people.
As we see in the next section, proprietorship is not usually a suitable form of business
organization to carry out capitalist production and trade. Sole ownership becomes increasingly
difficult to manage a capitalist production and trade because of the intensified competition
created by large corporations. There are many reasons why proprietorship is regarded as an
inefficient way of carrying out capitalist-production and trade. The major reason is its inherent
limits to growth.
(1) Financial: Capitalist growth ultimately depends upon the availability of capital. Sole
ownership is restricted to the amount of money that can be provided from its own resources
or raised from banks or other lenders. The proprietor always faces a potentially vulnerable
financial position in capitalist society. The profits accrue to a single person but so do the
losses which force most sole traders to go bankrupt. Limited capital resources often make the
sole trader particularly vulnerable to sustained competition from large business units.
(2) Organizational Skills: Even if a person is able to acquire large amounts of capital, he has
only limited ability to exercise effective control and manage an organization. As capitalist
business grows specialized management skills increase in importance and complex business
forms replace the sole trader.
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Partnership
A partnership is similar to a proprietorship, with the main difference being the number
of owners. It is a firm owned and operated by two or more persons. Each partner generally shares
in the risks, profits and liabilities of the firm. Partnerships may be formal organizations, but two
or more people running a stall in a local Jumma-Bazar would almost certainly be in partnership
with each other although they have signed no formal contracts. The maximum number of
members possible in most partnerships is often fixed by law.
Partnership depends upon mutual trust between partners—each one of them must rely on
the others for the success or failure of the firm. The responsibilities may or may not be divided
among partners: one partner in charge of management, another of production, and the third of
accounts. The division of responsibilities could also extend to one partner operating the firm and
a limited partner providing only financial capital. This form of business became increasingly
popular with the emergence of capitalism because it is more suited to management of capitalist
production. Most management consultancy firms in Pakistan are organized as partnerships.
Corporation
A corporation is a distinct legal entity that exists independent from its owners. Since it is
separate from its owners, it can sell ownership shares, called stocks. The term joint-stock
company is also often used in place of corporation. This is a business form consisting of persons
who contribute money to a common stock used in business for making profit. This common-stock
is the capital of the company and the persons who contribute it are its members. The share of
each member is the proportion of capital to which he is entitled. The ability of a corporation to
sell stocks allows it to raise far greater amounts of financial capital than a partnership and a
proprietorship. But keep in mind that the shareholder in a corporation risks only the initial amount
invested in the firm, called the principle of limited liability ownership. This means that an
investor’s liability to debt is limited to the extent of his shareholdings in the corporation. For
example, if you own Rs 1,000 shares in a corporation and if it goes bankrupt, then the most you
can lose is the Rs 1,000. This system encourages investment because it limits the risk investors
take to the amount they have actually invested in the corporation. In contrast, the owner of a
proprietorship has unlimited liability which means that all of the owner’s personal assets can be
used to pay the firm’s liabilities in case it becomes insolvent. Unlimited liability also applies to
partnerships, with the exception of limited partners who, like shareholders, risk only their initial
investment.
The need for more and more capital partly explains the development of joint stock
companies. In mature capitalist countries, joint stock companies are the dominant form of
business organization in terms of capital and manpower employed. An important and heatedly
debated issue in this form of business organization is the separation of ownership from control—
he who ‘owns’ capitalist property has no control over its use. The legal owners of the firm are the
shareholders, who may number in thousands, and each of them has a very small proportion of the
total equity of the company. They bear the risk in the sense that fluctuations in the profits of the
company imply fluctuations in their income and wealth (dividends and shareholders value).
However, as corporations become larger, the management functions also grew. The growth of
management control over corporations and wide spread share ownership distributed among many
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small and powerless owners has meant that managers now control corporations. In principle, the
directors of a firm are supposed to be ‘stewards’ for the shareholders to look after the operations
of the company on behalf of shareholders. But the boards of directors are dominated by the senior
executives of the company which means that senior executives of the company, rather than
shareholders, effectively control the decision making activities within corporation. Thus, if there
is any conflict between managers’ and shareholders’ interests, the separation of ownership from
control permits managers to pursue their own interests rather than those of shareholders. There is,
therefore, a great deal of theoretical disagreement on ‘who runs the corporation and for whose
interest’.
It is important to stress that this is one way in which capitalism abolishes private property
(just like socialism) in the sense that control of property is denied to its owners. This abolition of
private property is necessary for the effective domination of profit-maximization orientation at
the mass level. This is so because as long as property remains under the control of non-economic
men, there is every possibility of using it for non-profit-maximizing purposes—man can anytime
repent from the so-called rationality of profit-maximization. Abdullah Zhagzai never thinks of
profit-maximization when he enters a business transaction. On the other hand, the corporation is
legal entity which exists solely for the accumulation of capital. This is its only moral and social
duty according to law. No share holder can legally question the nature of business, Halal or
Haram, conducted by the corporation. The ownership of a company is so widely and weakly
dispersed among shareholders that the maximum a shareholder can actually do is to withdraw
from business by selling its shares only to be purchased by someone else in the market. Thus,
when property is organized in the form of a corporation, ‘capital’ is the uncontested owner.
The corporation first appeared at the beginning of the seventeenth century—the East
India Company was among the first corporations to be established—and during the seventeenth
and eighteenth century it was universally regarded as a corrupt and fraudulent form of business. It
acquired legal legitimacy in the first half of the nineteenth century in Britain, France and America
and about half a century later stock markets were formally and legally organized in all countries
for the regular trading of company share. The law requires the corporation to conduct its business
for the over riding purpose of capital accumulation. It is literally illegal for the corporation to
regard any purpose other than profit maximization as its primary objective. Every activity must
ultimately be justified in terms of its impact on the bottom line and every activity is ruthlessly
priced by the stock market on this basis and on this basis alone. A company which is judged by
the stock market not to be effectively seeking profit maximization goes out of business—it
becomes bankrupt or is taken over by its rivals.
This compulsion to maximize profit effectively establishes the ownership of capital.
Capital is not owned by anyone in the sense that he cannot continue to own it without using it for
its own accumulation. Share “ownership” is a legal fiction. In capitalist society capital is the real
owner—the corporation reflects the real personhood of capital. Capital owns labor, management,
land, technology, knowledge and all “factors of production” must continue, for ever, to work for
capital accumulation. Any money or other resource withdrawn from this circuit of capital ceases
to have value for it is no longer capitalist property.
The separation of owner from control raises the question of ‘who runs corporation and for
whose interest’. Within a corporation, three groups can be identified for whose interest it is run:
shareholders, wage-laborers and salaried managers. As stated above, although shareholders have
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the formal (fictional) ownership rights, they are so dispersed and have so little information about
the firm that it is impossible for them to control the corporation and determine the use of its
profit. No doubt wage-laborers have some power and organization to withdraw their labor
collectively, but their economic vulnerability to long-term loss of income limits their ability to
exercise control over the corporation. Thus, corporations are largely controlled by managers.
Large offices, plush carpets, large expense accounts, and executive dinning rooms and cars are
evidence of corporate conspicuous consumption. Off course, if managers do posses economic
rationality—of maximizing utility—then their utility depends upon their salaries and other
prerequisites, such as company car, expense accounts, subsidized food, drink and housing, status,
prestige, power and security. However, the managers cannot ignore the interests of shareholders.
Baumol, Marris and Williamson have argued managers aim to increase the sales of the
corporation as fast as possible subject to the constraint that some minimum profit or dividend
must be paid to shareholders in order to avoid take over.
However this obscures the fact that managers’ salaries are ultimately determined by the
profits that their corporation makes and stock markets are continuously valuing its share on this
basis and this basis alone. Moreover in the 21st century a major proportion of managers’ own
earnings are generated as dividends and capital gains on stocks they hold. This fact plus the
increasing dominance of the institutional investor—the ‘mutual fund’ which is controlling
billions of dollars of shareholders funds—has meant that profit maximization has become a
managerial policy imperative and the inclination to sacrifice profit for conspicuous consumption
has become increasingly unaffordable. As long as stock markets provide the barometer for
assessing firm performance, managers are compelled to seek profit maximization as the ultimate
end in itself.
9.2: DYNAMICS OF PRODUCTION IN CAPITALIST SOCIETY
Having understood the nature of the firm and its social objective, we now take up the
issues of the nature and process of production activity and its relation to social institutions in
capitalist society. The importance of the issue lies in the fact that only after discussing the
dynamics of capitalist production process can we appreciate the essence of capitalism. Let’s begin
with a brief historical account.
9.2.1: How it All Got Going: Transformation to Capitalist Production

In the 1780s ‘M‘Connel and Kennedy, two Scotsmen traveled south and became
apprentices in the Lancashire cotton industry. After gaining some experience and earning some
money, they started their own firm in 1795 with an initial capital of £1,770. They made good
profits. By 1800, their capital had increased to £22,000, by 1810 to £88,000. The company had
three mills by 1820 and had established itself as the leading cotton spinning unit in Manchester,
the global metropolis of cotton spinning. But high profit rates could not be maintained over a long
period of time as they induced other firms to enter the market. By 1819, there were already 344
cotton mills and this number increased to 1,815 by 1839. Technological improvements brought
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about huge increases in productivity in the 1830s and competition forced companies to invest
increasing amounts of money in new machines.
M‘Connel and Kennedy’s labor force grew from 312 in 1820 to approximately 1,500 by
1830, an increase of about 380% over a decade. Not surprisingly, much of this labor was cheap
child labor and nearly fifty percent of those employed were under the age of 16. There were 100
children under the age of 10, including some as young as 7, who were made to work from 6 am
till 7:30 pm. The mill owners tried to keep wages as low as possible because the total wage bill
was rapidly increasing as the number of workers grew. Replacement of craft workers with less
skilled and cheaper labor and invention of new automatic machines reduced wage costs. But such
practices gave birth to wage-conflicts which became increasingly organized over time. Labour
resisted wage reductions through their unions. We will have more to say on the issue of conflicts
among laborers and agents of capital (i.e. manager) in the last part of this book while discussing
economic theories of income distribution.
As business ventures became larger, the size of investment needed to operate business
also became greater. This led to market domination by the corporate property firm—the joint
stock company. However the joint stock form of organization largely developed not from the
local requirements of the size of industry, but from foreign trade booms of the colonial era—the
era of the worst form of mass exploitation and butchery ever known in the history of mankind. At
first, there were regulated companies, e.g. the Muscovy Company (1553), which were established
for a single business venture. However, one of the most important joint stock companies which
had a continuous existence for two and a half centuries and was run and controlled by a board of
directors was the British East India Company, founded in 1600. In April 1601, the company sent
its first expedition to the East Indies. After some 18 months, four of its ships; Ascension, Dragon,
Hector, and Susan, had returned from Sumatra and Java. The success of this venture led to a
second voyage by the same ships which left London in March 1604. This time Ascension,
Dragon, and Hector could make it back to England in May 1606 while Susan was lost at sea. The
shareholders in these two voyages made a profit of 95% on their investment. A very large amount
of capital was needed for this type of trade. An East Indianman—as the ships engaged in this
trade were called—had to be built, fitted out, armed with cannon against Dutch and Portuguese
rivals, and repaired, when it returned. The Company’s capital was obtained largely but not
entirely from rich London merchants who controlled and administered it. Aristocrats were another
welcomed source of income because of their influence at Court. The Company’s privilege depended
upon Royal favor. Foreign money was also involved. The first 12 voyages were financed separately.
This was, however, a risky way of financing long-distance trade because it exposed capital to a long
period of uncertainty in far away and unknown places. Risk could be spread by sending several
ships on each expedition, so that not all eggs were in one basket. Thus the company shifted to a
method of finance that spread risks over a number of voyages and then became a full fledged joint
stock company in 1657, and in 1688 trading on its stock was formally organized.
Since prices, when left to market forces, tend to fluctuate in capitalist society, therefore
every capitalist market provides opportunity for making money through speculation. This occurs
when something is purchased in the expectation of selling it at a higher price in the future without
increasing its value by processing it in some form. Speculation can occur in relation to almost any
commodity: it may be grain, currency or a derivative—the sophisticated financial instruments that
derive their value from the value of something else, such as oil or coffee. Speculation is an
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unproductive and freeloading activity that is wholly separable from the real economy where
production of goods and services takes place. However, when speculation is based on real goods
and services, its scope is limited by the fact that goods must physically exist to speculate on. This
limit is relaxed in stock markets which provide a perfect opportunity for speculating on company
shares without having much concern with its production activity. The existence of markets for
capital—something that has never existed in the whole history of mankind—is central to the
functioning of capitalism because capital markets bring together those seeking to finance
economic activities by taking risks and those with money to invest. Since the stock prices (of
company shares) change, sometimes due to changes in their profitability and most of the time due to
artificially created bubbles, there are opportunities for speculating on future price movements.
Because share price fluctuation has very little to do with actual production, money can be made by
speculating on prices of company shares—nothing more than pieces of paper! Speculation is not
something separate from capitalism but an inevitable and integral part outgrowth of its essence.
There is another sense in which stock markets are essential to capitalism. Capital is
money that is invested solely to make more money. In other words, it is a means for converting a
given amount of money into a ‘larger amount of money’ by passing through a production or trade
process. It is easy to see that the rate of expansion in capital depends upon the speed at which
money is circulating in the economy—the rate at which it changes hands, called the velocity of
money. The slower the production process, the slower will be the circulation of money and vice
versa. One way of increasing the circulation of money is to increase the speed of the production
process, say by producing and promoting the use of products, such as glass-ware instead of metal
utensils or earthenware. However, the circuit of production, no matter how fast it becomes, places
an upper limit on the growth of capital. Another way of increasing the circulation of money is to
bring money into financial markets, such as stock markets and money markets, so that money can
now change hands with greatly reduced dependence on the production cycle of a specific
commodity. Thus, stock market trading provides an ideal opportunity for never-ending expansion
of capital—the material form of freedom.
It is also interesting to note that at the time, when industry and commerce were finding it
necessary to adopt the joint stock company property form, the government was also finding it
necessary not to interfere in the economy. It was also in 18th century Britain that typically
capitalist ways of thinking about the economic basis of society were first put forward. The merits
of the division of labor, competition, free operations of markets and generation of ever increasing
profits were clearly spelled out by Adam Smith. The key thinkers of this time were examining the
mechanisms and principles of capitalist society that they saw emerging all around them. The
question ‘why capitalist production became so extensive in 18th century Britain’ is itself worth
investigating. However, the scope of this book does not allow us to go about tracing its historical
causes.
9.2.2: Impact of Capitalist Production on Society

Trade has existed in all civilizations. There were merchants who used to invest money in
goods and sell them at a profit throughout history. But except for Jews and money lenders, profit
maximization was not the objective of the enterprise. That is why growth in trading stock
remained limited and merchants played a major role in sustaining religious institutions such as the
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mosque, khanqah (‫ )ﺧﺎ ﻧﻘﺎﻩ‬and mazar (‫)ﻣﺰﺍﺭ‬. Trading profits were a major source of the resources
mobilized for all Ghazwat (‫ )ﻏﺰﻭﺍﺕ‬after Uhud (especially Ghazwa-e-Tubuk) and the Prophet
(Peace Be Upon Him) has said “the honest merchant will accompany the Prophets, the martyrs
and the truthful in Paradise”.
In pre-capitalist societies most people’s livelihood did not come from economic activities
financed by the investment of profit maximizing businesses. Private property was universal, self-
employment was common and wage labour was rare. In fact, wage labor was stigmatized in such
societies. Being an employee was often considered a menial activity even when it yielded higher
income than being self-employed or working for one’s family (‫)ﺧﺎﻧﺪﺍﻥ‬. Since the societies were
dominated by the religious virtues of contentment and love, as opposed to ‘more is better’
(accumulation) and ‘competition’, people spent little time to earn their livelihoods because only a
small basket of goods was enough to support their families. Imam Ghazali recommends that
working for one’s living should be structured to the time between Ishraq (‫ )ﺍﺷﺮﺍﻕ‬and Zuhr (‫)ﻅﮩﺮ‬
prayers (roughly 8 am to 1 pm) in the Arabic speaking countries. With the emergence of
capitalism, things changed dramatically. Greed and envy became the dominant expressions of
social rationality and people started searching for meaning of life in consumption and investment.
This tendency was socially reinforced by the fact that in capitalist production the whole economy
depends upon the investment of money for making profit, and this occurs when not just trade is
financed in this way but production also. Capitalist production requires the universalization of
‘wage-labor’. Labor is treated like a commodity, similar to any other that can be sold and
purchased in the market at its going ‘equilibrium’ price. Labour markets are more like the ancient
‘slave-markets’—capitalism develops ‘labor-markets’ with the majority of the population in
society having no option except that of selling their skills and time to some capitalist firm in order
to earn their livelihoods. The only other choice is ‘to starve’. Commodifying labour is the
beginning of a process of comprehensive social change as discussed below.
Capitalist Production Imposes New Social Discipline
As capitalist production speeded up through the expansion of new industries, increasing

number of citizens were turned into wage-laborers. Therefore, the efficient working of such a
system of production needed a new kind of ‘discipline’ among workers. Industrial production
requires continuous and regular work in order to reduce cost. Expansive machinery cannot be left
unused. This means that idleness and wandering around, even conversation, among workers could
not be tolerated during work hours. Initially British cotton mills faced a great deal of trouble
recruiting labor because people simply hated long, uninterrupted shifts and close supervision.
Employers had to find ways of enforcing a discipline that was quite alien to the first generation of
industrial workers. Corporal punishment (especially for children), fines or the threats of dismissal
were common. Gradually more sophisticated and apparently ethical ways of controlling workers
were developed by some of the mill owners. Read Application Box 9.2 which discusses an
interesting way of maintaining work discipline developed by Robert Owen.
32B
Owen’s Factory Discipline

Many so called ‘ethical’ ways of monitoring workers were developed by mill-owners in
the eighteenth century. Robert Owen usually thought of as a utopian socialist reformer introduced
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‘silent monitors’ at his New Lanark mills. In this system, each worker had a piece of wood, with
its sides painted with different colors standing for different performance appraisals: black for bad
work, blue for indifferent, yellow for good, and white for excellent. Every morning when workers
came back to their work station, the side turned to the front provided them a constant reminder,
visible to all, of the quality of the previous day’s work. Each department had a ‘book of
character’ recording the daily color for each worker. Discipline was not only a factory matter,
because Owen also controlled the community. He sent round street patrols to report drunkenness
and fined the drunks next morning. He also insisted on cleanliness and set detailed rules for the
cleaning of streets. There was even a curfew that required everyone to be indoors after 10:30 p.m.
in the winter.
As the Owen case shows he was not only controlling factory matters, but also the
community at large. Community control was necessary because disciplined work not only
required regular performance at the factory, but also timely work. It meant turning up early every
day, starting on time, and taking breakfast of a specified length at exactly a specified time.
Employers had to battle even against some of the well established traditions, such as turning up
late on Monday mornings. Time turned into a battleground and some ruthless employers put
clocks forward in the morning and back at night. There are stories of watches being stolen by
workers so that employee’s control of time could not be challenged. Ownership of timepieces and
watches became widespread during the Industrial Revolution in Europe. Much of the organization
of institutions which evolved at this time, such as hospitals and schools, was modeled on factory
discipline. The leading twentieth century French philosopher Foucault provides fascinating
details of these in his book Discipline and Punish!
Capitalist Production Producing New Social Networks
Not only did capitalist production create a new form of work; i.e. wage-labor, it also
created leisure as the most important part of modern life. This statement might seem surprising
given the fact that cotton masters wanted to keep their machinery working for twenty four hours a
day. However, the practice of continuous work during work hours ruling out all types of non-
work activities separated out leisure from work—a distinction unknown in non-capitalist
societies. In capitalist production, work became monotonous and boring as one did not feel ‘at
home’ in the work place. Only in leisure time did workers feel ‘at home’ and in control of their
lives. This leisure activity normally took the form of holidays, week-ends, and evenings. It was
the disciplined and bounded work created by capitalist production that gave birth to the idea of
leisure as a distinct ‘non-work time’ activity. As a result, workers wanted more and more leisure
and leisure time became an agenda item to be negotiated by unions. This started initially in the
cotton industry and eventually new laws were passed to limit working hours and to provide
holiday-entitlements to workers.
The importance of the idea of leisure, and the universalization of wage labour, can only
be appreciated by understanding its role in the enhancement of capitalist production through the
commercialization of leisure. Capitalist enterprises started organizing leisure activities.
Traditional sports and pastimes, even religious ceremonies, were managed to generate profit and
an entire separate entertainment industry blossomed. The new railway companies offered cheap
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excursion tickets and Lancashire cotton workers could visit resorts for the day. 1841 saw the first
excursion tour by rail from Leicester to Loughborough organized by Thomas Cook. Tourism
emerged as a distinct industry. Commercialization of leisure made it possible to charge people for
entry in activities ranging from mass travel to spectator sports. The lure to make profit gave birth
to the idea of providing entertainment through T.V. and radio at home. These ideas inspired a
new range of paid professional singers donors and musicians to emerge in society—characters
that were traditionally regarded as immoral and base. A whole range of new industries were
developed to exploit and promote leisure markets creating a huge source of consumer demand,
employment and profit. This commercialization of leisure gradually converted the lives of people
into a never ending hunt for pleasure which become the sole purpose of existence. This dynamic
interaction of production and consumption explains why capitalist production expanded so very
rapidly once it got going. Capital now has a wide range of activities to move through depending
upon which of them suitably rewards it—i.e. offers higher and higher profitability.
Capitalist Production Eliminates the Natural Order of Life
The introduction of rapid means of traveling is another outcome of capitalist production

that drastically changed people’s life. Rapid expansion in communication and transportation were
necessary as capital needed to be transferred quickly from one place to another in order to speed
up its accumulation for the sake of further accumulation. Though the speed of travel was
increasing from year to year, yet more and more time was devoted to traveling itself. The
commercialization of the vehicle industry brought about one of the most troublesome by-products
of industrialization: the terrible traffic congestion in towns, cities and suburbs. One consequence
of this is that strolling along the streets of a city is now a forgotten memory. Lorries, motor-cycles
and taxi fumes, filth and snarling engines and visual disturbances have compounded to make
movement through the city a nightmare for the pedestrian. Towns and cities have been rapidly
transformed into roaring work-shops. This has forced authorities to come up with the policy of
road-widening, tunneling and bridging. Such policies soon resulted in the development of cities
where the greater part of the metropolis was converted to road space with massive signs,
bypasses, and weirdly shaped junctions and circuses across which traffic flows from several
directions. Ask any person who belongs to the previous generation how difficult urban life has
become.
Many other important features of the natural order of life have also been corrupted by
capitalist production.
• Erosion of the country side
• ‘Uglification’ of coastal towns
• Pollution of the air and of rivers with chemical wastes
• Accumulation of thick oils on our coastal waters
• Sewage poisoning of beaches
• Destruction of wild life
• Change-over from animal farming to animal factories
• Spread of pandemic diseases resulting from environmental depletion and sexual
immorality (especially AIDS and homosexuality)
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• And visible to all who have eyes, a systematic destruction of natural beauty and a rich
cultural heritage
In short, to preserve what little is left from capitalist production requires a major revision in the
vision and purpose of life beyond growth.
Capitalist Production Destroys Family Institution
But the story does not end here. Capitalist production has also destroyed one of the most
important and strong social institutions even in the Christian Europe, namely the family where
women used to play their part as house wives and men as bread winners. Capitalist production
could not afford to tolerate strong family sentiments. On the one hand, increasing number of
industries meant even greater demand for workers. On the other hand, as pointed out above, high
profit in any industry, such as spinning, attracted new entrants which depressed prices and, hence,
profits. One way to maintain high profits was to hire cheap labor, such as children and women.
Companies competed against each other to offer jobs to women. However, the traditional family
structure and prevailing public conceptions of ‘normality’ and ‘appropriateness’ related to social
responsibilities of women were effective barriers to women’s participation in labor markets.
Therefore, deceptive slogans, such as ‘women-rights’ and ‘gender-equality’, were popularized to
expand women labour market-participation. Firms were willing to provide flexible working hours
and other fringe benefits to women in order to increase their participation in capitalist production
because they were found to be more disciplined and unthreatening and ‘union apathetic’.
Advertisement firms saw women as an effective instrument for promoting their products. The
existing home responsibilities of women had to be reduced so as to facilitate and maintain their
commitments to their jobs. This opened up an entirely new avenue of production possibilities for
capitalist firms including:
• Fast and canned food, paper-glasses and plates and soft drink industries (which heavily
reduced the burden of kitchen activities)
• Baby nappies or pampers industry
• Dry milk and feeder industries
• Washing and drier machines etc.
Women’s participation in the work force and their unrestricted social interaction with
men has led to the inevitable break-down of the family as divorce, fornication and nudity spread
throughout society. Capitalist production has transformed not only people’s work and leisure
preferences and activities; it has invaded the most ‘private’ aspects of social life.
There is another important dimension in which capitalist production has forced people to
change their living habits. In capitalist order a large number of workers are concentrated in
factories and offices where they have to work in a continuous and disciplined manner under the
supervisor’s watchful eye. Residence of workers close to their work places had to be planned to
reduce traveling costs as well as to enforce work discipline. Industries are often located in urban
conglomerations to exploit location advantages. Residential and industrial concentration produced
modern metropolitan life styles in which urban residents know a lot about the world’s business
from minute to minute, but nothing about people who live in their neighborhood. Serious
environmental depletion was another consequence of modern urbanization. Sanitation, water
management and sewerage disposal problems became increasingly severe. Joint families
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disappeared and the typical urban residence is a flat designed for four people to live away from
their relatives, such as brothers and sisters. This separate and private living reinforced the whole
ideology of individualism—to be the master of one’s own life.
Thus, destruction of family is a necessary result of industrialization, urbanization and
emancipation of women. All of these three tendencies operate simultaneously and go hand in
hand. The promise of high wages and other material benefits resulting out of modern
industrialization lures large numbers of the able-bodied from close-knit, well integrated society of
village to anonymous city life. With industrialization the family ceases to be a self-sufficient
economic unit.
Capitalist Production and Capitalist Individuality
Capitalist production presumes satisfying infinite ever growing human wants as an

ultimate end in itself. The law of eventually diminishing marginal utility—as discussed in chapter
7—means that continuous growth cannot be sustained by a system of producing ever larger
quantities of the same commodities. This facet of the capitalist life system highlights the
importance of product innovation. New and more expansive goods and services must be
continuously brought into the market. When new kinds of goods appear, the older ones are
removed from production. And in order to ensure that people keep on changing their wants as
rapidly as product innovation requires; the social and economic network is geared to creating
dissatisfaction. As pointed out in chapter 6, producers—e.g. through advertisement—
continuously persuade consumers to choose that which is being produced today and ‘unchoose’
that which was produced yesterday. Thus, the market is not a want-satisfying mechanism; rather a
want-creating system. The share of national resources devoted to creating new wants keeps on
increasing. The success of this system is symbolized by the emergence of ‘pace-setters’—an ideal
type, hyperconscious of being in the van of fashion and filled with unlimited ambitions.
Manufacturers strive to create an atmosphere which simultaneously glorifies the ‘pace-setters’
and ridicules the fashion laggards. The more affluent a society, the more covetous its citizens
need to be. Keeping a man covetous and unthankful in order to maintain the pressure of scarcity
is a matter of survival for capitalism. The fear of ‘falling out of the race’—created in a capitalist
society by the pressures of pursing prestige, position and recognition among colleagues—is the
driving force of capitalist production. Anxiety and stress spread at mass levels. Few men in
capitalist societies can say that they live, in this age of accelerating change, without anxiety. The
services of psychiatrics and therapists become most wanted in mature capitalist societies.
To appreciate the importance of creating new wants, note that an unchanging pattern of
wants—the hall mark of non-capitalist societies—would not be sufficient to absorb the rapid
growth in the flow of consumer goods coming to the market. If everyone behaves like Abdullah
Zaghazai capitalism cannot flourish in Pakistan. One of the pre-requisites for the ‘take off into the
self-sustained growth’ is the collapse of Islamic values—faqr, zuhd, qana’at—and the growth of
dissatisfaction with the status quo. In non-capitalist Muslim societies, people lived comfortably,
whether in towns or villages. Their satisfaction was derived from their closeness to each other and
to the natural order of life, and not from the frenzied search for the satisfaction of infinite wants.
Life was centered on the mosque, through which people of all ages and circumstances organized
their social activities and became familiar with each other. Capitalist-production cannot flourish
without creating and sustaining economic man—individuality committed to satisfying infinite
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wants. It was at the beginning of capitalist production when intellectuals and philosophers, having
rejected the teachings of the Prophets, started to think what should we do on the earth now, rather
than what we are supposed to do to reach heaven in the future. They tried to convince the
multitude that the ‘Kingdom of God’ is to be realized here, and now, on this earth; and it is to be
realized via technological innovation, and capital accumulation at an exponential rate. Science
was the new deity people started to rely on for solutions to their problems. One of the major
objectives of economics is to equip the state with policy tools so as to foster capitalist
individuality.
Briefly speaking, many of the institutions and relations that we today regard as ‘natural’
and from which we derive the meaning of our lives are merely the off-shoots of capitalist
production—production organized for the sake of accumulation of capital as an end in itself.
Their legitimacy depends upon the continued dominance of the capitalist production process.
Capitalist production started, as pointed above, after rejecting success in life-after as the major
end of life. When capitalism collapses, life will become quite simple, natural and beyond artificial
disciplines needed to sustain capitalism.
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Key Concepts
Capital is money that is invested in order to make more money
Capitalist production is the organization of production of goods and services for the sake of
accumulation of capital as an end in itself
Commercialization of leisure means the organization of leisure time for further enhancement of
capitalist production by arranging activities for the sake of making profit, such as entertainment
industry, through capitalist enterprise
Corporation is a distinct legal entity that exists independent of its owners
Entrepreneur is a person who takes risks for finding new channels of profitable investments for
the sake of further accumulation of capital
Firm is an entity that undertakes the activity of production for maximizing profit
Industry is the collection of all firms concerned with a particular line of production
Limited liability ownership means that an investor’s liability to debt is limited to the extent of
their shareholdings or initial investment
Limited partner in partnership is one who, like shareholders, risks only his initial investment in
a firm
Plant comprises the physical capital of a firm at a particular location used for producing
commodities—i.e. it is the unit of production in a firm
Partnership is a firm owned and operated by two or more people
Product innovation is the practice of continuously bringing new and more expansive goods and
services in the market in order to sustain continuous economic growth
Production is the activity of combining and processing goods, called inputs, in technological
process to convert them into some other goods, called output.
Proprietorship is a firm which is owned and headed by a single person
Speculation occurs when something is purchased in the expectation of selling it at a higher price
in future without increasing its value by processing it in some way. It is an unproductive and
freeloading activity that is wholly separable from the real economy where production of goods
and services takes place.
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Chapter Summary
• The demand and supply model is the central conceptual tool used by economics to explain
self-interested behavior
• Economics regards all objectives except the profit maximization objective as irrational. This
is so because economics is a moral science
• The question ‘profit maximization for what’ cannot be raised in economics
• Economics defines the firm in terms of the technical character of its function—i.e. conversion
of inputs into outputs—without recognizing that production may be and historically has been
undertaken for several objectives besides profit maximization. There is no certainty that
pursuing profit maximization will automatically lead to the achievement of other objectives
• Undertaking production for purposes other than profit maximization becomes more and more
difficult as capitalist society matures
• The firm is an organized hierarchy in which the Chief Executive Officer takes responsibility
for evolving a strategy for continuing profit maximization
• Proprietorship is an inappropriate form of capitalist business because the growth of such
businesses is limited by financial and skill constraints which make its expansion and even
survival difficult
• Corporations are characterized by the existence of the principle of limited liability
ownership—each shareholder’s risk being limited to his own investment in the corporation.
The corporation is also characterized by the separation of ownership from control with
managers taking and implementing all decisions
• Managers are legally bound to pursue the maximization of shareholder’s value. Capital
accumulation is the corporations’ sole legal purpose of existence. Therefore, neither
managers nor shareholders but capital itself is the real owner of the corporation. Money
withdrawn from the circuit of accumulation ceases to have value because it is no longer
capitalist property
• The development of the corporate property form significantly expanded scope for speculation
which now takes place on stock exchanges and was not limited to speculating in
commodities. Stock market speculation is only tenuously related to the production activities
of the corporation and is therefore in principle unlimited. The development of speculative
trading in corporate shares was thus a crucial phase in the development of capitalist property
• Capital is money used solely for the purpose of making money. The rate of capital
accumulation depends upon the velocity of the circulation of money
• Non-capitalist societies organize production and trade on the basis of private property and
self-employment
• Wage labor is universalized in capitalism. Labor becomes a commodity and it is priced in
terms of its contribution to capital accumulation. Both managers and workers are employed
by capitalist which is the real owner of all labour in capitalist order
• Universalizing wage labor requires the imposition of capitalist social discipline at the
workplace and in the whole of society. It also requires the separation of ‘work’ from
‘leisure’—the time when the wage slave is in control of his own life—the commercialization
of labor and nurtured capitalist individuality by universalizing the quest for pleasure
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• The imperative for accelerated capitalist accumulation has led to rapid urban degeneration
and to an increasingly serious multi-dimensional global environmental crisis
• The capitalist organization of production has also destroyed the family by forcing women into
the labour market and commodifying female labor
• Capitalism requires the creation of dissatisfaction and unlimited wants for sustaining product
innovation. This is the main function of the ever growing marketing and advertisement
industries. The market is not a want satisfying but a want creating mechanism
• Capitalist society must destroy Islamic values—zuhd, faqr, qana’at—and create ‘the
economic man’. This is necessary for its survival
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Review Questions
1. Why must the firm maximize profits?
2. Why cannot economics answer the question: “profit maximization for what”?
3. What is a firm?
4. “The profit maximization motive may conflict with the objective of serving Allah”. Discuss.
5. Why cannot Hazrat Usman’s trading business be called a firm?
6. Cause related businesses—such as the KFC restaurant employing deaf waiters—do not
abandon profit maximization. Discuss.
7. What is the difference between a plant and a firm?
8. Why is proprietorship an inappropriate legal organizational form for capitalist business?
9. Why is the corporation the dominant and the most suitable form of business in mature
10. What is the meaning of the ‘separation of ownership from control’ and why does this enhance
the appropriateness of the corporation as a capitalist form of ownership?
11. “Capital is the real owner of the corporation”. Discuss.
12. What is capitalist property and what determines its value?
13. How did the East India Company become a full fledged corporation?
14. What role does the stock market play in the development of capitalist property?
15. What is capital?
16. Show that the rate of capital accumulation depends upon the velocity of money.
17. Compare and contrast capitalist property and private property.
18. Why does Imam Ghazali recommend that working for one’s living should be limited to the
time between Ishraq and Zuhar prayers?
19. Why is wage labor universalized in capitalism?
20. What changes did the universalization of labour bring about in the social organization of the
work process and in community life?
21. Why and how did capitalist organization of the work process create leisure?
22. How does the commercialization of leisure promote the development of capitalist
individuality?
23. How has capitalism created the modern urban hell
24. How does capitalism destroy the family?
25. “Capitalism creates scarcity. It does not overcome scarcity”. Discuss.
26. Why must capitalist order create “the economic man”?
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10
Chapter
NEOCLASSICAL THEORY
OF PRODUCTION
One of the primary objectives of neoclassical theory of production and cost is to show
that there is positive relation between price of a commodity and its output produced by firms.
This is so because only then it can be shown that supply curves, as drawn in chapters 3 and 4, are
positively sloped. As we have pointed out at several places that this model of demand and supply
curves represents the theoretical premises for postulating that capitalist social arrangements are
merely sum total of utility / profit maximizing agents. It has already been shown in chapter 8 that
the demand-half of this model is flawed which means that this vision of economists—both of
individuals as freedom maximizers and society as their sum—is fallacious. It is now time to see
the validity of the remaining-half of that model. We begin this chapter by examining the
neoclassical vision of production activities that take place in capitalist societies. Section 2 and 3
then outline the standard way in which economists model production activities. We would also be
pointing out side by side the fundamental short comings of neoclassical production theory.
10.1: THE PRODUCTION FUNCTION
One of the important aspects of capitalist societies is that the majority of the population
has no direct experience and knowledge of how the commodities it consumes are produced. As
capitalist production (i.e. for profit-business enterprise) matures, there remains only a small and
decreasing minority which is directly involved in the control of production process. To make
matters worst, only a minority of that minority has direct knowledge of how factories are
designed and managed. In contrast to consumption, the conditions under which commodities are
produced are a mystery to most of the population. Economics attempts to unveil this mystery of
production-activity.
Standard neoclassical analysis of production assumes that the relation between output and
input is merely technical one. This means that production possibilities available to a firm are
dictated and constrained by the natural forces which are beyond its control; i.e. neither any firm
has designed them nor can it alter them. This vision of production spells out the idea that
production relations between labor and agents of capital—managers—are determined by physical
or natural forces. More will be said on this vision of production relations in later chapters. The
production function is the technical concept used to express this vision of production relations.
Production function is an abstract way of discussing how the firm gets output from its inputs. It
describes, in mathematical terms, the technology available to the firm. It can be written in general
form as:
Output = f (inputs ) (10.1)
This function simply says that the amount of output a firm can produce depends upon the inputs
used to produce something. Such a function expresses relationship between inputs and output. As
suggested in chapter 3 that production of some commodity, say y, depends not only on the
available inputs but also on technology. For the purpose of this chapter, we define technology as
‘profit-maximizing method of combining inputs to transform them into output’. An automobile is
not merely the sum of steel, rubber, glass, labor time management skills, etc.; rather only after the
firm combines these resources in a specific way that makes it an automobile. Of course, not all
combinations of inputs in any form will count as an ‘automobile’. Something is called an
automobile only after inputs have been put together in a specific combination. The point to make
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from this example is that producing something requires not only inputs, but also technique—
inputs are like ingredients of a food-recipe while technology as its ‘method’ of cooking; i.e.
which ingredient to use in what combination and proportions. Thus, a production function shows
how much output a firm can obtain using a specific combination of inputs in order to maximum
profits, given the prices of out put and inputs.. In other words, it shows production technology
available to a firm.
For example, a production function for farmer’s output of wheat during one year might
depend upon the quantity of machinery, the amount of labor used on the farm, the amount of land
under cultivation, the amount of fertilizers and seeds used, and so on. Now any given amount of
output, say 100 bushels wheat, may be produced in different ways. One way is that farmer can
use labor-intensive technique that would require only a small amount of mechanical equipments
and heavy use of labor (as is the case in most of the rural areas of Pakistan and India). However,
it is also possible to produce 100 bushels using large amount of capital equipments (such as
tractors, thrashers, etc.) with very little labor (as is the case in America and Europe). All of such
combinations are represented by the general production function (10.1). For any combination of
land, labor, capital equipments and other inputs, the function records the maximum wheat output
that can be produced from those inputs. The important question about the production function
from economists’ point of view is ‘how the firm chooses its levels of inputs or input
combination’—the problem named as problem of choice of technique by economists. Before we
answer this question in the next chapter, let us spell out some details regarding the nature and
behavior of this production function in this chapter.
Classification of Inputs
Equation (10.1) says that output depends upon inputs. But what are these inputs?
Typically, inputs are classified into factors of production such as land, labor, capital and
entrepreneur by most economics text books. This classification of inputs leaves students
wondering about ‘what about material-inputs’ because it is not only the labor and capital, but also
raw material also that is needed to produce any given commodity. Generally speaking, we can
classify inputs into three broader categories as listed in Table 10.1. This classification is based on
(i) whether inputs become part of the output produced (embodied in output), and (ii) whether
inputs are able to retain themselves in their original form at the end of production process to be
utilized for producing further output, as shown by the third columns of this table. Consider the
production of chairs or tables.
Table 10.1: Classification of Inputs

Features
S. No Category of Inputs
Embodied in output Retained after production
1 Material inputs Yes No
2 Factors of Production No Yes
3 Energy inputs No No
Note that material inputs, such as wood, glue, nails, foam, polish etc. become part of the output
produced; i.e. chairs or tables. Since these inputs are embodied in output, therefore they are no
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longer available for producing more chairs—wood that is used to make one table changes its
shape and cannot be used as ‘a piece of wood’ after the production process ends. On the other
hand, inputs such as hammer, saw, carpenter, shop premises, etc. are no longer embodied in
chairs and tables produced. The important feature of factors of production is that they, more or
less, retain themselves in their original form even after the production process has ended and,
hence, are ready to participate in producing more output. Inputs that fall under this category are
generally called factors of production. Typically, economists categorize them into land, labor,
capital and entrepreneur skill. Finally, energy inputs, such as electricity and gas used to generate
power, have also emerged as important determinant of production capabilities. They have distinct
feature in the sense that they are neither embodied in output nor retained after the production
process. For example, electricity used to operate carpenter’s machines, such as saw, does not
become part of the chair. Similarly, the electricity used to run machines is lost once for all.
Economists’ Preferred Form of Production Function
Our thus far discussion implies that a general production function can be written
including all types of inputs, as:
Output = f (Material Inputs, Factors of Production, Energy ) (10.2)
This function can also be written in many ways, including different combinations of inputs such
as shown in these equations:
Output = f (Material Inputs ) (10.3a)
Output = f (Material Inputs, Factors of Production ) (10.3b)
Output = f (Factors of Production, Energy ) (10.3c)
Output = f (Factors of Production ) (10.3d)
All of them are technically valid production functions and there is nothing to rule out any of them
from consideration except the objective of the analyst / policy maker. Micro economists are
interested only in the last version (10.3d) of these combinations. The reason for this choice is the
property of retainability of these inputs—i.e. they exist at the end of production process. Note
that once the commodity has been produced by combining some inputs, the question ‘to whom it
belongs to’ or ‘who gets how much of this commodity’ arises. Clearly, inputs that do not retain
their form cannot claim its ownership rights—so no point of discussing their share in total output,
except counting them as mere expenses. However, the retainability of factors of production begs
the question ‘which of them is responsible for producing how much of this commodity’? The
question is important because the share of each factor of production depends upon the answer to
this question. As outlined in chapter 2 that ‘distribution of income’ has been a major bone of
contention in capitalist order. On the one extreme we have Marx who regards labor as the only
factor responsible for producing surplus value or profit. To him, therefore, all surplus production
should accrue to labor class with all other factors, including capital, receiving only the
expenditures incurred upon them—i.e. they are treated just like material inputs. The theoretical
foundations of this idea of Marx appeared so rigorous and sound that it generated mass political
support among workers of almost all Western European Countries during late 19th and early 20th
centuries—Marx made the future of market capitalism look very gloomy. Neoclassical economics
was the theoretical response to Marx’s theoretical criticism of capitalist production process. One
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of the objectives of neoclassical theory of firm is to show that production takes place under
harmonious conditions in market capitalism and each participant in this process—land, labor
and capital owners—participate on voluntary basis; i.e. no one is forced to do anything for
anyone. In other words, all inputs are logically and socially equal and, hence, must be treated
symmetrical. Since economists want to investigate, rather formulate, the conditions which dictate
the behavior of these factors of production, therefore they prefer to study the behavior of
production function involving only ‘factors of production’—of the form (10.3d)—neglecting
other inputs as these inputs carry no property claim over the ‘output produced’.
Given this explanation, we can now write the production function as:
Output = f (Land, Labor, Capital, Enterpreneur ) (10.4)
You can see that this function involves five variables; output, land, labor, capital and
entrepreneur. As it is difficult to plot all of them in a two dimensional graph, therefore economists
write it in a reduced form involving only labor and capital, such as:
Output = f (Labor, Capital ) (10.5)
If you see early editions of Samuelson’s book, you will see the production function written with
labor and land as its main arguments. It is claimed by the economists that their analysis of
production with labor and capital holds no matter which of the two out of these four you put in
this function. However, this is an a wing claim as discussed below in this chapter. Behavior of
production resulting from land-input may not necessarily hold that for labor or capital in general
due to their distinct features. Finally, note that output is normally denoted by Y, while L and K are
the standard notations used to denote labor and capital respectively in microeconomics. The
production function (10.5) can thus be written as:
Y = f (L , K ) (10.5)
What is Capital?
This chapter will expose you to some apparently trivial concepts leaving their analytical
importance to be explained to the later chapters. But you must understand and keep them all in
your mind, may be at the back, so that you may recall them when asked to do it later on. One of
such seemingly unimportant, but devastatingly vital, point is regarding the meaning of the term
capital. This term is used to refer two different things in economics: one is a sum of money,
called financial capital, and a collection of machines, called physical capital. Neoclassical
production function uses this second meaning of capital in expression (10.5); i.e. K refers to the
sum of all physical capital. It is in fact a grab-bag for all non-human inputs such as factory
building, machines, computers, electric circuitry etc. But if capital refers to physical quantities,
then it is impossible to use K as a sum of such input items. The reason for this impossibility is given
by the fact that different units of capital are measured in different measurement scales and, hence, it
is impossible to obtain an aggregate measure of them by summing them all. For example, it is
literally impossible to add two machines and, say, one story building. Thus K can never be
measured in physical terms. If not this, then it must be a value concept. The only way to sum up all
differently measured units of capital is to add their values (price of capital multiplied by its physical
quantity) instead of their physical quantities. That capital must be a value expression and not
physical quantity is so obvious that all big neoclassical economists know it, at least, today because
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this issue had been decided as early as in 1960’s after a well known debate lost by neoclassical
economists, namely capital controversy—a debate in economics that occurred during the 1960s
concerning the nature and role of capital goods, largely between economists such as Joan Robinson
and Piero Sraffa and Luggi Posunetti at the University of Cambridge in England and economists
such Paul Samuelson and Robert Solow at the Massachusetts Institute of Technology in Cambridge,
USA. It is thus sometimes called the Cambridge Capital Controversy (CCC).
But pick up any well known economics textbook and you will see its author interpreting
K as physical quantity. The reason for this intended negligence is that once it is accepted that K is
necessarily value and not quantity; then all of neoclassical theory of production as well as theory
of income distribution becomes irrelevant (see chapter 16 for detailed discussion on this issue).
This is one of the major and fatal short comings of neoclassical economics that capital cannot be
treated as physical quantity in production function as against labor that can be expressed in
physical terms (let us say in hours, or days of work). Therefore, the two inputs; labor and capital,
cannot be treated symmetrical to each other—there must be a well defined hierarchy between the
two factor inputs, something that microeconomics completely assumes away in order to save its
fallacious ideology. But not surprisingly, economists continue with their mysterious production
function to analyze the behavior of production.
Short Run and Long Run for Firm
Before we begin the formal analysis of the behavior of this function, we must note that it
can be analyzed in two ways: changing all of the inputs at a time, and changing only one of them
while keeping other constant. This distinction is important because capitalist production decisions
are usually taken at two levels of planning horizon; long-run and short-run. The overall design of
a production facility, the technology to be used, its capacity and location, and the types of man
power to be employed are planned over the long run. On the other hand, there are also some
short-run decisions that are to be taken on immediate basis; such as how many hours to work this
week or month, how many workers to use, what pieces of equipment to take out of use, and so on.
In brief, some factors of production are not going to be changed continually whiles others are
subject to more frequent changes. The short-run is the period of time during which the firm can’t
easily adjust its fixed factor(s). In a two input production function like (10.5), it is the duration of
production horizon when at least one input is a fixed factor. In this time duration, adjustments to
changes in production capacity could only take place by varying the use of variable factor. On
the other hand, long run is the time when all inputs can be adjusted.
It is highly important to keep in mind that short-run and long-run are not defined in terms
of time-duration; rather they are discussed in terms of flexibility of inputs. The question ‘how
long is the short-run’ can’t be answered in some clock-time; say one day, one week, one month or
one year. The time it takes firms to change all its inputs is short-run time, no matter whether it
takes them one day or one year. This is because the exact duration of time in which firms can
change all of their inputs varies from business to business. See Application Box 10.1 to read how
time-frame of short-run varies as the nature and scale of business varies.
Time Horizon of Short-Run and Scale of Production
Consider cars’ production plant, say of Honda or Toyota. After the easy credit-facilitation and
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car financing policies by banks in 2004, the demand for cars has increased rapidly in Pakistan.
Such a rise in demand for cars also requires expansion in the production capacity of motor-car
companies. However, it is not possible for companies to expand their plant size immediately as it
requires constructing new building area for plant, buying and installing heavy and expansive
machines. It takes not only money but also time for all this to happen. But how can then
companies meet the extra demand in short run using their existing plant size? They might force
their assembly line to work over time; or they might continue operation in two or three shifts.
This is the best they can do in short run as long as one of their factors input is fixed. In motor car
industry case, the duration of short run would be one to two years. But this would not be the case
for all business ventures. For example, think of a Thela (‫ )ﮢﻬﻴﻠہ‬business (suppose you sell burgers
on Thela) and assume that your business begins to shine. In this case, your capital would mainly
comprise of thela. As the demand for your burger increases, it would become more and more
difficult for you to run the business on a single thela. If you are not a profit-maximizer and do
this business merely to serve your family with a given basket of goods, then you would be more
than happy to see all your burgers being sold out quickly everyday leaving with you much time,
say, for the service of Islam and offering Nawafil (‫)ﻧﻮﺍﻓﻞ‬. On the other hand, say, Laloo is running
this business for the sake of maximizing profit, then he might see the success of his business as
an opportunity to plug in one more thela into it. How long would it take him to bring or hire an
additional thela? May be two or three days; and of course not more than a week. In other words,
the short run for thela business is seven days at maximum because it is for seven days that he
cannot change his fixed input.
Thus, the examples in Box 10.1 show that the exact time duration of ‘how long is the
short-run’ depends upon ‘how long it takes firms to change all these inputs’—i.e. how quickly
they can vary their its production scale to adjust all inputs in production process. One question
might be teasing you and that is ‘what are the factors that affect the flexibility of inputs in
production process and, hence, prolong the time-duration of short-run?’ In other words, what are
the factors that determine ‘how quickly firms can change all of their inputs in production
process?’ Broadly speaking, there are two determinants of the flexibility of inputs: (1) scale of
production; the larger the scale of production, the longer it takes firms to build new factories,
purchase more capital equipments and hire more labor to increase its output, (2) complexity of
production technology; the more sophisticated the technique and skills required for production of
a commodity, the more difficult it is for firms to increase all inputs.
We now begin developing the formal neoclassical model of production technology. The
simplest model involves a single variable input and single output. This model is used to study the
short-run behavior of production process with other factors of production held fixed.
10.2: PRODUCTION WITH SINGLE INPUT VARIABLE: SHORT RUN ANALYSIS
As explained above that in the short-run one of the inputs is held fixed. Thus the
production function (10.5) for short run would be:
(
Y = f L, K ) (10.6a)
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Y = f (L ) (10.6b)
where line over K in (10.6a) indicates that capital is assumed as fixed factor of production.
Additional output can be obtained only by changing the labor input. For example, each year a
farmer must make the decisions about what corps to put on a given amount of land. Assume that
labor is the only input used besides land ignoring the possible use of chemicals, pesticides, or
machinery on the land. In this case, the short-run production relates the quantity of output that
can be produced by the use of a specific quantity of labor. Since K is held fixed and cannot be
changed in short-run, therefore we can write short-run production function with labor as its only
argument as in (10.6b). However, the omission of K from this expression does not mean that
capital is absent from production process; rather it simply means that it has been given in some
fixed amount to be combined with changing amounts of labor input. Now the important question
to understand the relationship between output and input is ‘how output will respond to changes in
labor input; i.e. what happens to output when labor input is increased?’ Just note here that the
relationship between output and input is viewed by economists as technological one—dictated by
the constraints of nature and natural laws and our knowledge of that law and how to make use of
that knowledge. We discuss the problems associated with this vision of production relations in
chapter 16.
10.2.1: Returns to Factor Input
To answer the above question, begin by thinking what if no labor is used? Obviously, no
output would be obtained because labor is required to harvest corp. From here we know that the
production function must start from zero:
Y = f (0) = 0
i.e. output would be zero at zero level of output. If we plot this information in a labor-output (L-
Y) space of figure 10.1, then we are at the origin, 0. To draw a curve in this space, we must know
what happens to output when labor is increased? It is expected that output will increase with each
additional unit of labor added into the production process. In other words, if labor is changed by
some positive amount (ΔL > 0), then output will also change by a positive amount (ΔY > 0);
increase in labor will increase output and not decrease it. This implies that the slope of production
function drawn in figure 10.1 must be positive:
∆Y
Slope of Production function = >0 (10.7)
∆L
It says that change in output induced by increase in labor is positive—both move in the same
direction. Note that the extra output given by an extra unit of labor is termed as marginal
product of labor. We encountered the term ‘marginal’ in chapter 6 as well where we discussed it
in terms of marginal utility—described as extra utility given by an extra unit of consumption of a
commodity. So, in terms of the slope of production function, we find that:
∆Y
MPL = >0 (10.8)
∆L
which simply says that marginal product of each input should be positive—output must increase
when more inputs are added to production process. One can, at this moment of analysis, pose a
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valid question: why is it the case that we assume output to increase after increasing input; i.e.
what is the justification for this assumption?
Note that the restriction of positive marginal product is no longer some physical or
natural necessity that must hold in all cases. Physically, it is quite possible for an input not to
produce any amount of output or even make it to fall. For example, if an additional worker just
keeps sleeping all the times during work-hours, there is no way that its marginal product could be
positive. The point to make is that the status of the assumption of positive marginal productivity
is not of some natural law like that of gravitational force. Rather its justification lies in the fact
that economic analysis of production function is carried out from the point of view of profit
maximizing firm; and no profit maximizing firm would ever hire an input that has zero or
negative marginal productivity. This is simply because if each labor is hired at some positive cost
(i.e. if its wage is positive), then zero marginal productivity of an input means cost is increasing
without increasing the value of the output of the firm and, hence, profit would fall. Thus, the
possibility of zero or negative marginal productivity is not consistent with profit maximization
and, hence, it is ruled out from the domain of economic analysis. See Application Box 10.2 to
understand why the rule of ‘positive marginal productivity’ is necessary for sustaining capitalist
production system. After clarifying the justification of this assumption, let’s go back to the
concept of marginal product again.
Negative Labor Marginal Productivity in Labor Surplus Economies:
The Lewis Model
W. Arthur Lewis, a Noble prize winning West Indian economist, argued that in developing
countries the marginal productivity of agricultural labor was normally negative. For example, the
farmer’s seventh son in Tharparker contributes nothing to the production of the farm, he actually
gets in the way of the other six sons and thus reduces aggregate production—his marginal
productivity is therefore negative. According to Lewis this provides an opportunity for turning
the non profit-maximizing non capitalist farm into a capitalist one and also aids the development
of a capitalist economy in Pakistan.
Move the seventh son to Hyderabad. He will have to work as a laborer in a capitalist firm
producing, say, glass work. Moreover the output of the farm in Tharparker will also increase
(because the seventh son’s MPL was negative). The farm will therefore produce a surplus which
it will have to sell on the, say, grain market. The farm will thus become subject to the discipline
of the market. It will be thus forced to organize production on capitalist lines, hence, becoming a
capitalist farm. It will no longer permit the seventh son to return to Tharparker. This is the
message of the Lewis Model.
Before considering a numerical example to understand the idea of marginal productivity,

look at the slope term (10.7) again. From the positive sign of this function, we can infer that the
curve drawn in L-Y space will be positively sloped—it will be a rising function. However, the
mere information that the slope of production function is positive is not enough to draw the exact
curve in this space. This is so because there are many possible shapes of a curve that can have
positive slope, as three of them are shown in figure 10.1. Note that all of them are positively sloped
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but with different patterns of slope: (a) has decreasing positive slope [it is because its tangent is
getting flatter], (b) has a constant positive slope while (c) has increasing positive slope [it is because
its tangent is getting steeper]. So which of these curves represents the exact relation between labor
and output? What other information is required to draw the exact production function?
Figure 10.1: which one is the production function?
Total
Output (a) Positive but (b) Positive but
decreasing slope constant slope
(c) Positive but

increasing slope
0 Labour
Diminishing Marginal Product
It is believed by the economists that the productivity of each input decreases as we keep
on adding additional unit of an input with some fixed factor in production process. To understand
this idea, suppose that a farmer has got a fixed one-hundred hectares of land to produce wheat.
The only way he can produce more wheat is by hiring more laborers to work on this fixed piece
of land. Now ask yourself: what happens to wheat output as more and more labor is added on
fixed land? Initially, it is possible that output may increase rapidly when you add the second or
the third laborer because one farmer may not to use the land properly as it is too big a piece of
land for him to work on properly. This is shown in the third and forth columns of Table 10.2.
Output increases from 10 to 24 kg when second labor is added in production process. The change
in output (ΔY = 14) due to change in labor (ΔL = 1) is the (marginal) product of second laborer
has produced 14 kg wheat. Similarly, the (marginal) product of third farmer is 18 kg—greater
than that of second one. Note that marginal product is increasing up to third labor unit in this
table. Economists argue that this rising tendency of output cannot continue infinitely because, if it
so happens, then it implies that all of the world wheat production will be undertaken at a fixed
piece of land—keep on adding more and more labor on this fixed land to obtain higher and higher
output every time. This means that after a certain point, though the extra farmer will add some
positive amount of wheat in total production, however its contribution will be less than that of the
previous farmer. This tendency can be seen in this table from the forth laborer onwards. You can
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see that change in output due to each additional farmer is becoming smaller and smaller as more
farmers are added onto the fixed land. In other words, marginal product of an input ultimately
starts decreasing.
Table 10.2: Total and Marginal Productivities

Capital Labor Total product Marginal product Capital-Labor Ratio
K L Y = f (L ) ∆Y K
MPL =
∆L L
100 0 0 - -
100 1 10 10 100
100 2 24 14 50
100 3 42 18 33.33
100 4 54 12 25
100 5 62 8 20
100 6 68 6 16.66
This tendency is called diminishing marginal product of a factor which refers to the economic
assumption that output obtained from each extra unit of variable input will be less than its
previous unit in production process—i.e., output will increase after each additional dose of an
input, but at decreasing rate. When we plot these numbers, we get the shape of production
function as drawn in figure 10.2.
Figure 10.2: A typical production function
Total Typical production

Output function
68
62
60
54 50
50
42
40
30
24
20
10
0 1 2 3 4 5 6 Labour
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It should be noted that this would not be a straight line because in that case its slope would be
constant at all points and this can be the case only if we assume that marginal product is
constant—remember that the slope of production function (ΔY / ΔL) is also the marginal product
of input. Since we assumed above that marginal productivity may increase initially and then
ultimately decrease, this implies that the slope of total product curve (or production function) will
increase initially for some units of labor and then start decreasing thereafter.
What is the rationale for such a behavior of production function? According to standard
economic justification, the productivity of each additional worker decreases because the ratio of
worker—the variable input—to machinery—the fixed input—decreases as more workers are added
on fixed capital. To see this, note that the capital-labor ratio is given by:
K
Capital - Labor ratio = (10.9)
L
With K being fixed along the production function in figure 10.2, adding more labor means the ratio
K / L decreases as shown in the last column of Table 10.2. This column measures the capital-labor
ratio—the average amount of capital available to each worker. The economic plea for diminishing
marginal productivity is that productivity of additional worker falls after capital-labor ratio has
exceeded some optimal level. The idea is that each machine produces at its most efficient level
when a particular number of workers are operating it; i.e. say productivity of machine is highest for
K/L* capital-labor ratio. We can now see that when:
o actual K/L < K/L* → productivity of additional variable input increases because capital is
underutilized
o actual K/L > K/L* → productivity of additional variable input decreases because capital is
over-utilized
o actual K/L = K/L* → productivity of additional variable input is maximum
In other words, it is the variability in the proportion of variable-to-fixed factor that affects the
productivity of a variable input; i.e. diminishing marginal productivity arises due to diminishing
capital-labor ratio.
Production Functions without Diminishing Marginal Product Assumption
What would a production function look like if we drop the assumption of diminishing
marginal product? Recall from your intermediate mathematics course (or see Appendix to chapter
1) that the slope of a curve at any point is given by its tangent (a 90o straight line drawn) at that
point. Also recall that a steeper line means a greater value of slope while a flatter line indicates a
smaller value of slope. Given these relations, consider figure 10.3 which gives three possible
shapes of total product curve. If marginal product is assumed to be constant, then the slope of
total product curve would be constant and the resulting production function would look like a
straight line as shown in panel (a). On the other hand, if marginal product is ever increasing, then
the tangent of total product curve would be getting steeper which implies that the slope of total
product curve would be ever increasing as in panel (b). Finally, if marginal product is always
decreasing, then we get a decreasing slope production function of panel (c). All of these three
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shapes can be possible production functions depending upon what we assume about the behavior
of marginal product and economists’ preferred assumptions about it are that ‘it increases initially
but then decreases forever, other things remaining the same’.
Figure 10.3: Production functions under different marginal product behaviours
TP (a) Constant MP TP TP (c) Decreasing MP

(b) Increasing MP
production function production function production function
b
c
0 0 Labour 0 Labour
Labour
These tendencies are debugged in the law of returns to factor inputs or law of marginal
productivity which states that as you increase the quantity of a variable factor while keeping other
factors fixed, the returns (in terms of output) on extra unit of input may increase initially but keep
on decreasing thereafter. These two tendencies are termed by economists as the laws of increasing
and diminishing marginal productivity or returns to a factor input. The importance of these
assumptions would become explicit when we analyze the neoclassical theory of supply in
chapters 11 and 12. There we show how vital and precious the assumption of diminishing marginal
product is for the survival of economic theory—once this assumption is lost, all of the economic
theory of firm and production is lost into air.
Deriving Marginal Product Curve
If we do accept the economic argument that marginal productivity rises initially to decrease
ultimately, then production function should like as in panel (b) in the initial stages of production but
then takes a shape of panel (c). Combining these two segments we get a typical production function
just like the one drawn in the upper panel of figure 10.4. Note that the tangent of this curve is
becoming steeper initially (i.e. its slope is increasing) and then starts flattening after reaching its
maximum steepness at point b. The below panel draws the resulting marginal product curve of
labor against units of labor derived from the above total product curve. We can see that marginal
product is maximum at point b (exactly the same point where tangent of total product curve takes
maximum steepness, hence implying maximum value of slope or marginal product). It then starts
decreasing after point b, such as shown at point c.
Theoretically, it is quite possible that marginal product may reach zero or is negative at
some quantity of labor units, but from economic point of view, the relevant range of the
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production function is the one where marginal product is strictly positive. This is so because after
that point, total output starts decreasing as more labor units are brought into production process.
We have now reached the point where it would be appropriate to spend some on evaluating how
sound the assumption of diminishing marginal productivity is.
Figure 10.4: Total and marginal product relation
TP
The typical production function
( )
Y = f L, K
c
yc
yb b
ya a
La Lb Lc Labour
MP 0
Initially rising Ultimately

MPL falling MPL
0 Lb Labour
10.2.2: Evaluating Diminishing Marginal Productivity
However, the justification offered for diminishing marginal productivity is not very
convincing. Firstly, adding additional units of labor (variable input) to capital (the fixed input)
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makes little sense in reality because most machines are built to operate with a fixed number of labor
units—i.e. with a given capital-labor ratio. To explore this idea fully, just reverse the capital-labor
ratio (10.9) to obtain labor-capital ratio as:
L
Labor - Capital ratio = (10.10)
K
which measures the number of workers operating per unit of capital. Imagine for example a firm
that digs holes using jackhammers.
Figure 10.5: Neoclassical story of production
(a) Ideal worker- (b) Six Jackhammers (c) Initially one worker is hired to
machine ratio = 1:1 are available to firm operates all jackhammers
(d) Ideal worker- (e) MPL falls when

jackhammer ratio case worker-jackhammer ratio
is greater than 1
? ?
?
?
There is obviously an ideal worker-to-machine ratio where productivity is maximum; say one
worker per jackhammer as shown in part (a) of figure 10.5 which depicts the whole story. Suppose
that firm has six jackhammers available with it for production (i. e. digging holes). The standard
way in which economists model the production decision of the firm is to assume that the firm would
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initially hire one worker to operate six jackhammers. In other words, worker to jackhammer ratio in
this case would be 1-to-6. But this would of course be very inefficient way of utilizing six
machines, so firm would hire more workers. Adding additional workers might show increasing
productivity per worker for a while (i.e. marginal productivity may increase initially), because, say,
two workers operating 3 jackhammers each would be less messy than one operating 6; and so on for
three workers operating two each. Eventually, an ideal ratio is reached when six workers are
working on six jackhammers; or when worker-to-machine ratio is 1 [as in part (d)]. If firm wants to
dig more holes, it has to hire more workers and, hence, operate at more than one worker per
jackhammer [see part (e)]. Economist would argue that more total holes can be dug with 2 workers
per jackhammer than with one, but productivity of two workers per jackhammer would be less than
one worker per jackhammer. In other words, rate of increase in output would start decreasing. But
does such a modeling of production make any sense to you? Clearly not, as it is merely non-sense to
use all jackhammers when less than six workers are in operation and only an irrational manager
would utilize his resources in this way. The only rational way for firm is to work at one worker per
jackhammer: if it has less than six workers, why put all jackhammers at operation? On the other
hand, operating at more than one worker per jackhammer is not a desirable combination for firm to
function with because this will simply increase to its cost: why hire two people to use one
jackhammer when one person can do the same job?
Piero Sraffa was the man who successfully disputed the standard economic modeling of
production right back in the 1920s. He argued that a firm is likely to produce at maximum
productivity right up until the point where diminishing marginal productivity sets in. Any other
pattern of production means the firm’s behaving irrational (i.e. in a non profit maximizing). The
crux of his criticism is that there is no sense in using every last inch of ‘fixed factor’ if demand is
less than capacity—a point that neoclassical production analysis misses altogether. To understand
the logic of this idea, let’s compare the production decisions of a neoclassical manager and a
Sraffian manager. Consider a wheat farm of 100 hectares where one worker per hector produces an
output 1 bushel per hectare, 2 workers per hectare produce 3 bushels, and so on as shown in the data
given in Table 10.3. Note that marginal productivity of the variable input is maximum when
workers are spread on this land such that each hectare of the farm is operated by four workers; i.e.
when L/K ratio is 4.
Table 10.3: Productivity Data
Worker per Bushels per Productivity of
hectare hectare extra worker
L/K Y/K
1 1 -
2 3 2
3 6 3
4 10 4
5 12 2
Now assume that a farmer has 100 workers available to work in this farm. How should he use
them? According to neoclassical manager, he should spread them out in 100 hectares which means
that labor-to-capital ratio would be 1 worker per hectare (= 100 workers / 100 hectares). When
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operating in this way, total wheat production will be 100 bushels because one worker per hectare
produces 1 bushel per hectare. This can be calculated as:
Output = Output per hectare × Hectares employed
bushel
Y =1 × 100 hectares = 100 Bushles
hectare
On the other hand, a Sraffian manager would ask farmer to leave 75 hectares of the farm idle, and
utilize only 25 hectares with 100 workers. With this combination, worker to capital ratio is 4 (100
workers / 25 hectares). What would be the output produced in this case? Note that with 4 workers
per hectare, output per hectare is 10 bushels per hectare. So, output is given by the above expression
as:
bushel
Y =10 × 25 hectares = 250 Bushles
hectare
Clearly, the farmer that behaves according to the Sraffian manager’s advice comes out 150 bushels
ahead of farmer who listens to neoclassical manager. Similarly, if farmer had 200 workers,
economic theory implies that he would spread them over 100 hectares so that 2 workers are now
working per hectare producing an output of 300 bushels (= 3 bushels / hectares × 100 hectares).
Table 10.4: Outcomes of Neoclassical and Sraffian Decision Makers

With Neoclassical Sraffian manager Difference in
manager output
Hectors used 100 25
L/K 1 4
100 Workers
Y/K 1 10
Total Output 100 250 150
Hectors used 100 50
L/K 2 4
200 Workers
Y/K 3 10
Hectors used 100 75
L/K 3 4
300 Workers
Y/K 6 10
Hectors used 100 100
L/K 4 4
400 Workers
Y/K 10 10
But according to Sraffian manager, a sensible farmer would instead leave 50 hectares unused;
utilize only 50 hectares so that L/K ratio is 4 workers per hectare again—where productivity is
maximum. With this Sraffian scheme, output would be 500 bushels (= 10 bushels / hectares × 50
hectares), again getting 200 extra bushels. The same pattern continues right up to the point where
400 workers are employed after which finally the diminishing marginal productivity begins to
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start. Table 10.4 summarizes the outcomes of both managers in terms of total output produced.
Plotting the resulting total output in both scenarios (the italicized numbers in the above table)
against number of workers give figure 10.6.
Figure 10.6: Comparing neoclassical and Sraffian production functions
Total Sraffian
Output PF
1000 Neoclassical
PF
750
600
500
300
250
100
0 100 200 300 400 Labour
The shaded area (area between Sraffian and neoclassical production function) indicates the output
lost by a farmer who utilizes all of the fixed resource all the time, rather than leaving some of it idle
until it reaches at maximum productivity. A rational firm having a fixed resource would leave some
of it idle when operating below its optimum scale. This implies a straight line production function
as shown by the dotted line here.
Therefore, we can conclude that diminishing marginal product does not apply in the real
world because modern engineering allows factories to be designed in such a way as to avoid the
problem that economists believe force productivity to fall. Factories are designed with significant
excess capacity, and are also designed to work at high efficiency right from low to full capacity.
Only products like oil that can’t be produced in factories or farms are likely to show production
behavior the way economists expect. This point might seem trivial at this point in our analysis, but
we will see in the coming chapters how crucial this point is for the demolition of neoclassical theory
of firm. Let’s, for the time being, return to the standard analysis of production function as drawn in
figure 10.2. But before that, it would be good for you to know that if diminishing marginal
productivity assumption is unwarranted in reality, then from where did this assumption come into
economics? Read FYI Box 10.1 for the historical origins of this concept and then move on to the
standard analysis.
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F Y I B O X 10.1
Origin of Diminishing Marginal Product Assumption
The concept of ‘diminishing marginal productivity’ of labor, as well as of capital, has been taken
from Ricardo’s application of this concept for land in order to explain the theory of rent (briefly
discussed in chapter 2). The set of economic theories that were proposed in the late 19th century
and were described as a “marginalist revolution” focused precisely on the generalized application
of the “marginal principle”. This was introduced first to account for consumer behavior (the
theory of marginal utility as discussed in the previous part of this book); then it was applied, by
extension, to the theory of production and distribution (and not only to land and rent). The use of
the marginal principle in the theory of production and distribution did not come about as a result
of any new observations of reality by the neoclassical economists. It came about (as the
economist Pasinetti puts it) merely by analogy, as a convenient, indeed as an elegant,
aesthetically attractive, extension of Ricardo’s principle of diminishing returns (originally
concerning land alone) to all the resources in existence. As industrialization spread from Great
Britain to the continent, the emphasis of economic theory naturally shifted from agricultural to
industrial production. The accumulation of capital, much more than the extension of the
cultivation of land, increasingly came to be at the centre of the economists’ attention.
However, the extension of this principle into labor and capital required the formulation
of a series of assumptions which gave these factors of production characteristics similar to those
of land (in order for them to be treated, so to speak, as if they were land). The consequences of
this “adjustment” of capital to land, though good for some fictitious analytic purposes, proved to
be unexpectedly loaded with serious negative consequences that are detailed out in chapter 16.
The underlying reason for these problems has already been pointed out above during our
discussion on production function. It is never correct to treat capital as if it is land because both
of these two types of aggregate quantities belong to two different logical classes—land and labor
are expressed in physical terms while capital is necessarily expressed as value—and can thus
neither be placed on the same level nor be inserted symmetrically in the same function. This
fundamental mistake of neoclassical economics was for long neglected until the 1960’s when it
was once and for all proved that the microeconomic theory of production and income distribution
is based on fundamentally faulty assumptions.
10.2.3: Relationship between Marginal and Average Products
The typical (microeconomic) shape of production function generates a particular type of

relationship between marginal and average products of an input. Average product is given by
total output divided by total units of an input employed in production process. Table 10.5
calculates average product of labor in the forth column using the same set of data as in Table
10.2. For example, average product of two farmers is 12 kg wheat/farmer; i.e. if two laborers
together produce 24 kg wheat, then on average each of them produces 12 kg. Remember that
average is a total concept (total output / total labor-units) while marginal is a change concept
(change in output / change in labor-units).
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Table: 10.5: Marginal Average Relationship

Labor Total product Marginal product Average product Marginal-Average
L Y = f (L ) ∆Y Y Relation
MPL = APL =
∆L L
0 0 - - -
1 10 10 10 -
2 24 14 12 MPL > APL, APL
3 42 18 14 MPL > APL, APL
4 54 12 13.5 MPL < APL, APL
5 62 8 12.4 MPL < APL, APL
6 68 6 11.33 MPL < APL, APL
For instance, the number 12 in the average product column (against two labor units) measures
average productivity of each farmer, while the corresponding number 14 in marginal product
column shows the additional output obtained from the second farmer. To clarify the difference
between them, think of the statistics of a cricket batsman which are shown on TV screen when he
makes his appearance in ground for playing his innings. Suppose his career average is 30 Run per
match. This number simply indicates that if we spread his total number of runs equally on his total
matches, then he has scored 30 runs in each match. This is what average stands for. However, the
runs that he scores in his next match would be his marginal runs—change in his total runs / change
in his matches. Be very clear about the meaning of these two concepts.
Now the formal relationship between these two magnitudes is shown in the last column
of Table 10.5. You can see that as long as the next marginal number is greater than previous
average number, average is increasing. On the other hand, when the next marginal number is less
than previous average number, average is falling. For example, the average product of two
farmers is 12 kg wheat / laborer, but the marginal product of the next laborer, third one, is 18 kg
which is greater than 12 kg wheat/laborer, the average product of three laborers will increase
from 12 to 14 kg wheat/farmer. The same holds for all next numbers. The general relationship
between them can be expressed as:
o f MPL is greater than APL → APL increases (10.11a)
o If MPL is less than APL → APL decreases (10.11b)
o If MPL is equal to APL → APL is constant at its maximum point (10.11c)
The first two of these two statements can be observed from the above Table. What about the last
one? Consider the cricket batsman’s example again whose average score was 30 runs per inings.
Now think what will happen to his average if his marginal score—runs that he scores in the next
match—is more than 30 (say he scores 35 runs). Clearly, his average will increase. Similarly, if
his marginal runs fall short of his previous average (say he scores 20 runs), then his average will
decrease. Finally, if he happens to score exactly 30 runs in his next match, then his career average
will remain unchanged. This is a straight forward logical relation between average and marginal
magnitudes of any function. However, the last phrase ‘at its maximum point’ of the third
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statement ‘APL is constant at its maximum point’ is yet not clear from this example. This can be
seen by plotting the two magnitudes, average and marginal, against labor in the same diagram, as
in figure 10.7. The dotted line shows the average product curve in this graph. Note that average
product curve is rising as long as marginal product curve is above average product curve. On the
other hand, it starts decreasing when marginal is less than average. This means that marginal
product curve will intersect average product at its maximum.
Figure 10.7: Marginal-Average relation
MPL,
APL
MPL = APL,
so APL at its maximum
20
f
e
15
APL curve
10
5
MPL curve
0 1 6
2 3 4 5 Labour
MPL > APL, so MPL < APL, so

APL rises APL falls
This idea is further developed in figure 10.8. Panel (a) shows the situation where average product
is increasing even when marginal product is less than average (look at the range above La).
Clearly this cannot be the case: how can average increase while marginal is less than it? On the
other hand, panel (b) shows another incorrect situation where average product curve starts
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decreasing when marginal product is still greater than average: average cannot decrease as long as
marginal is greater than it. Finally, panel (c) draws the correct diagram where marginal product
curve is intersecting average product at its maximum. The reason behind this relation is that to the
left of intersection of the two curves, marginal is greater than average, so average must be rising. On
the other hand, to the right of their intersection, marginal is less than average, so average must be
falling. This implies that average must be at its peak where the two curves intersect each other.
Figure 10.8: Deriving correct marginal-average relation
TP TP TP
(a) Incorrect (b) Incorrect (c) Correct
APL
a
APL
MPL
APL
MPL MPL
0 Lc L
0
0 La L Lb L
Stages of production
The marginal-average relation is often used by economists to classify production into

three stages:
Stage 1: MP > 0 and AP rising, thus MP > AP
Stage 2: MP > 0 and AP falling, thus MP < AP, but TP is increasing because MP > 0
Stage 3: MP < 0, so TP is falling
These stages are depicted in figure 10.9. We saw earlier that marginal product is maximized at
point a, while average product is maximum at point b where MP = AP. Note that total output
reaches its maximum at c, thus marginal product becomes zero at this point in the below panel.
Such a division of production process in three-stages helps identify the relevant range in which a
profit-maximizing firm would try to operate. To see this, note that no profit-maximizing producer
would like to produce in stage 1 or 3. This is so because in stage 1, average productivity of inputs
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is increasing, so they can benefit by adding one additional labor unit because this will increase the
average productivity of all inputs.
Figure 10.9: Depicting stages of production
TP
Stage 1 Stage 2 Stage 3
0
La Lb LC Labour
MP,
AP
APL
MPL
0
La Lb LC Labour
Therefore, it would be irrational (unprofitable) for the capitalist firm to stop producing in this
stage 3, it is clear to see that it does not pay producers to operate in this region because marginal
product is negative here which means total output actually decreases as more laborers are hired in
this region. In fact, they can increase total output by reducing the labor inputs, and hence can save
cost of hiring those extra labor units. Thus we find that the economically meaningful range of
production is given by stage 2.
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Note that this diagram (10.9) cannot tell us anything about the non profit maximizing
non-capitalist producer. Abdullah Zaghazai may produce below the point at which profit /
production is maximized (Stage 1) if he is undertaking production to satisfy his very limited
needs because he practices tawakkul and stops economic activities as Imam Ghazali advises as
soon as he has enough earnings to meet his meager and continuously decreasing needs. On the
other hand, Abdullah Zhaghzai may also produce in Stage III and cheerfully accept a loss due to
revenue fall if expansion of such loss making production is necessary to sustain the jihad in
Afghanistan. This shows us that the microeconomic analysis of production—like the
microeconomic analysis of consumption—attempts to explain the behavior of only capitalist
(profit / utility maximizing) individuals. It cannot explain the behavior of Abdullah Zhaghzai or
of any member of his family—are you not one of his relatives?
10.3: PRODUCTION WITH TWO INPUTS VARIABLE : LONG RUN ANALYSIS
When it comes to analyzing properties of production process by changing all inputs at a

time, the first step is to obtain some graphical tool to represent this scenario. After allowing both
inputs to change at a time, the production function takes the form:
Y = f (L , K )
without bar over K this time. Note that we have three variables in this function (Y, L and K) while
we have only two-axes in a two-dimensional graph. What to do now? One possibility is to use
three-dimensional graph which, however, in itself is a source of difficulty for students to grasp it
properly. So the problem is ‘is it possible to project three variables in a two-dimensional graph?’
Yes, the technique is to hold one of them constant at some desired level and then find the values
of the other two variables that are consistent with this constant value. It is exactly the same
technique that we employed while drawing indifference curves which represented all the two-
dimensional consumption bundles equally valued by a consumer.
To begin with, assume that a firm wants to produce some target level of output; say Yo (may be 10
or 20 units of some commodity). In order to produce this much output, the firm needs to utilize
some units of labor and capital. Suppose that it can produce this much output level by combining
4 units of capital with two laborers. This information is recorded as Y0 = f (2 L ,3K ) . Point A in
the left panel of figure 10.10 gives exactly the same information. Note carefully that output is not
shown on any of the axis of this diagram; it comes into perspective by the idea that any given
combination of inputs would produce some level of output and here it is assumed to be Yo.
However, in principle, A is not the only way by which society or firm can produce Yo level of
output. There could be some other ways, or technologies, as well that can produce the same level of
output. One of such method is shown in the right hand panel of this figure which combines 4
capital units with 3 of laborers. Now the question is ‘which of these two techniques of production,
A and B, are desirable for the profit maximizing firm (or for the society which is merely a toal of
profit maximizing firms and utility maximizing individuals - i.e. civil society). It is clear that the
answer to this question depends upon the objective for which the production process is being
organized in any society. From the point of view of capitalist-firm—one that organizes
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production for the sake of maximizing profit—technique B is clearly inefficient method of

production as it utilizes more inputs to produce same output level.
Figure 10.10: Modeling two inputs production techniques
Capital Capital =
4 units of K and 2 of K Another method of
=K
L producing Yo output producing Yo output
A B
4 A 4
0 2 L= 0 2 3 L=
Labour Labour
The capitalist firm will never employ such a technology of production as it argues like
this: ‘why hire an extra laborer to produce exactly the same level of output when we can go
without it’. From its point of view, combination B is desirable only if it yields more output profit
as compared to A. If output is exactly the same at A and B, it means that no extra output is
obtained by hiring an extra unit of labor. In other words, the marginal product of third labor
would be zero in this case. And, as discussed above, a profit-maximizing firm would not hire the
input unit that has zero marginal productivity. So, technique B is not desirable from capitalist
firm’s and society’s point of view if it brings it same output as technique A. Further note that as
long as we assume that a firm always employs a technology to combine inputs in such a way that
the marginal product of each unit of an input is strictly positive, then it is not possible that
combinations A and B yield the same level of output for this firm. If technology of this firm is
such that the third unit of labor also adds some positive amount in total output (i.e. its MP > 0),
output at point B must be greater than output at A.
However, if a society organizes production for some other objective than maximization
of profit—as is normally the case in non-capitalist societies—then we cannot regard B as inferior
to A. Moreover as our discussion of the Lewis Model (Application Box 10.1) shows moving
resources out of sectors characterized by negative marginal productivity of labor in developing
countries is advocated as a means for transforming non-capitalist economies and societies into
capitalist ones. Some microeconomic analysis of mining investment have shown that capitalist
firms tolerate profit loss in the short run to generate maximum profits in the long run.
Capitalist Vs Non Capitalist Technologies of Production
The statement that ‘technique B is superior to A’ holds only within capitalist society where
production takes place for maximizing profit. However, it does not hold in non-capitalist
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societies. Consider a traditional religious society where people prefer to live together in a joint
family (‫ )ﺑﺮﺍﺩﺭی‬system. In such societies, production process is normally undertaken on family-
basis; the Zhaghzai tribe for example. People of such societies do not organize production for
maximizing profit, rather for providing their livelihoods by involving as many of their family and
community members in production process as possible. When young boys reach the age of
maturity, they are supposed to go to the fields with their elders in order to help them and get
trained. The objective of taking them to the fields is not perpetuating ever increasing profits, but
the strengthening of the community ties and passing on the sense of responsibility among them.
In such societies, working within one’s own family and community is preferred to working else
where even if the latter is more productive and profitable. Working in other’s fields as wage-
laborer on the grounds that ‘this gives me higher opportunities to produce and hence earn more
profit’ is considered dishonorable in these societies. Production methods that allow most number
of community members to participate in producing a given amount of output are preferred to
those that allow fewer members, because such technologies help them socialize their desired
values of love and cooperation among their communities. In other words, these societies would
regard technique B as superior to A. This simply means that technological improvement that
takes place within religious societies is fundamentally different from that of capitalist societies—
both are meant to achieve different goals and are based on conflicting values.
10.3.1: Iso-Quant Curves: Modeling Production with Several Inputs Variable
So, B is not efficient way of organizing production if technology A is available to it. Let’s
determine some other technically-efficient production techniques of capitalist firm. The
conceptual tool that is employed to do this job is termed Iso-quant curve. The idea is to trace
those methods of production that produce same level of output—something very similar to the
idea underlying indifference curve.
To begin with, note that as long as all inputs have positive marginal product, both A and B cannot
produce same level of output. Combination B must, therefore, be technically superior to A in the
sense that output with (3L, 4K) must be greater than that with (2L, 4K). In other words, if output
is Yo (say 10 units) at A, then it must be Y1 = Yo + ΔY (say 12 units) at B. Now consider panel (a)
of figure 10.11. This again is an example of technically unequal ways of producing in the sense
that if output is Yo at A, then it must be less at C because it involves less amount of capital. Thus,
input combinations like A-B or A-C cannot be treated technically equally efficient because output
is not same at them. Stating alternatively, they cannot fall on the curve which represents
combinations of inputs that produce same level of output. You can easily reason that if marginal
product of each unit of an input is positive (as is assumed to be the case), then output can remain
constant only if both inputs are varied in opposite direction: if you increase L, then K must be
decreased and vice versa, as is shown panel (b). The intuition behind this is that when an extra
labor is added, output would increase from its previous level. In order to bring it back to its
previous level, amount of capital must be decreased. What is important at this moment is to
understand the idea of input-substitution for identifying technically equal ways of production; i.e.
ones that gives same output level. Don’t worry about the rate of input substitution here—don’t
think why we have substituted one labor unit with 2 of capital to keep output constant, as this rate
can be different with different technologies.
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Figure 10.11: Identifying technically efficient production methods
(a) Two technically unequal (b) Two technically-equal (c) A third technically-
K ways of production K ways of production K unequal way of production
Extra labour
A A A in E than F
4 4 4
3 E
3 C F
D
2 2 D
0 2 L 0 2 3 L 0 2 3 4 L
The challenging question is to find a third combination of inputs in this graph that is
technically equal to A and D. Finding this point is important because otherwise it is not possible
to obtain the exact shape of a curve that joins these two points (recall from our discussion in
chapter 6 about indifference curve that we need at least three points to find out exact curvature of
a curve). Consider first the combination E (4L, 3K) in panel (c) of figure 10.11. To determine
whether this combination can be equally productive as A and D, note that all weighted-average
combinations of A and D fall on the straight line joining these two points (recall our discussion on
constructing weighted-average bundles from chapter 6). This line shows that if A and D are two
ways of producing a given level of output Yo, then firm can produce the same level of output
using any weighted-average combination of these two methods. F is one of such weighted-
average combinations available to firm. Thus, if F can produce the same level of output, Yo, as A
and D, then output must be greater at point E since it employs at least more of one input as
compared to F (i.e. labor). This means that a curve that joins equally-productive combinations of
inputs cannot be concave to the origin; i.e. line joining A and D cannot extend to the right of line
segment AD.
Finally, it can be shown that input combinations that produce same level of output fall on a
convex to the origin curve as shown in the left hand panel of figure 10.12. This curve is called an
Iso-quant curve—where Iso means ‘same’ and quant stands for ‘quantity or output’. This curve
shows all combinations of input that produce same level of output, a concept very similar to
indifference curve introduced in chapter 6. The exact shape of this curve cab be explained using
slope of this curve. Graphically, the slope of iso-quant is given by its tangent, as drawn at points
A, B and C.
Algebraically, the slope of an Iso-quant curve drawn in L-K space is given by:
∆K
Slope of Iso quant = <0 (10.12)
∆L
i.e. it must be negative.
The negative slope of this curve gives the idea of input-substitution as discussed above—in order
to keep output constant, both inputs must be changed in opposite direction, hence negative slope.
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Figure 10.12: Input-combinations yielding equal output

K (a) Third technically equal way K (b) Technically unequal
of production ways of production
A A
B B
Ko Ko
C
C
0 Lo L 0 Lo L
Secondly, note that slope of this curve is decreasing as we move down along it from A to B to C.
This is so because as we move down on this Iso-quant curve, more and more labor is added into
production process with ever decreasing amounts of capital. This means that each worker has less
capital to work with and, hence, becomes less productive. Thus it gradually becomes increasingly
difficult to substitute labor for capital as one increases the amount of labor along an Iso-quant.
This is something that affects the iso-quant’s slope. To have further insight into why this curve
behaves like this, let’s develop an expression for the slope of iso-quant curve.
Marginal Rate of Technical Substitution
What is the meaning of the slope of iso-quant? It reflects the ability to substitute labor for
capital, while still producing the same amount of output. In other words, it measures the rate at
which labor can be substituted for capital in production process, called marginal rate of
technical substitution (MRTSLK). This rate of substitution is much like MRS for consumer’s
indifference curve. The difference between the two is that MRS measures substitution in
consumption bundles allowed by consumer taste such that utility remains constant, while MRTS
measures input-substitution allowed by production technology such that output remains same.
Just as with an indifference curve, the rate of substitution is given by the negative of the slope of
iso-quant:
 ∆K 
MRTS LK = − −  (10.13)
 ∆L 
which means that MRTS is a positive number. For example, if slope of an iso-quant curve at any
point, say A in figure 10.12, is -3, then MRTSLK is +3, which means that 1 labor can be
substituted with 3 capital units in production process. To see this explicitly, note that the value of
MRTS = 3 would be expressed in terms of expression (10.13) as:
∆K 3
MRTS LK = =
∆L 1
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where 3 refers to change in capital, ΔK, while 1 stands for change in labor, ΔL. This is exactly
how we interpreted the value 3 of MRTS: production technology allows substitution of three units
of capital with one labor while still producing the same output level. It can be further shown that
MRTS equals the ratio of marginal productivities of labor and capital; i.e.
∆K MPL
MRTS LK = = (10.14)
∆L MPK
This result is the same graphically as well as algebraically as that developed for indifference
curve. So, it would be a mere repetition to develop this expression again. However, we do give its
intuitive explanation here. Consider again the value of MRTS = 3 as discussed above. Note that
one labor can be substituted for three capital units at constant output level only if the marginal
product of an extra labor is equal to the marginal product of three capital units—only if an extra
labor can produce as much output as do three machines that firm can substitute one labor with
three capital and still produce the same output. Expressing the value MRTS = 3 in terms of
(10.14), we have:
∆K MPL 3
MRTS LK = = =
∆L MPK 1
which is exactly what we wanted to show. Briefly speaking, the rate of substitution between two
inputs shows the marginal productivities of two inputs. We have thus reached a very strong result:
even when we cannot calculate the underlying marginal productivities of inputs directly, the mere
information about the rate of substitution between two inputs is enough to infer their relative
marginal productivities! It means that we need not worry about calculating marginal
productivities of inputs, the most we need is information about the rate of input-substitution.
Now go back to figure 10.12 again. Given that the slope of iso-quant equals MRTS and
that the expression for MRTS is (10.14), it follows that an iso-quant cannot be straight line like
the one drawn in the right hand panel of figure 10.12. This can be seen by the fact that a straight
line has a constant slope, so MRTS must be constant for an iso-quant to be a straight line.
Expression (10.14) shows that MRTS can remain constant only if the ratio of marginal
productivities remains constant. However, we have seen above that marginal productivity of an
input decreases as more of it is used, and vice versa. As we move from point A to, say, B, more
labor is added and capital is decreased. This means that marginal product of labor is expected to
decrease while that of capital is expected to increase. With numerator of expression (10.14)
decreasing and denominator increasing while moving from A to B, the ratio of the two marginal
productivities cannot remain same at point A and B. To illustrate using numbers, let MPLA = 4
and MPKA = 2 be the marginal productivities of labor and capital at point A and MPLB = 3 and
MPKB = 3 at B. MRTS at two points is then given by:
4 3
A
MRTS LK = > = MRTS LK
B
2 3
Hence, an iso-quant cannot be a straight line as the value of its slope (or MRTS) is expected to
decrease as we move down along it. From this explanation of the slope of iso-quant, it can now be
easily seen that a typical iso-quant curve would be convex to the origin. For example, at point A,
the slope of iso-quant is quite steep which means a higher value of MRTS (recall that the steeper
the slope, the larger the value of slope). This higher value of MRTS can be explained in terms of
marginal productivities. To see how, note that too much capital is employed as compared to the
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amount of labor at point A. This means that marginal productivity of capital is low at this point
relative to labor. In other words, MRTS would be large at point A (because the fraction is larger
when denominator is small). On the other hand, marginal productivity of labor would be quite
low at point C as more of it is employed as compared to capital. Thus, MRTS would be small
here. The convex shape of iso-quant curve implies that MRTS tends to decrease as more and
more labor is added to production process. This tendency is called diminishing marginal rate of
technical substitution. The reason for this tendency has already been explained: it gradually
becomes increasingly difficult to substitute labor for capital as one increases the amount of labor
along an Iso-quant because each worker has less capital to work with and hence becomes less
productive.
Properties of Iso-quant Curves
An iso-quant has same properties as does an indifference curve. Among them are:
o Iso-quant must be negatively sloped
o Two iso-quant curves cannot intersect each other
o Higher iso-quant represent combinations of inputs that can produce higher level of output
o An iso-quant is convex to the origin
We leave the justification of these properties to you, as it is a mere repetition of the same
arguments presented in chapter 6. However, one key difference between indifference curve and
iso-quant must be noted. Each iso-quant has a number attached with it—the level of output that
can be produced with some input combinations—and that number has observational meaning in
the sense that output is a real quantity. On the other hand, utility numbers attached to an
indifference curve are unobservable because they are merely proxies representing the mental state
of a consumer—recall that indifference curve merely orders consumption baskets in ordinal
numbers. Though the geometry of iso-quant is more closely related to the real world than is of
indifference curves; but this does not mean that indifference curves are ideological constructs
while iso-quants are not. Both show how capitalist consumers and producers are expected to
behave and measure actual market outcomes in terms of these ideological expectations.
Behavioral economics how that there is as, large a gap in actual production outcomes and
theoretical expectations as there is in consumption expectations and market outcomes.
Changing a Single Input When Several Can be Changed
The single-variable input production function of section 10.2.1 can be brought together
with factor-plane diagram in this section. To see the relationship between both of them, note that
convexity of iso-quant relied in part on the idea of diminishing marginal productivity of labor.
The same idea was related to our framing of single-input production function. We start at point A
in the upper panel of figure 10.13. Consider changing only labor from point A keeping amount of
capital constant at Ko. Now the possible input-combinations different from A only in labor used
are along a horizontal line through A since K is held fixed.
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Figure 10.13: Relating single input production function with factor plane diagram
A
Ko
A
Y20
Y16
Y10
0 Lo L
TP
f(L, Ko)
Y10 A
0 Lo L
The effect on output of changing labor alone is just like the production function analyzed
above, and drawn in the below panel. If production is subject to diminishing marginal product of
labor, then increase in output for each unit increase in labor would be smaller, as shown by the
numbers attached to iso-quants (10, 16 and 20). We are now in a position to take up the question
that we set out to answer at the start of this section: ‘how can we study the effect on output when
all factors are allowed to change together?’ This is in fact the long run analysis of production
function.
10.3.2: Returns to Scale
When we ask the question ‘what happens to output when we change all inputs’, we need
some rule about ‘how to change all inputs’. Obviously, changing all inputs in different proportion
and then studying their effect on output will make analysis unmanageable. This is because in this
scenario, the question of ‘how to separate out the effect of both inputs’ would arise, and there is
no way to answer this question. The only conceptually feasible way of answering the above
question is to change all inputs in the same proportion. With this rule, both capital and labor are
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expanded by equal percentage. The idea of proportionate change in all inputs takes us to the
concept of returns to scale which answers the question what happens to output when we change
all inputs in the same proportion. For example, we can see what will happen to output if we
double the use of labor and capital simultaneously; i.e. 100% increase in all inputs. In other
words, the proportionate-change-rule in all inputs in the long run means ‘how big the production
level should be’—the question of production scale. Algebraically, scale of production is denoted
by factor λ > 0. To see what it means, note that returns to scale means what happens to output if
we multiply all inputs by the same positive factor, say λ. Consider point A in figure 10.14, A = (Lo,
Ko). Any point along the ray 0A is point (λLo, λKo) for some positive λ.
Figure 10.14: Returns to scale as proportionate change in inputs
Ko A
B Y10
0 Lo L
Point A is defined by λ = 1, and any point between the origin 0 and A, such as B, is defined by λ <
1. Beyond A on the ray, the λ must be greater than 1, such as at C.
The relevant question now is ‘how does output respond to the change in scale?’ This is just like a
slope type relation:
∆Y
∆λ
Since return to scale is a percentage concept, we need to convert the slope relation into elasticity
to obtain its behavior:
% ∆Y Percentage change in output
ε= = (10.15)
% ∆λ Percentage change in all inputs
We can see that there can be three possibilities for the value of ε:
o If ε = 1, it means %ΔY = %Δλ. In other words, if we double all inputs, output also doubles.
This tendency in production is called constant returns to scale (CRS)
o If ε > 1, it means %ΔY > %Δλ; i.e. doubling all inputs increases output by more than
double. This tendency in production is called increasing returns to scale (IRS)
o If ε < 1, it means %ΔY < %Δλ; i.e. doubling all inputs increases output by less than double,
called decreasing returns to scale (DRS)
The doubling of inputs and equal, more or less than doubling of output can be seen by the
expression:
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% ∆Y = ε × % ∆λ
Let us now convert the above ideas on graph. Consider figure 10.15 which shows a set of
iso-quants.
Figure 10.15: Modelling Returns to Scale
K (a) Production technology K (b) Production technology K (c) Production technology

exhibiting CRS exhibiting IRS exhibiting DRS
b b b
4 4 4
Y20 Y22 Y18
a a a
2 2 2
Y10 Y10 Y10
0 2 4 L 0 2 4 L 0 2 4 L
At point a in panel (a), 2 labor and capital (2L, 2K) units are combined to produce, say, 10 units
of some commodity. Now if we double all the inputs we move out along the ray 0a until we reach
point b where we have inputs (4L, 4K). If technology exhibits constant returns to scale, then at the
iso-quant that point b is on, we see that output should be 20 units, exactly double of 10 units; i.e.
by doubling inputs we have doubled our output. However, it is not necessary that technology
always exhibit constant returns to scale.
Increasing Returns to Scale
In panel (b), doubling of inputs leads to more than doubling of output, which means the
production technology shows increasing returns to scale. A major source of increasing returns to
scale was explained by Adam Smith in the very first chapter of his book Wealth of Nations. It is
the division of labor, or specialization in work. As the size of the firm and its output increases,
the possibilities of dividing work in smaller parts and, hence, allowing workers to increase their
productivity by specializing in certain tasks also increases. For example, if one needs to stitch one
shirt a day, then a single person using an ordinary sewing machine can do the job pretty well.
However, if one is going to stitch 100 or 1,000 shirts a day, then the best solution is not to have
100 or 1,000 people with 100 or 1,000 machines to make them. On the other hand, it is far less
costly in terms of human effort, materials, and especially energy to use if each of the persons
working in factory specializes in his activities: one might purchase raw-material; one might cut
cloth; one might stitch those cut cloth; another might make button holes and yet another put on
the buttons etc. Through this specialization, 10 people can easily do as much as 100 who do not
specialize. A large scale of production permits a greater division of labor to be used and average
costs to be lowered. Another reason for increasing returns to scale to arise is technical and/or
managerial indivisibilities. Certain capital inputs do not make sense when used in small-scale
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production but will generate large savings in cost if used in large-scale. One of the basic features
of capitalist industrial production is the existence of mass production methods which are available
only when the level of output is large, like the assembly lines in cement plants or in the motor-car
industry. Clearly, if the large scale process were equally productive as small-scale ones, no firm
would ever use rather the firm would prefer to duplicate the smaller scale process with which is
familiar. The use of computerized procedures and her mass production techniques are efficient
only when the output level is large.
Decreasing Returns to Scale
If on the other hand, returns to scale are decreasing, then we have the case as depicted in
panel (c) of the above diagram where scaling up all inputs by 100 scales up output by less than
100. One factor responsible for decreasing returns to scale is bureaucracy or the managing of
large numbers of people. Obviously, watching a tailor in a shop is not really hard. But when you
operate in a garment factory where several thousand work, then it is very hard for manager of the
firm to monitor every employee. Controlling employees pilfering of office supplies and product
inventory is almost impossible, and several thousand rupees a year per worker are lost in the
Pakistan Corporate Sectors due to these problems. Similarly, coordinating activities of various
departments of the firm becomes increasingly difficult as the size of firm’s operation expands,
especially in more than one city. Even when authority is delegated to individual department
managers (sales manager, HR manager etc.), the final decision is yet taken by the ‘top
management’. The decision making and its implementation process becomes less and less
efficient as scale of production grows because of the stretched long managerial hierarchy, a
tendency termed diminishing returns to management. Another important area where decreasing
returns to scale arises is in the case of exhaustible natural resources. For example, doubling the
fishing fleet may not lead to doubling of catch of fish; or doubling the plant in an oil or gas
extracting field may not double the output obtained.
10.3.3: Input Substitution
Thus far we have discussed one short run and one long run property of production
function: returns to input (short run) and returns to scale (long run). Besides return to scale, there
is another long run feature of production technology that is directly relevant to a firm’s decision
of ‘choice of technique’ and its expansion path in the long run (to be discussed in next chapter).
This property is technically termed as elasticity of substitution which shows the ease with which
inputs can be substituted for each other in the production process without losing output. The
formal algebraic measure for elasticity of substitution will be developed in the next chapter; here
we discuss the graphical intuition behind this idea. This property is related to the shape of a single
iso-quant curve. To see how, note that an iso-quant projects the idea of producing a given level of
output with a number of different input combinations—i.e. firm has the freedom to substitute
labor for capital while still producing same output. However, the ease with which inputs can be
substituted with each other in production process may vary from one industry to another. In some
cases, substitution can be accomplished rather easily and quickly in response to changes in
economic circumstance. But in other cases, firms may have little choice about the input
combinations available to them. Here we consider one case where input substitution is impossible.
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Fixed Proportion Production Function
Consider figure 10.16 showing a technology that allows no input substitution resulting in
L-shaped iso-quant curve. The idea behind this is that labor and capital must be used in exactly
fixed proportions. In other words, there is one and only one way of producing a given level of
output and both inputs are perfect complements—every unit of capital has a fixed complement of
workers that cannot be varied no matter how much output you produce. For example, if 1
machine is in use, 3 workers are required to produce Yo output. Combining more than 3 labors with
1 machine will not increase output. Point C shows a redundant amount of labor used. In other
words, output does not increase as long as more labor is not combined with additional capital in a
fixed proportion; i.e. marginal productivity of labor is zero beyond 3 units of labor. Graphically, it
means that iso-quant is horizontal beyond point (3L, 1K). This can be seen by comparing upper
panel of figure 10.13 with 10.16. Note that adding extra labor into production process with fixed
capital puts firm on a higher iso-quant curve in figure 10.13, but firm remains on the same iso-
quant in 10.16.
Figure 10.16: Fixed proportion production function
K Expansion Path slope = ⅓
2 Y1
B
1 Yo
A C
0 3 6 L
Such a production function is called fixed-proportion production function that shows no

possibility of trade-off between inputs; i.e. there is no way to substitute labor for capital or vice
versa. Both inputs are fully employed only if a combination of K and L that lies along 0AB is
chosen. Otherwise, one input will be redundant in the sense that it could be reduced without
decreasing output. Secondly, note that since more output can be produced only if more of both
inputs are available in a fixed proportion, say at B where 6 of labors and 2 of capital units produce
Y1 output which is exactly twice the factors at point A, thus, doubling the inputs doubles the
output—hence the process shows constant returns to scale.
The question now is ‘how to write a function representing such a fixed proportion
production process?’ For this, note that for each unit of output to be produced, we need at least
one unit of capital. Turning this around, this means that firm can produce no more output than the
number of capital units available. For example, if it has 10 machines in our figure 10.16 example,
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then the maximum it can produce is 10 units. However, the mere availability of capital in a
certain amount does not guarantee 10 units of output as labor is also required in a particular fixed
amount. So, output can be less than 10 units. This can be stated algebraically as an inequality:
Y≤K
Since at least three units of labor are required to produce one unit of output, so output cannot be
greater than one third the amount of labor available:
1
Y≤ L
3
For example, if 60 workers are available, then the maximum the firm can produce is 20 units [=
60 / 3]. The above conditions create two requirements that must be satisfied to produce a unit of
output. For example, if there is enough labor to produce 20 units of output (i.e. L = 60), but there
are only 10 units of capital, then maximum 10 output units can be obtained. In other words, the
smaller of the two input availabilities restricts the output. Such a condition is expressed as:
L 
Y = Min  , K 
3 
which says that output, Y, is the minimum of the two inputs, K and L/3. Generally speaking, if aL
units of labor (aL may be 3) and aK of capital are needed to produce one unit of an output, we find
that:
L K
Y≤ and Y≤ or
aL aK
 L K 
Y = Min  ,  (10.15)
 aL aK 
This is the general form of a fixed-proportion production function. To take an example of fixed-
proportion production function, consider the input-requirements for, say, shirts in terms of its raw
material: cloth (C), buttons (B), thread (T) and buckram [‫( ]ﺑﮑﺮﻡ‬M). Let’s assume that an average
shirt needs at least 3 meters cloth (ac = 3), 10 buttons (ab = 10), 10 meter thread (at = 10) and
1/10 meter buckram (am = 1/10; i.e. a shirt needs one tenth of one meter buckram, or
alternatively, one meter buckram can be used in 10 shirts). Now the production function for shirts
can be written as:
1 1 1 
YS = Min  C , B , T ,10 M 
 3 10 10 
The ease with which inputs can be substituted for each other in production process is of
great relevance to capitalist firms. Read Application Box 10.3 to see why the shape of iso-quant
matters to profit-maximizing firms as well as to economy as a whole in rapidly changing
technological societies.
37B
Why Input Substitution Matters?

To illustrate an example, suppose that capital-labor ratio in manufacturing industry is
two to one—it takes two machines to employ one worker, or alternatively one worker operates
two machines. On the other hand, assume that capital-labor ratio in agriculture is one to one.
Now if consumers’ preferences change in favor of industrial production as has happened in most
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capitalist societies over time, then agricultural production will decrease while that of
manufacturing industry will increase. When output in agricultural industry decreases, it will
release capital and labor in the ratio of one to one; i.e. every time when one machine is released,
one worker is also unemployed. However, manufacturing industry can absorb capital and labor in
the ratio of two to one. In other words, transferring two machines from the agricultural sector
employs one more worker in manufacturing. Thus, half of the workers released by agricultural
sector would be unemployed. However, the released labor could easily have been absorbed if
capital-labor ratio in manufacturing could be changed. The effect of a shift in demand for a
product on inputs depends upon the flexibility of production technique.
However, the above type of situations where economists study the cross-industry
substitution of inputs assumes away a highly important feature of reality: specificity of capital.
Almost all capital units are specific to the task for which they ware originally designed and it is
almost impossible to use them for producing some other type of output. Consider, for example,
the thresher machine used in agricultural production. If agricultural production decreases, some
of the thresher machines would cease to operate. Now think: do these thresher machines have
anything to do with manufacturing output? Is it possible to fit thresher machines anywhere in
manufacturing industry? Clearly no, but economic theory assumes that capital can be
instantaneously and costlessly moulded so as to be suitable for producing any type of output.
This is clearly a non-sense assumption. Some of the capital must be lost forever even if we
assume that we can transfer capital from one shape to another using technological innovation.
Similarly, it is also difficult to absorb laborers working in agricultural industry into
manufacturing simply because both industries require different types of skills: people who are
trained to do one type of job can’t fit into other jobs without loss of some output in between this
transition. It can only be through some sort of magic that instantaneous transformation of inputs
is possible.
Why Typical Iso-Quant?
The typical shape of iso-quant as drawn in figures 10.13 to 15 assumes that technology
allows infinite possibilities of substituting labor for capital in production process; i.e. it is always
possible to substitute labor for capital for even very small changes in capital. But this is in fact not
a correct description of production technologies made available to firms. Not only is it the case
that technology usually does not allow such input-substitution, but also the industrial production
(the dominant mode of production in capitalism) takes place more or less under the conditions of
fixed-proportion production methods—very small adjustments cannot be made between inputs in
industrial production. No matter how firm the economists’ belief may be in magic, it is literally
impossible in this physical world to transform capital costlessly and instantaneously to be suitable
for operation by any number of workers. Even if we accept all of the revolutionary characteristics
of modern technology, the maximum we can get is an iso-quant as shown in figure 10.17. The
point that such a shape highlights is that even if technological innovations allow firms some
substitution between labor and capital, however, this substitution is never infinite to make an iso-
quant look like a smooth negatively sloped curve—an iso-quant must have kinks. The smooth
curve can emerge only if we assume that even very small changes in capital can be substituted
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with or for labor; but this is clearly an absurd idea because it is physically impossible to add some
very small unit into machines or take away some very small portion from machines.
Figure 10.17: Impossibility of small changes in inputs results in kinks

in iso-quants
Y1
Yo
0
L
The question then is: why economists insist that an iso-quant must have a typical shape?
The answer to this question does not lie in the fact that economists have somehow empirically
observed the underlying production technology through some microscopic eye; rather this
fictitious shape is adopted because this is the only shape of iso-quant that fits within the
microeconomic theory of income distribution as discussed in part 5 of this book in detail. We
show in the next chapter that if iso-quant takes even a shape of 10.17 which is much less rigid
than fixed proportion production, then neoclassical economics fails to justify its theory of faster
decrease in response to changing input prices. This and only this can explain why all major
economics text-books use “well behaved “ shaped iso-quant curves in their modeling of capitalist
production.
Moreover as we have argued throughout this book a central purpose of microeconomics
is to develop ideal types of the optimal behavior of capitalist individuality as consumer, producer
and exchangers. The iso-quant is not smooth, and nor it can be. But it ought to be smooth
according to microeconomic theory. Why? Because the ideal capitalist producer is not committed
to the production of any specific good or the employment of any specific technology, rather he is
committed to the maximization of the rate of capital accumulation. This alone is the end in itself
and every thing else—choice of technology production of specific commodities—is an instrument
for achieving this supreme end in itself. Inputs must be infinitely substitutable if they are merely
instruments for maximizing capitalist accumulation. Thus in capitalist order factors of production
have no intrinsic value. The value ascribed to them is solely determined by their relative
contribution to capital accumulation and that is why value of all physical assets is ultimately
determined in the financial markets. A central purpose of the financial markets is to reduce asset
and commodity market rigidities so that factors of production can become infinitely substitutable.
This is achieved for example through securitization and through the organization of merger and
acquisition (M and A) transactions. The capitalist ideal is to make all factors perfectly
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substitutable since no factor has any intrinsic value; its value is derived solely from its relative
contribution to capital accumulation.
Of course the universal dominance of the financial markets that capitalism requires cannot
be achieved. This illustrates the inherent incoherence and irrationality of capitalist order.
Microeconomics cannot of course acknowledge the essential irrationality of capitalist order. It
continues to use a false criterion for measuring performance of capitalist agents in capitalist market.
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Key Concepts
Average product is the ratio of output to labor

Constant returns to scale means returns to scale is 1, reflecting the fact that output increases at
the same percentage rate as do all inputs
Decreasing returns to scale means returns to scale is less than 1, reflecting the fact that output
increases at a less percentage rate than all inputs
Diminishing marginal product of a factor refers to the tendency of marginal product of a factor
to decrease, other factors held constant
Diminishing marginal rate of technical substitution refers to the tendency of MRTS to
decrease as more labor is added to production process
Division of labor means allocation of task between workers such that each one of them performs
fewer distinct tasks in producing output; i.e. each worker produces a very small part of total
output produced
Factors of production are inputs that are not embodied in output and are retained after the end of
production process. They include labor, land, capital and entrepreneur
Fixed factor is the input that cannot be changed in short run (also called fixed input)
Fixed-proportion production function refers to the situation when there is only one technically
efficient way of producing a given amount of output and, hence, shows no possibility of trade-off
between inputs; i.e. there is no way to substitute labor for capital or vice versa
Increasing returns to scale means returns to scale is greater than 1, reflecting the fact that output
increases at a greater percentage rate than all inputs
Iso-quant curve shows different combinations of inputs that yield same level of output
Long-run is the time duration when all inputs can be changed
Marginal product of a factor is the change in output due to change in an input
Marginal rate of technical substitution (MRTS) measures the rate at which labor can be
substituted for capital still producing the same level of output
Production function is a relation between the amount of output a firm can produce with given
inputs
Return to factor / inputs refers to the behavior of change in output in response to change in a
single input: what happens to output as we change single input
Returns to scale measures the percentage change in output due to percentage change in all
inputs: what happens to output as we change all inputs
Short-run is the time duration when at least one input is fixed
Variable factor is the input that can be easily varied in the short run (also called variable input)
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Chapter Summary
• The theory of production attempts to show that there is a positive relationship between price
and the output supplied. This is necessary to derive “well behaved” individual and market
supply curves
• Since it is logically (except on very stringent assumptions) and empirically impossible to
justify the existence of such “well behaved” aggregate demand and market supply curves
microeconomists cannot justify their view that capitalist society is merely an aggregate of the
free choices of utility and profit maximizing individuals
• Microeconomics assumes that production—conversion of inputs into output—is merely a
technical process. Thus the relationship between laborers and managers are determined
purely by physical and natural forces. The production function models the presence of the
conversion of inputs into output on the basis of a profit maximizing technology
• Factors of production are those inputs which do not become embodied in output but retain
their existence after the end of the production process
• Microeconomists prefer the form of the production function which relates output to factors of
production (and abstracts from other inputs) because this allows them to justify capitalist
property rights. All factors of production and their owners are seen as equal capitalist
contractors establishing harmonious relations of production and willingly appropriating the
part of the value of the net output which has been produced according to their individual
contribution
• Microeconomists usually write the production function as Y = (L, K) and claim that all inputs
can be accommodated within this general form. But as Sraffa has shown no unambiguous
meaning can be attached to the microeconomists’ conception of capital K in this production
function. Usually this ‘K’ is supposed to mean physical capital (i.e. the total machinery,
building etc., used in the production of a specified amount of output). But it is impossible to
sum up the separate constituents of “K”— how do you add machines to rooms, to electric
circuits etc. You can only add up their values (price times quantity). ‘K’ cannot therefore be
‘physical capital’. Labor on the other hand can be measured in physical units as hours
worked for example. Therefore L and K are logically different—and therefore not equal but
asymmetrical concepts. Recognizing L and K as unequal, different, asymmetrical concepts
undermines the microeconomic justification of capitalist property and its theory of income
distribution as we shall see in later chapters. Since microeconomics is a justification of
capitalist rights, it cannot abandon the fictitious notion that K and L can be measured in
physical terms
• The short run is the period in which at least one factor of production remains fixed. In the
long run there are no fixed factors of production
• Microeconomics assumes that marginal productivity is usually positive since profit
maximizing firms would not hire labor whose wage is positive while its marginal productivity
is negative or zero. Where negative MP exists as it does in developing countries, Lewis
suggests that this is an opportunity to turn non-capitalist production units into capitalist ones
by moving the laborers with negative MP from the non capitalist firm to the capitalist factory
in the city where their MP will be positive
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• Microeconomists subscribe to the Law of Diminishing Marginal Productivity and expect

marginal produce to decline as the scale of production expands. This implies that the slope of
the production function (the total product curve) increases for some time but ultimately starts
decreasing
• According to microeconomic theory the marginal productivity of labor (MPL) declines
because as more and more of labor is added to the fixed factor K, the capital-labor (K/L) ratio
will decline. The amount of capital each laborer has to work with falls. This assumption of
decreasing returns to input is of vital importance in microeconomic theory
• As Sraffa pointed out that assumption leading to the law of diminishing marginal productivity
cannot apply to mature capitalist order where machinery is built to operate with fixed
(optimum) quantity of labor all the times. It therefore makes no sense to keep on adding
labor to fixed capital. Sraffa showed that a profit maximizing firm is likely to operate at
maximum productivity (optimum level of K/L). Otherwise it will not be able to maximize
profit. Profit maximizing capitalist firms would leave the portion of the factor the marginal
productivity of which is less than optimal. Sraffa showed that a profit maximizing capitalist
firm would/should leave some of its fixed factor unutilized. This implies a constant return to
scale production function. The law of diminishing marginal productivity does not apply to
mature capitalist economies.
• When marginal product is greater than average product/cost, average product rises. When
marginal product is less than average product, then average product falls. Finally, when
average product equals marginal product, average product is at its maximum point. The
marginal product curve intersects the average curve at its maximum height
• The profit maximizing capitalist firm continues to increase production as long as marginal
product is positive Non capitalist producers on the other hand may stop production when
marginal product is rising. A non capitalist producer may continue to expand production
when marginal production is negative. This is because the non capitalist producer rejects
profit maximization as the objective of production
• Capitalist firms choose technologies of production which allow them to maximize profits.
Non capitalist firms choose technologies of production on the basis of other considerations
• Iso-quant identifies different technologies of productivity which produce the same level of
output. Iso-quants are expected to be convex to the origin like indifference curves and
roughly for the same reasons. The iso-quant curve is negatively sloped and shows input
substitution to keep output constant. The marginal rate of technical substitution (MRTS)
measures the rate at which one factor can be substituted for another in the capitalist /
production process. This implies that information about the role of substitution between two
inputs can be used to infer their marginal productivities
• MRTS tends to decrease as more and more of one input is substituted for another. This
tendency is known as the diminishing marginal rate of technical substitution
• The Iso-quant like indifference curves are negatively sloped and cannot intersect. However,
iso-quants can be measured cardinally reflecting the amount of production different input
combinations yield at different iso-quant curves. Indifference curves can only be measured
ordinally
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• The concept of returns to scale measures the impact on output of changing all input in the
same proportion. Returns to scale may be (a) constant (b) increasing or (c) diminishing.
Returns to scale is a long run concept
• Iso-quant sets take different shapes depending on input substitution and taste. Production
function is L-shaped when there is a fixed proportion production function. Such a productive
function shows constant returns to scale
• Microeconomics often ignores fixed factor proportions and input substitution rigidities and
works with models which assume infinite substitution of inputs. Capital can be substituted for
labor and one type of capital for another type of capital without cost and without any loss of
time. The typical iso-quant therefore takes a shape that assumes infinite substitutability of
capital for labor. In the real world the typical iso-quant must have kinks
• The smoothly downward sloping iso-quant must be assumed to justify the microeconomics
theory of income distribution
• The iso quant is shown as smooth because microeconomics is a moral science. The capitalist
producer is committed only to profit maximization. He is not committed to the production of
any specific commodity or the employment of any specific inputs. Choice of technology and
production of specific commodities is only means to the maximization of capital
accumulation which is the only end in itself. Factors must be infinitely substitutable if they
are merely means for maximizing accumulation. No factor of production in capitalist society
has any intrinsic value. Financial markets operate to reduce factor substitution rigidities.
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Review Questions
1. What is the production function?

2. What are factors of production?
3. Why do microeconomists prefer the form of the production function which relates output to
factors of production only?
4. Why can ‘K’ and ‘L’ in the neoclassical production function not be regarded as equal and
symmetrical concepts?
5. Define the ‘short run and the long run’ in production.
6. What is “marginal productivity”? Why do microeconomists expect marginal productivity to
be positive?
7. State and explain the law of diminishing marginal productivity with the help of a diagram
showing a typical production function. Derive a typical marginal product curve assuming
some numerical numbers
8. Illustrate Sraffa’s criticism of the theory of diminishing marginal productivity using an
example of your own.
9. Why are capitalist firms more likely to operate on a constant rather than diminishing
productivity?
10. Why must the marginal product intersect the average product curve at its minimum level?
11. Why cannot the theory of marginal productivity explain the behavior of a non capitalist
producer such as Abdullah Zhaghzai?
12. Why would a typically Islamic society—e.g. the Zhaghzai tribe for example—prefer a non-
profit maximizing technology of production?
13. What are the characteristics of an iso-quant curve and how are they justified by
microeconomic theory?
14. Why the iso-quant curve is negatively sloped?
15. Define and explain the concept of the marginal rate of substitution.
16. Explain / justify the tendency of diminishing marginal rate of technical substitution.
17. What is the meaning of the concept ‘return to scale’?
18. Define a fixed proportion production function. State and explain its general form with a
numerical example.
19. What do you understand by ‘factor substitution’?
20. “Typical iso-quant assumes infinite substitution possibilities between inputs”. Explain.
21. “In the real world the typical iso-quant must have kinks”? Explain why.
22. “Iso-quants are assumed to be smoothly downward sloping eventually for ideological
reasons.” Discuss.
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11
Chapter
NEOCLASSICAL THEORY
OF COST
The last chapter modeled production technology as conceived in microeconomics. But

technology alone cannot determine what to produce and how to produce. This chapter goes on to
explain the microeconomic theory of how capitalist firms make choices about input usage and
output scale in response to changes in output level. The first section clarifies the specific sense in
which micro economists use the term ‘cost’. The model of input-choice in section 2 is then
extended to derive standard microeconomic cost curves in sections 3 and 4.
11.1: THE ECONOMIC CONCEPT OF COST
The concept cost is often used in ordinary language, but it has a very specific and
somewhat different meaning in economics. Cost refers to the sum of expenditures needed to
produce a given level of output. First note that cost cannot be defined independent of the level of
output—you can’t tell how much cost a farmer incurs on producing wheat until you specify how
much output he produces. For example, cost of producing 100 bushels of wheat may be Rs 50, but
cost will be different for the output level of 200 bushels. For micro economists, the cost of
producing something is opportunity cost— the value of foregone consumption. Recall from
chapter 1 that the assumed scarcity of resources by capitalist implies that any decision to produce
more of one good means giving up some other good. For instance, when an automobile is
produced, an implicit decision has been taken not to produce, say, bicycles. If it is possible to
produce 50 bicycles using the same labor and capital that goes into the production of one
automobile, then the opportunity cost of one automobile is 50 bicycles.
In order to calculate the total opportunity cost of something, care must be given to include
not only the explicit cost but also the implicit cost elements. Explicit cost refers to expenses which
the entrepreneur has to pay from his own pocket for the purchase of inputs. It includes:
• Labor cost i.e. expenditures on salaries and wages. When considering the wage rate, micro
economists assume that this rate is the amount that workers would earn in their next best
alternative job. If a firm hires a worker, say, at Rs 50 per hour, micro economists say that this
number represents what the worker would earn elsewhere.
• Borrowed capital cost: if capital is borrowed from financial markets such as banks, then the
cost of capital is the interest rate paid to the lender of capital. For example, if the market
interest rate is 10% and a firm borrows Rs 100 for one year, then its interest cost will be Rs 10.
Implicit cost, on the other hand, measures the cost of foregone alternative actions though no
physical payment is made against them. Such costs occur when an the entrepreneur uses his own
capital or labor.
• Owner’s own capital cost: If, instead of borrowing, a person invests his own capital into a
business, then the cost of using this capital is also the forgone interest rate that he could have
earned had he lent out this capital instead of using it personally. For example, if he invests his
own Rs 100 in some business, then apparently it seems that he has no cost to pay for its use
after one year. What if he had put this amount in some financial market, say deposited in a
bank, for one year instead of using it himself? If the market interest rate is 10%, then this
person could have earned Rs 10 after one year. So, by continuing to use this amount of
capital, he is implicitly foregoing the interest that someone else (say a bank) would be willing
to pay for its use. Alternatively, he is paying a price of Rs 10 for using his own capital. In
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general the cost of capital is the interest rate for the capital that a firm must pay for its use
regardless of whether the firm owns the capital (in which case it is an implicit cost) or
borrows the capital from someone else (in which case it is an explicit cost).
• Entrepreneurial cost: Legally, the owner of a capitalist firm is entitled to receive whatever is
left from the firm’s revenue after all costs have been paid. This excess of revenue over cost is
treated as profit by the accountant. However, micro economists ask the question: whether
owners (or entrepreneurs) also incur opportunity costs of being engaged in a particular
business. If so, then their services should also be treated as input to the firm and some cost
should be imputed to that input. For example, suppose a highly skillful business graduate
starts his own business. Again, apparently he seems to work for free. But, the wage that he
might earn if he worked for someone else is the implicit cost of working at his own business.
Let us consider a simple example to clarify these concepts. Suppose a capitalist (Nomi) runs a
coaching centre at his home. Nomi may make a typical income statement of his business as
shown here:
Profit Ignoring Implicit Cost
Fee collection Rs 1,000
Wage bill Rs 500
Explic Utility bills Rs 200
it cost Miscellaneous Rs 100
Profitaccountant Rs 200
However, this calculation does not impute full opportunity cost of Nomi business as it ignores the
cost of using Nomi’s own house and his personal labor. A micro economist would prepare the
following balance sheet taking into account not only of explicit cost, but also of implicit cost:
Profit Taking Account of Implicit Cost

Fee collection Rs 1000
Wage bill Rs 500
House rent Rs 100
Implic
it cost Personal wage Rs 50
Profiteconomic Rs 50
Note that economic profit (Rs 50) is less than accounting profit (Rs 200). In fact, economic
(capitalist) profit could be negative if the opportunity cost of renting the house and personal wage
exceeded the accounting profits being earned by the business. Application Box 11.1 looks at these
cost ideas in relation with capitalist cost of studying at some business school.
Cost of Education
Suppose Nomi is an MBA student at some business school in Karachi. How would he calculate
his cost of obtaining a 2-years MBA degree? If the tuition fee is Rs 150,000 and some other
expenses (e.g. daily traveling and refreshment expenses etc.) amount to Rs 50,000, then Nomi
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would count total expenses equaling Rs 200,000. However, this calculation includes only the
explicit cost of doing an MBA. Considering implicit cost would reveal that the cost of an MBA
degree is much higher than this explicit cost. But what is the implicit cost of the MBA? Assume
that after graduation, instead of taking admission in MBA, Nomi could have started a job that
paid Rs 10,000 per month. This means that taking admission in a 2-year MBA involves a loss of
Rs 240,000 (Rs.10000 × 24) because he could have earned this amount by not taking this study
program. In other words, Rs 240,000 is the implicit value of the time Nomi is putting into an
MBA program. The total opportunity cost of a 2-year MBA degree now equals Rs 440,000. We
consider Nomi to be a capitalist student because the purpose for which he is doing his MBA is to
maximize his lifetime earnings and consumption, and the money that he spends on the MBA is
capitalist money i.e. investment.
However, it is possible that Farooq, on the other hand, is doing his MBA to understand how
capitalist business work. Farooq is a member of the Dawat-e-Islami and Maulana Muhammad
Ilyas Qadri, the Sheikh of the Dawat-e-Islami, has ordered him to do an MBA so that the
knowledge of how capitalist business works can be used by the Dawat-e-Islami to destroy the
global capitalist system. Farooq is not doing the MBA to maximize his lifetime
income/consumption, rather to contribute to the Jihad against global capitalism. Therefore no
capitalist value can be ascribed to Farooq’s action and the concept of opportunity cost becomes
meaningless. For analyzing Farooq’s behavior implicit cost in particular cannot be calculated
because the real value of Farooq’s output is the rewards he will become entitled to as a Mujahid
in heaven which, according to Hadith. is in principle infinite and therefore incalculable.
The Cost Equation
With this meaning of cost in mind, let’s obtain an algebraic expression for cost. Since
cost in general is defined as the sum of expenditures on the purchase of inputs:
Total Cost = Sum of expenditures on all inputs (11.1)
With two inputs, labor and capital, the equation becomes:
Total Cost = Expenditures on labor + Expenditures on capital
By definition, expenditures on labor is given by the wage rate (w) multiplied by number of
laborers employed while, similarly, expenditure on capital equals interest rate (r) times amount of
capital; so we have:
Total Cost = wage rate × labor + wage rate × capital
or TC = w × L + r × K (11.2)
Note that the cost equation for the firm is very similar to the budget equation for the consumer
discussed in chapter 7. The next section will develop further similarities between consumer and
cost theory.
11.2: CHOICE OF TECHNIQUE AS COST MINIMIZATION
The last chapter discussed how to model production technology of the firm, but
technology alone cannot tell what and how to produce—i.e. which combination of inputs would
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be best to use. Technology embodied in the production function shows physical trade-offs
involved in the production process. For microeconomics theory of production to make proper
sense, prices of all inputs, as well as output, must be given and known to the firm in advance
before undertaking the production. Technically it is assumed that all inputs are hired by the firm
in perfectly competitive markets (discussed in the next chapter) where all firms are price takers—
no firm has any control over market prices and accepts them for making its input and output
choice decisions. In other words, a firm can hire any number of laborers at given market wage
rate and borrow as much capital as it wants at the given market interest rate. This is to say that
wage and interest rates are fixed for a single firm. The cost equation now becomes:
TC = w × L + r × K (11.3)
where the bar over w and r indicate that they are held fixed.
Stating the Problem of Cost-Minimization
We know that profit (π) is given by the difference between total revenue (TR) and total
cost (TC):
π = TR − TC
with total cost given by expression (11.3) and TR equaling price (P) times quantity (Y):
(
π = PY − wL + r K ) (11.4a)
Substituting the production function Y = f (L, K) for Y we have:
(
π = P f (L , K ) − wL + r K ) (11.4b)
This equation says that with given prices of output and inputs, profits earned by a firm depend
directly on the amount of labor and capital employed. We can see that profit can be increased
either by increasing revenue or by reducing cost of producing some given level of output. Here
we investigate the later issue of minimizing cost; i.e. which production technique (or input mix)
to choose so that cost is minimum. In other words, of the many ways to produce a given level of
output, how would a firm trying to minimize cost choose to produce?
Obviously, the problem of cost-minimization cannot be addressed unless some specific level of
output is given because the amount of labor and capital that a firm needs to hire depends upon how
much output it produces. A farmer cannot decide on how much land he needs to cultivate unless he
knows how much wheat is to be produced in any specific time period. The problem is formally
depicted in figure 11.1 which shows an iso-quant curve for an output level say, 10 dozen-donuts
daily. The curve shows that many technically efficient ways are available to the firm to produce this
output as some are shown by points A, B and C. With output level fixed, the scale of production is
given, so the only relevant question is the choice of technique—how to produce this output level.
Moreover, with given output, revenue is also fixed, so the only way to increase the profit is to keep
cost to a minimum. The desire for profits implies that the firm would try to produce this output by
choosing that combination of inputs where cost of production is the lowest. So the cost-
minimization problem of the firm can be stated more formally as:
Minimize TC = w × L + r × K
By choosing optimal amounts of L and K
Subject to the constraint: Y = f (L , K )
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Again this expression is a concise way of expressing the capitalist firm’s choice of technique
problem.
Figure 11.1: Problem of choice of technique along iso-quant
C
Y10
0 L
It tells us that : (a) First what is the objective of the firm—minimize cost; (b) Second what is the
firm choosing—a combination of inputs L and K, and (c) Third what are the constraints the firm
faces—the given output level. Obviously, cost will be least when it is zero; i.e. when the firm
hires no labor and capital at all. But this strategy will not work because with zero labor and
capital, no output can be produced and hence revenue will be zero. So, the objective of the
capitalist firm is not merely the minimization of cost; rather it is to minimize cost such that the
given output is also produced. More precisely, the capitalist firm wants to minimize cost by
choosing quantities of L and K such that those quantities can produce the given output level, Y .
Let us develop an answer to this problem.
11.2.1: Cost Minimizing Input Choice
The first issue in the solution to this problem is how to represent the cost of various input
bundles in the factor-plane (L-K) diagram 11.1. The cost-equation can be drawn in this figure by
keeping cost fixed at some specific level, just as we did in the case of the budget equation by
keeping income constant. For example, if total cost is Rs 100, w = Rs 1 and r = 2, then the cost
equation becomes:
100 = 1L + 2 K
The vertical intercept of this equation is given by 100/2 (TC/r) while the horizontal axis is 100
(TC/w) as shown in figure 11.2. This line is called the iso-cost line—the curve representing
different combinations of inputs where cost is the same. Note that this line is very similar to
consumer budget line as discussed in chapter 7. The slope of an iso-cost line is given by the ratio
of input prices; i.e.
∆K w
Slope of iso - cost line = =− (11.5)
∆L r
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which is the price of the input on the horizontal axis over the price of the input on vertical axis. This
ratio of input prices is called the factor-price ratio.
Figure 11.2: Iso-cost lines in factor plane diagram
120/r
w
Slope of iso - cost = −
r
100/r
0 100 120 L
The proof of this expression is very similar to the one we discussed in the case of the budget line in
chapter 7. Briefly speaking, the slope of the iso-cost line while moving from its vertical intercept to
its horizontal one can be calculated as:
TC
−0
∆K
Slope of iso - cost line = = r
∆L TC
0−
w
∆K  TC  w  w
or Slope of iso - cost line = =  − =−
∆L  r  TC  r
For our iso-cost equation drawn in figure 11.2, the value of the slope is
w 1
− =−
r 2
which says that in order to purchase one extra unit of labor half a unit of capital must be sacrificed,
and this can be directly confirmed by the prices of the two inputs. Moreover, note that all iso-cost
lines have the same slopes; they differ only in their vertical intercepts which reflects the level of
cost for which they are drawn. The iso-cost curve away from the origin represents a higher cost
level, as shown above. The cost minimization can now be viewed as the problem of choosing an
input combination that produces the desired level of output and is on the lowest iso-cost line.
Graphical Solution
The solution to this problem is shown in figure 11.3 which draws four different iso-cost
lines along with iso-quant curve representing Y10 level of output. Obviously, Rs 100 is too little
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amount to produce Y10 output as no point on Rs 100 iso-cost line intersects the Y10 iso-quant
curve. In other words, with Rs 100, no input combination can be purchased that are required to
produce the desired level of output. On the other hand, Rs 120 are enough, but this amount is too
large. To see this, consider combination B. Here the firm can minimize its cost by moving from
combination B to A as A is on a lower iso-cost line and can also produce the desired level of
output—so B is not the cost-minimizing point.
Figure 11.3: Locating minimum cost point
K
120/r
Y10
100/r
A
Ka
C
0 La 100 120 L
The same holds for point C because this would also fall on a higher iso-cost line as compared to
A. We can see that as long as the iso-quant is intersecting iso-cost line, there will always be a
trading set for firm to move into and this move will enable it to reduce its cost. The cost
minimizing input combination reflected in the iso-cost curves must be tangential to the iso-quant
as shown in figure 11.3. Point A is the best technique to producing the desired level of output as
no other point on the same iso-quant is any cheaper than this point. Thus this fourth referred the
producer equilibrium.
What condition applies at the cost-minimizing input combination? We have shown above
the best technique is chosen when the two curves are tangent to each other. The tangency
condition means that the slope of the iso-quant and the iso-cost line must be equal. Recall from
the last chapter that the slope of the iso-quant is given by the negative of the MRTS, and (as
discussed above) the slope of the iso-cost line is the negative of the factor price ratio. Equating
them (and removing the negative signs) yields:
w
MRTS =
r
Also remembering that MRTS equals the ratio of marginal productivities, we get:
MPL w
MRTS = = (11.6)
MPK r
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This says that the cost minimizing input combination is the one where the marginal rate of
technical substitution is equal to the factor price ratio. Equation (11.6) can be converted into
another meaningful expression by rearranging it as:
MPL MPK
= (11.6a)
w r
The marginal productivity of an input divided by its price is the marginal productivity of a rupee
spent on that input, measured in terms of the output. For example, if MPL = 6 bushels of wheat
and w = Rs 3, then the marginal productivity is 2 bushels per rupee—each the rupee spent on
labor gives 2 bushels of wheat output. Now the equation (11.6a) says that cost minimizing input
combination is achieved when the marginal productivity of the last rupee spent on all inputs is the
same—i.e. when marginal productivity of the last rupee spent on labor is equal to the marginal
productivity of the last rupee spent on capital. Clearly, if the marginal productivity of the last
rupee spent on labor is less than that of capital; then the firm should not spend that last rupee on
labor; rather it should spend it on capital because here it is more productive. Almost everything in
this result is similar in nature to the one we have already discussed in consumer theory, so there is
no point in explaining this result any further (see the discussion on equi-marginal principle in
chapter 7 if you are not clear yet).
Uniqueness of Equilibrium and Convexity of Iso-quants
The last sub-section of the previous chapter stated the type of shape—smooth and convex
to origin—that an iso-quant must take for micro economics to make sense. We can now show
why it is also necessary for the iso-quant to take this particular shape if micro economic theory is
to be justified. Look at the equilibrium point A in figure 11.4 again. This point shows that if a
particular wage and interest rate (say w* and r*) prevail in the market, then a firm would hire La
and Ka amounts of labor at these input prices. In other words, producer equilibrium shows how
many units of inputs a firm demands at given market factor-prices. If factor prices were different
than w* and r*; then the firm would choose some other combination of inputs (because changing
input prices would change the slope of the iso-cost line just like changing goods’ prices changes
the slope of the budget line (for detailed discussion, see chapter 15). As long as iso-quant curves
are strictly convex to the organ the problem of cost-minimization will have a unique-solution; i.e.
there will be one and only one point of input demand for each particular factor price. This is
shown in the left hand panel of figure 11.5 where the lower panel projects the information from
input-space to input-wage space. Point a in the lower panel gives the information about demand
for labor at wage rate w*. The upper part of the right hand panel draws a kinked iso-quant curve.
Note that if tangency occurs in the flat region of the iso-quant, then more than one input
combination is consistent with cost-minimization. Such a possibility of non-unique solution
implies more than one level of input demand at a single wage rate as shown in the lower panel.
We will see in chapter 15 that this situation has devastating implications for micro
economics theory of income distribution—according to which the share of an input in national
income is a function of its market wage rate which is, in turn urgently, determined by the
intersection of a negatively sloped demand and a positively sloped supply curve of that input. It is
for protecting their fallacious conceptual framework that economists assume iso-quant curves to
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be strictly convex—because it is this and only this shape which yield a unique-solution to the
cost-minimization problem.
Figure 11.4: Non-convex Iso-quants are not consistent with micro economic theory of firm
K K
Y10 Y10
Kb A
A
Ka B
Ka
0 La L 0 La L
Lb
wage wage
a a b
w* w*
0 La L 0 La Lb L
11.2.2: Firm’s Expansion Path
The tangency between a single iso-quant and an iso-cost line defines an equilibrium point
only for some specific level of output. The impact on choice of technique of changes in input
prices and output level can now easily be examined. In this chapter, we will analyze the effect of
changes in output on the choice of technique while the effect of factor-price changes is left to
later chapters (see chapter 15). The above analysis can be performed for many different output
levels. For example, the bakery might get another large order or it may simply want to know its
cost at various levels of output. At each possible level of output, we can find an input
combination that minimizes the cost of production. With given input prices, the problem is just
like the one already analyzed and results in the tangency solution, as long as the firm is able to
adjust both inputs, as shown by the ray coming from the origin in the left hand panel of figure 11.5.
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This ray records the cost minimizing tangencies for successively higher levels of output. The set of
all cost-minimizing input combinations at different output levels is termed the expansion path,
because it records how input use expands as output expands. Note that this expansion path may not
necessarily be a straight line as drawn here.
Figure 11.5: Short run and long run expansion paths of firm
K K
Y25 Y25
Expansion Y15 Short run
Y15 Expansion path
path Y10
Y10
C
B D C E
K
A B
Ka A
0 La L 0 Ld Lb Le L
The expansion path in the left hand panel assumes that the firm can adjust both of its
inputs when choosing the best choice technique or input combination. However, the short run (the
duration of time when one input is fixed) expansion path would look different from this long run
one. Assume that the bakery has a fixed amount of capital, K , to work with. What difference
does it make to the expansion path of the firm? The resulting expansion path is shown in the right
hand panel which effectively a horizontal line is representing the existing level of the fixed factor
combined with varying amounts of the other input. This is the short-run expansion path. For
example, to produce Y10 output, the bakery must use Ld units of labor, similarly Lb units of labor
must be used to produce Y15 and Le units of labor to produce Y25. Note that combinations A and C
are not available in the short-run because of the inflexibility of capital. A somewhat detailed
comparison of short-run and long run expansion paths is carried out below in section 11.4.2. The
point to note here is that to vary its output in the short-run, the firm is forced to use ‘non-optimal’
input combinations—i.e. it cannot fully minimize its cost of production because of its inability to
adjust all inputs.
If you have gone through this chapter with some care, you must have found clear
resemblances between the theories of capitalist consumer and capitalist producer behaviors. A
summary of comparison between them is given in table 11.1.
You can easily construct a table listing similarities as well as dissimilarities between
microeconomic consumer and microeconomic producer theories from the above table. We leave
this as an exercise for you to test your understanding. With this background of cost minimization,
we are in a position to relate this with cost curve analysis. We begin by deriving short run cost
curves and then move on to long-run cost curves of capitalist firms.
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Table 11.1: Comparison between theories of consumer and producer behaviors

Theory of Capitalist Consumer Theory of Capitalist Producer
Behavior Behavior
1 Agent Consumer Producer
2 Objective Maximization of utility, given by Minimization of cost, given by Iso-

utility function U(X,Y) cost line = C = w × L + r × K
3 Given Variables o Taste represented by utility o Technology represented by
function U(X,Y) production function f(L,K)
o Goods Price, Px and Py o Input Prices, w and r
4 Constraint Budget line: M = Px×X + Py×Y Given output level, Y = f (L, K )
3 Choice Variable Goods X and Y Inputs L and K
4 Analytical tool Indifference curve: Iso-quant
o Negatively sloped, convex o Negatively sloped, convex and
and unique unique
o Slope of IC = o Slope of Iso-quant =
MU x MPL
− MRS = − MRTS =
MU y MPK
5 Conditions to MUX > 0and MUY > 0 MPL > 0 and MPK > 0
satisfy
8 Solution Px w
condition MRS xy = MRTS LK =
Py r
11.3: SHORT RUN COST CURVES
Once a cost-minimizing input combination is determined, a specific cost level required to

produce a given level of output is also determined. For example, in figure 11.3, the cost of
producing 10 dozen donut is given by:
TC (10 Dozen, w, r ) = w × La + r × K a
Clearly, we can see that the cost minimizing cost level, TC(Y, w, r), is a function of the particular
output level to be produced. At larger amounts of output, costs would be higher, as shown in
figure 11.5. Further, the input prices also affect the cost but this relation is studied later in chapter
15. Let us explore the relationship between cost and output here.
11.3.1: Deriving Total Cost
Short run total cost can be separated into two elements for analytical purposes: fixed cost
and variable cost. To see this, recall that total cost is given by:
TC = w × L + r × K
Since K is held fixed in the short run, the equation turns out to be:
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TC = w × L + r × K (11.7)
You can see that the cost of capital, rk, is now a fixed cost in the sense that changes in output do
not cause any change in this cost element —thus it can be treated as fixed cost. Note that this
fixed cost occurs in the short due to a fixed input. On the other hand, variable cost can be reduced
by cutting back on hiring the variable input. Here, the variable factor is labor, so that the wage
bill, wL, is the variable cost component. Thus we can write the short run cost equation (11.7) as:
TC = VC + FC (11.8)
Since fixed cost is not affected by changes in output, any change in total cost due to change in
output is caused by the variable cost component. The question now is: how do these costs change
as the capitalist firm’s output varies?
Fixed and Variable Cost Curves
Fixed costs are obviously fixed as they do not change as output changes. This relationship
is shown in the left hand panel of figure 11.6 represented by a horizontal line. However, the shape
of the variable cost curve as drawn here requires some explanation. To see what determines the
shape of the variable cost curve, recall that variable cost is given by
VC = wL
What we need to study is changes in variable cost due to change in output;
∆VC
Slope of var iable cos t =
∆Y
i.e. what happens to variable cost as output increases? First note that producing more output
requires hiring more labor inputs as shown by the right hand panel of figure 11.5. For example, if
the firm needs to produce Y10 output level; it needs Ld units of labor. However, production of Y15
output requires Lb units of labor. So, we can write:
VC = w × L(Y ) (11.9)
where L(Y) is not in multiplicative form, rather it says that the amount of labor input hired by the
firm depends upon the amount of output to be produced—i.e. it shows the functional dependence
of the input on the level of output. Now we can see the channel through which output affects cost:
More output   → More inputs ifinputs
requires
 arenotfree,
 → More cost
then
which can directly be seen in figure 11.4 (as we move to a higher iso-cost line while producing
Y15 level of output). So, if output is increased by ΔY amount (by any positive number, say 5 units
as shown in the right hand panel of figure 11.4 between iso-quants Y10 to Y15), demand for labor
will change by ΔL amount (Lb - Ld), which will cause cost to increase by some amount. Let that
change in cost be ΔVC (say Rs 20); then from (11.9), we have:
∆VC = w × ∆L
which says that change in cost is equal to wage rate times change in labor inputs. For example, if
labor is increased from 10 to 12 units while the wage rate is Rs 10 per laborer, then change in cost
is 20 [= 10 × (12 - 10]. Dividing it by ΔY we get:
∆VC  ∆L 
= w 
∆Y  ∆Y 
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Figure 11.6: Fixed Cost, variable and total cost curves

TC
Cost Cost
VC VC
FC FC
0 Yo Y 0 Yo Y
The left hand side measures the change in cost due to change in output, called marginal cost
(MC)—cost of producing an extra unit of output. What about the right hand side of this
expression? Obviously, w represents the wage rate which is clear enough to understand, but what
is there in the bracketed term? To see its meaning, recall from the last chapter that marginal
productivity of labor was defined as change in output due to change in labor:
∆Y
MPL =
∆L
You can see that the bracketed term is just the opposite or inverse of the marginal productivity
expression. Thus we can write it as:
 
∆VC  1 
MC = = w 
∆Y  ∆Y 
 
 ∆L 
∆VC w
or MC = = (11.10)
∆Y MPL
This is the desired result that we needed to explain the behavior of the variable cost curve. Two
results can directly be obtained from this expression:
1) Since both w (wage rate) and marginal productivity are positive, their ratio will necessarily be
positive (because a ratio can be negative only if one of the two numbers is negative). Because
ΔVC/ΔY is the slope of the variable cost curve, this means that the variable cost curve will be
positively sloped in output-cost space as drawn above
2) Since w is constant, the value of the slope of the variable cost curve depends upon the
behavior of MPL. Because MPL appears in the denominator, there emerges inverse
relationship between productivity and cost:
a. When MPL is increasing, MC will be decreasing
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b. When MPL is decreasing, MC will be increasing

c. When MPL is constant, MC will be constant
We discussed in the last chapter that the marginal productivity of the variable factor (labor) is
assumed to increase initially as more labor is added to the production process because the fixed
factor (capital) is ‘underutilized’. Because MPL is increasing initially, marginal cost would be
decreasing which means that variable cost rises less rapidly as output expands—in its initial
section, the slope of VC decreases, or it is concave. In other words, the range where productivity
of each additional input is increasing, each extra unit of output costs less as compared to the
previous one. Ultimately beyond some output level, say Yo, the marginal product of labor will begin
to decline due to over-utilization of the fixed factor, marginal cost of producing each extra unit of
output will begin to rise. Stating alternatively, beyond Yo, the slope of the variable cost curve starts
increasing or it becomes convex to the origin. Note that the tangent (or slope) of the VC curve is
flattest at output level Yo which means that marginal cost is minimum at this level of output.
The Total Cost Curve
The (short run) total cost curve can now be simply derived by summing up the two cost
curves, as shown in the right hand panel of figure 11.6. This curve has two features. First when
output is zero, total costs are not zero but equal the fixed cost component. Since the capital input
is held fixed, it must be paid its interest rate even if no production takes place. The firm cannot
avoid these fixed costs in the short run. Therefore, the short run total cost curve does not pass
through the origin. Since the firm can avoid all variable cost simply by hiring no labor, so the
variable cost curve originates from the origin. Secondly, the shape of the total cost curve is solely
determined by the shape of the variable cost curve. Because fixed costs are constant, they play no
role in determining the shape of the total cost curve other than determining its zero-output
intercept. The vertical difference between total cost and variable cost curves is fixed cost.
Alternatively, total cost is the variable cost curve shifted upward by the amount of fixed cost.
Therefore, the slope of the total cost curve must be the same at each output level as that of the
variable cost curve, as shown at output level Yo.
∆TC ∆VC w
or MC = = = (11.11)
∆Y ∆Y MPL
11.3.2: Per Unit Cost Curves
These cost concepts can also be defined in terms of per-unit cost—defined as cost of
producing one unit of output. This transformation of the total into the per-unit concept is useful
for analyzing many important problems regarding the supply decision of the capitalist firm as
discussed in the next chapter. Let’s first discuss the marginal cost concept a bit formally.
Deriving the Marginal Cost Curve
The marginal cost curve can be derived either from the variable or total cost curve as
explained earlier. Let’s look at the broader concept of the total cost for this derivation. In general,
the marginal cost curve is defined as change in total cost divided by change in output; i.e.
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∆TC
MC =
∆Y
Expressions (11.10 and 11) show that marginal cost of producing one additional unit of output is
given by the ratio of the input price to the marginal product of that input. If the wage rate is fixed
as is assumed to be the case, then the only factor that can affect marginal cost is the behavior of
the marginal product of labor. This is formally shown in
Table 11.2. Clearly you can see that if marginal product is rising, marginal cost of producing one
unit of output is decreasing, and vice versa.
Table 11.2: Relationship b/w marginal product and marginal cost

1 2 3 4 5=4÷3
Labor Total output Marginal product Wage rate per Marginal
units of labor unit of labor cost
1 10 10 100 10
2 22 12 100 8.33
3 30 8 100 12.5
For example, if marginal product of the first laborer is 10 bushels of wheat per day and he is paid
Rs 100 per day, then an extra bushel of wheat costs Rs 10 [= 100/10]—that is change in cost due
to change in one unit of output is Rs 10. Now if the second laborer produces more output as
compared to the first one; i.e. if its marginal productivity is greater say 12 units, and he also gets
the same wages per day, Rs 100, then the marginal cost of output produced by this\ laborer
would be Rs 8.33 [= 100/12] which is less than Rs 10 of the first laborer. This is no magic: if two
inputs charge the same amount in rupees but one is more productive as compared to another, then
the output produced by more productive labor would cost less than that of a less productive input.
Or alternatively, if a worker works harder on Monday and produces more output than he done on
Saturday; the cost of output produced on Monday would be less as compared to output produced
on Saturday. The same logic applies in the reverse order as shown in the last row of the above
table where the fall in marginal productivity of labor has caused marginal cost to rise.
The graphical derivation of the marginal cost curve is shown in figure 11.7. First note
that the slope of the total cost is given algebraically by
∆TC
Slope of total cost =
∆Y
In other words, the slope of the total cost curve equals marginal cost. As explained above that
economists assume marginal productivity to increase in the early part of production, therefore
marginal cost must decreases as output increases initially. This tendency is shown by the tangents
at cost curve between points a to b in the upper panel of this diagram. You can see that the
tangent is getting flatter as output increases from Ya to Yb—i.e. slope of total cost (or marginal
cost) decreases in this range. The lower panel presents a decreasing marginal cost curve in the
range of output Ya to Yb. Note that the tangent of the total cost curve is flattest at point b (to its left
it is decreasing, and to the right of this point it is increasing). The same information is projected at
output Yb in the lower panel where marginal cost reaches its minimum. Thereafter, the slope of
the total cost starts increasing, so marginal cost continues to increase after Yb level of output.
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From the micro economic point of view, this rising segment of the marginal cost curve is the only
relevant portion for analytical purposes. Keep in mind that the rising portion of the marginal cost
curve is explained by diminishing marginal product of the variable factor in the production process.
We will dispute this shape of the marginal cost curve after discussing some other per-unit cost
curves first.
Figure 11.7: Derivation of marginal cost from total cost curve
TC Total cost
c
TCc
b
TCb
a
TCa
0 Ya Yb Yc Output
MC
Marginal cost
0 Ya Yb Yc Output
Relationship between Marginal and Average Total Cost Curves
First consider the average total cost (ATC) concept given by the ratio of total cost to
output. Mathematically,
TC
Average total cost = (11.12)
Y
It measures the cost of producing one unit of output, a concept with which people are most
familiar. For example, if a firm has total cost of Rs 100 in producing 20 units of output, then its
cost per unit of output is Rs 5. The marginal cost concept has already been discussed as cost of
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producing one extra unit of output. Note carefully that marginal cost is a change concept while
average is a total concept. Table 11.3 calculates values of average and marginal cost for a
hypothetical cost structure of a capitalist firm. The values in this table are constructed such that
marginal cost decreases initially and then starts increasing forever (look at column 5). Here, we
are interested in the relationship between columns 5, 6 and 7. Before exploring this concept, be
very clear about the meaning of marginal and average cost values. For example, for output level 2
units, marginal cost is Rs 20 which measures the cost of producing one additional unit of output
(obviously the second unit costs Rs 20 to the firm as its cost increases by Rs 20, from Rs 50 to Rs
70, after producing this unit).
Table 11.3: Introducing relevant cost concepts

1 2 3 4 5 6=4÷1 7=3÷1 8=2÷1
Y FC VC TC MC ATC AVC AFC
0 50 0 50 - - - -
1 50 20 70 20 70 20 50
2 50 30 80 10 40 15 25
3 50 35 85 5 28.33 11.67 16.67
4 50 45 95 10 23.75 11.25 12.5
5 50 65 115 20 23 13 10
6 50 95 145 30 24.16 15.84 8.25
7 50 135 185 40 26.42 19.28 7.14
On the other hand, average total cost of producing 2 units of output is Rs 40 which indicates cost
of producing one unit of output when the firm is producing two units of output.
The marginal-average cost relationship can be viewed in two ways. One is by comparing
values in columns 5 and 6. You can easily verify the following relationship between them:
o If MC is less than ATC → ATC decreases (10.13a)
o If MC is greater than ATC → ATC increases (10.13b)
o If MC is equal to ATC → ATC is constant at its minimum point (10.13c).
For example, in the range of output 1-5, each marginal cost value is less than the previous
average total cost value, so ATC is decreasing in this range. On the other hand, each value of
marginal cost after 5 units of output is greater than the previous average total cost value, so ATC
starts increasing. Such a marginal-average relation has already been discussed in chapter 10
between marginal and average product curves (see section 10.2.2). We, therefore, leave its
interpretation as an exercise for the students.
Another general way of looking at the same relationship, instead of focusing on any
specific numbers, is to recall the fact that there is an inverse relationship between productivity
and cost, as explained above. Expression (11.11) shows this fact in terms of marginal cost
∆TC w
MC = =
∆Y MPL
which says that marginal cost and marginal product are inversely related—the range where
marginal product is increasing, marginal cost must be decreasing and vice versa. A similar type of
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relationship can also be shown between average cost and average product. To see this, note that
average cost, ignoring the fixed cost element, is given by:
TC L
ATC = = w 
Y Y 
The bracketed term is the inverse of average product (APL = Y/L), so we have:
TC w
ATC = = (11.14)
Y APL
which, again, shows an inverse relation between average cost with average productivity (this is so
because average productivity appears in the denominator). These two expressions say that just
inverting the marginal-average product curves drawn in the input-output space will give us
marginal-average cost relationship drawn in the output-cost space as shown in figure 11.8. If you
draw the values of column 5 and 6 in output-cost space, you will get similar type of curves as
drawn in this diagram.
Figure 11.8: Marginal-average relationship
Rs/unit MC
MC = ATC where
ATC is minimum AT
MC < ATC, MC > ATC,

so ATC so ATC rising
0 Yo Output
Again, care must be taken while interpreting this marginal-average relationship. Students often
tend to misread this relationship as: ‘when marginal cost is decreasing, average cost is also
decreasing and when marginal cost is increasing, average cost is also increasing’. Note that the
marginal-average relation is not explained by this line of reasoning. The actual statement of
relationship goes like this: ‘when marginal cost is less than average cost, average cost is
decreasing and when marginal cost is greater than average cost, average cost is increasing’. In
other words, the marginal-average relationship is based on comparison of marginal and average
magnitudes—the behavior of the average curve depends on whether the marginal is less or greater
than the average.
The same type of relationship also exists between marginal and average variable cost
curves which can be confirmed directly by comparing columns 5 and 7 of table 11.3. Expressions
(11.13a-c) can be used to describe this relationship by just using notation AVC instead of ATC.
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However, in order to draw AVC curve in output-cost space, we need to know its position with
respect to ATC curve.
Relationship between Average Total and Average Variable Cost Curves
Again, this relationship can be seen either by comparing columns 6 and 7 of table 11.3,
or by using general algebraic expressions. We use the later approach to keep our results generally
applicable to all sorts of data sets, and compare the values in relevant columns of the above table
so as to confirm those general results. Three features can be listed regarding the average-total and
average-variable costs relationship:
i) The ATC curve will always by above AVC curve as long as average fixed cost is positive.
This can be shown rather easily using the relation (11.8):
TC = VC + FC
Diving throughout by Y we have:
TC VC FC
= + or ATC = AVC + AFC
Y Y Y
This says that average-total cost is also equal to the sum of average variable and average
fixed costs. Writing it as:
ATC − AVC = AFC (11.15)
The left-hand side gives the difference between average total and average variable costs.
The equation expresses the fact that the difference between the two is equal to average
fixed cost. Now we can see that ATC can equal AVC only if AFC = 0. Since AFC cannot be
zero in the short run (since FC is not zero in the short run), therefore the difference between
ATC and AVC must be positive; i.e. ATC must be greater than AVC. You can clearly see
that values in column 6 are greater than those in column 7 for all output levels in table
11.3. Also see that the difference between ATC and AVC equals AFC for any level of
output.
ii) The average-variable cost curve reaches its minimum point before that of average-total cost
curve. Instead of giving a rather rigorous proof of this statement, we discuss the intuitive
idea behind it. The fact that the minimum point of average-variable cost is always before
that of average total cost follows from:
o AVC is always below the ATC curve.
o Marginal cost curve is positively sloped and intersects both ATC and AVC at their
minimum points (as discussed above)
Consider figure 11.9 to see this relationship. Mere visual observation of this diagram
confirms that if the positively sloped marginal cost curve has to cut both the curves at their
minimum, then the curve that is positioned below will have its minimum point earlier as
compared to the one that is drawn above. There is no way to draw these curves other than
the one shown here. Since it is the AVC curve that falls below, this proves our desired
statement. To confirm this result in table 11.3, note that the minimum value of ATC is 23
against output level 5, while AVC has its minimum at output level 4 with 11.25.
iii) The difference between ATC and AVC keeps on decreasing as output increases. Expression
(11.15) can be used to account for this tendency. Because, as you know, average fixed cost
is given by dividing fixed cost by output, you should be able to see that AFC must fall with
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ever increasing output level (with numerator fixed and denominator increasing, the ratio
keeps decreasing). According to (11.15), the difference between ATC and AVC equals AFC
and since AFC keeps decreasing, this implies that the difference between the two curves
falls as output increases. Note carefully that the two curves cannot intersect each other
because as long as fixed cost is not zero; AFC cannot also be zero no matter how large the
level of output (as long as the numerator is positive, the ratio cannot be zero). It is for this
reason that the AFC curve is drawn like a hyperbola which is approaching zero as output
expands, but never actually becoming zero. Again values in table 11.2 can be checked for
confirmation.
Figure 11.9: Average-total and average-variable costs relationship

Rs/unit
Minimum point MC
of ATC
ATC
ATCmin
Minimum point AVC
of AVC
AVCmin
AFC
0 Yavc Yatc Output
11.3.3: The Sraffian Cost Curves
The last part of Section 10.2.1 developed the famous and rigorous criticism advanced by
Sraffa on the neoclassical theory of diminishing marginal productivity. We have seen in the
previous sub-section that diminishing marginal productivity is the key to obtain ‘typical cost
curves’ as drawn in almost all economic text books. In other words, once the idea of diminishing
marginal productivity is questioned, then all of the above cost curves will have different shapes.
Let us see what happens to cost curves if we reject this idea and begin with some alternative
assumption about the production process. Recall Sraffa’s main argument against diminishing
marginal productivity from chapter 10 which says that most production activities are undertaken
under constant marginal productivity conditions. This is because firms always use their fixed
factor in optimal quantity and leave some of this fixed factor idle when operating below their
optimum scale. Hence, under or over utilization of the fixed factor is ruled out. If we agree, as
every rational capitalist economist should, with Sraffa, then what type of cost curves would result
on the basis of the constant marginal productivity assumption? With marginal productivity fixed,
marginal cost (or the slope of total and variable cost curves) also becomes constant. This directly
follows from expression (11.11):
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∆TC ∆VC w
MC = = =
∆Y ∆Y MP L
With numerator (wage rate) and denominator (MPL) fixed, marginal cost is also fixed for all
levels of output. The resulting curves are shown in figure 11.10. Panel (a) draws the relevant total
(measured in rupees terms) curves.
Figure 11.10: Cost curves resulting from

50Sraffa’s production analysis
Rs (a) Sraffian total curves Rs/Unit (b) Sraffian per unit

cost curves
TC
VC
ATC
MC =
FC
0 Output 0 Output
The fixed cost curve is the same as shown previously. However, the variable and total cost curves
are now straight lines representing constant slope, instead of having concave and convex regions.
The right hand side depicts per-unit (measured in rupees per unit terms) cost curves. Since the
slope of the total cost curve (i.e. marginal cost) is constant due to constant marginal productivity,
the MC curve is drawn as a horizontal line at some fixed level. With marginal cost constant,
average variable cost is also constant at the same level as marginal cost. This fact can be seen
from conditions (11.13a to c) that average cost rises or falls when marginal cost is either greater
or less than it. Since marginal cost is constant through out in this case, so would be average
variable cost. On the other hand, the average total cost curve is decreasing and getting closer and
closer to marginal cost as output increases. This is so because average total cost curve includes
average fixed cost element and therefore it cannot equal average variable cost. A table like 11.3
can easily be constructed to confirm these shapes of the curves. The devastating implications of
these cost curves for micro economics theory of the firm’s supply decision will be presented in
the next chapter.
Moreover, apart from dismissing the diminishing marginal productivity assumption,
Sraffa also exposed a rather more technical and fundamental weakness of the micro economics
theory of the firm. We pointed out in chapter 10 that capital (K), one of the factors of production
in the micro economics production function Y = f(L, K), cannot be treated as a quantity because of
aggregation problems. Any meaningful interpretation of capital to make sense is to use it in value
terms (price of capital times its quantity; Pk × K). The cost equation now becomes:
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TC = w × L + r (PK × K )
Since the price of capital (Pk) itself includes interest payment (r) as its constituent part, the cost
equation turns into a complex non-linear relationship, instead of a linear one, that cannot be
drawn as a straight line. This non-linearity has serious negative implications for all of the micro
economic generalizations regarding the behavior of the firm. This is dealt in detail in chapter 16.
At this juncture, let’s move on to analyze the conventional micro economic analysis of the long
run behavior of cost.
11.4 : LONG RUN COST CURVES
When it comes to analyzing long run cost behavior, the fixed factor ceases to appear in
the cost equation as the long run is defined as the decision horizon when all inputs to production
are variable in nature. Therefore, the cost equation to be analyzed becomes
TC = w × L + r × K
without bar on either of the two inputs. This means that the factor ‘fixed cost’ is no more included
in the long run cost as all costs are variable costs. With the disappearance of fixed cost, total and
variable cost are synonymous to each other; and so is the case with ATC and AVC cost curves.
This means that the numbers of curves to be analyzed in the long run are three: long run total cost
(LTC), long run average total cost (LATC) and long run marginal cost (LMC). First we discuss the
long run average total cost curve.
11.4.1: Long Run Average Total Cost
Probably one of the most important of all cost concepts in micro economic theory of the firm is
the long run average total cost curve. Recall that average total cost is given by:
TC w × L + r × K
LATC = =
Y Y
To analyze this equation, we need to concentrate on what happens to the numerator (total cost)
and denominator (output) of this expression as all inputs are changed by certain percent, say
100%. Let us assume that the firm doubles all its inputs—i.e. 100% change in all inputs. What
happens to total cost? It is clear that with given input prices, if all inputs are purchased in exactly
double quantity, then total cost will also double. So the total cost or the numerator increases by
100% in this case. How much would the effect of this doubling all inputs have on output? Recall
from the last chapter that long run response of output to input changes depends upon returns to
scale. It depends upon whether there are increasing, decreasing or constant returns to scales. We
take each of the three cases one by one.
i) IRS: If there are increasing returns to scale (IRS), then output will increase by more than
100% after doubling all inputs. With denominator increasing by more than the numerator,
the ratio must decrease. This can be seen as:
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% ∆TC is 100
if → then LATC ↓
% ∆Y greater than 100
Thus, long run average total cost must be falling in the case of increasing returns to scale
in production. A firm facing production opportunities that allow increasing returns to
scale as output expands will experience decreasing average total cost in the long run. The
intuition behind this fact is easy to understand: if, after increasing all inputs by x%, total
cost increases by x% while output increases by more than x%, then cost of producing one
unit of output must fall.
Figure 11.11: Behaviour of a typical long run average-total cost curve
Rs/unit Constant Returns

to Scale
Increasing Decreasing
Returns to Returns to
Scale Scale
LATC
LATCmin
Efficient level of
plant size
0 Yoptimal Output
ii) DRS: One the other hand, if a firm is experiencing decreasing returns to scale (DRS) in
production, then output will increase by less than 100% after doubling all inputs resulting
in less than 100% increase in the denominator. This time with the denominator increasing
by less than numerator, the ratio must increase. Thus, a firm undertaking production in
case of decreasing returns to scale as output expands will see its average total cost rising
in the long run. Again, the intuitive idea behind this is easy enough to grasp.
iii) CRS: Here output will increase by exactly 100% after doubling all inputs, so the
denominator increases by 100%. The ratio remains the same because the denominator
and numerator change by the same amount in this case. Thus, all production techniques
characterized by constant returns to scale have constant long run average total cost
curves.
The verbal discussion is translated into graph i.e form in figure 11.11 that draws a typical long
run average total cost curve exhibiting all of the three tendencies. You can see that the LATC
curve is falling in the range of output where increasing returns to scale exist, while it is rising
where decreasing returns to scale exist. The tendency of falling LATC is termed economies of
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scale while that of rising LATC is called diseconomies of scale—a firm is said to experience
economies (diseconomies) of scale in the long run if its average total cost is decreasing
(increasing). The lowest point on this average cost curve, LATCmin, shows the minimum necessary
price that must prevail in the market if production is to take place at all in the long run by a
capitalist producer. Above this price, the firm will not only be able to pay all its inputs but also
earns some economic profit. This price level is important for analyzing long run decision making
of firms in competitive markets. These capitalist firms are often willing to sustain losses and
continue to produce between their minimum price even in the long run
Issue of Reserve Capacity
In the microeconomic theory of cost, the most efficient level of plant size is reached
when the capitalist firm is producing Yoptimal output where cost of producing one unit of output is
the least. Of course, if the capitalist firm is asked to choose the best plant size, it would like to
operate at minimum average cost level—because this would be tantamount to using plant at the
most efficient level. Such a level of output is termed efficient scale of production. Non-capitalist
production units will have quite a different definition of efficiency. Note that the U-shaped
neoclassical LATC curve is based on the critical assumption that there is one and only one
efficient plant size available for the capitalist firm each plant is designed to produce optimally
only a single level of output. Any departure from that particular level of output leads to
inefficiency in the sense that average cost of production would be more than its minimum at that
output. In other words, according to microeconomic theory of cost, the plant is completely
inflexible and capitalist firms do not plan any reserve capacity at all in their plants. Such an
unrealistic assumption about capitalist capacity policy has been questioned by many writers as
early as the 1930s. The crux of their criticism is that firms build plants with some flexibility in
productive capacity so that the average variable cost curve has a flat stretch over a range of output
as shown in the left hand panel of figure 11. 12.
Note that planning reserve capacity means constant average variable cost of production
over some range of output. This reserve capacity allows a firm to vary its output, say, in the range
Ya to Yb without incurring any increase in its average variable cost. Several reasons have been
advanced to explain this phenomenon. First, businessmen require such reserve capacity in order
to meet seasonal and cyclical fluctuations in demand. Second, reserve capacity gives better
opportunities for repair of broken-down machinery without disrupting the smooth flow of
production. Third, since all capitalist businessmen look for growth, they will want to have some
freedom to increase output in case demand increases. Firms do plan reserve capacity in
anticipation of excess demand because they cannot afford to lose all of their new customers to
their rivals as this endangers their future hold on the market. Fourth, some reserve capacity is
always allowed in the land and building since, otherwise, any expansion in production would be
seriously constrained if a new building has to be built. Finally, some reserve capacity will be
required with regard to the organizational and administrative staff to allow some increase in the
operation of the firm. In summary, capitalist firms do not choose the plant size which gives them
the lowest cost today, rather they choose that plant equipment which permits them greater
production flexibility for alterations of their production plans in future.
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Figure 11.12: Reserve and Excess capacity
Rs/ Rs/unit
unit
AVC
AVC
Reserve Excess
capacity capacity
0 Ya Yb Output 0 Ya Ym Output
Note that reserve capacity is completely different from excess capacity which emerges
with U-shaped cost curves of traditional micro economics theory of cost (see right hand panel of
11.12). Traditional theory is built on the assumption that each plant is designed without any
flexibility to produce only a single optimal output level (Ym). According to this theory as long as
the firm is producing an output smaller than Ym, say Ya, there would be excess (unplanned)
capacity equaling Ym - Ya. Obviously, excess capacity is undesirable because it leads to higher
unit costs. A vast empirical literature has also been accumulated in support of the shape of the
cost curve shown in Fig: 11.12. Given this it is surprising to see that almost all recently published
microeconomics textbooks are still based on the traditional U-shaped cost curves. The reason for
this adherence of micro economic theory to this conventional shape of the cost curve would be
discussed in the next chapter.
11.4.2: Relation between Short-Run and Long run: The Envelop Curve
Economists derive the long-run average cost curve from short run average cost curves in
a technical way that creates a sense of a neat relationship between the two time horizons. Since
the long run is defined as the duration of time when all factors can be varied, the long run average
cost curve becomes a planning curve of the firm in the sense that it provides guideline to the
entrepreneur in his decision to plan expansion of the output. Let us briefly develop this argument.
Suppose that a capitalist firm has three methods of production each requiring different plant size:
a small plant, medium plant and large plant. The respective average cost curves are shown in
figure 11.13 according to which the small plant operates with cost denoted by SACs, the medium
plant generates cost shown by SACm and so on for large plant. If the firm is planning to produce Y1
level of output, it will choose the small size plant as this is the most efficient size for producing Y1
output. Now assume that the demand for this firm’s product increases gradually from Y1 to Y2. The
average cost of production decreases up to Y* and then starts rising beyond this level of output.
However, if demand increases to Y** level, the firm can either continue to use the small size plant
or install the medium sized one.
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Figure 11.13: Decision making with different plant sizes

Rs/unit
C1 SVCs
C1* SVC
C2 SVCL
0 Y1 Y* Y** Y2 Yo Y3 Output
At this point, the decision does not depend upon the cost factor. It depends on the expectations of
the firm about its future demand situation: if it believes that demand will expand beyond Y**, it
will install the medium size plant because any output larger than Y** can be produced at lower
cost with the medium size plant as compared to the small one. This can be verified by comparing
cost levels at output Y2 with small and medium size plants. Clearly, average cost at the medium
size plant (C2) is smaller than that of the small plant ( C1* ). The firm faces the same kind of
considerations when it reaches Yo level of output where it can work either with the medium or the
large size plants. But the extra investment on the large plant is justified when output is greater
than Yo, say Y3, because this output can be produced at lower cost with the large plant.
Now relax the assumption of only three plants and assume that the available technology
allows many plant sizes (to be precise an infinite number of plants). Each plant size is suitable for
a specific level of output beyond which the firm would want to install a larger plant and, in this
case, the intersection points of consecutive plants would be many in numbers. Figure 11.14
shows the formal derivation of the long run average cost curve with five plant sizes. Each point of
this curve shows the least cost of producing the corresponding level of output.
Two points should be noted carefully regarding the shape of this curve. First, the long run
average cost curve is drawn as an envelop of short run average cost curves because long run
average cost is always less than that of the short run. To verify this fact, go back to figure 11.5.
The right hand panel shows that due to fixed capital in the short run, the firm cannot achieve the
minimum cost level (or tangency) for all levels of output. There is one and only one level of
output where the solution of the cost minimization problem is the same both for the short run and
the long run.
384
Figure 11.14: Long run average cost curve as envelop of short run ones
Rs/unit Constant Returns

to Scale
Increasing Decreasing
Returns to Returns to
Scale Scale
LATC
LATCmin = SATCmin
0 Yoptimal Output
It is exactly this level of output where the short run and the long run average costs would be the
same. For all other output levels, short run average cost would be greater than long run one.
Therefore, all of the short run average cost curves must be above long run average cost curve.
Secondly, the shape of this curve reflects the laws of returns to scale (see figure 11.11). Note that
in the range of output level where the firm is experiencing increasing returns to scale, long run
average cost is tangent to short run cost curves before their minimum. On the other hand, long run
average cost becomes tangent to short run ones in their rising portions where decreasing returns set
in. Finally, both short run and long run cost curves are minimum where constant returns to scale are
the case.
The relationship between short-run and long run marginal cost curves is a bit complex.
Unfortunately, the derivation of long run marginal cost is tedious but, fortunately, not learning it
causes no real harm to students as it adds very little in understanding the upcoming discussions in
the next chapter. Interested students can see any good text on microeconomics (e.g. that by
Koutsoyianis) to take a step ahead in this direction. We will now move on to analyze the supply
decision of the firm within different market structures.
385
Key Concepts
Average fixed cost is fixed cost per unit of output, calculated by the ratio of fixed cost to output
Average total cost measures total cost per-unit of output, calculated by dividing total cost by the
output level
Average variable cost is the ratio of variable cost to output
Choice of technique is the problem of choosing optimal combination of inputs to produce a
specific level of output at given factor-prices
Cost refers to the sum of expenditures needed to produce a given level of output
Diseconomies of scale refers to the phenomenon of increasing long run average cost as the scale
of output expands
Economies of scale refers to the phenomenon of decreasing long run average cost as the scale of
output expands
Efficient scale of production is the point on long run average cost curve where average cost of
production is the least
Expansion path is the set of all cost-minimizing input combinations at all output levels, given
the prices of inputs and knowledge about technology
Explicit cost refers to expenses which the entrepreneur has to pay from his own pocket for the
purchase of inputs
Factor-price ratio is the ratio of input prices—ratio of wage rate to rental rate—and measures the
relative prices of factors
Fixed cost is the part of cost that does not change as output changes and that can’t be avoided in
the short run
Implicit cost stresses the cost of foregone alternative actions though no physical payment is made
against them out of pocket
Iso-cost line represents different input combinations that cost the same amount
Long run average total cost curve is the envelop of short-run average total cost curves
Marginal cost is the change in total (or variable) cost due to change in output
Opportunity cost is the value of second best alternative
Producer equilibrium is the cost-minimizing input combination point where iso-quant and iso
cost line are tangent to each other
Reserve capacity is the fact of designing plants with some flexibility in productive capacity so
that average variable cost curve has a flat stretch over a range of output
Short run total cost is the total cost of production, given some level of fixed factor. It is the sum
of fixed and variable cost components
Short-run Expansion path is the set of all cost-minimizing input combinations at all output
levels, given the prices of inputs, knowledge about technology and the level of fixed factor usage
Variable cost is the part of cost that changes with output
386
Chapter Summary
• Cost is the sum of expenditures required to produce a given level of output. Opportunity cost
is the value of foregone consumption in producing a given level of output
• Opportunity cost theory cannot be applied to an analysis of the behavior of non-capitalist
individuals because capitalist value cannot be ascribed to the product / output of these
individuals
• Algebraically total cost can be written as:
TC = (w × L) + (r × K)
Where TC = total cost,w = te wage rate, r = the interest rate, L and K are total labor
and total capital employed by the capitalist firm
• The microeconomic theory of the firm assumes that every capitalist firm has to accept the
(perfectly competitive) market wage and interest rate as the cost of labor and capital. The
price of the output the capitalist firm produces is also assumed to be fixed and, therefore, the
capitalist firm can effectively choose only the total amount of capital and labor to produce a
given output—it can have no influence over the prices of inputs or output
• Capitalist firms are cost minimizers because they are profit maximizers (non-capitalist and
anti-capitalist firms need not be profit-maximizers. From the capitalist’s point of view the
rational choice of technique (combination of production inputs) is that which minimizes the
(capitalist) cost of producing a given level of output
• The choice of technique problem may be stated as; minimize TC by choosing optimal
amounts of L and K subject to the constraint that the given level of output can be produced
only by using a combination of L and K
• The iso-cost curve shows different combinations of input factors entailing the same total cost.
The slope of the iso-cost curve is given by the ratio of input prices (w/r) where w is the
market wage rate and r the market rate of interest. w/r is known as the factor price ratio and
shows the cost of using one unit of a factor of production (say labor) in terms of the other
factor (say capital)
• Since we assume that w and r are fixed (by the market) and the capitalist firm is a price taker,
all iso-costs have the same slopes and differ only in terms of their vertical intercepts which
reflects the level of costs for which they are drawn. The cost minimization problem is
therefore solved when the capitalist chooses the input combination which produces the
desired output and is on the lowest cost curve
• The cost minimizing input combination is indicated by the tangency of the iso-quant
producing a given level of output with an iso-cost line depicting that same level of cost. The
point of tangency between an iso-cost line and an iso-quant representing a given level of
output indicates capitalist producers’ equilibrium
• The best (i.e. cost minimizing) technique of production (input combination) from the
capitalist point of view is indicated by the equalization of the slopes of the iso-quant and the
iso-cost line. At this point the marginal rate of technical substitution—which is the ratio of
the factor productivities—equals the factor price ratio. This is the cost minimizing input
combination and therefore the best technology of production from the capitalist point of view.
This indicates that the best technology of production for the capitalist firm—the technology
387
which enables it to minimize costs and maximize profit—is indicated by the equalization of
the ratios of marginal productivities to input prices of all inputs used in producing a
predetermined level of output
• For a unique equilibrium input price to be identified for each level of output, iso-quant must
be assumed to be convex to the origin. Otherwise multiple input levels of usage can be
identified for the same input price and this renders microeconomic theory incoherent
• The long run expansion path of a capitalist firm depicts the loci of tangencies between iso-
quant and higher iso-cost curves. In the long run, the firm can vary the use of both inputs,
whereas in the short run one factor is fixed and therefore the line showing the short run
expansion path is usually drawn parallel to the x-axis because one factor of production is
fixed in the short run hence the capitalist firm cannot use the cost minimizing input
combination in the short run
• Comparison between the microeconomic theory of capitalist consumption and capitalist
production are summarized in Table 11.1
• In the short run we must take account of both fixed and variable costs. The short run variable
cost curve is positively sloped with respect to output. Since we assume that wages are
constant there is necessarily a negative relationship between marginal productivity and cost
• The slope of the total cost curve equals the marginal cost. Marginal cost has a negative
relationship with marginal productivity. Marginal cost decreases when marginal productivity
increases, is constant when marginal productivity is constant and increases when marginal
productivity decreases
• When marginal cost is less than average cost, average cost falls and when marginal cost is
greater than average cost average cost rises. Productivity is inversely related to average cost
• Average cost and average productivity are also inversely related
• The average variable cost curve reaches its minimum before the average total cost curve
reaches its minimum because average variable cost is always lower than average total cost in
this short run and because the marginal cost curve is assumed by microeconomic theory to be
positively sloped and to cut both the average total and the average variable cost curves at
their minimum points
• Sraffa rejected the theory of diminishing marginal productivity on the ground that most
capitalist production takes place in conditions of constant marginal productivity. With
marginal productivity fixed, the slopes of the total and variable cost curves also become
constant. On this basis “Sraffian” marginal and average cost curves are horizontal and
average total cost curve decreases and gets closer and closer to the marginal cost curve as
output increases
• Long run average total costs will (a) decrease in the case of increasing returns of scale and (b)
increase for decreasing returns to scale
• The optimum level of production for a capitalist firm thus is at the minimum level of average
total cost. Microeconomic theory assumes that there is one and only one efficient plant size.
But this implies that capitalist firms do not value production flexibility and plan no excess
capacity which can allow them to react quickly to changes in market conditions. This is an
unrealistic assumption
• Planning reserve capacity implies constant average variable cost of production
388
• The long run average cost curve is an envelope of short run average cost curves—the long
run average cost curve is always lower than short run average cost. Short run and long run
average cost curves are at their minimum when constant returns to scale prevail
389
Review Questions
1. Discuss the microeconomic concept of cost and opportunity cost.

2. Distinguish between explicit and implicit opportunity cost.
3. Why cannot the theory of opportunity cost be employed in evaluating the productive
activities of non-capitalist individuals and businesses?
4. What are the assumptions underlying the microeconomic theory of the choice of
techniques?
5. What choice of technique is considered rational by microeconomic theory and why? Would
non-capitalist producers consider this choice of technique to be rational? What would
determine the choice of technique of non-capitalist firms?
6. Discuss similarities between the budget line and the iso cost curve.
7. Geometrically demonstrate the solution to the cost minimization problem using iso-quant
and iso-cost curves. Why does the point of tangency between the curves represent the best
technology for producing a given level of output by the capitalist firm?
8. Show that the cost-minimizing input combination (capitalist technology of production) is
the one where the marginal productivity of all factor inputs is equalized.
9. Why does microeconomics assume that iso-quant is necessarily convex to the origin?
10. Construct a table showing similarities and dissimilarities between the microeconomic
theories of capitalist consumption and capitalist production.
11. Using a diagram, derive the marginal cost curve from the total cost curve.
12. Discuss the relationship between the marginal cost and the marginal productivity curves.
13. Discuss the relationship between average, marginal and total cost curves.
14. Discuss the relationship between the short run total cost and average variable cost curves.
15. What are the similarities and differences between Sraffian cost curves and ‘normal’ cost
curves of neoclassical theory?
16. Explain the concept of ‘economies of scale’ and ‘diseconomies of scale’.
17. Distinguish between the capitalist and the non-capitalist conceptions of “efficient
production level”.
18. “Even capitalist firms do not choose cost minimizing plant size in the short run.” Why?
19. Distinguish excess capacity from reserve capacity.
390
PART FOUR
Firm in the Output
Markets
Foundations and
Justification of
Market Empowerment
Chapter 12: Perfectly Competitive Output Markets

Chapter 13: Monopoly
Chapter 14: Monopolistic Competition and Oligopoly
12
Chapter
PERFECTLY COMPETITIVE
MARKETS
Chapter 12: Perfectly Competitive Market
Economic theory abounds with normative expressions, and ‘perfect competition’ is perhaps
the most value-laden of all of them. The doctrine of “pure and perfect competition” is a central
element both in contemporary economic theory and in the practice of the Anti-Trust Divisions of
the Department of Justice of most capitalist countries. “Pure and perfect competition” is the
standard by which contemporary economic theorists and Justice Department lawyers decide
whether an industry is working ‘rightly’ (competitively) or ‘wrongly’ (monopolistically). This
chapter outlines the widely used model of perfect competition. We begin this chapter with a
definition of perfect competition and its implications. Section 2 analyzes the profit-maximizing
supply decision of the firm and the shut-down rule. In section 3 we discuss the long run equilibrium
of the firm. Lastly section 4 lays the foundation for identifying weaknesses in the model of perfect
competition that we will further develop in the next chapter.
12.1: STRUCTURE OF PERFECT COMPETITION
“Pure and perfect competition” is totally unlike anything one normally means when using
the term “competition”. Normally the word “competition” has the connotation of intense rivalry;
among producers in which each firm strives to match or exceed the performance of all others. But
this is not what “perfect competition” means. Economists define markets as perfectly competitive
if and only if they fulfill the following set of conditions:
 Very large numbers of buyers and sellers are interacting in the market
 A homogeneous product is being exchanged
 Perfect information is freely available to all market agents ( a particularly unrealistic
assumption when information has become a commodity)
 There is free input mobility; i.e. no transaction costs
 There is absolutely free entry and exit for firms—i.e. no barriers whatsoever
12.1.1: Implications
The assumptions could best be understood by reflecting upon their implications. Let us
consider some of them here.
Price Taking Behavior
The first two of these assumptions say that the market should be composed of many small
firms that produce an identical product. This means that each firm should be a small part of the
market; i.e. its share in total market supply should be so small that it does not affect market
supply. Consider for example the market for wheat in Punjab. There are thousands of wheat
farmers, and even the largest of them produces only an infinitesimal fraction of total supply.
Moreover, once wheat produced by each farmer has been collected in huge heaps, no single
farmer can identify his product from that of others. In other words, all farmers produce more or
less identical wheat. This market structure (where many small sellers are selling identical
products of a relatively small category range) leads to price-taking behavior (discussed in
chapter 7). This refers to a market situation where no individual, whether consumer or seller, has
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the power to affect market price of the sold commodity. This is assumed to be so because when
there is a very large number of small sellers in the market, then share of each single seller will be so
small in total market supply that he can produce no significant pressure on market supply by his
individual decision to sell or not to sell at the given market price. Thus all individuals are forced to
accept the price of their products as is given by the impersonal market.
Law of One-Price
The third and fourth assumptions, when combined with the first two, lead to the concept
of the law of one-price—i.e. a commodity can be sold at one and only one price in a competitive
market. This happens due to arbitrage—the practice of making profit by purchasing a
commodity from where its price is lowest and selling where price is higher. To see why this must
be the case, consider what makes it possible for capitalist firms to engage in price-discriminating
policy. Suppose that a similar product, say milk, is sold at two different prices (Rs 32/liter and
Rs.36/liter) in Lyari and Clifton respectively. One possible reason for this price differential to
persist in Karachi markets could be the lack of information on the part of buyers; i.e. buyers may
not be aware of this price differential. A profit-maximizing seller tries to make use of such a
situation by charging different prices from different customers depending upon their demand
intensity (price elasticity of demand) or purchasing power. Application Box 12.1 shows how
jewelers do their best to benefit from imperfect information on the part of consumers. If
customers are simply unaware of differences in prices, price differential will persist.
Imperfect information and Jewelers at Saddar
If you ever visit Sadar Karachi, you would see dozens of jewelers shop all along Zaib-un-Nisa
street. Though all of them are selling almost similar gold (normally 21 and 22 caret), yet you
would experience slight differences in price, ranging from Rs 50 to 100 per gram, if you happen
to visit a dozen shops. Why does this price-differential exist even if there are so many sellers
selling almost identical product? Simply because not all consumers have access to information
about the current price prevailing through the market. Moreover, not all consumers have enough
time and energy to collect price information visiting all over the market before making
purchases. It is this lack of information on the part of consumers that capitalist sellers try to make
profit on.
However Abdullah may be a non-capitalist jeweler. He is not in the market to maximize profit
but to perform his religious obligations. He may be willing to sell at the lowest price required to
maintain a modest income sufficient to sustain his family which practices qana’at and fuqr.
Abdullah may probably discriminate among customers selling at loss making low prices to poor
widows to facilitate the marriage of their daughters. This shows that the law of one price as well
as all other aspects of microeconomic supply theory applies only to the behavior of capitalist
producers in capitalist markets.
Another reason that may result in price differential in capitalist markets is cost of transporting
goods from one place to another—transaction cost. If it costs, say, Rs 2/unit to transport milk
from Lyari to Clifton, then milk may be sold at a price Rs 2/unit greater in Clifton as compared to
Lyari—because it will not be profitable in this case for any capitalist to purchase milk from Lyari
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and sell at Clifton. Finally, prices may be different at two places because capitalist market agents
do not enjoy free entry or exit in the market. For example, even if one knows that price at Clifton
is higher than the price at Lyari, but Clifton Milk Association does not allow outsiders to do
business freely at Clifton and sell at lower prices. So there is no way to eliminate this price
differential.
Now consider the hypothetical perfectly competitive capitalist market where all agents
have perfect and free access to information regarding all profit maximizing aspects (e.g. price and
quality levels), further there is no such thing as transportation cost and all of the agents have got
perfect freedom to move in and out of the market —i.e. they face no barrier against their desire to
maximize utility/profit, whether legal, social or psychological. All individuals and social
organizations are fully committed to capitalist rationally. It would then be impossible to charge
two different prices for the same commodity. Consider the milk example again. If capitalist firms
know that there is a profit margin of Rs 4/liter sold at Clifton, they will practice arbitrage. In this
case, demand for milk will increase at Lyari which will put upward pressure on price at Lyari. On
the other hand, supply of milk would increase at Clifton resulting in downward pressure on price
there. Obviously, the margin of profit will start shrinking. But to what extent? Since we assume
that it costs nothing to move milk from Lyari to Clifton, the arbitrage will continue until prices
are at par throughout the Karachi market—the possibility of making a profit of even a single paisa
is not left unrealized in such a market. Thus, perfectly competitive capitalist markets ensure
single market price for all capitalist agents, whether consumers or producers, and this is the
reason why it is termed ‘perfect competition’. It provides ‘equal’ opportunities to all market
agents. All market participants face one and only one price in the market and all of them have no
power to change this one efficient (profit and utility maximizing) price.
The Fiction of the ‘Horizontal-Demand-Curve’
The most important consequence of the above two implications is the notational fiction of the
‘horizontal demand curve’ assumed to be faced by each single firm in a competitive market. Its
diagrammatic representation is shown in figure 12.1 where the left hand side indicates the market
position whereas the right hand panel shows a single representative firm operating in this market.
The diagram shows that the market price (say, Pc) is determined by the interaction of market
demand and market supply curves; which is the outcome of utility and profit maximization
decisions of all capitalist consumers and firms in this market. Since no single firm can change this
market determined price by its behavior, hence price is fixed for each single firm in this market.
In other words, a firm cannot change market price by adjusting its quantity offered for sale in the
market—it can sell whatever amount it wants at the given market price. This implies that a firm
will be facing a horizontal demand curve which means it has the possibility of selling very large
(or infinite) amount of goods in the market. Note two important things: first the possibility of
selling infinite output does not mean that a firm will actually sell this much amount, the exact
level of output offered for sale by a firm will be determined by its cost structure (discussed
below). Second; no matter how large a level of output a firm produces, its share in total market
output must remain relatively very small because we have assumed a very large number of firms
operate in the market. It is highly important that the market share of no single firm should be
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significant because the moment its share becomes large enough to control market price, the
market seizes to be perfectly competitive as it violates the ‘price-taking behavior’ assumption.
Figure 12.1: Situation of a typical firm operating in a competitive capitalist market
Price Rs/unit
Market Firm
SM
(sum of all firms’
supply
Pc Pc D
(demand curve facing
a single firm)
FC
DM
(sum of all consumers’
demand
0 Yc Y 0 Y
If you are thinking of ‘real world’ markets that are characterized by such an environment;
then you will soon learn that there is no market in this world which is (or has ever been) perfectly
competitive! Markets such as these of wheat and milk may seem come close to this standard;
however no real market can ever be classified as perfectly competitive. For example, consider the
market for wheat. Though it might be true that thousands of farmers produce almost identical
wheat in Punjab, yet the market is not free from transaction costs and entry barriers. If this is the
case, then why do microeconomists study perfectly competitive markets at all; especially when it
is known that such extreme conditions simply cannot hold in reality? FYI Box 12.1 sets out the
reasons for this.
F Y I B O X 12.1
Why Perfect Competition?
Remember that the reason to model such a market is not based on its empirical existence, but on
its capacity to serve as bench mark so as to evaluate real world market structures—the model of
perfect competition is the standard to judge all other market structures in terms of their capitalist
efficiency and quality. Recall from chapter one that the capitalist problem is to allocate scarce
resources efficiently. But the question is: ‘in which sort of environment maximum efficiency can
be achieved?’ Economists hope to show (as we discuss below) that perfectly competitive markets
provide an environment that guarantees efficient allocation of resources; i.e. if we can somehow
turn all markets into competitive ones, then efficiency will be maximum. Economists believe that
any departure from the five conditions underlying the perfectly competitive model means
inefficiency; and the larger the extent to which a market deviates from these conditions, the
greater will be efficiency-loss imposed on society. Remember ‘efficiency’ means maximization
of profit/utility and nothing else.
You might ask: ‘why should we have any standard or ideals at all?’ It is important for economists
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to develop a standard or ideal because economics is necessarily a normative i.e. moral science;
and not positive as claimed, as have been shown at several places in this book. The ideal of
perfect competition serves three basic purposes, as far as capitalist efficiency is concerned:
a. provides the bench-mark to evaluate real world markets (you may think of it as the
criterion of ‘good and bad’ to economists)
b. shows the direction in which markets must be geared
c. justifies appropriate policy tools and regulations required to move markets in that
particular direction
Economists believe that if a society is committed to the achievement of efficiency
(accumulation), it should, and must, strive hard to maximize on perfectly competitive markets.
To them, changes suggested by their theories in the existing social set-up will make this world a
better place because these changes will take the real world closer to their hypothetical ideal
world—a world order based on Enlightenment ideals with endless possibilities of accumulation.
This shows that the dictum of perfect-competition is not a positive-fact discovered through some
inductive observations, but a normative prescription based on dogmatic belief in freedom and
progress. Economics is by no means committed to a description of the world that we live in. It is
a prescription to which the actual world should be molded into. The conviction to subjugate the
fate of our world in the hands of economics is not because of the fact that economists have won
some public election; rather it is based on the belief that economic theory is sound. More on the
importance of this idealized market structure is said later in this chapter (see section 12.4). It
should be remembered that capitalism is a system—a complete and comprehensive way of life.
Every such system defines efficiency on the basis of its own perception of the good. The
capitalist conception of good is the maximization of freedom. The capitalist conception of
efficiency is derived from this conception of the good. In capitalist order the most efficient
pattern of resource distribution is that pattern which maximizes freedom of capital accumulation.
In Islam (and Christianity), on the other hand, the good is defined as achieving Allah’s approval
in paradise. Abdullah Zhaghzai regards that pattern of resource allocation as efficient which
makes it easier to earn Allah’s approval. This pattern of resource allocation universalizes Ibadat
and explicitly rejects the maximization of freedom as a value. Therefore, the capitalist efficient
pattern of resource allocation is the most inefficient form Abdullah Zhaghazai’s point of view for
it maximizes freedom/capital accumulation and the way of life this pattern of resource allocation
promotes makes it more and more difficult for Abdullah to take account of the impact of his
economic transactions on his quest for reaching Paradise. Historically the growth of the capitalist
market has been a fundamental cause of reducing religious consciousness and in delegitimating
the religious essence of production, consumption and exchange.
12.1.2: Revenue Structure of the Competitive Firm
Working out revenue structure of a competitive firm, is a straight forward matter. We

need revenue structure of the firm before analyzing its profit maximizing supply decision because
profit is the difference between revenue and cost; i.e.
Profit (π) = Total Revenue (TR) - Total Cost (TC)
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Behavior of cost has been discussed in the last chapter in detail; let’s deal with the second part on
the right hand side of this equation. Recall that total revenue equals price times output:
Total Revenue = Price × Output = P × Y
Since the competitive firm is a price taker; so price is fixed which gives:
TR = P × Y (12.1)
This means that total revenue is a linear function of output—i.e. the total revenue curve must be a
straight line. To see how, consider table 12.1. You can see that total revenue in the third column is
increasing by a constant amount, five, every time output increases by one unit. This translates into a
straight line total revenue curve as shown in the left hand panel of figure 12.2.
Table 12.1: Relation between MR, AR and Price

1 2 3=1×2 4 5=3÷2
Price Output Total Revenue Marginal Revenue Average Revenue
5 0 0 - -
5 1 5 5 5
5 2 10 5 5
5 3 15 5 5
5 4 20 5 5
Such a straight-line revenue curve bears an important relation between price, marginal
revenue (MR) and average revenue (AR). Marginal revenue is the change in total revenue due to
one unit change in out put:
Change in Revenue ∆TR
MR = = (12.2)
Change in Output ∆Y
Figure 12.2: Revenue structure of a competitive firm
Rs Rs/unit
TR
15
10 5= P D = AR = MR
0 1 2 3 Y 0 Y
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For example, marginal revenue from selling the first unit of output is Rs 5, from the second it is
again Rs.5/-, and so on (see column 4). The last column measures average revenue which is
given by the ratio of total revenue to output:
Total Revenue TR
AR = = (12.3)
Output Y
Again, for example, average revenue of selling two units of output is Rs 5 [= 10 / 2], of three
units it is Rs 5 [= 15 / 3]. Note very carefully the difference between marginal and average
revenues: the former measures revenue earned on selling an additional unit of output while the
letter measures revenue per unit of output.
The important thing to note from this table is that price, marginal revenue and average
revenue are always equal for all levels of output (look at columns 1, 4 and 5]. So, we can say that
for a competitive firm; P = AR = MR. The intuitive as well as algebraic derivation of this result is
straight forward. First consider price and average revenue. We can show that by definition
average revenue is equal to price-- price measures average revenue because price itself is revenue
per unit of output. Using expressions (12.1) and (12.3) we have:
TR
AR = =P (12.4)
Y
This means that average revenue and price must always equal each other. Now consider price
and marginal revenue relationship. If price is fixed for all units of output, then each extra unit of
output will earn an amount of revenue equal to price—if price is Rs 5/unit, then each extra unit
sold will bring extra revenue of Rs 5 for the firm, thus establishing equality between price and
marginal revenue. To see this algebraically, use (12.1):
TR = P × Y (12.1)
With price being fixed, if output changes by some amount, say ΔY, total revenue also changes by
some amount ΔTR. So we have:
∆TR = P × ∆Y
Dividing throughout by ΔY we get the desired result:
∆TR ∆Y
MR = =P =P (12.5)
∆Y ∆Y
With price equaling both average and marginal revenues, we have P = AR =MR—exactly what
we wanted to show. The relevant curves are depicted in the right hand panel of figure 12.2 where
a single horizontal line represents demand, average revenue and marginal revenue of a
competitive capitalist firm all equal to market price.
12.2: PROFIT-MAXIMIZATION AND FIRM SUPPLY
12.2.1: Choice of the Scale of Output
A capitalist firm exists in order to maximize profit by undertaking production and

exchange. As far as production is concerned the firm faces two problems; the first is the choice of
production technique (how to produce output), and the second is the choice of output-scale (how
much output to produce). The solution to the problem of choice of technique was discussed in the
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previous chapter where we outlined how a profit-maximizing firm makes choice about the
combination of inputs to produce some given level of output. Here we will discuss the second
part of the question, i.e. the choice of the scale of output. The formal way to express this problem
is:
Max π = TR − TC
(Y )
or (
Max π = PY − wL + r K
(Y )
)
From our discussion of the input demand decision (L and K) in the previous chapter, we get:
(
Max π = TR − TC = PY − wL + rK
(Y )
) (12.6)
So the only choice variable remaining is with respect to output (Y). Expression (12.6) says that
the firm tries to ‘make the difference between total revenue and total cost as big as possible’.
What is the firm choosing? It is ‘level of output’. Alternatively, the firm wishes to choose that
level of output where profit is maximum (i.e. difference between cost and revenue is the greatest).
The ‘Total-Condition’
The graphical solution to this problem is shown in the three layered diagram 12.3. Note
that all three panels plot different variables against output: the upper one plots total revenue and
cost, the middle one shows profit while the lowest panel depicts marginal revenue and cost
against output. Consider the upper panel first. Here the total revenue curve is plotted as a straight
line as shown above while the total cost curve takes its standard shape from chapter 11. The
vertical difference between the two curves at any output level measures profit. Only points a-to-e
on this diagram have analytical importance to understand the issue at hand. Let’s take them one
by one.
o Consider output level zero [Y = 0] first. At output equaling zero, total revenue is also zero.
But total cost is not zero at Y = 0 due to the fixed cost element; it is positive at point a
[distance 0a]. Therefore profit must be negative at Y = 0 [π = TR – TC < 0]. This gives us
point a in the negative quadrant of the middle panel which indicates negative profit (or loss).
Note that profit is negative exactly by the amount -a.
o Now consider point c where output is Yc [Y = Yc]. It is clear that total revenue and cost both
are equal at this output level, so profit must be zero here. The same is the case at point e with
Y = Ye. So we get points b and e in the middle panel along the horizontal axis indicating zero
profit at outputs Yc and Ye
o We are now left with segments 0c and ce. Consider first the segment 0c where the total cost
curve is above total revenue [TC > TR] which again means negative profit in this whole range
of output. Further you can see that difference between the two curves is increasing initially
and after reaching a maximum it then starts decreasing
How should one locate the maximum-difference point between these two curves? The rule
says that their difference will be maximum where their tangents are parallel. Since the tangent
of the total revenue curve gives the slope of total revenue whereas the tangent of the total cost
curve measures its slope, so we have the condition that negative profit (or loss) is largest at
point b where slopes of total revenue and cost are equal. To the left of b (from output 0 to Yb)
loss is getting larger therefore the profit curve is falling at point b we have maximum loss so
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the profit curve is flat at this point. Finally between point b and c the difference between
revenue and cost starts decreasing, therefore the profit curve becomes positively sloped in the
negative axis indicating that loss is now decreasing (or profit is increasing)
Figure: 12.3: Solution to the profit maximisation problem d

TR
TC
TR, TC
Maximum
Profit e
0 Yb Yc Yd Ye Y
Profit
c e
0 Yb Yc Yd Ye Y
-a
b
MR, MC
b d
P MR = AR
0 Yb Yd Y
o The case for segment ce is exactly the same, with the only difference that profit will be
positive in this whole range because total revenue is greater than total cost. Again we can
divide segment ce into segments cd and de. Between points c and d, the difference between
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revenue and cost is increasing, therefore the profit curve is rising. But between d and e profit
starts decreasing; therefore the profit curve becomes negatively sloped to become zero at
point e. obviously, profit is maximum at d where slopes of the two curves are equal.
You can now easily answer the question at ‘which output level will a profit maximizing firm
produce. Clearly, if a firm is committed in producing output level associated with the maximum
profit, then it must produce at Yd level of output. We thus have the general rule that the profit-
maximizing firm produces output at the point where the vertical difference between total revenue
and cost is largest. Alternatively, it is the point where the slopes of total revenue and costs are
equal. But one small ambiguity is still left. The rule that ‘profit is maximum where slopes of
revenue and costs curves are equal’ does not seem to be complete because the slopes are equal at
two points; i.e. b and d with profit being minimum at point b and maximum at d. Now how to
make this rule a comprehensive one? The complete statement goes as follows: ‘profit is largest
where the slopes of total revenue and costs are equal and total revenue is greater than total cost.
Total Condition for profit maximization
where Slope of TR = Slope of TC and TR > TC (12.7)
Marginalism: the Per-Unit-Condition for Profit Maximization
The same result can also be explained in per-unit terms using marginal analysis indicated
by the bottom panel of this diagram. Recall that marginal revenue is the slope of the total revenue
curve ; i.e. MR = ∆TR ∆Y . Since the slope of the revenue curve is fixed as it is a straight line,
therefore MR-curve is constant. The marginal revenue (the slope of total revenue) curve is
therefore drawn as a straight horizontal line in the lowest panel, just like the one in figure
12.2.curve. The standard, initially decreasing and then increasing, marginal cost curve from
chapter 11 is also drawn in the lowest panel. Where would the two curves intersect? Since
marginal revenue is the tangent of the total revenue curve and marginal cost is the tangent of the
total cost curves. Therefore the two marginal curves will intersect at points where the tangents of
the two total curves are parallel and, hence, equal in the upper panel—at points b and d. This
implies that profit will be maximum (or minimum) where MR and MC curves interest each other.
Thus, the condition (12.7) for the profit maximizing level of output can be restated as: profit is
maximum at output where MR = MC. However the equality of marginal revenue and marginal
cost does not guarantee the maximization of profit. Why? It is simple to see that the above
condition holds at two points, b and d, and profit is minimum at point b. To complete the profit-
maximization rule in terms of marginal analysis, we define it as:
Marginal Condition for profit maximization:

where MR = MC and MC-curve cuts MR from below (12.8)
Economists normally prefer to use the marginal-condition to express the profit-

maximization rule as it has intuitive meaning. Let’s explain the two-intersection points of the
marginal revenue and cost curves. At point b, with output Yb, consider a small increase in output
from Yb. Increasing output increases both total revenue as well as total cost as can be seen in the
top panel. But since MC is now below MR, total revenue increases by more than total cost. For
each unit past Yb, total revenue goes up by amount P (price per unit) while total cost goes up by
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MC which is less than P. This means that the increasing output from Yb increases profit of the
firm. So point b is not a profit maximization point; rather it is the point where profit is minimum.
On the other hand, if you consider increase in output at the point d, increase in revenue is given
by P while increase in total cost is measured by MC which is more than P. So profit decreases
beyond output Yd, showing that d is the point where profit is maximum. Thus we find that as long
as:
1. MR > MC, increasing output will increase profit as total revenue will be rising by more
than total cost
2. MR < MC, increasing output will decrease profit as total revenue will rise by less than
total cost
3. Only when MR = MC profit will be maximum because both total revenue and cost will
rise by the same amount
12.2.2: Firm Equilibrium and Derivation of the Supply-Curve
We now ask a question regarded as very important as critical by macro economic theory;
what quantity of output would a competitive capitalist firm be willing to supply at any specific
price? The firm is assumed to produce that level of output which maximizes its profit i.e., where
marginal revenue is equal to marginal cost. Since, as noted above, marginal revenue also equals
price for a competitive firm, thus implies that profit-maximization occurs at the point of equality
between price and marginal cost:
Short run equilibrium condition for the capitalist firm:
P = MC (12.9)
This says that at any specific price, a competitive capitalist firm will produce at the point where
its price is equal to marginal cost of production. This is shown in the left hand panel of figure
12.4 where at price P, the firm supplies output level Yd.
Figure 12.4: increase in price leading to rise in quantity supplied by the firm
MR, MC MR, MC
MC MC = S
f
P MR1=AR1
d MR = d
P AR P MR = AR
0 Yd Y 0 Yd Yf
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If it tries to produce more, the marginal revenue (equaling price P) would be less than marginal
cost, so profit will decrease. On the other hand, a reduction in output below Yd reduces revenue Y
more than reduction in cost, and thus profit must also decline. Point d is therefore the short run
equilibrium of the capitalist firm. It is called as equilibrium point because the capitalist firm will
not want to change its supply-decision from this point unless some outside variables undergo
some change. For example, if the market price increases to, say, P1 as in the right hand panel, the
capitalist firm will then increase output supplied to Yf where marginal cost equals price P1. Thus,
we obtain two important results: (a) the supply decision of a competitive capitalist firm always
occurs at points on the MC curve, (b) increase in market price leads to an increase in quantity
supplied. This means that the positively sloped marginal cost curve is itself the supply curve of
the capitalist firm. But a small modification is required in this statement. In order to explore that
restatement, let’s analyze the situation in which a firm is making losses in the short run.
Profit-and-Loss
The amount of profit/loss earned by a firm can easily be calculated by measuring the
vertical difference between total revenue and total cost in the total-diagram (the top panel of
figure 12.3). However, the case of the per-unit diagram (bottom-panel) requires some more
information for the calculation of profit at any specific output level. Note carefully that the MR =
MC equality tells us only about the profit-maximum level of output, it does not tell us anything
about how much profit the firm is making at that output level. In order to determine profit/loss
associated with the profit-maximizing level of output in this diagram, we need to look at the
average total cost curve as well. To see this, recall that profit is given by:
π = P×Y - TC
To obtain profit in per-unit terms on the right hand side, note that total cost also equals average
total cost times output [TC = ATC × Y], so we have:
π = P×Y - ATC×Y
or π = (
P − ATC ) × Y

(12.10)
Profit/loss per unit
The bracketed term, price minus per-unit cost, gives profit per-unit of output produced. This
multiplied by the number of output units (Y) produced gives total profit (π). For example, if price
of a commodity is Rs 10 and ATC is Rs 5/unit, then profit per-unit of output will be Rs 5 (= Rs 10
– Rs 5). Now if a firm decides to produce 50 units of the output, profit will be Rs 250 (= Rs 5 ×
50). Thus we find that in the per-unit diagram, we need the ATC curve in order to calculate profit.
This is drawn in figure 12.5. The left hand side shows the case when price is greater than per-unit
cost of producing Yd output and, therefore, the firm is making a profit equal to the amount of the
area AbdP (the white shaded area). To see how, note that the height of the ATC curve at any level
of output, say Yd, gives per-unit cost of production, which is here amount 0A (say Rs 5). The
difference between price P (say Rs 10) and A measures profit earned per-unit of output. Finally
profit-per unit multiplied by the units of output Yd gives total profit. The right hand of Figure
12.5 side shows the case of a firm making loss in the short run because average total cost is
greater than price per unit here. The loss equals amount PdcA (the white shaded area). Now the
question is: what should the capitalist firm do if it is making losses? Should it continue operation
or stop production; i.e. shut down?
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Figure 12.5: Profit and loss in the short run
Rs/un Rs/un
Loss MC
Profit ATC
MC
c
ATC A
d
P MR P MR
= AR d = AR
A b
0 Yd Y 0 Yd Y
The Shut-Down Rule and the Supply Curve
One might be tempted to say that the capitalist firm should shut down its business the
moment losses begin to occur. However, a capitalist firm will normally not do this. The logic for
shut-down is straight forward: if a capitalist firm is making loss, then profit maximization
requires it to minimize its loss. The shut-down rule can be expressed in three equivalent ways:
a) Comparing fixed cost and operating loss: when a firm is losing money in the short run, it
should compare its fixed cost and operating-loss (OL)—loss incurring in operation. To see
why, note that the firm loses all its fixed cost in case it shuts down operation completely
because fixed cost cannot be avoided anyhow. So a profit maximizing firm will compare
losses that occur in the two scenarios, loss in case of continuing operation (i.e. OL) and loss
in case of shutting down (i.e. FC). Therefore, the rule as:
• If OL > FC → Shut down
• If OL < FC → Continue operation
b) The above rule can also be expressed alternatively by comparing variable cost and total
revenue. Note that variable cost measures costs that can be avoided by shutting down the
business as these costs include only those components of costs that are required to keep
business in operation. The rule therefore is :
• If VC > TR → Shut down
• If VC < TR → Continue operation
As long as firm is able to cover its running cost completely and some part of fixed cost as
well, it should continue its business because shutting down will involve losing all of the fixed
cost. On the other hand, if revenue is not enough to cover even the variable cost, then it
should shut down the business because that will minimize loss—the capitalist firm will only
lose its fixed cost by shutting down, while with continuing operation it will not only be losing
its fixed cost but also its variable cost.
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Figure 12.6: Expressing shut-down rule
Rs/un Rs/un
Loss Loss
MC
MC
ATC
ATC
c
c A
A
P MR g AVC
d V
V AVC = AR MR
g P d = AR
0 Yd Y 0 Yd Y
c) A third way of expressing the capitalist shut down rule can be obtained by dividing the
second one by Y:
VC TR
• If > or AVC > P → Shut down
Y Y
VC TR
< or AVC < P → Continue operation
Y Y
This simply says that when price is less than average variable cost—when price does not cover
AVC— a capitalist firm should shut-down its business. This third expression is the easiest one is
illustrated in figure 12.6. In the left hand panel, price is greater than AVC, so capitalist firm
should continue operation. The right hand panel shows the case of shut down with price being
less than AVC. Note that in this case the operating loss (PdcA) is greater than fixed cost (VgcA)—
the difference between average total and variable costs time output [FC = AFC × Y = (ATC -
AVC) × Y]. Application Box 12.2 shows how capitalist firms put this decisions rule into
application even during Ramdan.
Capitalist Restaurants During Ramadan
Have you ever visited a restaurant during day time in Ramadan in Karachi or Lahore? Surely,
you would find it almost empty. Clearly, the revenue made from the few customers could not
possibly cover the total cost of running the restaurant. Then why don’t restaurant owners shut
down their business during day time? While deciding whether to open for lunch, capitalist
restaurant owner must keep in mind the distinction between variable and fixed costs. Many
restaurant costs; e.g. rent, kitchen equipments, tables, crockery and so on, are fixed, so shutting
down the restaurant would not reduce these costs. Therefore, in order to decide whether to serve
lunch, capitalist owners should only consider variable costs; e.g. the price of the additional food,
the wages of the extra staff and electricity bill. The shut-down rule says that the capitalist owner
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should shut-down the restaurant at lunch-time only if the revenue from the few lunchtime
customers fails to cover the restaurant’s variable costs.
However, such reasons will only attract a profit-maximizing capitalist businessman such as Bill
Gate. Abdullah Zhaghazai would, of course, dismiss the idea of opening up restaurant during day
time in Ramadan because he would not like to participate in the sin by offering lunch facility to
those who do not fast in Ramadan. Even the very idea of creating new opportunities of making
profit by employing marketing tactics—say by giving price offers—would be considered sinful
by him. On the other hand, he would see the day time as an opportunity to raise his status in the
sight of Allah by obtaining moral purification while spending time in prayer and seeking
repentance. Economic theory fails to explain the behavior of society if capitalist rationality of
utility and profit maximization is rejected by the majority of the individuals within society. The
behavior of non-profit maximizing non-capitalist firms cannot be analyzed on the basis of
microeconomic theory of supply. This again illustrates that microeconomics is a normative and
not a positive discipline.
This analysis shows that when price is less than average variable cost the capitalist firm
will shut its business down in the short run and will not supply anything in the market. As long as
price is above average variable cost the capitalist, firm will continue its production along its
marginal cost curve—i.e. where marginal cost is equal to price. Thus we find that:
MC-curve above AVC is the supply curve of a competitive capitalist firm
Figure 12.7 draws the supply curve of such the firm as the segment of MC above AVC curve (the
cut-marked segment of MC-curve).
Figure 12.7: The capitalist firms Supply curve
Rs/unit
MC = S
AVC
0 Y
Market Supply Curve
We learnt in chapter 3 about how to derive the market demand curve from individual
demand curves. Economists believe that the market supply curve can also be obtained in a similar
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manner, i.e. by aggregating individual firm’s supply curves horizontally. The idea is that if each
of , say 50, firms supply, say 10 units, of output at the going market price, then market supply is
500 units [= 50 × 10]. Thus we add up quantity supplied by all firms at each price to arrive at the
market supply function as:
S M (P, w, r ) = Market Supply at Price P = ∑ j S j (P, w, r ) (12.11)
where Sj (P, w, r) is the supply function of each of the firms labeled j, and Σj means we add up
quantities of all j firms. The terms in brackets (P, w, r) show functional dependence of quantity
supplied— output supply depends on its own price and input prices. The formal procedure of this
derivation has already been discussed in chapter 3 [figure 3.11], so it will merely be a repetition
to reproduce it here. Some economists have raised objections to such a deviation (discussed
below).
12.3: TRANSITION TO LONG RUN EQUILIBRIUM
The preceding section shows that it is quite possible for firms to make positive or
negative profit at some going market price (see figure 12.5). But the question is: can such a
position continue for long in a competitive market with no barriers to entry or exit? To answer
this question, let’s take this issue step by step. Since the only real world case where the
neoclassical model of competition may be applied with some degree of practicality is for
agricultural products, market we consider the market for vegetables in Mandi Bahauddin as an
example.
Market Period Supply
Usually in Mandi Bahauddin, trucks arrive at night with new supplies from nearby farms and the
produce is sold during the day. If the vegetables can’t be stored, even over night, during
summer—then must either be sold or disposed of somehow. Let’s consider the market for
tomatoes (which quickly go bad) where sellers are trying to sell off their produce by the end of
the day. The market period for fresh tomatoes is the single selling day. More generally, the
market period refers to the time duration when the supply quantity available for immediate sale
cannot be increased. Before additional tomatoes reach the market next night, the amount available
for sale during the market period is fixed. This fact is represented by a vertical supply curve, as in
figure 12.8 at quantity To which shows the quantity of homogenous tomatoes available for sale
during the market period at whatever price they can bring. Assume that it is a normal day and
demand is Do. Now if the supply-demand model is appropriate for this market, then the
equilibrium price would be Po where all tomatoes are sold out during one day. See Application
Box 12.3 on how price adjustment takes place according to economists / theory.
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Figure 12.8: Market period equilibrium
Price
So
P1
Po
D1
Do
0 To Tomatoes
A Story of Price Adjustment in Mandi Bahauddin Fruit Market
If you ask your economics teacher how would the price Po actually reached in reality, he would
offer you a competitive process as its description: if one vendor’s price is too high compared to
others, then capitalist buyers are not likely to buy from that stall. Charging higher price does not
pay if a seller is unable to sell much, he will gradually adjust price down. If all vendors have set
too high a price, then all would notice that their sales are too low, compared to normal, and they
will begin to adjust prices. Further each would see that other vendors are also selling slowly,
which would reinforce the assessment that the price was set too high. Price setting goes on until
ultimately equilibrium price is arrived at and competition thus removes the power of a vendor to
set price arbitrarily in capitalist market: But this applies only to capitalist markets. Suppose the
price of tomatoes is Rs. 50 per kilo and suddenly a large number of new buyers arrive at the
market. If the tomato sellers at Mandi Bahaudin are capitalists they will see this as an opportunity
to increase profit and as microeconomics theory says price will rise to a new level.
If, however, sellers are like Abdullah Zhaghazai they will not raise prices but will be glad to sell
all their tomatoes as soon as possible. The Market will close in time for Asr Prayer instead of at
Maghrib. Once again we see that microeconomics theory is unable to explain the behavior of
Abdullah Zhaghazai and all non-capitalist buyers and sellers.
The description of price determination in the above box seems persuasive, but it ignores an
important element of competitive capitalist markets and that is the law of single price for all
market agents at all times—the explanation pays no attention to the buyers who arrive early on
the day when vendors start with a high price and adjust later in the day due to slow sale! These
early capitalist buyers face only the non-equilibrium price and buy less than what they would
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have bought later in the day at a lower price. This means that if price is set by the above kind of
trial-and-error competitive mechanism, then not all buyers face the same price in the market and,
hence, everything does not happen in equilibrium. It is in fact to avoid this problem that
economists assume that all market exchanges take place after the equilibrium price has been set.
Why can’t the economic model afford to allow exchange of goods at out-of equilibrium prices?
One reason is that this disturbs distribution of income—above equilibrium, sellers gain income
while below equilibrium they lose in favor of buyers—which as a result will change the position
of market demand curve (as discussed in chapter 8 that changes in income distribution affects the
position of the market demand curve). Since there is a possibility that non-equilibrium prices
might never converge to equilibrium, economists have invented a fiction to avoid this problem
which allows no trades in any market until all markets are in equilibrium. According to this
fiction, price is set by an impartial and costless ‘auctioneer’, a hypothetical individual who
coordinates market exchange. He announces to all decision takers a single market price which
they take as a parameter in making their choices of demand and supplies. All of them record their
choices with the a ‘market umpire’ who aggregates them to find excess demand or supply at the
announced price. He then revises the announced price, and the process continues and no trading
takes place until and unless equilibrium price is reached where sellers deliver exactly what
demanders want to buy. This mechanism is termed the tatonnement process by economists.
Remember that the so called price-determination story, just as the one in Box 12.3, given in
economics textbooks and often by your teacher to relate the theory of perfect competition to real
market process is fallacious because the theory of perfect competition works on the assumption
that everything happens in equilibrium which in fact is never the case in reality.
Capitalist markets can never be in equilibrium for as a famous twentieth century
economist Joseph Schumpeter has shown that this negates progress, which is a central capitalist
value. Why then this insistence on analyzing equilibrium situations? It is simply because
economics is a moral and not a positive science. Equilibrium outcomes are produced when buyers
and producer display complete capitalist rationality (absolute commitment to aggregate
profit/utility maximization as the sole legitimate end in itself). Equilibrium outcomes are the
optimum in the sense that actual behavior of decision takers must be judged on their basis, policy
must force all buyers and sellers, traders and consumers to behave on the basis of capitalist
rationality. Hence the microeconomics emphasizes on equilibrium as the supreme value
determining criteria in all capitalist markets.
We leave the nonsensical price-determination process at this stage and move on to see
how, according to economists, market adjusts from market period equilibrium to the short run
one. Suppose that T.V. programs broadcast that tomato is an important diet element to preserve
health. Figure 12.8 shows its effect as increase in demand from Do to D1 during the market
period. Since the trucks have already delivered tomatoes before new health advertisements,
supply has not adjusted at all in the market period while the price has been increased to P1.
However, during the next few days and weeks, capitalist tomato growers can adjust production
somewhat in response to the increased price. The short run is defined as the time period when
firms have some inputs fixed but can change output by adjusting variable factors. Thus the short
run supply curve is upward sloping as shown in the left hand panel of figure 12.9 with new
equilibrium price at P2. This price is below the market period price P1 due to increased supply
while quantity sold is also increased to T2. The right hand panel shows the decision of a typical
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capitalist competitive firm producing t2 quantity in the short run. Market supply T2 is the sum of t2
quantities produced by each firm in the market; i.e. T2 = Σj t2 of all j firms operating in the market.
By what channels did quantity increase in the short run? Response to market period change in
price may come from several sources. First, consumers in the vegetable market may compete
against other uses of the same tomatoes. Tomatoes can be frozen, can be sold at other vegetable
market, can be sold to companies making ketchups etc. If price of tomatoes is increased at the
Mandi Bahauddin market, tomatoes are bid out of its other uses. Some tomatoes may have been
stored for the short period of time and increase in price would bid them out of inventory.
Increases in price may even cause capitalist producers to increase their variable factors and,
hence, increase the quantity of tomatoes offered for sale.
Note that the price is still high enough to create long run disequilibrium in the sense that
firms are making super normal profit at price P2. Point e is not a position of long run equilibrium
because this profit creates incentives for new firms to enter in the market, and hence quantity will
further adjust to some other level. Recall that equilibrium is defined as a state where no agent,
whether a potential entrant or an existing market participant, would want to change his/her
decision. So far we have discussed up to the point we reached in figure 12.5. What happens when
new firms enter into the market?
Figure 12.9: Short-run Equilibrium
Price Rs/un
SMP
Prof MC = SF
SSR
P1 P
ATC
e
P2 P MR=AR
A
Po b
D1
Do
0 To T2 Tomato 0 t2 Tomato
12.3.1: Moving to Long Run Equilibrium
New entrants in the market mean that the market supply curve shifts outwards leading to
a fall in price. As price falls, the demand curve for the individual firm falls downward. Not only
does that profit attract new entrants, existing capitalist firms also adjust their plants so as to
achieve minimum point of their long run average total cost curve. Obviously, as new and existing
firms tend to expand their output, demand for some inputs will increase which means there will
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be changes in the cost structure of the firms. Clearly, as market price falls, profit margin will
decrease for all firms in the market. For how long will new firms continue to enter? Simple, if it
is profit that attracts new entries, firms will continue to enter as long as all profit opportunities
have not been fully exploited; i.e. entry stops when super normal profit is zero. Figure 12.10
shows adjustment to the long run equilibrium position. Since the firm was making profit at price
P2 in figure 12.9, therefore it has the incentive to build new capacity while new firms are also
entering the market. As quantity supplied increases in the market, the market supply curve shifts
to the right and price falls until it reaches the level P3 where all profits are eliminated from the
market. This means that all firms are making zero super normal profit in the long run. Thus the
long run equilibrium for firm is defined where marginal cost, average cost and price are all equal:
Long run equilibrium condition for firm P = MC = ATC (12.12)
Note that at long run equilibrium, the firm has adjusted its plant size so as to produce that level of
output where average total cost is the minimum possible; i.e. it uses its plant at its most efficient
level.
Figure 12.10: Long-run Equilibrium
Price Rs/unit
SMP
Zero economic profit
Long run equilibrium
SSR SSR1 MC = SF
P1 P1
ATC
P2 P2 e
P3 P3 MR=AR
Po
D1
Do
0 To T2 Te Tomato 0 te Tomato
The Meaning of Normal Profit
The idea of firms earning zero-profit in the long-run often seems surprising to the
students: after all why do capitalist firms enter business if they earn nothing at the end of the day?
Note that zero economic (normal) profit does not mean zero accounting profit. To see this, recall
that economists define cost differently from accountants. To economists, cost includes both
explicit as well as implicit costs. Given this, economic and accounting profits can be defined as:
Accounting Profit = Revenue – Explicit Cost
Economics Profit = Revenue – Explicit Cost – Implicit Cost
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You can see that a part of what accountants include in profit is treated as cost (reward of the firm
owner) by economists, so even when economic profit is zero accounting profit may not be. Let us
go back to our tuition fee example of chapter 11 (see table 12.2).
Table 12.2: Tuition fee example revisited

Fee collection Rs 1000
Wage bill Rs 500
Profitaccounting Rs 200
House rent Rs 100
Implic
it cost Personal wage Rs 50
Profiteconomic Rs 50
The accounting profit of this firm is Rs 200 which does not include implicit costs; i.e. rewards of
personal labor and house rent of the owner of the business. If market value of these two inputs is,
say, exactly Rs 200, then economic profit will be zero while accounting profit will still be Rs 200.
In this case, what accountants count as profit will be termed as reward for personal labor and
house in this particular business by the economists. How does competition force economic profit
to become zero?
To understand this, think what if, instead of running the coaching center, the house was
rented and the tutor sold his labor at the market wage rate. Suppose that market house rent is Rs
50 (per month), while market wage rate is Rs 100 (per month), then the market value (MV) of the
owners personal inputs will be Rs 150 (per month). Since accounting profit, Rs 200, shows what
these inputs earn in this particular business, thus we find that market value of these inputs is less
than what they fetch in this particular business. In other words, the reward for these inputs in this
particular use is greater than their second best use in the market. This excess earning will attract
other capitalists to enter the coaching center market by starting their own coaching centers and
renting out their houses for tuition centers instead of for housing. The entry will continue until all
super-normal earnings on these factors in this particular use are driven down to their market
value. This will be the level where economic profit turns out to be zero; i.e. where accounting
profit exactly equals market value of personal inputs. As long as economic profit is positive in
any particular business, some input must be getting more than its normal market reward. It is for
this reason that positive economic profit is considered super-normal profit while zero economic
profit is termed normal profit. Remember that when firms are earning zero economic profit, they
are earning normal accounting profit—all inputs are getting their normal market rewards.
The case of the firm making a loss—negative economic profit—is now straight forward.
For example, if market value of personal inputs is Rs 250 while accounting profit in this business
is Rs 200, then the capitalist would be better off by renting out his house and working in the
market instead of doing this business. In other words, firms will transfer resources from this use
to another until economic profit is again zero for all existing firms. Thus, normal profit is one
which is necessary to keep any input in its current use, and that is its market value in the second
best alternative.
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Alleged Efficiency of Competitive Markets
Recall from chapter one the basic question that economics is supposed to address: This is
to identify where resources could be allocated most ‘efficiently’ i.e. so allocated that profit is
maximized. Theory claims that this happens in competitive markets. In other words, competitive
markets provide the basis for achieving maximum efficiency. To see why economists make this
claim, note that long run competitive equilibrium is said to be efficient in two senses:
(a) The competitive process leads to long-run equilibrium where average total cost is at its
minimum possible for all firms as shown in figure 12.10. This means that in the long run,
all firms use their plant size such that average total cost of production is the lowest.
Alternatively speaking, production takes place at efficient scale of production in
competitive capitalist markets. This is called cost efficiency
(b) The competitive process also leads to allocative efficiency which refers to the market
situation where resources have been allocated in a way that maximizes total utility. A firm
is said to be allocative efficient when it produces output where price is equal to marginal
cost of production. This is so because price of a product, according to neoclassical theory,
measures the value that society as a whole places on its consumption while marginal cost
measures the effort and resources required to produce that particular product. Only when
price and marginal cost are equal that total utility will be maximum—society is sacrificing
for the last unit produced exactly what it is receiving from its consumption (detailed and
graphical representation of allocative efficiency is given in the next chapter). The above
discussion reveals that perfectly competitive firms produce output in the long run where
marginal cost equals price; i.e. they are allocative efficient in the sense that they generate
maximum total utility.
12.3.2: The Real Politics behind Competitive Markets
The previous section has given the conventional proof of why economists believe
capitalist markets to be the most efficient (i.e. profit and utility maximizing) way of allocating
resources. The model of perfect competition was developed explicitly for legitimizing particular
capitalist practices. From the above analysis, three strong policy implications are derived by
economists.
A Night Watchman State
Competitive markets based on free exchange achieve efficiency in resource allocation

(i.e. an allocation of resources which maximizes profit and utility) without the presence of any
benevolent social planner. The message is that no central planning by some non-market agent,
e.g. government, is needed to attain efficient outcomes (profit/utility maximization) because the
sum total of individuals’ tastes and talents guided by their own self-interests are sufficient to
achieve this objective. Greed of one man is considered to be the adequate check on that of another
and universal greed is assumed to work out the highest attainable utility. If it is the case that
markets automatically attain efficient, equitable and stable equilibrium (i.e. maximization of
profit) neither the state nor the church have any rights to interfere in the process of resource
allocation. Economists regard any interference by the state in price determination as necessarily
416
evil. Every individual has an inalienable right to determine his own preferences—the state and the
church has no rights to tell him what he is ought to prefer and value is determined in the market
by the voluntary interaction of such autonomous individuals. The state has no role in value
determination.
Cut Throat Markets
We saw that it was quite possible for firms to make super-normal profit in the short-run
which is regarded by some economists unfair in the sense that some factor is receiving more than
its opportunity cost. If, however, entry is free, then the long run competitive equilibrium is
characterized by zero-economic (normal) profit for all firms in the industry. This means that the
possibility of making super-normal profit using entrepreneurial talent is constrained by the threat
of new entry. The power of influencing market price by firms is removed from them by the
existence of a very large number of small firms and free-flow of information. Therefore, perfect
competition makes entrepreneurship a struggle for survival rather than the exercise of power and
it is the struggle for survival that Adam Smith identified as the control of unfettered self-interest
before it threatens social order—to Smith, ‘competition was absolutely essential if the “beast” in
man was to be harnessed productively’. The social function of competition is to solve the problem
of misuse of economic power by denying anyone power of monopolists. Thus, the entrepreneurs’
ability to erode consumer sovereignty is eliminated by assuming quantity supplied as a function
of entry and exit and not as a function of the expansion and contraction of existing firms.
This analysis legitimizes specific type of support, protection and regulation of capitalist
property by the state. It creates something of a moral paradox for economists. On the one hand
their theory says that the capitalist state should be “night watchman” and not interfere in value
determination process of market, but capitalist markets if left unregulated necessarily lead to
concentration and centralization of property and shrinking of small firms. This creates the danger
that competition will die out (as it did in soviet and East European state capitalism) and if agents
are not competitive—i.e. jealous—they will not be subjects to capital. Policy must therefore
regulate capitalist market to ensure that the death of the small firms does not lead to an
elimination of competition and the markets they operate in must mimic competitive markets. How
this is sought to be achieved is explained on the chapter on imperfect competition.
If this is what the competitive market is—that individuals face no transaction costs and
barriers whatsoever—then the question is: what is it that actually motivates individuals’ decisions
in capitalist society? The answer is ‘lure for profit’—the model of perfect-competition says that
an ideal society is where the only motivational force behind individuals’ decisions is profit-
making and utility (i.e. consumption) maximization. Everyone keeps on freely switching from
one segment of the market to another in order to exploit opportunity for profiting whenever and
wherever possible and, thus, adding to his capital. Perfect competition is regarded ideal by
economists because it allows maximum opportunities for accumulating capital to all individuals
on equal terms. The model of competitive markets provides the framework for realizing
capitalist-justice prioritizing the unending endeavor for accumulating.
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Freedom and Market-Justice
Economists regard perfect competition as the most just and idealized social order because
it:
(a) provides all market agents equal opportunities to participate in the market since they all
face the same structures of prices
(b) allocates resources such that profit/utility is maximized
(c) allows no input to make reward more than its contribution to actual accumulation
The perfectly competitive market outlines conditions for the achievement of capitalist justice.
Every system—every complete way of life—has its own conception of justice and capitalism is
also a complete way life. Capitalist justice sanctions and nurtures those values and relations
which:
 Facilitate the maximization of aggregate profit and utility
 Reward/punish each contributor to the capital accumulation process strictly in accordance
with contribution he is making to this process
 Ensure the dominance of the capital accumulation motive over all other motivations
influencing individual behavior
The perfectly competitive market fulfils these conditions and is therefore regarded as the ideal
form of capitalist society; i.e. civil society, since the time of Fredric Hegel (1770-1831) who
idealized it in his famous lectures published as Reason in History as early as in the nineteenth
century. The competitive market colonizes the whole of society (as a contemporary American
philosopher has shown in his book Spheres of Justice. The individual is free to enter or exit a
specific competitive market. He is not free to enter or exit the capitalist system—the total set of
capitalist markets within civil society. John Locke, one of the founding fathers of modern
political economy, called this unjust rebellion “for rejecting participation in capitalist markets is
denying the universality of capitalist justice” and capitalism has throughout history resisted such
rejection through the use of brutal state force. Michel Man in his famous book The Dark Side of
Democracy shows why this must happen in his analysis of the continuing slaughter of 80 million
Red Indians during the 17th, 18th and 19th centauries in America.
Capitalist justice is in reality injustice because it rejects all religious values. No
religion—neither Islam nor Christianity nor Hinduism—has ever sanctioned maximization of
profit or utility as a morally valued objective of life. All religions have regarded the quest for
maximization of profit and utility as evil, that is why capitalism is described as a “celebration of
sin and evil!” Capitalist justice promotes sin and vice, an example will make this point clear.
Suppose Abdullah is offered a job at Los Vegas casino with a wage fifty times greater
than what he is earning as a Quranic teacher in Aleemiyah Madrassah, Karachi. Abdullah will of
course immediately reject this offer because:
• America is dar–ul–harb, a country at war with the Muslim Ummah
• The casino business is filthy and sinful
• Abdullah wants to earn Allah’s pleasure by containing to teach the Quran to little children
• He does not want to leave Karachi because here he can easily serve his old father and sick
mother
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Capitalist rationality—as expressed in economics—regards these tendencies as psychological

barriers to Abdullah’s participation in the market. Capitalist rationality requires that Abdullah
should:
• Betray the Ummah and overlook America’s mass slaughtering of Muslims in Iraq,
Afghanistan, Somalia and Pakistan
• Agree to become a sinful gambler
• Reject the Sawab (reward) he is getting as a Quran teacher
• Abandon his old father and sick mother
All of this is necessary if Abdullah has to maximize his utility—i.e. the present value of his life
time consumption opportunities. The capitalist market however cannot force Abdullah to submit
to capitalist rationality; but the capitalist state can. It can peruse a set of policies—indeed it must
pursue some of such policies if it is to remain a capitalist state—which forces and pursues
Abdullah to accept the dominance of capitalist rationality. The capitalist state can follow some or
all of the followings:
• shut down Aleemiyah Madrassah accusing it of terrorism
• impose direct and indirect taxes on the Madrassah revenues
• force the Madrassah to teach social and physical sciences which can serve as transmitters
of capitalist values to Madrassah teachers and students
• refuse to recognize Madrassah qualification in determining social hierarchy
• motivate, and also force, the parents of Madrassah students to send their children to
secular schools
All these evil and exploitative policies are regarded as just within capitalist order. The capitalist
state must pursue such polices so that barriers to market entry are removed and the market is
enabled to allocate resources efficiently for maximizing total utility and aggregate profit.
12.4: PERFECT COMPETITION IS NOT PERFECT
This model of competitive markets based on self-centered individuals leading to efficient

(profit utility maximizing) resource allocation is presented as one of the most powerful results of
economic reasoning in support of legitimizing liberal state policies. However, as we show below,
the model of perfect competition faces several theoretical problems. These problems belong to
two general categories: one of the model being based on either unrealistic or incorrect
assumptions, and second of having internally contradictory assumptions. Here, we take on two of
these problems to show that the results economists hope to derive from this model are
unwarranted because the model is internally inconsistent. The next chapter will take up more
problems inherent to this model.
12.4.1: Sraffa on Perfect Competition
We have been spelling out Sraffa’s critique on neoclassical theory of production and cost,
it is now time to apply his critique to expose another fundamental flaw in neoclassical theory of
the firm and the market. We proceed in steps with his criticism.
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Competitive Market with Constant Marginal Product
Recall from chapter 10 that Sraffa’s criticism involved refutation of the law of
diminishing marginal product. His argument can’t be taken lightly as it constitutes a fundamental
criticism of economic theory. This is so because diminishing marginal product determines
everything in the economic theory of production. The following list of statements would make
this point easy to understand:
Figure: 12.11: Perfect competition with Sraffa’s production analysis
Rs
TR
Breakeven
point
TC
e
VC
0 YBE Y
Rs/Unit
ATC
MR
MC
0 YBE Y
• Output function determines marginal product, which in turn determines marginal cost
• With diminishing marginal product, the marginal cost of production eventually rises to equal
marginal revenue
• This equality of rising marginal cost to marginal revenue gives maximum profit and hence
determines the level of output
420
If it is shown that constant, instead of diminishing, marginal product actually prevails in capitalist
markets, then the production function would turn out to be a straight line through the origin and
lead to straight line total cost curve (see figures 10.6 and 11.10), just like the total revenue curve.
Now if the slope of total revenue curve is greater than that of the total cost curve, then the
marginal revenue curve would be above marginal cost one as shown in figure 12.11. This means
that for each output unit produced after output level YBE, profit will keep on increasing, hence
more output means more profit never reaching any maximum level. So we find that in terms of
economic theory of profit maximizing production, there would be no limit to the amount a
competitive firm would wish to produce. The conventional economic model of the competitive
market cannot explain how capitalist firms choose to do what they do; i.e. it can’t explain the
decision of how much to produce. Ironically, if Sraffa is correct, then economic theory predicts that
firms would produce infinite amounts of output. This rather awkward implication of Sraffian
production analysis hits right at the foundation of neoclassical theory of the firm.
Diminishing Marginal Product and Independence of Demand-Supply
Not only did Sraffa dismiss the assumption of diminishing marginal product by
establishing forth the fact that a rational capitalist firm having a fixed resource would leave some
of it idle when operating below its optimum scale, he went a step further by exposing two
contradictory assumptions working behind the neoclassical theory of the firm. Those are the
assumptions that there are factors of production which are fixed in the short run, and that supply and
demand are independent of each other; i.e. the decisions of consumption and production are taken
independently by separate rational capitalist agents. He argued that the two assumptions cannot hold
simultaneously. Briefly speaking, circumstances when it is valid to assume some factor of
production as fixed in the short run, supply and demand would not be independent, which means
that every point on the supply curve would be associated with a different demand curve.
Conversely, in conditions where supply and demand can be treated as independent, then in general
it would be impossible for any factor of production to be fixed, which means that marginal product
and hence marginal cost of production would be constant. Let’s see how Sraffa’s reasoning works
to devastate the economic theory of the firm.
To begin with, recall that marginal product falls in neoclassical theory because the ratio
of ‘variable factor’ to ‘fixed factor’ exceeds some optimal level. The question then is: when is it
legitimate to regard a given factor, say land in wheat production, as fixed. To Sraffa, this is a
valid assumption only when industries are defined very broadly, but this contradicts another
assumption of the model that demand and supply are independent. Let’s consider a very large
definition of industry, say agriculture. In this case, it is valid to treat factors it uses heavily, e.g.
land, as fixed because additional land can only be obtained by converting land from other uses
such as manufacturing or tourism. So, when agricultural output is increased at fixed agriculture
land by employing more variable factors, the agricultural industry will suffer from diminishing
returns as predicted by economic theory. But what happens to other industries as agricultural
industry output increases? Clearly, such a broad definition of industry means changes in its output
must affect other industries. Particularly, increasing agricultural output will affect the price of its
chief variable input, say labor, as it is driven from other industries. This feed back affect might
seem to strengthen the case for diminishing marginal product because input price is increasing
421
while its productivity is decreasing. However, it also undermines two other equally important parts
of the neoclassical model: firstly the assumption that demand for and supply of a commodity are
independent, and secondly the proposition that one market can be studied in isolation from all other
markets. This is so because if increase in the supply of agricultural output changes the relative price
of land and labor, then it will also change the distribution of income. We have already seen in
chapter 8 that any change in the distribution of income changes the position of the demand curve—
change in income distribution changes the position of the consumers’ budget line and hence their
demand point). There will therefore be a different demand curve for every different position along
the supply curve for agriculture output, depicted in figure 12.12.
Figure 12.12: Multiple demand curves with broad industry definition
Price
D1 Sagr
D2
Do
Pw = ?
0 Wo W1 W2 Wheat
The essence of the argument is that it is impossible to draw independent demand and supply
curves that intersect just at one point in price-commodity space because factors that alter supply
will also alter demand. Demand curve for agriculture will shift with every movement along its
supply curve; hence they will intersect at multiple points and it is impossible to tell which price or
quantity will prevail in the market. So we find that while diminishing marginal product does exist
with the broad definition of industry, but then no industry can be considered isolated from all
others and demand-supply become interdependent.
Can this problem be overcome by taking a narrow definition of industry, say wheat
instead of agriculture? Off course, but this gives birth to another equally important problem of
non-diminishing marginal product. Sraffa argued that though the assumption of independent
demand-supply would work under this case, but now it would be invalid to treat some factor as
fixed. With such a narrow definition of industry, firms will normally be able to draw all factors of
production rather easily either from other industries or from stocks of under-utilized resources.
422
Fro example, if demand for wheat increases, then instead of farming a given quantity of land
more intensively, farmers would convert some land from another crop to wheat, or they might
convert some of their own lands currently laying fallow, or farmers who currently grow some
other crop will convert to wheat. In all circumstances, the ratio of one factor to another will
remain fairly constant while total amount of resources devoted to wheat production will increase.
This means that marginal product remains constant which results in a straight-line production
function as discussed in chapter 10. As we have seen that the shapes of total, variable, marginal
and average total cost curves determined by the shape of the production function, so a straight
line output function results in constant marginal and falling average total cost curve as shown in
the bottom part of figure 12.11. With this picture of a firm, every additional sale after YBE brings
forth more profit. This implies that sales are not constrained by rising cost as claimed by
economic theory. Given the economic assumption that a competitive firm faces a horizontal
demand curve, then according to economic theory the firm would be seeking to produce an
infinite amount of output. Thus, if marginal cost is constant rather than falling, the neoclassical
explanation of everything collapses—it can neither explains neither the output decision of the
firm nor the determination of wage and interest rate (to be discussed in chapter 15 and 16).
Though taking the narrow definition of industry helps avoid the problem of interdependence in
demand and supply, it takes away all of the explanatory power of economic theory.
Sraffa’s argument is therefore fundamental in the sense that if his argument is accepted,
then the entire structure of economic theory Crum. Despite such a fundamental weakness,
economic theory has continued as if Sraffa’s paper was never published. Capitalists may hope
that this might be because there is some fundamental flaw in Sraffa’s argument, or because
economists have discovered some deeper truth to justify the old model with a new explanation.
But, neither is the case and Sraffa’s “deconstructions” of economic theory is as valid as it was in
1926.
What about the Real World?
Ironically, although economists always boost of themselves being the practitioners of an

empirical science, yet the fundamental postulates embedded in their model of perfect competition
are never reformulated on the base of empirical investigation—they are accepted as tautological
postulates that are necessarily true by definition. When tested empirically, several researches
supported Sraffa in that the vast majority of firms operate with constant or even falling marginal
costs, and set prices without reference to the economic concepts of marginal cost or marginal
revenue. For example, Table 12.2 summarizes the result of a survey conducted among factory
managers about different ways in which their costs change with output.
Table 12.2: Empirical support for firm setting price where MC=MR
By Firm By Product
Supports MC = MR 18 62
Contradicts MC = MR 316 1020
Percentage Supporting MC = MR 5.4 5.7
Percentage Supporting MC = MR 94.6 94.3
Source: Eiteman and Guthrie, 1952
423
Surprisingly, almost 95% report non-increasing marginal cost up to a very high level of output.
Similarly, in a more recent survey Blinder showed in 1998 that “over 89 per cent of respondents
indicated that ‘marginal’ costs either declined or stayed constant with changes in output (sometimes
involving discrete jumps). Only four out of 200 enterprises had both elastic demand curves and
increasing marginal costs.” Eiteman explains these results as follows: Engineers design factories
“so as to cause the variable factor to be used most efficiently when the plant is operated close to
capacity. Under such conditions an average variable cost curve declines steadily until the point of
capacity output is reached. A marginal cost curve derived from such an average cost curve lies
below the average cost curve at all scales of operation short of capacity, a fact that makes it
physically impossible for enterprises to determine a scale of operations by equating marginal cost
and marginal revenues”. The best assessment of neoclassical idea that the factor that constraints
firms’ output is built into their own cost structure was given by Sraffa himself in 1926: “Business
men, who regard themselves as being subject to competitive conditions, would consider absurd
the assertion that the limit to their production is to be found in the internal conditions of
production in their firm, which do not permit of the production of a greater quantity without an
increase in cost. The chief obstacle against which they have to contend when they want gradually
to increase their production does not lie in the cost of production—which, indeed, generally
favours them in that direction—but in the difficulty of selling the larger quantity of goods without
reducing the price, or without having to face increased marketing expenses.”
If economics is a positive and an empirical science, why do then neoclassical economists
ignore these researches which have been appearing during the last 90 years. As we have
maintained throughout this book, economic theory was never meant to describe how a capitalist
society actually works, It’s chief concern was to give prescriptions regarding how ideal capitalist
society ought to operate; i.e. it is necessarily a normative science as discussed in FYI Box 12.1
(you are recommended to read that box again).
We hope that by the time you have reached this far in the book you will immediately ask:
“Efficiently for what?”—of course the answer is “allocate resources efficiently for the
maximization of profit/utility/capital accumulation as an end in itself”. This capitalistically
efficient pattern of resource allocation is the most inefficient if the purpose of economic objective
is seen as the promotion of virtue or the winning of God’s approval. Economics argues that it is
irrational to seek God’s approval or promote religious virtues as an objective of economic
activity. Economics presents a capitalist conception of rationality and assumes that every one
possesses this rationality i.e. unreserved, unqualified commitment to maximization of total utility
and profit as an end in itself. Its models of price and output determination based on
capitalistically rational individual and firm assumes that only ‘one person’ exists—everyone is
equally capitalistically rational, hence market demand is the aggregation of individual demand
and market supply is the aggregation of the supply function of individual firms. The interaction of
such market demand-supply curves are shown to yield equilibrium / harmony by yielding unique
(profit / utility maximizing) structures of price and output in the market.
But Sraffa has shown that such a derivation of unique output/price configuration is not
generated by actually existing capitalist markets where conditions of conflict and exploitation
prevail. Economic theory cannot explain how prices and output decisions are made in actually
existing capitalist markets because when everyone behaves rationally—everyone seeks
utility/profit maximization—the result is irrationality (i.e. non-maximization of total utility /
424
profit. When everyone seeks his own profit / utility, maximization of total utility/profit cannot
maximized because everyone is preying upon everyone else. Everyone is intensely selfish,
demonic, greedy, jealous, lustful and evil. How can harmony exist in such circumstances? There
is endless, limitless conflict, exploitation and domination in capitalist markets and as Sraffa has
shown prices, output levels and distribution of income are all determined by antagonistic forces.
Economic theory thus fails to provide moral justification for the existence of capitalist order
which is inherently and essentially evil. We will return to these themes in detail in the chapters on
income distribution.
425
Key Concepts
Allocative efficiency refers to the market situation where resources are allocated to activities that
earn higher rates of return. Firm is allocative efficient when it produces output where marginal
cost equals price
Arbitrage is the practice of making profit by purchasing a commodity from where its price is
lower and reselling where price is higher
Average revenue is given by the ratio of total revenue to output
Cost efficiency in production takes place at efficient scale of production in competitive markets;
i.e. production should take place where average total cost is minimum possible
Firm equilibrium means firm doing its best to maximize profit. This is characterized by the
condition when marginal revenue equals marginal revenue
Law of one-price means a commodity can be sold at one and only one price in a competitive
market. This happens due to arbitrage
Long run equilibrium of a competitive firm and market is achieved when marginal cost, average
total cost and price are all equal; i.e. P = MC = ATC. In the long run equilibrium, no firm has
incentive to exit or enter the market
Marginal condition for profit maximization implies that maximum profit output is one where
marginal revenue equals marginal cost and marginal cost curve cuts marginal revenue from below
Marginal revenue is the change in total revenue due to one unit change in out
Market period refers to the time duration when the supply quantity available for immediate sale
cannot be increased
Normal profit means all firms are earning zero economic profit in the market
Price-taking behavior is a competitive behavior when all agents in the market lack any control
to determine market prices and take them as given information by the market for making their
choice decisions
Short run equilibrium of a competitive firm is achieved when it produces where its price is
equal to marginal cost of production, i.e. P = MC
Shut down rule says that under circumstances of loss, firm should try to minimize its loss. Firm
should shut down its business only when operating loss is greater than its fixed cost.
Alternatively, it should shut down when revenue is less than variable cost of operation
Super normal profit refers to positive economic profit earned by firms in the market
Tatonnement process refers to a hypothetical perfect market setting where an impartial and
costless auctioneer coordinates market exchange
Total condition for profit maximization says that profit is maximum where slopes of total
revenue and cost curves are equal and revenue curve is above cost curve
Transaction cost is the cost of executing exchange; e.g. transportation and brokerage costs
Zero economic profit means amount of profit which is necessary to keep an input in its existing
use. It is attained when all inputs are receiving their market reward; i.e. their opportunity costs
426
Chapter Summary
• Perfect competition is the moral ideal of capitalist economic theory. All capitalist markets are
judged on this basis both by capitalist economic theory (ideology) and by the Departments of
Justice of capitalist states
• Perfectly competitive markets are those in which (a) there are an infinite number of buyers
and sellers none of whom can individually influence price (b) a homogeneous product is
being provided (c) transaction costs are zero (d) information is perfect and costless (e) there
are no barriers to entry or exit
• Arbitrage is the practice of making profit by buying a commodity where it’s price is lower
and selling where its price is higher
• The Law of one price states that a uniquely determined efficient price will prevail throughout
the capitalist market. This law will not apply to non-capitalist markets where producers do
not seek profit maximization
• Theoretical commitment to the law of single price leads to the assumption of the horizontal
demand curve faced by the firm. The individual capitalist firm cannot influence price and its
supply is determined by its cost structure
• Perfectly competitive markets have never existed nor can they ever exist in the real world
• Economists’ analysis is focused on perfect competition as it illustrates the full implications of
universal capitalist rationality and therefore provides a vital benchmark for both evaluating
existing capitalist markets and for formulating system wide capitalist policies
• In a perfectly competitive market the total revenue curve for a firm is a straight line
dependent only on level of output as price is assumed to be fixed. This also implies that in
perfectly competitive markets price, marginal and average revenues are equal to each other
• The capitalist firm chooses to provide that level of output where it maximizes profit. Profit is
maximized at the output level where the positive distance between the total revenue and total
cost curves is greatest and their tangents are parallel to each other. This is also the case where
the MR and MC curves intersect, with the MC curve cutting the MR curve from below
• Profit is minimum when the MC curve intersects the MR curve from above
• In the short run a capitalist firm will produce at the level where MC equals price in perfectly
competitive markets
• The “shut down rule” may be stated in three ways. The profit maximizing firm should shut
down if:
o Operating loss exceeds fixed cost
OR
o Variable costs exceeds total revenue
OR
o Average variable cost exceeds price
• The positively sloped MC curve above the average variable curve is the supply curve of the
profit maximizing firm in competitive markets since supply decisions always take place on
the MC curve of a competitive capitalist firm
• The market supply curve is obtained by aggregating individual firms’ supply curves
according to the microeconomic theory of supply
427
• Economic theory insists that exchange takes place only at equilibrium price which is set by a
neutral auctioneer through a trial and error process. This assumption is made to avoid
considering the impact on income distribution and hence a change in market demand as price
changes
• Capitalist markets are never in equilibrium, indeed Schumpeter has shown they cannot be in
equilibrium. Since economics is a moral science the concept of equilibrium is indispensable.
It allows economists to claim that when capitalist rationality is universalized; all outcomes
are freely chosen and reflect a pattern of value allocation bared on the simple aggregation of
the free choices of all capitalist individuals
• In the short-run some factors are considered variable. Supply is therefore not fixed. Price is
expected to be lower than in the market period. The short run supply curve slopes upward to
the right, and above normal profits can be made
• In the long run the supply curve shifts upwards. Firms produce output level at the lowest
point on their average total cost curves and abnormal profits are eliminated
• Economic profit is the rate of return that is required to keep a factor in its present businesses
because that is its market value
• Economics defines efficiency as that pattern of factor use which maximizes profit. Long run
competitive equilibrium is said to be “efficient” because average total cost is the lowest and
total utility is maximized
• Competitive markets allocate resources “efficiently” from a capitalist prospective—i.e. they
allocate resources in a manner which maximizes both total utility and total profit
• This implies that the state should not interfere in the process of price determination.
Competitive markets spontaneously generate just and efficient prices which fully reflect the
freely chosen desires of autonomous individuals
• Perfectly competitive markets are regarded just in capitalist order because all capitalist agents
face the same prices and because factor rewards are strictly equal to their contributions to the
capital accumulation process. These markets establish the social dominance of capital
accumulation as an end is itself
• Capitalist justice is injustice because capital accumulation is another name for the flourishing
of the vices of greed (hirs) and jealousy (hasad). The capitalist states promote the flourishing
of these vices
• Perfect competition cannot exist in capitalist order. This means that even in its own-terms
capitalism is an unjust order. The assumptions on which economists premise their
justification of perfect competition are mutually inconsistent
• One such inconsistency is exposed by Sraffa who shows that since constant (and not
diminishing) marginal productivity characterizes capitalist markets, the output decision of
firms cannot be explained by microeconomic theory. Assuming constant marginal
productivity in the standard model implies firms would produce an infinite level of output in
competitive markets
• Sraffa also showed that supply and demand decisions cannot be viewed as independent when
(as in the short run) some factor of production is taken as fixed. When it is realistic to assume
the independence of supply and demand, no factor of production can be taken as fixed and
this implies the constancy of marginal product (and marginal cost)
428
• If demand and supply are seen as interdependent then the determination of unique
equilibrium prices become impossible
• Empirical evidence has shown that in developed countries the over-whelming majority of
firms does not experience diminishing marginal productivity and does not take account of
marginal cost in setting their prices
• Economic theory can afford to ignore such market realities because it is not a positive, but a
normative and a moral science. It describes how the capitalist system and all capitalist agents
ought to work, not how they actually work
• Capitalist markets are a sphere of conflict and chaos not a sphere of equilibrium and
harmony. Economic theory seeks to, but cannot, hide this evil essence of capitalist order and
as Sraffa has shown all market decision—regarding prices, output and income distribution—
are determined by the relative forces of conflicting antagonistic agents, each committed to his
own utility / profit maximization by exploiting everyone else
429
Review Questions
1. Why is perfect competition a normative concept?

2. What are its characteristics?
3. State and evaluate the doctrine of the law of one price?
4. Illustrate with the help of an example how the process of arbitrage works in capitalist
markets.
5. Why is the price generated by perfectly competitive markets regarded as the just price of
capitalist order?
6. Derive the horizontal demand curve of the firm from the assumptions underlying the theory
of perfect competition.
7. Although perfectly competitive markets cannot exist in the real world microeconomic
theory focuses upon them. Why?
8. Using some numerical date redraw Fig 12.3 to show what level of output will be chosen by
a profit maximizing firm.
9. Explain why profit may not be maximized at a point where MR = MC.
10. State and justify the short run equilibrium condition of a capitalist firm in a perfect
competitive market.
11. Why is the MC curve the supply curve of the profit maximizing firm in a competitive
market? Why does it slope upwards to the right?
12. State and explain different versions of the shut down rules.
13. Describe the tatonnement process through which equilibrium prices are supposed to be
generated in capitalist markets
14. Why do economists insert on using equilibrium analysis when capitalist markets can never
be in equilibrium in the real world?
15. Define the short run period and distinguish it from the “market period”.
16. Distinguish between short and long run equilibriums with the use of diagrams.
17. Distinguish between economic and accounting concepts of profit with the use of an
example.
18. Define “economic profit”. Why is it regarded as norma?
19. Define and evaluate the economic conception of efficiency.
20. Why is perfect competition a model of capitalist justice?
21. Why is capitalist justice regarded as injustice (zulm) by all of the world’s religions?
22. “Capitalist justice cannot exist even in capitalist society”, comment.
23. Why does the microeconomic theory of output determination in competitive markets break
down if we accept Sraffa’s view that constant and not diminishing marginal productivity
characterizes capitalist markets?
24. Why is it not realistic to assume both that (a) some factor of productions is constant and (b)
that supply and demand are independent? What are the implications of rejecting?
25. Why does microeconomics theory continue to pretend that Sraffa never wrote anything?
26. Why does microeconomic theory continue to ignore how prices are determined by firms in
actually existing capitalist markets?
430
Appendix Chapter 12: Consumer and Producer Surpluses
Appendix Chapter 12
Consumer and Producer Surpluses

Economists measure the efficiency of a market in terms of consumer surplus and
producer surplus. This appendix will briefly outline how economists measure these two important
concepts.
Consumer Surplus
Consumer surplus (CS) refers to the extra value a capitalist consumer receives over and
above what he pays for a commodity. Alternatively, it is the difference between what a consumer
is willing to pay for a specific quantity of a commodity and what he actually pays for it in the
market. Formally, it is:
CS = Amount consumer is willing to pay – Amount he actually pays
To make sense of what the above expression says, consider the demand curve in figure
12.1A. You can see that the height of the demand curve at any quantity measures the amount a
consumer is willing to pay for that quantity. For example, initially he is willing to pay Rs 10, for
the second unit he is willing to pay Rs 8 and so on. Alternatively, we can interpret the consumer’s
willingness to pay as a monetary measure of value a capitalist consumer receives from a
particular unit. Viewing this way, we can say that the value of the first unit is Rs 10 while that of
the second is Rs 8 for this consumer. Adding his willingness to pay for all the units (here 1 to 3)
gives the amount he is willing to pay for all the units. Therefore, the area below the demand curve
0ABQb gives his willingness to pay for the three units. In other words, 0ABQb measures the
value of three units to this consumer.
Next we have to determine the amount he actually pays. Note that if the market price is
Rs 6 per unit, then the consumer can purchase all the units, from 1 to 3, at this market price: he
buys the first unit at Rs 6, second also at Rs 6 and so on for the third. This means that he receives
a surplus value of Rs 4 on the first unit because he was willing to pay Rs 10 for it but he actually
pays only Rs 6. Similarly, the second unit brings him unpaid value of Rs 2. The consumer is
indifferent about the last unit because he is paying what he is willing to pay for it. Adding up the
price paid for each unit we get the amount which the consumer pays in the market, area 0PBQb.
If we add up the surplus value received by him on all the units, we get the consumer surplus.
Graphically speaking, consumer surplus is the area below the demand curve and above the price
level; the area PAB. This area measures the extra value a consumer receives over and above what
he pays for. Given this description, we can also define consumer surplus as:
CS = Value of output to consumers – Amount paid by them (12.1A)
431
Figure 12.1A: Calculating consumer surplus

Px
A Consumer Surplus = ABP
10
B
6=P
Dx
0 1 2 3 = Qb Q
Producer Surplus
This concept is similar to that of consumer surplus. Here the idea is to subtract the
amount firms need to produce a given unit of output from the amount that they actually receive in
the market.
PS = Amount firms actually receive for output – Amount they need to produce this output
Consider figure 12.2A where the standard upward sloping supply (or MC) curve is
drawn. The height of this supply curve against any output level measures the marginal cost of
production—amount needed to produce a given unit of output. For example, the MC of producing
the first unit of output is Rs 2 while that of the second is Rs 4 and so on. Summing up the
marginal costs of producing all units (here from 1 to 3) gives total cost (or amount needed to
produce this level of output). Therefore, the area 0CBQb below the supply measures total cost of
producing 0Qb output. Since each item is offered at a given market price in a competitive market,
the firm receives Rs 6 per unit sold; i.e. all units from first to third earn it Rs 6. Alternatively, the
revenue received from selling 3 units is equal to the rectangle 0PBQb. This area measures the
amount received by the firm for a given level of output. If you subtract the amount needed to
produce the output from the amount received by selling a given level of output, you will end up
with producer surplus equal to the triangular area CPB. Graphically speaking, producer surplus is
the area below the price line and above the supply curve. We can now define producer surplus as:
PS = Amount received by the firms – Cost of producing output (12.2A)
432
Figure 12.2A: Calculating producer surplus

Px
Producer Surplus = CPB

MC =
S
B
6=P
0 1 2 3 = Qb Q
Social Welfare or Total Surplus
If you add up consumer and producer surpluses in a capitalist society, you will obtain
total surplus as shown in figure 12.3A. Algebraically,
Social Welfare = Consumer Surplus + Producer Surplus
Substituting in this the expressions of consumer and producer surpluses we get:

Social Welfare = [Value to the consumers – Amount paid by them] + [Amount received by
the firms – Cost of producing output]
Since the amount paid by the consumers equals the amount received by the firms (0PBQb), the
second and third entries cancel out in this expression and we end up with:
Social Welfare = Value of output to consumers – Cost of producing output (12.3A)
This says that total surplus in a capitalist market and economy is the value of output to consumers
measured in terms of their willingness to pay minus the seller’s cost of producing that output. An
allocation of resources is said to be capitalistically efficient by economists if it maximizes total
surplus. Economists maintain that when markets are free (i.e. prices and output levels are
determined by individual’s self-interest), then total surplus is automatically maximized and no
all-knowing benevolent social planner is required to maximize social welfare—i.e. the
consumption possibilities. No can increase social welfare by altering this market outcome. The
socially desired level of outcome is achieved naturally by the pursuit of self-interestedness. Smith
called this pursuit of self-interestedness the operation of ‘invisible hand’ that guides people to
promote social welfare without intending to do so.
433
Figure 12.3A: Social welfare or total surplus

Px
Total Surplus = CS + PS
A
MC = Sx
B
6=P
Dx
0 3 = Qb Q
It should be noted that only capitalist societies seek social welfare maximization for they
alone measure welfare in terms of net utility yielded by an economic process. Non-capitalist
societies reject this conception and typically they seek to promote virtue, not social welfare
(maximization of total surplus). In non-capitalist society economic practices are valued in terms
of their ability to enhance virtuous behavior among individuals (this is the predominant discourse
with regard to economic transactions in Islamic fiqh for example) and not in terms of the net
utility these practices generate.
434
13
Chapter
MONOPOLY
The last chapter outlined the idealized fiction of the perfectly competitive market.
However, real world markets are by no means characterized by perfect competition. When you shift
in an apartment, it is not difficult for you to choose the company producing electrical power as there
is only one in the country. The same holds for natural gas and water supply services. This chapter
begins the analysis of what the economist’s term as imperfect competition or markets. Markets
are said to be imperfect when any of the conditions of the competitive markets are missing or
lacking to any degree. Broadly speaking, market structures are differentiated by economists on the
basis of three important features as listed in table 13.1.
Table 13.1: Differentiating Market Structures

Market Structure No of Firms in Market Nature of Good Sold Entry / Exit
Conditions
Perfectly competitive Free Entry & Exit / No
Infinite or very large Homogenous
Barriers
Monopolistic Heterogeneous /
Large Easy Entry
competition Differentiated
Oligopolistic Homogenous /
Few Significant Barriers
competition Differentiated
Monopoly One No Close Substitute No Entry
To make more intuitive sense, we can place these capitalist market structures along a spectrum
measuring the intensity of competition as shown in figure 13.1. The spectrum runs from left to right
and shows that the extent of competition is decreasing with movement from left to right. Monopoly
is placed at the right hand corner of this spectrum
Bwssweazaqzaaaaaaazazazaqqqqqqqqqqqqqqqqqqqqqqqqqqq1ssssssssdddecause it is the least
competitive market structure. On the other hand, perfect competition is on the left hand corner
because this involves large number of firms competing with each other. The other two structures are
placed in between the two polar extremes. Note that monopolistic competition is closer to perfect
competition while oligopoly is farther away. It should be clear that, according to economic theory,
the two key factors that determine the extent of competition in any market structure are the number
of firms operating in the industry and entry-exit conditions; i.e. market barriers.
Figure 13.1: Competitive Structures
Most Least
Competitive Competitive
Perfect Monopolistic Oligopolistic Monopoly

Competition Competition Competition
The chapter begins with the description of the monopoly structure and examines its
The chapter begins with the description of the monopoly structure and examines
its implications for firm behavior in markets characterized by monopoly. We then go on to
analyze the supply decision of the monopolist. Section three describes the meaning of monopoly
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power while section four takes up the question of what makes monopoly possible. Section five
explains the standard justification offered for policy preference for competitive market structures
and then explicates the regulatory tools available for correcting monopoly behavior. The last
section will outline a detailed critique of the standard neoclassical theory of firm.
13.1: STRUCTURE OF MONOPOLY
Monopoly is placed at the polar extreme of perfect competition. The word monopoly
itself says all about its nature: mono means single while poly stands for producer. Thus monopoly
is a market structure characterized by a single-firm supplying an entire market. Formally
speaking, monopoly is defined by three features:
 Single seller in the market
 No close substitute of the product
 No entry in the market due to significant barriers
Clearly, the assumptions suggest that this market structure is exactly the opposite of what we call
perfect competition because there is no competition at all. Strictly speaking, there is hardly any
firm in Pakistan that can be described as monopoly in the literal sense of sole-producer. Take for
example the case of Pakistan Railways. Thought it carries most of the middle class passengers,
yet substitutes are available, e.g. bus services. The only businesses in Pakistan that come close to
monopoly in its strict sense are WAPDA, Sui-Southern-and-Northern Gas Supply Corporations
and perhaps KESC. And the reason why they are monopolies is because of the state imposed
legal restrictions for potential entrants. Once state imposed restrictions are removed, entry begins
to occur which is obvious from the case of the telecommunication industry in Pakistan where
once PTCL was the only operating firm. Thus, we can say that there is no private sector business
in Pakistan that may be called a monopoly in its strict sense.
But for practical purposes, monopoly is defined in a looser way. According to this view,
if the market-share of a single firm exceeds fifty percent of total market sales, then such an
industry is said to be a monopoly. This is so because one firm is leading or dominating the rest of
the firms in the market—the dominating firm sets the price while the rest are forced to follow it if
they want to survive in the industry. The model describing this market structure is technically
called the dominant firm model. Think of Microsoft in Pakistan software industry and Railways
in Pakistani travel. Though there are some competitors of Microsoft, yet their market share is too
small to affect Microsoft business strategy in Pakistan. This can be contrasted with the case of
Pepsi and Coca Cola where both the firms ruthlessly compete with each other none enjoying a
dominant share in the market. This is the case of oligopoly which we will study in the next
chapter.
13.1.1: Implications
How a profit-maximizing capitalist firm behaves in the market largely depends upon the
structure of the market. The above examples show that the model of competitive markets with
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very many firms operating with free entry and exit cannot describe the reality of a market with a
single seller—the analysis on the supply side of the monopoly firm has to be changed. There are
significant differences in the behavior of a monopolist as compared to a competitive firm. To
begin the modeling of these differences, let’s start with identifying the behavioral implications of
the monopoly structure of market.
Price Setting Behavior
When discussing monopoly behavior, economists are often interested in how much
monopoly power any firm (not necessarily a sole producer) has. Monopoly power refers to the
extent to which a firm can raise prices without losing all its customers. Since a monopoly
producer supplies the entire market demand, it is unlikely that it will take the market price as
given. It would recognize its influence over the market price because it is the only firm in the
market. This implies that a monopoly faces a downward sloping demand curve for its product and
it ignores other firms’ reactions to its own pricing decisions. This situation is shown in figure
13.2 which can be compared with that of competitive market where the firm’s demand curve was
horizontal and not downward sloping. This negatively sloped demand curve shows that the
monopolist can change market price by adjusting its quantity decision—this is what is meant by
monopoly power.
Figure 13.2: Demand curve faced by a monopolist
Rs/unit
P1
P2
0 Y1 Y2 Y
It should be clear that only when a firm faces downward sloping demand curve does it have the
opportunity for price strategies and does not have to accept market determined prices. Thus we
find that a monopoly is a price setter or price maker and not price taker. Obviously, the fact that
the monopolist can set price independent of other firms’ decision does not mean it can charge
whatever price it wants—no monopolist can ever have infinite monopoly power. For any given
price, it will be able to sell only what the consumers are willing to buy. If it chooses a very high
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price, such as P1, it will be able to sell only a small quantity. True that WAPDA has monopoly
over electricity supply, but it does not mean that it can charge Rs 1,000 per unit and yet be able to
sell its desired level of output. Demand behavior will obviously work as a constraint on the
monopolist’s choice of price. In other words, monopoly power depends upon the price elasticity
of demand for its product—the lower the price elasticity of demand, the larger the price increase a
firm can make without losing too many customers, and vice versa. Only in the highly unlikely
case of perfectly inelastic demand can the monopolist charge whatever it wants. Remember that a
monopolist firm operates to maximize its profit and, thus, it will charge that price level which
maximizes its profit.
Revenue Behavior
The revenue structure of a monopolist is different from that of a competitive firm due to
the fact that price changes as quantity sold changes. To see this, recall that total revenue for a
competitive firm was a linear function of quantity sold which resulted in a constant marginal
revenue curve. The Marginal revenue was fixed because price of the product was assumed to be
constant for a firm as it was a price taker. As discussed above, the assumption of price taking is
not valid for the monopolist because he has the power to control market price. This changes the
shape of the marginal revenue curve.
Table 13.2: Revenue behavior of the monopolist

1 2 3=1×2 4 5=3÷2
Price Quantity Total Revenue Marginal Revenue Average Revenue
(P) (Y) (TR = P × Y)  ∆TR   TR 
 MR =   AR = 
 ∆Y   Y 
5 1 5 - 5
4 2 8 3 4
3 3 9 1 3
2 4 8 -1 2
1 5 5 -3 1
Figures 5.6 and 5.7 in chapter 5 show the formal derivation of the total revenue curve when the
demand curve is negatively sloped (refresh your understanding from chapter 5). You can see that
with a falling demand curve, total revenue curve takes an inverse U-shape. Table 13.2 shows the
logic behind this phenomenon. The same definitions of average and marginal revenues are used
as in chapter 12.
First note that the average revenue and price are equal for all levels of output (compare
columns 1 and 5). This is the same result as given by expression (12.4) which says that price and
average revenue are two names for the same thing. Intuitively, average revenue is the price per
unit charged on quantity. Similarly, the demand curve shows the price that can be charged per
unit, so both are the same. The demand curve and AR functions are always the same—nothing
new in this case. However, the behavior of marginal revenue is different in the monopoly case, as
it is not constant. Clearly, you can observe that marginal revenue is always less than price (or
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average revenue) for all levels of output (see columns 1 and 4). For example, for price level Rs
4/unit, MR is 3 and so on. This slightly complicated behavior of MR arises because output moves
in the opposite direction as price varies. When price is reduced, the monopolist not only earns
extra revenue on the additional unit of output sold, but it also loses revenue on all the previous
units (called infra-marginal units) that are now sold at this lower price. For example, after
reduction in price, say, from Rs 5 to Rs 4, the monopolist is able to sell one extra unit which
brings him extra revenue of Rs 4. Let us call this Radd. But the reduced price is applied on all the
units sold. This means that the first unit which was previously sold at Rs 5 is also offered at Rs 4
after reduction in price. The monopolist loses Rs 1 on this infra-marginal unit. Denote this change
in revenue by Rlost. Thus the change in revenue for the monopolist is given by revenue earned on
extra units minus the revenue lost on all previous units:
MR = Radd − Rlost = Rs 4 − Rs 1 = Rs 3
Similarly, the monopolist makes extra Rs 3 (Radd = Rs 3) when he reduces price from Rs 4 to Rs 3
as he is able to sell one extra unit (sales increase from 2 to 3 units). But he also loses one rupee on
each of the previous two units as they were previously sold at Rs 4/unit; i.e. Rlost = Rs 2.
Therefore, MR is Rs 1 ( = Radd − Rlost = Rs 3 − Rs 2 = Rs 1 ). The same logic applies to all other
units. This shows why MR of monopolist is always less than the price or AR for all levels of
output—lowering revenue on infra-marginal units means the MR from selling another unit
through a price decrease does not equal price or average revenue.
The formal derivation of the MR-curve is given in figure 13.3. The top two panels of this
figure are redrawn from figure 5.7 in chapter 5—the upper panel draws the demand curve facing
the monopoly and the middle panel shows the corresponding total revenue curve. How is the
marginal revenue curve derived as drawn in the bottom panel? Remember that the tangent of a
total curve is the marginal curve. Consider the situation at point B. At this price, the price that can
be charged is Pb as shown in the top and bottom panels. Total revenue is TRb in the middle panel.
The tangent at point b measures marginal revenue while the slope of the ray coming from the
origin to point b gives average revenue (equaling TRb over Yb). 3 You can see that the ray is
steeper than the tangent at point b, so we have shown that MR < AR at point b. Pick up any point
on this total revenue curve and you can confirm the result that the ray is steeper than the tangent
of the total revenue curve.
Algebraic Treatment of Marginal Revenue
Let us work out the expression for the marginal revenue function. Note that a small
decrease in price from, say, Po to P1 allows the firm to increase its sales from Yo to Y1. So, change
in total revenue is given by:
∆TR = TR1 − TRo = P1Y1 − PoYo
3
To see how the slope of a ray from the origin to any point at the total revenue curve gives average
revenue, note that the slope of ray 0b is given by:
TRb − 0 TRb TRb
Slope of 0b = = while AR at b =
Yb − 0 Yb Yb
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Figure 13.3: Total, average and marginal revenue curves of monopolist
Price
A
B
Pb
Demand
curve
C
0 Yb Y
TR
b
TRb e
a
0 Yb Yo c Y
Rs/unit
b
Pb
MRb
MR-curve D-curve
0 Yb Yo Y
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Further, the new price P1 can be defined as P1 = Po + ΔP. 4 Similarly, Y1 also equals Y1 = Yo + ΔY.
Substituting them in the above function gives:
∆TR = (Po + ∆P )(Yo + ∆Y ) − PoYo
or = PoYo + Po ∆Y + Yo ∆P + ∆P∆Y − PoYo
or = Po ∆Y + Yo ∆P + ∆P∆Y (13.1)
The last term in this expression will be equal to zero for a small change in price and quantity,
hence ignoring this term gives us:
∆TR = Po ∆Y + Yo ∆P (13.2)
This says that when a monopolist decides to increase its output by ∆Y, there are two effects on
revenue. First, it sells more output and receives additional revenue on the sale of additional output
which equals P∆Y. However second, the monopolist pushes the price down by ∆P to sell
additional units and gets this lower price on all the output it has been selling previously at higher
price. The loss in revenue due to reduction in price will be Y∆P. Thus, the total effect on revenue
of changing output by ∆Y is given by (13.2). For calculating marginal revenue; i.e. the change in
revenue divided by the change in output, divide both sides of (13.2) by ∆Y
∆TR P∆Y + Y∆P ∆P
= = P +Y
∆Y ∆Y ∆Y
Taking P common we get:
∆TR  P ∆P 
MR = = P 1 +  (13.3)
∆Y  Y ∆Y 
Note that the second term in brackets is the reciprocal of the price elasticity of demand:
1 1 P∆Y
= =
η yp Y∆P Y∆P
P∆Y
Thus, the expression for MR becomes
 1 
MR = P 1 +  (13.4)
 η 
 yp 
Since price elasticity is always negative, we can also write this expression as
 
MR = P 1 − 
1
(13.5)
 η 
 yp 
Expression (13.5) has shifted the minus sign of the price-elasticity and considers only the
absolute values of elasticity (irrespective of its sign). This is the desired expression to consider
the relation between price and marginal revenue. A number of results can be derived from this
expression:
1. The first immediate result is that as long as elasticity is not zero or infinite, marginal revenue
must be greater than price. For any number of price elasticity, the fraction 1 η yp is less than
4
This can be seen by the fact that ∆P = P1 − Po
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(
one which means that the bracketed term 1 − 1 η yp ) is also less than one and hence we
have:
 1 
MR < P 1 − for η yp > 0
 η yp 

This simply says that as long as price-elasticity is positive (in terms of its absolute value),
MR will be less than the price of a commodity. This is exactly what we learnt graphically in
the previous discussion.
2. Secondly, if the price elasticity of the demand curve that a firm is facing in the market is
infinite (as is the case for competitive firms), then MR will be equal to price as
 1 
MR = P 1 −  ⇒ MR = P
for η yp > ∞
 ∞ 
exactly the case we had in competitive markets. FYP Box 13.1 works out the mathematics
behind this relation for a linear demand function.
F Y I B O X 13.1
MR for a Linear Demand Curve
Understanding this box requires a bit of mathematics, so if you are not good at it leave this box
and move to the main text. Let us consider the specific case of linear demand curve [as that of
figure in our previous discussion] and plot marginal revenue curve. The equation of linear or
straight line demand curve is given by
P = a – bY (13.1.1)
Here a is the vertical intercept (measured at zero value of Y showing the level of price at which
quantity demanded will be zero), while b is the slope of the demand curve (preceded by the
negative sign because demand curves are negatively sloped)
∆P
= −b (13.1.2)
∆Y
which shows the change in price per unit change in quantity (this is the slope of the inverse
demand curve). Recall from expression (13.3) that marginal revenue is
∆TR ∆P
MR = = P+ Y (13.3)
∆Y ∆Y
Substitute the slope term (13.1.2) for ∆P ∆Y in this expression as:
MR = P - bY
And now substituting P from (13.1.1)
MR = a - bY - bY
or MR = a - 2bY (13.1.3)
It can be seen from this expression that MR curve has the same vertical intercept a as does the
demand curve [this can be confirmed from figure 13.3]. However, the slope of the MR curve is
twice as steep as the slope of the demand curve, as claimed earlier.
The output level where marginal revenue is zero can be calculated by setting (13.1.3) equal to
zero and solving for Y as:
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a
MR = a - 2bY = 0 Y=
2b
Moreover, marginal revenue is negative when Y > a/2b. Further, the quantity a/2b is the quantity
at which the elasticity is equal to 1 (in absolute term). This can be seen by recalling the
discussion of elasticity of the linear demand curve, from the chapter of elasticity, that its
elasticity of a straight line demand curve is given by:
− bP − bP
η= =
Y (a − bY )
The value of P at which elasticity is equal to one is:
a
P=
2b
So, marginal revenue is zero when Y = a/2b which is exactly the half way of the demand curve.
At any larger value of Y, the demand will be inelastic which implies that the marginal revenue is
negative.
13.2: PROFIT-MAXIMIZING OUTPUT AND THE MONOPOLIST’S PRICE
The supply decision of the monopolist can now easily be expressed using the standard
revenue-cost curves apparatus. Figure 13.4 draws marginal and average revenue (or demand)
curves of the monopolist as well as marginal and average cost curves. The question is: at what
point will the monopolist be able to maximize his profit? Mathematically expressed, the
monopolist would like to solve the profit-maximization problem subject to cost constraint:
Max π = TR − TC = P × Y − TC (13.6)
(P,Y )
Note that unlike a competitive firm, the monopolist can not only choose output (Y) but also price
(P) to maximize profits because it is price-setter—i.e. has control over market price. For the
monopoly firms, price is not a given social parameter emerging out of an impersonal market
mechanism. The implication of this market power in the hands of monopolist firm will be
discussed later in the chapter when we raise policy issues related to curbing monopoly power.
Let’s solve the above mentioned problem that the monopolist is facing.
The Marginal Condition
The general marginal solution for any maximization problem says that an activity should
continue up to the level at which marginal benefits equal marginal costs. This occurs for the
monopolist at the level where marginal benefits (MR) equal marginal cost (MC)—exactly the rule
we derived in the last chapter. So, point E shows the equilibrium condition for a profit-
maximizing monopolist in figure 13.4 where MR and MC curves are intersecting and the
monopolist produces Ym output. The price Pm that it would charge for this output level is given
along the demand curve corresponding to the output level Ym (at point M)—this is the maximum
price that consumers would be willing to pay for Ym level of output, hence Pm is the profit-
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maximizing price. Note that the monopolist charges a price greater than MC—unlike a
competitive firm—because it equates MC with MR and its MR is less than price at all levels of
output. Therefore, the equilibrium condition for the monopolist can be stated as:
MR = MC < P (13.7)
Figure 13.4: Profit-maximizing by the monopolist
Rs/unit
MC
M ATC
Pm
B
A
MR E
D-curve
MR-curve
0 Ym Y
The reason why E is the equilibrium or profit-maximizing point was explained in detail in the last
chapter, so you should go through the relevant section in order to consolidate your understanding.
To summarize, if the firm raises quantity beyond Ym, profit would fall because MR is below MC
(addition to revenue will be less than addition in cost by increased output). On the other hand, if
price is increased, this will reduce quantity sold cutting down revenue by MR. The forgone cost
would MC which is less than the revenue loss. This means that the result of raising price would
be to lower cost by less than revenue is reduced, so the profit would decrease. Only the
intersection point of MR and MC curves is the best output level if the firm is to maximize profits.
How much profit the monopolist is making at point E? Profit is given by the difference
between total revenue and total cost, so we have also drawn the ATC curve to calculate total cost
in figure 13.4. The revenue is given by the area 0PmMYm (= Pm × Ym) whereas area 0ABYm shows
the total cost of producing Ym output. Therefore area BAPmM shows the profit of monopolist
which is clearly positive in this case. Since the monopolist is the only seller in the market and no
entry is allowed for a new firm, therefore it will continue to make this supernormal profit both in
the short run as well as in the long run. But it is not guaranteed that the monopolist will always
make positive economic profit, it may lose money depending upon its cost situation. Pakistan
Railways is probably the best example of a monopoly losing money. What should a monopolist
firm do if it is making losses?
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Total Condition and Shut Down Rule
We said in the last chapter that the marginal condition can be combined with the
corresponding total condition for equilibrium. The total condition is especially helpful in
identifying the shut-down point for firms. Figure 13.5 shows the case of a monopolist making
lose (may be because demand for its product has decreased alarmingly—say for WAPDA the
electricity demand has decreased drastically because many people have reverted back to doing
without electricity). Of course the best operating point is E where MR and MC curves intersect.
However, at that point price Po is below average total cost A, since the demand curve lies below
ATC curve.
Figure 13.5: Monopoly incurring losses
Rs/unit
MC
ATC
C
A
Loss
Po
M
D-curve
MR-curve
0 Ym Y
Here, the demand curve is always below ATC curve which means that no matter what the level of
output, consumers value the firm’s output less than the cost of resources needed to produce it.
Thus even a monopolist cannot make profit in these circumstances. The monopolist, say
WAPDA, will ultimately shut-down if this tendency of incurring losses continues for a long
period of time because capitalist firms—whether competitive or monopolist—are necessarily
profit-maximizing entities.
The shut-down rule for a monopolist is exactly the same as the for competitive firm; i.e.
Shut down in the short run if TR < VC
Shut down in the long run if TR < TC
You should go through section 12.2.2 if you are not yet sure why this is the shut-rule for
monopolist.
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13.2.1: Monopoly Supply Curve
It is important to note here that ‘marginal cost curve is the firm’s supply curve’ holds true
only for the competitive firm which is, according to economic theory, a price taker. On the other
hand, marginal cost is not the supply curve for a monopolist. In fact, the monopoly has no
specific supply curve as shown in figure 13.6. A competitive firm always produces on its
marginal cost curve no matter what the level of demand. This is so because price is assumed to be
equal to marginal revenue for a competitive firm, therefore the amount it produces corresponds in
every case to its marginal cost curve. On the other hand, the output a monopolist produces
depends both on the firm’s marginal cost function and the market demand curve. Since both are
needed to determine supply, and many different demand curves can be drawn through the same
point each having a different slope and therefore a different MR curve, it is impossible to derive a
curve which shows how much a monopolist will supply at each price level.
Figure 13.6: No supply curve can be derived for monopolist
Rs/unit Rs/unit
S2
S1 S1
S2
P MC MC
a
P P
P
e1 D2
eo eo
D1 D1
MR1
MR2 MR1 D2 MR1

0 Yo Y 0 Yo Y2 Y
The left hand panel of figure 13.6 shows the possibility of monopolist producing the
same output level with two different price levels. This happens when two marginal revenue
curves having different slopes pass through a MC-curve at the same point (eo). The right hand
panel shows the situation when the monopolist is supplying more output at a lower price. Even if
the two demand curves are passing through the same point (a), the amount produced for the two
demand curves differ because their marginal revenue curves differ. Supply curves thus can’t be
drawn for monopolist independent of demand curve—there is no unique combination of price and
output supplied for a monopolist. This is result becomes very important when we compare
competitive markets with monopoly later in this chapter.
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13.3: MONOPOLY POWER
We have seen that the monopolist enjoys market power; i.e. the ability to change market
price. This ability of a monopoly business is reflected by the fact that it charges a price greater
than marginal cost of production. Let us develop a quantitative measure of this monopoly power.
13.3.1: Measuring Monopoly Power
Before doing this, it would be useful to have a practical rule of pricing for monopolist
firms. The above analysis says that the monopolist should choose his price and output such that
MR and MC are equal, but how can a monopolist manager find his correct price in practice? The
question is important because managers have only limited knowledge of the average and marginal
revenue curves of their firm. Similarly, they might know the firm’s marginal cost over a limited
output range. Fortunately, the MR-MC rule can be translated into a rule of thumb that can be
applied easily in practice.
A Rule of Thumb for Monopoly Pricing
To accomplish this task, begin with the expression of marginal revenue in (13.4):
 1 
MR = P 1 +  (13.4)
 η 
 yp 
P
or MR = P +
η yp
Since the firm wants to charge profit-maximizing price, setting marginal revenue equal to
marginal cost we have:
P
P+ = MC
η yp
This can be arranged to have:
P
P − MC = −
η yp
P − MC 1
or =− (13.8)
P η yp
which is the desired result. The left-hand side is the mark-up over marginal cost as a percentage
of price. For example, if price is Rs 10/unit while marginal cost is Rs 8/unit, then price mark-up is
20% [= (10 − 8) 8] . The relationship says that this mark-up equals the negative of the inverse of
price elasticity of demand (of course, this will be a positive number because price elasticity of
demand is a negative number). Equation (13.8) can be used by a monopolist as a rough guide to
determine price mark-up level once the value of price-elasticity of demand is known—however
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the estimation of elasticities remain problematic. 5 For example, for a value of price elasticity -2,
the market up would be 50%. Clearly, the smaller the value of price elasticity, the larger will be
monopoly mark-up over marginal cost and vice versa. The expression (13.8) can be rewritten to
express price directly as a mark-up over marginal cost as:
P  1 
P+ = MC or P 1 +  = MC
η yp  η 
 yp 
MC
or P= (13.9) 6
 1 
1+  
η 
 yp 
For example, if elasticity of demand is -4 and MC equals Rs 9/unit, the price should be:
Rs 9 Rs 9
P= = = Rs 12 / unit
 1  0.75
1+  
−4
The expression (13.9) can also be used to compare the price charged by a monopolist to that of a
competitive firm. We learnt in the last chapter that the competitive firm charges price equal to
marginal cost whereas, as explained above, the monopolist charges price that exceeds marginal
cost. Expression (13.8) shows that the amount by which the monopolist charges the surplus price
over marginal cost depends inversely on the price elasticity of demand.
Figure 13.7: Price Mark-up and elasticity of demand
Rs/unit Rs/unit
MC M MC
M Po
Po
P - MC
MC E
P - MC D
MC E MR
D
MR
0 Y Y 0 Y Y
5
These values can be derived using standard regression or estimation techniques or from published sources
6
Though the rule expressed in (13.9) provides a guide to determining price, however it should be used with
care because it applies only at equilibrium or profit-maximizing point. If elasticities of demand and supply
vary considerably over the range of outputs under consideration, you may have to know the entire demand
and MC-curves to determine the optimum output level. The equation can be used to check whether a
particular output level and price are optimum.
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This means that if demand is highly price-elasticity; i.e. ηyp is a very large (negative) number, then
price will be very close to marginal cost and monopolized markets will function very much like
competitive ones. In fact with very high demand elasticity, there is little benefit in being a
monopolist. As an extreme case, if price elasticity of demand is infinite (as is the case for
competitive firm), monopoly market becomes a perfect competition in practice. The situation is
depicted in figure 13.7.
Lerner Monopoly Power Index
What does the above analysis have to do with the measurement of monopoly power—the
problem we started with? A vigilant student can sense that that the expression (13.8) directly
gives a measure of monopoly power. The concept of monopoly power was first introduced by
Abba Lerner in 1934, and therefore it is called the Lerner index of monopoly power. The formal
expression of his index is:
P − MC
L= (13.10)
P
which simply says that monopoly power is reflected by percentage surplus of price over marginal
cost; so that the larger the value of L, the greater the monopoly power. We have seen that the
value of this index can be expressed in terms of price-elasticity of demand as given by:
P − MC 1
L= =− (13.11)
P η yp
As noted above, the value of the Lerner monopoly power index depends inversely upon the price-
elasticity of demand.
One thing should be noted at this stage rather clearly: considerable monopoly power does
not necessarily imply high profits. Remember that profit depends upon average cost relative to
price. It is possible that a firm might have monopoly power but may end up as losing money as
was shown in figure 13.5. Exploring the sources of market power is equally important as is its
measurement. But this issue will be tackled in the chapter on monopolistic and oligopolistic
competition because it requires some additional concepts for grasping it properly. Here we move
to the factors that make monopoly possible at the first place.
13.4: CREATING AND SUSTAINING MONOPOLY POWER: ENTRY BARRIERS
Monopoly is of course a desirable state for a profit-maximizing firm, but it is not easy to
create and maintain it. Application Box 13.1 gives an example of an attempt of creating a
monopoly in Brazil.
Brazilian Rubber Monopoly
The Brazilian rubber monopoly yielded enormous profits for Brazilian land-owners in the 19th
century and the government tried its best to protect its monopoly. However, a British citizen
managed to get some rubber trees out of Brazil and transplanted them in British held Malaya.
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After a decade when a large numbers of the rubber trees in Malaya came into production, there
was a crash of rubber prices in 1910 and Brazil lost its monopoly power.
The question we ask in this section is ‘how does someone create a monopoly?’ We will highlight
the strategies firms employ to maintain their monopoly position. The problem of creating and
maintaining monopoly could be seen in terms of barriers to entry—factors that either make entry by
a new firm impossible or difficult. Let’s discuss these barriers in the following sub-sections now.
13.4.1: Franchise Rights
Probably the easiest way of creating a monopoly is to have the government to create one
for you. An obvious example is WAPDA which has sole legal rights on the distribution of power
and water in Pakistan. The same was the case for PTCL until the late 1990’s. PTV also enjoyed
these legal rights for a long period of time until private channels were allowed in the business. A
monopoly created by the government is often termed as franchise monopoly. The government
granted rights restrict others’ entry into an industry in an area. Most franchise monopolies are in
the transport and public sectors of the economy. Some of the conventional forms of these
franchise rights are the following.
• Patens
One common form of franchise rights offered for protecting intellectual property rights
are patents, usually advanced for new products or processes. These rights are normally limited to
50 years in Pakistan and include disclosure of the invention in the application documents. A
patent holder can exploit the patent on its own (e.g. by selling the specific designs of product),
sell it to another firm or license anyone else who pays royalty to the patent holder. Patents are
important to many industries because they are means to recover costs involved in researching and
developing new products and processes.
• Copyrights
Copyrights are means of protecting intellectual property. Copyrights normally last for the
life of the author plus some (usually 50) years. For anonymous works and those written under pen
names or by corporate authors (such as newspapers), the copyright lasts for 75 years. A copyright
protects a particular expression of idea, not the idea itself. For example, if someone writes a book
on microeconomics (such as the one in your hands), then copy rights will protect only the specific
themes and coverage of the theory of microeconomics covered in that particular book, they will
not disallow anyone writing another book on microeconomics. This is why we have hundreds of
books on microeconomics all with some variations in their central themes. Copyrights protections
are normally offered to musical works and recordings, lyrics, book authors, broadcasting and TV
channels. These rights have also been extended to computer programs.
• Trademarks
Trademarks are yet another type of intellectual property rights; especially in computer
industry. Trademarks usually take the form of a distinctive mark or logo by which a person can
distinguish one firm’s goods from those of others; e.g. KFC, Sony etc. Unlike copyrights and
patents, trademarks protections never expire—an obvious advantage to the firm that has been in
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the market for a long period of time and wants to continue to use the protection. The functions of
trademarks are to stop foreign clones from being sold in the domestic market and to subject
consumers to a particular brand. Allowing one’s trademarked name to become the common term
for the whole class of similar products makes it almost impossible to stop infringers through the
courts. That is why ‘Coca-Cola’ and ‘Pepsi’ try their level best to maintain their brand names—to
ensure that when one orders a ‘Coke’ or ‘Pepsi’ in a restaurant, a substitute cola drink is not
automatically sold.
Why Franchise Rights?
How could one justify the above franchise rights within the framework of economics
which puts great emphasis on the moral/ethical value of the model of perfectly competitive
markets—markets where it is absolutely impossible for firms to differentiate their products from
one another and no barriers (including legal) are available to firms to hide information from
others? Two arguments are given to justify franchise rights. First, if large initial investments are
required to set and serve a market at all, then the firm making this investment should be protected
from entry, at least for some period of time. To understand the logic behind this argument, think
of a firm planning to make large fixed investments to serve a new market in a country. Of course,
it would be worried about its investment being overtaken by new technology. The firm may be
investing not only in plant and equipment but also in creating a market for its product. Once
investment is made and demand has been created, a new firm might enter with a slightly better or
cheaper version of the commodities and take away the revenue needed to cover the large initial
investment. If easy entry by new firms is allowed in the market, then possibly no firm would ever
start the business by making large fixed investment. Without some form of protection from entry,
the outcome could be inefficient compared to that which franchise monopoly could create. The
electricity and telecom companies have been historically granted monopoly rights on this basis—
their investments were very large and market for their product initially very small and uncertain.
Note that the underlying rationale behind this argument is ‘to increase the accumulation of
capital’. Economists hope that in general competitive markets provide maximum opportunities
and impetus for growth—accumulation of capital. However, in some cases competitive markets
fail to achieve this end and whenever this happens, capitalist government should look to achieve
this end using strategies that may apparently go against the spirit of competitive markets but do
advance the ultimate end that is actually desired from competitive markets—i.e. accelerated
accumulation. Thus, deviations from competitive market policy are allowed if such deviations are
aimed at exploiting the opportunities for capital-accumulation which are otherwise not possible to
avail. You will see more examples on these forms of legitimate policy deviations in this chapter.
Another important argument for justifying franchise rights emerges from natural
monopoly case. But before explaining this argument, we need to discuss natural monopoly and
some other related issues.
13.4.2: Natural Monopoly
Natural monopoly, often also termed technical monopoly, is a business with increasing
returns to scale at the level of the whole market. The obvious outcome of such a business
structure is that the average total cost (ATC) curve keeps declining as firm expands its operation,
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a phenomenon termed as economies of scale in chapter 11. Let us look more closely at the
conditions that make natural monopolies possible. A new profit-maximizing capitalist is thinking
of building a water treatment and supply plant for the city of Karachi—say because it is the
largest city in the country and hence the market size is very large. Of course this venture will
involve purifying the water from its existing source and providing it to the customers at a price
they are willing to pay. It is expected that this business would be capital-intensive and involve
extensive fixed capital expenditures for the treatment of plants and for equipments such as pipes,
filters, storage tanks etc—in other words fixed costs would be very high for this business.
However, the variable cost component is not going to be significant because a small work-force
can monitor a well-designed water treatment plant. This means that the firm’s cost will compose
mostly of fixed costs. Because average fixed cost [AFC (= FC / Y)] decreases as more output is
produced, the more water the firm supplies the more it can spread its heavy fixed cost. Therefore,
average total costs would decline over a large amount of output. Figure 13.8 depicts this type of
cost behavior where average total cost is decreasing up to q2 units, say 70 thousand gallons of
water per day. The average cost function in figure 13.8 gives rise to natural monopoly where
technically the cheapest way to produce any given level of output in the market is to have one
firm—i.e. the cost of production by a single firm is less than that of more than one firm. For
example, consider output q2 which costs Rs 12 per gallon. So the total cost of producing 70,000
gallons of water is calculated as:
TC (q2) = TC of Monopoly Firm

TC (q2) = ATC × Y
TC (q2) = 12 × 70,000 = Rs 840,000 (= ATC × Y)
But what if the total of 70,000 gallons water is processed and supplied by two firms? If both firms
serve half of the market, then each firm will supply 35,000 gallons with per unit cost of Rs 16.
The total cost of producing 70,000 gallons in this case would be:
TC (q2) = TC of Firm 1 + TC of firm 2

TC (q2) = 16 × 35,000 + 16 × 35,000
TC (q2) = 560,000 + 560,000 = Rs 1,120,000
Clearly, total cost is less for monopoly firm as compared to the two firms serving the market.
Technically, it is desirable to have only one firm operating in the market than two or more
because with a falling ATC-curve, the monopolist is able to produce output in the least cost way
at all levels of output up to q2. If total demand for water per day is 70,000 gallons in Karachi,
people will benefit if the water monopoly is granted to our capitalist and he is charging a price Rs
12/gallon of water, instead of two firms operating and charging a price Rs 16/gallon (of course no
capitalist firm would like to charge a price below its average total cost because that would simply
mean losing money). Thus one of the conditions for natural monopoly to develop is to have a
falling ATC-curve over a large scale of production—i.e. production technology to exhibit
increasing returns to scale. This condition is satisfied for the water-supply monopolist for all
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quantities below q2 = 70 thousand gallons of water per day. It is due to these technical reasons
that we see public utilities like electricity, gas, water and telephone services, being supplied by
public sector firms in many societies. Competitive markets are not desired in this case because
inclusion of more firms in the market disallows firms to benefit from economies of scale.
Figure 13.8: Cost behavior that makes monopoly possible
Rs/unit
a
40
ATC
30 d
b
16
c
12
0 10 q1 = 35 q2 = 70 q3 =105 Y
However, two points should be noted here. First, development of natural monopoly does
not require falling average total cost every where. We can have technical monopoly even in the
case of non-decreasing segment of ATC-curve. In our monopoly case, this would be possible if
per day water requirements are slightly more than 70,000 gallons, say 75,000 gallons. In this case
we will have a point on ATC-curve near by the right of point c for the monopoly and by repeating
the above type of analysis for more than one firm with different combinations of output that add
up to 75,000 gallons per day we can confirm the above result. Secondly, firm experiencing
technology producing cost function as drawn in figure 13.8 is not a natural monopoly at every
level of output. For example, consider output level q3, say 105,000 gallons per day. If this amount
is produced by one firm, the total cost would be Rs 3,150,000 [= 30 × 105,000]. However, the
same output can be produced more cheaply by three firms each producing 35,000 gallons costing
Rs 1,680,000 [= 16 × 35,000 × 3], or by two firms one producing 70,000 while other 35,000
gallons and costing only Rs 1,400,000 [= 12 × 70,000 + 16 × 35,000]. Hence, there could be a
level of output beyond which a firm with the cost function depicted in figure 13.8 is no longer a
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technical monopoly. This fact gives rise to the issue of sustainability of natural monopoly; i.e.
under what circumstances a natural monopoly could be sustainable.
Sustainable Monopoly
The mere fact that the water-supply firm is a natural monopoly does not protect it from
entry by rival firms. Consider panel (a) of figure 13.9 which draws the same average total cost
curve as in 13.8 except that market demand curve has been superimposed. If the total water
requirement for Karachi city is yb gallons, then Rs 15 a gallon is the lowest price that will allow
our monopolist to cover cost of producing this output level. We can see that for all output levels
below yb, any producer is a natural monopolist. Is there any possibility for a new capitalist firm to
make entry in this market, take customers away from the existing monopolist and make a profit?
The answer is yes. To understand how, think of a firm that enters the market and produces ya
output at an average total cost of Rs 12/gallon. Such an entrant can set a price between Rs 12 and
Rs 15 (the existing monopolist’s lowest price), sell ya gallons of water and make a profit. This
new firm will be successful because it needs not supply the entire market when it enters; rather it
can provide only ya gallons and enjoy low costs associated with producing this output.
Figure 13.9: Sustainability of natural monopoly
Rs/unit (a) Natural Monopoly Rs/unit (b) Natural Monopoly

with possible entry with no entry possibility
ATC ATC
Pd d
b
15 c
a Pc a
12
Do Pe
Do
0 ya yb Y 0 yd yc Y
Such a strategy of market entry will force the existing monopolist to produce less than total
market demand and accept the new entrant. As this happens, two firms will start serving the entire
market and price will rise in the longer run as average total cost starts increasing due to the fact
that both firms are unable to exploit full benefits from falling average total cost.
A natural monopoly that can prevent entry and keep others out of the market is called
sustainable monopoly. This monopoly is characterized by the situation where average total cost
is decreasing every where up to the level of the whole market. This is shown in panel (b) of
figure 13.9 where market demand of water is yc gallons. This quantity can be sold at price Pc
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where demand curve is intersecting the ATC-curve at point c. Because average total cost is
decreasing up to that point, the firm has sustainable natural monopoly for that quantity. What if
another firm tries to make entry in this case by selling quantity less than yc? In order to avoid loss,
the entrant must set price equal to or above pc. Suppose it sets price pd and hopes to sell yd
amount. Since this price of pd is higher than that existing monopolist charges, consumers will not
buy from the new entrant. The only way to take customers away from the monopolist is to set
price below pc. If the entrant does so, and chooses a price pe, its price will have to be lower than
its average cost of production which means it loses money and hence does not enter. Therefore,
output of yc is sustainable for the monopolist, as is any quantity at which the demand curve
intersects the average cost curve to the left of point a. Note that the sustainable price-output
combination must be a point where the demand curve intersects ATC-curve. Alternatively, the
capitalist can have sustainable monopoly if he sets a price and quantity with demand equaling
average total cost (the marginal cost pricing rule is not consistent with natural monopoly, this
point will be discussed below).
To summarize the above discussion in rather technical language, we can define a
sustainable natural monopoly as one that meets the following three conditions:
1) y = D (p)—output of the firm (y) satisfies all market demand (D) at any price
2) P × y = TC (y)—the firm covers its cost by producing that output (y)
3) P’ × y’ < TC (y’) for all p’ < p and y’ < D (p)—and sets a price p such that any competing
firm that tries to enter by selling a smaller quantity (y’) at a lower price (p’) incurs loss
The above conditions confirm that a market characterized by always decreasing average total cost
must be a sustainable natural monopoly. Thus if a market structure is characterized by the above
conditions, it becomes an effective barrier to entry for new firms. Such market structures allow the
existing firms to engage in pricing strategies that prevent entry by new firms as discussed below.
13.4.3: Active Pricing Strategy
Having considered the conditions under which natural monopoly would be successful, the
capitalist decides to establish his water supply firm. Figure 13.10 shows the decision making
process of the capitalist. Since this is a profit-maximizing firm, given the demand situation the
profit-maximizing price is Pm and Ym is profit-maximizing quantity. You can see that Ym quantity
is determined at the point where marginal revenue equals marginal cost and the price is set above
the marginal cost depending upon the elasticity of the demand curve in expression (13.9). The
monopolist makes super-normal profit equal to the area AbcPm. Obviously, this profit will attract
a new entrant. Is the monopolist ready to tackle this event? If a competitor tries to enter the
market, he can immediately reduce the price to Ps which is the sustainable price for the market
(price Ps is comparable to Pc in figure 13.9).
Inertia Shopping Rule
Note that the monopolist does not need to charge Ps price all the time to prevent the
entry. In fact, the pay offs associated with each move in this market make it possible for the
monopolist to continue charging Pm price and yet no entry would take place.
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Figure 13.10: Using Limit pricing to prevent entry
Rs/unit
MC
c
Pm
ATC
b
A d
Ps
e
MR Do
0 Ym Ys Y
To understand how, suppose the capitalist is currently charging price Pm. Of course this price will
attract new competitors because it promises super-normal profits. Will it not be possible for the
competitor to make successful entry by charging price Ps which is lower than Pm—the price the
existing monopoly is charging—and take away the market from the monopolist? The answer is
‘no’ as long as customers suffer from inertia—the tendency of customers not to shift their
demand to the entrant immediately. In these circumstances, the monopolist assumes that
customers will behave according to the inertia shopping rule when deciding which firm to buy
from. The rule is simple: buy from the firm that charges the lowest price, but if you are already
buying from a firm and another firm enters the market with a lower price, give your current firm a
chance to meet the entrant’s price before shifting your demand. This behavior on the part of
customers gives enough time to the monopolist to decrease its price and prevent the entrant from
taking away its customers, despite the fact that the entrant starts with a lower price than the
existing monopolist. The strategy of the new entrant can be summarized as follows:
o If the existing monopolist is currently charging price Ps, there is no point in entering the
market
o If the monopolist initially sets monopoly price Pm and, after the entry occurs, he lowers it to
the sustainable price, the entrant will gain no customers (this would be true as long as the
inertia shopping rule holds). The entrant will lose whatever amount he invested in the plant
It should be clear to any potential capitalist entrant that if it enters the market after the monopolist
has set the monopoly price, the monopolist will subsequently lower its price, force the entrant out
of the market and cause it to lose its investment. Hence, even the monopoly price will deter the
entry of any potential competitor. Because no entry will take place whether the price is Pm or Ps,
the monopolist will set the monopoly price. Thus, pricing strategies used by existing firms are
also barriers to entry. The above is an example of limit pricing where the existing firm sets a
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price so that an entrant can’t make profits at that price. More on such pricing strategies will be
said in our discussion about oligopoly in the next chapter.
13.4.4: Investment Requirements and Capital Market Imperfections
Entry barriers can be distinguished on the basis of the degree of space they leave for new
entry. Barriers discussed above are called absolute barriers—barriers that rule out new entry
whatsoever over some time horizon. Such barriers arise out of legal impediments, such as
franchise rights, or out of specific market conditions, such as characterized by natural monopoly,
or out of active pricing strategies. Unlike them there are some relative barriers which place a
new entrant at a disadvantage, but they are not insurmountable ones. Relative barriers may also
arise due to a number of factors: capital market imperfections, specific competitive advantages
etc. Here we discuss some of them; first take large investment requirements and capital market
imperfections.
We learnt in the last chapter that super-normal profits lure new firms to enter the market.
What do you understand by new firm? Normally, economic theory gives an impression that such a
new firm is launched by a person who was initially not a supplier; i.e. an ordinary person
becomes a capitalist by starting his own business. The model of perfect competition presents a
simplistic picture of entrepreneurship—something realized merely by the possibility of making
‘super-normal profit’. In fact, such a conception of ‘spontaneous new entrepreneur’ is the
requirement of the ‘large number of firms’ assumption to make a market perfectly competitive—
markets can be perfect only when all people consider themselves as potential capitalists and
actually keep transforming themselves into ones whenever profits exist. However, this conception
of the entrepreneur is largely heroic and superficial since, in capitalist order, it is not the entry by
new firms that increases production in response to profit-margins; rather it is due to the expansion
of scope of business by the existing firms. Indeed, a great deal of the new entry in capitalist
markets takes place in the form of diversification and integration by already established firms. To
look for the examples to confirm this statement, ask yourself: ‘who bought KESC or PTCL in
Pakistan?’ Ordinary household agents? Of course not, rather they were purchased by already
established large capitalist firms such as Siemens. One reason behind this phenomenon has been
the large initial investments required to set up a business. As capitalist markets grow and
production becomes capital and technology intensive, the fixed cost of entering the market keeps
mounting sky high. Suppose you are thinking of starting a new mobile subscription company
today. Clearly, you can’t begin this business by incorporating an out-dated technology hoping for
gradual updation later as your business succeeds. Instead, you need to start in this business using
the current state of mobile technology to have any hope for success whatsoever. Since this
‘starting point’ of entering the market tends to become higher and higher with improved
technological production, entry by genuinely new firms becomes more and more difficult as
capitalism matures. A reflection of this fact can be seen in the job market for MBAs as discussed
in Application Box 13.2.
MBAs: Entrepreneurs or Wage Laborers?
Universities regularly offer courses on entrepreneurship in their MBA programs giving students
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the illusion that freely available possibilities of ‘entrepreneurship’ is what make market
economies more efficient and dynamic as compared to planned economies. Students are often
fascinated after going through these subjects as if the only barrier they need to overcome in order
to become an entrepreneur is to get an MBA. However, in reality fewer and fewer people can
afford to become entrepreneurs as markets mature. This tendency is reflected in the fact that only
a negligible proportion of graduates of business administration go for the entrepreneurship option
while the vast majority opts for wage-labor. It can safely be stated that almost 95% of MBAs
from all universities of Pakistan become wage laborers. Thus as far as most students are
concerned, becoming an entrepreneur is simply not a realistic option.
The competitive market model assumes away the entry problems arising out of
investment requirements because it assumes that capital markets work competitively which
implies that:
1. all market agents have borrowing access to whatever amount they need
2. the real cost of borrowing remains constant irrespective of the amount borrowed and
3. there are constant returns to scale in the market
But these assumptions are never true in reality as different borrowers pay different interest rates
and this interest rate also increases with the amount borrowed. This means that a new entrant will
have to pay a higher interest rate than the well-established monopolist. This tendency is further
strengthened if the lender regards the entrant as risk—interest rates tend to rise as investment
becomes more and more risky. The above tendencies are further enforced when increasing returns
to scale (or economies of scale) exist in the production of the monopolized good. In this case, if
the entrant sets up production on a scale smaller than at which average costs are at a minimum,
then it will incur average costs which exceed those of the monopolist. On the other hand, if it
enters on a scale large enough to achieve minimum average costs, then the required capital
expenditures will be very large, and may again involve the payment of higher interest costs than
those incurred by the existing monopolist. The entrant may not even be able to obtain the required
amount of funds to set up an optimal production scale if there is capital rationing in the capital
markets. Thus, ever improving production technology leading to large fixed costs and capital
market imperfections pose significant market barriers. More on the difficulties of market entry
due to these reasons will be presented in the next section.
13.4.5: Competitive Advantages
Another category of barriers arise because of competitive advantages enjoyed by

existing firms due to product differentiation—when markets are characterized by product
differentiation, firms may have advantages over new entrants because of a number of factors.
Competitive advantages exist when a firm is able to deliver the same benefits as do its
competitors but at a lower cost, called cost advantage, or deliver greater service for the same
price to its competitors, called differentiation advantage. Thus, a competitive advantage enables
the firm to create superior value for its customers and, hence, superior profits for itself. Firm
develops competitive advantages by having unique resources or by excelling in certain
capabilities as compared to its competitors and the competitors are unable to replicate what the
firm is doing. Examples of resources that create such advantages to firms, for example, are:
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• Patents and trademarks: exclusive control of superior product design or formula through
patent protection
• Trade or business secrets: contractual right created between a pair of firms doing business or
between an employer and employees. Application Box 13.3 gives an example of trade secret
• Consumer preferences or installed customer base: brand loyalty on the part of customers
An example of a firm’s capability is efficient supply and distributional chain—ability to bring a
product to the market faster than its competitors. Such capabilities are embedded in the routines
of the organization and are not easily documented as procedures and thus are difficult for
competitors to replicate.
Coca-Cola’s Formula as Trade Secret
Coca-Cola’s formula for its syrup has never been patented or had any other form of legal
protection. The Coca-Cola firm has kept the formula secret, revealing it only to people and firms
that have signed contracts explicitly requiring them not to reveal its composition. In 1987, when
the government of India attempted to force Coca-Cola to turn over the formula without such
trade secret provisions, Coca-Cola backed out of the negotiations and went out of India’s market.
The firm’s competitive basis is the composition of its syrup. Imitators might take much of its
market away if it were to reveal this trade secret. This is also true for KFC and Mc-Donald’s.
Since new firms need to make additional expenditures to acquire these advantages,
existing firms therefore have absolute cost advantage over the new entrant and they can hence
charge a lower price to discourage entry. However, these disadvantages will be only of limited
duration as new entrants establish their products in the market during an initial ‘break in’ period.
But keep in mind that the new entrants are not new firms; they are new product and service lines
established by existing large firms.
Capitalist Dynamics and the Emergence of Monopolies
This section tells us something about capitalist order. As capitalism matures, organized
units controlling capitalist property become fewer and fewer. The perfectly competitive model
becomes less and less relevant as a description of capitalist market reality. It retains its usefulness
as an ideological benchmark for evaluating the behavior of capitalist individuals (consumers,
producers, financers, regulators etc.).
At the end of the 1980s there was much talk of “unorganized capitalism” and the
emergence of dynamic small producers and distributors in countries like Italy and Spain was
widely celebrated. A Pakistani economist working at the Institute of Development Studies Sussex
U.K also found such dynamic firms in Sialkot! Schumpeter, Schmidt and many other capitalist
economists proclaimed the end of large scale capitalism. But this euphoria soon evaporated. The
“dynamic new firms” were soon integrated into global supply chains managed and controlled by a
handful of capitalist conglomerates. Capitalist organization has shown that this is quite
compatible with the concentration and centralization of capitalist property in fewer and fewer
hands. This centralization and concentration of capitalist property is an essential aspect of
globalization.
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Centralization and concentration of control is necessary for the survival and reproduction
of capitalist order. Capitalism, just like socialism, also abolishes private property. All wealth in
capitalist order is controlled by a small group committed to using it for the sole purpose of
accelerating the rate of capital accumulation and for ensuring that all economic activities are
valued and assessed solely on the basis of their relative contribution to the acceleration of the rate
of capital accumulation. Private property allows its owner to use wealth for purposes other than
capital accumulation–––Abdullah Zhaghazai uses his wealth to repair the mazar of Pirbaba and
Abdul Basit uses it to support the Chechen Jihad. Capitalist order must therefore restrict the
opportunities of Abdullah and Abdul Basit to acquire wealth for they take wealth out of the
circuit of capital where wealth becomes solely an instrument for the self-expansion of capital.
Hence capitalist property––in the form of banks, corporations and state owned firms—:
• destroys private property,
• turns Abdullah and Abdul Basit into capitalism’s wage-laborers and
• concentrates the control of all wealth in the hands of those fewer and fewer entrepreneurs
who are committed to and have the necessary skill for using wealth for the sole purpose of
accelerated capital accumulation
Capitalism concentrates the control of wealth (all wealth becomes capital). But it does so in a
manner which allows competition to flourish in capitalist order. Competition is the central
mechanism for sustaining capitalism’s foundational virtues––avarice and covetousness. If the
scope of competition is constrained, scope for the practice of these capitalist virtues; avarice and
covetousness is also constrained and capitalist morality tends to ‘wither away’. That is why “State
Capitalism” usually succumbs to market capitalism. Scope for competition––the practice of
avarice and covetousness––is smaller in state capitalist (socialist) order than it is in market
capitalist (liberal) order. Therefore, competitiveness has to be sustained for ensuring capitalist
survival.
Competition intensifies in market capitalist order in two main ways. First there is
intensified competition among individuals as capitalist property replaces private property. The
category of wage-labor is universalized. Every man owns nothing except his labor power. And be
he operative or manager, he must be an employee and must compete against all other employees
to maximize the rate of capital accumulation. Structuring the reward / incentive system to ensure
that competition is intensified within each firm is a primary means for universalizing competition.
Secondly capitalist order is necessarily unstable, crisis prone and vulnerable to systemic shocks.
Most prices––especially prices of financial products and services––are determined by
speculation. There are always a large number of losers and some winners in every capitalist order
which is never in a state of system wide equilibrium (‘general equilibrium’) or in a state of
steady-state growth. Capitalist markets necessarily become imperfect and remain imperfect
forever. Oligopoly, not perfect competition or monopoly, is the normal market structures of
liberal capitalist order. Competition in oligopolistic markets is intense––characteristics of
oligopolistic market structure will be discussed in the next Chapter.
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13.5: NEED FOR REGULATING MONOPOLY AND STATE POLICY
Most of the capitalist governments try to restraint and regulate monopolies so that more
competition could flourish. We first examine the justification offered by standard economic
theory for such state regulation of monopoly and then move on to the instruments of these
regulations. Suppose that a monopolist establishes a water supply firm and charges a monopoly
price. With the passage of time he finds things going the way he planed as no entry takes place
and he continues to make super-normal profits. Is this state of affairs a satisfactory one for
capitalist (or civil) society? Economists would say no. If you think that the reason for this answer
is the super-normal profit made by the monopolist, then you are wrong because economists have
another criterion to evaluate the efficiency of market structures. The following sub-section explains
the logic behind this criterion, but you must go through the appendix to chapter 12 that outlines the
necessary tools—i.e. consumer and producer surpluses—to understand this section fully.
13.5.1: Social Cost of Monopoly: The Standard Story
The trick (used in almost all standard microeconomics textbooks) is to compare the
equilibrium output of the competitive firm with that of the monopolist. We have seen that in a
competitive market, price equals marginal cost while monopoly implies that price exceeds marginal
cost. The monopolist charges a higher price and produces a lower quantity as compared to the
competitive firm. This can be seen by comparing points em and ec in figure 13.11. Point em is the
monopoly equilibrium point with MR equaling MC associated with Pm price and Ym output. On the
other hand, ec is the competitive market equilibrium point because competitive firm produces where
MC equals price (or average revenue, AR).
Figure 13.11: Deadweight loss from monopoly power
Rs/unit
Deadweight
loss MC
A B
Pm
C D E ec
Pc
e
F
G
em AR = Do
MR
0 Ym Yc Y
463
This means that competitive equilibrium is achieved in this diagram where MC curve intersects
demand (or average revenue) curve. The competitive and monopoly output-price combinations
can now easily be compared.
Monopoly and Deadweight Loss
How should we compare the two equilibrium points; i.e. which of them is the better from
a capitalist point of view? The capitalist benchmark for evaluating two economic states is the sum
of consumer and producer surpluses: market structure resulting in larger consumer and producer
surpluses is treated as welfare superior. Let us compare the corresponding surpluses under
monopoly and competitive situations. Consider competitive equilibrium first. Recall from the
appendix in chapter 12 that consumer surplus (CS) is given by the area under the demand curve
and above the price level while producer surplus (PS) is the area below the price level and above
the supply curves. Given these definitions, consumer and producer surpluses in figure 13.11 are
represented by the following areas:
CScom = A + B + C + D +E
PScom = F + G
TScom = A + B + C + D +E + F + G
Similarly, surpluses under monopoly case are given by the areas:
CSmon = A + B
PSmon = C + D + G
TSmon = A + B + C + D +G
We can now easily examine how surpluses change if we move from competitive to monopoly
equilibrium. Algebraically, the change in total surplus is given by subtracting competitive surplus
from monopoly surpluses; i.e.
∆TS = TSmon – TScom
Therefore,
TSmon = A + B + C + D +G
– TScom = – A – B – C – D –E – F – G
∆TS = –E – F
The result shows that civil society has lost the welfare (consumption possibilities) equivalent to
the area E-F as indicated by the shaded area in the diagram. But what is the intuitive meaning of
this calculation? Consider what happens to consumer and producer surpluses when we move from
point ec to em. It can be seen that consumer surplus falls by the areas C, D and E because price has
increased. Algebraically, it can be calculated by subtracting consumer surplus under competitive
equilibrium (A + B + C + D + E) from that under monopoly:
CSmon = A + B
– CScom = – A – B – C – D –E
464
∆CS = – C – D –E
Unlike this changes in producer surplus are a little more complex. Areas C and D have been
added to producer surplus after rise in price from Pc to Pm while area F is lost by the producer
because it is now producing lower quantity, Pm. These changes are given as:
PSmon =C+D+G
– PScom =–G–F
∆PS = C + D –F
Adding the two changes we get the change in total surplus:

∆TS = ∆CS + ∆PS
= (– C – D –E) + (C + D –F)
= –E – F
which is exactly what we had above. You can see that out of the total changes, areas C-D have
been transferred from consumers’ to producers’ surplus, so this merely represents a redistribution
of income. If society places the same value to the gains of producers as that of to the loss of
consumers, then the reduction in consumers’ welfare by C-D is compensated by the gains in
producer welfare by the same amount. The two areas thus cancel each other out. But what about
the loss in consumer surplus shown by area E and that in the producer surplus by area F? This is
the net loss in social welfare resulting from monopoly power—called deadweight loss. You can
see that the deadweight loss is independent of monopoly profit; i.e. it exists whether or not the
monopolist makes a super-normal profit. Even if the monopolist’s profit is completely taxed away
and redistributed to the consumers of its products; there would be inefficiency because output
would be lower than that under competition. The deadweight loss shows the social cost of this
productive inefficiency. Remember, as explained in the last chapter, that firms achieve production
efficiency when they follow marginal-cost-pricing. Table 13.3 summarizes the differences
between the monopoly and the competitive firm model.
Table 13.3: Differences between monopoly and competitive model
S. No Competitive Firm Monopoly Firm

1 Price taker Price setter
2 Faces horizontal demand curve Faces downward sloping demand curve
3 Marginal revenue equals price Marginal revenue is less than price
4 Charges price equal to marginal cost Charges higher price than marginal cost
5 Results in efficiency Imposes deadweight loss on society
Since according to economic theory, monopoly business is associated with deadweight loss and
inefficiency (i.e. loss of consumption), this sets the grounds for preventing firms from exercising
465
monopoly power. Putting the argument in the context of our water-supply monopolist, people see
no reason why a monopolist should make profits and yet not provide water to all the customers
who want it.
13.5.2: State Instruments for Regulating Monopoly
Given the above situation, economists would quickly ask government officials to do
something about this situation in order to increase civil society welfare—i.e. consumption.
Economists suggest a number of policy options available to the state for regulating monopolies.
We discuss them one by one.
Price Regulation
One of the objectives of price-ceiling is to eliminate deadweight loss. Figure 13.12

illustrates how this policy works. Here, Pm and Ym are the price-quantity combinations that result
without price regulation. Now assume that the government regulates price to be no higher than
P1—sets a maximum price limit. How would the demand and marginal revenue curves change
after this price regulation? Because the firm cannot charge anything more than P1 for output
levels up to Y1, its new demand (or the average revenue) curve is a horizontal line at price P1
(look at the dark thick horizontal line at P1). The dashed part above P1 is no longer effective after
the imposition of price ceiling. This is very similar to the competitive firm’s horizontal demand
curve when price is fixed.
Figure 13.12: Monopoly with price-ceiling

MR-curve when price
Rs/unit is regulated to be no
higher than P1
MR
A
Pm
B MC
P1
P2 = Pc ec
e3 e3’
P3
ATC
e1 AR = Do
P4
em
0 Ym Y1 Y3 Yc Yo Y
But for output greater than Y1, the new demand curve is identical to the old one because at these
output levels the firms will charge less than P1, and so would be unaffected by the regulation.
466
Since the marginal revenue curve is derived from the demand curve, the new marginal revenue
curve will also change as it will correspond to the new demand curve now. For output levels Y1,
marginal revenue equals the demand (or average revenue) curve. On the other hand, for output
greater than Y1, the new MR curve is identical to the original one. Note that the MR curve is
vertical from price P1 up to the level where it corresponds to the old MR curve. Thus, the
effective MR curve after price regulation is the dark line. With price ceiling, the monopolist will
produce Y1 output because that is where its MR curve intersects MC curve (point e1).
It can now easily be seen that the deadweight loss has been reduced from area emAec to
e1Bec due to this price-regulation. As price is further reduced, quantity produced continues to
increase and deadweight loss decreases. At price Pc, where the demand curve is interesting the
MC curve, quantity supply has increased to the competitive level, Yc, and the deadweight loss has
disappeared. What if price is further reduced to, say, P3 level? Note that this will result in
reduction in quantity to Y3 because in that case the firms’ demand and MR curves will be
horizontal at price P3 up to the quantity level Yo. This means that MR curve will intersect MC at
point e3 and the monopolist will produce Y3 output. This reduction will also create a shortage
equivalent to (Yo – Y3) because demand is greater than quantity supplied at this price. As the price
is lowered further, the quantity produced continues to fall and the shortage grows. Finally, if the
price is set below P4, the minimum average total cost level, the monopolist loses money and will
opt out of business.
• Price Regulation and Natural Monopoly
Price regulation is often practiced for natural monopoly. The above analysis shows that the best
way to regulate monopoly price is to set it equal to marginal cost of production. What if the price
regulatory authority tries to implement the marginal-cost pricing rule to natural monopolies, such
as our water supply monopolist? Unfortunately, the policy will not work as it will force the
monopolist out of the business. To understand why, consider figure 13.13 which shows the case
of natural monopoly. Note that average total cost is falling everywhere due to increasing returns
to scale (the ultimately rising segment of ATC curve is not shown because that is irrelevant in the
natural monopoly case). Since average total cost is decreasing everywhere, therefore MC curve is
always below ATC curve. Unregulated, the firm would produce Ym and charge Pm price. If the
regulatory authority pursues the ideal pricing policy of pushing price down to the competitive
level Pc where the MC curve cuts the demand curve, then the firm will not be able to meet its cost
as this price is below its average total cost by distance Bec. Here, the regulatory authority has two
options. First, force the monopolist to use welfare optimal price Pc, but in that case government
must pay him subsidy to cover his losses so that he can stay in business. Second, set the
monopolist’s price where it can break-even. This price is achieved where the demand curve
intersects the average total cost at point er with price Pr. With this price, the monopolist earns no
monopoly profit and output is as large as it could be without driving the firm out of business. This
pricing rule is called average-cost-pricing. True that this plan will not produce welfare
(consumption) optimal result for society, but it will achieve the second best result from civil
society point of view. Though average-cost pricing seems to have solved the problem of
monopoly power, but it is not an easy option to use in reality because of informational
467
requirements about cost and demand structure of monopoly business. Firm’s demand and cost
curves keep shifting as market conditions evolve.
Figure 13.13: Regulating natural monopoly
Rs/unit
A
Pm
er B
Pr ATC
em
Pc MC
ec
Do
MR
0 Ym Yr Yc Y
Rate of Return Regulation
Another option for regulating monopoly business is the use of the rate of return
regulation which is not only simple to administer but requires less information that the price
regulatory scheme. The underlying idea behind this regulation option goes as follows: when
capitalist agents invest money in an enterprise, they expect to receive at least a rate of return they
could have earned by investing their money elsewhere, most probably in a bank saving account.
If they do not expect this rate of return, they will conclude that the investment is not worthwhile
and should be dismissed or ended. So the regulatory authority must allow any firm under its
jurisdiction to make a rate of return sufficient to keep its capital in the given business. This means
that the monopolist would not be allowed to earn more than a fair or competitive rate of return. If
profits are large enough to create excessive rate of return, the firm will be directed to reduce the
price of its product.
How could such a price be calculated? Let K stand for the amount of capital invested by
our water-supply monopolist and rr for rate of return (say x%) permitted by the regulatory
authority. After the firm has paid its variable costs, it must earn enough money to pay its
shareholders rK amount. The key is to make sure that rr is large enough to satisfy the investor.
Since the amount of capital K is something observable, so the regulatory authority should find it
relatively easy to measure that amount. If we assume that labor and capital are the two inputs in
operation; and w is the wage rate for labor, Y be the output and P the price of output, then the
formula for rate of return regulation is:
P × Y − wL ≤ rr K (13.12)
468
This expression says that after the firm has subtracted its labor (or variable) cost from revenues,
the amount left over must not be greater than what is necessary to pay the rate of return rr on
capital K. This can now be solved for the price P that guarantees the desired rate of return as:
wL rr K rK
P* = + = AVC + r (13.12)
Y Y Y
Since the rate of return regulation is based on the amount of capital stock, one difficulty
arising in case of this regulation is the information on true valuation of the monopolist’s capital
stock. The difficulty of agreeing on a set of cost numbers to be used in the rate of regulation
calculation often leads to delays in regulatory response to changes in cost and other market
conditions, as well as long and expensive court hearings. The major beneficiaries of this situation
are lawyers, accountants and sometimes economic consultants. The net result is regulatory lag—
the delay of months usually required to change the regulated price. These lags benefit the
regulated firms if average long run average total costs are falling over time (due to the realization
of economies of scale as firms grow). The regulatory lags allow these firms to enjoy actual rate of
return higher than those regarded fair at the end of regulatory proceedings. Application Box 13.4
shows how the rate of return regulated firm can become very lucrative for capitalist regulators. It
also explains how regulatory authorities are jeopardized by capitalist firms via promoting formal
corruption—one of the glaring hallmarks of capitalist societies.
Rate of Return Regulation and Job Career as Regulators
The politicizing of pricing decision and the investment decisions of a rate-of-return regulated
firm can become very lucrative for regulators. One of the common career paths for staff members
of a regulatory commission is to take such a job immediately after graduating from law school.
After spending a few years with the law commission, learning its procedures and developing
relations with personals, the staff members can work for one of the regulated firms. The insider
knowledge and contacts obtained can then help the regulated firm. Many economists have argued
that regulatory bodies become ‘captured’ by the firms they regulate. Only the regulated firms
have a large sustained interest in the regulatory process and devote substantial resources to
influence regulatory authorities. The outcome is the regulation works in the interest of those
regulated firms. This means that getting the benefits of natural monopoly through regulation
reflects a trade-off for the costs regulatory system creates.
However, sometimes regulatory lags go against the monopoly. For example, when oil
prices rise sharply, electric utilities and railways need to raise their prices. Regulatory lags cause
them to accept rate of return well below the fair rates they have been earning earlier.
Price-Cap Regulation
The above regulation schemes are problematic because they provide monopolists an
incentive to maximize costs—the greater a firm’s costs are, the greater the price it will be allowed
to charge. For example, under average-cost-pricing, the amount the monopolist is allowed to
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charge for a product is based on the average cost of producing that product. This means that a
higher cost leads to a higher price. Moreover, this policy enables the monopolist to survive
without paying close attention to new cost-reducing opportunities. Similarly, rate of return
regulation provides an incentive to use more capital than is necessary or efficient to produce in
order to increase the firm’s rate base. An alternative tool of regulating a monopoly firm is to use
price-cap regulation which is a regulatory method designed to encourage efficient production by
allowing firms to share in any cost savings that they have achieved in the production process. The
idea behind this scheme is simple. It is expected that as firms continually produce the same
product, they should improve on its production and average costs should decrease. Price-
regulation tries to give exactly this incentive to monopolist by permitting them to keep at least a
portion of the cost savings they achieve. Suppose that the productivity of our water-supply
monopolist increases, say, by 2% each year so that average cost falls every year by this amount.
For implementing price-cap policy, the regulatory authority announces that it will adjust the price
of purified water each year by the following formula:
∆P = Rate of increase in input cost – 2% (i.e. expected yearly increase in productivity)
You can see that if input costs increase at a faster rate than 2%, the price of water will rise, while
if the input costs increase at a slower rate than 2%, the price will decrease. Thus, if the regulated
monopoly can increase its productivity greater than 2%, it can keep the additional cost savings for
itself. This type of regulation gives the monopolist a real incentive to reduce its costs because all
cost savings beyond the ‘cap’ belong to him. Obviously, consumers will also benefit because of
lower prices or at least smaller increase in prices than would occur with other regulated method.
An important aspect of regulation has been anti-trust laws, but they will be explored in the
chapter on oligopoly.
It must be stressed that capitalist states regulate monopolies with the primary objective of
maximizing welfare–––i.e. the value of goods produced and consumed in civil society. As we
have repeatedly stressed goods are valued solely in terms of the contribution their production and
consumption makes to shareholders’ value (i.e. capital accumulation). Capitalist state regulators
sometimes regulate markets and firms for non capitalist purposes. For example nationalizing the
educational system (with some exceptions) following the implementation of the Beveridge Report
in Britain during the late 1940s was justified on the basis that every citizen has a natural right to
education. But as several researchers have pointed out successor British governments have
increasingly adhered to capitalist rules in pricing educational sector products and this has led to a
commercialization and denationalization of almost all segments of British education. This is
because the educational system is “locked in” to civil society ––it has to buy its inputs and sell its
output to civil society and the tax payers’ money which finances education sector investment
depends upon income generated by the tax payers within the circuit of capital and their tax paying
ability depends on their performance as valued ultimately by capitalist markets. Capitalist states
are thus necessarily subservient to capitalist markets.
We have of course not discussed regulatory policies of non capitalist states. This is
because capitalist firms ––competitive, monopolistic, oligopolistics or otherwise–––are not
allowed to exist in non capitalist state orders. An Islamic state will for example seek to
universalize private property and maximizing consumption / welfare or share holders value will
not be its regulatory objective. The Islamic state will regulate economic transactions with the
470
objective of promoting the moral impact of economic activities on the activities of individuals. It
will try to promote consumption patterns, production relations and distribution structures so that
the virtues of faqr, taqwa, wara and zuhd are universalized and avarice and jealousy disappear
from society. This is however not an appropriate topic for a book on microeconomics which seeks
to describe the functioning of capitalist individuals, markets and states.
13.6: COMPETITION MANIA UNVEILED: YET ANOTHER UNTOLD STORY OF

ECONOMICS
We have already exposed an important inconsistency in neoclassical theory of consumer

behavior (see chapter 8). This is the time to unveil another equally important weakness of the
neoclassical theory of firm. Based on the neoclassical theory of firm as discussed in the previous
and current chapters, all major microeconomics text books teach two strong welfare
(consumption maximizing) propositions about competition:
• Perfectly competitive industries produce an aggregate quantity at which the equilibrium
market price equals the marginal cost of production, whereas a monopoly produces a lower
quantity at which marginal cost equals marginal revenue. The level of output is lower and
the price higher under monopoly than under perfect competition (refer to figure 13.11)
• Perfect competition results in the maximization of consumer surplus, whereas monopoly
results in a transfer of some consumer surplus to the producer as well as a deadweight welfare
loss (see figure 13.11)
This model of competitive markets based on self-centered individuals leading to efficient
resource allocation is presented as one of the most powerful results of economic reasoning in
support of legitimizing liberal state policies to promote competition and remove monopolies.
However, almost every proposition in this generally accepted neoclassical theory of the firm
either abounds with logical fallacies, starting with one that has been shown to be false since
1957—the horizontal demand curve of the competitive firm—or applies under highly restrictive
conditions. These problems may be categorized into two broad categories: one of unrealistic or
incorrect assumptions about the function of capitalist order and the second of internally
contradictory assumptions. We will see that when these fallacies are corrected, nothing of
substance remains in the neoclassical argument: (a) price equals marginal cost ceases to be the
profit-maximizing equilibrium, (b) competition does not lead to price equaling marginal cost, (c)
monopoly in general can be expected to generate a higher level of consumer welfare than
competitive firms, and (d) standard cost-curve aggregation of monopoly and perfect competition
is only valid in highly restrictive circumstances. Here, we analyze some of these problems, along
with their implications. The full-fledge proof of these problems requires the use of mathematical
tools that are beyond the scope of this book. Therefore, we will try to develop as much
understanding of these problems as is possible using a graphical approach.
471
13.6.1: Horizontal Demand Curve Fallacy
An essential part of the argument for perfect competition is that each firm is so small that
it can’t affect the market price and, therefore, takes it as given. As a result, the demand curve, as
perceived by a firm, is effectively horizontal at given market price. The firms are also so small
that they do not change their output in response to a change in output by another firm. This
behavior of firms is termed conjectural variation and it says that conjectural variation in
competitive markets is zero. Both of these assumptions mean that the slope of the single firm’s
demand curve is zero: market price does not change when a single firm changes its output. Given
this horizontal demand curve, marginal revenue equals price and the firm maximizes profit where
price equals marginal cost of production. This guarantees allocative as well as cost efficiency.
Thus, the key in this efficiency result is the assumption of the horizontal demand curve facing a
firm. However, both of these assumptions are inconsistent. To begin with, note that the two
assumptions say that if a single firm increases its output by one unit, then total industry output
must also increase by one unit because other firms do not react to the changes in output by one
firm. Therefore, if the market demand curve is negatively sloped, then an increase in total market
output must mean a fall in the market price, regardless of how small this fall might be. To have a
graphical intuition of this result, look at figure 13.14 which shows a market demand curve for an
industry with a large number of firms. Consider the slope of the demand curve between points
A and B consisting of a change in output and in price.
Figure 13.14: Slope of firm’s demand curve is identical to market demand curve
Price
A
P
ΔP a
δP b
B
P
Deman
0 YA YB Y
δy
ΔQ
The slope is given by:

∆P PB − PA
Slope of Market D-curve A-and-B = =
∆Y YB − Y A
472
Now consider points a and b. The slope between these points is given by:
δP Pb − Pa
Slope of Market D-curve a-and-b = =
δy y b − y a
It is clear that both of these slopes must be equal. This is because the demand curve is a straight
line and the slope of any tiny line segment δP δy is equal to the slope of over all section
∆P ∆Y . The effect of an increase in output by one firm on market price and quantity is now
shown in figure 13.15. You can see that if a single firm changes its output by a small amount, say
δy, then market supply curve must shift by δy amount and price will fall by δP. The market price
does change because of the actions of a single firm. In this case, the demand curve facing a firm
must be downward sloping and its slope will be exactly equal to that of the market demand curve.
The only way market price could not react would be if all other firms reduced their output by as
much amount as the single firm increased its output. In that case, market supply curve would not
shift and price would remain constant. But this reaction by other firms negates the assumption
that conjectural variations are zero; i.e. firms do not react to each other’s behavior.
Figure 13.15: Effect of a firm’s increase in output on market price and quantity
Price Small shift in S-curve due

to small change (δy) in
output by a firm So
S1
δP
Market
Demand
0
Y
δy
The economic argument, effectively, is that if you break a large downward sloping line
(market demand curve) into lots of very small lines (demand curve perceived by each firm), then
you will get a huge number of flat lines. If you then add all these perfectly flat lines together
again, you will get one downward sloping line. But this is mathematically erroneous. Adding up a
huge number of flat lines gives a very long flat line. Similarly, breaking one downward sloping
line into many small ones gives many downward sloping lines. The economic concept of a
horizontal firm demand curve, and hence perfect competition, is based on a mathematical error of
confusing a very small quantity with zero. The above argument is just like convincing someone
that the world is flat by the following argument: ‘if you take a small enough segment of the
world, say the two feet the other person is standing on, then the curvature of that sphere is so
473
small that it is flat. Then consider the segment you are standing on, and it is also so small that it is
effectively flat. Next take the angel between the two segments and it will also be so small that it is
effectively zero. Finally, extrapolate your argument from these two tiny segments and the angel
between them to the level of entire world: consider the segment behind the other person and that
is also flat, and keep going like this to prove that the world is flat.’ Clearly, the fallacy in this
argument is that while treating your immediate surrounding flat will work as an approximation,
but it will not work to ignore those small but imperceptible angles if you move from the scale of
one or two to the entire globe’.7
Interestingly, the above exposed fallacy is not a new one, the assumption—that firm faces
horizontal demand curve—has been known to be false since 1957 when Stigler published a
simple piece of calculus in his article “Perfect competition, historically considered”:
∆P ∆P ∆Y
= × (13.13)
∆y i ∆Y ∆y i
The capital Y stands for market output produced by all firms while the small case, y, represents
the output produced by any single firm, say firm-i. The above expression makes use of the Chain
Rule and both sides are literally equal. To understand this, note that the left hand side (∆P ∆y i )
is the slope of the demand curve facing firm-i. The first part at the right hand (∆P ∆Y ) shows
the slope of the market demand curve while the second expression (∆Y ∆y i ) measures the
change in market output due to change in output by firm-i. The above expression now says that
the slope of the demand curve facing the individual firm (∆P ∆y i ) always equals the slope of the
market demand curve (∆P ∆Y ) , multiplied by how much market output changes due to change in
output by a single firm (∆Y ∆y i ) . Since we are dealing with competitive firms with no conjectural
variations, a change in output by one firm doesn’t bring forth any instantaneous reaction by the
others. Therefore, the factor “how much market output changes by a change in output by a single
firm-i” is one; i.e. (∆Y ∆y i ) = 1 . As a result, the slope of the individual firm’s demand curve is
exactly the same as the slope of the market demand curve:
∆P ∆P
= (13.14)
∆y i ∆Y
This argument can’t be avoided by an appeal to the proposition that competitive firms are “price
takers”—so that marginal revenue equals price for competitive firms by assumption—because
this simply introduces one of the two logical contradictions into the theory. It either means that
the firms are irrational or they react to changes in output of others firms, and hence ‘playing-
games’ becomes the characteristic feature of firms operating even within competitive markets (a
phenomenon which is not consistent with competitive firms since conjectural variations are zero).
Consider Figure 13.16 which shows the inbuilt irrationality involved in assuming ‘as if’ demand
curve is horizontal. Clearly, if market demand curve is downward sloping, then any tiny part of it
slopes down with the same value of the slope, no mater how small the difference between the two
points is—if the market demand curve slopes downwards, then any increase in output (and hence
in supply), no matter how small, must cause market price to fall, however infinitesimally. Thus, if
7
The example is taken from Keen (2004), Debunking Economics
474
a firm assumes that its demand curve is horizontal, it is behaving irrationally in the sense that it is
nurturing a false belief that ‘infinitesimal small quantity equals zero’. Believing that the demand
curve is horizontal means all neoclassical results regarding the superiority of competition depends
upon ‘irrational behaviour of firms’. Moreover, since competitive firms are independent—i.e.
output decision of one firm does not depend upon the output decision of another—if firm-i
changes its output, then the rest of the industry (YR) will not change its output in response to firm-
i's decision.
Figure 13.16: Acting ‘as if’ demand curve is horizontal is irrational
Price Price
P (Y) < P (Y) + yi
∆P δP
=
∆Y δy P (Y) P (Y) + yi
P1
Irrational Belief: P (Y) + yi = P (Y)

δP
Rational Belief: P (Y) + yi > P (Y)
P-ΔP
Demand
0 Y1 Y +ΔY yi for ith firm yi

Y
δy
Mathematically,
∆YR
=0 (13.15)
∆y i
i.e. the amount of output firm-i expects the rest of the industry to vary in response to a change
in firm-i output is zero. The only way marginal revenue of firm-i can be equal to the price of
output is if other firms in the industry output by others firms is reduced exactly by the amount of
output increased by firm-i. FYI Box 13.3 gives the mathematics behind the thus far discussed
fallacy.
F Y I B O X 13.3
Mathematics of Horizontal Demand Curve Fallacy
We can make the mathematics more explicit using summation notation in expression (13.13).
475
Assuming n identical firms, total output Y is the sum of the outputs of n firms each producing yi
units. Therefore:
∆P ∆P ∆Y
= ×
∆y i ∆Y ∆y i
∆P ∆ n
= × ∑ yj (13.3.1)
∆Y ∆y i j =1
n
The expression ∑ y j says that the market output Y is equal to the sum of output produced by all
j =1
firm, say j in total numbers. Expanding it we have:

∆P ∆
= × ( y1 + y 2 + y3 + ... + yi + ... + yn ) (13.3.2)
∆Y ∆y i
∆P  ∆y1 ∆y 2 ∆y 3 ∆y ∆y 
= ×  + + + ... + i + ... + n 
∆Y  ∆y i ∆y i ∆qi ∆y i ∆y i 
Since all firms are independent and do not react to each other’s decision, we have:
∆P
= × (0 + 0 + 0 + ... + 1 + ... + 0 )
∆Y
∆P ∆P
=
∆y i ∆Y
which is exactly the same as (13.14) and says that the slope of demand curve which a firm is
facing in a competitive market will be exactly equal to that of market demand curve.
Another reason why firm’s demand curve can’t be assumed horizontal by assumption can be
illustrated using the concept of “conjectural variation”. The assumption that marginal revenue
equals price for the ith firm means
∆TR ∆(P × y i )
MRi = = =P (13.3.3)
∆y i ∆y i
Differentiating we have:
∆Y ∆P
= Pi + yi
∆y i ∆y i
∆P ∆P ∆Y
Now introduce = × into this marginal revenue expression and expand:
∆y i ∆Y ∆y i
 ∆P ∆ 
= P + y i  × Y 
 ∆Y ∆y i 
By definition, Y = yi + YR (industry output equals output of firm-i and that of the rest of the firms
in the industry), we have:
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 ∆P ∆ 
= P + y i  × ( yi + YR )
 ∆Y ∆y i 
 ∆P  ∆y i ∆YR 
= P + y i  ×  +  

 ∆Y  ∆y i ∆y i 
 ∆P  ∆YR  
MR = P + y i  × 1 +   (13.3.4)
∆ ∆ 
 Y  y i 
∆ ∆Y
Returning to the assumption that (P × yi ) = P , the only way this is possible if R = −1 .
∆y i ∆y i
But this contradicts condition (13.15); i.e. the concept of firms’ independence or of no
conjectural variations. This is “proof by contradiction” that the slope of the demand curve for
the i th firm must equal the slope of the market demand curve.
The horizontal demand curve fallacy can be summarized as follows:

The Horizontal Demand-Curve Fallacy: The slope of a competitive firm’s demand curve can’t
be zero until we assume that either (a) the firm treats infinitesimal changes as zero and, hence,
behaves irrationally or (b) firms react to each others’ output and, hence, reject the firm’s
independence assumption under competitive markets
The crux of this fallacy is that either the rationality or independence assumption must be
forsaken to derive the firm’s ‘horizontal demand curve’ for competitive markets, but economists
cannot afford to compromise on either of these assumptions as they constitute the very
foundations of the neoclassical theory of firm. This yet again means that the intellectually
dominating neoclassical theory of the firm is based on internally contradictory assumptions.
13.6.2: No MR-Curve Fallacy
Another problem with the neoclassical theory of competitive markets is the nature of its
marginal revenue function. This fallacy may be seen as a corollary of the above mentioned
fallacy. Economic theory asserts that a monopolist produces output where marginal revenue is
equal to marginal cost and charges a price greater than marginal cost. On the other hand, it is
claimed that, a competitive industry, not firm, sets price where the supply and the demand curves
intersect without any mention of industry marginal revenue curve. The economic model of
competitive markets thus assumes that marginal revenue curve at the market level is a function of
the number of firms that produce the industry’s output—it exists when there is a single firm but
disappears when there are large numbers of firms! However, the marginal revenue curve exists
independent of the number of firms in the industry. If the market demand curve is downward
sloping, then so must be the marginal revenue curve as is the case for the monopolist (because the
total revenue function is inverse U-shaped in this case as drawn in figure 13.3). The standard
demand-supply diagram must have three, not two, curves; supply, demand and marginal revenue
curves.
The No-Marginal Revenue Curve Fallacy: If the market demand curve for competitive industry
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is downward sloping, then the marginal revenue must be less than price at all output levels as it
is for a monopolist. Marginal revenue can’t equal price until we assume that the market demand
curve is horizontal (however, the model of competitive markets becomes indeterminate in this
case as discussed below)
13.6.3: ‘P = MC Maximize Profit’ Fallacy
This fallacy of ignoring the marginal revenue curve for the competitive market at
industry level creates a serious paradox between the firm and market aspects of the model of
perfect competition: if a competitive industry produces output at the intersection of demand and
supply curves, then at collective level it is producing where marginal cost exceeds marginal
revenue, hence resulting in non-profit maximizing behavior at the aggregate level. To understand
this inconsistency, consider figure 13.17 which gives the standard market comparison between
monopoly and competitive industry. In the lower panel, the monopolist sets the price where
marginal revenue equals marginal cost and produces Ym quantity because this output maximizes
its profit. Similarly, each competitive firm produces at a point where its MC equals MR. The
competitive industry (not single firm) produces Yc output where price equals marginal cost (or
supply curve) which clearly exceeds marginal revenue (since the MR-curve is below MC at Yc
output level). The top panel shows the outcome of these decisions in terms of aggregate profit
both for the monopoly and the competitive firms. The diagram uses standard total revenue curve
consistent with downward sloping demand curve (see figure 13.3) and the ever rising total cost
curve from chapter 11. The diagram also draws a profit-curve which is the difference between
the revenue and the cost curves. This curve is at zero level where total revenue and costs are
equal and maximum where the slopes of both these curves are parallel (not drawn in the diagram,
but can easily be sketched against output Ym to confirm this statement). You can see that the
monopolist produces output Ym, sells it at Pm and makes a profit of πm. On the other hand, the
competitive industry produces a larger output Yc, charges a lower price Pc, and also makes lower
profit πc. Clearly, the monopoly has produced where profit is maximum but the competitive
industry has produced output beyond this point, so that the industry’s output past the point of
monopoly output has been produced at a loss.
In general, competitive firms’ behavior is not consistent with aggregate industry profit-
maximization. Where did this loss come from? Of course, the loss can’t be seen in the standard
graph economic text books draw for competitive markets. This loss is hidden in the detail that
economic theory ignores by treating infinitesimal as zero (as discussed above). By producing at
MC = P, the competitive industry has produced part of its output past the point where MR = MC,
and hence has incurred loss on these additional units. But as shown above the demand curve for a
single firm can’t be horizontal, and must slope downward—because if it does not, then the market
demand curve has to be horizontal as well. Therefore, marginal revenue will be less than price for
the individual firm. However, by arguing that an infinitesimal segment of the market demand is
effectively horizontal, economic theory treats this loss as zero and summing up zero losses over
all firms means zero losses in the aggregate. But treating an imperceptible quantity as zero and
then adding all these zeros to obtain zero at the scale of the market level is conceptually and
mathematically erroneous. The economic ideal of perfect competition is based upon a
mathematical error of confusing a very small quantity with zero.
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Figure 13.17: Higher output of competitive industry relative to monopoly means losses at industry
level
Rs Total
Cost
A
πm
C
πc
Total
Profit Revenue
curve
0 Ym Yc Output
Rs/unit
b
MC
Pm
Pc c
MR
Demand
0 Ym Yc Output
Therefore, we can conclude the following fallacy:

The ‘P = MC at Maximum Profit’ Fallacy: Given that marginal revenue curve must be
downward sloping, the level of output where P = MC does not maximize-profit of competitive
firms because they produce beyond profit-maximizing level of output
This paradox simply means that the individual rational profit-maximizing capitalist firm’s
behavior leads to a collective irrational outcome. In other words, the individual and the market
level aspects of the model of perfect competition are inconsistent with each other.
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13.6.4: The Competition Better than Monopoly Fallacy
The above criticism raises an interesting question: what will be the price and output of a
competitive industry if we drop the invalid assumption that output of a single firm has no effect
on the market price. The answer is that once we remove the proposition that the demand curve
perceived by individual firm is horizontal, the price and output levels of a competitive industry
will be exactly the same as those for the monopolist (this result is subject to a particular cost
condition that we explain shortly). This result undermines all economic argumentation for more
competition against less. Let’s prove this proposition. You can see from the above discussion that
the economists’ claim that price and quantity are set by the intersection of demand and aggregate
MC-curve relies on the erroneous proposition that the demand curve perceived by an individual
firm is a horizontal one. Once we remove this fallacious proposition, the price that the
competitive firm takes as given is the price determined by the intersection of the market demand
and the aggregate marginal cost curves which is precisely the same price as monopolist would
charge. To argue otherwise is to argue for either individual irrational behavior at the level of the
firm—so that part of the output is produced at a loss—or that individually rational behavior leads
to a collective irrational behavior at the level of the market—so that profit maximizing behavior
by one firm leads to the industry producing part of its output at a loss. Therefore, the price that
the competitive firm takes as given while adjusting its output is not a market price set by equating
price with marginal cost, but a market price set by equating marginal revenue to marginal cost. If
we sum up output produced by all competitive firms, the quantity produced at this price will be
equivalent to the output of a monopolist. This can be seen in the lower panel of figure 13.17
where the equilibrium is at point a both for the monopolist and for the competitive firm industry
while price is at point b at the demand curve. This means that corrected economic theory
recognizes no intuitive difference between competitive and monopoly market structures—both
produce the same welfare (consumption) outcome.
But worse is still to come for economic theory. One of the key assumptions embedded in
the standard economic comparison of monopoly and competitive industry is that the marginal
cost curves are identical for both monopolist and competitive industry. This is why we had only
one MC-curve in figure 13.11. Effectively, this assumption says that the marginal cost of many
small firms is equivalent to the marginal cost of one single large firm at all possible levels of
output. This assumption is necessary because without it the marginal cost curve which would be
drawn for the monopolist could be different to the sum of the curves drawn for the competitive
industry. If they are different in theory, then it is impossible to say that monopoly output will
necessarily be less than perfectly competitive output, and that a monopoly’s price will be higher.
If the curves are different, then it would be quite possible for monopoly output to be greater and
monopoly price to be lower than the competitive price, even if competitive firms did set marginal
cost equal to price. This is shown in Figure 13.18. The curve MCc is the sum of all competitive
firms’ marginal cost curves while MCm is the corresponding curve for monopolist. The curves are
showing the possibility that the sum of the small competitive firms’ marginal cost curves (MCc) is
much higher than that of the monopoly. As a result, even if the competitive industry sets price
equal to marginal cost at point b, its output of Yc is less than the monopoly output of Ym—even
though the monopoly’s price is much greater than its marginal cost. Similarly, the competitive
industry price Pc exceeds the monopoly price Pm. Moreover, when the two MC-curves differ, then
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the definitive welfare comparison will also not be possible as the monopolist is producing a
higher output at a lower cost and generating a greater level of consumer welfare, even though it is
subject to a deadweight loss (the area not shown here to avoid complicating the diagram) while
the competitive market is not.
Figure 13.18: Higher consumer welfare with monopoly if marginal costs differ
Price Increase in consumer surplus

due to monopoly
MCc
ec MCm
Pc > MCm em
Pm < Pc
e
Demand
MR
0 Yc Ym Output
The fallacy can be summarized in the following proposition:

Competition better than Monopoly Fallacy: Given that any definitive comparison of monopoly
and perfect competition is feasible under constant marginal cost, if the market demand curve for
competitive industry is downward sloping, then a monopoly is identical to competitive industry.
However, if the monopolist benefits from economies of scale, as expected, then monopoly may
produce better results than competitive industry, even if we accept the standard economic way of
comparing both of them
13.6.5: Other Fallacious Arguments
Beside these technical arguments, economists also offer some other arguments in favor of
competition. Here we discuss one of important ones of these.
Argument from Market Dynamics
One of the arguments is based upon economist’s unsound description of the dynamics of
market mechanism. This argument is explicated with most clarity in the microeconomics
textbook by Schotter which tries to provide a reassuring link between perfect competition and
the real world: that profit-maximizing behavior converges to the perfectly competitive ideal as
the number of firms in the industry increases—i.e. if we begin with monopoly business and leave
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the world alone to the individual’s self-interest, it would automatically converge to the perfectly
competitive model. The idea is that markets, if left free from government protection, are
characterized by entry from new firms whenever super-normal profits exist. This mechanism
tends to make markets reasonably competitive, if not perfectly competitive. However, this picture
of market presents an exactly opposite description of what actually happens in capitalist order—
i.e. when we begin with perfect competition, the market mechanism tends towards monopoly (one
large firm prevailing) or at best towards oligopoly (few large firms operating in the whole
market). This point is lacking in economics textbooks because the formal treatment of the
economic process outlined in those books neglects the implications of technological
advancements for the breakdown of competition. In fact, the very nature of competition itself
induces changes in the market mechanism that undermine perfect competition. The process can
be seen by the fact that under the given structure of competition, firms are always under social
pressure to introduce new technological innovations quite rapidly in the production process. So
because a single firm has to face market price as a constraint as it cannot affect it in competitive
conditions, the only way to increase profit is the reduction in costs. The cost-reducing and output-
increasing innovations help make more profit for those firms which introduce them first, but the
very act of innovation tends to increase gap between competitive capitalists. This happens due to
two reasons: first, the growth of output due to technological advancement decreases market price
and this reduction in price eliminates those firms from the market which are slow in innovating
because prices have fallen lower than their minimum unit cost of production. Secondly, the higher
technological invention incorporated in the production process also means a higher fixed cost of
production which implies higher entry cost (as explained above in section 13.4.4). This constraints
and limits the potential increase in the number of firms within the market. Moreover, since
technology usually translates into higher production, therefore, the introduction of higher
technology means that fewer, much larger, producers are needed to satisfy the requirement of any
given market.
The above tendency is further enhanced by the existence of increasing returns to scale.
The standard economic theory assumes that monopoly has no scale-advantages over a perfectly
competitive firm. But, in general, this assumption of scale-invariant costs is invalid because large
firms do benefit from returns to scale. Increasing returns to scale occur when the cost of
production rises less rapidly than the output as the scale of production increases. The concept
applies in numerous ways. For a substantial range of output, a large blast furnace will be more
effective than a smaller one, a large ship than smaller one, a large car factory than a smaller one.
If large firms do have cost advantages over small ones, then given free competition, the large
firms will drive the small ones out of business. In reality, no capitalist market can sustain
hundreds or thousands of competitive firms for a long time because economies of scale are
always there to be exploited. Hence, increasing returns to scale means that the perfectly
competitive market is unsustainable. It will, over time, break down to a situation of either
monopoly or oligopoly. The theoretical response of economists to this dilemma has been to
presume constant returns to scale. With constant returns to scale, the size of the firm does not
matter; a small firm will be as effective as a large one. But the reality is that size does matter
because economies of scale are an important part of the reason that all capitalist industries are
dominated by a small number of large firms.
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Similar to technical advancements and increasing returns to scale are the problems of
indivisibilities in production. Once an entrepreneur controls more and more resources, the size of
that firm increases relative to the market and one entrepreneur may become powerful enough to
affect the price of a good by varying output rather than accepting it as a fact for decision
making—this is the situation called imperfect competition. The argument is further strengthened
if the given firm can constraint entry either by manipulating information (say by advertising to
influence consumer motivation), by having patents on production technology or by using an
active pricing strategy. Thus the very logic of market mechanism—profit-maximization—tends to
reduce, and not increase, the number of competitors and changes the nature of competition in the
market. Veblen (1904) has rightly commented that the result of historical process has been the
transformation of industry from a larger number of small producers to that of a few larger
producers.
13.6.6: Abandon ‘one for all’ policy
Economics has championed the idea that the best guarantee of social welfare; i.e.
consumption maximization, is competition and therefore society ought to pursue the model of
perfect competition as its ideal. We have seen that this economic bias in favor of small firms and
against monopolies is almost totally misplaced. Economic theory of policy encourages the
abolition of existing monopolies or the use of competitive approaches to the provision of public
services when a state monopoly approach would be superior in welfare / consumption
maximizing terms. Above all, this fallacious economic theory is used as policy guide to promote
free trade and finance throughout the world for capital accumulation and welfare maximization.
However, this does not mean that monopoly markets do not have costs or are necessarily
ideal for capitalism. There could be plenty of reasons why monopolies can be a ‘bad thing’ for
capitalist order. For example, they can obstruct potential competitors, set higher markups and use
monopoly powers to exploit other markets. The neoclassical argument against monopolies has
directed attention away from the real qualitative issues confronting capitalism to the simple issue
of whether a monopoly exists. This simplistic criterion treats all monopolies as tainted instead of
attacking monopolies for particular types of behavior and assessing whether or not that behavior
serves capitalist order affectively. The type of blind-belief economic theory bestows upon its
believers and its resulting attitude can be sensed in the following passage by Ishrat Hussain, the
former governor of State Bank of Pakistan:
“I will now turn to the economic rationale of privatization that is not fully understood by
many. In particular, there is a popular view that it is okay to sell the loss making
enterprises but retain the profit making entities such as PTCL and PSO in the public
sector. It is true that the budgetary stress and commercial bank borrowing factors are not
valid in such cases but there is a larger economic case for the divestiture of even such
profit making enterprises. The main logic behind this divestiture is that it will promote
efficient allocation of scarce resources (and) optimal utilization of resources” 8
The economic argument can therefore lead to monopolies being broken up where there were no
signs of such behavior or where there were extremely good reasons why a single firm was more
8
Address of the State Bank Governor delivered as Chief Guest at the 11th Get Together of the Overseas Universities
Alumni Club and the 21st Century Business & Economics Club on August 12, 2005 at Karachi
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efficient in providing maximum consumption possibilities than a number of competing firms. Far
from being a guide about how to achieve greater capitalistic efficiency, economic theory may
even encourage the dismantling of efficient companies and replace them with inefficient ones.
This is guaranteed when the firms are natural monopolies. Public firms, subject to regulation, will
perform far better than privatized firms under a similar regulatory regime in maximizing
welfare/consumption. Ironically, the recent wave of privatization from 1999 onwards has been
concentrated in telecommunications, energy and other public utilities where the market simply
cannot be competitive and is near natural monopoly case.
Probably, the proper manner in which the issue of ‘monopoly versus competition’ in
capitalism should be approached is on a case by case basis where the merits of one form or the
other of organizing capitalist production could be considered. Delvin has argued that a country
should privatize a state-owned enterprise if this would result in a positive net change in social
welfare/consumption. This occurs when the social value of the privatized firm and the net social
value of the public sector’s proceeds from the sale are greater than the social value of the firm
under public ownership. Thus, the effect of a different regime of asset control, in this case a shift
from public to private control, must lead to an improvement in asset management for it to be
superior to the previous asset control regime. Governments, however, do not necessarily embark
on detailed cost-benefit valuations of the public enterprise sector to determine whether
privatization is appropriate. Instead, they often rely on formal, though fallacious, economic
frameworks to decide whether a privatization program should be initiated. The main factors
supporting the privatization process have been more general in nature, although important
differences between regions and countries exist. Privatization is neither a necessary nor a
sufficient condition to improve enterprise performance and welfare maximization. It is not
necessary because enterprise performance can be improved through management reforms in
public enterprise. It is not sufficient because privatization in and of itself, in the absence of an
adequate regulatory and legal framework, can cause loss of consumption/welfare, as the Chilean
privatization experience in the 1970s painfully demonstrated.
Finally, the question of objectives is of fundamental importance when addressing the issue
of performance. Many public enterprises are formed to provide a specific good or service, often
for a particular population group. In such cases, providing the good or service was the goal, not
profitability. In addition, some public enterprises are formed in order to meet other socioeconomic
goals. These include job creation, promoting industrialization and defending national interests.
This list of objectives may make public enterprise less efficient. However, capitalist states do
assign appropriate weights to these objectives while evaluating the performance of any particular
monopoly. Whether a change in ownership is necessary to improve capitalist efficiency will
depend on a host of factors, but in any case this points to the need for reform of public enterprise
and not its auction.
Why Economics Preach Free Competition?
It is time again to raise the same question at this point: why does economic theory since
Adam Smith’s time continue to extol the welfare superiority of perfectly competitive markets
despite the fact that capitalist order necessarily destroys itself? This is because economic theory’s
primary purpose is ideological and normative (not positive or discursive). Economic theory
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justifies capitalist order as a completed project which has resulted in the possibility of the final
triumph of universal reason over both Nature and Passion (religion). That is why Hegel saw
capitalist order as the end of history. At history’s end when everyman is equally rational and
equally knowledgeable there is no room for the type of exclusion that monopoly implies. In this
world of perfect knowledge, perfect equality must reign. Cost must be at its minimum and
therefore MC must equal AC. The demand curve must be horizontal for if it is downward sloping
this means that some demand remains unsatisfied—an impossibility in capitalism’s utopia (as in
Marx’s full-blown communism).
But the supply curve also should be horizontal–––everyman should be able to produce
whatever he wishes at a uniquely determined ‘optimal’ cost (MC must equal AC). But if both
supply and demand curves are horizontal (and co-incidental) both price and output levels become
indeterminate. To avoid this indeterminacy economics presents state where men are rational (and
this rationality is reflected in the relations between them as depicted in the model of perfectly
competitive markets) but the conquest of nature is not yet complete. That is why cost curves slope
upwards and the production process and the associated relations of production are seen as
essentially technical phenomenon. It is this scarcity which justifies the science (Economics) that
provides a paradigm for the determination of a unique price-output configuration in every specific
situation of scarcity.
Economics is an imperfect science because it does not have a framework for conceiving
the overcoming of scarcity––that is why technological change is typically regarded as exogenous
to the economic process. But economics does have a moral project––to make everyman more
rational and the perfectly competitive model provides a heuristic basis for promoting capitalist
rationality in civil society. Men in capitalist order have to be forced to be rational in capitalist
sense—how to achieve this objective is the purpose of economic policy. Moreover when men
behave ‘rationally’ they necessarily prey upon each other. Civil society is conflict ridden, vicious,
exploitative, cruel, savage and fragmented. Men maximize welfare at each others expense.
Competition is a brutal, ruthless, blind and egotistical process which tears men apart. This is the
social reality of capitalist order reflected partially in the monopolization of capitalist markets.
Economics must shut its eyes to this reality if it is to continue to justify capitalism on moral
grounds. It does so by continuing to extol the virtues of perfect competition.
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Key Concepts
Absolute barriers are those that rule out new entry whatsoever over some time horizon
Average-cost-pricing means setting price equal to average cost of production. This is usually
practiced in case of natural monopolies
Competitive advantage means delivering the same service at a lower cost, called cost
advantage, or greater service for the same price, called differentiation advantage
Deadweight loss is the net loss in social welfare resulting from any other than competitive
market approach, say by monopoly power. It is measured by the difference between output
(produced and made available for consumption) by the perfectly competitive firm on the one hand
and the monopolist on the other
Dominant firm model is a market with one firm having a market share of more than 50%,
though other small firms do exist with negligible market shares
Franchise monopoly is a monopoly business created out of state granted legal rights or
protection
Imperfect competition means market structure where any of the single conditions of perfectly
competitive markets are missing or lacking
Inertia shopping rule says that consumers tend to buy from the firm that charges the lowest
price, but if he is already buying from a firm and another firm enters the market with a lower
price, he gives his current firm a chance to meet the entrant’s price before shifting his demand
Limit pricing is a pricing strategy used by existing firm by setting a price such that an entrant
can’t make profits at that price
Marginal-cost-pricing means setting price equal to marginal cost of production
Monopoly is a business dominated by single firm which ignores pricing reaction of any other
firms to its pricing decision
Monopoly power refers to the extent to which a firm can control market price
Natural monopoly is a business with increasing returns to scale at the level of the whole market.
The result of such a business structure is that the average total cost (ATC) curve keeps declining
as firm expands its operation
Price cap regulation is a regulatory method designed to encourage efficient production by
allowing firms to share in any cost savings that they have achieved in production process
Price setting behavior means firm is facing downward sloping demand curve and hence can set
price
Privatization is the sale of state owned enterprise to private individuals
Rate of return regulation means setting a maximum rate of return on invested capital that a
utility is allowed to earn
Relative barriers are the ones which place a new entrant at a disadvantage, but they are not
insurmountable ones
Sustainable monopoly is natural monopoly that can prevent entry and keep others out of market
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Chapter Summary
• A monopolized market structure is characterized by (a) the existence of a single producer (b)
a strongly differentiated product with no close substitutes (c) insurmountable barriers to entry
in the market
• For practical purpose a monopolized market is defined as a market where the market share of
the dominant firm is about or above 50 percent and this firm is the price setter. This is also
called the dominant firm model
• The dominant firm can ignore the reaction of other firms to its price setting behavior
• The demand curve facing the monopolist is downward sloping––not horizontal as in the case
of the perfectly competitive firm. The monopoly firms can change price by changing the level
of output produced. The monopoly firm is a price setter in this sense
• Demand elasticity is a constraint on the monopoly’s ability to set the price of its choice
• The marginal revenue for a monopolist is always lower then the price at all levels of output
• Profits are maximized for the monopolist at the output level where marginal revenue equals
marginal cost. Price is the corresponding point on the average revenue / demand curve––this
is the maximum price the consumers are willing to pay for this output level of the monopolist.
This is the profit maximizing price and this price is greater than marginal cost at this level of
output.
• The shut down rule for the monopoly is the same as that for the perfectly competitive firm i.e.
the firm should shut down if
Total Revenue < Variable Cost in the short run
Total Revenue < Total Cost in the long run
• The marginal cost curve is not the supply curve for the monopolist. The monopoly has no
specific supply curve. The output a monopoly produces depends on its MC and its demand
curve––hence both are needed to determine supply and many different demand curves can be
drawn through the same point having different slopes. Hence a unique shape of a monopolist
supply curve cannot be derived
• A rule of thumb for monopoly pricing is that mark up over marginal cost should equal the
negative of the price elasticity of demand. The knowledge of the elasticity of demand should
provide the basis of the ‘optimal’ (i.e. profit maximizing) mark up over MC which should
determine the monopolistic price. The greater the elasticity of demand the closer is the
monopolists’ price to MC
• The Lerner Monopoly Power Index measures monopoly on the bases of the percent excess of
the price the monopolist is charging over MC
• Barriers to market entry leading to the creation of monopoly structures include (a) franchise
rights (b) patents (c) copy right and (d) trade marks. Franchise rights are usually justified on
economic grounds as rewards for undertaking large and risky initial investments
• A natural monopoly is a business with increasing returns to scale at all levels of market
demand––ATC declines as output expands––and having more than one firm in the market is
therefore inefficient. As long as the market cannot sustain more than one efficient (minimum
cost) firm, the market is a natural monopoly whatever the slope of the ATC
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• A natural monopoly that can prevent entry is called a sustainable monopoly. In this case ATC
decreases every where up to the whole level of the market
• If there is “consumer inertia”–– i.e. consumers continue to buy from the monopolist at a price
higher than that of a competitor for a specified time period—the monopolist need not lower
its price to prevent market entry
• Relative barriers also include large investment requirements and capital market
imperfections. These barriers are usually so high that there are very few entrepreneurs in
capitalist order. Most people become wage laborers. Even managers are wage laborers risking
other people’s money not their own
• Relative barriers also include competitive advantages of existing firms taking the form of
either cost advantages and / or product differentiation advantages. Entry occurs as outside
firms overcome these advantageous but in capitalist order those who enter monopolized
markets are usually not new firms that are starting up business but firms from other sectors of
the economy that are expanding the scope of their operations through mergers and
acquisitions
• In capitalist order capitalist property replaces private property. In capitalist property all
wealth is dedicated to the sole purpose of capital accumulation and hence capitalist property
is controlled by managers who have the capability of using wealth for the sole purpose of
accelerated capital accumulation
• Universalization of capitalist property means abolition of private property. It also means
necessary increase in the concentration and centralization of capital. A handful of
conglomerates dominate (are price setters in) all major markets and the increased popularity
of “supply change management” shows increased integration of new firms within production
and distribution structures dominated by these conglomerates
• Increased concentration of capital leads to a restructuring of competition, competition
becomes more intense. It takes the form of competition within the firm among its workers
and different organizational units and competition among different strategies based on
speculation about the future. Neither perfect competition nor perfect monopoly is compatible
with capitalist order. Capitalist market are typically oligopolistic
• State regulation of monopoly is justified on grounds of decrease in the sum total of consumer
and producer surpluses yielded by monopoly pricing as against pricing by perfectly
competitive firms. Dead weight loss is the amount of total surplus lost (called social welfare
loss) due to monopoly pricing. Deadweight loss measures the difference between output
(produced and made available for consumption) by the perfectly competitive firm on the one
hand and the monopolist on the other
• Instruments for regulation of monopoly include:
o Price regulation usually practiced in the case of natural monopolies along with
government subsidization that compensates for the loss created by the excess of ATC
over the regulated price level
o Regulation of rate of return. A “fair” rate of return (above which profits are taxed away)
is determined on the basis of estimation of what investors regards as an acceptable rate of
return on investment sufficient to maintain the desired level of production in the
monopolized sector. A market price is fixed to ensure that the monopolist does not earn a
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rate of return which exceeds the investors’ acceptable rate of return on the desired level
of investment
o But estimation of required rate of return on investment is problematic for this requires
valuing the capital stock of the monopoly producer. Changes of regulated price (to ensure
a ‘fair’ return) must be frequent as cost and market conditions are in a continuous process
of change. Hence there are long and expensive regulatory lags in price adjustments. The
regulatory process offers fertile ground for corruption benefiting bureaucrats. Regulation
authorities are easily penetrated by private monopolists and price regulatory processes are
manipulated to serve the cause of multinationals
o Price caps. Both price and rate of return regulations create an incentive for increasing
cost and ignoring efficiency by the monopolist. Price caps are fixed producing incentives
for firms to reduce costs greater than those in the price cap determining formula
• The purpose of state regulation of monopoly in capitalist order is only production /
consumption (welfare) maximization—it is nothing else. Production is valued solely in terms
of the contribution that is made during the production and distribution process (of the goods
and services) to capital accumulation. Non-capitalist states will not regulate markets for these
objectives
• An Islamic State will abolish capitalist property, seek to universalize private property and
regulate production, consumption and distribution of goods and services mainly to promote
the moral impact of these activities on the lives of the people. State regulation of production
by an Islamic State will be for promoting Ihsan, Zuhd and Faqr
• Neoclassical economics regards perfectly competitive markets to be superior to monopolized
markets because:
o Perfectly competitive markets are supposed to produce output at the point where MC =
MR = P. Monopolized markets produce it a point where MC = MR < P. P is therefore
expected to be higher and output lower under monopoly
o Consumer surplus yielded by perfectly competitive markets is expected to be greater than
that by monopolized markets which are characterized by the existence of ‘deadweight
loss’
• But this welfare superiority of perfect competitive markets is based on several unrealistic
assumptions
o A major false assumption is that the perfect competitive firm faces a horizontal demand
curve. This is based on the view that each firm is so small that it has to take the market
determined price as given. This is summed in the Horizontal demand Curve Fallacy
o Neoclassical theory omits any mention of a market marginal revenue curve in its analysis
of price-output determination for perfectly competitive market. The MR curve is assumed
to exist for the individual firm but not for the whole market
• If the perfectly competitive industry’s equilibrium output is determined by the intersection of
the Average Revenue (i.e. demand) curve and supply curve while the AR / demand curve is
downward sloping then the MR curve must be below the AR curve at equilibrium. Therefore
the perfectly competitive market is behaving (capitalistically) irrationally. It is producing an
equilibrium output at a level where MC > MR–– it is incurring a loss not maximizing profit.
If we assume that market demand is the summation of the demand of each firm in the market
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and that each firm is accepting the same price (< MR) then each firm must be behaving
(capitalistically) irrationally, i.e. incurring a loss––not maximizing profit
• If we abandon these assumptions no difference remains in the determination of equilibrium
output-price configuration in the case of perfectly competitive and monopolized markets
• Another dubious assumption of neoclassical theory is that the MC curve is the same for
monopolized and competitive markets. This is not so, in a particular capitalist market (say oil
or electricity or railway transport). It is not possible to say that in principle a monopolist’s
price will always be higher and a monopolist’s output always lower than that of a perfectly
competitive market. If the market MC of the perfectly competitive firms is higher than the
MC of the monopoly, the monopoly’s price will be lower and its output higher than that of
the perfectly competitive market. The monopolist may be producing a higher level of welfare,
despite deadweight loss
• In fact monopolies have typically been welfare superior to non-monopolies in capitalist order.
That is why maturing capitalist order is always characterized by (imperfect and incomplete)
monopolization of markets (for goods, services and finance)
• As Schumpeter showed almost a centaury ago capitalist markets require monopolization. This
is because risky technological innovation is both driven by and nurtures monopolization.
Continuing technological change––a key feature of capitalist order––reduces output prices
and increases entry investment costs, both monopolization facilitating features of capitalist
markets which are also characterized by increasing returns to scale. Scale economies
necessarily undermine the sustainability of small firms
• Welfare (consumption) maximization and capital accumulation can often be promoted by
market monopolization. Public monopolies usually are more efficient as providers of efficient
levels of output-price configurations in capitalist order than are private monopolies (or
oligopolies) especially in the ‘natural monopoly’ markets. Privatization is neither a necessary
nor a sufficient condition for improving firm efficiency in capitalist order. It can often lead to
a loss of welfare in civil society
• Economic theory’s continued idealization of perfect competition as being ‘welfare superior’
to monopoly reflects the ideological and normative character of Economics. Economics
justifies capitalism as a uniquely rational way of life in which all inequality and zero sum
conflict has been eliminated and in which all men possess complete knowledge about how to
maximize their welfare given specific scarcity constraints. Production is optimally efficient
and consumer welfare is maximized. The perfectly competitive model presents this vision.
Economics closes its eyes to the reality of capitalist order where competition is usually
conflictive and where men maximize their individual welfare at each others’ expense (If I win
you must lose). Market monopolization reflects this reality of civil society. Economics must
ignore this reality if it is to continue to serve as the ideology justifying capitalist order
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Review Questions
1. What are the characteristics of a monopolistic market structures?

2. Compare the demand curve facing a monopolist firm with that of a perfectly competitive
firm?
3. Can the monopolist firm set any price it want to or are there any constraints on its price
setting?
4. With the help of diagrams illustrate the differences between profit-maximizing equilibrium of
a monopoly and a perfectly competitive firm
5. What is the shut down rule for the monopolist? Is it different from the shut-down rule for
perfectly competitive firm?
6. What is the supply curve for a monopoly firm?
7. How can a monopoly firm determine its ‘optimal’ price? How is it different from the one set
by competitive firm?
8. What is the Lerner Monopoly Index? Does it provide an accurate measure of the extent of
monopoly in a market?
9. What are the main barriers to entry in a monopoly markets?
10. What is a “natural monopoly”? Is the State Bank a “natural monopoly”? Is KESC a natural
monopoly?
11. What is the difference between capitalist property and private property?
12. “There can be neither sustainable perfect competition nor sustainable perfect monopoly in
capitalist order.” Do you agree?
13. What is the justification for state regulation to monopoly and which instruments are likely to
be the most effective?
14. What is the purpose of state regulation of monopoly and oligopolistic markets in capitalist
order?
15. State and evaluate the orthodox neoclassical arguments for state regulation of monopoly. Are
these arguments valid?
16. What are the assumptions on the basis of which economists claim that perfectly competitive
markets are welfare superior to monopoly?
17. Schumpeter argued that “capitalism needs monopolization of markets.” Discuss
18. Under what circumstances can monopoly markets yield a higher level of welfare and be more
efficient than perfectly competitive markets?
19. Why does economic theory continue to idealize the perfect competitive market although
empirical evidence shows that it cannot exist in capitalist order?
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14
Chapter
MONOPOLISTIC
COMPETITION AND
OLIGOPOLY
Chapter 14: Monopolistic Competition & Oligopoly
The previous chapter discussed how firms with monopoly power can choose prices and
output levels to maximize profit. However, in many industries several firms compete with each
other having some market power. This chapter deals with models of imperfect market structures
other than pure monopoly that can give rise to monopoly power. The chapter begins with
description of decision making under monopolistic competition and then goes on to develop
oligopoly models.
14.1: MONOPOLISTIC COMPETITION
Up to the early 1920’s, economic theory appreciated only two major market structures:
perfect competition and monopoly. Interestingly, oligopoly models (e.g. duopoly) were treated as
intellectual exercises rather than real world situations despite the fact that the real world was
characterized by oligopolistic competition. It was by the late 1920’s that dissatisfaction spread
against economic modeling of the business world in the shape of perfect competition. This was
because of the fact that the idealized economic theory could not explain empirical facts—the
ultimate objective of any scientific theory. Table 14.1 compares real world capital homes with the
picture of real world portrayed by economic theory.
Table 14.1: Comparing real world capitalist firms with standard economic theory
Dimension Real World Capitalists Firm in Economic Theory
Size From corner store to Microsoft Small size
Operation From one outlet to almost all countries Single industry and location
Product diversity • From single product (wheat farm) to Single and homogenous
numerous (Sony) product
• From one industry to many
Ownership From sole proprietorship to multinationals Privately owned sole proprietor
Structure • From one person operations to multi- • No internal structure
departmental considered9
• From sole operations (production to • No specialization: firm
sale) to specialization in does everything from
manufacturing, wholesale, retail, manufacturing to sales
marketing, consulting
Apart from these factors, widely used advertisement and other selling practices in real businesses
could also not be accommodated by the model of perfect competition. And above all, actually
existing capitalist firms expand their output with falling average costs without ever becoming
infinitely large, as the model of perfect competition would predict with falling average costs. The
dissatisfaction with economic theory brought about a long series of arguments and publication
which began the ‘Great Cost Controversy of the 1920’s’ a summary statement of which can be seen
in Sraffa’s article. Sraffa pointed out that the falling average cost dilemma could be resolved
9
Though agency theory tries to take account of this aspect, but the basic model abstracts from these details
495
theoretically by taking account of the fact that individual firms face down-ward sloping demand
curve which constraints their ability to sell output beyond a certain limit. This line of argument was
adopted by a number of other economists, such as Chamberlin and Robinson, and the tradition gave
rise to the model of monopolistic competition. To understand the nature of the market model
proposed by Sraffa and other economists, let’s first define monopolistic competition.
14.1.1: Structure and Implications
Following features are assumed to classify a market as monopolistically competitive:

1. There are large number of buyers and sellers in the industry
2. The products offered for sale by sellers are differentiated, yet they are close substitutes
3. There is free entry and exit in the market
4. Firms’ decisions are independent of one another; i.e. no conjectural variations exist
You can see that monopolistic competition is similar to perfectly competitive market in the sense
that there are many firms in the industry and no significant entry barriers exist. However, it
differs from perfect competition because the product is differentiated—each firm sells a brand of
the product that differs in quality, appearance or reputation and each firm is the sole producer of
its brand. Laundry detergents, bath soaps, toothpastes, shampoos are some examples of this type
of industry.
Marketing as Essential Ingredient of Firm
Chamberlin suggested that in monopolistically competitive markets, the demand for a

product is determined not only by its price, but also by the style of the product and selling
activities of the firm. Thus he introduced two additional policy variables in the theory of firm; (a)
the product itself and (b) selling activities. Thus the demand curve will shift if:
• the firm changes the style of its product or other selling strategy
• competitors change their price, style or selling policies
Note that product differentiation is intended to distinguish one’s product from another in the
industry. The difference among goods could be real or merely superficial or cosmetic. Real
differentiation exists when either the specifications of the product or the services offered by the
product are different. On the other hand, superficial differentiation means that the products are
basically the same, yet the consumer is persuaded somehow that the products are different. Such
differentiations are established by advertisement, differences in packaging, differences in design,
or by brand names.
The concept of advertisement and other marketing activities by firms makes selling-cost
an important element of total cost of production. Selling-expenses in general either shift the
demand curve or make it less elastic by strengthening the preferences of consumers for the
advertised product. What about the shape of selling-cost curve and its effect on average total cost
curve? Chamberlin assumes that selling-cost curve will be U-shaped implying that there are
economies as well as diseconomies of advertising as output expands. This is shown in figure
14.1. At the initial stage expansion in output will not require an increase in advertisement
expenditures by the same amount, and this will lead to a fall in average selling-expenditures.
However, beyond a certain level of output, the firm will have to spend more on selling-activities
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per unit of output in order to attract customers from other firms. This means that adding a U-
shaped selling cost curve into standard average total cost curve will yield a U-shaped average
total cost curve as shown in figure 14.1.
Figure 14.1: Effect of selling-cost on average cost curve
Rs/unit
ATCwith
selling cost
ATCwithout
selling cost
Average selling
cost curve
0 Y
Advertising is exclusive to capitalism. Non capitalist societies have no tradition of

organized advertising. The purpose of advertising is to create a product image which appeals to
the consumer’s psyche and imagination and excites his passion. An Islamic society which seeks
to minimize consumption and abstains from exaggerated usually false claims about product and
service characteristics of course has no place for an organized advertising industry. Prior to
imperialist conquest, no Muslim country had an advertisement industry. On the other hand
Islamic banks make extensive use of advertisements and their media messages are usually
indistinguishable in their emphasis on material benefits from those of conventional banks. Islamic
banks have been fully integrated into capitalist finance.
The advertising industry, like all other capitalist industries, is profit driven. Profits can be
maximized by serving non utility maximizing needs (remember utility can only be measured in
terms of consumption units). So Haj related services can be advertised in capitalist societies. The
nature of the service or product advertised does not influence the orientation of the advertising
industry. That is why if profit maximization is rejected as an organizing principle for the conduct
of business the advertising industry will collapse.
Monopoly Power and Negatively Sloped Demand Curve
Product differentiation gives rise to a negatively sloped demand curve for the product of
an individual firm. This means that the firm has control over the price of its product. In other
words, he is not a price-taker, but has some degree of monopoly power to exploit. If the firm
increases its price, it will lose some but not all customers, while if it reduces its price it will
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increase its sales by attracting some customers from other firms. But its monopoly power is
limited because consumers can easily substitute other brands. Therefore, though the demand
curve in figure 14.2 is downward sloping, it is highly elastic. The amount of monopoly power a
firm enjoys depends on its success in differentiating its product from those offered by other firms
in the industry.
Figure 14.2: Demand curve facing a firm in monopolistic competition
Rs/unit
0 Y
14.1.2: Output and Pricing Decision: Equilibrium of the Firm
The name of this market structure as ‘monopolistic-competition’ comes from the facts
that it shares elements of both monopoly and competition—product differentiation creates brand
loyalty and gives rise to a negatively sloped demand curve and, hence, to monopoly power while
easy entry conditions shows the potential for earning profits which will attract new entrant and,
hence, maintain constant competitive pressure of competition. Both of these features are reflected
in the equilibrium price and output decision of a monopolistically competitive firm.
Short-Run Equilibrium
Figure 14.3 shows the short-run equilibrium of a monopolistically competitive firm.

Since the demand curve for this firm’s product is negatively sloped, so its MR-curve is below its
demand curve as discussed in the previous chapter. Profit-maximizing output Ymc is found at the
intersection of MR and MC-curves. Since the corresponding price Pcm exceeds cost of production,
the firm earns super-normal profits in the short-run as shown by the shaded rectangle in the left
hand panel of Figure 14.3.
Long-Run Equilibrium
In the long run, this profit will induce entry by new firms. As they bring competing
brands in to the market, the existing firm may opt for one of the two options available to it: active
response or passive response.
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Figure 14.3: Equilibrium of monopolistic firm in the short-run and long-run
Rs/unit Rs/unit
MC
MC
ATC ATC
PS
Profit PL
A
E DSR F
DLR
MR
MR
0 YSR Y 0 YLR Y
• Passive response: if the firm responds passively, it does nothing and ultimately will lose its
market share in favor of new entrants and its demand curve will shift down, as in the right
hand panel of figure 14.3 (it should be noted that average and marginal cost curves will also
shift in the long run adjustment of the firm, but we have not discussed these changes for
simplicity’s sake). Where would this process end? The long run equilibrium will be achieved
where no potential for super-normal profits exists in the market. This happens when the long-
run demand curve, DLR, is tangent to the firm’s average cost curve. Here profit maximization
implies a quantity of YLR, the price of PLR and zero profits because price equals average total
cost of production. Note that the firm still has monopoly power; its long run demand curve is
negatively sloped because the firm’s particular brand is still unique. But entry and
competition by other firms have driven its profit to zero.
• Active Response: if the existing firm goes for an active response, it will have to engage itself
in selling activities and product service enhancement in order to maintain its market share.
Increased selling activities and additional value creation means that its average cost curve
will shift upward. Since the market is getting more and more congested due to the entry by
new firms, more and more selling expenses would be required to keep customers loyal to the
firm’s product. Again the long-run equilibrium will be achieved when ATC-curve is just
tangent to long-run demand curve of the firm. We leave the diagram for this particular case as
a practice for interested students.
Thus, in both cases monopolistically competitive firms tend towards zero economic profit in the
long run. There will be no further entry into the industry because equilibrium profits are normal.
The equilibrium is also stable because any firm will lose by either increasing or decreasing the
price from PLR.
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14.1.3: Efficiency of Monopolistic Competition
We have seen that monopolistic competition is somewhat similar to perfectly competitive

markets—the most desirable ones from the perspective of economic theory as they are
economically efficient. What about the efficiency of monopolistic competition? To answer this
question, let’s compare the long run equilibrium of a monopolistically competitive equilibrium
with that of perfectly competitive. Figure 14.4 makes this comparison explicit. It is obvious from
the two panels that at the long run equilibrium of competitive we firm have MC = MR = ATC = P,
while for monopolistically competitive firm MC = MR and ATC = P but P > MC. As a result of
this difference in equilibrium conditions, price will be higher and output will be lower in
monopolistic competition as compared to the competitive model. However, profits will be normal in
both models. Though there would be many small firms in monopolistic competition, each will be
producing an output at a cost higher than the minimum level. Since each competitive firm is
assumed to face a horizontal demand curve; so the zero-profit point occurs at minimum average
cost as shown in the left hand panel. But the demand curve for a monopolistic firm is downward
sloping, so the zero-profit point is to the left of minimum average cost.
Figure 14.4: Comparing competitive and monopolistic competition equilibrium
Rs/unit Rs/unit
MC
ATC MC
ATC
E
PC MR = AR PL
a
F DLR
MR
0 Yc Y 0 YLR Yc Y
Excess capacity
This means that according to standard economic measures of efficiency, there are two
sources of inefficiency in a monopolistically competitive industry. First, unlike competitive market,
equilibrium price exceeds marginal cost which means there is allocative inefficiency. If output were
expanded to the point where the demand curve intersects marginal cost curve, total surplus could be
500
increased (this analysis is very similar to comparison between competitive and monopoly markets).
Second, the monopolistically competitive firm operates with excess capacity as its output is below
Yc which minimizes average cost of production. The excess capacity is conventionally measured by
the difference between the ideal output Yc corresponding to the minimum average cost level and the
output actually produced in the long run by monopolistic firms, YLR. This excess capacity is treated
as inefficient because average cost would be lower with fewer firms in the industry—monopolistic
competition leads to ‘too many too small’ firms in the industry.
Justifying Excess Capacity
The immediate question arising from the above discussion is if monopolistic competition is
inefficient, should it be subject to capitalist state-regulation? For two reasons, the answer is
probably no. First, in monopolistically competitive markets, monopoly power is small. Since no
firm has significant market power, therefore, any deadweight loss from monopoly power in this
market structure would be very small and the cost regulation may exceed this.
Second, and most important, whatever inefficiency monopolistic competition creates is
balanced against an important “benefit” that it provides; i.e. product differentiation. Most capitalist
consumers—individuals who treat utility-maximization as an end in itself—value the ability to
choose among a wide variety of substitute products. The gain from this product choice range could
easily outweigh the inefficiency resulting in this market structure. In fact economists, e.g.
Chamberlin, have argued that even the term excess-capacity associated with monopolistic
competition as a symbol of inefficiency is misleading. The criticism of excess capacity and
misallocation of resources is valid in figure 14.4 only if we assume that there is a firm facing a
horizontal demand curve and, hence, Yc is the socially desirable level of output (after the discussion
in last chapter, you should by now be able to reject this economic postulate of horizontal demand
curve). Chamberlin argues that if the demand curve is downward sloping and the firms enter into
active price competition with easy entry conditions, Yc cannot be considered as the socially optimal
level of output. Since consumers desire an expanding variety of products, product differentiation
reflects the desires of consumers who are willing to pay higher prices in order to enjoy a wide
product range. The higher cost resulting from producing to the left of minimum average total cost is
thus socially desirable in capitalist societies. This means that the difference between actual output
YLR and the minimum cost output Yc is not a measure of excess capacity; rather a measure of the
‘social cost’ of producing and offering variety to the capitalist consumers. The output YLR is, hence,
a kind of ideal for a market characterized by product differentiation. If government somehow forces
monopolistic firm to produce output where price equals marginal cost, the firm will have to produce
at a loss in the long run (you can see that MC-curve intersects demand curve at point a which is
below ATC-curve in figure 14.4). Any pricing policy aiming at the equalization of price and
marginal cost would force the firm to close down in the long run. Thus, according to standard
economic theory, the capitalist state is faced with a dichotomy: with monopolistic competition
output is lower than society would ‘ideally’ like to have, but the socially desired P = MC can’t be
achieved without destroying capitalist order and the ‘preference for preference’ itself.
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14.2: OLIGOPOLY: MEANING AND EQUILIBRIUM
Oligopoly is a unique form of capitalist market structure in that, though it is the most
prevailing market structure in capitalism yet, unlike other market models, there is no hard-and-
fast model that can fully explain how these markets operate—i.e. it is difficult to explain the
behavior of the firm operating under oligopolistic market structure. Further, it is also not easy to
give a rigid definition of what oligopoly is. However, it is always nice to begin with a working
definition.
14.2.1: Structure of Oligopoly
Table 13.1 (of chapter 13) shows that the product may or may not be differentiated in an
oligopolistic market; what matters is that only a small number of firms supply most or all of the
total output. Oligopoly is the most prevalent market structure in mature capitalist societies.
Examples include automobile, steel, petroleum, computer, air-line and surgical and electrical
equipments almost everywhere in the world. Another important feature that differentiates
monopolistic competition from oligopoly is entry-exit conditions. To see the importance of this
point, let’s compare the market for toothpaste and automobiles. Both are characterized by product
differentiation. However, it is relatively easy for firms to introduce new brands of toothpaste that
might compete with, say, Colgate or Medicam and so on. If the profits or selling Colgate are
large, other firms will spend the money (for development, production, advertisement and
promotion) to introduce new brands of their own. On the other hand, the large investment
requirements and economies of scale involved in the production of automobiles make entry by
new firms difficult. This means that the toothpaste market is monopolistically competitive while
the automobile industry is better characterized as an oligopoly. This implies means that firms
make large profits in the long run because of significant entry barriers.
Firm Interdependence
One of the important differentiating factors of oligopoly market structure is firm’s

interdependence—the decision of one firm is also affected by decisions of others in the industry.
This makes management of an oligopolistic firm a complicated matter because pricing, output,
advertisement and investment decisions involve strategic considerations. The word strategy
involves the existence of ‘other than you’ and it means making plans taking account of the
behavior of others. An oligopolistic firm takes into account how its actions will affect its rivals
and how the rivals are then going to react. This situation is very similar to a game where the plans
and actions of one player or team are directed affected by those of his rival. To take an example,
suppose because of declining sales and compiling losses, Pepsi is considering a 10 percent price
cut to stimulate demand. While doing this, it must think carefully about how Coca-Cola will react
to this action. It is possible that Coca-Cola might not react at all or might cut its price slightly. If
so, then Pepsi will enjoy substantial increase in its sales at the expense of its rival. But it is
possible that Coca-Cola might cut prices to match Pepsi’s prices. In this case, both firms might be
selling more but making less profit because of the lower prices. And worse could happen if Coca-
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Cola reduces its prices by more than Pepsi did, say, to punish Pepsi and this in turn might
stimulate a price-war leading to a substantial fall in profits for both the firms. This means that a
firm must carefully weigh all of the possibilities resulting from the possible responses of its
competitors.
The strategic situation gets more complex when we note the fact of reaction to
reaction—when making a decision, each firm must weigh its rival’s reaction, knowing that these
rivals will also weigh its reactions to their decisions. This process of decision, reaction, reaction
to reaction and so forth is dynamic, evolving over time. While making any decision and
evaluating its potential consequences, the manager of the oligopolistically competitive firm must
assume that his competitors are also “rational”—i.e. profit maximizers. In short, one must put
oneself in the other’s place before making any decision. This shows that non-profit maximizing––
non capitalist–––firms cannot survive in oligopolistic markets. Non capitalist firms must
transform themselves–––must become profit maximums–––if they are to effectively respond to
the strategy of their oligopolistic rivals.
There is thus no room in capitalist markets–––which are usually oligopolistically
structured–––for Islamic producers and merchants. Oligopolistic markets transform Islamic
businesses into capitalist (profit maximizing) firms. If Islamic businesses–––businesses which are
instruments for earning Allah’s approval and promoting Islamic virtues–––have to be revived the
traditional Islamic bazzar must be reconstructed. This requires a deliberate elimination of the
capitalist property form and of all capitalist financial contracts and this is a task which can only
be accomplished by an Islamic state. Recreating the social dominance of the Islamic bazzar is an
important responsibility of the Islamic state.
In this section, we will discuss some of the important models that give an explanation of
the behavior of firms competing with each other under oligopolistic market conditions.
Specifically, we will examine four models of duopoly, which is the limiting case of oligopoly.
The next section will take account of market models resulting from firm’s collusion.
Defining Oligopoly as Market Concentration
Many text books differentiate between monopolistic and oligopolistic market structures
on the basis of number of firms in the market; i.e. a market is oligopolistic if the number of firms
in that market ranges between two to ten or twelve. However, this line of characterization is
fallacious as well as misleading because it gives very little attention to the structure and intensity
of competition in the markets. If, say, we have fifteen firms operating in a market with two of
them enjoying more than sixty percent of the market share while the rest have only the remaining
30 percent or so, then such a market structure can’t be characterized as monopolistic even though
the number of firms is more than twelve. For example, consider the case of petroleum sales
companies in Pakistan with many firms recently emerging in this market. However, Shell, PSO
and Caltex are the dominating forces in this particular industry in Pakistan while the others are
minnows. Therefore, the ‘number of firms’ criterion will wrongly classify petroleum sales
industry of Pakistan as monopolistic. It is for this reason that economists, especially industrial
economists, have developed other and more complex criteria to define market structures. One of
them is the concentration ratio which attempts to measure the market concentration of output.
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The concentration ratio measures the size of the largest firms’ share in total market sales.
In other words, these ratios refer to the degree to which production in any specific industry is
concentrated in the hands of a few large firms. It is traditional to consider four-firm and eight-
firm concentration ratios, denoted by CR4 and CR8; however, they can be calculated for any
number of firms as we see below. The idea behind the concept of concentration ratio is that the
pattern of sales distribution among firms in any market can help identify underlying market
structures and the level of imperfection. Sales are more evenly distributed among firms in a
competitive industry, while it is concentrated heavily among a few firms in oligopoly. In the
extreme case of a monopoly, sales are concentrated in a single firm. Thus, a market is said to be
more concentrated (and hence imperfectly competitive), the fewer the number of firms in
production or the more unequal the distribution of market shares.
Consider the following shares of six firms in an industry arranged in decreasing order:
Table 14.2: Calculating cumulative market share

Firm Market Share of Each Cumulative Market
Firm Shares
1 0.45 0.45
2 0.25 0.70
3 0.15 0.85
4 0.10 0.95
5 0.4 0.99
6 0.1 1.00
The last column calculates the cumulative percentage shares of the firms as:
Cumulative share of n-firms = Sum of n-firms shares
The concentration ratio can now be defined for any n number of firms as:
For 2-large firms: CR2 = 0.70
and so on. In general, the concentration ratio for n-firm can be defined as:
n
∑S i
CRn = i =1
(14.1)
M
where Si stands for the share of ith firm while M is total market or industry sales. We can plot the
cumulative percentage of sales against the cumulative number of firms from largest to smallest.
The resulting curve is called the concentration curve as shown in figure 14.5 for the given data in
table 14.2. A number of features should be noted about this curve. First, the curve is concave
from below because the firms are arranged from largest to smallest in terms of their market share
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which means that each additional firm will add smaller number to cumulative market share. If it
is the case that all firms are of equal size; i.e. have equal market shares, then the concentration
curve would be a straight line. Thus the concavity of this curve reflects the inequality of firm size
in an industry.
Figure 14.5: Drawing concentration curve
Cumulative percentage
of market share
Concentration
curve
1
0.75
0.5
0.25
0 1 2 3 4
No of firms cumulative from largest
Consider figure 14.6 with concentration curves for three hypothetical industries A, B and C. You
can see that the total number of firms operating in any industry are indicated, and can be
compared, by the intersection of the curves with 100 percent output level. For instance, industry A
is operated by Fa number of firms while Fb firms are producing in industry B, and so on for
industry C (not shown in the diagram). Further, given the above definition of market
concentration, we can say that concentration is high in an industry if its concentration curve lies
everywhere above that of another industry. This means that industry A is more concentrated than
industries B and C; i.e. for any number of n-large firms, such firms control a large proportion of
market sales or output. For example, the four largest firms in industry A account for 90% of sales
in this industry while the same number of firms in industry B and C make up 60% of output in
these industries. However, such a unique ranking of industries becomes difficult when the
concentration curves cross each other as in the case of industries B and C in this diagram. In fact
their ranking depends upon whether we are taking concentration ratio of less than four or more
than four firms in the industry. If we take CR for less than four firms as bench mark, then
industry C is more concentrated than industry B, but according to CR for more than four firms
industry B turns out to be more concentrated. In this case, it is not possible to rank industries
uniquely by market concentration since such a ranking assumes particular weighting to different
parts of the concentration curve (the details of this discussion are beyond the scope of this text,
interested readers should see texts on industrial economics).
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Figure 14.6: Analyzing concentration curves
Cumulative percentage
of market share
100
A
90 B
C
60 E
0 4 Fa Fb
No of firms cumulative from largest
This is a general problem associated with all concentration indices. Another problem with
concentration ratios is that the ranking of industries depends upon the choice of variable in
question. Industry A may be more concentrated than B in terms of sales, but vice versa if we
consider profits or assets as the measure of market concentration instead of sales. Despite these
difficulties, we can yet infer some of the following general conclusions from this analysis:
a. Concentration ranking principle: Concentration ratio ranks an industry as more concentrated
than another if its concentration curve lies above that of another everywhere
b. Sales transfer principle: If sales is transferred from a small to large firm in an industry,
market concentration will increase
c. Entry condition: If a small firm enters the market, market concentration will decrease
d. Merger condition: The merger of two or more firms will increase market concentration
The point to make in this discussion is that concentration ratio is a better guide to define market
structure than merely counting ‘number of firms’ in an industry as pointed out earlier. A low
concentration ratio is an indicator of a high degree of competition and a high concentration ratio
refers to the absence of competition. A monopoly has a concentration ratio of 100 percent—the
largest possible. Roughly speaking, a market is characterized as oligopoly if concentration ratio
for its four largest firms is more than 40 or 50 percent of market share. A four firm ratio of less
than 40 percent is regarded as an indication of a relatively competitive market. Viewed this way,
concentration ratio is a measure of market power enjoyed by n-largest firms in an industry.
14.2.2: Equilibrium in Oligopoly Markets
One of the important objectives of studying any market structure is to determine the
equilibrium price-output configuration—the point form where no firm would like to change its
behavior. For example, we saw that a monopolist produces at the point where its marginal cost
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equals marginal revenue, and so on for monopolistic competition. As we have seen above that in
all of the other market structures, a firm either takes price or demands as given and ignores the
behavior of its competitors. However, in oligopolistic markets, a firm’s choice of output and price
is also partly dependent upon the choices of its competitors. How can we define the concept of
equilibrium in this changed scenario? Recall that we have so far defined equilibrium as a position
when firms are doing the best they can and have no reason to change their decision. The same
concept of equilibrium is also true for oligopoly markets with slight modification. Here each firm
will try to do its best given the behavior of its competitor. Since this concept was first introduced
by John Nash in 1951, therefore it is defined ass Nash-equilibrium. It is an outcome or position
in which no firm would like to change its behavior given the behavior of its opponents. The
question that arises in mind at this point is: what should you assume or expect about your
competitors’ behavior? Because the other firms are also behaving rationally (i.e. maximizing
profit), it is natural to assume that the competing firms will also try to do their best given what
you are doing. In short, each firm while choosing its own decision takes into account its
competitor’s decision by assuming that the other firm is also trying to maximize its own profit.
The concept may seem abstract at first but will be easily understandable when we apply it in the
next section on non-collusive oligopoly.
14.3: NON-COLLUSIVE OLIGOPOLY
While discussing about oligopoly, it is important to make distinction between collusive

and non-collusive oligopoly markets and firms. An oligopoly market is said to be non-collusive
when the firms in the market do not collude (join their hands together) and therefore have to be
attentive of the reactions of other firms when making price decisions. This section elaborates a
number of different models used to analyze the working of oligopoly markets.
14.3.1: Cournot Duopoly Model
Duopoly, as the word indicates, means two-producers. The earliest of duopoly models
was presented by Augustin Cournot in 1838. He devised this model to explain the behavior of
quantities, prices and profits in a two firm market. In his model both the firms produce
homogenous goods and decide how much to produce simultaneously. To understand his model,
let’s take up the case of our water-supply monopoly firm from the previous chapter. With the
existence of another firm, after successful entry by another firm, the water supplier now needs to
understand what the industry might look like with a competitor around—for example it needs to
know the kind of market equilibrium it now faces. It should be noted that the price a firm receives
depends upon total output of the two firms they supply in the market, and not on its individual
output. This means that their demand curve takes on the following form:
P = f (Y1 , Y2 ) (14.2)
i.e. market price P is a function of joint output of both duopolists; Y1 and Y2. The cost function for
both the firms can be expressed in its typical form:
TC1 = f (Y1 ) (14.3a)
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TC 2 = f (Y2 ) (14.3b)
You can see from the three equations that while the price depends upon joint output, each
duopolist’s cost function is determined by its own output level. For the sake of simplicity,
suppose that cost function takes on linear form which means that marginal cost, and hence
average cost, is constant, say amount c per unit of output. Given this demand and cost structure,
the Cournot model answers the basic question ‘what will be the equilibrium output levels of the
two duopolists?’ Here equilibrium means a pair of output levels, one for each firm, which once
attained will leave no incentive for any firm to change its output.
Output Decision of Cournot Duopolist
The essence of Cournot model is that each firm will assume that the other firm will keep
its output fixed at the existing level when it changes its own output. In other words, each firm will
treat the output of its competitor as constant and then decides how much to produce. More
technically, we can say that conjectural variations are zero. Figure 14.7 shows how this works for
firm 1. Though each firm knows that its own profit depends upon the output of other firm, but the
problem is that it does not know the output choice of its competitor.
Figure 14.7: Output decision of a duopolist

Rs/unit
D (0)
a MC
c b
D (50)
D (75) MR (0)
MR (75)
MR (50)
0 Y1c = 12 Y1b = 25 Y1a = 50 Y
Let’s say firm 1 thinks that firm 2 will produce nothing at all. Then firm 1 faces market demand
curve denoted as D (0), which means the demand curve for firm 1 assuming firm 2 produces zero.
The diagram also plots the corresponding marginal revenue curve MR (0). Firm 1’s profit-
maximizing output is attained at point a with output Y1a, say 50 units, where MR equals MC. So if
firm 2 produces zero, then given market demand and cost functions, firm 1 should produce Y1a
output. What if firm 2 produces a higher level of output, say Y2a = 50 units? In this case, the
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market demand curve facing firm 1 will shift down by an amount 50. The reason for this shift is
simply that since firm 1 treats firm 2’s output as given, so it can supply only that part of market
demand which is not served by firm 2; i.e. if Y = Y1 + Y2, then Y1 = Y – Y2. The new demand curve
for firm 1 is denoted D (50) and corresponding marginal revenue curve is labeled MR (50). Firm
1’s profit-maximizing supply is now Y1b, say 25 units, the point where MR intersects MC curve.
Continuing with this line of reasoning, if firm 1 thinks that firm 2 will produce a yet higher level
of output, say 75 units, then firm 1’s demand curve will be further shifted down by 25 units as
labeled D (75) associated with MR (75). Here firm 1 will produce at point c supplying output Y1c
= 12 units. Finally, if firm 2 produces 100 units, then firm 1’s demand and marginal revenue
curves will be at vertical axes (not shown in the diagram) and it will produce nothing at all.
Reaction or Best Response Function of Cournot Duopolist
The above discussion shows that depending upon the output level chosen by firm 2, we
can define the output level that represents the best response—profit maximizing—for firm 1. The
process is to locate demand curve for firm 1 associated with output chosen by firm 2, and then
find the profit maximizing output level for firm 1. We have seen that the profit maximizing
output of firm 1 is inversely related to output level it thinks firm 2 will produce. This relation is
called reaction function of firm 1 to firm 2’s output denoted as Y1(Y2) in figure 14.8.
Figure 14.8: Reaction functions of Cournot duopolists

Y2
100 D
75 C
Reaction function
50 of firm 2; Y2(Y1)
B
Reaction function
of firm 1; Y1(Y2)
A
0 12 50 100 Y1
Firm 1’s output is placed on the x-axis while y-axis measures the output level of firm 2. It is
important to realize that each point on this reaction function represents the optimal choice or best
response of firm 1 to a possible output level of firm 2. We have shown four of the possible output
combinations as points A, B, C and D as discussed in figure 14.7.
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We can make a similar kind of analysis for firm 2 in order to determine its reaction
function and find its best response to each level of output that it thinks firm 1 might produce.
Firm 2’s reaction Y2(Y1) function is shown in figure 14.8 (we come to the slopes of two reaction
functions below). You can again see that the optimal or profit maximizing output level for
duopolist (firm 2) is a decreasing function of that of another duopolist (firm 1).
Determining Cournot Equilibrium
In equilibrium, each firm will determine its output on its own reaction function which
shows the amount of output a firm will produce given the output of its competitor. The point of
intersection, Ce, of the two reaction curves represents the equilibrium as shown in figure 14.9.
The resulting set of output levels, Y1e for firm 1 and Y2e for firm 2, is called Cournot equilibrium.
When firm 1 is producing Y1e output, the best response of firm 2 is to produce Y2e output.
Similarly, if firm 2 produces Y2e, then best response of firm 1 is to produce Y1e. If both firms
choose these output levels, neither firm will have an incentive to change its choice. In Cournot
equilibrium, each duopolist is producing an amount that maximizes its profit given what its
competitor is producing.
Figure 14.9: Stable Cournot equilibrium

Y2
Reaction function
of firm 1; Y1(Y2)
Cournot
Equilibrium
Y2e Ce
e
c Reaction function
Y2b
d of firm 2; Y2(Y1)
b a
Y2a
0 Y1e Y1b Y1a Y1
Stability of Cournot Equilibrium
The theory says that the duopoly model will be in equilibrium if the two firms produce
Y1e and Y2e quantities. But what is the guarantee that the two firms will actually tend to choose
these output levels? To see the process that takes outputs towards their equilibrium levels, let’s
assume that the firms are initially producing outputs different from their equilibrium levels, say at
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point a on the reaction function of firm 2 in figure 14.9. You can see that at this point firm 1 is
producing output Y1a which is higher than its equilibrium quantity while firm 2 is producing
output Y2a which is lower than its equilibrium output level. At point a firm 2 is on its reaction
function but firm 1 is not. When firm 2 chooses an output level Y2a, firm 1’s reaction function
indicates that it will decrease its output from Y1a to Y1b at point b. However, with the output of
firm 1 at Y1b, the reaction function of firm 2 shows that it will now increase its output from Y2a to
Y2b at point c. This process goes on like this until we reach point Ce, the Cournot equilibrium
point. It is important to note that the process in figure 14.9 is convergent—if allowed to continue,
it will lead the firms to converge on equilibrium quantities Y1e and Y2e. In other words, the
equilibrium is stable.
Unfortunately, convergence on the equilibrium depends on how we draw the reaction
function. Figure 14.9 draws the reaction functions such that the one for firm 2 is flatter than the
one for form 1.
Figure 14.10: Unstable Cournot equilibrium
Y2
Reaction function
of firm 2; Y2(Y1)
Unstable
Equilibrium
Ce
Y2e
q Reaction function
Y2p
p of firm 1; Y1(Y2)
r s
Y2r
0 Y1e Y1p Y1q Y1s Y1
If the opposite is the case—the one for firm 2 being steeper than that for firm 1—we have the
situation as depicted in figure 14.10. With these shapes of reaction functions, markets do not
converge to equilibrium. However, it is true that if the market ever reaches the equilibrium
quantities at point Ce, it will remain there but we cannot rely on the process of convergence to
bring about equilibrium. To grasp this point, let’s once again begin with a point beyond
equilibrium, say p where firm 1 is producing Y1p and firm 2 is producing Y2p. You can see from
firm 1’s reaction function that it will tend to increase its output towards Y1q when firm 2 is
choosing output Y2p, hence moving further away from the equilibrium. With the output of firm 1
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not at Y1q, the reaction function of firm 2 shows that it will decrease its output from Y2p to Y2r;
moving it further away from the equilibrium as well, and so on it goes. Obviously, this process is
divergent—at each stage, it moves the two firms further away form the equilibrium position. The
discussion in the following sub-section illustrates Cournot model using a mathematical function.
Though it involves a bit of mathematics, but we have not presented it in an FYI Box because it
directly adds to the understanding of the Cournot model and, moreover, the model in the next
section is developed on the basis of this particular example.
Linear Demand Curve Example of Cournot Duopoly Model
Consider two firms facing a linear demand curve:

P = 50 − Y (14.4a)
where Y is total output produced by the two firms; i.e. Y = Y1 + Y2. For the sake of simplicity,
assume that marginal cost of production is identical and constant for both the firms (the result we
derived here will not change with different and rising marginal cost assumptions):
TC1 = TC 2 = 2Y (14.4b)
hence MC1 = MC2 = 2 (14.4c)
Firm 1’s total revenue function is given by:

TR1 = P × Y1
Replacing (14.3a) for P we have:
TR1 = [50 − (Y1 + Y2 )]Y1
or TR1 = 50 Y1 − Y12 − Y1Y2 (14.4d)
The marginal revenue function is just the incremental revenue ∆TR1 resulting from a change in
output ∆Y1 (derived by applying differentiation):
∆TR1
MR1 = = 50 − 2Y1 − Y2 (14.4e)
∆Y1
Similarly, total and marginal revenue functions of firm 2 are given by:
TR2 = P × Y2 TR2 = [50 − (Y1 + Y2 )]× Y2
or TR2 = 50 Y2 − Y1Y2 − Y22 (14.4f)
∆TR2
MR2 = = 50 − Y1 − 2Y2 (14.4g)
∆Y2
ow setting marginal revenues equal to marginal costs for each firm and solving for output of the
firm gives reaction function.
Reaction function for firm 1: MR1 = MC1
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50 − 2Y1 − Y2 = 2
or Y1* = 24 − 0.5Y2 (14.4h)
Reaction function for firm 2: MR2 = MC2
50 − Y1 − 2Y2 = 2
or Y2* = 24 − 0.5Y1 (14.4i)
We know that the equilibrium output levels are found at the intersection of the two reaction
functions. Mathematically, the solution values are given by solving (14.4h) and (14.4i)
simultaneously as:
Y1 = 24 − 0.5(24 − 0.5Y1 ) or Y1 = 24 − 12 + 0.25Y1
12
Y1 = Y1 = 16 (14.4j)
0.75
Substituting Y1 from (14.4j) into (14.4i) we have:
Y2 = 24 − 0.5 × 16 Y2 = 16 (14.4k)
Since the two firms were assumed to be identical in cost structures, therefore we have equal
solution values for both the firms. The total output supplied in the market is:
Y = Y1 + Y2 = 32
and the market price is:
P = 50 − 32 P = 18
Profits of the duopolists are:
π 1 = TR1 − TC1 = (18 × 16) − (2 × 16) π 1 = 288 − 32
π 1 = 256 and also π 2 = 256
The graphical representation of reaction functions (14.4h), (14.4i) and Cournot equilibrium is given
in figure 14.11. Again, Firm 1’s reaction function shows its output Y1 as a function of firm 2’s
output Y2 and so is the case for firm 2’s reaction function. The Cournot equilibrium is at the
intersection of the two curves where each firm is maximizing its profit given the output of its rival.
Welfare Properties of Cournot Duopoly
What about the welfare properties or efficiency of duopoly outcome? More specifically,
how does Cournot duopoly compare with competitive and monopoly market structures? We have
seen in the last chapter that economists compare all market structure with their idealized model of
perfect competition in order to evaluate its desirability. What if we apply this criterion on duopoly
model? As anticipated, duopoly firms are in between the welfare results (when welfare is
measured in terms of consumer and producer surpluses) produced in competitive markets and
those that occur under monopoly. To prove this, let’s continue with out numerical example. Thus
far, in the above example, we had assumed that the two firms compete with each other. Suppose
that the two firms decide to collude and make joint output decision to maximize total profit (the
distribution of resulting profit is a secondary issue here). Under this case, the firms would behave
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like a monopolist and their total profit is maximized by choosing output Y such that marginal
revenue MR, not MR1 or MR2, equals marginal cost. Total revenue for the two firms is
TR = P × Y = (50 − Y ) × Y = 50Y − Y 2 (14.4l)
So marginal revenue is
∆TR
MR = = 50 − 2Y (14.4m)
∆Y
Figure 14.11: Cournot Duopoly example
Y2
48
Reaction function of
firm 1; Y1(Y2)
Competitive Output
Contract Curve
Ec
24 Cournot
Equilibrium
Collusive duopoly or
Ce Monopoly Output
16 Contract Curve
12
Reaction function of
Em firm 2; Y2(Y1)
0 12 16 24 48 Y1
Setting MR equal to MC, which is 2 in this example, and solving for Y we have
50 − 2Y = 2 or Ym = 24 (14.4n)
which means that if duopolists behave like a collusive-duopoly or monopoly, then they should
produce 24 units. Any combination of outputs Y1 and Y2 that adds up to 24 maximizes total profit.
If all is produced by firm 1, we have equilibrium on the horizontal axis at quantity 24, and
alternatively on the vertical axis quantity 24 if firm 2 supplies the whole market. If both agree on
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splitting the market and profits evenly, then each will produce 12 units and we have monopoly
equilibrium point Em. The line drawn between the two monopoly outputs, 24-24, is monopoly
output contract curve. It has the property that any output along this line is such that total output
on the market will be the monopoly output. The points along this line differ only according to the
amount each firm individually supplies to the market. It is easy to see that collusive-duopolists
will charge a higher price Rs 26, [= P = 50 − 24] than so non-collusive Rs 18.
Finally, we can calculate competitive output by equating, according to standard economic
theory, price with marginal cost and solving for Y:
P = MC 50 − Y = 2 or Yc = 48 (14.4o)
So if the two duopolists are forced to behave like competitive firms, they would jointly produce
48 units and charge a price Rs 2 [= P = 50 − 48] , equal to marginal cost of production. In this
case, their profits are driven down to normal or zero economic profit level. The amount of output
produced by each firm, again, would depend upon the distributional share they agree on. If they
agree to share market equally, each will produce half of the total output; i.e. 24 and we have
competitive equilibrium at point Ec. Similar to the monopoly contract curve, we can draw a line
between the two competitive output levels 48-48 passing through Ec called competitive output
contract curve—along all points on the line, total output equals optimal or competitive quantity.
You can now see that the Cournot equilibrium point Ce is strictly in between monopoly
and competitive lines. Since price decreases as quantity produced increases, it must be true that
price and quantity are in between monopoly and competitive levels at the Cournot equilibrium.
This proves the premise that non-collusive duopoly market outcomes are between monopoly and
competitive ones in terms of social welfare.
14.3.2: Stackelberg Duopoly Model: First Mover Advantage
The previous model assumes that the two duopolists; say our water-supply monopolist
and the new entrant, make their output decisions simultaneously. In other words, the Cournot
model treats firms symmetrically. However, it is more reasonable to assume that the new entrant
will treat the existing water-supply firm as a kind of leader and will view himself as a follower.
When this is the case, the market situation is said to be asymmetric with one firm being the
leader and the new entrant taking the role of follower. You can think of the situation by imagining
a new firm starting to manufacture automobiles in Japan in competition with Toyota. Clearly, a
theory that treats all firms in this market symmetrically would be unrealistic. The Stackelberg
model takes account of such market asymmetries. This model is merely an extension of Cournot
model but allows asymmetrical behavior in a duopolistic model. It assumes that the leading firm
sets its profit-maximizing output first; taking into consideration the quantity it expects the
follower to produce in reaction to its (leading firm) choice. Though the follower also tries to
maximize its profit, but it takes the output of leader as given. As we explain, this assumption
allows the leader to predict the follower’s output choice. To see how this situation works, again
continue with the example from previous section. Suppose firm 1 is the Stackelberg leader while
firm 2 is the Stackelberg follower. Since firm 2 makes its output decision after firm 1, it takes
firm 1’s output as fixed. Therefore, firm 2’s profit maximizing output is given by its Cournot
reaction function as found in (14.4i)
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Y2 F = 24 − 0.5Y1 (14.4i)
What about firm 1, the leader? In order to maximize its profit, firm 1 chooses output Y1 so that its
marginal revenue equals marginal cost. Firm 1’s revenue function was
TR1 = 50 Y1 − Y12 − Y1Y2
Figure 14.10: Stackelberg Duopoly example
Y2
48
Reaction function
of firm 1; Y1(Y2)
Stackelberg Equilibrium
with firm 2 as leader
24 Cournot
ES Equilibrium
Stackelberg Equilibrium
Ce with firm 1 as leader
16
12
ES Reaction function
of firm 2; Y2(Y1)
0 12 16 24 48 Y1
Since TR1 depends on Y2, firm 1 must anticipate how much firm 2 will produce. The leader knows
that firm 2 will choose Y2 according to reaction function (14.4i). Therefore, firm 1 can predict the
choice of firm 2’s output level from its reaction function. Substituting (14.4i) in revenue function
of firm 1, the leader, for Y2 we have
TR1L = 50 Y1 − Y12 − Y1 (24 − 0.5Y1 ) or TR1L = 50 Y1 − Y12 − 24Y1 + 0.5Y12
or TR1L = 26 Y1 − 0.5 Y12 (14.4p)
so its marginal revenue is
MR1L = 26 − Y1 (14.4q)
This revenue function incorporates the reaction function of firm 2, the follower. Setting marginal
revenue equal to marginal cost give profit-maximizing output choice for firm 1:
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26 −Y1 = 2 Y1L = 24 (14.4r)

Substituting this output of firm 1 into the reaction function of firm 2 gives its output level, given
the output of firm 1:
Y2 F = 24 − 0.5(24 ) Y2 F = 12 (14.4s)
Market price facing both firms will now be Rs 14 [= P = 50 − 36] . The profits for both firms can
be calculated as
For firm 1: π 1S = P × Y1L = 14 × 24 = 336 , and
For firm 2: π 2 F = P × Y1F = 14 × 12 = 168
Point Es on the reaction function of firm 2 in Figure 14.12 shows the Stackelberg equilibrium.
Note that the total output produced by the two duopolists in the Stackelberg model [= 36 = 24 +
12] is greater than that of in Cournot model [32] while price is lower. Interestingly, the model
predicts that the leader will produce more than the follower and, hence, make larger profit. This
means that going first gives advantage, called the first mover advantage. If we assume firm 2 to
be the leader and firm 1 as follower, the situation would simply reverse in favor of firm 2 because
the two firms are assumed to be identical in cost structures. In that case, firm 2 will produce 24
units while firm 1 set a quantity of 12 units. The profit levels would also simply reverse in
numbers. The extent to which firm 1 can move on the reaction function of firm 2 to find its profit-
maximizing point depends upon the cost and revenue structures of firm 2.
Two Many Cooks Spoil the Curry
Moving first is advantageous in the Stackelberg model because no matter what your
competitor does, your output will be larger. To maximize its profit, the laggard rival must take
your larger output as given and set a low level of output for itself. However, so is the case as long
the other firm is willing to accept the role of follower. What if both firms try to behave as
leaders? Clearly, assuming for itself the position of market leader and treating other as follower
guarantees larger profit for each firm as shown above. But the model becomes unstable when
both try to assume the leading role—the situation known as Stackelberg disequilibrium. The crux
of this situation is that when both firms try to become the leader, there expectations will not be
fulfilled and one of three outcomes may result:
a. Both firms will get involved in price-war until one firm, probably the financially weaker one,
will surrender and agree to act as follower while the other will succeed in becoming the
leader. This process will bring about Stackelberg equilibrium
b. Both firms will converge to a Cournot equilibrium position and share the market and profits
c. Both firms will collude and produce monopoly output
The Cournot and Stackelberg models are alternative explanations of oligopolistic behavior.
The answer to the question which one of the two is a more appropriate description of capitalist order
depends upon the nature of industry. An industry composed of roughly similar sized firms none of
which has leadership position, the Cournot model more appropriately explains the behavior of firms
in this industry. Conversely, if some firms in the industry take leading position in, say, introducing
new products or setting price, then the Stackelberg may be more realistic.
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14.3.3: Bertrand Duopoly Model: Criticism of Cournot
An aspect of the Cournot model that seems odd is the fact that it presents firms
competing in market by choosing quantities of goods they produce. Normally, we observe that
firms compete through prices they charge for their products. For example, price is an important
dimension in which automobile companies compete with each other. Clearly, the fact that firms
compete through prices is at odds with the assumption of the Cournot model. The economist
Joseph Bertrand developed a different kind of duopoly model in 1883, usually referred after his
name as Bertrand model.
Demand Function of the Bertrand Duopolist
In this model, firms sell identical products and consumers choose to buy from the firm
that charges the lowest price (the assumption of identical products will be relaxed below).
Therefore, firms set prices and leave quantities to be determined by the market. This is exactly
opposite to the Cournot model. The two firms face a demand function with the following
characteristics:
a. If firm 1 charges a price higher than that of its rival, the demand for its product would be zero
as all people will purchase from firm 2
b. If it charges a price below its competitor, it will capture all the demand (D) in the market (the
model assumes that all firms have enough production capacity to supply the entire market.
We relax this assumption below to see its implications for the result derived in this section)
c. If both firms charge equal price, each firm would supply half of the market demand
This type of demand function can be expressed in algebraic form as:
 D (P1 ) if P1 < P2 
 
D1 ( P1, P2 ) = (1 2 ) D (P1 ) if P1 = P2  (14.5)
0 if P1 > P2 
 
The first line says that of firm 1 sets price below that of firm 2, all consumers will buy from firm
1 and it will be selling as much as market wants at that price, D(P1). The second tells that if firm
1 and firm 2 set the same price, they will split the market between them at that price. The
meaning of third line also goes like this.
Bertrand Equilibrium and its Efficiency
What is the equilibrium in this model? Equilibrium for this model would be a pair of
prices that once attained would leave no incentive for any firm to change its price, given the price
of its competitor. What set of prices will take firms to this equilibrium position? If you think
about this situation minutely, you would realize that the equilibrium prices will be those
prevailing in competitive market due to the incentive to cut prices—i.e. both firms would set
prices equal to marginal cost of production: P1 = P2 = MC. No firm would have any incentive to
change its price from this level because if increased it price slightly, it will lose all of its
customers to other firm and would be worse off. On the other hand, if it reduced its price, it
would capture the entire market but would lose money on every unit it produced because price is
now less than marginal cost. Hence neither firm 1 nor firm 2 has any incentive to deviate from
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this price level—each is doing the best it can given what its rival is doing. Why can’t we have
equilibrium where firms charged the same but higher than marginal cost price so that each firm
made some profit? To understand why not, suppose we have the situation P1 = P2 > MC so that
prices set by two firms are greater than marginal cost. Since the two duopolists are not making
joint a decision, but they are competing with each other, both firms have incentive to decrease
their prices and hence capture the entire market. Since by slightly under-pricing the competitor
firms can increase their profit, there will remain incentive to reduce price for both the firms until
they reach marginal cost of production.
Even though the Cournot and Bertrand equilibriums are the applications of the same
equilibrium concept, just by changing the strategic choice variable, they lead to very different
welfare-outcomes. The Cournot model predicts a price and quantity that in between monopoly
and competitive levels. On the other hand, the Bertrand equilibrium results in the welfare-optimal
(competitive) price, quantity and profit. Interestingly, by simply changing the basis of
competition from quantity to price, the Bertrand model has produced dramatically different
perception about the desirability of duopolistic market than the Cournot model.
There is something intuitively unappealing about the welfare results of the Bertrand
model because with only two firms in the market it is hard to believe that the price will be driven
down to the competitive level—price that maximizes consumers’ welfare and minimizes
producers’ profit. The Cournot model seems more appropriate as it says that price will drop
gradually as more firms enter the market. The Bertrand model brings about magical results by
adding just a single firm in a monopoly market. The welfare results of the Bertrand model can be
contested by relaxing a number of its assumptions:
• Firstly, the model assumes that the firms produce homogenous products so that a firm loses
all of its sales if it increases its price slightly. But in reality we observe some degree of
product differentiation in oligopolistic markets. Market shares of firms are determined not
just by prices, but also by other factors such as differences in design, performance and
durability of the product. More importantly, advertisement and selling activities of the firms
have lasting contribution in creating brand and customer loyalty. These considerations make
it possible for a firm to charge higher than competitive prices for its product because it does
not lose all of its customers, no matter what the rival is doing
• Secondly, the model assumes that the firms do not learn from their mistakes and keep on
under-cutting each other’s prices instead of working out a more favorable pricing agreement
between themselves. In other words, we can expect firms to collude on prices. This issue is
taken in detail in the section on collusive oligopoly
• Another way of modifying Bertrand results is to relax its assumption that the firms face no
capacity constraints and can produce as much output as demanded by the market. The next
sub-section shows what happens once this assumption is relaxed as suggested by the
economist Francis Edgeworth.
14.3.4: The Edgeworth Model
The Edgeworth model explains how duopolists can find a more profitable equilibrium
than are produced by welfare-optimal prices and quantities according to Bertrand model. The
model provides a solution to the problem of price-war such that prices do not fall to marginal cost
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of production. However, the model does not have equilibrium of the type economics’ students
normally expect to see. In Edgeworth model, prices in oligopoly markets move in cycles—as
each firm attempts to maximize its profit, prices rise and fall but never settle permanently at one
level. The underlying assumption used by Edgeworth is that the firms in duopolistic markets face
capacity-constraints which means that neither of the firms have enough capacity to produce the
quantity that would be demanded at marginal cost of production. Suppose that both of our
duopolists are charging price equal to marginal-cost, and jointly, not individually, they have
enough capacity to satisfy market demand. As a result of this situation, none of them is making
any profit. What if one of the firms, say firm 1, increases its price above marginal cost? Clearly,
all customers would like to purchase from firm 2. But since firm 2 is capacity constrained, it
cannot serve everyone in the market. This means that there would be some left-out customers
willing to pay more than marginal cost to buy this product. Firm 1 can now sell its product to
these customers at a price greater than marginal cost of production and hence make profits. The
marginal cost price is not an equilibrium position in capacity constrained markets. To see why
prices will keep fluctuating in such a market, let Pm be monopoly price while Pc be competitive
price and that Pm > Pc (as assumed by economic theory). Assume that each firm is individually
large enough to satisfy monopoly output Ym but not competitive output Yc where price is equal to
marginal cost. Now say that currently prices are set such that Pm > P1 > P2 > Pc; i.e. both firms are
charging greater than competitive price and firm 1 is charging a higher price than firm 2. In this
scenario, all customers would like to shift their demand to firm 2. Since firm 2 cannot satisfy the
entire market, firm 1 will receive some customers. This will leave firm 1 an incentive to raise its
price to P1 – ε, where ε is a small number; i.e. firm 2’s price is now closer to that of firm 1,
though it is still less). Though the higher price will derive some customers away from firm 2, it
will increase its profit. The price configuration in the market will now be firm 1 charging P1
while firm 2 charging P1 – ε. But this is not an equilibrium too because firm 1 want to reduce its
price to P1 – ε – ε because this small reduction in price will bring a large increase in demand for
firm 1 because it will capture the market from firm 2. Prices will now continue to fall until they
reach marginal cost level. But since marginal-cost price is not an equilibrium position as we saw
above, once one firm increases its price the process of changing the price will start once again.
Thus, capacity constraints cause prices to fluctuate endlessly and never settle at any particular
level—oligopolistic industry will be characterized by periods of ‘price-wars’ and ‘price-hikes’.
This reinforces the idea that outcomes of the oligopolistic markets are indeterminate and
economic theory cannot predict the behavior of the firms operating in oligopolistic markets.
14.4: COLLUSIVE OLIGOPOLY
We said above that one option open for oligopolistic firms is to cooperate with each other
in order to maximize joint-profit instead of competing with each other. When firms are involved
in such cooperative decision makings, this is called collusive oligopoly. Cooperation is profitable
because it helps firms behave like a single monopolist. However, collusion may be illegal. But is
it not possible for firms to cooperate with each other without colluding explicitly? If both firms
can figure out joint profit-maximizing price, why can’t they just set this price hoping that the
competitor would also do the same? In this section we first discuss the problem that makes such
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collusions unstable, if not impossible, for capitalist (profit-maximizing) firms. We then spell out
the conditions that make collusive agreements more viable than it apparently appears.
14.4.1: Instability of Collusion
Though collusion on prices is attractive, but the problem is that such agreements are
usually not stable because each capitalist firm has strong incentives to cheat and sell to some
customers at a price below the agreed price, say Pa. It is reasonable to think that once cheating
starts, a price-war will begin resulting in the break down of collusion. To understand this
phenomenon, consider a typical Bertrand price competition example. Table 14.3 points to a
situation that the two duopolists face. Each firm has two strategies: cheat or respect the
agreement. Each cell in this table shows the profit level for both firms given their particular
strategies. The first entry in each cell is for firm 1 while the second one is for firm 2. For
example, the upper-left hand corner of this pay-off matrix says that if both the firms keep their
agreements and work cooperatively, each receives a pay-off of Rs 2 millions. The upper-right
hand cell tells us that if firm 1 keeps the agreement while firm 2 cheats, then firm 1 receives Rs
2.5 millions while firm 2 yields Rs 0.5 million (the cheater is better-off). Similarly, the lower-
right hand corner shows the profit levels when both the firms cheat; each yields Rs 1 million.
Finally if firm 2 cheats and firm keeps its agreement, firm 1 receives Rs 0.5 million while firm 2
earns Rs 2.5. Table 14.3 has now converted the market situation into a game where each firm is
trying to do its best, given the behavior of its competitor.
Table 14.3: Pay-off matrix for collusive duopolists
Firm 2
Cooperate Cheat
Cooperate 2, 2 0.5, 2.5
Firm 1
Cheat 2.5, 0.5 1, 1
We can now answer the question ‘why is it difficult for capitalist firms to behave co-operatively
and earn higher profit?’ You can see that if both firms cooperate, each receives Rs 2 millions.
However, the problem is that each firm makes more money by cheating no matter what the other
firm is doing. To see this, consider the decision making process for firm 1. Ask yourself: what
should firm 1 do if firm 2 agrees to cooperate? Clearly firm 1 has two options: if it cooperates, it
will receive Rs 2 millions but if it cheats it will receive Rs 2.5 million. This means that if firm 2
cooperates, the best response of firm 1 is cheating (because that is more profitable). Now ask:
what should firm 1 do if firm 2 cheats? Again firm 1 has two options: if it cooperates, it receives
Rs 0.5 million but if it cheats it receives Rs 1 million. Once again, cheating is more profitable
option to firm 1. The situation of firm 2 is also similar to that of firm 1: it also does best by
cheating no matter what the firm 1 is doing. This shows that cheating is the dominant strategy
for both the firms and each will be tempted to cheat, not cooperate in the market. Thus cheating
by both firms is the only equilibrium point in this situation. The lesson of this outcome is that
collusive agreements are inherently unstable and vulnerable to cheating by all the parties involved
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in that agreement. Unless the firms can sign an enforceable legal agreement, neither of them can
expect their competitors to work cooperatively.
This illustrates the essentially conflictive nature of capitalist order. All economic agents
in capitalist order maximize gain at each others’ expense, and not by co-operation. Exploitation is
thus built into capitalist market structures. It is the task of the capitalist state to regulate this
exploitation and set limits to its practice. Application Box 14.1 gives an example of the relative
failure of even enforceable legal agreements.
Cooperation difficulties at OPEC
OPEC (Organization of Petroleum Exporting Countries) is a collusive cartel of twelve countries;
namely Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the
United Arab Emirates, and Venezuela. Its primary goal is to safeguard and ensure the member
countries interests, individually and collectively. It also seeks to ensure the stabilization of prices
in international oil markets. However, OPEC has found it difficult to control oil prices effectively
due to disagreements among its members. Widespread cheating by member countries on
producing quotas is one of the many problems that OPEC has faced in trying to enforce price
fixing rule. This is a reflection of the basic weakness of collusive agreement as discussed in the
text.
Oligopoly Markets as Prisoner’s Dilemma
Prisoner’s dilemma illustrates a classic example of the problem faced by oligopolistic

firms; i.e. the problem of breaking promises. The story goes as follows. Consider two thieves who
have been accused of collaborating in a crime and they have been arrested by the police. Both of
them are kept in separate jails and cannot communicate with each other. The officer asks each of
them to confess. If both of them confess, each will receive a prison term of 5 years indicated by
the upper-left hand vector of table 14.4. If neither of them confesses, the case might be difficult
to settle, so the prisoners can expect to plea bargain and receive term of 2 years as shown by the
lower-right hand vector of the pay-off matrix (the pay-offs will be in negatives numbers because
imprisonment creates disutility). However, if one prison confesses while the other does not, the
confessor will be imprisoned for only 1 year while the other one will be sent to jail for 10 years.
What would you do if you were one of these prisoners?
Table 14.4: Pay-off matrix for prisoner’s dilemma
Prisoner 2
Confess Don’t confess
Confess -5, -5 -1, -10
Prisoner 1
Don’t confess -10, -1 -2, -2
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We can see that the prisoners face a dilemma. If they could somehow agree not to
confess, then each would go to jail for only two years. Since they can’t talk or trust on each other,
if any of the prisoners does not confess, he gives the other prisoner the possibility of gaining
advantage over him by not confessing. You can easily work out that no matter what one prisoner
does in this situation, the other finds it in his own interest to confess (we leave this as an exercise
for you). Therefore, both of them will confess and go to jail for five years—an outcome that is not
the best one for either of them!
The discussion shows that oligopolistic firms find themselves in prisoner’s dilemma.
They have two strategies: either compete aggressively to capture larger share of the market at the
expense of their competitors; or cooperate to co-exist with competitors, setting higher price and
sharing higher profits than if they compete. But just like the two prisoners, each firm has an
incentive to renege on its promises and undercut its competitor. Though both the firms can do
better by cooperating as table 14.3 shows, but they can’t trust each other. As long as the pay-off
matrix does not change, even communication among the playing parties cannot help maintain
cooperation in this prisoner’s dilemma situation. The pay-off structure must represent gains from
trade if cooperation has to be supported.
14.4.2: Making Collusion Stable
Does the above discussion mean that oligopolistic firms always get involved in intense
competition resulting in low profits? From the preceding section, one apparently gets an
impression that all collusive agreements among oligopolistic firms are doomed to failure as they
are inherently unstable. However, the instability outcome is based on a number of assumptions
and if these assumptions are relaxed, it may turn out that collusive agreements are more feasible
than one might think. Let’s work out the conditions that make collusion viable.
Repeated Games and Stability of Collusions
In our prisoner’s dilemma game, the prisoners were given only one opportunity to
confess. In other words, the game was to be played once and only once between the two prisoners
or the duopolist. Such games are called one-shot game. However, in reality firms interact with
each other in the marketplace repeatedly and set output and price over and again. This repeated
interaction among facilitates collusion because it permits firms to punish a cheater by lowering
their price once the defection of cheater is known. Consequently, if we treat a collusive
arrangement as a repeated game instead of one-shot game, then collusive arrangements can
become much more stable. Repeated interaction allows firms to develop reputations from which
trust can arise. Consider an industry made up of three or four firms that have co-exited for quite
sometime, such as in Pakistan air-line industry. It is possible that the managers of the firms might
get tired of losing money because of price-wars. This might create an implicit understanding
among all firms about maintaining high prices and not lowering price to take away market share
from its competitors. Although each firm will have the temptation to undercut its competitors, its
managers know that the gains will be short lived as the competitors will definitely retaliate
resulting in price-war and lower profits in the long run.
However, it should be remembered that the repeated game solution of prisoners’ dilemma
game is not without limits. This resolution might not be relevant for all oligopolistic markets.
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Some managers who are not content with the moderately high profits are more aggressive in
nature and therefore prefer to compete aggressively in order to capture larger market share.
Implicit understanding is also difficult to develop when firms have different cost structures and
different assessments of market demand because this makes agreement on ‘correct collusive price’
difficult. Firm 1 might believe that the correct price is Rs 15 while firm 2 thinks that it should be Rs
13. When firm 2 sets a price Rs 13, firm 1 can view this as an attempt to undercut its price (Rs 15)
and can retaliate by lowering its price to Rs 12, hence leading to price-war. Collusive agreements
are therefore short-lived because of an element of mistrust among capitalist firms.
The Kinked Demand Curve Conjecture
Stable collusion on price among oligopolistic firms can be created even without repeated game
assertion. The kinked-demand curve model spells the possibility of price-rigidity in
oligopolistic markets. The model explains why oligopolistic firms could be reluctant to change
currently prevailing market price even if their costs or demand conditions change. According to
this model, each firm faces a demand curve which is kinked at the prevailing market price Po
(point a) as shown in figure 14.13. What is the meaning of such a demand curve? The kink in
demand curve is created on the assumption that any action one firm to raise price from the
prevailing one will not be matched by its competitor, but any action to lower the price will be
matched. Above price Po, the demand curve is very elastic which means that if firm 1 raises its
price above this level, others will not follow its action and firm 1 will lose much its sales and
market share to its competitors.
Figure 14.13: Kinked demand curve model of oligopoly
Rs/unit
a MC1
Po
MCo
e1
eo
AR = Do
MRo
0 Y0 Y
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On the other hand, the demand curve is relatively inelastic below price level Po because firm 1
believes that if it lowers its price below this level, others will try to match its action because they
would not want to lose their market share. In this case, though the demand for firm 1 will increase
at lower price, but its profit will fall below joint profit level (so because demand is inelastic below
Po, so lowering of price will decrease revenue of the firm, recall this result from the chapter on
elasticity). The demand curve has higher price elasticity in the upper part of the kink segment
than on the lower part which means that the firm would experience more fall in its sales by
increasing price than the rise in its sale after reduction in price. Thus, the dotted line segments of
the demand curve Do are irrelevant from firm’s point of view. Due to the kink in demand curve,
the marginal revenue curve is discontinuous at the kink point of the demand curve. The MR-curve
has two segments: the upper segment corresponds to the upper portion of demand curve while the
lower one corresponds to the less elastic one.
The equilibrium of the firm is defined by the point of the kink where it is producing Yo
output and charging Po price. This is because at any point to the left of the kink, the MC-curve is
below the MR-curve, while to the right of kink the MC is larger than the MR. The MC-curve
passes through the discontinuous segment of MR. You can see that there is a range within which
costs may change without affecting the price and output decisions of the firm. So long as the MC-
curve passes through the discontinuous segment of the MR-curve, the firm maximizes profit by
producing Yo and charging price Po as shown in figure 14.13. This price-output configuration is
consistent with a wide range of costs. The greater the difference in price elasticities of the upper
and lower parts of the kinked-demand curve, the wider the discontinuity in the MR-curve and,
hence, the wider the cost conditions compatible with the equilibrium price. Thus the kinked-
demand curve model can explain price-rigidity in oligopolistic markets.
Figure 14.14: Limitation of Kinked demand curve model

Rs/uni
P1
Po
Do
D1
0 Y
Though the kinked-demand curve is attractive, however, it should be noted that it does
not define the level at which the price will be set in the market—i.e. does not explain the price at
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which kink would occur. Figure 14.14 draws two demand curves with kinks occurring at
different price levels. The model can’t define which of the two kinks (i.e. prices) will materialize
in the market. Since the kinked-demand conjecture does not explain the height of the kink,
therefore it is not a theory of pricing or price-determination. In fact it is tool for explaining price-
rigidity—why the price, once determined in one way or another, will tend to remain constant in
oligopolistic markets. Remember that the kink in demand curve is generated due to the
uncertainty and interdependence in the decision making of oligopolistic firms.
14.4.3: Cartel Pricing Analysis
Cartel is special category of business venture where oligopolistic firms directly agree to
cooperate in setting price and output levels. The objective of such a business arrangement is to
reduce the uncertainty arising from mutual interdependence of the firms. By agreeing on price-
output configuration, firms can maximize industry or joint profit, just as a monopolist does.
Cartels are usually considered illegal as it distracts market efficiency. However, they do exist
either because anti-trust laws are poorly enforced in some capitalist countries or because law does
not prevent countries (or companies owned by foreign governments) from forming cartels. OPEC
is an international agreement of oil producing countries.
An All-Inclusive Cartel
First consider the case of a cartel including all firms of an industry—i.e. no firm is left
out of the cartel. Usually, cartels are managed by a central agency to which firms delegate the
authority to decide not only the total quantity and the price, but also the share of production and
profit among the members of the cartel.
Figure 14.15: Cartel pricing-output and allocation decision
Rs/unit Rs/unit Rs/unit

Panel (a) Panel (b) Panel (c)
MCa MCb
MCa + b
ATC ATC
Pj Pj Pj
ea eb
D
MR
0 Ya Y 0 Yb Y 0 Yj E Y
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From this perspective, a cartel can be viewed as a large single monopolist operating in a market to
maximize its joint profit. To analyze this situation, assume that there are two firms in the cartel
with the cost structure given in panels (a) and (b) of figure 14.15. By horizontally summing up
the MC functions of firm (a) and firm (b) we get the market MC-curve; MCa+b in panel (c). The
central agency sets MCa+b equal to MR in order to find joint profit-maximizing quantity and price
for the cartel. Thus total output produced is Yj which would be sold at price Pj. The output is
allocated among the firms on the basis of equating MR with individual firm’s MC functions.
Thus, firm A will produce Ya at point ea while firm B will produce Yb at point eb (note that Ya + Yb
= Yj). We find that the firm with the lower average cost (here firm B) produces a larger amount of
output. However, it should be noted carefully that the larger output of B does not guarantee her
larger share in the profit as well. The aggregate industry profit is the sum of the profits of the two
firms given by the shaded area. The distribution of output is usually decided by the central agency
for each member of the cartel.
Cartel as Dominant Firm
The analysis becomes slightly different when all firms do not participate, or are not
included, in the formation of the cartel. In this scenario, the cartel is formed only among the
large-firms (in terms of market share) while the rest are left out of it. An example of such a cartel
is OPEC which leaves out many oil producing countries (such as Indonesia which left OPEC in
2008). This type of cartel resembles what economists call the dominant firm model. The other
firms (non-cartel) will behave like small competitive firms since they take the price set by the
cartel as given. Since this type of cartel accounts for only a portion of total market supply,
therefore it must take into account the production response of its non-cartel producers while
setting its price. To see how it works, consider figure 14.16 where Do is the market demand while
SSF is the supply curve of the small non-cartel firms (the sum of their marginal cost curves).
Figure 14.16: Deriving cartel’s demand curve
Rs/unit Rs/unit
SSF
Do
Do
P3 P3
Small firms’ Eo
supply
d2
P2 P2
A
Leaders’ demand
P1 P1
Dcar
MR
0 Y 0 Y
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Given these curves, the dominant firm will now determine its demand curve. At each price, the
leader’s demand will be equal to the difference between total demand, Do, and small firms’
supply at that price. For example, at price P3, the demand for the cartel’s product will be zero
because all the market demand is supplied by small firms at this price (point Eo). On the other
hand, small firms will sell nothing at or below price level P1, so the cartel faces the entire market
demand curve. You can see that as price falls from P3 to P1, the demand for cartel’s product
increases. At price P2, the total market demand is d2 of which P2A is supplied by the small firms
while the remaining Ad2 by the cartel. Between prices P1 to P3, the cartel faces the solid line
demand curve as drawn in the right hand panel of figure 14.16. Hence, cartel’s demand, Dcar, is
simply the difference between market demand, Do, and small firms’ supply, SSF. The diagram also
depicts MR-curve corresponding to cartel’s Dcar curve.
The cartel (or dominant firm) chooses its profit-maximizing output, Ycar, where its MCcar
equals MR as shown in figure 14.17. The MC-curve for the cartel is drawn below the supply
curve for non-cartel firms because the dominant firm is expected to have lower costs than do non-
cartel producers.
Figure 14.17: Dominant cartel’s price-output decision
Rs/unit Do SSF
b a c
Po MCcar
Pc
d
Eo
MR Dcar
0 YSF Ycar YT Y
The price, Po, is given at the cartel’s demand curve Dcar (point a). Since the smaller firms are
price takers, at market price Po, they sell output YSF determined at their supply curve, SSF (point
b). This means that total output supplied is YT = Ycar + YSF, given at the market demand curve Do
corresponding to price Po (point c).
From the above analysis we can derive two general rules for the successful operation of a
cartel. First consider figure 14.18 which shows a cartel facing a relatively flat (elastic) demand
curve and has a cost structure very similar to non-cartel members. That is why MCcar is drawn
only slightly below the SSF-curve. The cartel price is given at P1. Note that if the cartel is forced to
behave like a competitive firm, the price will equal marginal cost of the cartel’s production which
is given at point d (where MCcar-curve intersects demand curve, Dcar) in figure 14.17 and at f in
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14.18 (some of the points are omitted in this diagram to keep it simple). You can see that the
cartel facing inelastic demand curve enjoys much more monopoly power as compared to the one
facing elastic demand curve (recall from chapter 13 that monopoly power is measured by the
difference between price and marginal cost). Alternatively, monopoly power can also be viewed
as the ability of a firm to raise its price above competitive price level. When the cartel has
substantial monopoly power, it can raise its price above competitive level without any fear of
response from the non-cartel members. However, when the supply of non-cartel producers is
relatively price elastic (i.e. SSF-curve is flat as in 14.18), the ability of the cartel to substantially
increase price above competitive one is reduced because the non-cartel firms can easily expand
their supply of prices do increase.
Figure 14.18: Dominant Cartel’s price-output decision with little monopoly power
Rs/unit Do
SSF
MCcar
a
Po
Pc
f
Eo
MR Dcar
0 Ycar Y
Thus, cartelization is more successful when:

• Market demand for the product must not be price elastic
• Either the cartel should be almost all-inclusive (it controls nearly all the market supply) or the
supply of non-cartel firms must not be price elastic.
Since the two conditions are empirically valid for very few commodities, many international
cartels have failed. Application Box 14.3 compares the case of OPEC with that of CIPEC
(International Council of Copper Exporting Countries) to illustrate why the former was successful
while the later was not.
OPEC Vs CIPEC
Historically considered, OPEC has been a successful cartel in terms of making super-normal
profits while others are either doing poorly (e.g. CIPEC) or have failed to survive. One reason
why OPEC has been successful is that the demand for oil is price inelastic as it has very few
alternatives. Secondly, OPEC has been much more cost efficient than non-OPEC producers of
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oil. Both of these conditions give OPEC considerable monopoly power in the oil production
industry. On the other hand, CPEC (consisting of four countries: Chile, Peru, Zambia and Congo)
accounts for less than half of world copper supply. Further, the cost of producing copper in these
countries is only slightly lower (except for Chile where it is higher) than that of non-CIPEC
producers. Moreover, the demand for copper is also price elastic as other materials such as
aluminum can easily be substituted for copper. All these factors imply that CIPEC enjoys little
monopoly power. This means that its potential to charge price above competitive price level is
very low as non-CIPEC countries can easily increase their supply to world if CIPEC raises
copper price.
Moreover political factors play a major role in determining cartel success. OPEC pricing strategy
has been frustrated by Saudi Arabia and Nigeria which have disregarded output quotas. Saudi
Arabia has usually acted to serve American interests within OPEC and has been willing to
sacrifice national economic gains to guarantee political support from America. America has tried
to use OPEC as an instrument for disciplining and persecuting Iran and Venezuela. Saudi Arabia
has been the preferred American tool for this purpose.
14.4.4: Mergers and Acquisitions
Mergers and acquisitions (M&A) is an important dimension of oligopolistic markets.

Merger represents the decision of a number of independent firms to form a single corporation.
The new firm can act as a cartel; i.e. enjoys the power to decide upon the output quota of each
plant. Acquisition, on the other hand, represents the absorption of one company by another one;
i.e. one of the companies remains while the other one ceases to exit as a separate entity. Usually,
the smaller of the firms is merged into the larger. It may refer to the purchase of assets from
another company, the purchase of a definable segment of another entity such as subsidiary, or the
purchase of an entire company (usually called take-over). For example, we had a recent example
of acquisition in Pakistan when Standard Chartered Bank purchased ANZ bank. However, in the
modern literature, the terms mergers and acquisitions are usually used interchangeably for a
number of different activities. For example, the Competition Ordinance 2009 of Pakistan treats
followings as a form of mergers:
a) two or more companies, previously independent of one another, merge to form a new
company in such a way that they cease to exist as separate legal entities
b) one company is absorbed by another with the latter retaining its legal entity and former
ceasing to exist
c) one or more persons or other companies who or which control one or more companies or
acquire direct or indirect control of the whole or part of one or more other undertakings
Motives for Mergers
Companies enter into M&A for a variety of reasons. Some use merger as a means to
achieve growth while others seek to diversify their businesses. In any case, the motive behind any
proposed merger is important to assess its rationale. Followings are some of the reasons why
companies opt for M&A:
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• Synergy
One of the most important motives for merging is to seeking synergy—the situation that
the whole of the combined company will value more than the sum of its parts. Synergies created
through mergers either reduce costs or enhance revenues for the company.
• Growth
Companies’ managers always find themselves under pressure to grow. One way of
growing is to make investment internally (i.e. organic growth) or by purchasing the necessary
resources externally (i.e. external growth). Typically, it is easier for firms to grow externally and
M&A help in this regard. Usually, M&A take place when a firm is operating in a mature industry.
• Increasing Market Power
Merger can be a great source of increasing market power when an industry is occupied by
few competitors or when market share is sufficiently concentrated. Such a market allows firm to
have greater influence on market prices.
• Acquiring unique capabilities & resources
Mergers is also undertaken in order to pursue competitive advantages or obtain lacking
resources. When cost-effective and internal creation of key capabilities is difficult, company may
seek to acquire them from elsewhere.
Some other reasons, such as diversification, are also cited for the justification of mergers, but we
would now like to move to the issue of oligopoly-regulation resulting from M&A practices.
14.4.5: Antitrust Laws: Regulating Oligopoly
Though explicit cartels are considered illegal, M&A are usually allowed in most
capitalist countries, even rationalized, on the ground that it helps attain better utilization of
resources by benefiting from economies of scale. However, such practices do call forth regulation
because they can result in the accumulation of significant market power in the hands of a firm. Anti-
trust legislation is justified in capitalist countries on the grounds that market dominance by a firm
(or a group of firms) may lead to concentration of market output, distorted commodity and factor
price structures and significant aggregate welfare / consumption reduction for society as a whole.
We have seen in the last chapter that in the case of natural monopoly, direct price
regulation can be used. But this option is not easy to implement in case of oligopoly firms. Here,
the ideal strategy is to prevent firms from acquiring excessive market power in the first place, and
to limit the use of market power if it has been acquired some how. In order to promote a
competitive society, most countries have antitrust laws and regulatory bodies which prohibit
mergers and acquisition that impede, or are likely to impede, competition. Such laws are intended to
keep markets competitive. In Pakistan, we have the Competition Commission of Pakistan (CCP),
formerly Monopoly Control Authority (MCA), which looks after the enforcement of rules and
regulations regarding antitrust laws. The Commission mentions following as its objective statement:
“to provide for a legal framework to create a business environment based on healthy
competition towards improving economic efficiency, developing competitiveness and
protecting consumers from anti-competitive practices”
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CCP ordinance declares participation in cartel an administrative offense punishable with fines
which may extend to twenty five million rupees. However, the Competition Commission may grant
exemption in respect of some cartel (or M&A) agreements, which substantially contribute to:
i. improving production or distribution
ii. promoting technical or economic progress, while allowing consumers a fair share of the
resulting benefit; or
iii. the benefits of that agreement clearly outweigh the adverse effect of absence or lessening
of competition
Regulation Methodology
The important question now arises is how do the regulating bodies, such CCP, determine
whether any merger in question will hamper market competition? Earlier, the regulating bodies
across the world used market shares (discussed above) as bench marks to determine market power
when deciding upon whether a particular merger violates antitrust laws. By using industry
concentration rations and the market shares of the acquirer and the target firms, companies could
themselves determine in advance whether the merger would be challenged or not by the
regulating body. However, the ‘market-share approach’ proved too simplistic. This is the reason
why antitrust laws enforcing agencies have shifted to a new measure of market power called
Herfindahl-Hirschman Index (HHI) defined as:
2
 n
Sale or output of firm i 
HHI = ∑  × 100  (14.6)
i  Total Sales or output of market 
By squaring market shares, the index gives most weight to the larger firms in the industry. 10
Regulators calculate the HHI based on post-merger market shares. Given its value:
• if market shares results in an HHI of less than 1000 (HHI < 1000), market is not considered
to be concentrated and challenge is unlikely
• if market shares results between HHI of 1000-1800, market is considered moderately
concentrated and challenge is likely
• if market shares results in an HHI of greater than 1800 (HHI > 1800), market is highly
concentrated and calls forth intervention and regulation from the regulators
Let’s work out an example to see how HHI index is calculated. Consider an industry with 10 firms
and the market shares as given in table 14.5(a).
Table 14.5(a): Hypothetical data of 10-firms’s market shares

Company 1 2 3 4 5 6 7 8 9 10
Market Share (%) 25 20 10 10 10 5 5 5 5 5
To calculate HHI, first square the market share of each firm [see table 14.5 (b)]. Adding them
gives HHI = 1,450 which indicates that this industry is moderately concentrated. To see what
happens if firms 2 and 3 make a merger, list down the market shares for all firms including that of
the sum of firm 2 and 3 and add them after squaring. You can see that the HHI has jumped by 400
points to 1,850. The large change in HHI combined with the high post-merger HHI value shows
10
For further exploration of the properties of HH-index, see texts on Industrial Economics
532
that this merger would most like invoke objections from the regulating authorities. On the other
hand, if companies 9 and 10 were to combine, the HHI would climb only 50 points to 1,500. This
merger is less likely to ask for regulation because the post-merger HHI is only slightly higher than
that of pre-merger HHI.
Table 14.5(b): Calculation of Herfindahl-Hirschman Index

Pre-Merger Post-Merger: Post-Merger:
Firms 2 and 3 Firms 9 and 10
Firm Market Market Firm Market Market Firm Market Market
Share Share Share Share Share Share
(%) Squared (%) Squared (%) Squared
1 25 625 1 25 625 1 25 625
2 20 400 2+3 30 900 2 20 400
3 10 100 4 10 100 3 10 100
4 10 100 5 10 100 4 10 100
5 10 100 6 5 25 5 10 100
6 5 25 7 5 25 6 5 25
7 5 25 8 5 25 7 5 25
8 5 25 9 5 25 8 5 25
9 5 25 10 5 25 9+10 10 100
10 5 25
HHI = 1,450 HHI = 1,850 HHI = 1,500
HHI Change = 400 HHI Change = 50
Source: Adapted from CFA readings on Economics
Apart from the HHI value, regulating bodies also consider some other factors to make
regulations flexible. This additional information may include market power measured by price
elasticity of demand for the product, efficiency of the firms in the industry, or financial viability
of the potential merger candidates etc. This shows that regulating oligopoly firms is not an easy
task. The regulation becomes more difficult when the merging company has a global presence. In
this case, merging firms fall within multiple jurisdiction of regulatory control. Global companies
face dozens of regulatory agencies with different standards, formalities and requirements. For
example, in 1999 Coca-Cola acquired Cadbury Schweppes beverage brand which involved sales
and production in more than 160 countries requiring antitrust approval in more than 40
jurisdictions around the world. Regulations for cross border M&A have not been developed and
there is no international agency responsible for their regulation.
Oligopoly Redefined
We used concentration ratio as a tool to define oligopoly in the above discussion.

However, market structures can also be differentiated on the basis of HHI. In a perfectly
competitive market, the HHI is very small (probably less than 1). For example, if each of the
largest 50 firms in an industry has a market share of 0.1 percent, then HHI would be:
HHI = (0.1) × 50 = 0.5
2
For 50-firms competitive markets
533
Similarly, we can see that HHI will be:

HHI = (100) = 10,000
2
For monopoly market
A market with HHI less than 1,000 is considered relatively competitive. A market in which HHI
lies between 1,000 and 1,800 is regarded as moderately competitive. But a market where HHI is
greater than 1,800 is classified as uncompetitive.
14.5: CONCLUSION
This chapter has presented the orthodox microeconomic theory which seeks to explain
the functioning of oligopolistic markets. The most marked feature of this theory is its
indeterminacy. In the most widely prevailing and most common of all capitalist markets, neo-
classical microeconomic theory has the lowest explanatory power. Oligopolistic markets are most
prevalent but least predictable in capitalist order.
Standard microeconomic theory cannot specify what changes in cost structures will
trigger changes in equilibrium prices. How can the ‘prisoner’s dilemma’ which oligopolistic firms
typically face be overcome? When will prices converge towards their “equilibrium” levels in
oligopolistic markets and when will they diverge? What determines the distribution of monopoly
profits between duopolists, dominant firms and non-dominant ‘price takers’? What erodes the
stability of collusive agreements? etc.
This once again demonstrates that economic theory has very limited explanatory power.
It does not tell us how prices are formed, output levels are decided upon, factor proportions are
determined, profits and incomes are distributed in actually existing real world capitalist markets–
––management theory does explain this (although imperfectly).
Economic theory is normative. Economics is a moral science which shows how markets
and all agents within markets ought to behave on the basis of the absurd assumption that
rationality/self-interestedness ought to be universal and hence all individualities should collapse
into that of a natural, omniscient archangel representative agent. This fictional Ubermensch
(superman) has never existed and capitalist markets can, therefore, never be what economic
theory expects them to be.
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Key Concepts
Acquisition represents the absorption of one company by another one

Antitrust laws refer to the rules and regulations prohibiting actions that restrain, or are likely to
impede, competition
Asymmetric in economics refers to a state in which two agents (buyer Vs. seller or seller Vs.
sellers) carry inharmonious and unequal status
Bertrand model is that oligopoly model which says that firms produce a homogenous good, each
firm treats the price of its competitors fixed, and all firms decide simultaneously what price to
charge
Cartel is a form collusive business venture where all or some oligopolistic firms directly agree to
cooperate in setting price and output levels in order to maximize their joint-profit
Collusive oligopoly means firms involve in cooperative decision makings in order to maximize
their joint-profit
Concentration ratio measures the size of the largest firms’ share in total market sales. This ratio
refers to the degree to which production in any specific industry is concentrated in the hands of a
few large firms
Cournot model is an oligopoly model in which firms produce a homogenous good, each firm
treats the output of its competitors as fixed, and all firms simultaneously decide how much to
produce
Dilemma represents the problems which arise when addressing an issue the resolution of which
leads to several equally unacceptable consequences
Dominant strategy is the optimal strategy or option no matter what the opponent does
Duopoly is a market where two firms compete with each other
Edgeworth model of oligopoly provides a solution to the problem of price-war such that prices
do not fall to marginal cost of production. It explains the cyclical behavior of prices in oligopoly
markets
External growth is a companies’ expansion in sales or output achieved through the purchase of
necessary resources externally (i.e. via mergers and acquisitions)
Herfindahl-Hirschman Index is a measure of market concentration that is calculated by
summing the squared market shares for competing firms in an industry
Merger represents the decision of a number of independent firms to form a single corporation
Monopolistic competition refers to a market structure characterized by many sellers competing
with each other on differentiated products and facing easy market entry conditions
Nash equilibrium is a set of actions where each player does the best it can, given the best of its
competitor
Non-collusive oligopoly means that the firms are competing with each other in the oligopoly
market instead of joining hands together and therefore have to be attentive of the reactions of
other firms when making price decisions
Oligopoly is a market structure in which few firms compete with each other while entry barriers
are significant
One-shot game is one in which players take actions and receive pay-offs only once
Organic growth is the growth in companies’ sales or output achieved by making investment
internally (i.e. excludes growth through M&A)
535
Pay-off matrix refers to a tabular representation of profit (or payoff) to each player given its
decision and the decision of its competitor
Price-rigidity is a characteristic of oligopolistic markets which explains why firms can be
reluctant to change prices even if costs or demand change
Prisoner’s dilemma attempts to demonstrate why two agents might not cooperate even if it is in
their best interests to do so
Reaction function is the relationship between a firm’s profit-maximizing output and the amount
of output it believes its competitor will produce
Repeated game is one where actions are taken and pay-offs are received by players over and
again
Stackelberg model of oligopoly in which one firm sets its output before other firms do
Strategy is the rule or plan of action defined for playing a game
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Chapter Summary
• Actually existing capitalist firms do not correspond to the assumptions underlying the neo
classical theory of the firm. They are large and growing larger with no obvious ‘optimum
size’ since they have falling ––– not rising average costs as output expand. Hence a need for a
more realistic model of the behavior of firms.
• The theory of monopolistic competition recognizes that products are differentiated and not
homogeneous as assumed by perfect competition models. Moreover in monopolistically
competitive market, the marketing activity of firms also determines sales.
• The selling cost is therefore an important element of total cost. Selling cost can shift the
demand curve or make it more elastic. Conventional theory assumed that the selling cost
curve was U-shaped and adding it to total costs makes the total cost curve also U-shaped.
• Monopolistically competitive capitalist firm have some control over price –– the demand
curve they face is downward sloping but usually highly elastic. The monopoly power of such
a capitalist firm depends upper the extent of its success in differentiating its product.
• Long run equilibrium in monopolistically competitive market will entail an elimination of
super normal profits and an equalization of prices and average costs.
• However monopolistically competitive markets will not be efficient. Price will be greater
than marginal cost in such markets where as in perfectly competitive capitalist markets price
well equal marginal cost. Monopolistically competitive firms produce output at a cost higher
than that of perfectly competitive capitalist firms. There is allocative inefficiency in
monopolistically competitive markets. Monopolistic firms also operate with excessive
capacity. There are too many small firms in monopolistically competitive models.
• Capitalist state refrains from regulating monopolistically competitive markets because (a)
cost of regulation may exceed efficiency loss (b) higher prices may be preferred by capitalist
consumers for ensuring access to a wider range of products.
• Mature capitalist order typically takes the form of olegopolistic product, services and factor
market (with unskilled labour being the only major exception). Olegopolistic markets are
those dominated by a small number of firms. Entry to olegopolistic markets is highly
restricted firms make large profits in olegopolistic markets because of their significant entry
barriers.
• In an oligopolistic market firms are interdependent. Decisions of one firm affect decisions of
all other oligopolistic firms. Strategies must take account of other firms in the market who
will react to actions taken. The chain of reaction can extend indefinitely. Hence game theory
provides an appropriate theoretical framework for the analysis of oligopolistic markets.
• The concentration ratio is used to characterize oligopolistic markets. The concentration ratio
measures the market output share of the top four or eight firms. The choice of the number of
firms to measure the level of concentration influences market ranking. Concentration levels
will also be different in terms of the variables on the basis of which they are measured sales,
output or profit.
• In an oligopolistic market a firm’s choice of output and price is partly dependent on the
choices of its competitors. Oligopolistic markets are characterized by Nash equilibrium. This
is an equilibrium position in which no firm can gain by changing its output level or price
given the price and output levels chosen by its competitors.
537
• Non collusive oligopolistic markets are those in which firms do not collude and therefore
have to take account of and react to other firm’s actions.
• In a Cournot duopoly the price a firm charges depends upon the total output of the market.
Cost to a firm however depends upon the level of output of that firm.
• In the classical Cournot model of duopoly each firms will assume that the output of its
competitors will remain constant in deciding how much to produce. However although this
firm knows that its profit depends upon the output decision of its competition, it does not
know how much output the competitor will produce. The profit maximizing output of a firm
is inversely related to the output level it thinks it’s competitor will produce. This is the
reaction function of the firm in response to anticipated output levels of its competitor
• The reaction function shows the amount of output a firm will produce to maximize profit
given the output of its competitor. Equilibrium in the duopolistic market is given by the
intersection of the reaction function of the two firms in the market. This is the Cournot
equilibrium. Firm is producing a profit maximizing output level given the level of output
chosen by its competitor
• The stability of Cournot equilibrium position depends upon the slope of the reaction functions
of the two firms in the duopolistic market. Whether production by the two duopolistic firms
will converge or diverge towards the equilibrium position is indeterminate. Welfare generated
by duopoly market structures is indeterminate but lower than that of perfectly competitive
markets and higher than that of monopolistic markets
• Collusive oligopolistic firms charge a price and produce an output identical to that of a
monopoly firm. Non colluding oligopolistic firms will, economic theory says, charge a lower
price and produce a higher output. The Cournot equilibrium point is between the pure
competition and the pure monopoly output-price configuration. So output produced by non-
collusive oligopolistic markets is lower than that in perfectly competitive markets and price is
higher
• The Cournot model assumes that the two duopolistic firms make output/price decisions
jointly. This is unrealistic usually one duopolistic is the leader and the other is a followers.
This situation is described as ‘asymmetric’. The Stackelberg model extends the Cournot
model to take account of such asymmetry. The leading firms takes it’s output decision first on
the basis of its estimate of the follower’s output level. The follower takes the output level of
the leader as given and seeks profit maximization on this basis. This allows the leading firm
to predict the follower’s output level. Total output produced in the Stackleberg equilibrium is
higher and price lower than in the Cournot equilibrium ––– the Stackleberg equilibrium is
therefore welfare superior. However in this situation the leader will produce a greater output
and have a higher profit than the follower’s––this is the advantage of going first
• If leadership is contested by the follower firms a price war may be initiated and the outcome
of such a conflict is uncertain. It may result in (a) defeat of one of the firm (b) market sharing
or (c) collusion.
• The Bertrand duopoly model seeks to determine not the equilibrium output but the
equilibrium price level in a duopolistic market. These equilibrium prices would be the prices
prevailing in competitive markets. Equilibrium duopolistic market prices will be equal to
marginal cost. This result holds on the basis of the assumptions that the duopolistic firms are
independent price setters and do not collude. This is in sharp contrast to the Cournot model
538
finding which show that the equilibrium duopoly price and output will be somewhere
between the perfect competition and pure monopoly price-output configuration
• The Bertrand model is unrealistic because of its assumptions of (a) product homogeneity (b)
non collusion in oligopolistic markets and (c) lack of constraints on capacity expansion
• In Edgeworth’s model of oligopolistic markets, prices move in cycles. They never converge
permanently in equilibrium. Edgeworth recognizes the reality of capitalist order constraints.
Firms cannot supply to the entire market at the point where marginal cost equals price. In the
face of constraints on capacity, prices must keep on fluctuating. Price wars are the natural
state of existence of oligopolistic firms
• Collusion is inherently instable because cheating is the best option in a typical capitalist
market
• Oligopolistic firms face a “prisoner’s dilemma”. Although duopolistic firms can both gain
from collusion but they cannot trust each other, therefore both are forced to betray the other’s
‘trust’ and therefore both obtain lower profit than they would if they colluded. Collusive
agreements may be unstable
• However collusive agreements can be stable. Firms are involved not in one shot gain but on
continuous and repeated interaction. This provides opportunities for punishing those who
violate collusive agreements.
• Implicit agreement is difficult to reach when duopolistic firms have different cost structures
and different estimates of the elasticity of demand
• Price rigidity in oligopolistic markets is reflected in the kinked demand curve. Oligopolistic
firms are reluctant to change prices when cost / demand conditions change. Above the point
of the kink (the equilibrium price) the demand curve is very elastic and below it is very
inelastic. The MC curve passes through the kinked segment of the MR curve. The greater the
difference in the elasticity of the above and lower kinked portions of the demand (AR) curve
the larger the kink. The equilibrium price and output level at the kink remains unchanged for
a wide range of cost conditions. However orthodox neo classical theory does not identify the
point at which the kink in the demand curve will occur
• The cartel represents a group of oligopolistic firms that explicitly agree on price and output
levels. Firms in a cartel seek to maximize joint profits the distribution of profits in a cartel is
usually determined explicitly (by the central cartel committee)
• A cartel may be formed by the leading firms in a market leaving out other (usually smaller)
firms. The “left out” firms are price takers. The price is the profit maximizing price of the
dominant firms. A successful cartel requires inelasticity of demand on the one hand and the
price inelasticity of the supply curve of the non cartel firms in the market on the other
• Mergers and acquisitions (M and A) are undertaken to (a) maximize shareholders value (b)
maximize growth and (c) increase market power.
• Anti trust regulators seek to reduce oligopolistic collusion and market dominance. Anti-trust
legislation to prevent “undesirable” M and A is the principle instrument used for this purpose.
The Herfindahl-Hirschman Index (HHI) is used to measure market concentration. High
values of the HHI are supposed to justify market regulation on obstacles imposition on M and
A. Regulation may also be justified on grounds of demand inelasticity, firm inefficiency and
financial viability of potential M and A participants
539
• Market regulation becomes very difficult when multi-nationals dominate a market because
there is no international capitalist regulatory agency thus far in the system
540
Review Questions
1. “The neo classical theory of the firm does not describe real world firms in capitalist order.”
Do you agree? Give reasons for your answer.
2. Describe the main features of monopolistic markets and the demand and supply curves of
monopolistic firms.
3. With the help of diagrams, compare and contrast long run equilibrium in perfectly
competitive and monopolistic markets. Are monopolistic markets necessarily “inefficient”?
4. State and evaluate the case against state capitalist regulation of monopolistic market.
5. Compare and contrast oligopolistic and monopolistic market structures in capitalist order.
6. Why does economic theory recognize the need for strategic behavior in oligopolistic
markets? Give an example of such strategic decision making in the Pakistan air transport
industry.
7. What is game theory? Why is a game theoretic framework useful in understanding the
functioning of oligopolistic markets?
8. Calculate the concentration ratio in the Pakistan banking industry on the basis of (a) profit (b)
deposits and (c) advances. Which measure in your opinion is the most appropriate for
measuring banking sector concentration?
9. Define “Nash equilibrium. Is any market in Pakistan characterized by the possible existence
of Nash equilibrium?
10. Under what conditions would capitalist oligopolistic firms benefit from collusion?
11. Describe the main features of the Cournot model. Under what conditions is Cournot
equilibrium stable?
12. Compare and contrast duopolistic, monopoly and perfectly competitive markets on the basis
of allocative efficiency and welfare maximization using Cournot model.
13. Compare and contrast a monopoly’s price and output determination behavior with that of (a)
colluding and (b) non colluding oligopolistic firms.
14. What are the main differences in the Cournot and the Stackelberg models of duopolistic
output determination? The Stackelberg model is often regarded as more realistic. Do you
agree? Does any duopolistic market exist in Pakistan?
15. What is meant by a “price war”? Under what conditions is it likely to occur? Suppose a price
war breaks out in the Pakistan automobile industry. What will be its likely outcome?
16. How is equilibrium price determined in duopolistic markets according to the Bertrand’s
model. Contrast Bertrand’s theory with that of Cournot. Which model is more reflective of
capitalist reality, Bertrand’s or Cournot’s?
17. “The Edgeworth model describes capitalist duopolistic models most realistically.” Evaluate
this claim.
18. “Cheating is the best (profit maximizing) option in oligopolistic markets characterized by
collusions.” Do you agree?
19. Describe what is meant by “the prisoner’s” dilemma? Why does it often characterize
duopolistic capitalist markets?
20. What limits the prospects of collusion in duopolistic and oligopolistic capitalist markets?
Illustrate your answer with reference to the oil distribution industry in Pakistan.
541
21. How can the concept of repeated games create the possibility of collusion among
oligopolistic firms? Will your answer remain the same if the game is played over a finite time
horizon?
22. “OPEC is a cartel”. What evidence can be produced to substantiate this claim?
23. Is the Pakistan insurance industry a cartel? Give evidence for your answer.
24. What conditions are required for the operation of a “successful” cartel? Is OPEC such a
“successful” cartel? Is the Pakistani insurance industry a successful cartel too?
25. When can mergers and acquisitions be successful? Why are they undertaken frequently in
times of capitalist crisis?
26. What are the objectives of “anti monopoly regulation”? What are the reasons underlying the
continuing failure of the Competition Commission of Pakistan?
542
PART FIVE
Firm in Input Markets:
Income Distribution
Foundations and
Justification of
Capitalist Justice
Chapter 15: Market for Land

Chapter 16: Market for Capital
15
Chapter
MARKET FOR LABOR

Chapter 15: Market for Labor: Determination of Wages
The previous part of the book described the functioning of the market process in the output
market. This part will seek to explain the market process in the input markets, especially in the
market for labor and capital. The input market analysis outlined in this and the following chapter is
meant to provide a rationalization for the distribution of income generated by the market
mechanism. Neoclassical economics treats labor as one of the commodities subject to the laws of
demand and supply. This chapter will begin with an outline of demand for and supply of labor and
the standard economic argument in favor of allowing the markets to determine both wages and
employment level. We shall then discuss the real politics behind this idealization of the market
mechanism. Finally, we will illustrate the technical problems associated with the neoclassical
analysis of labor markets.
Labor: an inverted commodity
However, before we move on to the neoclassical analysis of demand for and supply of a
factor input, a small modification is required in their analytical framework. As we saw in the
previous part, the demand for an output commodity is made by the consumers while its supply is
made by firms. Unlike other commodities, the demand for labor is actually determined by firms
while its supply is determined mainly by consumers. Thus, according to standard economics,
demand for an input reflects firms’ choice to hire workers while its supply represents workers’
decision about how long to work.
15.1: DEMAND FOR LABOR IN A COMPETITIVE MARKET
Given this modification, the natural way of starting input-demand analysis is to begin an
explanation of the meaning of demand for an input. According to neoclassical economics the
demand for factor inputs is a derived demand. The idea is that factor inputs are not valued for their
own sake by consumers or firms; rather they are valuable because they can be used to produce
valuable goods and services. If an input is good at producing a commodity which is not valued by
consumers, the value of that input will be zero as its demand is derived from the demand for the
commodities it produces. For example, the value of a Muhaddis labor or Mufassir is very little in
capitalist societies because they can’t produce MBAs, engineers or scientists valued relatively
highly in such societies. Therefore, in capitalist societies it is not possible to discuss demand for
inputs without reference to their productivity in producing valued outputs. Remember that capitalist
order ascribes values to all products and activities in terms of the contribution they make to profit
maximization. Normally the muhadith cannot make much of a contribution to profit
maximization and capital accumulation hence capitalist markets assign a relatively low value for
his labor. However if the muhadith works to legitimize capitalist financial transactions for some
Islamic bank, the value of his labor will increase dramatically. This is because his labor is now
contributing significantly to profit maximization.
Economists usually classify inputs into four categories: land, labor, capital and
entrepreneur. The prices or rewards of these inputs are respectively called rent (r), wage (w),
interest (i) and profit (π). Until the early 19th century, each of these rewards were examined by a
separate set of theory. However, from the later half of the 19th century onwards, the symmetric
547
treatment of all inputs in the production function came into fashion due to the Marginalist
revolution—this point as to be discussed in detail later in this chapter. This new synthesis or
framework of analyzing input markets like any other market came to be known as neoclassical
economics which sees no difference between the determination of input-prices from that of other
commodities. It assumes that input prices are determined in the market by the forces of demand and
supply—though the difference lies in the derivation of the demand for and supply of factor inputs.
This section will develop the concept of demand for labor in a perfectly competitive market under
two conditions: (1) when only one input is variable; i.e. short-run analysis, and (2) when both
inputs are variable; i.e. long run analysis. But before that you must understand the meaning of
perfectly competitive markets for a profit-maximizing firm.
The Meaning of Competitive Input Markets
Recall that one of the implications of competitive markets was price-taking behavior which
was the direct result of large number of sellers and homogeneity of good sold. For the input market,
the assumptions are translated with the meaning that there are very many identical workers willing to
supply their labor services at a given market wage rate to the firm. Neither the single laborer nor the
firm can change the market wage rate determined by the forces of market demand and supply of labor.
Hence, the market wage rate is given for all firms; i.e. all workers are forced to accept the market
wage rate as given. This implies that the supply of labor to the individual firm is perfectly elastic as
drawn in figure 15.1 which means that a firm can hire any number of workers it wants at a given
market wage wo. Note that to analyze factor demand, we need to use the material from chapters 10 and
11 (production and cost) that show how a firm chooses its production inputs.
Figure 15.1: Typical firm facing labor supply curve in a competitive market
Wage
wo SL
(labor supply curve
facing a single firm)
0 L
548
15.1.1: Factor Demand with One Input Variable
Given this, now ask yourself the question ‘when is it profitable for a firm to hire a worker?’
The answer is: the firm will hire a worker only if additional benefits of hiring outweigh its costs.
This means that we need to compare the benefits and costs of hiring a worker. The cost of hiring a
worker is simply the wage rate (w) the firm pays to the worker. For example, if the market wage
rate is Rs 200/day and the firm employs one worker, then its cost will increase by Rs 200—i.e. the
marginal cost of hiring one worker is Rs 200/labor. So we have a measure of the cost of hiring a
worker for a firm.
What about the benefits of employing a worker? Of course the benefit of hiring a worker
stems from the fact that he adds to the production of goods and services for the firm. So we can say
that the benefit of hiring a worker to the firm is his marginal product (MPL). For example, if a
worker produces 10 tables a day, then his marginal product is 10. The problem that now arises is we
can’t compare the productivity of an input (MPL) with its cost (w). To see why, try to compare the
above given numbers. We said that the marginal product of a worker is 10 tables per day while its
marginal cost is Rs 200 per day. How can you compare 10 tables with Rs 200? Of course there is no
way of comparing tables with rupees without converting the value of tables into rupees. This means
that we need to multiply the productivity of labor with the price of output in order to obtain a
measure of its benefits. Thus, if, say, the market price of a table is Rs 25, then the value of output
produced by a worker will be Rs 250 (=10 tables × Rs 25 / table). Multiplying the output produced
by an input (MPL) with the price of output we get value of marginal product (VMP) of that
input—sometimes also called marginal revenue product (however we will a make distinction
between the two due to the reasons explained later). VMP simply indicates the change in revenue
resulting from the sale of output produced by one additional input. Algebraically speaking, value of
marginal product is given by:
VMP = P × MPL
Since the value of the marginal product is defined as change in revenue due to change in labor, we
can write this as:
∆TR
VMP = = P × MPL (15.1)
∆L
Since, as discussed in chapter 10, the marginal product of labor is assumed to keep decreasing as
additional labor is hired with fixed capital, while the price of output (P) is fixed in expression
(15.1), the value of marginal product of an input is also a decreasing function as shown in figure
15.2. Note that VMP-curve is above MP-curve because price (P) of the output is positive (hence
when multiplied by MP will yield a higher value).
We are now in a position to understand the answer to the question: ‘when is it profitable for
a firm to hire a worker?’ A profit maximizing firm will hire a worker only if the value of marginal
product of that worker is greater than his wage (i.e. its marginal cost). In our example, since the
VMP of worker, say Nomi, is Rs 300 while his hiring cost is Rs 200, it is profitable for the firm to
put him in the production process. Suppose Farooq is another worker who can produce only five
tables a day. His VMP will be Rs 125 (= 5 tables × Rs 25 / table).
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Figure 15.2: Relation between marginal product and value of marginal product
MPL,
VMPL
VMPL
MPL
0 L (labor)
Since the wage rate is fixed for all workers, so he also costs Rs 200 to the firm. Because his VMP is
less than the wage rate, the profit-maximizing firm will not hire Farooq. Hence we can derive the
following rules for a profit maximizing firm:
• Hire more of an input if VMP > w
• Don’t hire (or fire) an input if VMP < w
This means that the profit is maximized when the firm hires input up to the level where value of
marginal product is equal to the wage rate. So the profit-maximizing demand condition for a firm in
the input market is:
VMPL = w (15.2)
Table 15.1 uses some numbers to illustrate this point. Here the value of the marginal product of the
first two laborers is greater than the wage rate. Therefore, the profit of the firm will increase if it
hires these two laborers. However, hiring the fourth worker is not profitable.
Table 15.1: Hypothetical data of a firm’s demand

Labor Units Marginal Price of Value of Marginal Wage Firm Decision
Product output Product rate
(L) (MP L) (P) (VMP L) (w)
1 12 25 300 200 Hire more
2 10 25 250 200 Hire more
3 8 25 200 200 Equilibrium hiring
4 6 25 150 200 Don’t hire
The firm will incur losses by hiring him. Therefore, the profit-maximizing level of input demand is
where VMP is equal to wage rate. Figure 15.3 shows the equilibrium point of the firm at point E
where VMP equals wo. To the left of E, VMP is greater than the wage rate (VMP > w), hence the
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firm can make profit by hiring more workers. On the other hand, VMP is less than the cost of
hiring workers (VMP < w) to the right of E, therefore profits are reduced. It follows that only at
point E profits are maximum. The firm employs Lo workers at this equilibrium point. We can
conclude from this analysis that the MRP-curve is the demand curve of a firm for a single
variable input; i.e. its short run input demand curve.
Figure 15.3: Equilibrium input demand by a competitive firm
Rs/unit
E
wo SL
VMPL
0 Lo L
The Shut Down Rule Revisited
However, a little qualification needs to be made in the above proposition regarding the
input-demand curve. The qualification is related to the shut-down rule. Consider figure 15.4 where
we have drawn the VMP curve along with the average revenue product curve (ARPL = P × APL).
You should be able to recognize that this diagram is merely a reflection of figure 10.7 in chapter
10. The ARP-curve gives the revenue per-worker:
Y Total revenue
ARPL = P × APL = P × = (15.3)
L L
Expression (15.3) is based upon the facts that AP equals output per unit of labor and total revenue
equals price times output. The ARP-curve can easily be seen indicating short-run shut-down
decision for a firm. Chapter 12 outlined that a firm should operate only if the revenue exceeds
variable cost; i.e. the total cost of the variable factor:
Operate if Total revenue ≥ VC
Because labor is the only variable factor in our analysis, so the variable cost consists only of wage
bill:
Operate if Total revenue ≥ wL
Dividing both sides gives us shut-down (as well as operation) decision per unit of labor:
P × Y wL
Operate if ≥
L L
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or Operate if P × APL ≥ w (15.4)

This says that if the wage rate rises above the top of the ARP-curve, as is the case above w*, then
the firm should stop producing in the short-run. Thus, the VMP-curve is the demand curve for
labor only at w* or below w*. The lighter parts of the two curves are no longer applicable into the
firm’s decision making.
Figure 15.4: Short-run demand-curve of a factor for a competitive firm
Rs/unit
h
w* SL
ARPL
Short run VMPL
demand curve
0 L* L
Digression on Similarity between Input-Output Markets
Before moving ahead, you should note an important similarity between input and output
market equilibrium conditions for a firm as specified by microeconomic theory. The factor
market equilibrium condition says that VMP should be equal to the wage rate:
VMPL = P × MPL = w (15.2)
While the output market profit-maximizing position is that marginal revenue should be equated
with marginal cost of production:
MR = MC
Dividing (15.2) by MPL we get:
w
P=
MPL
Since price equals marginal revenue for a competitive firm, we can write this as:
w
MR = (15.5)
MPL
According to expression (11.10) from chapter 11, the right hand side of the above equation is the
MC of production. So the above condition reduces to:
MR = MC
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The equation (15.5) states that both the hiring and output choice of the firm is dictated by the
same rule: choice of input or output is determined at levels where the marginal revenue (from the
sale of output) equals the marginal cost (from the purchase of inputs).
Changes in Input Demand
Consider what happens to labor demand if the wage rate increases from wo to w1. You can
see in the left hand panel of figure 15.5 that labor demand decreases to Lf as equilibrium point
shifts to point f. We thus see that the demand for a factor input is negatively related to its price.
Now think of the effects of an increase in output price P on input demand. Clearly this will shift
the value of marginal product outward as shown in panel (b) of figure 15.5. The equilibrium
moves to point g which implies an increase in input demand to Lg. This means that input demand
is increasing as output prices increase. Changes in the use of capital services, the fixed factor, will
also affect variable input demand in a similar fashion the output prices—increase in capital stock
will make each unit of labor more productive, hence the VMP-curve will shift outwards. Hence
we can state the short-run demand for a factor as:
DLSR = f SR (w; i, p, k ) (15.6)
which says that short-run demand for a factor, say labor, is a function of input and output prices
as well as amount of capital stock used.
Figure 15.5: Changes in input demand by a competitive firm
Rs/unit (a) Effect of increase Rs/unit (b) Effect of increase

in input price in output price
Shift in VMP-
curve due to
change in P
f
w SL1
E g
w SLo w SLo
VMP1
VMPo
VMPL
0 Lf Lo L 0 Lo Lf L
15.1.2: Factor Demand with Two Inputs Variable
Demand for a factor input becomes more complicated when we have choice involving
two variable inputs. In this case, the value of marginal product is no longer the input demand
curve of a firm because a change in the price of one factor leads to changes in the use of the
others. This second change can shift the marginal product curve of the input whose price initially
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changed. In fact, the change in, say, the wage rate can be decomposed into two effects:
substitution effect and output effect. The algebra of this decomposition is:
∆Ltotal ∆Lsub ∆Loutput
= + (15.7)
∆w ∆w ∆w
The problem is how to sign the two effects on the right hand side.
Substitution Effect of an Input Price Change
The substitution effect is a straight forward one. Consider figure 15.6 where 0A is the
original expansion path of the firm which shows the cost-minimizing input combinations for
producing different levels of output at given input prices, wo, io. What if wage rate decreases?
Clearly, at any given level of output the effect will be to bias the input-choice towards
substituting more labor for the now relatively expansive factor; i.e. capital. Keeping output
constant at Ya we can isolate the pure-substitution effect of a change in input price. The shift in
the expansion path is unambiguous as shown in the figure. Reduction in the wage rate decreases
the slope of the iso-cost line and it becomes flatter (the dotted line). The tangency moves from A
to B with an increase in the use of labor associated with the decrease in wages. The new
expansion path 0B employs more labor to produce the same amount of output, at all levels of
output. Thus the substitution effect has a negative sign:
∆Lsub
<0 (15.8)
∆w
Figure 15.6: Substitution effect of an input price change is negative
Original
Ya Expansion path
New Expansion path

A with lower wages
Ka
B
Kb
0
La Lb L
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Output Effect of an Input Price Change
The output effect is, however, not so much direct. Before we can determine the sign of
the output effect, we must understand the effect of changes in input price on marginal cost of
production. Recall from chapter 11 that the marginal cost is given by:
w
MC =
MPL
Also from the cost-minimization condition (11.6) we have:
MPL w
= (11.6)
MPK r
w r
or =
MPL MPK
This implies the symmetric form:
w r
MC = = (15.9)
MPL MPK
This equation can be used to study the effects of increase in factor price on marginal cost.
Consider the decrease in the wage rate. When w falls, the firm will wish to substitute labor for
capital along any iso-quant. The substitution of labor for capital causes the marginal product of
labor to drop (because more of labor used) and that of capital to increase (because now less of it
is employed). Given the marginal cost equation (15.8), say, in terms of capital:
r
MC =
MPK
Figure 15.7: Output effect of a factor price change is negative
Rs / New Expansion path

K Yc with lower wages
unit
Ya
MC MC C
A C A
P Ka
B
Kb
0 0
Ya Yc Y La Lb Lc L
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An increase in the denominator, with the numerator fixed, means the ratio must go down. This
means that an increase in the wage rate will cause marginal cost to fall at all levels of output.
Thus, marginal cost curve will shift down from MCo to MC1 as shown in the left hand panel of
figure 15.7.
What, then, is the output effect of a wage decrease? Given that a fall in wage rate shifts
the MC-curve to the right, the profit-maximizing supply of the firm increases from Ya to Yc. The
relevant iso-quant is now Yc, to the right of Ya. The new tangency point for Yc iso-quant is attained
at a higher iso-cost line, say at point C. Thus, the output effect (from B to C) is a negative relation
between the price and the use of any normal factor—factor whose use increases with the
increase in output. Putting this together with the substitution effect (from A to B), we can sign the
total effect (from A to C):
∆Ltotal ∆Lsub ∆Loutput
= + <0
∆w ∆w ∆w
so because each of the two terms added together are negative. The vigilant students will notice
that the analysis in this section is very similar to the effects of a price change on the demand for a
commodity discussed in chapter 8.
This decomposition of the total effect of a factor price change tells us that the slope of the
factor demand curve must be negative. Again, the independent variables determining the choice
of productive factors (in a competitive market) are the prices given by the market—both of inputs
and output.
DLLR = f LR (w; r , p ) (15.10)
Graphing the use of labor against wage rate (L-w space) produces a labor demand curve. How
would this labor demand curve be different from the one we discussed above (with one input
variable); i.e. why is a VMP-curve not the labor demand curve for a firm in the long run? We
have just seen that a fall in wage rate motivates a firm to expand its capital equipments in the long
run (compare the use of capital at points A and C) in figure 15.7. This will cause the marginal
product of labor to increase because now there is larger quantity of capital with which labor is
combined. Increase in MPL shifts the MP-curve to the right. This means that a fall in factor input
price, given the output price P, causes the VMP-curve to move to the right when more than one
inputs are used in the production process. This is shown in figure 15.8 where initial equilibrium
is shown at point A at wage wa. As wages fall to wb, the equilibrium moves to point BS in the short
run at the given VMP-curve, VMPo. But the VMP-curve shifts to VMP1 in the long run. The long
run equilibrium point is attained at point BL with LL quantity of labor demanded. The locus of
points A and BL is the long-run demand for an input by a firm. You should note that the long run
demand for input is more elastic than both of the VMP-curves. This greater elasticity of the long
run labor demand curve reflects the fact that firms can substitute capital for labor in the
production process. FYI Box 15.1 summarizes the key factors responsible for the determination
of demand for a factor input by an individual firm.
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Figure 15.8: Long-run demand for a factor by a competitive firm
Rs/unit
VMPo VMP1
A Long-run labor
wa demand curve
BS BL
wb
DL
0 La Ls LL L
F Y I B O X 15.1
Determinants of the Demand for an Input
The demand for a factor input depends upon the following variables:
1. The price of the input in question—the higher the price of an input, the lower its demand and
vice versa
2. Marginal product of the input—the higher the productivity, the higher the demand for an
input
3. Price of the commodity produced by the input—the higher the output price, the higher will
be the demand for input
4. Quantity of the other factors combined in the production process—increase in capital stock
increases the marginal product of labor and hence its demand
5. Prices of the other inputs—as changes in other inputs prices affects the demand for an input
6. Technological progress—improved technology increases the marginal product of an input
and thereby its demand
15.1.3: Market Demand for an Input
The next step is to derive the market (or industry) demand curve for an input by all the
firms. Algebraically, at each wage rate the competitive market demand curve for an input is the
sum of the demands by each of the i firms:
DLM = ∑ LDi (w; i, p ) (15.11)
However, a small qualification should be noted rather carefully regarding the summation of
individual firm’s demand curve to obtain market demand for an input. Remember that the market
demand for an input is not the simple aggregation of individual firms’ demand for input. This is
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so because when the price of an input falls, all firms, and not any single firm, in the industry will
seek to hire more of this input. Consequently, hiring of more inputs by all firms will lead to more
output produced by the industry. The supply curve of this commodity shifts to the right implying
a fall in its market price. Since output price is one of the factors determining input demand, the
VMP-curve will shift to the left in response to fall in output price. For example, when the wage
rate is wa, the firm is at point a on VMP-curve VMPo in figure 15.9. Summing up the labor
demand by all firms at wa, we obtain the market demand at point A in the right hand panel. Now
suppose the wage rate decreases to wb. If only a single firm were to change its demand decision
for input, it would move along VMPo to point like b employing Lb workers. However, since the
wage rate has decreased for all firms in the industry, price of the output falls which causes the
VMP-curve to shift from VMPo to VMP1. This means that after the fall in wage rate, the firm
finds its equilibrium at point c, and not at b. By aggregating horizontally the demand for all firms
we obtain point C in the right hand panel. However, if the fall in output price was not taken into
consideration, one would over-estimate the demand for labor at point B as shown by the lighter line
in the right panel. It should be noted that point B is no longer relevant to the market demand curve
for labor. The relevant market labor-demand curve is the darker line in the right hand panel.
Figure 15.9: Deriving market demand curve for an input
Rs / Rs /
unit unit Horizontal sum with
product price unchanged
VMP
VMP a A
wa wa
c b C B
wb wb
Shift in VMP
Actual market
due to change in
demand curve
output price
0 Lc Lb 0 LC LB
La L LA L
15.2: SUPPLY OF LABOR: THE IDEOLOGY OF THE INDIFFERENT WORKER
In this section we will seek to derive the supply curve of labor. The labor supply decision
is seen as an individual’s choice between work and leisure. In fact the labor-leisure choice is itself
an outcome of what economists call the ‘time allocation problem’.
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15.2.1: Time Allocation Problem
The basic idea is that an individual has available with him 24-hours a day to allocate
among different set of activities. A person’s options to do with time are reduced to two uses:
market labor (or work) and leisure. Both of these activities are seen as mutually exclusive. Work
or labor hours refer to the amount of time an individual chooses to offer to the market at a
specific wage rate, whereas the time spent off the job is leisure. To graph this choice of an
individual, we will make use of the ‘leisure-income’ space. Figure 15.10 shows the basic set up
for analyzing time allocation problem of an individual according to microeconomic theory. Note
that there is an upper limit to the availability of time to an individual—maximum of 24 hours a
day, 168 hours a week and so on. That is why we have drawn a vertical line at 168-hours mark.
Also note that each point in this space represents not only the amount of leisure hours (R) but also
the number of work hours (L) along the horizontal axis. For example, point A (120, 48) represents
a consumption of 120 leisure hours per-week. This means that the worker would be spending the
remaining 48 of 168 hours at market work or labor; i.e. 168 – 120 = 48 hours. Since work (L) and
leisure (R—for rest) are mutually exclusive and exhaust the possible uses of time, we have the
condition:
L + R = 168 (15.12)
The linear relation between L and R implies that we can measure both labor as well as leisure
hours along the horizontal axis. The origin for labor hours is at the 168 point with R = 168 and L
= 0—the work hours are measured from right to left in this diagram.
Figure 15.10: Set up of the time allocation problem
Income
Io
B
68
A
48
0 100 120 168 R (Leisure

hours)
68 48 0 L (work
hours)
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Preferences for Leisure and Income
Figure 15.10 also depicts a normally shaped indifference curve Io passing through point
A and B. This curve shows the ‘preference’ of the individual between leisure and income. For
example, Nomi is indifferent between points A and B—i.e. between the options of ‘120 hours of
leisure and 48 hours of work’ which earns him an income of Rs 480 per week’ and ‘100 hours of
leisure and 68 hours’ from which he earns Rs 680 per week’. Both these options, A and B, are
valued equally by the individual because they yield equal utility to him—these points fall on the
same indifference curve. The indifference curve for leisure-income choice is drawn convex to the
origin for the same reason it was so drawn for the choice of consumption goods discussed in
chapter 6—as an individual has less and less amount of leisure available to him, the marginal
utility of leisure hours keeps on increasing to him and, thus, he requires increasing amounts of
income to sacrifice one extra hour of leisure for work. Also note that the indifference curve ends
after hitting 168-hours line because no choices are available beyond this point.
Budget Set for Leisure and Income
Suppose that the only way Nomi can get money to spend is by selling his labor services
in the market at a competitive wage rate, say wo. This means that the market offers Nomi a wage
rate w per hour, and he can choose his preferred number of hours to work. In other words, as a
capitalist worker Nomi is a quantity-adjuster in the competitive labor market. Figure 15.11
depicts the standard budget set AR for the capitalist worker.
Figure 15.11: Solution of the time allocation problem
Income
168 A
Io
E
45w =Me
R
0 Re = 123 168 R (Leisure
hours)
Le = 45 0 L (work
hours)
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To understand how it is generated, think of moving from point R towards the origin 0. In this
movement, the leisure hours are decreasing while the work hours are increasing thereby. When
Nomi moves left from R, each hour spent on working earns him w amount of income. This
income is measured along the vertical axis. The budget set can now be expressed by an equation:
M = wL
which says that the income of the worker equals the number of work hours times the market wage
rate. Making use of the relation L = 168 − R , we can insert leisure (R) as an argument in this
equation:
M = w(168 − R ) = 168w − wR
The right hand side expresses the sources of income for the capitalist worker. To convert this
equation into standard form (having two commodities on the left hand side) given the fact that we
have R and M on our two axis, just bring the second term to the left side:
M + wR = 168w (15.13)
This equation has a clear economic meaning. The left hand side says that the price of an hour of
leisure is w—i.e. a capitalist worker has to ‘buy leisure’ at a price of w. This is so because in
order to enjoy an hour of leisure, capitalist worker reduces his market work by one hour which
costs him a loss of income by w amount. So the left hand side of expression (15.13) states the
trade-off between leisure and income. The budget line AR has a slope of –w which measures the
rate at which a capitalist worker can substitute leisure for income. The right hand side tells us that
the total resources available to a worker for allocating between work and leisure are 168w—the
capitalist worker is actually being paid for each and every hour of his life. The right hand side is
therefore called worker’s full income.
The kind of thinking expressed here will definitely seem odd to a non-capitalist
individual, say a religious person like Abdullah. However, this clearly reflects the true essence of
rationality underlying economic science—it simply assumes that all of the resources available to
society (whether physical or human) are originally meant for and should be subject to the
accumulation of capital, and any deviance in the use of resources from this end actually reflects a
cost to society. Economic science motivates you to devote your each and every single hour to
make money in the market; i.e. contribute to profit / welfare maximization. If you happen to
spend an hour away from the capitalist work, it asks you to treat it as a ‘cost’ generating activity
by calculating its opportunity cost. For example, if Abdullah devotes an hour to offer prayer, or to
serve his parents, or may be to visit his relatives, economic rationality demands that he should
consider these activities as ‘costs’ since he could have made money by working in the market
instead of indulging in such non-market activities. Participation in non-market activities may be
rational provided they are expected to generate higher levels of income in the future, such as
students in pursuing capitalist academic disciplines, e.g. business administration, science or
engineering etc. Given this conception of rationality, it is no surprise that we see the downfall of
the family system in America and Europe where the capitalist rationality has assumed the
dominant expression in the lives of overwhelming majority of individuals.
We should remind ourselves that the analysis of input demand and supply presented by
microeconomic theory is quite useless when we consider factor pricing in non-capitalist societies.
Thus, the Prophet (SAW) has described the laborer as “God’s beloved” and in his great work
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Ihya-ul-Uloom al-deen Imam Ghazali (RA) describes the purpose of all work–––tilling land,
craftsmanship, merchandizing, soldering, public administrative service–––‘as means for acquiring
the pleasure of Allah’. Production and trading, like praying and almsgiving, are seen as religious
activities in both Islam and Christianity. In both Christian and Islamic societies, the level of
wages and the length of the time period devoted to production and markets were not determined
on the basis of considerations of utility maximization by labor and profit maximization by
merchants and traders. Indeed wage labor was a rarity in non-capitalist Islamic and Christian
societies where a large proportion of the labor force was self employed.
Choice for Leisure and Income
The choice of the capitalist worker along the budget line AR occurs at the tangency point
between the budget line and his indifference curve. This is shown at point E where he chooses to
work for, say, 45-hours a week and enjoys 123-hours in leisure. His income will equal 45w (say
Me) amount.
15.2.2: Changes in Labor Supply
Let’s analyze the effects of an increase in market wage rate, say from w to w*, on the
work decision of the capitalist worker. The budget line will get steeper to become BR in this case
rotating around the point R in figure 15.12. This is the case because each hour offered for work
will now bring him a higher wage rate than before. What happens to the equilibrium of worker;
i.e. in what direction will he change his work-leisure decision? The increase in wage rate creates
two effects:
• the substitution effect: leisure now becomes more expansive to consume (as the forgone wage
has increased). This will induce the worker to substitute work for leisure which means lower
consumption of leisure and more hours for work
• the income effect: since the worker is a seller of labor services, the higher price for labor
increases his income. If leisure is a normal good, then its demand will increase after increase
in the wage rate which will reduce the supply of labor
This means that the substitution and income effects of a wage change work in opposite directions
on the labor supply decision of a worker. The total effect will, thus, be indeterminate. Let us
develop this analysis to illustrate this point more clearly.
Substitution Effect of a Wage Change
The substitution effect is examined by projecting the new price budget line at the old
demand point. In figure 15.12, the substitution budget line is CD passing through the old demand
point E. The expected substitution away from leisure is observed from E to F along CD. This
change is expected because as the price of leisure (the wage rate) increases, the worker is
motivated to substitute leisure with more work hours as the new equilibrium is to the left of E at
F. Thus, the substitution effect is negative with respect to leisure—increase in wage decreases the
consumption of leisure by a worker (alternatively increases the supply of labor).
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Figure 15.12: Substitution effect of a wage increase
Income
B
168w*
A
168w
F
48w =Mf
45w =Me
E
D R
0 Rf Re 168 R (Leisure
hours)
0 L (work
Lf Le
hours)
However, you should note that the separation of the substitution effect of a wage change
is not only irrelevant but also unintuitive—a point not often discussed in the standard economics
text books. To see why, note that when the budget line is determined by relative prices and
income of the consumer, as is the case in the choice of goods discussed through chapters 6 to 8,
we can hypothetically change income of the consumer to keep him on the original equilibrium
point. On the other hand, in the case of time allocation problem, the y-intercept of the budget set
is determined by the wage rate but its x-intercept is given by the maximum physical number of
hours available in a week. No doubt that the budget line, in this case, can be pivoted by altering
the wage rate, but it cannot be moved in or out by changing the length of the day—this as far a
physical impossibility. You can see in figure 15.12 that it is exactly this unintuitive shift in the
budget line that is required to separate the substitution effect of a wage change (look at the x-
intercept of the substitution budget line CD which is less than 168 hours). Consequently, it makes
no sense to separate the effect of a wage change partly into the substitution effect. Similarly, the
fact the substitution effect will always induce more work hours is irrelevant in the sense that
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everyone will always have 168hours to allocate between work and leisure—there is no point in
‘substituting’ here as it is simply a negative linear relation between the two.
Income Effect of a Wage Change
The income effect is shown by shifting the substitution budget line CD to the actual new
budget line BR in figure 15.13. If both income and leisure are normal goods, their demand will
increase due to increase in the wage rate. This means that the tangency point at budget line BR
will fall to the right as compared to point F, such as at G. Since this point falls between E and F,
this means that the negative substitution effect is greater than the positive income effect.
Therefore, the demand for leisure has decreased in total (and supply of labor has increased) while
moving from E to G.
Figure 15.13: Income effect of a wage increase with substitution effect larger than income effect
Income
B
168w*
A
168w
G
F
Mf
45w =Me
E
D R
0 Rf Rg Re R (Leisure
168
hours)
L (work
Lf Lg Le 0 hours)
However, there is no guarantee that the point G will fall to the left of point E. The
equilibrium can also move to its right at point H as shown in figure 15.14. In this diagram, the
positive income effect more than offsets the negative substitution effect which results in an
increase in the consumption of leisure (and a fall in labor supply) following a wage rise. Figure
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15.14 shows the possibility of having a negatively sloped labor supply curve as the work hours
have been reduced from Le to Lg after increase in the wager rate. If we draw the points E and H in a
labor-wage space, we will see a negative relation between wage rate and supply of labor in the
market as shown in figure 15.15. This possible negative slope of labor supply curve is termed a
backward bending labor supply curve.
Figure 15.14: Income effect of a wage increase with income effect larger than substitution effect
Income
B
168w*
A
168w
F
Mf H
45w =Me
E
D R
0 Rf Re Rh 168 R (Leisure
hours)
Lf Le Lh L (work
0 hours)
Note that figure 15.15 draws two regions for labor supply curve: initially positively sloped and
then bending backward at higher wages. What is the meaning of this typical labor supply curve?
Slope of the Labor Supply Curve
Of course, according to standard economic theory, joining all price-consumption points

for all wage rates in a wage-labor space generates the labor supply curve. The labor supply curve
is shown to be positively sloped initially on the assumption that when wages are relatively low,
increase in wage rates induces a worker to supply more labor hours in the market. But as wages
become high enough, say at point G, a further increase in wage rates will be followed by a
reduction in working hours because the worker has achieved a certain minimum standard of
living. Suppose Nomi’s existing wage rate is Rs 1,000 per hour and you are choosing to work 8-
hours a day (hence making Rs 8,000 a day). A further increase in your wage, say to Rs 2,000 an
hour may actually induce you to work for less number of hours, say 6-hours a day, because now
this will earn you more amount (Rs 12,000 a day) than working 8-hours at initial wage rate.
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Economists claim that by aggregating such well-behaved labor supply curves of all workers we
can obtain the market supply of labor which looks like the curve drawn in figure 15.15.
Figure 15.15: Typical labor supply curve with backward bending region
w (wage
rate) SL
H
wh
wg G
we E
0 Le Lh Lg L (Work
hours)
15.3: EQUILIBRIUM IN THE LABOR MARKET
We have once again developed the two blades of the scissors. Given the input demand and supply
curves, a competitive labor market is in equilibrium when the wage rate clears the market; i.e.
quantity demanded of labor equals its supply. Figure 15.16 shows such a point at E where
equilibrium or market wage rate is we and the employment level is Le. Since each point of the
labor demand curve measures the benefits of hiring an additional unit of labor (i.e. VMP) and the
wage rate reflects the cost of employing a laborer, the marginal benefits (the VMP) and marginal
costs (the wage rate) are equal at point E. According to economic theory, any intervention in the
market mechanism will create inefficiency and hence is undesirable. Application Box 15.1 gives
an example of using labor market model to tackle an issue of shortage of labor in a competitive
market.
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Figure 15.16: Labor Market Equilibrium
w (wage
rate)
SL
we E
DL
0 Le L (Work
hours)
Shortage of PhD Faculty in Public Universities in Pakistan
The Higher Education Commission (HEC) has been struggling hard for about a decade years to
hire PhD faculty for public universities. The objectives behind the HEC move are to make
postgraduate studies at public universities more successful and more rigorous. However, the
HEC has found it difficult to attract many PhDs because the private sector universities usually
offer a much more handsome salary package as compared to public universities. In order to
attract the PhD faculty and eliminate the shortage, the HEC has introduced the Tenure Track
System (TTS) which promises a competitive salary package to the PhD faculty but imposes strict
conditions (e.g. the faculty member must produce two quality research papers every year and so
on). Such conditions, though justifiable, have made PhD faculty reluctant to opt for TTS—of
course, why accept any conditions when the private sector is ready to offer the same amount
without any conditions?
An important aspect of market wage determination is the emergence of economic rent at the
equilibrium point. Economic rent is the payment for a factor over and above what is required to
keep it in its current use; i.e. the difference between the payments actually made to an input and
the minimum amount that must be paid to keep it in its current use. Figure 15.17 makes this
point. The equilibrium wage rate is we and equilibrium quantity of labor supply is Le. At this
point, the total payments actually made to the workers are equal to the wage rate (0we) times the
number of workers employed (0Le). So:
Payments made to workers 0 we × 0 Le = ELe 0 we
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Figure 15.17: Economic rent arising in competitive labor markets
w (wage
rate)
SL
Economic Rent
E
we
A
DL
0 Le L (Work
hours)
This payment can be divided into two parts. To see how, first recall that the upward sloping labor
supply curve gives the information about the amount of labor that will be supplied at each level of
the wage rate. This means that the minimum amount required to employ 0Le labor in the market is
given by the area below the labor supply curve SL to the left of equilibrium labor supply Le:
Minimum Payments needed for 0Le workers = ELe 0 A
Now note that in a competitive labor market, in fact all workers receive this equilibrium wage
rate we. But this wage rate is needed to obtain only the marginal (or last) worker. This means that
all infra-marginal workers earn payment over and above what is needed to employ them in the
market. Thus, the remainder amount is the economic rent flowing to the workers as a group:
Economic Rent = Amount Actually Paid – Amount Needed to be Paid
EAwe = ELe 0 we − ELe 0 A
This is shown by the shaded area in this diagram. The economic rent, in this sense, can be
interpreted as producer’s (or factor’s) surplus, as Alfred Marshal termed it.
This discussion makes it clear that a factor input, such as labor, receives an economic rent
as long as its supply is less than perfectly elastic; i.e. as long as it is not a flat curve. You can see
it by drawing a diagram yourself that economic rent will be zero with a flat labor supply curve.
Thus, the more inelastic the supply of a factor input, the larger will be its economic rent.
As a corollary, this means that if a factor input has perfectly inelastic (or fixed) supply,
all of its payments will be economic rent because the input must be supplied no matter what price
is actually paid—its present use is not affected by whether its price is high or low. Alternatively,
such an input will have no opportunity cost as it has no alternative usage. The supply of land may
be seen as one of such factors because total area of productive land is available in fixed amount at
any point in time. Figure 15.18 illustrates the case for such an input. With the supply of rental
houses fixed at SLf, its price (also termed as rent) is completely determined by the demand
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conditions. For example, if demand for rental houses increases to D1, their price increases to r1.
The economic rent paid to rental house owners would thus increase from an amount EoSLf0roto
E1SLf0r1.
Figure 15.18: Economic rent of a perfectly inelastic input, e.g. land
r (rental
rate)
r1 E1
Eo
ro
D1
Do
0 SLf Rental
Houses
15.3.1: The Politics behind Labor Market Analysis
We discussed the politics behind studying perfectly competitive product markets in

chapter 12. Let’s briefly discuss the underlying politics advocated by neoclassical economists via
their input market analysis. When capitalist market structure emerged after the fall of Christian
societies in Europe, it brought with it one of the most striking aspects of ever increasing
inequality among the poorest and the richest. These social inequalities raised questions about the
desirability and justice of capitalist order. Some theorists argued for over throwing market
capitalism in favor of some other variants of capitalism (such as socialism). Economists right
from the time of Adam Smith have been struggling to justify the market mechanism—i.e. they
seek to prove that market outcomes are the most just. Smith tried to prove that the income
distribution generated by market forces is exactly the one that would prevail in natural (non
market order) order. Similarly, Malthus also argued that income inequalities arose from the laws
of nature itself. However, it was not until the development of neoclassical economics in the later
half of the nineteenth century that a full fledge justification for naturalizing social inequalities
was offered. The model of wage determination discussed in this chapter is a representative of
neoclassical analysis that attempts to rationalize social inequality of capitalist society. Two of its
features deserve brief description.
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‘Can’t Beat the Markets’—disintegrate the unions
Economists like Ricardo and Sraffa believed that the determination of wages had nothing
to do with the productivity of workers. Rather, to them, wages are determined by the bargaining
process (or by natural and biological laws to Ricardo) between unorganized masses of laborers
and organized group of firms. Since, according to these economists, firms are more organized and
powerful as compared to workers, this means that the decisions about who is to be employed and
at what wage rate are not the outcomes of anonymous market forces. These decisions are products
of the power struggles where people are discriminated against and exploited by the firms. From
this argument, these economists legitimize the need for assisting unemployed workers through
union collective bargaining and state institution.
However, in order to deny these political rights to the workers, the neoclassical model of
demand and supply points out that the wages paid to the workers are actually determined by
impersonal forces of the demand for and supply of labor. Hayek, one of the leading theorists of
liberalism, says that within market, distribution of income and input prices are not designed by
the intentions of any single individual and that no single individual can foresee what each
participant will get in the market. Therefore, the distribution of income generated by the market
mechanism cannot be regarded as just or unjust unless proved that it was created by fraud,
violence or special privileges. It is for this reason that Hayek proposes the term ‘dispersion’
rather than ‘distribution’ of income because, he believes, no one distributes income in a market
order. If a government attempts to improve workers’ incomes by imposing minimum wage laws,
then this will create unemployment (see chapter 4). The neoclassical model of wage
determination maintains that state intervention in the labor market in the name of protecting
workers via minimum wage laws actually hurts the cause of workers themselves. Thus, no one
can do better for workers than the market!
Based on this analysis, neoclassical economists like Hayek reject trade unions, which
they term labor monopolies. They believe that trade unions are a greater threat to the smooth
functioning of competitive market order than monopoly firms because, while monopoly firms are
treated as ‘bad’ and hence subjected to strict regulations; trade unions are usually given special
privileges—privileges not enjoyed by any other association or individuals in capitalist societies—
in the form of complex discriminatory laws. Further, they believe that these laws are usually used
against the workers themselves by denying them the right of free association and free movement.
These economists feel that such powers of unions are no longer a reflection of the fact that they
are paid less than their productivity in the market, but a result of the false general acceptance of
the views in the field of labor policy that it is in the public interest to comprehensively and
completely organize labor, and that in the pursuit of this aim the unions should be as little
restricted as possible.
However, the economists’ normal opposition to labor unions, to interventionist labor
market policies and to attempts to reduce income inequalities is not very well grounded, as we
will see in the next section. A case for unionized labor can be presented following exactly the
standard microeconomic logic.
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To Each According to his Contribution
While many intellectuals disliked market capitalism for engineering social inequalities,
neoclassical economists ask us to celebrate it as an objective reality: ‘the best of all possible
worlds’. Their economic model argues that the growing gap between the poor and the rich is
simply the reflection of the higher productivity of those who get higher returns in the market. So
the second piece of advice for policy makers stemming from neoclassical labor market analysis is
that a person’s income is determined by his or her contribution to the profit making production
process. Market wages simply reflect the marginal productivity of workers. Given the
propositions that (a) wages are determined by impersonal market forces and (b) wages reflect the
contribution of workers to output, thus lends support to the argument that highly paid workers
(such as managers of large corporations, stock and money market traders and brokers etc.)
deserve these high payments simply because these economic agents are more productive than
workers, such as manual laborers. Another important aspect of market wages is that not only do
they incorporate the productivity of workers but also reflect their voluntary participation in the
labor market process because the very activity of ‘supplying labor in the market’ simply reflects
workers’ freely determined preferences towards work and leisure. The emergence of ‘economic
rent’ at equilibrium wages, as shown in figure 15.17 then shows that participation in labor
markets makes workers better off than not participating in it. This implies that labor markets are
not a source of subjugating or exploiting workers. Quite contrary, it is a means of expressing their
productivity with freedom. No one forces anyone to do anything for anyone in the market;
everyone participates in the market because it is in his/her own interest to do so.
Thus, no matter whatever society may believe is a fair wage or a socially desirable level
of employment to be, it is ultimately the market which ought to decide what wages should be
offered and the level of employment. Both of these market outcomes will be just because they
reflect workers’ productivity on the one hand and their work-leisure choices on the other. Thus,
the competitive labor market equilibrium reflects the neoclassical slogan: ‘you get what you
deserve and deserve what you get’.
15.4: PROBLEMS WITH THE NEOCLASSICAL THEORY AND POLICY PACKAGE
We saw in chapters 12 and 13 that neoclassical models of output markets have many
internal contradictions. This is also the case with the neoclassical analysis of the labor market as
outlined in the preceding sections. Here we discuss four of those problems. You will see that the
neoclassical policy package is dependent upon a fallacious picture of actually existing capitalist
world order.
15.4.1: Backward Bending Labor Supply Curve: The Case for
Interventionist Labor Policy
Figure 15.15 depicted a well-behaved positively sloped labor supply curve derived from
an individual’s labor-leisure preferences. However, standard economic theory provides no
guarantee that such a shaped supply curve will exist. We can as easily derive a negatively sloped
labor supply curve for all wage levels as shown in figure 15.19. The diagram shows that the labor
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supply by a worker decreases as wage rate increases and vice versa. You can see that the
tangency moves from E to F and G as wage rate increases (and the budget lines moves out). One
way of conceiving such a labor supply curve is to note that the standard positive relationship
between labor supply and wages implies that a fall in the wage rate is followed by a reduction in
hours offered for work. Consequently, the worker’s income—the product of hours worked and
the wage rate—falls for both reasons (due to reduction in work hours as well as wage rate) and
hence at a faster rate than the fall in the wage rate. This standard economic analysis means that
after a fall in the wage rate the workers will substantially reduce their incomes, and
simultaneously devote more time to leisure activities. However, this economic reasoning is quite
unappealing because it begs the question: ‘how can one enjoy leisure time without income in
capitalist society?’ Probably, the only leisure activity available in a capitalist society without any
cost is ‘sleeping’ (a homeless person might give a different answer though). In reality, most
leisure activities are ‘active’; i.e. they cost money. Chapter 9 explained how the capitalist
business venture converted leisure into a commercialized activity in order to enhance its
profitability. In capitalist countries, one can’t think of enjoying leisure time without watching
T.V. channels, visiting parks, dancing at bars etc., all of which entail monetary costs.
Figure 15.19: Negatively sloped labor supply curve derived from the time allocation problem
Income
g
w
G
wg f
wf
F
wf
e
E w
we
R SL
0 Re Rf Rg 24 R (LH) 0 Lg Lf Le L (WH)
L
Le Lf Lg 0 (WH)
The only way workers can behave according to the principles of standard economic is
when they already have some alternative sources of income at their stake before entering the
market. Only then they can afford to reduce work hours in response to a fall in the wage rate. But
assuming this to be the case is to assume that workers are the owners of ‘capital’—i.e. they have
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their own means of production! Though this may be true for a small minority within capitalist
societies, for the majority of the people work is no longer an option. It is a necessity. Thus, under
normal circumstance, it makes more sense to assume that a fall in the wage rate is more likely to
induce laborers to work more hours in order to maintain their standard of living—hence the
possibility of negatively sloped labor supply curve. Technically speaking, the income effect of a
wage change is more likely to dominate the substitution effect.
The picture becomes even more gloomy if we conceive of the downward sloping labor
supply curve in terms of extreme positions: very low (wl), very high (wh) and also perhaps some
intermediate or middle wage levels (wm) as shown in figure 15.20. At very low wage levels, the
individual’s work hours are likely to be very high. This is because the tangency point between a
very flat budget line and indifference curve is likely to be near the origin (zero point of leisure).
Such a tangency point makes perfect economic sense: with lots of leisure and very little income
available to the consumer, the marginal rate of substitution between income and leisure will be
quite high—i.e. the consumer will be willing to sacrifice large amount of leisure (of which he has
a lot) for a small increase in income (of which he has very little). Alternatively, when the wage
rate is just a little above the level of subsistence, the worker will have to work a lot of hours, say
18-hours a day, just to stay alive. On the other hand, the tangency is expected to be close to the
zero point of work hours for very high wage levels—why work more if wages are astronomically
high. So we have obtained two points in the labor-wage space in the right hand panel, one at a
very low wage rate (point l) and another at a very high one (point h).
Figure 15.20: Actual labor supply curve resulting from time allocation problem
Income
w
SL
h
Very high wage, w Actual labor
wh, budget line supply curve
Very low wage, wm

wl, budget line
l
L wl
0 Rl Rh 24 R (LH) 0 Lh Ll 24
L L (WH)
Ll Lh 0 (WH)
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What about intermediate wage levels? Of course the outcome will be indeterminate, as
standard economic theory says. The supply curve can take any shape in between these two
extreme points (except the well-behaved positively sloped curve because it requires all consumers
to have identical taste) as shown in the right hand panel. If we try to obtain aggregate or market
labor supply curve by summing up many such ‘ill-behaved’ individual labor supply curves, we
can end up with any shape at all; and the standard economic theory can place no limitations to
prevent such awkward shapes. Thus, there is no ground on the basis of which we can
unambiguously relate the aggregate supply of labor with the market wage rate. The possibility of
backward bending labor supply curve is often pointed out to the students by instructors as well as
textbooks, but it is then ignored on the basis of the assumption that the labor supply curves, in
general, will be upward sloping. Unfortunately, there is no theoretical or empirical justification
for this assumption.
The above analysis poses two serious negative implications for neoclassical economic
theory. First, the ill-behaved labor supply curve implies that there could be multiple intersections
of the supply curve with the downward sloping demand curve. This means that there is no
guarantee for the achievement of a unique equilibrium wage in the labor market; rather we can
have more than one equilibrium wage rates prevailing in the market (one may be low and another
a high one) and no one can tell which one is the efficiency maximizing one. Economic theory,
therefore:
a) fails to prove that employment is determined by the supply and demand
b) fails to prove that wages are uniquely determined by the impersonal market process
Figure 15.21: Minimum wage stabilizing the inherently unstable labor market
w (wage DL
rate)
SL
E
we
wb
0 Le Ld Ls L (Work
hours)
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The second negative consequence relates to neoclassical policy recipe. The unwarranted
economic assumption that ‘labor supply curves are generally upward sloping’ may well be
tolerated if economists did not derive any strong policy recommendations from their labor market
analysis. But they do derive strong policy implications such as that the minimum wage laws are
not only ineffective but also harmful as they create unemployment. The truth of this conclusion
depends upon the upward sloping labor supply curve. But if the supply curve is negatively sloped,
the situation becomes problematic. Figure 15.21 draws both the curves as downward sloping
with demand curve being steeper than the supply curve. This labor market is unstable. To see
why, think of the wages below the equilibrium wage we, such as wb. Here, the labor supply (Ls) is
greater than the demand for labor (Ld) which means that wages should fall in response to excess
supply (unemployment). But a further decrease in wages will increase the gap between demand
and supply and, hence unemployment. The market mechanism cannot spontaneously come out of
this trap. This means that increasing the wage rate and setting it to we through legislation can
eliminate the gap between demand and supply. Therefore, a minimum wage law can not only
stabilize the labor market but also decrease unemployment.
We can thus conclude that the ‘ill-behaved’ labor supply curve eliminates the concept of
‘a unique’ equilibrium wage which is the ultimate basis of economic argument against non-
interventionist labor policy.
15.4.2: Market Power & Labor Market: The Case for Unionized Labor
We have rejected the argument for one of the economic policy recommendations (i.e.
state should not intervene in the labor market and let it free). Let’s now take the second one (i.e.
workers should not be allowed to organize in unions). This policy mantra can be dismissed using
models of imperfectly competitive markets. The neoclassical argument that wages reflect the
value of marginal productivity of workers depends upon the assumptions that (a) the labor market
is competitive (both on the demand and supply sides) and that (b) the market of the output
produced by the workers is also perfectly competitive (i.e. the firm is competitive both in the
labor as well as output markets). By relaxing these assumptions we can show that wages do not
reflect the value of marginal product of workers; rather firms exploit them. Let us relax these
assumptions one by one.
Market Power in the Output Markets
What happens to labor market analysis if we assume that the firm which hires workers
has some monopoly power in the output market—it is either monopoly or a monopolistic firm?
Since nothing is changed by this assumption in the supply side of labor market, the labor supply
curve will remain the same (of course we are assuming, for the sake of argument, that the
standard labor supply curve is valid). Market power in the labor market will change the demand
side of the labor market. To see how, recall from chapters 13 and 14 that when a firm is not a
price taker, i.e. not a competitive firm, it faces a downward sloping demand curve for the
commodity it produces. This implies that the marginal revenue curve is below the demand curve
at each output level, as reproduced in the left panel of figure 15.22. This shows that marginal
revenue will be less than price of the output. Under these circumstances, the value of marginal
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product will not be the same as that of the competitive firm. Instead, the marginal benefit of
selling an additional output unit of a monopolistic firm will be less than VMP. Let’s term these
marginal benefits of a monopolistic firm its marginal revenue product (MRP) to differentiate
them from VMP. So we can say that the marginal revenue product curve will not be equal to it,
rather below the value of marginal product (VMP) curve for a monopolistic firm. This can be seen
by looking at the expression:
MRPL = MR × MPL = P × MPL = VMPL for competitive firms
Since price, P, equals MR in the competitive output market, thus MRP equals VMP. On the other
hand, since P < MR under imperfectly competitive markets, the above equality does not hold in
this case:
MRPL = MR × MPL < P × MPL = VMPL for monopolistic firms
This means that an imperfectly competitive firm does not measure the worth of hiring a labor by
its VMP, rather by its MRP (which is less than VMP). This firm does not receive VMP by selling
an additional unit of output, rather it receives MRP (as its MR is less than P). Therefore, we have
shown the MRP-curve [MR × MPL] below VMP-curve [P × MPL] in the right hand panel.
Figure 15.22: Demand for labor by an imperfectly competitive firm
Rs/unit Rs/unit
(a) Imperfectly competitive (b) MRP and VMP curve for
output markets imperfectly competitive firm
VMPL
D
MRPL
MR
0 Yo Y 0 Lo L
Since the labor market is assumed to be perfectly competitive, the supply of labor to a
single firm is drawn as a horizontal line in the left hand panel of figure 15.23. When imperfectly
competitive firms take their hiring decision along MRP-curve, instead of value of marginal
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product curve, they hire workers up to the point where wage rate (marginal cost of hiring) equals
MRP-curve (point E). The market wage is, again of course, determined by the market demand
and supply in the right hand panel, but now the market demand is constituted by MRP-curve and
not VMP-curve. At monopolistic equilibrium point, wage rate is wm with Lm people getting work
in the market. Note that the value that consumers place on the output produced by Lm workers is
given at VMP-curve, here ve, but the workers receive a wage of wm which is less than their
contribution in the output.
Thus, when a firm has monopoly power, the factor inputs receive MRP which is less than
their VMP. The difference between the two was called monopolistic exploitation by Joan
Robinson, a famous critic of neoclassical economics. According to her, a factor input is exploited
whenever it receives a payment less than its value of marginal product. Inputs are not exploited,
according to her, in the competitive markets because the wage rate equals VMP (as well as
MRP):
w = VMPL = MRPL for competitive firms
Figure 15.23: Demand for labor by an imperfectly competitive firm
(a) Monopolistic Firm (b) Comparison of Monopolistic and

Rs/unit Competitive Industries
Monopolistic
Monopolistic
exploitation SL
exploitation
ve f
wc
E F
wo SLf wm e
VMPL
VMPL
MRPL MRPL
0 Lm Lc L 0 Lm LC L
The right side panel compares the competitive industry equilibrium with that of monopolistic one.
Point f is the competitive industry equilibrium satisfying the non-exploitation condition.
However, the equilibrium condition for monopolistic firm is given by:
w = MRPL < VMPL for monopolistic firms
which means that the difference ‘ve – we’ (or ‘wc – wm’) measures the exploitation of workers
resulting from the monopolistic behavior of firms. Further, the monopolistic firm, as well as the
industry, is also a culprit of employing less number of workers (Lm) than what a competitive firm
(industry) would do (Lc). It should be clear that this exploitation is not a result of any ‘wrong’
doing on the part of workers. Thus, according to economic theory, a firms having market power
cuts workers at both ends: they hire less number of workers and pay them less than their
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contribution in the output. Application Box 15.2 gives some industry statistics to prove that
exploitation is the hall mark of actually existing capitalist markets.
Evidence on Exploitation in Mature Capitalist Societies
It is commonly believed that workers are exploited only in under-developed countries, such as Pakistan,
where working conditions are not up to international standards. However, the preceding analysis has
shown that the presence of exploitation has nothing to do with the violation of internationals standards;
rather it is related to the presence of monopolistic power of the firm which guarantees the exploitation of
workers in capitalist market structures. The following two tables give the structure of businesses in USA
to show the market power enjoyed by the large corporations. Table 1 shows that though more than three
quarters of all US firms are proprietorships-partnerships and only a one fifth are corporations,
corporations capture 86% of total US revenue.
Table 1: Number of firms and their revenue shares in US economy 2001

Proprietorships & Partnerships Corporations
Number of Firms 80% 20%
Total Revenue Controlled by 14% 86%
Source: US Bureau of the Census, Statistical Abstract of the US: 2001
Table 2: Revenue shares of firms in some US industries 2001

Percentage Revenue Controlled by
Industry Proprietorships & Partnerships Corporations
Agriculture 50 50
Services 30 70
Construction 20 80
Retail trade 17 83
Mining 19 81
Transport 16 84
Finance 10 90
Wholesale trade 6 94
Manufacturing 3 97
Source: US Bureau of the Census, Statistical Abstract of the US: 2001
Similarly, it is evident from Table 2 that almost all the US industries are dominated by a very few large
corporations. These numbers clearly illustrate that firms have considerable market power in the US
market economy which means that workers are exploited even in the most mature capitalist societies
such as US—the hegemon of the capitalist order. Ignoring these numbers and assuming that actual
capitalist markets behave as if they were perfectly competitive is in fact to make a mockery of capitalist
realities. Thus, exploitation is the hall-mark of capitalist markets because capitalism is, by default, an
unjust and irrational system of life.
You should note that throughout this discussion we are using the microeconomic definition of
exploitation. Neoclassical theory holds that a worker is exploited (treated unjustly) when he
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receives a wage lower than the value of his marginal product. We show that this is always the
case in monopolistic markets. Since monopolistic markets dominate all real world capitalist
orders, worker exploitation in the capitalist sense (wage ≠ VMP) is universal in capitalist
systems. Capitalist order is unjust even on its own terms.
Monopsony: Market Power in the Input Markets
Consider now the case of a firm that has monopolist power in the factor market, instead
of in the output market. For simplicity, assume that the firm is the sole employer in the market, a
situation known as monopsony. This could be the case when a single firm dominates the local
market for a particular type of labor skill. For example, an oil refinery may be a monopsonist in
its hiring of petroleum engineers in a local labor market. Since this firm is the sole buyer of
workers, it faces the entire supply curve of labor and the firm is no longer a price taker. With an
upward sloping supply of labor, the firm will not be able to hire additional workers without
paying them a higher wage rate. Note that the firm has to pay a higher wage not only to the newly
employed workers but to all existing employees. If, say, the going wage rate is Rs 200 per day
before the new contract, and Rs 250 must be offered to attract new workers, then Rs 250 must be
paid to the existing work force as well. You may ask the question: will not the firm hire new
employees at higher wages and still pay the existing work force their old lower wages? This
strategy will not be workable because the higher wages for the new workers would be hard to
conceal from other workers. Of course the existing staff is not going to like these lower wages as
compared to the new employees. This can create a morale problem for the firm—a worker who is
paid less will produce less than what he would normally produce (if he is a utility maximizing
rational economic agent).
Let’s us now explore the implications of an upward sloping labor supply curve to a
monopsonist using figure 15.24. We need to examine how the wage bill [wage rate times
employment level] of the firm behaves as the firm’s employment decision changes. The top panel
shows the supply curve facing a competitive firm as well as a monopsonist. Suppose that the
market wage rate is wo at point A. If the firm were a price taker, it would assume that its labor
supply curve is a horizontal line at wo wage rate. However, since the firm is a monopsonist, it
perceives that the labor supply curve is upward sloping. Note that the supply curve of labor shows
the average expenditure or price that the monopsonist must pay at different levels of employment.
For example, at employment level Lo, the firm must pay wo per worker. In other words, the labor
supply curve is the average expenditure curve of the monopsonist. Multiplying the factor price
with the employment level gives the total wage bill of the firm:
Wage Bill (WB) = Wage Rate × Employment Level (15.14)
When the firm is a price taker as in a competitive labor market, the wage rate is fixed. This means
that the wage-bill will be a linear function of the employment level (i.e. a linear upward sloping
curve in the middle panel). Under these circumstances, the average as well as the marginal
expenditures (ME) of the firm will be equal to the wage rate as shown in the lower panel (the
horizontal line at wo). The marginal expenditures represent the amount needed to purchase an extra
unit of labor. Technically speaking, the marginal expenditure on labor is the change in total wage
bill due to hiring of one extra unit of labor:
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Figure 15.24: Average and marginal expenditure functions of monopsonist
Rs/unit
SL facing a
monopsonist
A SL facing a
wo competitive firm
bill
0 Lo L
Wage Bill
Monopsonist
wage bill
Competitive wage
bill
a
wo Lo
Slope of the
monopsonist wage
0 Lo L
Rs/unit
MEmonopsonist SL or
AEmonopsonist
MEo b
SL or AE = ME for
wo
a competitive firm
0 Lo L
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∆WB
ME L = (15.15)
∆L
This expression gives the slope of the wage bill curve. With the wage rate fixed for a competitive
firm, its ME will be equal to wage rate:
∆WB
ME L = = wo for competitive firm
∆L
But when the labor supply curve is positively sloped as is the case for the monopsonist, his wage-
bill curve is not only positively sloped but also convex from below. The curve has a positive
slope because hiring more workers increases the total wage bill. It is convex because the rate at
which the wage bill increases keeps on increasing as more workers are hired; i.e. the slope of the
wage bill curve is not constant but increasing. This is so because the wage rate goes up for a
monopsonist as he employs more workers. The result of this is that the marginal expenditure
(ME) curve lies above the average expenditure or labor supply curve for a monopsonist as shown
in the bottom panel. These slopes reflect the fact that hiring an additional worker increases the
wage bill by more than the price of this worker because all previous units employed have also to
be paid the new higher price. To consolidate your understanding of why the ME-curve must be
above the AE-curve for a monopsonist, consider point a in the middle panel. We have seen above
that the ray coming from the origin and passing through point a in the middle panel would be the
wage bill curve if the firm were a price taker in the labor market. The slope of this curve would
be wo at each employment level. However, the slope of the convex monopsonist wage-bill curve
is given by the tangent at point a. The convex shape ensures that the tangent must be steeper than
the slope of the competitive wage bill (compare the dashed tangent with the competitive wage bill
curve). Thus we find that the ME exceeds wage rate at each level of employment—hence we
have ME-curve above AE or labor supply-curve in the bottom panel.
Figure 15.25: Equilibrium of monopsonist having no monopoly power
Rs/unit
Monopsonist
Exploitation MEmonopsonist
SL
M
B
wc
wm A
VMP
0 Lm Lc L
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Given these curves, the monopsonist is in equilibrium when he follows the marginal
principle: he compares the marginal benefits of hiring another worker with its marginal cost. If
we assume that the firm is a price taker in the output market, then the marginal benefits are
measured by the VMP-curve as shown in figure 15.25. The marginal cost of an extra labor unit is
given by the ME function and not by the AE-curve for a monopsonist. This means that he will be
hiring Lm workers at point M where VMP is equal to ME. The wage rate wm is determined at the
labor supply curve (point A) corresponding to Lm employment level. If we now compare the
monopsonist equilibrium with that of the competitive one at point B, we can see that the
competitive industry would hire up to the point where VMP equals the supply curve SL hiring Lc
workers and paying wc wage rate. The difference between the competitive wage wc and
monopsonist wage wm is called monopsonist exploitation. You can see that even when a firm is a
price taker in the output market but has monopsonist power (in the input market), it pays to the
workers a wage less than their VMP. Further, the monopsonist also employs less number of
workers (Lm) than what competitive industry would do (Lc).
It should be noted clearly that the monopsonist exploitation is something over and above
the monopolistic exploitation discussed in the previous sub-section. There we saw that monopolistic
exploitation arises when the firm faces a negatively sloped demand curve for a commodity. When
the firm has monopoly power in the output market, its MRP-curve (or factor demand curve) lies
below VMP-curve as reproduced in figure 15.26. Under these circumstances, profit-maximization
requires that the firm equates its ME with MRP (and not with VMP) at equilibrium point E. The
wage rate now paid is even below the MRP of workers. The difference between competitive and
monopsonist wage (wc - wm) can be divided into two parts: the part wcwn is due to the monopoly
power of the firm because this would exist even if the firm did not have monopsony power in the
factor market. However, the part wnwm is attributed to the monopsony power of the firm.
Figure 15.26: Equilibrium of monopsonist having monopoly power
Rs/unit Monopolistic
Exploitation
MEmonopsonist
SL
E
wc B
wn N
w
VMP
Monopsonist MRP
Exploitation
0 L Ln Lc L
Summarizing the above two sub-sections, we can say that:

1. In competitive markets, the workers are paid their VMP (if we assume that economic
theory is correct, which in fact it is not as we show shortly)
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2. When the firm has monopoly power in the output market and no power in the input
market, the workers are paid a wage equal to MRP which is less than their VMP (w =
MRP < VMP)
3. When the firm has both monopoly as well monopsony powers, workers are paid a wage
which is less than even their MRP
This analysis consolidates what we concluded in the previous chapter: exploitation is built into
actually existing capitalist order and the only way to assume it away is to assume that we live in a
non-existing perfectly competitive capitalist world. Ironically, instead of accepting the harsh
realities of capitalism, economists prefer to befool the masses by putting a veil on reality. They do
this because economics is a moral, not essentially an empirical, discipline.
The above analysis also justifies the existence of labor unions because, as shown, the
workers will be paid less than their contribution if they behave as unorganized masses trying to
compete over each other in the market against a monopsonist or monopolist buyer. Thus, while
economists usually portray unions as a ‘necessary evil’ on the grounds that they reduce
competition in the market, however unions may be seen as a preferred option by capitalist
workers trying to avoid exploitation in monopolistic and monopsonistic markets.
Monopsonist Vs Labor Union
This discussion leads us to explore the more realistic situation of what happens when the
monopsonist faces a trade union. If unionized workers behave like a single seller of their services,
the wage rate may even rise as more workers are hired. This can be shown in figure 15.27 using
the standard tools we have thus far employed. The diagram shows what happens when a
monopsonist faces a non-competitive labor supply from workers. For simplicity, assume that all
workers are organized under a single union which makes decisions on the part of the workers and
behaves like a single monopolist seller. The situation where a single buyer of an input
(monopsonist) faces a single seller of that input (monopoly) is also known as bilateral
monopoly—we have monopoly agents on both sides of the input market. The market model
where all workers are organized in a labor union acting as a monopolist and which faces a single
buyer can be analyzed as a bilateral monopoly model. We can think of it as a single petroleum
extraction company and a petroleum engineers’ union in a small town, say Soi. The basic feature
of this market structure is ‘indeterminancy’. To begin with its exploration, consider figure 15.27
where the monopsonist firm is facing an upward sloping labor supply with the ME-curve lying
above the SL-curve. The firm would, as earlier discussed, wish to employ Lm workers where its
marginal expenditures on labor are equal to MRP at point M. However, this will not be possible
for the firm because the position of workers has changed from competitive to monopolist sellers.
The union, being a capitalist union, will also be solving its optimization problem of choosing the
combination of employment and wage that is the best for workers—maximizes their utility.
The union perceives the MRP-curve as its demand curve which is, from the union’s point
of view, its average revenue curve. Therefore, we can denote this curve Du = ARu. The union’s
marginal revenue curve can be derived in a similar fashion as discussed in the previous chapter:
the MRu-curve will lie below its ARu-curve. Let’s now combine the four curves. In a perfectly
competitive market, a firm perceives SL as the workers’ supply curve while MRP (assuming it is
equal to VMP) as their labor demand curve. Hence:
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• the competitive equilibrium is attained at point C with a wage rate wc and an employment
level Lc
• in a monopsonistic market, the firm perceives the ME-curve as the relevant labor supply
curve, sets its employment where ME equal MRP (point M) and pays a wage wm
• however, the labor union perceives SL as its supply curve (or marginal cost curve) while
MRPu as its marginal revenue curve. It will seek to set a contract where SL-curve intersects
MRPu curve (point U) asking an employment level Lu and wage of wu (which appears on the
MRPu curve at point B).
Figure 15.27: Monopsonist facing a trade union—bilateral monopoly
Rs/unit
MEmonopsonist
MRPu
SL
wu B
M
wc C
U
wm A
MRP = Du = ARu
0 Lm Lu Lc L
Note that the wage wm offered by the monopsonist (firm’s manager) is the lower limit of
the wage which would be realized if the management could somehow force the union workers to
act as a competitive seller (i.e. it treats wage offered by the firm as a given parameter in its
choice). On the other hand, the wage wu demanded by the union is the upper limit of wage that
would be realized if the union can force the company management to behave like a competitive
buyer (i.e. it treats wage desired by the union as given). Since both are trying to take their
decision misperceiving the other party as price taker, their expectations are unlikely to be realized
because neither of the party is actually a price taker (basically, as discussed in chapter 13, a
monopolist has no supply curve because having a specific supply curve requires that the firm
takes price as a given parameter and adjusts its quantity to this price). Consequently, the result is
indeterminate: neither side necessarily achieving its optimal employment-wage combination. The
maximum we can say is that the negotiated wage will fall between its lower (wm) and upper limits
(wu). What would determine the actual outcome in this situation? The answer is: bargaining
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power, negotiating skills, political affiliations of the parties etc. In other words, the outcomes in
actually existing capitalist orders are:
i. inherently indeterminate or non-unique
ii. influenced and determined by factors that are governed by political power
What does the power of each participant stand for? The power of each participant reflects and is
determined by:
• his ability to inflict losses to the opposite party, and
• his ability to resist the losses inflicted upon him by the opposite party
The strike is the main weapon available to the union while a lockout is the extreme option
available to a firm—each party can threat on a strike or a lockout to get an agreement in its own
favor. Sometimes, when the two parties cannot agree upon the wage or other employment
conditions in a collective bargaining process, they agree to submit their disagreement to a
binding arbitration—a process wherein a third party determines wages and other work related
conditions on behalf of the negotiating parties. Apart from these two options (strikes and
lockouts), the financial position of the union and the firm, the general attitude of the public and
government towards strike, and many others play an important role in determining the bargaining
powers of the two parties.
Strikes and Negotiation in Pakistan
Often we listen to news that workers in a specific industry or institution have gone on strike against state
policies. Some recent examples include:
• the strike of secondary teachers in Punjab against the Education Commission for not releasing their
15% salary increment as per the announcement of federal government in its annual budget
• the walk out of PIA pilots from taking off passenger flights in want of high salary demands
• the refusal of railway drivers to drive trains until their demands for improved working conditions
are satisfied
The most important aspect of all these instances is the fact that none of them were resolved through the
spontaneous working of market mechanisms. Rather, the issues were settled through non-market
negotiations between the workers’ union and the company management. The outcome of each case
reflected the bargaining power of the striking party. Railway drivers’ strike was the least successful
while that of PIA pilots was the most gainful because the demand for pilots is relatively inelastic as
compared to rail-drivers.
Modern capitalism seeks to disorganize workers since the greater the power of capitalist
unions the higher the wage the firm will have to pay. In order to achieve this end, a whole new
management sub-discipline has been created–––Human Resource Management (HRM). HRM has
replaced the former subject of Industrial Relations (IR) which was essentially a sub discipline of
political sociology. IR recognized the functionality of collective bargaining and argued that
recognizing the working class collective rights was in the long term interests of capitalist order.
IR provided a basis for incorporating unions into capitalist governance structures. During the
early Cold War period (1945-1979) corporatist states with strong trade union representation
585
existed for long period in several West European countries (Britain, France, Germany, the
Scandinavian countries etc) and a “high wage” policy was endorsed by most (ruling) Keynesian
policy makers. Since the early 1980s IR has gone out of favor and has been replaced by HRM
which rooted in Psychology (not in political psychology). HRM seeks to “de-collectivize” the
working class. It advocates management practices which induce the worker to identify with the
goals, organizational culture and operational strategies of the firm. HRM has been spectacularly
successful––real wages have stagnated in America during 1979-2009. While workers real wages
have remained constant and increase in per capita consumption is entirely debt fuelled,
unemployment has been hovering around ten percent during2007-2010 in most OECD countries
and unions have virtually disappeared as major players in the labor markets of the metropolitan
capitalist countries.
As we will argue in the final chapter of this book, this victory of the firm over the union
has been made possible by practicing the ‘Science of Management’––not by the preaching of the
economists because economics is a moral and not an applied science (which is what management
is). It provides measures for evaluating market behavior of producers, workers, consumers and
traders. It is of limited use as a means for persuading these agents to accept and behave on the
basis of capitalist rationality. This is Management Science seeks to do.
Monopsony and the Minimum Wage Laws
As discussed above (and in chapter 4) economists oppose interventionist state policies, such as
minimum wage laws, on the ground that they create unemployment in the market. However, this
policy claim is valid only if we assume that labor markets are perfectly competitive on both sides;
i.e. workers’ supply as well as firms’ demand. Once we change this assumption and assume that
firms have monopsonist power (as it is normally the case in real world capitalist societies), the
neoclassical policy mantra of the ‘optimality of non-interventionist policy’ becomes highly
vulnerable. Rather, the opposite turns out to be the case—a minimum wage law can increase both
the wage as well as employment level. To see how, consider figure 15.28 which shows a
monopsonistic labor market with equilibrium wage rate wm (we have drawn only the single MRP-
curve as the relevant labor demand curve of the firm which can be interpreted both as MRP and
VMP curve depending upon whether the firm has monopoly power or not in the output market).
Suppose a minimum wage regulation is passed which requires employers to pay at least wc. This
means that the monopsonist now faces a labor supply curve which is perfectly elastic (horizontal)
at wc wage up to Lc level. However, to hire workers beyond this level, the monopsonist has to pay
more than wc because its labor supply curve is positively sloped beyond Lc (as the regulation will
affect his decision only in the region where his labor supply curve is below wc) and hence ME-
curve is above wc wage after Lc level of employment. Since the wage rate wc is fixed up to the
employment level Lc, the marginal expenditures will also be constant in this segment (the
horizontal line at wc up to Lc). The minimum wage law makes the ME-curve discontinuous at
point C. The dashed segments of labor supply and ME-curves are no longer applicable after the
wage law enforcement. Profit maximization requires that the monopsonist sets its ME equal to
MRP of labor which occurs at point C where he hires Lc workers at a wage of wc. We can see that
the minimum wage law has made workers better off on both fronts: it has not only increased the
wages paid to the workers but also the number of workers employed in the market.
586
Figure 15.28: Minimum wage law with monopsony
Rs/unit MEmonopsonist
SL
M
Minimum
wc wage
C
wm A
Increase in MRP
employment due to
minimum wage
0 Lm Lc L
Hence the economic argument for a non-interventionist state policy is baseless and
grounded on unrealistic assumption—the argument applies to a capitalist world order that has
never existed on the earth. Thus, we find that the preceding analysis is sufficient to dismiss both
of the policy claims of neoclassical economics. Since wage earners normally exceed non-wage
earners in capitalist societies and since their consumption is expected to have a higher welfare
weight (due to the low-grade position in the pattern of income distribution) than non-wage
earners, therefore policy allowing wage earners to maximize their utility increases social welfare
concomitantly.
15.4.3: Perfect Competition Equals Monopsony
The previous chapter exposed the fallacy behind the economic dictum that perfectly
competitive markets are welfare superior to monopolies. The underlying false assumption in the
standard economic comparison of the two models was to assume that competitive industry did not
have a marginal revenue function. However, the assumption, as we showed, is unwarranted. A
similar type of mistaken assumption is operative behind the welfare superiority claim of
competitive input markets over monopsonistic ones. Figure 15.29 shows that the only difference
between the two input market models is the appearance of the marginal expenditure function for
the monopsonist (in the lower panel) which forces him to employ (Lm) less than the competitive
level of employment (Lc). The standard model of competitive labor market makes the assumption
that there is no ME-curve for competitive industry because each firm is a price taker and it can
hire any amount of workers without changing the market wage rate. The market wage may be
affected in response to changes in the employment decision of a number of firms, but does not
change due to changes in the demand of a single firm.
587
Figure 15.29: Valid comparison of competitive and monopsonistic labor markets
Rs Wage Bill with

positively sloped
labor demand curve
Total Revenue
m Product of labor
Maximum profit
πmax employment level
(ME = MRP)
Less than
maximum profit
m employment level
(ME > MRP)
0 Lm Lc L
Rs/unit
ME
M SL = AE
wc C
wm A
MRP
0 Lm Lc L
However, this assumption is analogous to what economic theory erroneously assumes

about competitive output markets. When a single firm changes its demand for labor even by one
unit, the market demand for labor must increase by one and, consequently, the market demand for
labor will shift rightward leading to a rise in the market wage rate—no matter by how small a
quantity, that small number can’t be zero. Again, economic theory of competitive input markets is
based on the false impression that the sum of infinite (or many) small numbers equals zero! The
competitive firm must also face a positively sloped labor supply curve, no matter how flat, and
have a ME-function above the labor supply curve. The upper panel shows the outcome of
competitive and monopsonistic decisions in terms of aggregate profit for both of them. It draws a
positively sloped and convex total wage bill which is consistent with an upward sloping labor
588
supply curve (see figure 15.24). Recall that the slope of this WB-curve is ME. The total revenue
product (TRP) curve is also drawn positively sloped but it has a decreasing slope reflecting the
fact that MRP (which is the slope of the TRP-curve) is decreasing as more labor is hired [TRP-
curve can be obtained by multiplying the production function (of chapter 10) or output curve with
price level]. The vertical difference between the two curves measures profit at each level of
employment. The profit-maximizing employment level is attained when the slopes of the two
curves are equal—i.e. ME = MRP. This happens at the employment level where the tangents of
WB and TRP are parallel as shown in the upper panel. The monopsonist operates where ME
equals MRP but the competitive firms collectively display an irrational behavior by hiring beyond
profit-maximizing point. This happens to a competitive industry due to treating infinitesimal as zero
which misguides it to employ some of the workers past the point where ME = MRP. You can see
that by not incorporating the ME-function into its decision making, the competitive industry has
hired labor up to the point where ME > MRP and, thus, its profits are not maximized as shown in
figure 15.29. On the other hand, since the monopsonist correctly equates ME with MRP, his
decision to employ Lm is consistent with maximum profit level. But, as argued, the labor supply
curve to a single competitive firm can’t be horizontal, and must slope downward—because if it does
not, then the market supply curve has to be horizontal as well. Therefore, marginal expenditures
will be more than wage for the individual firm.
If we now drop the invalid economic assumption that the labor supply curve perceived by
an individual competitive firm is horizontal, the wage-employment configurations of a competitive
industry will be exactly the same as those for the monopsonist. Once we correct the economic
theory, we find that the wage rate which a competitive firm takes as given is actually determined by
the intersection of the MRP-curve and the aggregate ME-curves of all firms. This wage rate is
precisely the same as any monopsonist would offer. To repeat the same from chapter 13:
• to argue otherwise is to argue for either individual irrational behavior at the level of the
firm—so that some of workers are hired at a loss—or
• that individually rational behavior leads to a collective irrational behavior at the level of the
market—so that profit maximizing behavior by one firm leads to the industry offering part of
the employment at a loss
Therefore, the wage that the competitive firm takes as given while adjusting its employment
decision is not a market wage set by equating wage with MRP, but a market wage set by equating
ME to MRP. If we sum up the number of workers hired by all competitive firms, the total
employment at this wage will be equivalent to the employment of a monopsonist. This means that
both competitive as well as monopsonist industries are in equilibrium at point M in figure 15.29.
This result seriously undermines all economic arguments for more competition against
less in factor markets. The corrected economic theory recognizes no intuitive difference between
competitive and monopoly market structures—both produce the same welfare (employment)
outcome. If this is the case, then the economic plea for free labor markets, non-interventionist
labor policy and disintegration of unions stands dismissed. Capitalist labor markets—whether
competitive or monopsonist—always require strong state intervention and regulatory regimes to
resolve conflicts among self-interested individuals. The picture of harmonious capitalist markets
as self-adjusting mechanisms spontaneously resolving and mediating individual interests is not
only erroneous but also a misleading policy guide.
589
15.4.4: Sraffa’s Aggregation Issues
We discussed the implications of Sraffa’s criticism for competitive markets in chapter 12

on perfect competition. The criticism was raised at two levels: one about a broad definition of
industry and another about its narrow definition. The labor market defined as an ‘industry’ is
obviously a case for revisiting Sraffa’s criticism. Recall that with a broad definition of an
industry, it is not feasible to draw independent demand and supply curves. This is because any
change in supply will bring about income distributional effects which in turn change the position
of the demand curve.
The same is also the case when we speak of labor supply referring to the entire work
force. With the aggregate labor supply curve positively sloped, increase in labor supply requires
increase in the wage rate. But increased wages clearly alter the income distribution in the
economy and, as a result, the demand for commodities also changes. The changes in demand will
change the price of the commodity produced by the workers. Since the labor demand curve is
merely the aggregate MRP (= P × MP) of workers, this means that a different demand curve for
labor will appear at each different point along the labor supply curve. Again, the central idea of
the argument is that it is not possible to sketch independent demand and supply curves
intersecting just at one point in wage-labor space because of the fact that factors that alter supply
will also alter the demand for labor. The standard economic analysis ignores the repercussions of
income distributional effects on labor markets. For example, as shown in figure 15.30, the
standard textbooks pretend that when the labor demand curve shifts out from DLo to DL1, say due
to increased MP of workers, a new and a unique equilibrium point is attained moving along the
supply curve with higher wages and employment level at point B. In other words, the transition
from A to B is smooth and unique.
Figure 15.30: Multiple demand curves with broad labor market definition
Rs/unit
DL1
SL
DL
B
wb
A
wa
0 La Lb L
590
But this analysis neglects the fact that increased wages along the labor supply curve will cause the
distribution of income, demand for commodities and, hence, prices of goods to change in an
‘unknown direction’ until or unless we assume that there is one and only one individual in the
economy (see chapter 8 if you are unable to grasp this statement).
As we start moving along the labor supply curve SL from point A, the labor demand curve does
not remain fixed at DL1; rather it may shift to any of the positions as shown by some of the labor
demand curves drawn in the diagram. Demand curve for labor will shift with every movement
along the supply curve which means they will intersect at multiple points and it is impossible to
tell which wage or employment will prevail in the market.
The picture shown in figure 15.30 illustrates that there is no guarantee for a unique
equilibrium to exist in labor markets; rather multiple equilibrium points can exist. Thus, the
economic methodology of reducing labor market contracts to simple demand-supply tools is
unsuited to analyze labor market dynamics. Sraffa was right to point out that income distribution
is determined in capitalist societies through power struggle and factors beyond the domain of
input markets. This theme will be further developed in the next chapter on ‘market for capital’.
591
Key Concepts
Average expenditure equals the wage paid per worker. Labor supply curve measure average
expenditures
Backward bending labor supply curve has an initially positive sloped but becomes negatively
sloped at higher wage rates, reflecting an income effect greater than substitution effect
Bilateral monopoly is a market structure where a monopsonist buyer of an input faces a
monopolist seller of that input
Binding arbitration is a process in which a third party determines the wages and other work
related conditions on behalf of the negotiating parties (usually managers and union)
Competitive wage is a contract that allows an employee to adjust his time allocation between the
number of hours to work and rest each day or each week
Derived demand is the principle which says that inputs are valued only because they can be used
to produce valuable goods and services
Economic rent is the payment for an input over and above what is required to keep it in its
current use; i.e. the difference between the payments actually made to an input and the minimum
amount that must be paid to keep it in its current use
Full income is a consumer’s maximum possible labor income (including non-labor income)
assuming all of his time is sold at the market wage rate
Labor refers to the amount of time an individual chooses to offer in the market at a specific wage
rate
Leisure is all the time spent off the market job
Lock out is a firm’s refusal to operate its plant and employ its workers
Marginal expenditures represent the amount needed to purchase an extra unit of labor.
Technically speaking, marginal expenditure on labor is the change in total wage bill due to hiring
of one extra unit of labor
Marginal revenue product also indicates the change in revenue of a firm due to the sale of output
produced by one additional input, but it is less than the VMP of a competitive firm (if we do make a
distinction between the two)
Monopolistic exploitation is the difference between the wage offered by a monopolistic firm and
that offered by a competitive market
Monopsonistic exploitation is the difference between the wage offered by a monopsonistic firm
and the one offered by a competitive market
Monopsony is a business structure where only a single buyer faces the entire market supply
Normal factor is one whose use increases with the increase in output produced
Labor demand curve shows the number of workers firms are willing to hire at different wage
levels
Labor supply curve reflects the working hours which the workers are ready to sell at different
wage levels in the market
Strike refers to the refusal of a group to work under the prevailing working conditions
Time allocation problem suggests that the fundamental scare resource in the economy is the
availability of human time and a rational economic agent tries to allocate his time between work
and leisure activities such that it results in maximum utility
592
Value of marginal product indicates the change in revenue of a firm resulting from the sale of
output produced by one additional input
593
Chapter Summary
• Classical economic theory sought to explain determination of factor input prices––the price
of labor, capital and land–––separately. Neoclassical economics has developed a common
framework for the analysis of all factor markets
• In competitive labour markets supply is assumed to be unlimited and the market wage rate is
given and fixed.
• Firms hire a worker if the cost of hiring him is below the profit his work generates
• Value of the marginal product of a worker is given by multiplying marginal product of that
worker by the price of that marginal product. The value of marginal product reflects change
in the total revenue of the firm due to change in the number of workers employed.
• The value of marginal product is a decreasing function of the labor employed, as is marginal
productivity assumed to be in neoclassical theory
• A profit maximizing firm will hire a worker if the value of his marginal product exceeds his
wage. A profit maximizing firm will employ workers up to the point which the value of the
marginal product is equal to the (given and constant) wage rate in the labor market
• It labor is the only variable cost the shut down rule can be stated as operate only if average
revenue product exceeds the wage
• The treatment of input and output markets is similar / uniform in microeconomic theory.
Equilibrium in both markets occurs where marginal revenue equals marginal cost short run
input demand depends on both on its own price and the price of the output as well as on the
amount of the fixed factor employed.
• When both factor inputs are variables the demand for a factor depends on the relative price of
the two factors (the substitution effect) and change in the level of output produced by that
factor (the output effect). This is similar to the effect on demand of output of change in its
price
• The long run demand curve of an input takes account of the shift of the variable marginal
product curve of the input and the induced demand for the other input caused by a change in
the price of the first input. Hence the long run demand curve for an input is more elastic then
it’s short run demand curve. This analysis is again quite similar to that of long run demand in
competitive output markets. Thus the market input demand curve is seen to be the sum of the
input demand curve of all firms in the market with the qualification that since all firms in the
(input) market are price takers, a fall in input price affects not just one firm but all firms
inducing a fall in the price of the (homogeneous) output they produce therefore the rise in
input demand (induced by the fall in its price) is lesser than the increase in demand that
would be obtained by summing up infinitesimal changes in the input demand of individual
firms
• Labor supply is modeled by microeconomic theory along the same lines as the supply curve
in product markets. The capitalist workers “trades off” work for labor and his indifference
curve is convex to the origin showing that the marginal utility of an activity (work, leisure)
decreases as the quantity ‘consumed’ by the capitalist worker increases. The capitalist worker
like the capitalist consumer is a utility maximize.
• In non capitalist societies input prices are not determined on the basis of profit and utility
maximization considerations. Input markets are typically small and restricted Microeconomic
594
theory does not provide an appropriate analytical framework for understanding price and
output determination in non capitalist (commodity and factor) markets
• The substitution and income effect of a change in the wage rate on the supply of labor have
opposite effects and the overall effect of wage rate changes on labor supply remains
indeterminate
• The labor supply curve may be backward sloping if the substitution effect of a change in
wage is outweighed by the income effect––a rise in wages in these circumstances will lead to
a reduction in the supply of labor. The labor supply curve is expected to become negatively
sloped at relatively high wage rates
• Equilibrium in a competitive labor market (like in a goods market) is achieved at the point
where the demand and supply of labor are equal to a unit wage rate equal to the marginal
product of labor. Macroeconomic theory expects full-employment equilibrium in the labor
market–––i.e. there can be no involuntary unemployment in competitive labor markets
• Infra marginal workers receive a “rent” equal to the wage of the marginal worker and the
wage they receive in the labor market. This “rent” is the producer’s surplus. The elasticity of
the labor supply curve determines the extent of the “rent’ that will accrue to infra marginal
workers
• Neoclassical theory justifies price structures and employment levels generated by competitive
factor market mechanisms. The unequal pattern of income distribution this produces is
justified by economic theory
• Neo Sraffian and Keynesian economists reject the view that wages are determined by labor
productivity. They argue that wages are determined by bargaining among unequal partners
and therefore unionization and state support of labor is necessary. Liberal economists such as
Heyek deny this and argue that by artificially pushing up wages unions and governments can
only create unemployment
• The backward bending labor supply curve is a fiction for most groups of workers. The
income effects usually outweigh the substitution effect of wage change and a fall in wages
leads to a rise in work hours
• Summing individual labor supply curves does not yield a “well behaved” market labor supply
curve. The market labor supply curve can take any shape at all the relationship between the
wage rate and labor supply cannot be specified by microeconomic theory. There can therefore
be multiple intersections of the market supply and demand curve for labor and several
equilibrium wage levels
• Microeconomic theory cannot prove that wages are determined by market forces. If the labor
supply curve is downward sloping market mechanisms will not operate to ensure restoration
of equilibrium and market intervention (minimum wages) will be justified
• Firms with a monopolistic position in output markets do not measure the benefit of hiring a
worker by its VMP but rather by its marginal revenue product (which is lesser than VMP). In
monopolistic firms workers receive the marginal revenue product which is lesser than their
value of marginal product. Monopolistic firm also generate a lower level of employment than
competitive firms.
• Similarly neoclassical theory shows that a profit maximizing firm which is a monopsonist in
the input (labor) market pays a wage which is lower than the value of marginal product and
employs fewer workers than a competitive firm. A monopsonist who is also a monopolist in a
595
product market pays a wage which is lower than the wage paid by a monopsonist who does
not have monopolistic power in the product market
• Unions emerge as monopolistic force in the labor market. They seek to force firms to pay a
wage rate they would have to pay if they were not a monopsonist in the factor market.
Employers seek to induce the union to accept a wage rate as if the union was not a
monopolist. These are the highest and lowest limits of wages consistent with profit
maximizing behavior. The actual wage is determined by relative bargaining power of the two
groups between these two levels. Microeconomic cannot determine where it will settle
• If the unrealistic assumption that the labor supply curve of a competitive firm is horizontal is
dropped, profit maximizing employment position of such a firm will be identical to that of a
monopsonist. Reducing wage in the labor market does not lead to higher employment or
increased welfare
• Sraffa showed that it is not possible to draw independent aggregate demand and supply
curves for the labor market. Since factors that alter the supply will also alter the demand for
labor, therefore no unique equilibrium point in the labor market identifying equilibrium wage
and employment level can be identified.
596
Review Questions
1. Why do capitalist firms hire a worker? Why do non-capitalist businesses hire a worker?
2. Who is a capitalist worker? What distinguishes him from a non-capitalist laborer?
3. Define and calculate the marginal product of labor using some numerical numbers.
4. Evaluate the neoclassical theory of diminishing marginal productivity.
5. Assuming that wages are the only variable cost, state the shut down rule for a capitalist firm.
6. Demonstrate the similarity of microeconomic analysis of capitalist output and capitalist factor
input markets. Was this similarity a feature of classical political economists such as Smith
and Ricardo? It not, why?
7. What is the difference in the microeconomics analysis of short run and long run labor market
equilibriums?
8. What assumption about the preferences of capitalist workers underlies the slope of the
“normal” labor supply curve in microeconomic theory?
9. “There can be no involuntary unemployment in competitive labor markets”. Asses the
assumptions behind this proposition.
10. Who are “infra marginal workers”? What determines the size of the “rent” they receive in
capitalist input markets?
11. Income distribution patterns generated by capitalist markets must necessarily be unequal.
Why? What is the microeconomic theoretical justification for the necessary existence of this
income distributional inequality?
12. State and evaluate the Keynesian case for wage determination through collective bargaining
between workers, firms and the capitalist state.
13. Does Keynes accept the marginal productivity theory of wage determination?
14. State and evaluate the Sraffian critique of neoclassical wage determination theory.
15. “The slope of the labor supply curve is necessarily indeterminate”. Comment.
16. Assess the impact of changes in output market structures on wage and employment
determination in capitalist order.
17. Identify the upper and lower limits within which wages are typically determined between
capitalist unions and capitalist firms in input markets.
18. Reducing wages does not always lead to higher employment. Why? How does it justify a
case for wage floor?
19. Why, according to Sraffa, is it not possible to draw independent supply and demand curves
for labor markets?
597
598
16
Chapter
MARKET FOR CAPITAL

The previous chapter outlined the neoclassical theory of income distribution with reference
to the labor market. This chapter will apply the same theoretical apparatus for an analysis of the
market for “capital” to complete the argument. After developing the conventional theory, we will
explain inconsistencies embedded in the conventional theory of “capital” pricing.
In the previous paragraph we have put the word “capital’ in inverted commas. This is
because microeconomic theory attributes a distinctive meaning which is not assumed by others
economists, especially Sraffians and Marxists. We must therefore begin this chapter by
explaining what microeconomists mean by “capital’. Once this meaning is clear we can remove
the inverted commas around “capital” and can also use substitute words for this term.
“Capital” in capitalist-order has two forms of existence–––money and (what Smith
called) ‘stock’––machinery, raw material, inventories and land. Remember these are only the
firms in which “capital’ exists. It’s essence as described by Muhammad Marmaduke Pickthall is
‘takathur’–––lust and greed. In capitalist order lust and greed become universalized in the sense
that every act is valued in terms of the contribution it makes to the expansion of lust and greed.
Capital is the universalized form of ever expanding lust and greed. In capitalist order lust and
greed endlessly flow through money and material to dominate both individual conscious and
social being (i.e. civil society and the republic state). All economic schools–––classical,
neoclassical, Keynesianism, Sraffian, Marxist, Intuitionalist, Behaviorist etc–––accept that it is
natural and rational for lust and greed (i.e. capital) to dominate individuality and society.
Societies in which lust and greed are regarded as vices and public rationality endorses values of
zuhd, infaq and chastity are regarded irrational by the economists. It is in this fundamental sense
that all economic schools legitimate capitalist order––an order in which value is ascribed to acts
in accordance with their relative contribution to the expansion of lust and greed.
Although all economic schools endorse the essence of capital they differ about the form it
takes––and about the form it should take–––in capitalist society. Thus microeconomists argue
that the difference in the two forms that capital takes–––money and materials–––is irrelevant, for
materials which is used for producing final goods have their value expressed in money, like
everything else in capitalist order. Money is the great “leveler” in capitalist order. It relates
everything to everything in (exchange) value terms. When macroeconomists speck of capital they
refer to essential commonality of all capitalist acts, every capitalist act has (relative) value to the
extent to which it contributes to the expansion of lust and greed. Final goods, materials used for
their production (including labor), knowledge, spirituality and money itself should be ascribed
value on this basis and this basis alone.
Sraffian economists have argued that financial markets do not perform this valuation task
efficiently. The money value of machinery does not reflect the quantity of machinery used in
production and the money value of machinery as determined in capitalist––specially financial—
markets does not accurately represent the contribution the use of this machinery has made to
capital accumulation in general–––i.e. the rate of return to specific capitals does not reflect the
specific contribution to capital accumulation in general. 11
11
Note that both in his 1926 and 1961 writings Sraffa uses the word ‘production’ for what is actually
capital accumulation in general for in capitalist order production can only be valued in terms of its
exchange value
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Microeconomists have not been able to answer the question Sraffa raised. They continue
to hold that “capital” in its money form is the universal equivalent accurately reflecting relative
value of all capitalist acts as contributions to capital accumulation in general. This is the meaning
of the word “capital’ in microeconomic analysis and since the chapter presents the
microeconomic theory of valuation in capital markets, therefore we will remove the inverted
commas and by “capital we will mean capital as understood by microeconomic theory throughout
this chapter.
16.1: DEMAND FOR “CAPITAL” IN A COMPETITIVE MARKET
The standard education in economics attempts to explain and justify the determination of
rate of interest12 on lines similar to its explanation of the wage rate: the payment to capital
represents its marginal productivity. This section develops the standard neoclassical model to
explain the determination process of the interest rate in an idea capitalistic market economy.
16.1.1: Demand for Capital
The demand side of the capital market is analogous to the demand for labor. The upper part
of figure 16.1 simply substitutes capital for labor on the horizontal axis and draws the standard
production function exhibiting diminishing marginal productivity of capital. Multiplying it by the
price of the output we get total revenue product curve. The lower panel substitutes interest rate for
wages and labor with the amount of capital. If the firm is a price taker in a competitive market, it
will face a horizontal supply of capital at given market interest rate, say io. This means that its
interest payment bill will be a straight positively sloped line as shown in the above panel. The value
of the marginal revenue product curve is drawn negatively sloped in the bottom panel because
marginal product of capital is assumed to fall as more capital is hired. Now a similar hiring rule for
capital can also be defined: a profit-maximizing firm will hire capital up to the point where its
contribution (marginal benefits) to the output just equals its hiring cost (marginal cost). Since the
marginal cost is given by the interest rate while marginal benefits are measured by the value of
marginal product of capital, the profit-maximizing point is:
∆TR
VMPK = = MR × MPK = i (16.1a)
∆K
∆TR
or VMPK = P × MPK = i (16.1b)
∆K
Since P equals MR for a competitive firm. Summing up the individual demand curves for capital by
all firms gives the market demand for capital:
12
The literature on ‘capital theory’ usually uses ‘rate of interest’ and ‘rate of profit’ as interchangeable
terms. However, we will prefer the use of former expression here. The behavior of profit will be treated
separately later in this chapter (see section 16.5)
602
DKM = ∑ k iD (i; w, p ) (16.2)
Figure 16.1: Demand for capital by a competitive firm
Rs
Total Revenue
c Product
TRPc
Production
Function
Competitive
πmax Interest Payment
Bill
IPc
c
Maximum profit
capital hiring
0 Kc K
Rs/unit
C
ic SK = AE = ME
VMPK
0 Kc K
However, the above argument is not intuitively appealing. The equilibrium condition refers
to the short run period (the period in which usually production takes place), when at least one factor
of production can’t be varied. This concept of ‘short-run production’ is arguably justified when we
keep capital fixed and allow labor to change. But it makes very little sense to suppose that
603
machinery can be variable keeping labor constant. In fact, capital is the least flexible factor of
production—if this could be changed, then everything else can be varied too.
16.1.2: Supply of Capital
Again, the neoclassical economic theory maintains that the supply of capital is also made
by the households or consumers (we discuss the implications of this assumption later). As we learnt
in the last chapter the supply of labor input results from the potential employee’s choice between
work and leisure, similarly the supply of capital originates from a capitalist individual’s decision
about consuming today or tomorrow—called the inter-temporal choice problem. The basic idea is
that a consumer has a horizon of full life-time spending involving the choice of how much to
consume and how much to save. The more he consumes today, the less he will be able to save for
tomorrow. While making this trade-off, the consumer must look ahead to his expected future
income as well as his future consumption plan. Irving Fisher developed the model wherein
economists analyze the choices of rational and forward-looking consumers.
Intertemporal Budget Set
When people decide about how much to consume today and how much to save for
tomorrow, they face an intertemporal budget constraint. Understanding the capitalist consumer’s
choices about current and future consumption requires an understanding of this budget constraint.
For simplicity, consider a capitalist consumer who is planning his consumption over two time
periods: period 1 is his youth (today or current period) and period 2 is his old age (future period).
Let’s denote his current consumption or consumption in period 1 by C1 and that of in period 2 by
C2. Further, he earns income M1 today and expects M2 income in future. Suppose initially that the
only way the consumer can transfer money from period 1 to period 2 is by saving it without interest.
Also assume for the moment that he has no possibility of borrowing money. This means that the
most he can spend today is M1—i.e. his current consumption equals current income due to the
assumed borrowing constraint. His budget set will look like the one shown in figure 16.2. Facing
the borrowing constraint, the consumer has two choices: either to consume M1 today and M2
tomorrow and make no savings, in this case he will be at point E (his endowment point) where he
just consumes his income of each period; or he can choose to consume less than his current income
and save some for period 2. This allows the consumer to move along segment FE where his current
consumption is less than his current income. The difference between the two equals his saving in
the first period:
S = M 1 − C1 (16.3)
In the second period, his consumption will equal his income in period 2 plus the accumulated
savings; i.e.
C2 = M 2 + S
Since the consumer cannot earn interest on his savings, the opportunity cost of consuming today is
the forgone amount he can consume in future. Here, his opportunity cost will be one; i.e. by
consuming one rupee today he sacrifices the opportunity to consume it tomorrow. The slope of the
budget line is -1—one rupee today equals one rupee tomorrow.
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Figure 16.2: Intertemporal budget set with borrowing constraints
C2
F
Slope = -1
b
C2 =M2 +S
E (Endowment
M2 point)
Savings
0 C1 M1 C1
Think now of a capitalist society where each and every resource is treated as capital—
originally dedicated to the accumulation of more capital. There will be money markets which offer
some io percent interest tomorrow on each rupee saved today. This means that the consumer can
convert one rupee of today into one rupee plus interest accrued tomorrow. Therefore, the one rupee
saved today will not be equal to one rupee tomorrow. If the market offers interest rate i on each
rupee saved, then the future value of current 100 rupees can be calculated as:
F = 100 + i100 or F = 100 (1 + i )
With interest rate 10% (= 0.1), the 100 rupee will equal 110 [= 100 (1 + 0.1) = 100 + 10]. In
general, the future value of current P rupees will amount to following after one year:
F = P (1 + i ) (16.4)
Conversely, it means that the one rupee tomorrow will be less than a rupee today. This can be seen
by simply converting the relation (16.4) as:
F
P= (16.5)
(1 + i )
Thus if you expect to earn rupees 100 tomorrow and the interest rate is 0.1, its present value will be
rupee 91 [= 100/1.1].
Equipped with the ideas of compounding and discounting, if the consumer now consumes
less than his income in the current time period, he will save amount M1 – C1 today on which he can
earn an interest rate of i tomorrow. This means that his current savings will be worth the following
in period 2:
605
S = (M 1 − C1 ) + i (M 1 − C1 ) = (M 1 − C1 )(1 + i )
The amount that he can now consume in period 2 by is given by:
C 2 = M 2 + (M 1 − C1 )(1 + i ) (16.6)
This says that his consumption tomorrow will equal his future income (M2) plus the amount saved
today including the interest earned on that saving.
Let us now allow the consumer to borrow any amount he wants at the given interest rate io.
If the consumer is a net borrower today, this means that his consumption today is greater than his
current income (i.e. C1 > M1). The consumer will now have to pay interest amount i(C1 - M1) in
period 2 on whatever he borrows today. Of course he will also return the borrowed amount (C1 -
M1). His budget constraint is now given by:
C 2 = M 2 − i(C1 − M 1 ) − (C1 − M 1 )
or C 2 = M 2 + (M 1 − C1 )(1 + i )
which is exactly what we had in (16.6).
We are now in a position to draw the feasible set of consumption points for the consumer in
figure 16.3. At point E, the consumer is on his endowment point. If he consumes nothing today and
saves all of his income, the future value of his income (and his consumption in period 2) at interest
io will equal:
F = M 2 + M 1 (1 + i0 ) (16.7)
Figure 16.3: Intertemporal budget set without borrowing constraints
C2
F
M2 + M1(1 + io)
Slope = -(1 + i)
E (Endowment
M2 point)
P
0 M
M1 M + 2 C1
1 (1 + io )
This gives the vertical intercept F of the intertemporal budget line FP which measures the
maximum amount of second period consumption when C1 = 0. Similarly, the present value of all his
income is measured by:
606
M2
PV = M 1 + (16.8)
(1 + io )
which gives us the horizontal axis P. At this point, the consumer plans to consume nothing in period
2 and borrows as much as possible against his future income. Joining the three possibilities for the
consumer, we get FEP budget line. All the points on this budget line are feasible for the consumer
in the sense that they are all available to him. Any point along the line segment FE implies that the
consumer is a net saver while a point along segment EP means he is a net borrower. The slope of
this budget line equals– (1 + i)— the opportunity cost of present consumption. The consumer can
transfer each rupee of present consumption into (1 + i) by not consuming it today. The negative sign
indicates the trade-off facing the consumer between present and future consumption; i.e. both can’t
be increased with income being fixed in both the periods.
Intertemporal Preferences
The intertemporal preferences of the forward looking capitalist consumer are represented
by indifference curves. This indifference curve shows the combinations of consumption today and
tomorrow that make the consumer indifferent. If the consumer’s first period consumption is
reduced, his second period consumption must increase to keep him equally happy. The shape of the
indifference curve indicates the consumer’s taste for consumption at different time periods—how
much extra amount of consumption he requires in period 2 in order to be compensated for a one unit
reduction in period 1 consumption. If, for example, we draw an indifference curve with a constant
slope of -1 in (the dotted line) figure 16.4, it would represent the taste of a consumer who does not
care about consuming today or tomorrow. Technically speaking, his marginal rate of substitution
between today and tomorrow is -1. Such a consumer cannot be called a capitalist consumer
because he is not concerned about accumulation. The typical capitalist consumer is one who has a
relatively high preference for future consumption made possible by accumulations. This point has
been stressed by major economic historians (Weber, Tawney, Schmoller, Phyllis Deane) seeking
to explain the transition from feudalism to capitalism in Western Europe. Modern economic
history, particularly Foster and Arrghiri, have taken note of the consumption explosion in the
United States and the virtual disappearance of non-corporate private sector saving (erroneously
called household saving for the household itself is disappearing in America).
The intertemporal marginal rate of substitution is termed the rate of time preference—the
rate at which the consumer is willing to substitute second period consumption for first period
consumption. Figure 16.4 draws two usual shaped convex indifference curves. To understand what
they mean, consider two choice points A and B which are mirror images of each other:
A = (C1a , C 2 a ) = (10, 30)
B = (C1b , C 2b ) = (30, 10)
Though the two bundles offer equal total consumption, but A has more of consumption today as
compared to bundle B which offers more in the future. Since future events are uncertain and can
change, this means that the consumption of one-rupee today will be worth more than the same
amount of consumption in future.
607
Figure 16.4: Modeling intertemporal preferences
C2
A
30
C
20
B
10 Slope = -1
0 10 20 30 C1
Alternatively, the capitalist consumer will require more than one rupee of future consumption if
his current consumption is reduced by one rupee. This means that a consumer who discounts
future consumption will prefer B to A. The two indifference curves reflect this behavior of the
consumer. Since he prefers more consumption to less, points on the higher indifference curves (such
as point C) are preferred to lower ones (such as point A). The consumer’s rate of time preference along
such indifference curves depends upon the level of consumption in the two time periods. The marginal
rate of substitution keeps on decreasing as he gets more and more of present consumption—i.e. when
current consumption is very low, the consumer requires much extra future consumption to give up a
unit of current consumption.
Optimization: Choice about Saving and Borrowing
Given the standard apparatus, economists model the choice about how much to consume
today and tomorrow. The capitalist consumer would like to end up at the highest possible
indifference curve in his effort to maximize utility. The right hand side of figure 16.5 shows the
optimal choice of consumption at point D where the consumer consumes D1 today and D2 in time
period 2. At equilibrium, the slopes of the budget line and indifference curve are equal:
MRS = − (1 + io ) (16.9)
Since current consumption is less than current income at point D, the consumer is a net saver at
market interest rate ro. His savings equal:
S = M 1 − D1
on which he earns S(1 + io) amount in future.
608
Figure 16.5: Intertemporal choice with borrowing or saving possibilities
C2 C2
F F
Debt repayment = Interest earnings =
B(1 + io) S(1 + io)
D
D2
M2 M2 E
E
G
G2
P P
0 M1 G1 C1 0 D1 M1 C1
B = Borrowings S = Savings
But suppose Nomi is another capitalist consumer having a strong time preference for current
consumption. His equilibrium may be at point G in the left hand panel where he ends up as a net
borrower because he consumes today more than what he earns today. His borrowings will be equal
to:
B = G1 − M 1
and he will repay this amount plus interest accrued on this borrowing in future: B(1 + io).
Effects of Changes in Interest Rate
Let us now see what happens to the decision of capitalist consumer to lend or borrow when
the interest rate changes. Assume that the interest rate rises from io to i1. What happens to the budget
line? To see this, consider expressions (16.7) first:
F = M 2 + M 1 (1 + io ) (16.7)
We can see that the increase in the rate of interest from io to i1 increases the future value of
consumer’s income:
Fo = M 2 + M 1 (1 + io ) < F1 = M 2 + M 1 (1 + i1 ) for io < i1
This means that the vertical intercept of the budget constraint will increase. Similarly, expression
(16.8) shows that the horizontal axis of the budget line will decrease as the increase in the rate of
interest will reduce the present value of consumer’s income. The budget line tilts to a steeper
position QR in figure 16.6 having a slope –(1 + i1): for a given reduction in current consumption,
609
the consumer will get more consumption in the future when the interest rate is higher. Note that the
budget line has rotated around the endowment point of consumer because this point always remains
affordable for the consumer, no matter what the interest rate is—he will always have the possibility
to consume what he earns today. This change in the interest rate will bring about changes in his
consumption plans in the two time periods. Here we can have two cases depending on whether the
capitalist consumer is a net lender or a borrower.
• Effects on a borrower
Suppose that he is a borrower initially (point G). It can be seen in figure 16.6 that his
current consumption will decrease and that of the second period will increase while moving from
point G to H. The model predicts that the consumer’s borrowings will fall in response to a rise in
the rate of interest (because the current consumption has decreased). Again, the total effect of
interest rate changes can be decomposed into two effects: the substitution effect and income effect.
The substitution effect is the change in consumption plan that results from changes in the relative
prices of consumption in the two time periods. When interest rate increases, the current
consumption becomes more expensive in the sense that each rupee spent today means giving up
more interest earnings by not consuming it. The substitution effect, therefore, tends to make the
consumer choose less today and more in period 2.
Figure 16.6: Effect of interest rate increase on a borrower
C2
Q
New budget line
Slope = -(1 + i1)
M2 E Old budget line Slope

= -(1 + io)
H G
G2
R P
0 M1 H1 G1 C1
Reduction in
Borrowings
The income effect also works in the similar direction. Since the consumer is initially a borrower
(this is true of present day American capitalist consumers but not of Chinese capitalist
consumers), increase in interest rate makes him worse off because now he has to pay more in debt
610
repayment [B(1 + i1) > B(1 + io) if i1 > io]. If consumption in both time periods is a normal good,
then income effect will reduce both of them. Since the current consumption has decreased due to
both effects, we can conclude that an increase in interest rate reduces the borrower’s amount of
borrowing.
The reduction in interest rate will work in the opposite direction and hence we leave its
drawing to the students as a practice. The first two rows of table 16.1 summarize the effects of
interest rate changes on the borrowing decision of a capitalist consumer.
Table 16.1: Summary of the effects of interest rate changes

Type of Direction of Interest
Effects
Consumer Rate Change
borrowing reduces: both substitution and income effects
Increase
reduce the current consumption
Borrower
borrowing increases: both substitution and income effects
Decrease
increase the current consumption
indeterminancy in savings: substitution effect reduces but
Increase
income effect increases the current consumption
Saver
indeterminancy in savings: substitution effect increases
Decrease
but income effect reduces the current consumption
Source: Adapted from Microeconomic Analysis by Denzau T. Arthur
• Effects on a saver
Now consider a capitalist consumer who is initially a saver in figure 16.7. The substitution
effect carries the same sign; i.e. negative—reduces the current consumption. But the income effect
changes its sign and becomes positive. This is so because increase in the interest rate makes a lender
better off as he can now earn a higher return on each rupee lent. Given that consumption in both
periods is a normal good, the consumer would spread this improved income over both periods and
current consumption increases. Since the total effect is the sum of a negative substitution effect and
a positive income effect for a saver, the result is ambiguous and indeterminate. Hence, it is not
possible to determine the net effect of increase in interest rate on current consumption as well as
lending decision of this type of capitalist consumer. The summary of these results is presented in
table 16.1. Figure 16.7 shows the case of a net lender who has decreased the supply of savings
following an increase in interest rate as his equilibrium point moved from D to J—hence implying
the possibility of a negative relationship between the supply of savings and interest rates. The
diagram is drawn with a negative substitution effect greater than the positive income effect. We can
also draw the opposite case with income effect larger than the substitution term and hence resulting
in a positive relation between interest rate and supply of savings (the diagram is left for the students
as a practice).
Remember that standard economic theory cannot guarantee a smooth positive relation
between savings and rate of interest in capitalist society. It can place only a loose restriction on the
outcome of interest rate changes on the decision of a net lender: a lender must remain a lender after
increase in the interest rate. This is illustrated in figure 16.7 where the consumer is initially at point
D with a consumption bundle to the left of his endowment point E. If the interest rate increases, his
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new equilibrium cannot move to the right of the endowment point in the segment ER because
choices to the right of point E at segment EP were available to the consumer when he faced the
original budget line FP but they were all rejected in favor of point D (the choice point at FP).
Figure 16.7: Effect of interest rate increase on a lender or saver
C2
Q New budget line
Slope = -(1 + i1)
F J
D
D2
E
M2 Old budget line Slope
= -(1 + io)
R P
0 J1 D1 M1 C1
Since the original optimal bundle D is still available at the new budget line QR, the new equilibrium
point must be a point outside the old budget line FP. This means that the new optimal choice point
must be to the left of the endowment point after the increase in the interest rate implying that a net
lender must remain a lender if the interest rate goes up. Apart from this loose restriction that an
interest rate increase cannot induce a lender to become a borrower, microeconomic theory can give
no definite prediction about the direction of the relationship between interest rate changes and the
saving decision of a capitalist consumer. With several consumers in capitalist society having
different rates of time preferences, it is possible to derive any shape of the supply curve of savings
by aggregating their individual supply decisions. However, the economists insist that the saving
supply curve is normally of the ‘right shape’ (positively sloped), as in figure 16.8, and the rest of
the shapes are either ‘anomalies’ or merely a matter of some ‘intellectual discussions’. Standard
textbooks draw a positively sloped supply of savings against interest rate rarely mentioning the
facts that:
• the standard theory provides no definite justification for this ‘right shape’, and
• the ‘right shape’ of the market supply of savings requires that there is one and only one
capitalist consumer in society who never changes his taste with changes in his income
Even by assuming the only capitalist consumer the theory remains indeterminate. For a single
consumer can neither be a net-lender nor a net-borrower–––there is no one to lend to or borrow
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from in a case of a single consumer. Assuming the existence of a single capitalist consumer
illustrates the absurdity and essential incoherence of Economics. For if there is only one
(representative) consumer there is no possibility of exchange and no possibility of the realization
of exchange value in commodity or factor markets–––macroeconomic has no credible
microeconomic roots (there are no markets in Robinson Crusoe’s island and none in the island of
the Swiss family Robinson either).
Figure 16.8: Typical upward sloping supply curve of savings
i (interest
rate)
SS
0 S
(savings)
16.1.3: Equilibrium in the Capital Market
Joining the demand and supply sides, economists jump to the conclusion that the
equilibrium interest rate is determined at the intersection of demand for and supply of capital in the
capital market, as shown in figure 16.9. Since the demand curve for capital represents its MRP, the
equilibrium level of capital hiring reflect the fact that capital is also paid its fair contribution in the
total output. This conclusion makes three specific claims:
• the reward for capital (interest rate) is determined by the quantity demanded and quantity
supplied of capital
• the market rate of interest reflects the marginal productivity of capital
• the market mechanism always determines a unique equilibrium rate of interest
Having completed this basic model, we now move on to explain the political assumptions
underlying the microeconomics.
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Figure 16.9: Equilibrium in capital market
i (interest
rate)
Sk
io E
Dk
0 Ko K
(Capital)
16.2: EULER’S EXHAUSTION THEOREM: SOLUTION TO CLASS CONFLICT
The neoclassical model of income distribution developed in this and the previous chapter
seeks to show that the returns to the factors of production are determined by marginal productivity
theory (also termed as functional distribution of income). According to this theory:
• when each factor of production is paid in line with its marginal productivity, it is getting its fair
and just reward since this reward equals to what it contributes to the welfare / accumulation of
the society as a whole, and
• the configuration of factor prices (wages and interest) that are generated by the competitive
markets actually reflect the marginal productivities of factor inputs. Hence, the factor rewards
determined in a market economy are fair and just ones
• when economic agents, say workers, unite and ask for more than what the market offers, they
are actually trying to violate the rules of marginal productivity theory (i.e. they are working
against the rules of justice and hence against their own self-interest). Such deviance should be
met with force by capitalist state
However, this description is merely the first half of the neoclassical theory of income distribution. A
complete theory of income distribution should answer two questions:
1) One the one hand, it should explain exactly how much each factor of production will receive
out of the total value of goods produced in a capitalist society
2) On the other hand, the theory should also show that the sum of the payments made to all factors
of production fully account for the value of goods produced in an economy—all the value is
‘exhausted’ in factor payments and nothing is left over. Technically, speaking it should show
that
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Value of Output = Sum of Payments to Factors of Production

With labor and capital being the only two inputs, we should have the identity:
Value of Output = Wage Payments + Capital Payments
or Y = wL +iK (16.10)
where w = wage rate and i = interest per unit of capital both expressed in terms of the physical
output. The neoclassical response to the first question has been developed above. The theory treats
the national product (or national income) (Y) as a function of capital (K) and labor (L):
Y = f (L, K) (16.11a)
where all the quantities are expressed in physical terms. Multiplying Y by price we can obtain
the value of output in monetary units. This output is distributed between the capital-owners and
the workers, in accordance with the accounting relationship (16.10). If the markets are left free
without any intervention, each factor will receive a return which equals its marginal product:
∆Y
w= = MPL (16.11c)
∆L
∆Y
and i= = MPK (16.11d)
∆K
Using (16.11c) and (16.11d), the shares of labor and capital are given by:
∆Y
Share of Labor = w × L = × L = MPL × L (16.11e)
∆L
∆Y
Share of Capital = i × K = × K = MPK × K (16.11f)
∆K
That is all as far the first question is concerned. But obviously it is not clear from this part of the
story whether the theory answers the second question as well—i.e. whether the sum of (16.11e)
and (16.11f) will exhaust the total output produced. Even if we assume that the marginal
productivity theory is valid in explaining the determination of factor shares, it does not ensure
that when all factors are paid their marginal products no surplus is left over for either of the
factors to appropriate to itself. Similarly, the theory also does not rule out the possibility that the
sum of the competitive payments may even exceed the total output. In this case, the claims will
be inconsistent since the sum of the factor shares will be greater than total output produced.
Importance of the answer to the second question can be appreciated by noting the fact that one of
the major objectives of marginal productivity theory of income distribution is to show that the
market mechanism organizes production and its distribution in a fair and harmonious manner. To
see what this means, note that the above formulated neoclassical theory is quite consistent with
the interpretation that the distribution of income / output depends upon who initiates and
conducts the production process. For example, if the production process is controlled by the
capital-managers, then the maximum that the marginal productivity principle says is that the
wage rate cannot exceed the marginal product of labor; i.e. w ≤ MPL while the rest of the output
flows to the managers of capital. Similarly, if the workers take control of the production process,
then the reward for capital could not exceed the marginal product of capital; i.e. i ≤ MPK and the
remaining output is taken away by the workers. However, the theory does not guarantee that once
the ‘hired factor’ as well as the controlling class has been paid out their marginal product shares,
no surplus output will remain with the controlling class to be appropriated to itself. The theory
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also does not recognize that if the workers take control of capital, they will themselves become
capital controllers and the decision to distribute the product value between wage and non-wage
payments will become subject to planning––it will move out of the market. If the ‘remaining part
of the output flowing to the controlling class of production process after paying the marginal
product of subordinate factor’ is greater than its own marginal productivity, this means that the
control over the production process pays dividends to the controlling class in addition to their
contribution in output. However, this interpretation of marginal productivity theory is not
endorsed by economists since it indicates the existence of class-conflict in a market economy—
after all, if the control of the ‘production process’ is the ultimate determinant of income shares,
why should a factor input be content with its marginal product and not look for taking over the
production process itself? The idea of class-conflict was at the center of classical economists’
(such as Smith, Malthus and Ricardo’s) theories of income distribution. These economists
maintained that capitalist economies are structured by classes (such as workers, landlords and
holders of ‘stocks’) and the share of each group is determined largely by social and political
conditions. For example, Malthus and Ricardo conceived that the wage share of workers is
determined not in accordance with their contribution to output, but by the principle of
‘subsistence wages’—i.e. workers receive out of the total output only what is required to
reproduce their labor services and their family. The exact amount of this ‘subsistence wage’ may
differ as it is dictated by the level of development that has taken place in any society at any
specific time (e.g. subsistence wage in Pakistan will be far lower than that in the US). Marx took
this ‘class-based’ analysis to its logical conclusion by showing that capitalism is a system of
production where workers are exploited by the capitalist class.
The marginal productivity theory of income distribution was developed to refute the
‘class-based’ theoretical analysis put forward by the Classical economists in the early and middle
parts of the 19th century. Neoclassical economics set itself the task to prove that the fundamental
characteristic of the market economy is ‘harmony’ and not ‘class-conflict’; and that the market is
not a source of exploitation but of welfare maximization. The response to the Classical heritage
came in the form of ‘equilibrium based analysis’ which asserted that competitive markets
generate prices which leave all market participants in a state which cannot be improved upon by
any other means—no one can be made better off by means other than participating in the market.
Hence, ‘market equilibrium’ is not only efficient but also welfare maximizing for all agents. The
marginal productivity theory (an off-shoot of marginalist framework of analysis) contended that
the shares of all factors of production are determined by ‘objective and technical’ conditions
(such as their marginal productivities). However, as shown above, this ‘marginal productivity
principle’ is not enough to dismiss the existence of class-conflict in capitalist societies. If
neoclassical economists had to prove that the fundamental characteristic of market economy is
‘harmony’ and not ‘class-conflict’, they must show that their income distribution theory also
answers the second question—the factor prices generated by the marginal productivity theory are
such that the total factor shares are equal to the total output. Fortunately, the rescue to the
problem came, but neither from some rigorous economic theory nor from some ‘new empirical
observations’, rather it came out of a mathematical relation suggested by the mathematician
Leonhard Euler. According to him, if the production function (16.11a) displays constant returns to
scale, then the marginal productivity theory satisfies the ‘adding up’ identity (16.10) as:
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Y = MPL×L + MPK×K (16.12a)
To obtain its monetary version, simply multiply by price:
PY = PMPL×L + PMPK×K (16.12b)
The Euler’s theorem simply says that the factor prices generated by the competitive input
markets:
• reflect the marginal productivities of those factor—hence they are just and fair
• are efficient because they maximize the social welfare of all, and
• also rule out any possibility of ‘surplus value’ to be appropriated by one class or another—
whether the dominant or dominated.
Thus, the theorem rendered ‘control over the production processes’ as irrelevant in capitalist
societies since the reward of each factor depends upon what it contributes to the production
process, nothing more and nothing less. Since this mathematically elegant proposition solved the
missing element of marginal productivity theory, it tempted economists to assume that the
production function (16.11a) is precisely a function of this type. Thus, if we assume that capitalist
production process takes place under the conditions of:
• infinite possibilities of substitution between inputs (so that the iso-quants are continuous and
smooth), and
• constant returns to scale
then market economies will uproot class-conflict as a fundamental expression of capitalist
societies.
If we reject these assumptions, then marginal productivity theory cannot demonstrate the
non-existence of surplus product and its appropriation by dominant classes. There is irrefutable
evidence to shows that in both product and factor markets there exist increasing return to scale
and relatively low elasticities of factor substitution.
16.3: COMPLEXITIES CREEP IN: SOME UNTOLD PROBLEMS WITH CAPITAL

MARKET ANALYSIS
All of the strong theoretical and policy claims of neoclassical economics rest on a number
of inconsistent assumptions. This section will develop some of the devastating criticisms leveled
against neoclassical theory of income distribution in general and the theory of capital remuneration
in particular. However, it should be kept in mind that the criticisms developed in the last chapter
(such as ‘perfect competition equals monopsony’) are also applicable to the theory of capital.
16.3.1: Sraffa on Diminishing MP and Return on Capital
Recall Sraffa’s criticism of marginal productivity from chapter 10 and 11. That criticism
can be applied here with its full force (it was first put forward by Bhaduri in 1969). The physical
capital market must also be defined in a broad sense which means that there are in fact thousands of
different machines that are lumped together to call them ‘capital as a factor of production’. This
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means that a change in the price of such an input would bring changes in numerous industries and
therefore it would change the distribution of income. This point can now be developed in a more
explicit form. Consider a capitalist economy composed of workers and capital-controllers. At the
level of a firm, the following equality holds:
Y=w×L+i×K (16.10)
In order to derive the marginal product of capital, we need to change output. Of course, the change
in output equals the sum of changes in wages and interest payments:
∆Y = ∆(wL ) + ∆(iK ) (16.12a)
Decomposing the second term in this expression (leaving the first one aggregated because we are
interested in the MP of capital):
∆Y = ∆(wL ) + i × ∆K + K × ∆i (16.12b)
This says that the change is the sum of the two parts: interest rate times the changes in capital and
capital times the change in the rate of interest. Dividing through by change in capital (ΔK) we have
this expression for the marginal product of capital:
∆Y ∆(wL ) ∆K ∆i
MPK = = +i +K
∆K ∆K ∆K ∆K
∆Y ∆(wL ) ∆i
or MPK = = +i+ K (16.12c)
∆K ∆K ∆K
The standard economic theory assumes that the first and the last terms of (16.12c) on the right hand
side are zero for a competitive firm—i.e. increase in output due to more hiring of capital by a single
firm has no impact on the wage rate (Δw = 0) and interest rate (Δi = 0). So cancelling out the zero
terms we have the desired result of those who advocate marginal productivity theory:
∆Y
MPK = =i (16.12d)
∆K
Though this ‘desired result’ may make sense at the level of the firm, it is definitely not a good
approximation at the level of the industry. At this level, changes in capital will cause changes in
wages as well as rate of interest. Therefore, the full relationship is given by (16.12c) which means
that the interest rate does not equal marginal product of capital unless the terms are zero. This was
the essence of Sraffa’a concern also raised in the previous chapter: with broadly defined industry,
changes in the demand or supply will affect the distribution of income in society. We can conclude,
in the words of Keen, from this discussion that ‘distribution of income is neither meritocratic nor
determined by the market. The distribution of income is to some significant degree determined
independently of marginal productivity and the impartial blades of supply and demand’.
16.3.2: The Problematic ‘Circular Flow’ of Economics
One of the problematic assumptions underlying the neoclassical theory of income distribution is its
‘dual treatment of capital as one’. To understand this, consider the standard flow of economic
activities which says that all commodities—ranging from bread to a steel mill—are produced by
‘factors of production’ which are reduced to labor and capital. Figure 16.10 shows the standard
circular flow diagram. The outer flow tells us that the factors of production move from ‘households’
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to the business sector while goods flow from firms to the households. The inner circle shows the
monetary flow of funds—firms make payments against the supply of inputs to the ‘households’
while the latter purchase the goods and services produced by the business sector. This circular flow
can be valid if the firms transform inputs into output while households convert output / income into
factors of production. The first part of the circular flow seems quite reasonable because factories do
convert labor and capital into output. However, for the circle to be complete, consumers must
transform goods they receive from firms into labor and capital. Of course it seems correct to say
that households convert goods into labor services they supply to the firm. But the most problematic
proposition is to say that the household sector also supplies capital by converting goods into capital.
If by ‘capital’ we mean ‘physical capital’ (machines etc.), this begs the question ‘where these
machines are produced’. As far as physical capital is concerned, the argument runs as follows: the
households receive goods produced by the firms, internally convert them into machines and then
sell them to the firms. Clearly, this is nonsensical because if households transform goods into
machines, this implies that they must also be ‘firms’. Thus we find that the flow of capital from
households to firms cannot be in physical terms.
Figure 16.10: The standard economic circular flow
Supply of Output
(Goods and Services)
Purchase of Output
(Goods and Services)
Households Firms
Input Payments
(Wages & Interest)
Supply of Inputs
(Labor and Capital)
Capital transformed from households to firms must be financial capital (deposits, bonds
etc.). But this raises another problem with the concept of the circular flow diagram as economic
theory treats this financial flow of capital as directly contributing to the production process of the
firms. The circular flow says that the flow of capital from capitalist consumers to the firms
generates an earning-flow back to the consumers and this interest earning reflects the marginal
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productivity of capital. This could be the case only if the financial capital directly adds to the
production process after combining with the labor input. Clearly, this is not the case. The standard
circular flow model is not complete and the only way to complete it is to appreciate the fact that
firms also produce ‘physical capital’ which in turn also requires the employment of labor and
capital produced earlier. Sraffa’s book The Production of Commodities by Means of Commodities
successfully challenged the neoclassical vision of the production process of a capitalist economy
and provided an alternative framework to analyze the capitalist production process where the firms
produce not only the consumption goods but also the capital goods (the details of his ingenious
method are beyond the scope of this text).
How could the standard economic circular flow be rescued from this dual treatment
problem? It could be rescued only if one can demonstrate that there is a direct and unique
relationship between the financial measurement of capital and its physical productivity—which is
not the case as shown in the next sub-section. The standard textbooks never mention these
complexities and directly jump to the conclusion that the reward of capital reflects its marginal
productivity, just as is the case for labor.
16.3.3: The Capital Controversy 13
Thus far, you should be familiar with the four diagrams drawn in figure 16.11. Make sure
you read them properly: all of them are drawn with quantity of capital on one of the axis. In brief:
• part (a) says that it is possible to insert quantity of capital into the production function of a firm
to obtain the standard well-behaved production function exhibiting diminishing marginal
product of capital
• Part (b) says that it is logical to draw iso-quant curves in a labor-quantity of capital space
(representing numerous possibilities of substitution between labor and capital) independent of
the price of capital (that is why changes in interest rates are assumed to affect only the iso-cost
line and not the iso-quant curve)
• part (c) asserts that there is a unique relationship between the demand for the quantity of capital
and the interest rate—changes in the interest rate will cause changes in the demand for the
quantity of capital in an opposite direction
• part (d) tells us that the price of the quantity of capital depends upon the demand for and supply
of the quantity of capital. Further, the income earned by controllers of capital equals the
marginal product of physical capital
The repetition of the word the ‘quantity of capital’ might sound a bit annoying, but we want you to
make sure that it is ‘quantity of capital’. That is at the heart of neoclassical analysis. Pick up any
good textbook on microeconomics and you will see that it is ‘quantity of capital’. This ties in with
the standard assumption of neoclassical analysis that money is neutral and plays no independent
role in the determination of value and prices.
But rarely would the textbooks (or your teachers) give you even a clue that there is some
fundamental problem with the concept of the ‘quantity of capital’. Microeconomics texts still
1313
The discussion in this section tries to abstract from some difficult mathematics required to grasp a full-
fledge understanding of the underlying issues. Interested readers can see material on Capital Controversy,
such as Harcourt (1972), “Some Cambridge Controversies in the Theory of Capital”
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remain silent about the debate (or the ‘intellectual war’) that was fought on the concept of the
‘quantity of capital’ some 50 years ago between the two Cambridges—Cambrdige, England and
Cambridge, Mass in USA. On the US Cambridge side, there were apostles of neoclassical
economics (such as Samuelson and Solow) while the England Cambridge party consisted of the
critics of neoclassical economics (such as Joan Robinson, Kaldor, Sraffa, Steedman and Pasinetti).
Their debate is referred to as the Capital Controversy because it focused on the nature and role of
capital as a means of production. Since the debate was largely fought between the two Cambridges,
it is sometimes also called Cambridge Capital Controversy (CCC). Though most of the debate was
polemic and highly mathematical in nature, there are some many issues that can be explained in
relatively plain language. It is important to note that the reason why this debate is not a part of
‘standard economic education’ is not due to the fact that it was something unimportant or
misconceived; it is ignored and sidelined by economists because of the simple fact that they lost this
debate! Let’s develop an insight into the nature of the issues involved in this debate.
Figure 16.11: Four hey diagrams of neoclassical economics involving capital as an argument
(a) Production function K (b) Optimal Choice of Capital

Y
Yo
A
C
Kc
B
0 0 Lc L
K (Capital)
i (interest rate
i
(c) Demand for Capital & (interest (d) Market Return of Capital
Interest Rate rate) Sk
A
ia
ie E
B
ib
VMPK = Dk
DK
0 Ka Kb K (Capital) 0 Ke K (Capital)
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To begin a survey of this controversy, first you should appreciate the need to focus on the
word quantity of capital. It should be clear to you from the above diagrams that whatever results
economists derive regarding the distribution of income from marginal productivity theory crucially
depend upon this ‘physical’ concept of ‘capital’. If economists really want to make people believe
that the distribution of income between workers and capital-controllers follows the marginal
principle in a market economy, they must prove that ‘there is a unit in which aggregate physical
capital can be measured and that unit of measurement is itself independent of income distribution
and output prices’. If (and this is a very big ‘if’) we can find such a number in which the quantity of
capital can be measured, only then we can insert ‘physical capital’ in the production function along
with labor. This will then allow us to analyze a system of production wherein capital goods play a
role in the production process along with labor on the one hand, and at the same time analyze the
distribution of income in a market economy on the other hand. The introduction of ‘physical
capital’ as a separate factor input plays multiple roles in neoclassical theory; i.e.
1) as a collection of machines it leads towards growth theory—a topic discussed in
macroeconomics
2) as technical knowledge and natural resources it leads towards international trade theory as an
expression of unequal endowments—a topic usually discussed in international economics
3) as a source of a form of reward, called interest, it leads to income distribution theory—
discussed above
Thus, the concept of physical capital is of utmost importance for the survival of neoclassical
theories of growth, trade and income distribution.
An Impossibility Theorem
The critics of neoclassical economics successfully established that it is impossible to

construct a measure of ‘capital’ the value of which is independent of the rate of interest and
wages in the economy. The reason for this ‘negative theorem’ is straight forward. The
measurement of the ‘quantity of capital’ involves a major hurdle: how can we add heterogeneous
capital goods? Basically, the concept of ‘physical capital’ includes too many things to be reduced
to one homogenous substance called ‘capital’. For example, it covers machines, factories and
buildings; trucks, ships and planes; steel mills, oil wells and power stations. Interestingly, each of
these items consist of a number of other types of capital inputs (think of different parts of a
truck). The problem is that the way we cannot add ‘apples’ in ‘oranges’, similarly we cannot
simply add up incompatible units of ‘capital’. The only thing that such heterogeneous
commodities have in common is a ‘monetary price’. This implies that capital is irretrievably a
value, and not a physical, quantity.
The neoclassical economists argued that there is no problem in adding up the money
value of all these different capital items to get an aggregate measure of physical capital.
Traditionally, their idea was that capital could be measured by multiplying the amount of each
type of capital good by its price and then adding up these multiples. The neoclassical economists
assumed that their theories of production and income distribution would remain unaffected, no
matter whether one uses ‘value of capital’ or ‘physical capital’ as an argument in the production
function. But this is not the case because ‘the financial aggregate stock of capital’ depends upon
the rate of interest paid out as part of the cost of goods included in this very ‘capital stock’. This
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creates circularity in the argument: the price of a piece of capital depends upon the rate of interest
(as it is one of its cost components) and the rate of interest will change as prices of physical capital
change. In order to determine the value of capital, it is necessary to know the rate of interest (and
hence the distribution of income) first, but the rate of interest cannot be worked out without having
the ‘price of capital’ first (because the rate of interest equals the ratio of interest to price)!
Figure 16.11: The circularity involved in the financial measure of physical capital
(1) (2) (3)

Changes in i Change in Changes in
(corresponding to the the
an opposite one distribution distribution of
(5) (4)
(6) Changes in Changes in
Changes in the prices of the prices of
the value of capital outputs
To further consolidate your understanding of the relationship between the ‘monetary

measure of capital’ and the distribution of income, note that as the distribution of demand
between different sectors of an economy changes, not only does the price of the product change,
but the price of capital goods used in producing those goods also changes. For example, if the
share of property income rises at the expense of wages in the economy, this will decrease the
demand for basic consumer goods and increase that of the, say means of production. This means
that the price of the capital goods used in producing means of production would rise and that of
the capital goods used in producing basic consumption goods would fall. This in turn would
change the sum of the prices of the two types of capital goods. Thus, changes in the distribution
of income lead to changes in the distribution of demand between sectors; which in turn means
that the total value of capital stock changes with the distribution of income. Figure 16.11
summarizes the nature of circularity involved in the economic measure of capital. It is clear to see
that any change arising from box (1) affects the value of capital in box (6). But the process does
not end here, changes in the prices of capital then also affect the changes in interest rate i in box
(1). The simple logic presented by Sraffa and party shows that the ‘monetary measurement of the
stock capital’ is not independent of the distribution of income between wages and interest rate
itself. The economic argument suffers from the logical fallacy of ‘begging the question’.14
14
This is a type of informal logical fallacy in which the arguer presumes the truth of what he seeks to
prove. This fallacy involves a circular reasoning
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Implications of the ‘Impossibility Theorem’
Why bother so much about the above measurement problem? Actually, the above result
falsifies economic theory right at its root which claims that the distribution of income is uniquely
determined by the markets and there is nothing that policy-makers can or should do to improve
the situation of someone in society. The Cambridge Capital Controversy had serious negative
implications both for the theoretical foundations and the associated policy claims of the
economists. This controversy showed that it is impossible to deduce unambiguous predictions
from aggregate capital models, where physical capital is measured by using prices to add up all
types of capital inputs. Here we discuss some of its implications leaving aside the technical
issues.
1. Badly behaved capital: Look at part (c) of figure 16.10 which draws demand for capital as a
function of the ‘quantity of capital’. It says that if the interest rates fall, the firm will smoothly
choose a higher ‘quantity of capital’ and hence we have a negatively sloped demand curve.
However, the curve is drawn on the assumptions that an ‘income distribution free measure of
capital’ is available and that changes in the interest rate do not bear any effects on this
measured ‘quantity of capital’ leaving it the same in value. But as we know that capital is
necessarily a value, and not a physical, quantity and its value does change after changes in the
interest rate. Given this, if we assume that there is a negative relation between interest rate
and the quantity of capital, when the interest rate rises the demand for physical capital will
decrease, however, the value of capital stock might rise or fall depending upon the
demanders’ intensity for capital—whether the value will decrease or increase depends upon
how the distribution of income and pattern of demand has changed in the economy.
Figure 16.12: Demand curve for capital in a multi-commodity economy
i (interest
rate)
Sk
Dk
0 K
(Capital)
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In a nutshell, there is no way to tell in which direction the value of capital will change after
changes in the interest rate, and hence there is no justification for drawing a negatively sloped
demand for capital. In fact, we can have any shape of the demand curve for capital in an
economy where more than one units of capital are used as a factor of production. Figure
16.12 shows a possible shape of the demand curve for capital that can result in a multi-
commodity economy. Thus, we find that it is the fallacious methodology of economists that
allows them to reach at strong and apparently rigorous conclusions: they mistreat capital
when they put its quantity on one axis and its price on another in the textbooks, and that too
without discussing the ‘citrus paribus’ conditionalities.
2. Refutation of marginal productivity theory of income distribution: The neoclassical theory of
income distribution, as outlined above, maintains that under competitive conditions the rate
of return on capital (i) equals the MP of capital, while the wage rate (w) equals the MP of
labor. The Capital Controversy showed that there was an inherent problem in applying this
model of income distribution to capital. It is evident from figure 16.12 that we can have
multiple equilibria since the demand and supply curves are intersecting at more than one
point. The interest rates actually prevailing at any moment in time in markets depend less
upon the demand-supply forces and more on factors beyond market control. If we
complement this diagram with the fact that the saving supply curve can also take any shape in
a heterogeneous capitalist society, the result becomes even more shattering for the standard
theory. The Capital Controversy concludes that instead of prices determining the distribution
of income in a market economy, the causation works the other way round—distribution of
income determines relative prices.
3. Dichotomy between financial and physical capital: Capital Controversy also dealt a telling
blow to the assumption that financial capital can stand for the physical capital of a firm or of
an economy. As discussed above, in order for the neoclassical vision of the circular flow to
be valid, the assumption that there is a unit of measurement in which capital can be added
independent of the distribution of income must be valid. Since this is impossible in a multi-
commodity economic model, hence the financial side of capital cannot represent its physical
side. Joan Robinson described this dichotomy in the following passage:
“we are accustomed to talk of the rate of profits on capital earned by a business as
though profits and capital were both sums of money. Capital when it consists of as yet
uninvested finance (i.e. when it is financial capital, it) is a sum of money, and the net
receipts (i.e. profits) of a business (on this financial capital) are sums of money (as
well). But the two never co-exist in time. When the capital is a sum of money, the
profits are not yet being earned. When the profits are being earned, capital has ceased to
be money and becomes plant. All sorts of things may happen which cause the value of
the plant to diverge from its original cost (i.e. financial value). When an event has
occurred, say a fall in prices, which was not foreseen when investment in the plant was
made, how can we regard the (financial) capital as representing the plant?” [Robinson
(1953): p. 84, quoted from Harcourt (1972): p. 19].
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Political Agendas of the Two Cambridges
Underneath the apparently technical debate of the Capital Controversy lies the clash of
ideological and political views of the two combating groups regarding the functioning of market
capitalist system. The Cambridge-England critics of neoclassical economics (who may be termed
as post and neo-Keynesians) regard market capitalism as an inherently antagonistic social order
where different classes (such as workers and managers of capital) are trying to dominate each
other. They argue that the distribution of surplus value cannot be understood independent of the
political institutional structures of the market capitalist system. These critics, having rejected the
marginal productivity theory of income distribution, argue ‘for a return to the Classical method of
analysis in which pricing is an aspect of distribution’ instead of ‘distribution being but an aspect
of pricing’ (Harcourt: 1972). The Cambridge critics, following Mill, distinguished between the
analysis of production and that of distribution. They reinforced Mill’s view that: ‘the laws and
conditions of the production of wealth partake of the character of physical truths. There is nothing
optional or arbitrary in them’, whereas, ‘It is not so with the Distribution of wealth. That is a matter
of human institution(s) solely’.
Neoclassical economists, on the other hand, have some other beliefs. They struggle to
show that capitalism is fundamentally characterized by harmony where each individual makes
voluntary choices as a market participant—this is the reason they employ the ‘equilibrium
methodology’ to analyze the market system. To them, the basic unit of a market capitalist system
is ‘a self-interested individual’ and not ‘social classes’. Hence, in the neoclassical theory of
income distribution there is no room for the analysis of ‘class-struggle’. Their theory pretends to
show that the supply of inputs is determined by a great mass of self-interested individuals and
both production as well as distribution is dictated by the ‘laws of nature’ (such as the laws of
demand and supply). The symmetric incorporation of ‘capital’ as a factor of production alongside
‘labor’ in the neoclassical production function is actually intended to incorporate the idea of
‘social and political equality’ of labor and capital in market capitalism.
In another sense, the neoclassical theory of income distribution was also developed to
justify the idea that capital is a factor of production whose return is determined by its marginal
productivity as is the case for labor. Interpreted this way, the neoclassical income distribution
theory was a theoretical response to the challenge of Marxism which questioned the fairness of
the reward flowing to capital as well as the political institutional arrangements of market
capitalist order.
16.4: WHY ECONOMICS?
Having gone through the book this far, you might be wondering why economics has not
ceased to exist as an academic discipline if it abounds with so many contradictions and inherent
problems. The answer to this question lies neither in the fact that there is ‘some deeper truth’ hidden
behind microeconomic theories nor that these theories have been shown to explain the empirical
realties of capitalist order, rather a major reason for the sustainability of neoclassical economics
rests on the fact that it continues to provide a justification for the agenda of liberal capitalism
against religious social order. Economics as a distinct academic discipline arose at a time when
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Europe was undergoing a social transformation—a transformation from Christianity to capitalism.

The new capitalist class was asking for the removal of political and social controls on individual
and society which were justified on the grounds of religious doctrine. Since a religious social order
seeks to structure all social institutions so as to maximize the opportunities for the fulfillment of the
Will of God, it necessarily imposes restrictions to discourage the immoral impulses of
‘accumulation and competition’ (i.e. greed and envy)—the impulses which ultimately commit an
individual to ‘rivalry in worldly goods’ as an end in itself. In the social environment of Europe
during the 18th century, economic theory provided a counter to the religious way of thinking about
individual, society and state. The emerging capitalist class faced social and political barriers and
restrictions and whenever they objected to these barriers, they were reminded that these controls
were needed to maintain the social order. At this critical juncture, economic theory armed the
capitalist class with an effective rejoinder against the priests: it brought forth the idea that a system
of government was not needed to maintain social order, instead social order and harmony arise
spontaneously and naturally in a market economy where each individual is guided by only his or her
self-interestedness. The echo of this idea was also found in Smith’s famous ‘invisible hand’ doctrine
which played a key role in the transformation taking place during the 18th century in Europe.
Economists, since that time, proposed that the essential feature of a market social order was
‘equilibrium’—reflecting a state of social harmony. They preached the assumption that a market
system necessarily and inherently tends towards equilibrium. If markets automatically attain
equilibrium, then everything happens in equilibrium, hence in harmony, in a market system. This
impersonal, spontaneous, natural and automatic ‘market equilibrium’ was presented to replace the
legislative order of the European Christendom. Keen has rightly pointed out that ‘if, instead of
equilibrium, economists had promised that capitalism would deliver chaos; if, instead of
meritocracy, economists had said that capitalism could concentrate inequality, then economists
could have hindered rather than helped the transition to capitalism’ [Keen (2004): p. 162]. It is
specifically due to the service of this ‘economic vision’ that economics has been able to resist all its
critics—though, over the last century, it has been proved that economic theory is fundamentally
flawed, but over the years the commitment to the ‘economic vision’ has become stronger. Thus, the
resistance to stick with economic theory is deeply embedded in ideological reasons. By using
economics doctrines, they try to rationalize the (false) belief that capitalism is a rational system—in
the sense that maximizing utility / self-interest / freedom maximizes social welfare. In this sense,
economics is the religion of modern or enlightened man who treats its ‘belief system’ as unshakable
dogmatic truths.
Another way in which this ‘unsmart economics’ has been preserved is by keeping the
masses ‘ignorant’ of its unsmartness. Most of the students of economics, and even a great
majority of its teachers and practitioners, do not know that the foundations of economics have
been refuted long ago. Most economics textbooks present an uncritical exposition of neoclassical
economic theory. Students are exposed to the ideas such as that ‘monopolistic power’ reduces the
efficiency of market system; but they are never told that the ‘proof of the proposition that markets
are efficient’ is itself fallacious!
A third reason why neoclassical economics has managed to survive despite its logical
fallacies is the absence of any grand alternative competing theory to microeconomics. The survey
of alternative schools of thought in the next chapter will show that though there are a number of
emerging trends against neoclassical economics, their work is mostly restricted to the critical
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evaluation of microeconomics and they largely fail to provide any rigorous alternative framework
to analyze capitalist social order. Economics will continue to celebrate its triumph, thanks to
missing alternatives.
Is Economics Free of Ideology?
Most economists dismiss the idea that ideology plays any role in the development of
economic theory and they boast of the notion that economics is fundamentally a value-neutral
science based upon some ‘objective natural laws’ easily distinguishable from value-judgments.
This is the reason why you would see terms ‘positive and normative economics’ in all text books
of economics to signify that as if there were some ‘descriptive’ and ‘natural’ aspects of economic
theory which are purely independent of value judgments. However this is one of the major
misconceptions economic practitioners have popularized. As discussed above, the very concept of
‘equilibrium’ presented as some ‘positive fact’ by economists is actually based upon a ‘normative
ideology’—i.e. self interestedness leads to social harmony. Contrary to what economists boast of,
it is the defense of this core economic ideology that has made economic theory so resistant to
change because, as shown above, the critics of economic theory have asked it to abandon the core
belief of ‘equilibrium’. Today, any policy maker who has the beliefs that:
• free markets automatically and naturally gravitate towards equilibrium positions,
• market equilibrium reflects maximum attainable efficiency and
• achievement of economic efficiency is the most prioritized individual and social end in itself
will assert that any other system than market mechanism will produce disequilibrium and hence will
reduce efficiency. Based upon this ‘ideology’ such a practitioner will, for example:
• oppose minimum wage laws—as they lead to labor market disequilibrium and unemployment
• oppose state controls on market prices—on the grounds that they create mismatch in product
markets
• oppose quantitative restrictions on imports—assuming that more trade is better than less
On the other hand, this policy maker will support only those policies which can the make real world
conform as much as possible to the idealized fiction of capitalist ideology—i.e. perfect competition.
The believer in economic theory will:
• ask for private business enterprise in the provision of all goods and services—assuming that
private enterprise is superior to public ownership of resources
• ask for minimum government intervention with private businesses—because governments, not
being subject to the discipline of demand and supply, frustrate the market mechanism either by
over or under production
• ask for more liberalization, privatization and deregulation
• ask for anti-monopoly and anti-union laws
• ask for more openness towards multinational companies ; so on and so forth.
Ironically enough, economic practitioners impose on all this proclaim that they are not ‘being
ideological’!
This analysis has once again reinforced one of the major themes of this book: ‘economics is
by no means a positive science—it does not deal with how societies actually work—rather it is a
normative science—deals with how they ought to function’. The very fact that economic analysis
leads to specific ‘social policy’ which has to be put in use to manoeuvre societies is more than
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enough to expose the reality of economics. The control of capitalist policy making institutions in the
hands of economic practitioners is in fact another reason for the perpetuation of economic theory
and ideology.
16.5: ECONOMIC THEORY OF PROFIT
This section will briefly outline the standard theory of profit. Mainstream economic
theory of profit begins by distinguishing between an “accounting” and “economic” conceptions of
profit. “Accounting profit” is the difference between total revenues and total costs incurred by a
firm. “Economic’ profit deducts from the excess of revenue over cost the implicit return on
capital owned by the shareholders. Sometimes “unpaid management time” is also subtracted from
accounting profit. So we write:
π Acc = ∑ TR − ∑ TC
and π Eco = π Acc − SCC − UCM (16.13)
where SCC is shareholders cost of capital while UCM is the unpaid cost of management. The
“implicit” cost of capital is calculated by multiplying a representative rate of interest (say six
month Treasury Bill’s rate) with shareholders equity:
SCC = r × SE
Where r = representative interest rate and SE= Shareholders Equity. So we have:
π Eco = π Acc − rSE − UCM (16.14)
It is difficult to derive some agreed upon measure of unpaid managers time mainly because most
managers salaries in advanced markets (and also in the case of market leader firms in Pakistan)
typically include stock returns and it has become almost impossible to decompose managers
salaries.
Types of Risks
Microeconomic theory treats profits as a reward for risk-taking behavior. Though many
risks are insurable in modern capitalist order but ultimately it is in the very nature of risks that
they cannot be insured against–––there is always a possibility that the whole system of claims and
obligations which constitute a financial system may collapse at a moment and all insurers may go
bankrupt. In the 2007-2009 global financial crises, there was a likelihood that this would happen
in America and the government of George Bush and Barak Obama had to spend about $5 trillion
(nearly 40 percent of US GDP) of tax payers money to bail out the banks and other financial
intermediaries.
Uninsurable risks are sometimes called systemic risks. Systemic risks increase
exponentially for all capitalist businesses during the downturn of a typical business cycle ––but
the impact of a typical business cycle downturn depends upon:
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(a) the exposure of that business to financial markets–––the higher the leverage ratio and the
greater the share of speculative investments in its assets portfolio, the greater the systemic
risk of a given capitalist business, and
(b) the nature of the products it is bringing to the market–––thus producers of goods and
services with high income elasticity of demand (say yachts, tourist services, financial
derivatives) will be much more “systemic” risk prone than producers of essentials such as
atta
It is also important to stress that for non-capitalist businesses capitalist crises provide an
opportunity for growth and consolidation. Thus, most small scale businesses in Pakistan are non-
capitalist––they have no dealings with financial markets. There is thus comparatively little impact
of the cyclical downturn on Sabzi Mandi, Anarkali, Raja Bazzar or Bara Market. Indeed as
heavily leveraged wholesalers and super-markets and agri-businesses collapse, there are
opportunities for the small non-capitalist businesses to expand their businesses. Crisis creates
opportunities and rewards for non-capitalist businessmen.
Capitalist businesses remain exposed both to such systemic risks and also to what is
called sovereign risk. “Sovereign” risk is the risk associated with lending to a capitalist
government which defaults on its debt obligations–––Mexico in 1994, Russia in 1998, Argentina
in 2001, the UAE in 2009 and Greece in 2010 experienced this (Italy and Portugal may soon
follow). There is no global bankruptcy law and court and no international lender of the last
resort–––thus, when Pakistan defaulted in 1972-3, no punitive action could be taken against
Pakistan by American, the IMF or the International Court of Justice. Capitalist firms dealing with
a capitalist government that may default thus face an uninsurable “sovereign” risk. Table 16.2
summarizes the four types of risks recognized by microeconomic theory.
Table 16.2: For types of business risks

Types Example
Risk of default Loans to sick enterprises in the textile sector
Insurable risk Fire, accident, natural disaster
Systemic Inflation, changes in interest rates, stock market
collapse
Sovereign Pakistan 1972-73, Greece 2010
Such risks entail high volatility of profits. In capitalist order profit rates are usually
higher than interest, wages and rent. They include what is called an “equity premium” over and
above the “cost of capital” (i.e. interest / rent) and the cost of labor (the managers’ wage).
Typically the “equity premium” rises during a stock market boom and declines sharply when the
downturn begins and during the downturn. Indeed, during most recessions the interest rate is in
real terms higher than the profit rate implying a negative equity premium.
An upturn in economic activity is typically associated with an upsurge in what are called
“Schumpeterian profits”. Joseph Schumpeter, an Austrian economist, saw capitalism as a
dynamic system in a permanent state of disequilibrium. A typical capitalist business cycle is
presented in figure 16.13. The typical capitalist business cycle is divided into four phases:
• Trough (1999-2002): A decline in economic activity
• Boom (2002-2006): A recovery and continuing growth
• Peak (2006-2007): Near full employment and “potential” output produced
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• Trough (2008-2010)
The American economy boomed during most of the 1990s. But in the late 1990s there was a
“dotcom” crash. This was accentuated by the counter attack on America in 2001 and the decline
in the financial markets deepened. The government responded by a drastic reduction in interest
rates and there was a major revival of consumer demand in America. During 2002-2006, America
experienced boom conditions and peak conditions were achieved somewhere in early 2007. Then
the “sub-prime mortgage” bubble burst and there was another crash during 2008-2010. It is not
clear whether this trough has ended and a new sustainable upturn has begun as yet, although
positive growth has been recorded in America during the first two quarters of 2010.
Figure 16.13: Typical capitalist business cycle
Output
Index
Peak
Recess
Boom
Trough
0 Time
Schumpeter’s Account of Business Cycles and Profits
Schumpeter argued that cyclical upturn begins when there is an innovational

breakthrough. Schumpeter saw these “breakthroughs” as originating in production technology–––
steam, electricity, the rail road, the radio. The 1992 boom was also trigged by a breakthrough in
physical technology–––the ITC “revolution”. He argues that those who invest in the production
and commercialization of this new technology bear considerable risk and the technological leap
they make enables them to make “monopoly profits”. But these “monopoly profits” are temporary
and they are soon “competed away” by rivals and imitators. However, according to Schumpeter,
monopoly profits and disequilibria always characterize capitalist order (Hayek also emphasizes
this but in a different context). This is because, Schumpeter believed, that technological
innovations are a permanent feature of capitalist order. Monopoly profits are transferred from one
capitalist market to another for one technological breakthrough follows fast on the heels of
another. As profits become normal in one industry (airlines), they become monopolistic in
another (computer software).
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Innovations, however, need not necessarily be related to changes in production

technology. For example, there has been no major production technology breakthrough following
2002 but American economy still had an upturn––the main cause of the 2002-2006 upturn was
financial sector deregulation and the explosive growth of financial products and derivates.
Similarly the upturn after 1935 was sustained not by production technological innovations but by
a massive upsurge in military expenditure by America, Britain, Germany and Japan.
Keynes on Profit
What determines the rate of profit? Microeconomic theory has no answer to this question.
The often repeated rhetoric that “profit is a residual” is of course meaningless––i.e. no answer at
all. For the question that is being asked is “given that profit is the difference between the cost of
capital (rent plus interest) and the return on capital”, what determines this difference? What
makes this difference to increase or decrease? What induces people to take more or less risks?
When does the price of taking risk rise or fall?
The American economist Knight provided no answer to this question––he repeated the
“residual” buzzword––nor did Schumpeter. Two economists have taken the bull by the horns and
directly addressed this question. The first was Keynes. He said that risk taking and its price (i.e.
the rate of profit) were determined by “animal spirits”. It is these “animal spirits” which drive
expectations and expectations, said Keynes, were not rational. Fluctuations in stock and bond
prices are driven by speculation which reflects expectations and hunches based on “animal
spirits”. Variations in stock price indexes are reflected by “random walks”. There is no rational
basis for estimating what return on a specific stock will be–––except that in the “long run” it will
converge to the stock market average index price. But one can’t say what this average index price
will term out to be in “the long run”.
Empirical analysis seems to strongly confirm this view that there are no rational
explanations for variations in the price of risk taking in capitalist markets. Thus, nobody could
predict the stock market crash of 1929-33 or of 2007-2009. Nor could the mathematically
sophisticated models for risk evaluation prevent major banking sector bankruptcies in America.
International regulatory regimes based on the assumption that banks could themselves adequately
identify and manage risk exposure are clearly seen to have failed. The most conspicuous failure is
that of Basel Accord bank supervision regime.
Sraffian Position on Profit
As we argued in this chapter, Pierro Sraffa saw the share of gross profit in total value
added being determined by class struggle. By “gross profits” Sraffa meant rent plus interest plus
net profits (surplus). Total value added (GDP) is divided between wages (the share of the labor
class) and gross profits (the share of capitalist class). Each of these two classes seeks to maximize
their share of total value added. The greater the relative bargaining power and political strength––
reflected particularly in the control of state mechanisms and policy making processes–––of the
capitalist class the higher their share of gross domestic output (total value added). Gross profits is,
then, divided among the three major segments of the capitalist class; i.e. owners of physical assets
(who receive rent) owners of loanable funds (who are paid interest) and risk takers (who capture
net-profit). Again it is the relative bargaining power and political strength of the three capitalist
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subclasses which determine the distribution of gross profits between rent, interest and net profit.
Sraffa argued that:
• Gross profits rises in capitalist booms and declines more than proportionally in slumps and
troughs. Most Sraffians (e.g. Ian Stedman and Frances Cripps) argue that wages are relatively
inflexible both downwards and upwards. Real wages cannot fall below a fairly stable “floor”
in depression or rise very much in booms periods. Profits are much more volatile and display
much greater flexibility than wages. A wealth of empirical evidence exists to substantiate this
view
• The share of interest and rent in gross profits rises in capitalist slumps and recessions and
falls in relative terms in boom periods. Interest and rent are “sticky downwards” as Keynes
argued over eighty years ago. Risk taking drives the capitalist system but risk takers are
heavily punished when they take “undue” and “excessive” risks. It is the capitalist state which
bails them out by shifting the burden of failure from the risk takers to the tax payers. The
American government spent about $ 5trillion of tax-payers money bailing out failed banks
and financial intermediaries during 2007-2009. The burden is also shifted by throwing
“surplus” workers out of the jobs. Once again the capitalist state picks up the pieces by
income support payments funded once again out of tax-payers money.
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Key Concepts
Intertemporal choice is the choice involving different periods of time

Intertemporal budget constraint is the budget constraint applicable to income and expenditures
involving more than single time period
Rate of time preference measures the rate at which the consumer is willing to substitute second
period consumption for first period consumption
Saving is the residual amount of income left out of consumption expenditures
Discounting is the practice of reducing the value of a future payment to calculate its value today
Compounding is the process of calculating the amount to which a payment will grow at some
time in future (by accumulating interest on interest)
Euler’s Theorem says that when the production function displays constant returns to scale, it
satisfies the adding up property: output equals sum of the marginal products of inputs times their
level of use
Capital controversy refers to the theoretical debate fought between two Cambridges on the
nature and role of capital as a means of production
Marginal productivity theory of income distribution asserts that the income share of a factor of
production is determined by its contribution in output produced
Supply of saving reflects the amount of savings supplied by an economic agent at different rates
of interest
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Chapter Summary
• The theory of the demand for capital in standard microeconomics text is similar to the theory
of the demand for labor. The capital demand curve is negatively sloped for the competitive
firm which faces a horizontal capital supply curve. Equilibrium is achieved where the value
of marginal product of capital equals its cost / price –– the rate of interest. This maximizes
the profitability of the competitive firm.
• Short run equilibrium analysis seems intuitively misleading since capital in the form of
machinery is not as flexible as labor
• Supply of capital is supposed to reflect the inter-temporal choices of capitalist consumers
subject to their inter-temporal budget constraint
• The capitalist consumer’s inter temporal choice of consumption is determined by the interest
he can earn on his saving and the value of his present consumption discounted by this interest
rate
• The intertemporal consumption choice is also determined by his ability to borrow and the
interest he has to pay on this borrowing. This has to be offset against the interest he earns on
his saving, and the total amount available to the capitalist consumer depends upon his income
the amount he can borrow and the interest he earns on his savings and pays on his borrowings
• The intertemporal marginal rate of substitution in known as the rate of time preferences. It
measures the rate at which the capitalist consumer is willing to substitute future for present
consumption.
• The typical capitalist consumer is an accumulator. Therefore he has a preference for future
over present consumption but the future is risky and future anticipated consumption may or
may not materialize. Therefore future consumption has to be augmented by interest earnings
required to offset this riskiness and microeconomics analysis typically models indifference
curves showing time preferences of capitalist consumers to reflect this expected riskiness of
future consumption flows. These indifference curves are normal and “well behaved”–––
sloping downwards and convex to the origin. The marginal rate of substitution between future
and present consumption keeps on decreasing as the level of consumption rises
• The capitalist consumer’s borrowings fall when the interest rate rises. When interest rates rise
the capitalist consumer substitutes future consumption for present consumption which
becomes more expensive–––hence his present consumption falls. If we assume that the
typical capitalist consumer is a net borrower a rise in the interest rate will reduce his income
(and therefore his present consumption)
• The microeconomic theory of saving behavior cannot identify a uniquely rational relationship
between saving and interest rate at the level of the market. This is because capitalist
consumers with different time preferences (net lenders and net borrowers) rationally respond
differently to changes in the interest rate. The market supply function can take any shape
although microeconomic theory presents it as “well behaved” (upward sloping).
• Equilibrium in the capital market is determined by the intersection of the market demand and
market supply curve at a price (the interest rate) which equals its marginal revenue product.
Since interest equals marginal revenue productivity interest is a fair recompense for the factor
of production capital.
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• Marginal productivity theory holds that both labor and capital are recomposed by the market
in accordance with their marginal product ––– i.e. contribution to profit / welfare
maximization. This recompense represents capitalist justice and attempts to seek a higher
wage / interest should be resisted by the capitalist state since it violates the norms capitalist
justice.
• Marginal productivity theory cannot demonstrate that the value of output produced in capital
markets will necessarily equal the value of the recompense to capitalist factors of production
(i.e. labor and capital)
• If value of output is not equal to value of income the controllers of the production process
have the opportunely to appropriate the surplus product. Classical economists –––especially
Ricardo and Marx–––recognized that appropriation of surplus product was a central feature
of capitalist distribution
• Euler shows that assuming constant return to scale and infinite factor substitutability, the
aggregate value of income shares of factors of production determined by their marginal
productivity will equal the value of aggregate output. Hence there is no surplus product
available for appropriation
• The Sraffan criticism of marginal productivity theory holds that a change in the price of
capital brings about a change in the distribution of income since it affects prices of a large
range of product markets. Hence the pattern of the distribution of income becomes a
determinant of changes in factor prices, which therefore do not reflect solely the changes in
their marginal productivity.
• The Cambridge Capital Controversy (CCC) of the 1960s showed that the results regarding the
justice and equity of the pattern of income distribution generated in capitalist factor markets
where factor prices are determined by marginal productivity depended upon a particular
conception of capital by this theory. Capital was regarded as something physical such as
machines, buildings and raw material
• But physical capital can only be measured in value (money) terms and the value assigned to
physical capital is not independent of the prices of output (produced by that physical capital)
and of the pattern of income distribution. This shows that capital is necessarily a value and
can only be measured in terms of money.
• When the aggregate capital stock is measured in value terms it includes the interest paid on
this capital stock and included in its price. The price of a piece of physical capital
(machinery) depends on the interest rate (one of its costs of production). But the rate of
interest changes as the price of physical capital changes. As Sraffa has shown the monetary
value of physical capital goods changes with the distribution of income. The monetary
measurement of physical stock is not independent of the distribution of income between wage
earners and non wage earners.
• There is no income distribution invariant measure of physical capital stock. The value of
capital stock will depend upon (a) the pattern of income distribution and (b) the demand for
physical capital. Since changes in the interest rate necessarily change the pattern of income
distribution the impact of changes of the interest rate on the value of physical capital remains
uncertain
• The capital controversy debate showed that marginal productivity theory cannot provide an
explanation of the determination of the rate of interest–––which is set by the State Bank and
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is not an outcome of market forces. The pattern of income distributions determines relative
factor prices in a capitalist earning
• Recognizing that it is the distribution of income which determines prices means that it is the
institutional and political arrangements of a specific capitalist society which determine the
distribution of surplus product between waged and non waged income. It is the pre
determined pattern of income distribution which generates price structures in both commodity
and factor markets
• The neoclassical theory of income distribution presents capitalism as a harmonious order in
which self interested individuals achieve their ends in a mutually beneficial manner–––the
market permits positive sum games. Sraffian and classical economists see capitalist order as
conflictive where unending class struggle determines the pattern of income distribution
• Modern economics continues to ignore the criticisms leveled against mainstream neoclassical
analysis because this analysis justifies capitalist order. Economics presents capitalist order as
harmonious and just but Sraffian and Marxist analysis describes capitalist order as
conflictive, chaotic and exploitative
• Economics survives because it (a) continues to serve as an ideology justifying capitalist order
and providing a a tool box for rendering it functional and (b) its major critics–––Sraffians and
Marxists–––remains committed to capitalism and their criticisms of orthodox economic
theory do not reject fundamental capitalist values
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Review Questions
1. Compare and contrast the microeconomic theory of the demand for labor and the demand for
capital.
2. What is the price of capital in microeconomics theory, and why?
3. Distinguish between physical and financial capital. What is the relationship between the price
of physical and financial capital?
4. What are the determinants of the supply of capital according to standard microeconomics
theory? Who according to this theory supplies capital?
5. What does the ‘inter temporal marginal rate of substitution’ measure?
6. What is the weakness in the microeconomic theoretical prediction that the market capital
supply curve is “well behaved”–––sloping upward from left to right and showing a positive
relationship between changes in the interest rate and in the supply of capital by capitalist
consumers?
7. Show how equilibrium is achieved in the market for capital according to microeconomics
theory.
8. State and evaluate the microeconomics case for regarding interest as a fair reward for capital.
9. What is the just theory of input price determination according to economic theory?
10. If interest is the “fair recompense” to capital, what determines profit in capitalist markets?
11. What assumptions are required in the Euler theorem to refute the Marxist / Ricardian
assertion that profits are necessarily appropriated from labor shares?
12. State and evaluate the Sraffian critique of marginal productivity theory.
13. What was the Cambridge Capital Controversy of the 1960s? Who won the argument –––
Cambridge England or Cambridge Mass–––and what was the main argument of the winning
side?
14. “Capital is necessarily a value and can only be measured in monetry terms.” Explain.
15. What is the relationship between the pattern of income distribution and the monetary
valuation of the physical capital stock?
16. What is the relationship between changes in the value of physical capital and changes in the
interest rate?
17. Who sets the rate of interest in Pakistan and on what basis?
18. What is the relationship between the income distribution pattern and the structure of output
and input prices in capitalist markets?
19. Rejecting marginal productivity theory as the underlying principle determining income
distribution amounts to rejecting the view that capitalism is a harmonious, non-conflictive
system in which everyone gains from the functioning of efficient markets.” Discuss.
20. Why does modern microeconomics continue to ignore the criticism of the theory of
distribution by Sraffa, and several leading economists from Cambridge England, more than
fifty year ago?
21. Why do the Marxist and Sraffian critiques of microeconomic theory continue to remain
ineffective?
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17
Chapter
ALTERNATIVES TO
MICROECONOMICS
Chapter 17: Alternatives to Microeconomics
As pointed out in the last chapter that one of the reasons for the survival of
microeconomic theory, despite its incoherence, is the absence of any grand alternative competing
theory. This chapter provides a brief survey of alternative schools of thought in order to
substantiate the claim that though there are a number of emerging trends against neoclassical
economics, their work is mostly restricted to the critical evaluation of microeconomics and they
largely fail to provide any rigorous alternative framework to analyze capitalist social order. Note
that we will not provide a summary of this chapter, rather leave it for students to develop one for
themselves as practice.
17.1: MACROECONOMICS, KEYNESIANISM AND POST-KEYNESIANISM
It has become fashionable to speak of “classical macroeconomics” because Smith and

Ricardo analyzed variations in aggregate output and its distribution. Moreover the basic unit of
analysis in their work was not the a-social self determined individual but social classes. Smith and
Ricardo were pre-eminently political economists and it is torturous and unnecessary to separate
the ‘micro’ and ‘macro’ elements in their theories of price, distribution and growth. In any case
most of their “macro” insights have been incorporated in the work of Sraffa, his followers and
Marxist economics—and to a lesser extent in Post-Keynesian theories. We will therefore pan over
‘classical macroeconomics’.
Modern macroeconomics was a response to the capitalist crises of the interwar period
(1919 – 1945). It blossomed in what is described as capitalism’s “golden age” (1950 – 1970). It
has found to be seriously wanting in the stagflationary decade of the 1970s and has been in a
process of decline and deconstruction since the 1980s when the NeoClassical—actually new
neoclassical—heartlands came under the Ronald Reagan and Margaret Thatcher regimes.
Today macroeconomics theory has been almost totally subsumed by microeconomics.
Currently they teach ‘representative agent macroeconomics’—the national / global capitalist
economy is regarded as containing only one ‘representative’ consumer producer financer in the
IVY League universities and even at Oxbridge and the LSE. This absurd model of capitalist order
reflects both
• The essentially moral and normative character of economics. Economics requires everyman
to accept capital accumulation as an end in itself, as the sole purpose of existence. The
‘representative’ consumer-producer financer is a representative of capital—he is not a
representative of everyman. If Abdullah Zhaghazai rejects accumulation as an end in itself he
is irrational and economics can say nothing to him or about him. Representative agent
macroeconomics analyses how all rational (i.e. profit / utility maximizing) producers-
consumers-financers ought to behave. It provides (neo-Kantian) maxims for ordering /
evaluating empirically observed behavior on the basis of the moral criterion of efficient
• However even if everyman is a compulsive, eternal utility / profit maximizer, the
maximization of individual utility and profit cannot lead to the maximization of total (social)
utility and profit. This is because capitalist order is dominated by the vices of greed
(accumulation) and jealousy (competition). Capitalist individuals maximize utility and profits
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at each other’s expense. Capitalist order is vicious, filthy, rapacious and conflictive. It is not
harmonious as the representative agent macroeconomists pretend by postulating their absurd
model of the national / global capitalist economy. Capitalism is an irrational order even on its
own terms. Aggregate profit / utility (welfare) cannot be maximized. It ought not to be
maximized.
Keynesian macroeconomics was a partial and qualified recognition of the essential
irrationality of capitalist markets. Keynes demonstrated that supply does not create its own
demand and under consumption and over production were systemic tendencies nurturing
capitalist crises. Keynes stressed the non-neutral character of capitalist money, the role of
expectations in investment decision making under uncertainty of outcomes and the cyclical
behavior of aggregate demand and supply. Keynes therefore asserted that the capitalist state had a
crucially important role to play in sustaining full employment, equilibrium and steady state
growth. The capitalist state should use countercyclical fiscal and monetary policy to influence
expectations and expenditures and correct market failures. Keynes advocated that the state should
play a major directional role in the labour market and in the financial market. It should ensure the
existence of high and rising wages, near full employment, low interest rates, stable exchange rates
and restrict capital mobility.
Keynes’ followers such as Clover and above all Hicks developed a methodological
framework for reconciling Keynes and Walras—the leading inspiration behind the neoclassical
school. Clover and Leijonhufrud argued that Walras recognized the possibility that the sum of
effective (as against notional) excess demand could be negative and hence there could be
voluntary unemployment. The argument was that Keynesian analysis applied when there was
disequilibrium while Walras had described capitalism in equilibrium. But the capitalist market
system is constantly—and normally in a state of disequilibrium for without disequilibrium there
can be no accumulation (no “super normal” profit, no surplus). Capitalist markets are mechanism
for realizing / distributing surplus produced outside the market (remember the market is an arena
of exchange, neither of production nor of regulation). It is this necessary disequilibrium between
aggregate supply and demand which requires the existence of debt and credit and assigns a
crucial valuation role to financial markets within capitalist order.
The mainstream Keynesians therefore argued that Keynes was right in seeing the
capitalist market system as having no inherent equilibrating tendency and recognizing the non
neutral character of capitalist money, credit and finance. He was right in emphasizing the
necessary destabilizing role of investment and in seeing values generated in financial markets as
vulnerable to expectation shocks. Hicks cleansed Keynesian analysis of all those elements which
showed that individual capitalist agents when they behaved rationally (i.e. sought their particular
utility / profit maximization) necessarily made the market behave irrationally (i.e. it could not be
an instrument for maximizing aggregate utility / profit). Hicks forgot about Keynes’ concern
about uncertainty, expectations, liquidity preferences and arbitrary determination of asset values
by financial markets in capitalist order. Hicks developed his IS-LM model on the assumption that
expectation, uncertainty and speculative determination of asset values would never affect the
relationship between savings and investment on the one hand and the interest rate and the income
level on the other. Moreover the IS and LM curves were smooth, well behaved (the IS curve
sloping downwards like the aggregate demand curve and the LM curve sloping upwards like the
aggregate supply curve of orthodox economic theory) loci of product and money market
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equilibrium points—the problem of aggregating individual consumption, saving and investment

preferences were thus ignored, jus as the problem of aggregating individual tastes and individual
production response to changes in prices and incomes have been ignored in standard
microeconomic theory. However Hicks argued that because of the existence what he called “a
liquidity trap” the LM curve was likely to be near horizontal at origin and almost vertical at its
apex—increasing money supply would not reduce interest rates and stimulate investment beyond
a floor interest level nor would increase in money supply increase output beyond a ceiling output
level—Keynesian economics was the economics of depression and orthodox economics was
relevant when the capitalist economy was functioning at near full employment levels. Most
orthodox Keynesians believed that normally the capitalist economy reflected a phase where the
LM curve was sloping upwards smoothly and hence a combination of conventional and
Keynesian policies was needed.
During the ‘Golden Age’ (1950–1970) most metropolitan capitalist policy makers
accepted Hick’s view that the money supply and government expenditure were exogenous
variables—not determined by capitalist market forces but under the control of the capitalist states.
The capitalist government was therefore the agency which concatenated individual producer-
consumer-financier rationalities in such a manner that conflict within the capitalist market system
was mitigated and a maximization of aggregate welfare (utility / profit) was achieved.
Representative agents economics rejects the notion of the capitalist state’s over arching rationality
and by re-establishing the microeconomic foundations of macroeconomics insists that the
existence of uncertainty and the arbitrary speculative determination of asset values does not
negate the inherent and essential rationality of capitalist individuality.
Economists hold that capitalist individuals form expectations rationally. These
expectations confirm the prediction of the Hicksian IS-LM model. Thus if the government raised
money supply there would not be a time lag between output and price rise, inflation would occur
intensively because of “rational expectations”. The output level would not rise and state policies
would necessarily be totally ineffective. Everything done by the government would instantly lead to
counter veiling behavior by rational capitalist individuals. The government could do nothing to
stimulate or deflate the economy. All it could do was to synchronize the rate of grown of money
supply and real output. But once it became obvious that in mature capitalist economies—and even
in underdeveloped, imperialist dominated economies such as Pakistan—money supply was
endogenously determined, even this policy role of the capitalist state became suspect and rational
expectations based macroeconomics (sometimes called ‘Monetarism’) fell into disrepute.
Representative agent macroeconomics has usually been seen as an admission of policy
irrelevance. But this is very seriously misleading. When representative agent macroeconomists
analyze behavior as if they were only one consumer, producer and financer in the economy they
are not saying to the capitalist state: “Leave the economy alone, everyman is rational”. Quite the
contrary, they are saying “the representative model provides the authoritative paradigm for
evaluating every man’s behavior, adopt policies to force everyman to behave as a rational
representative agent of capital”. That is why policies of privatization, deregulation, liberalization,
monetary policy marketization, immigration control and corporatization of technology are being
forced upon all countries. That is why representative agent macroeconomics advocates such a
Paul Krugman and Paul Wolfowitz (both Jews) are the most enthusiastic supporters of the never
ending American slaughter in Afghanistan and Iraq. Representative agent macroeconomics is an
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admission of the inherent irrationality of capitalist order and a strident, militant call to arms. “We
will force you to behave as capitalist representative agent and slaughter you if you do not obey us.
There is no alternative!”
Keynesianism survives largely because the representative agent ideology—more
popularly and comprehensively known as neo con economics—has failed to mobilize resources to
enforce capitalist rationality on society as a whole and to eliminate conflict. It articulates the false
pretence that capitalism is rational on its own terms and therefore harmonious. As we have seen
this is a false claim. Capitalism is conflictive, exploitative and unfair. An agency is necessary to
reconcile everyman to the imbalances and frictions generated systemically by capitalist order.
That agency is the state and Keynesian policy therefore remains relevant.
Orthodox Keynesian policies were discredited in the 1970s when the Phillips’ curves
broke down. The Post-Keynesians have argued that these failures occurred because policy makers
failed to take account of two of Keynes fundamental insights—the non neutrality of money on the
one hand and role of uncertainty and expectations in the determination of market outcomes on the
other. Post Keynesians analyze distributional issues and attempts to take account of the political
context and implications of macroeconomic policy making.
Like Keynes the Post Keynesians accept the basic postulates of mainstream economics
but qualify its predictions by reference to capitalist reality—Post Keynesians pride themselves on
their realism. They can be seen as revisionists who insist that changed conditions require a
reinterpretation of economic orthodoxy and a reformulation of economic methodology to take
account for example of accelerated financialization, persistent unemployment, globalisation etc.
The capitalist market economy has changed so drastically that require far reaching revision of
microeconomic analysis. Their microeconomic analysis concentrates on monopolistic pricing and
output decision, the impact of macroeconomic conditions on the firms’ investment decision, the
need to regulate financial markets to ensure that the relative autonomy of the state monetary
authority is preserved and an analysis of firm behavior taking account of decreasing costs
increased scale and the need to preserve capacity, which becomes excessive in times of economic
down turn. Post Keynesians accept the opportunity cost theory of value; some even endorse
rational expectations theory in a qualified form. Neither Keynes nor Post-Keynesians present a
distinct methodology separate from mainstream Economist. Their emphasis is on qualifying
mainstream economics policy conclusions and identifying the limitations of this analysis. The
Post Keynesian represents a qualified, partial departure from economic orthodoxy and in political
terms they provide an analytical framework for the development of Social Democrat policies.
Social Democratic parties in metropolitan capitalist countries—America, France, Germany,
Scandanvia and Japan—have since the mid 1980s moved towards endorsing economic orthodoxy
and many Post Keynesian (sometime called “Right Keynesians”) have sought to justify
Keynesian policies with neoclassical references. Left wing Post-Keynesians have moved closer to
the Sraffians and analytical Marxists.
17.2: SRAFFIANS AND MARXISTS
Peiro Saraffa was the most profound and devastating critic of microeconomic theory in
the history of economic thought. We have drawn extensively on his insights in the chapter on
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factor pricing and supply in this book. His 1926 paper “The Law of returns under competitive
conditions” (published in The Economic Journal) and his slim 1960 monograph Production of
Commodities by Means of Commodities identified fundamental logical flaws in microeconomics
analysis and no mainstream economist has been able to refute Sraffa—although many have tried
and some have even been awarded the Nobel Prize by the imperialists for trying and failing.
Sraffa showed that it was impossible to derive the well behaved individual or aggregate supply
curve and therefore capitalist commodity markets are likely to yield no determinate unique
equilibrium. Neither is there any inherent tendency in these markets to gravitate towards
equilibrium. Sraffa’s theoretical observations have largely been vindicated by empirical studies
based on Chaos theory. Neither capitalist commodity market nor capitalist factor markets
generate a uniquely efficient or equitable (just) price for as Sraffa demonstrates the productivity
of capital does not determine profit. The conception of capital as a generic term has no basis in
logic outside the realm of finance and financial values are arbitrarily determined by speculative
expectations. Therefore the pattern of income distribution generated by capitalist markets does
not represent any technical imperatives for maximizing efficient or equitable utilization of
resources. Rather as Sraffa shows the distribution of incomes generated by market outcomes
reflects the distribution of power within that capitalist order. The rate of profit is an outcome of
the struggle for power between capitalist and workers says Sraffa and it is this rate of profit which
determines the price of finance (or capital in general). The rate of profit reflects the relative
power of capitalist and workers and is not determined by the marginal productivity of capital—
the technical capability of factories or otherwise of speculative expectations about investment
outcomes. The essential incoherence of neoclassical analysis has thus been convincingly
demonstrated by Sraffa. Capitalism is not a rational system in the sense that the ends it sets itself
cannot be realized. Political force must be employed to sustain the social acceptability of
capitalist market outcomes.
Thus Sraffa negates the utility theory of value and the marginal cost theory of price. As
we shall see below he also rejects the labour theory of value. However he seems to have
presented no coherent theory of value himself. Indeed most Sraffian economists—Ian Stedman
for example—argue that the concept of a “theory of value” is unnecessary for understanding
capitalist economics.
Sraffa subtitled his “Production of Commodities by Mean of Commodities” monograph
as a “Prelude to a critique of economic theory”. Although he lived for more than a quarter of a
century after the publication of “The Production of Commodities” (he died in 1983) he never
wrote this promised critique. Modern Sraffians continue in this tradition of excavating the hidden
assumptions underlying microeconomics, evaluating the relevance of these assumptions to
capitalist market reality and exposing the incoherence of microeconomic analysis. Sraffa’s
original motivation, as evident in his 1926 paper, was to make microeconomic analysis more
useful for capitalist businessmen. In this article he argued that the firm should be modeled so that
account could be taken of the necessary expense of marketing non homogenous products to non
homogeneous customers and the implication of the growth of finalization (he called it ‘credit
growth’) on the optimum size of the firm. He emphasized the need for microeconomics to focus
on “issues of importance to businessmen”. It is therefore somewhat paradoxical to see Sraffa as a
radical critic of capitalism. He is a radical critique of microeconomic theory only—not of
capitalist order. He wants to develop a more realistic and useful theory for sustaining capitalist
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order and in this has much more in common with Keynesians and Post Keynesians rather than
with Marx’s followers who are in principle committed to transcendence from market capitalism
to state capitalism. Sraffa’s criticism of microeconomics goes much further than the criticism
presented by Keynesians, however like them he fails to develop an alternative framework for the
analysis of the capitalist transaction form. His key finding that prices of commodities are
determined by the distribution of power between classes simply leads to the more fundamental
question: what determines this distribution of power and how is it sustained. Neither Sraffa nor
any of his followers have been able to seriously address this question. This is one reason why
Sraffian economists have generally moved away from dynamic analysis and from issues raised by
complexity (chaos) theory in particular.
Marx described (what we now call) microeconomics as ‘Vulgar economics’ and
contrasted it with ‘political economy’ (the thought of Ricardo, Smith etc). He was of course
writing at a time when neoclassical economics was not fully articulated and systemically
synthesized. Marx published Capital Vol. 1 in 1871 and died in 1883 and the key propositions of
modern microeconomics were synthesized in the late 1890s by (e.g.) Marshall. Marxists see
economics as a legitimating paradigm for (market) capitalist exploitation. In the Marxist view
exploitation takes place through the labour process where surplus product takes the form of
surplus value appropriated through the private ownership of the means of production. The market
is the arena for the realization of this surplus value in the form of gross profit and the distribution
of the gross profit in the form of rent, interest and net profit. Money is not neutral. It is the “nexus
rerum” of capitalist order and plays a crucially important role in the conversion of surplus product
into surplus value. Capitalism is seen as passing through several stages—petty commodity
production, finance capitalism, monopoly capitalism, imperialism etc. The relationship of the
commodity market to the market for labour and finance changes as capitalism passes through
these phases as does the relationship of the market to the state. On the whole the Marxists argue
that in the capitalist development process the role of the state is enhanced as an instrument for the
articulation of the dictatorship of the proletariat.
Marxists argue that the capital market system is ridden with contradiction. It is not
harmonious but conflictive. Capitalists are the private owners of the means of production—they
exploit and prey upon the workers but the increasing concentration and centralization of capital
creates opportunities for the working class to organize itself into a “class for itself”. It may gather
under the leadership of a vanguard party which may succeed in making a revolution.
The essence of this revolution is the abolition of the private ownership of the means of
production and the abolition of the market. In the USSR and in People’s China (until recently)
means of production were (on the whole) socially owned and prices and output decisions were
made through periodic national plans. The plan was an essential instrument for the exercise of the
dictatorship of the proletariat and the market (though never abolished) was subordinated to the
plan. The purpose of planning however remained the maximization of capital accumulation
(surplus). It is important to stress that this maximization of the rate of capital (surplus)
accumulation was an end in itself. It was just not necessitated by the need to compete with the
West. This is so because Marx believes that a principle consequence of the establishment of the
dictatorship of the proletariat would be an exponential growth of production and consumption.
Without this exponential growth of production the transition to communism would not be
achieved and communism was the stage when everyone could satisfy unlimited wants. Marx was
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an Enlightenment ideologist and like Kant, Hegel, Mill and Habermas he conceived of freedom as
everyman’s ability to do whatever he wants to do through subjecting universal material forces to
his will. It is the ultimate commitment to capital accumulation (freedom) as an end in itself which
justifies calling the USSR and China and Cuba and Vietnam and all other socialist orders state
capitalist. The essential failure of these regimes originates in the fact that they endorse capitalist
individuality. They continue to seek freedom, equality and progress for a class or state which in
their view is representative of all of humanity. But if freedom and progress is legitimated at the
collective / macro level there can be no moral transcendence at the level of individual
consciousness. That is why “socialist man” and “specie being” and “New Man” never appeared in
the USSR and China and the citizen of socialist republics continued to be personally
accumulative and competitive. Both Gorbachev and Deng Zhao Peng abandoned the quest for
socialist individuality and sought to harness individual acquisitiveness and competition for the
construction and sustenance of state capitalism in the USSR and China. Competition among state
owned enterprises and their relative autonomy from the central planning authority was first
legitimated by Tito after his break with Stalin in the late 1940s. Yugoslavia practiced “self
management” of its industrial system until its disintegration during the 1990s.
The upheavals in East Europe—which began with the Hungarian upraising in 1956 and
culminated in the collapse of the Soviet Union in 1991—had profound impact on Marxist
thought. Some would argue that Marxist disenhancement with Marx’s critique of capitalism
began much earlier—with Bernstein’s revisionist interpretations at the turn of the 20th century and
Lenin’s New Economic policy (1921–1924). The leading Marxist economics school today is that
of the Analytical Marxists whose leading proponents—Morishima, Roemer, Itoh—distance
themselves from Marx’s theory of value, endorse competition, efficiency and “market socialism”
and the policies they advocate are almost identical with those of the Post-Keynesians. Classical
Marxism is now virtually dead and Analytical Marxism has adopted the methodological
framework of mainstream economics. Marxism therefore has almost nothing to offer for
understanding contemporary capitalism. Ludwig Von Mises showed almost a hundred years ago
that the outcomes generated through a system of perfect planning would be identical to the
outcome configurations generated by a perfectly competitive market system. This is not
surprising since both are mechanisms for maximizing utility / profit and the rate of capital
accumulation. Analytical Marxism endorses this finding and concentrates its analysis on showing
why actually existing capitalism fails to realize this result. Social ownership of the means of
production is necessary for moving capitalist order from (output reducing) monopoly to
efficiency maximizing competition. So say the Analytical Marxist.
17.3: ISLAMIC ECONOMICS
Capitalism is profoundly anti-religious. It comes into existence by de-legitimating

religious knowledge, devaluing religious virtues (poverty, charity) in individual consciousness,
restructuring society on the basis of universal contract rather than universal love and establishing
a political order which replaces divine sovereignty with the sovereignty of human will as its
fundamental governance principle. Capitalism emerged historically by destroying Christian social
order in Europe. Today capitalism is seeking to destroy Islam in Asia and Africa.
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From the 16th century onwards religious leaders have sought to find a niche for religion
within capitalist order. This was natural for thinkers such as Calvin and Luther and Berkley for
Christianity has endorsed secularism since the time of St Augustine (4th century A.D). They
believed that national monarchs (who established the precursors of capitalist states) could behave
much as the Holy Roman Emperor had done for several centuries and sanction the authority of
the Church in the governance of personal lives and social order. In this they were profoundly
mistaken and the containment and infiltration of Calvin’s Saris Republic and Cromwell’s Puritan
regime showed that capitalism was an all encompassing totalizer. It sought to and succeeded in
creating its won individuality, society and state.
As both Weber and Tawney have shown (though in different ways) the Christian
legitimating of capitalist transactions—especially in the money market—was essentially a state
sponsored project reliant upon the power of the European princes. Islamic economics is exactly
the same project. It emerged as a Saudi Arabian initiative after the American protégé. Faisal
seized power in Riyadh with the help of the US Air Force. The Americans were concerned to
build up Faisal’s legitimacy as a Muslim world leader to counter the influence of Jamal Abdel
Nasir, who had joined the Soviet camp after the Suez war of 1956.
Faisal became a champion of Islam. He gave refuge to Islamic scholars who were being
persecuted and tortured by Nasir accommodated them within the Saudi bureaucracy and
universities. Ambitious young men from within the Islamic parties of Egypt, Sudan, Pakistan and
India saw this as an opportunity to build their career and create popular international Muslim
support for Saudi policies, especially the policy to ally Muslim groups and countries with
America. Islamic Economics was the most important epistemological paradigm developed
through Saudi sponsorship to reconcile Islam and capitalism. The central message of Islamic
Economics is that Islam is entirely compatible with capitalism.
Islamic Economics has been described as “a branch of neoclassical economics … a series
of minor qualifications to neo classical themes and texts”. Islamic Economics—an authoritative
summary statement is to be found in Maulana Taqi Usmani’s monograph Islam aur jadeed
maee’shat-o-tejarat—accepts economics as a value neutral science based on the laws of nature.
The Laws of Demand and Supply are natural laws and price should be determined through their
unimpeded functioning. Perfectly competitive market equilibrium generates output and price
configurations which Islam recognizes as just; i.e. both efficient and equitable. Capitalist property
is fully endorsed. The corporate property form and the transfer of ownership rights through
continuous speculative market transactions is fully endorsed. The consumer is naturally a utility
maximizer. He is not legally obliged to order his preferences according to the Shariah except that
he should abstain from what is explicitly haram. Similarly according to Islamic Economics the
producer and trader has right to seek maximization of profits. Accumulation as an end in itself
and the commodification of money is thus legitimated. The explosive growth of the Islamic
banking and finance industry as an adjunct to the world’s money and capitalist markets is a
practical manifestation of this legitimation. As Henry and Wilson have shown billions of dollars
are transferred to the West through Islamic banks and Islamic funds owned in the main by major
capitalist finance houses.
According to Maulana Usmani, “Islam does not possess an economic system of its own.
It fully endorses the market system and the profit motive”, [Islam aur jadeed maee’shat-o-tejarat
(p. 38–39)]. Therefore capitalist norms are legitimate and the utility / profit maximization
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objective is the purpose of resource allocation in the market. Incorporation of the economics of
Muslim countries within global capitalist order is welcome since it would facilitate the optimum
utilization of resources.
According to the Islamic economists the Shariah is not a set of prohibition on capitalist
practices but a means for promoting the long run self interest of citizens of capitalist states.
Maulana Usmani argues that taking account of the Shariah injunctions (of halal and haram for
example) strengthens the operation of the laws of demand and supply and eliminates
monopolistic tendencies within capitalist markets. Shariah constraints on production and
consumption are thus justified on rule utilitarian grounds. They are seen as necessary for realizing
the full utility / profit maximization potential of the capitalist economy. Islamic Economics is an
attempt to formulate principles and policies for establishment of capitalist justice by eliminating
unnecessary inefficiency and inequity from capitalist order.
The technical writings of the Islamic economists formulate the utility / welfare function
in a typically neoclassical manner. The theory of demand—detailing determinants of shifts in and
movement along the individual demand and the legitimacy of aggregating individual preference
schedules—is fully endorsed for non haram commodities as are conceptions of marginal utility,
laws of return, elasticity etc. Altruistic concerns such as taking account of one’s utility
maximizing action on the utility of others are sometimes taken into account in theorizing the
consumption function. Such concerns are however integrated within the framework of orthodox
consumer preference and rational choice theory. The list of products, especially financial
products, considered to be prohibited by Islamic Economics is being gradually reduced and this
once again reminds one of the similar relaxations of prohibitions by Christian clerics in the
nineteenth century. Islamic Economics holds that the perfectly competitive capitalist market
regulated by a night watchman capitalist state generates uniquely equitable and efficiently
maximizing equilibrium output and price configurations. The concept of “general equilibrium” is
enthusiastically endorsed in the technical writings of Islamic economists.
Factor market functioning and regulation is theorized by Islamic Economics on
neoclassical grounds. Capitalist property and capitalist employment contracts are recognized as
legitimate by Islamic Economics. Factor markets (both labour and finance) are seen as
functioning on the basis of the same demand and supply principle that determine product market
outcomes. Hence neoclassical labor market analysis is fully endorsed. Wages are seen as being
determined by the marginal productivity of labour. The interest equivalents sanctioned by Islamic
Finance theory are expected to reflect the marginal productivity of capital—this is the basis for
accepting the risk free interest rate as the basis for pricing Islamic financial products. Wage
flexibility is applauded and institutional mechanisms creating rigidity are deplored. The
neoclassical labour demand and supply curves are all endorsed by Islamic Economics, sometimes
with minor modifications along Keynesian lines to create room for collective bargaining in the
wage determination process. Both Keynesians and Islamic economists argue that this is not
inconsistent with the systemic determination of wages on the basis of the marginal revenue
productivity principle. There is of course no conception of transcending the capitalist
employment on finance contract within Islamic Economics since Islamic Economics legitimates
capitalist norms and the associated capitalist property form.
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Islamic Economics can thus be seen as a minor revision of conventional microeconomics

theory and practices. A more substantive revision—while endorsing capitalist norms in the same
way as done by the Islamic economist—is provided by Institutional Economics.
17.4: INSTITUTIONAL ECONOMICS
Institutional Economics bases itself on the work of the anti Marxist, Austrian and German
theorists writing in the late nineteenth and early twentieth century—Menger, Schmoller, Weiser
and Weber among others. These scholars endorsed the meta-ethical assumptions of the
neoclassical school but tried to modify its methodology by criticizing the concept of equilibrium.
These authors celebrate disequilibrium since it allows the capitalist / entrepreneur to make
“supernormal” profit and thus realize capitalism’s full potential as a dynamic and adaptive
system. Capitalist order, argue these thinkers, is best suited to deal with uncertainty which is
systematically structured into capitalist business decision making processes. The marginal
productivity theory of income distribution is qualified to take account of disequilibrium and
uncertainty. However the precursors of the Institutional Economics School have strong faith in
the self regulatory capacity of the capitalist system, its capacity to sustain disequilibrium now and
to benefit from it in a manner which allows capitalism to reach higher and higher levels of
productivity growth later. State interference with the market is strongly deplored and as Hayek, the
most preeminent successor of the Institutionalist precursors, argues the “visible foot” of the state
stamps out the work of the “invisible hand” within the capitalist market. Hayek and other
economists writing in this tradition have argued that the welfare state’s control of money supply has
been a major cause of business cycles. State monopoly control over money supply—which is seen
as absolute—should be abolished and the comprehensive privatization of the money market should
be institutionalized. The level of money supply and the structure of interest rates should be
determined in freely functioning money markets.
Karl Manger and Bohn Bahker emphasized the natural character of capitalist institutions,
i.e. property, money, credit, division of labour, trade etc. Both Manger and Hayek spent a lifetime
tracing the historical development of these institutions. Their central claim is that these
institutions have evolved spontaneously as expressions of the growth of human rationality.
Capitalist institutions are universal, natural, rational and untranscendible precisely because of this
spontaneous evolution. They have not been consciously engineered by a central authority
claiming a monopoly of knowledge. Comprehensive social planning is impossible because
knowledge appears in history as the unintended consequence of competitive and accumulative
pursuit of self interest by capitalist individuals. The capitalist state should thus refrain from
regulating the natural and rational evolution of capitalist market institutions
Institutional Economics suffered something of a decline during the first half of the
twentieth century due to the eclipse of the influence of the German Historical School and of
American authors such as Henry George and Theorstein Veblen. Since the 1950s there has been a
relegitimation of Institutionalist themes within mainstream economics due to the success of
authors such as Robert Coase, Douglas North and Oliver Williamson in refocusing Institutional
Economics so that it has become a supplement to neoclassical analyses. Modern revisionist
Institutionalists (Coase, North, Williamson and their followers) argue that institutions—defined
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as rules, enforcement mechanisms and beaurocratic hierarchies—should be designed to support

market transactions. These institutions have four crucial functions (a) legitimate capitalist
property (b) enforce capitalist contracts (c) structure informational transmissions and (d) manage
monopolistic / oligopolistic competition.
Orthodox Institutionalists—Karl Manger, Max Weber and recently Hayek—saw
themselves as “evolutionists”. Their central message was that (a) history is a process through
which Reason triumphs over unreason (b) capitalist institutions—corporate property, division of
labor, finance—reflect a rational restructuring of norms, procedures and organizational
hierarchies which (c) takes place spontaneously and unintentionally. Hence the orthodox
Institutionalists were concerned with justifying capitalist institutions, not with designing them.
On the other hand designing institutions for the legitimation of capitalist property and the
enforcement of capitalist contracts are the principle concern of modern revisionist
Institutionalists. They accept that the institutions which emerged after the triumph of capitalism in
Western Europe and America are quintessential expressions of human rationality. These
institutions are seen as the ideal types which should be the basis for evaluating all institutions
everywhere in the world and at all times. All institutions everywhere should be modeled on the
institutions which emerged spontaneously and unintentionally in Europe and America in the
eighteenth / nineteenth centuries.
However the revisionist Institutionalists assert there is no guarantee that this “modeling”
will take place spontaneously and unintentionally. Revisionist Institutionalists (sometimes called
“Neo institutionalists”) accept the Marxist teaching that non Europeans “are people without a
history”. Asians and Africans are savages like the Red Indians and the Aborigines of Australia.
Unfortunately America and NATO do not have the capability to slaughter all Asians and Africans
as America slaughtered eighty million Red Indians. Since all Asians and Africans cannot be
slaughtered—witness America’s failures in Iraq and Afghanistan and Somalia—they have to be
forced to design capitalist institutions. “Rational Institutionalization” has to be rammed down the
throats of Asian and African nationals through World Bank and IMF sponsored Structural
Adjustment and Poverty and Growth Reduction Assistance programs.
Oliver Williamson the leading contemporary Neo Institutionalist is also widely credited
with the primary authorship of the imperialist Washington Consensus. It was recognized that
Washington Consensus policies could be effectively implemented only if the subject people on
whom these policies were being imposed submitted to (or internalized) capitalist rationality. A
key element of World Bank policy intervention in Asian and African countries (and also of it’s
subordinate agencies such as the Asian Development Bank, the African Development Bank and
the Islamic Development Bank) became the designing and restructuring of institutions which
could:
• Increase monopolistic market competition.
• Reduce the social embeddedness of production, consumption and distribution units and
networks—i.e. destroy the traditional bazzar (sabzi mandi) and the extended family (the
Zhaghzai tribe) as an economic unit
• Commodify and corporatize information
• Impose capitalist quality and accountancy (‘disclosure’ and ‘corporate governance’)
standards on an ever broadening range of production and trading activities.
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• Financialize more and more production and trading activities and enhancing their
securitization and risk trading the social hegemony of money and capital markets and
establishment of the interest rate and stock prices as the key value referents throughout
society. The enhancement of the scope of insurance markets is of key importance in this
context
• Universalize capitalist property by systematically (institutionally / legally) relating earnings
to the rate of growth of capital accumulation
• Restructure civil and judicial administration and all state bureaucratic hierarchies in general
so that they become primarily focused on the defense of capitalist property rights the
enforcement of capitalist contracts and on the facilitation of capital accumulation as the
socially legitimated supreme end in itself.
The World Bank advises that the institutional redesigning process in Asian and African
countries should begin by asking the question “what is inhibiting the development of markets?”
Institutional design should then explicitly relate to the weaknesses of existing and missing markets
and the concern / objective of institutional redesign should be to strengthen capitalist market growth
and sustain capitalist individuality. As capitalist markets and capitalist individuality strengthen and
evolve the institutional infrastructure must reactively adapt to this re-articulation of capitalist
rationality. Institutions should thus serve as the hand maiden of capitalist individuality, capitalist
markets and civil (anti–religious) society. Since capitalist institutions are seen as “rational” the
World Bank thinks that they can easily be transplanted from America to Pakistan “(Pakistan) do(es)
not have to go through a long learning process in institutional development (Pakistan) can
complement and modify institutional forms and learn from America”.
In any case imperialist pressure is being exercised to force Asian and African countries to
submit to international norms, standards and procedures leading to enforced and compulsive
institutional restructuring. Pakistan is being coerced not just by the WTO, the IMF, the World
Bank, the Asian Development Bank and the Islamic Development Bank but also by the
International Accounting Standards Organization (ISO) and the financial rating agencies. The
purpose of this coercion is to force Pakistan to dissemble its institutional infra structure rooted in
Pakistan’s own norms and historical traditions and to rebase these institutions on internationally
legitimated capitalist norms, procedures and standards.
An important consequence of this rebasing of the institutional structure of Asian and
African countries is the destruction of the old blood and tradition based communities (biradries in
Pakistan) and the increased social dominance of interest based networks. What unites people
within the later type of networks is “interest tangentiality”, they identify with other as members of
a group, not because they love each other but because of the utility of others in the pursuit of
one’s own self-interest. Thus a “cyber community” has come into existence linking members of
the elite in imperialist countries and in the neo-colonies of Asia and Africa. Members of this
interest based “community” perceive a significant common self-interest in the continued
hegemony of global capitalist order. Building and sustaining such “interest communities” and
destroying bridaries is a key project assigned to imperialist sponsored and funded NGOs in Asia
and Africa. The World Bank also advocates the wholesale import of laws, procedures and
enforcement systems from the West to facilitate interest based community building in Asia and
Africa. It also recommends the “export of the enforcement of contracts”—Asia and Africa should
let America decide all judicial issues relevant to market transactions. Reducing jurisdictional
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authority of Asian and African states and eroding their national sovereignty is the key to the
building of internationally linked interest based communities. Localization and decentralization
of state authority in Asia and Africa are thus crucially important aspects of the imperialist project
for coercing Asian and African countries to undertake institutional restructuring.
Revisionist Neo-Institutionalist Economics can be seen as “pre-microeconomics” in the
sense that it tries to set out the social arrangements that are required to induce and force everyman
to behave as a capitalist individual / rational agent should behave. In other words, it prepares the
grounds for the application of microeconomic principles and policies which emanate from the
application of these principles. Adam Smith had also spent a great deal of time in both The
Wealth of Nations and The Theory of Moral Sentiments in setting out the institutional
arrangements required for the growth of the market and the continued expansion of the division
of labor. Like the modern, Neo-Institutionalist Smith had focused his attention on the education,
judicial and civil administration systems arguing that a capitalist restructuring was essential both
for the emergence and sustenance of capitalist individuality and for articulating the systemic
social dominance of the market. Like the revisionist Institutionalists, Smith was theorizing about
how to turn an undeveloped mainly pre-capitalist society in which capitalist governing elite had
recently captured power (eighteenth century Britain) into a mature capitalist order. Modern
revisionist neo-institutionalists can be seen as extending / reviving this Smithian tradition and their
work therefore has a complimentary relationship with microeconomics.
Behavioral economics—which we examine in the next section of this chapter—shows that
sustaining capitalist individuality and its social dominance is a contradiction ridden and necessarily
never completed project. Behavioral economics tries to modify some assumptions underlying
microeconomic analysis to take account of this uncomfortable fact to ensure that microeconomic
analysis better corresponds to capitalist reality.
17.5: BEHAVIORAL ECONOMICS
Behavioral Economics is being increasingly incorporated in microeconomics. It is no

longer a sub-discipline. Microeconomics accepts that behavioral economics draws attention to
facts and issues that should be taken into account by economic analysis and this can be done be a
broadening of the scope of mainstream microeconomic models of market operations.
“Behaviorally informal” microeconomics generates more accurate predictions without requiring a
fundamental change of methodological premises. Therefore, an explicit objective of behavioral
economists is to get their analyses recognized a “normal economics”.
Essentially Behavioral Economics is the application of the principles of orthodox
psychology to the analysis of capitalist agents in capitalist markets behavior. The standard
behavioral economics approach is to modify some assumptions of microeconomics analysis to
reflect some psychological consideration in order to make the microeconomic model more
“realistic”. Whether the modification of these selected assumptions leads to an erosion of the
“realism” of the other (non modified) assumptions of the microeconomic model is rarely
considered.
Behavioral Economics organizes around experimental findings that suggest
“incompleteness” of standard microeconomic analysis. We will now briefly review some major
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themes of modern Behavioral Economics. (An excellent recent survey has been published by C.
Camerer et al Advances in Behavioral Economics, Princeton 2006).
Expected Utility Theory
Standard expected utility theory assumes what is known as “the independence axiom”.
Formally this axiom can be stated as follows: the frequency with which a utility maximizing
individual chooses between package p over package q does not change when both packages are
mixed with some common package r. Behavioral economists have consistently shown that this
assumption is false. They have developed “Prospect Theory” to deal with the unrealism of this
fundamental assumption of Expected Utility Theory. They show that when analyzing choice
under uncertainty it is not enough to know the packages (usually called “lotteries”) over which
the utility maximizer is exercising his choices. The theorist must also know the utility
maximizing agent’s situation at the time the choice is being made. Experiments designed by
Behavioral economists have shown that the utility maximizing agents evaluate gains and losses
from specific choices in different situations. There is a specific situation reference point from
which choices are evaluated. Expected utility theory is thus modified to take account of the
situation specificity of the choice process.
The Endowment Effect
In standard microeconomic analysis demand is a function of income / wealth and prices.

Behavioral economists argue that this does not take account of the dependence of wealth prices
on a chooser’s “endowment”. Experiments undertaken by them have shown that a chooser values
a good more if it is part of his endowment than if it is not. The “endowment point” is a reference
point and utility maximizing choosers are shown to have a kink in their evaluation around this
“endowment point”.
Hyperbolic Discounting
Standard choice theory assumes that inter temporal choices do not depend on the decision
date. Whether the utility maximizing agent chooses consumption in the initial or sequential
periods has no effect on the choices if the budget constraint is the same in both cases. Behavioral
experiments show an “immediacy effect”. Utility maximizing agents display a tendency to choose
earlier smaller rewards over later larger rewards when the smaller earlier rewards offer immediate
satisfaction but reverse this preference when satisfaction is delayed.
Social Preferences
Standard microeconomic theory assumes that a utility maximizing agent’s choice

depends only on his own monetary pay off. Behavioral experiments have shown that in utility
calculations individuals take account of the effect of choices not only on their own but also on
others’ monetary pay off—remember Islamic microeconomists have also argued that this is what
the “Islamic consumer is ought to do”. Behavioral experiments also show that individual utility
maximizer agents are influenced in their choices by the character of the agents they are
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interacting with in the exercise of their choice. Thus, a utility maximizing chooser is more likely
to take account of the impact of his choice on the utility of a person who has the character that the
chooser approves of—a “good Muslim” in making his own utility calculation would pay greater
attention to the impact of his choice on the utility of other “good Muslims” rather than on the
utility of non good Muslims. Islamic economics and Behavioral economics (especially in social
preference applications) have strong convergence tendencies.
The focus of Behavioral Economics is on individual choice of utility maximizer and on
motives underlying that choice. Behavioral analysis starts with psychological experiments that
show violation of some assumptions of some microeconomic theory. New variables are then
added to the standard theory which “explain” deviation from the predictions of standard models
and describe systematic biases in decision making. Usually behavioral research ends up by
showing how these systematic “irrationalities” (often called “baises”) can be accommodated
within the microeconomic framework of analysis. Behavioral Economics seeks to develop more
“realistic” definitions of the objective function and its constraints that the utility maximizing
agent seeks to maximize. However microeconomists have often found it difficult to measure
using economic data the new variables that the Behavioralists suggest should be taken account of.
Usually, it is impossible to identify the “reference point” of Prospect theory of the consumers in
actually existing markets in an unambiguous manner. Moreover as we have stressed throughout
this book microeconomics is above all a moral science. The key question therefore is ‘what is the
optimum reference point that a rational utility maximizing consumer ought to have, so that
existing empirically verified reference points of utility maximizing agents can be evaluated on
that basis of the optimum? Behavioral economics is of course constitutionally incapable of
addressing this issue. Essentially Behavioral Economists spell out the manifold difficulties that
choosers face in acting “rationally”. Behavioral Economics shows how difficult it is for a normal
person to act and feel as microeconomics expects / instructs him to do. Men cannot perform the
mental tasks embodied in the assumptions underlying microeconomic models or can do this only
with extreme difficulty. Some features of the optimization procedure are typically performed
incorrectly by the typical decision maker. Behavioral economists assume that such irrational /
incorrect behavior can be taken account of without abandoning the microeconomics paradigm.
Some Behavioral analysis can be interpreted as producing some hints on how choosers can be
induced / forced to behave “rationally”. But the question why choosers “ought” to behave
“rationally” cannot of course be answered by any economic school—microeconomics, Marxist,
Sraffian, Institutionalist, Islamic, Behavioral whatever.
Behavioral Economics has psychological foundations—indeed it is sometimes described
as “economic psychology”. It explores the psychological mechanisms behind the economic
behavior of a typical capitalist chooser (investor / consumer / policy maker) within capitalist
society, identifying the difficulties he faces in acting “rationally” (i.e maximizing his utility in a
manner which maximizes the rate of capital accumulation in society as a whole). The central
message of Behavioral Economics is that standard microeconomics models should become more
realistic. Assumptions underlying these models should be modified to take accounts of the
“realities” of behavioral regularities within actually existing (mature) capitalist societies. Most
Behavioral analysis is focused on showing that minor changes in microeconomic models, leaving
the basic microeconomic theory unchanged, are required to make these models more realistic.
Standard models should in particular take account of the context dependence of decision making
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by capitalist choosers. But the key questions for microeconomics is of course, how can the
capitalist chooser be induced / concerned to abandon his many “irrationalities” and choose as he
“ought” to choose. The social science discipline which directly addresses this question nearest to
Economics is Management. We now turn to an analysis of the answer to this question from
management theory. Management sciences take up this crucially important issue of capitalist
governance.
17.6: MANAGEMENT SCIENCES
As we have seen in this book economics has the following main purposes:
• To justify capitalist norms, regulatory procedures and transaction forms
• To develop ideal types ‘models’ against which the behavior of actually existing individuals,
societies and sates can be evaluated
• To develop policies which can induce and force individuals, institutions and governments to
adopt capitalist norms, behavior patterns and regulatory procedures
Microeconomics is principally concerned with the first two objectives. It justifies capitalist
market order by pretending that it provides a value neutral analytical ‘box of tools’ which can be
utilized to achieve the optimal allocation of resources. It shows how society functions equitably
and efficiently (both terms defined on the basis of capitalist epistemology) when people are fully
capitalistically rational. These models of perfectly rational behavior provide a basis for assessing
price and output determination processes within both product and factor markets. They show how
consumers, producers and regulators ought to behave so that capitalistically optimal resource
allocation can be achieved and sustained.
Microeconomics is however weak as far as its policy prescriptions are concerned. It
subscribes to Smith’s “invisible hand” and Manger and Hayek’s “spontaneity” doctrines. Once
capitalist property rights are enforced (‘law and order’ ensured says Smith) capitalist markets will
spontaneously, unintentionally, necessarily and continuously produce optimal equilibrium
outcomes. Even the Institutionalist and Evolutionists recognize that this is a very naive and
simplistic model of actually existing capitalisms. People do not normally behave as capitalism
says they ought to (remember the behavior patterns of Abdullah Zhaghzai and his family
members). They have to be forced to accept capitalist norms. Force is exercised within society
and within the state.
The key capitalist institution is not the market but the corporation. Markets exist in non-
capitalist societies; corporations on the other hand are peculiar to capitalism (as is finance).
Capitalism created the corporation. The corporation is a legal person totally dedicated to the
maximization of shareholders’ value. Corporations can exist only within capitalist order, for the
maximization of (surplus) value—accumulation as an end in itself—has never been recognized as
the raison d’etre of any non capitalist society throughout human history, corporations are the
quintessential form of capitalist property. It is only when corporations achieve hegemony within a
market that it becomes a capitalist market. If corporations do not exist or are subordinated to non
capitalist property forms the market is not a capitalist market. Like our Sabzi Mandi it remains a
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socially embedded bazar whose output and price configurations do not reflect a quest for
continuously higher levels of capital accumulation.
It is the science of Management and not microeconomics which focuses theoretical attention
on how decisions are made within the corporations and among corporations. Since these are extra
market; a prior decisions—decisions the corporation takes before it enters the market—
microeconomics has almost nothing to say about them. It calls the corporation, a “firm” and in
most microeconomic analysis the firm is treated as a mysterious closed “black box”.
Management is also specific to capitalist order. Management subsumes administration as
the market subsumes the bazzar and corporation subsumes property in capitalist order.
Management is unknown in Islamic history before the imperialist conquest. We built and rebuilt
the Ka’aba over several centuries, organized trade spanning four continents, developed an all
Asia transport and communications network, undertook incessant jihad for a thousand and four
hundred years all without any study and practice of Management.
Management does not exist in non-capitalist society because management is dedicated to
deploying resources to produce continuous maximization of surplus. The corporation turns
private property into a legal fiction—the share holder “owns” the corporation just as much as the
citizen of the USSR “owned” the Socialist Republic and participated in the exercise of the
dictatorship of the proletariat. This devaluation of private property leads to the transfer of control
of the resources of the corporation from its legal owners to those trained to use these resources to
realize surplus, the corporations’ raison d’etre. Managers monopolize “knowledge” on the basis
of which resources are used solely for the purpose of a continuing, never ending increase in their
quantity (capital accumulation). This is known as ‘efficiency’ in capitalist epistemology.
As we have said capitalism’s central value is freedom. Capitalist individuality is nurtured
not through repression but through freedom. Promoting freedom requires that the preference for
preference itself (capital accumulation as an end in itself) be prioritized over all specific
preferences. A famous French philosopher of the twentieth century Michel Foucault said that
capitalism requires a delicate balancing of “unity” and “diversity”. Simply put this means that
every capitalist individual must:
(a) dedicate his life principally to accumulation
(b) be willing to explore many varied ways through which accumulation is achieved and
accelerated
Capitalist order has a unifying purpose—the maximization of utility / profit / rate of
accumulation—but seeks the achievement of this purpose through an ever expanding diversity of
thought and acts. Management, particularly self-management and self-discipline are crucial in
capitalist order because it is through management that diversity of thought and action is organized
in a manner which sustain continuing accumulation as the raison d’etre for individual being and
social life.
This becomes evident when we examine management theory. Management theory is an
American project. It appeared as an academic discipline in the universities of Pennsylvania and
Chicago in the late nineteenth century. Management is par excellence a multidisciplinary theory.
It combines themes from psychology, sociology, cultural anthropology, philosophy, political
science, economics, mathematics and statistics.
A first attempt to provide a coherent theoretical framework for the study of management
was developed in Henri Fayel’s theory of Universal Management Process. He argued that
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management consisted of the performance of five basic functions (a) planning (b) organizing (c)
commanding (d) coordinating and (e) controlling the managed. Management in Fayal’s view is a
process which begins with planning and culminates in controlling the managed. The purpose for
which these functions are performed is the achievement of efficiency defined in all management
literature as the production of greater output value with lower input costs. Fayal saw management
as an orderly and rational process and Frederick Taylor—the inventor of ‘scientific
management’—built upon this view. This approach focused upon improving quality cutting costs
and systematizing work processes. Taylor sought to create “a mental revolution” in both
managers and workers so that they saw each other as allies and not antagonists.
Taylor sought to derive “best practice” operational standards through systemic
observation, experimentation and analysis of various aspects of the work process. On the basis of
extensive time and task studies, Taylor made recommendation about work process reorganization,
employee selection and training and worker remuneration systems. He saw the capitalist worker
as being primarily motivated by high wages and developed a complex remuneration system
which links productivity and wage growth. Taylorist’s methods often proved very effective in
raising productivity and reducing costs at the plant level. Work motion study was developed into
something like an exact science by Taylor’s followers. Attempts were made by them to combine
production and cost control techniques and this led to the evolution of a more complex view of
worker motivation. Joseph Jaran taught management to view the worker as “an internal
customer”. The worker was to be motivated through teamwork, partnership, problem solving and
brainstorming. Other “stakeholders” specially those within the corporatist supply chain could also
be motivated through the use of these methods. The emphasis on quality management emerged
from these insights. Feigenbaum showed that ultimately it was the customer who determined
quality—quality was therefore a subjective, not an objective factor and managing customer
preference was the key quality improvement. Operations management showed how important this
was in purchase, inventory management, product and service design, design of the work flow
process and data processing and communication.
This concern with worker, suppliers and customer perception facilitated the emergence of the
Human Relations management school. In this view successful management requires that a manager be
capable of working effectively with people of diverse backgrounds, perceptions and motivations. The
manager must be capable of fusing this diversity into the singularity of accelerated capital
accumulation (efficiency and productivity growth). HRM instructs managers to be particularly
sensitive to employee diversity.
Human resource management (HRM) is an explicit response to the growth of
unionization in America. It emerged as a reaction to the 1935 Wagnar Act which recognized the
unions’ right to collective bargaining. HRM preaches that satisfied workers are less likely to join
unions. Productivity could be enhanced by changing the attitude of the worker towards each other
and towards management. HRM researchers tried to show that emotional factors were more
important determining factors of productivity growth than physical aspects—such as lighting, job
description and formal organizational communication systems, etc. Management should
consciously foster worker enjoyment of work. Mary Follett, a pioneering HRM philosopher,
urged managers to motivate performance not simply demand it. With the separation of ownership
from control the line demarking “management” from “operative” has become ambiguous. Both
work for capital and Follett argued that the worker could be taught to become “an organization
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man”. He could be taught to practice self-management (self-control) and shed his traditional
adversarial identity. He could be taught that productivity growth, efficiency enhancement and
profit maximization was necessary for his own well being. People are the key to productivity
growth. Technology, standards and work rules do not guarantee productivity growth. Instead
profit growth depends on skilled and motivated workers committed to capitalist norms—utility /
profit maximization as an ultimate end in itself.
The complexity of capitalist order reflected in its dialectical pursuit of unity through
diversity has been appreciated by authors who seek to address management on the basis of a
systems approach. They view the corporation as a co-operative system dedicated to the pursuit of
common end—i.e. productivity, efficiency, profitability maximization. Communication is the
necessary means for linking the individual worker’s motivation (his willingness to serve) to the
corporation’s purpose (maximization of profit). Understanding intra organizational
communication necessitates that the corporation be viewed as a complex dynamic network
structuring and sustaining capitalist individuality as an essential means for the realization of its
purpose (profit maximization). Management systems analysts portray the corporation as a living
thinking system and emphases organizational learning. Interaction between Chaos theorists and
some system’s management thinkers has led to the realization that environmental feedback is the
key to organizational learning. Systems theory therefore underlines the importance of viewing the
corporation as part of a complex whole (capitalist order).
Several attempts have been made by management theorists to combine different elements
of the Scientific Management, HRM and the Systems Approach. The most widespread of these is
the Contingency approach which emphases that there are no universally applicable principles for
relating diversity to singularity. Difference situations require different approaches—scientific
management may be more suitable for increasing efficiency in a steel mill and the HRM approach
may be a useful means for enhancing productivity in a corporation which mainly employs
copywriters. As a whole Management theory emphasizes that capitalist individuality is not
spontaneously produced in the market. It has to be structured and sustained within corporation
hierarchies (which are extra market phenomenon) through interaction between the corporation
and its stakeholders and though the regulation of the corporation by the capitalist sates.
Management theory therefore provides a much more realistic analysis of how capitalist order
functions than does microeconomics. However, microeconomics provides the ideal types—the
optimizing models—on the basis of which actually existing markets can be evaluated in term of
their conformance with capitalist ideology. Management science may therefore be viewed as a
practice for moving capitalist realities towards capitalist ideals.
17.7: CONCLUSION
As we have stressed throughout this book microeconomics provides:

a) a justification of capitalist order and
b) an analytical framework for identifying optimum transaction forms and regulatory procedures
for achieving capitalist objectives—the organization of individuality, social and political
relationships focused upon accelerating the rate of capital accumulation for its own sake.
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At present there is no paradigmatic rival to microeconomics (neoclassical economics) which can

serve these ends more effectively than it.
Institutional economics and complexity analysis may have the potential to articulate a
more coherent understanding of capitalist reality. The Institutionalist emphasis upon meso (i.e.
institutional structure) responses to disequilibrium and its understanding of the capitalist market
as a dynamic system incorporating uncertainty in its formal analysis makes it useful for
understanding how innovation and entrepreneurship is being institutionalized in capitalist order.
Some Institutionalists also develop a framework for showing that despite its evolutionary
characteristics the market system possesses inherent characteristics for assimilating crises
situation in its normal functioning process. They can provide a much needed discourse for
understanding capitalism’s resilience to systemic shocks.
The evolutionary variants of Institutional Economics may provide a more profound and
better explanation of capitalist state capacities and policies than modern microeconomics. Based
on orthodox microeconomic foundation, Institutional / Evolutionary Economics is also functional
in that it allows the analysts to methodically relax ‘Citrus Paribas’ assumptions of standard
microeconomic theory to develop a better understanding of the functioning of capitalist markets.
This is also true for Behavioral Economics, which is also functional and realistically adding depth
to microeconomics analysis.
Complexity theory applications to the study of market functioning can also deepen
microeconomic analyses. These applications (especially those on the basis of Chaos theory)
identify non linear relationships among elements within the market system and investigate the
capability of the market system to self organize. Chaos theory applications in the physical
sciences show that often behind apparently chaotic behavior there is an organizing force which
Lorenz called “a strange attractor”. Complexity theorists working on market systems sometimes
claim that behind the apparent persistence of dis-equilibrating price and output configuration
there exist similar “strange attractor(s)” which produce business cycles but (may) also ensure that
the cyclical behavior of the capitalist market system is self corrective and self sustaining. If
Complexity analysis can identify “strange attractor” or “attractors” it will make a major
contribution to the understanding of capitalist market order.
In Pakistan and in some other Muslim countries, Islamic Economics has an important
ideological role to play. Like Islamic Democracy theory, Islamic Economics is concerned to
provide an Islamic legitimation of capitalist order. Both Islamic Democratic theory and Islamic
Economics justify the integration of Muslim moral, social and political life within global
capitalism.
All economic schools of thought—neoclassical, Post-Keynesian, Sraffian, Marxists,
Islamic Economics, and Institutionalists etc.—seek to provide a justification of some form or
another of capitalist order (liberal, social democratic, socialist or Islamic) and to devise policies
which are expected to promote capitalist efficiency and capitalist justice. None seek the
transcendence or overthrow of capitalist order. This is because theory is always a justification of
practice and appears long after a particular practice has become systemically hegemonic. Thus,
microeconomics (neoclassical economics) was formulated more than a century after liberal
capitalism had become systemically hegemonic in most parts of the Western Europe. A fully
articulated theory of state capitalist (socialist) functioning was developed decades after the
Bolshevik revolution broke out. The theory explaining capitalist transcendence will appear after
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the capitalist political order has been challenged (most likely) by the Islamic revolutionaries and
the capitalist epistemology and ideology have been delegitimized. That theory may also explain
how Abdullah Zhaghazai views and solves the problems related to production, consumption and
exchange as he pursues non-capitalist objectives, consciously rejecting freedom, equality and
progress; i.e. capital accumulation as an end in itself.
661
Review Questions
1. What is “representative agent” macroeconomics?

2. Why cannot ‘representative agent’ macroeconomics describe how actually existing capitalist
order works?
3. What purpose does ‘representative agent’ macroeconomics serve?
4. What are the central themes of Keynesian macroeconomics?
5. How does the Hicksian IS-LM framework reconcile Keynesian macroeconomics with
mainstream economics while preserving a niche for the use of Keynesian policy?
6. What is Hicks’ “liquidity trap” and what does it show about the effectiveness of monetary
and fiscal policies at different stages of the business cycle?
7. Discuss the role of the capitalist state in the Keynesian model of capitalist order?
8. Discuss the implications of rational expectations theory for macroeconomic policy?
9. Explain the failure of Monetarism.
10. How does representative agent macroeconomics symbolize / illustrate the irrationality of
capitalist order?
11. Why do even Neo Con capitalist states continue to practice orthodox Keynesian policies?
12. Outline the main theories of Post Keynesianism? Why Post Keynesianism is usually regarded
as “revisionist” rather “rejectionist” of Economics orthodoxy?
13. Discuss Sraffa’s views on (a) the shape of the firm and market supply curve (b) the concept
of “capital” and (c) the determination of the rate of profit and the pattern of income
distribution in capitalist order.
14. Why is Sraffa regarded as the most profound and devastating critic of microeconomics?
15. Is Sraffa a radical critic of capitalist order? Why not?
16. Outline Marx’s theory about the exploitative character of capitalist markets.
17. Why is it justified to call Socialism as a State Capitalist order?
18. Why has Analytical Marxism almost no relevance in understanding capitalist order?
19. “Capitalism is profoundly anti-religious”. Do you agree?
20. “Islamic Economics is a sub discipline of neo classical economics”. Do you agree?
21. What are the major microeconomic theories endorsed by Islamic Economics?
22. Q22. Are Islamic banks really “Islamic”?
23. Why does Islamic Economics have no conception of the transcendence from capitalist order?
24. What are the similarities between the Institutional analysis of capitalist markets and
microeconomic analyses of capitalist markets?
25. Outline the Institutional critique of microeconomics.
26. Discuss and evaluate the Institutionalist perspective on the evaluation of capitalist
institutions. Does this view justify the Institutionalist prohibition of the state regulation of
capitalist markets?
27. What are institutions and what functions do they perform within capitalist order?
28. What is the difference between the objectives of classical and revisionist Institutionalism?
29. What are the similarities in the assumptions underlying classical and revisionist Institutional
Economics?
30. Why are Asian and African countries being forced by the World Bank and the WTO to
establish Western institutions and destroy their national institutions?
662
31. What are the essential features of institutional restructuring enforced by imperialist agencies
such as the World Bank and the WTO on Asia and Africa?
32. What is the impact of capitalist reinstitutionalization on the social and economic salience of
communities in the Asian and African countries?
33. “Revisionist Institutionalist Economics is pre microeconomics”. Discuss.
34. What is Behavioral Economics and what is its relationship to standard microeconomics?
35. Describe Behavioral Economics’ methodology.
36. Discuss some Behavioral modification to the assumptions underlying standard
microeconomic theories.
37. “Behavioral Economics shows why it is impossible for normal persons to act rationally”.
Discuss.
38. How does Management complement microeconomics?
39. Why does the theory and practice of Management not exist in non capitalist societies?
40. How does Scientific Management seek to universalize capitalist norms and practices among
the corporation’s (a) workers (b) other stake holders and (c) customers?
41. Why does Operations Management emphasize the importance of managing customer
preferences?
42. What does the Human Resource Management (HRM) School suggest should be done to
accelerate efficiency and productivity growth?
43. Analyze the systems approach to the sustenance of capitalist individuality.
44. What is the main message of the Contingency approach to Management theory?
45. What is required for the production and sustenance of capitalist individuality?
46. What are the strengths and weaknesses of economic schools which seek to provide an
alternative explanation of capitalist order?
47. Why has no general theory for the overthrow of capitalism been produced? When will such a
theory appear?
663
664
Glossary
GLOSSARY
Absolute barriers are those that rule out new entry whatsoever over some time horizon
Absolute price is the price of a commodity in some monetary terms
Acquisition represents the absorption of one company by another one
Allocative efficiency refers to the market situation where resources are allocated to activities that
earn higher rates of return. Firm is allocative efficient when it produces output where marginal
cost equals price
Arbitrage is the practice of making profit by purchasing a commodity from where its price is
lower and reselling where price is higher
Arc price elasticity reflects the change between two points along a demand curve
Asymmetric in economics refers to a state in which two agents (buyer Vs. seller or seller Vs.
sellers) carry inharmonious and unequal status
Average expenditure equals the wage paid per worker. Labor supply curve measure average
expenditures
Average fixed cost is fixed cost per unit of output, calculated by the ratio of fixed cost to output
Average product is the ratio of output to labor
Average revenue is given by the ratio of total revenue to output
Average total cost measures total cost per-unit of output, calculated by dividing total cost by the
output level
Average variable cost is the ratio of variable cost to output
Average-cost-pricing means setting price equal to average cost of production. This is usually
practiced in case of natural monopolies
Backward bending labor supply curve has an initially positive sloped but becomes negatively
sloped at higher wage rates, reflecting an income effect greater than substitution effect
Bads are the goods which give negative marginal utility to a consumer.
Bertrand model is that oligopoly model which says that firms produce a homogenous good, each
firm treats the price of its competitors fixed, and all firms decide simultaneously what price to
charge
Bilateral monopoly is a market structure where a monopsonist buyer of an input faces a
monopolist seller of that input
Binding arbitration is a process in which a third party determines the wages and other work
related conditions on behalf of the negotiating parties (usually managers and union)
Black-market is the practice of selling a commodity above its legal price
Budget constraint or budget line shows the largest available bundles of two commodities with
given prices and income. Its slope measures the relative price of x
Budget set shows the set of all income feasible consumption bundles
Budget share is the proportion of income that is spent on a particular commodity
Capital controversy refers to the theoretical debate fought between two Cambridges on the nature
and role of capital as a means of production
Capital is money that is invested in order to make more money
Capitalist production is the organization of production of goods and services for the sake of
accumulation of capital as an end in itself
665
Glossary
Cardinal utility function contains information about utility differences as well as preference
ordering that it represents
Cartel is a form collusive business venture where all or some oligopolistic firms directly agree to
cooperate in setting price and output levels in order to maximize their joint-profit
Choice of technique is the problem of choosing optimal combination of inputs to produce a
specific level of output at given factor-prices
Collusive oligopoly means firms involve in cooperative decision makings in order to maximize
their joint-profit
Commercialization of leisure means the organization of leisure time for further enhancement of
capitalist production by arranging activities for the sake of making profit, such as entertainment
industry, through capitalist enterprise
Comparative-static-analysis is analytical technique in which results of two static equilibrium
states are compared with each other
Competition is a process which involves rivalry among multiple individuals who are struggling
against each other to obtain the same scarce resource
Competitive advantage means delivering the same service at a lower cost, called cost
advantage, or greater service for the same price, called differentiation advantage
Competitive wage is a contract that allows an employee to adjust his time allocation between the
number of hours to work and rest each day or each week
Complements are the goods which share negative cross price elasticity
Compounding is the process of calculating the amount to which a payment will grow at some time
in future (by accumulating interest on interest)
Concavity is the property of a set which says that a set is concave if a line joining any two points
in that set remains entirely below that set
Concentration ratio measures the size of the largest firms’ share in total market sales. This ratio
refers to the degree to which production in any specific industry is concentrated in the hands of a
few large firms
Constant returns to scale means returns to scale is 1, reflecting the fact that output increases at
the same percentage rate as do all inputs
Consumer equilibrium is the consumption bundle that shows a consumer doing the best that he
can do. It is the point where indifference curve is tangent to the budget line reflecting the fact that
subjective valuation of a consumer for a commodity is equal to that of market
Consumption bundle is the quantities of each consumption commodities that a consumer has
available for his consumption. It is shown by a point in a commodity space representing some
commodities
Convexity is the property of indifference curve which says a weighted average sum of any two
bundles, say bundles A and B, is preferred to those bundles themselves. Mathematically,
convexity is the property of a function which says that a function is convex if a line joining any
two points of that function remains entirely above that function
Corner solution shows that the consumer purchases zero amount of one of the two commodities
and he specializes in the consumption of other one
Corporation is a distinct legal entity that exists independent of its owners
Cost efficiency in production takes place at efficient scale of production in competitive markets;
i.e. production should take place where average total cost is minimum possible
666
Glossary
Cost refers to the sum of expenditures needed to produce a given level of output
Cournot model is an oligopoly model in which firms produce a homogenous good, each firm
treats the output of its competitors as fixed, and all firms simultaneously decide how much to
produce
Cross price elasticity shows relation between quantity demanded of one commodity and price of
another. It measures the proportional rate of change in quantity demanded of one good due to
proportional change in price of another good
Deadweight loss is the net loss in social welfare resulting from any other than competitive
market approach, say by monopoly power. It is measured by the difference between output
(produced and made available for consumption) by the perfectly competitive firm on the one hand
and the monopolist on the other
Decreasing returns to scale means returns to scale is less than 1, reflecting the fact that output
increases at a less percentage rate than all inputs
Demand curve shows all consumer equilibrium points as does the price consumption-curve but
drawn in a price-commodity plane. It demonstrates the negative relationship between price and
quantity demanded of a commodity due to negative sign of substitution and income effects
Demand refer to the amount of a commodity that a consumer is willing and able to purchase
Derived demand is the principle which says that inputs are valued only because they can be used
to produce valuable goods and services
Determinants of demand are factors that affect a consumer’s decision of ‘how much amount of
a commodity to purchase’ with his income
Dilemma represents the problems which arise when addressing an issue the resolution of which
leads to several equally unacceptable consequences
Diminishing marginal product of a factor refers to the tendency of marginal product of a factor
to decrease, other factors held constant
Diminishing marginal rate of substitution (DMRS) is the tendency of MRS to decline. The
more x one has and less of y, the less is the relative value placed on the extra unit of x compared
to that placed on y. DMRS comes from the assumption about people behavior that they have a
taste for variety in their consumption
Diminishing marginal rate of technical substitution refers to the tendency of MRTS to
decrease as more labor is added to production process
Diminsihing marginal utility says that the utility derived from the consumption of a commodity
decreases as more of it is consumed
Discounting is the practice of reducing the value of a future payment to calculate its value today
Diseconomies of scale refers to the phenomenon of increasing long run average cost as the scale
of output expands
Division of labor means allocation of task between workers such that each one of them performs
fewer distinct tasks in producing output; i.e. each worker produces a very small part of total
output produced
667
Glossary
Dominant firm model is a market with one firm having a market share of more than 50%,
though other small firms do exist with negligible market shares
Dominant strategy is the optimal strategy or option no matter what the opponent does
Duopoly is a market where two firms compete with each other
Dynamic efficiency is to achieve the most from given scarce initial resources over time to
maintain permanent pressure of scarcity. It also refers to the generation of new resources through
innovation
Economic (wo)man is an abstract rational economic agent whose self is subordinated to his (her)
infinite desires
Economic rent is the payment for an input over and above what is required to keep it in its
current use; i.e. the difference between the payments actually made to an input and the minimum
amount that must be paid to keep it in its current use
Economies of scale refers to the phenomenon of decreasing long run average cost as the scale of
output expands
Edgeworth model of oligopoly provides a solution to the problem of price-war such that prices
do not fall to marginal cost of production. It explains the cyclical behavior of prices in oligopoly
markets
Efficiency means producing maximum output from given inputs or resources
Efficient scale of production is the point on long run average cost curve where average cost of
production is the least
Elasticity is a pure algebraically signed and unit-free measure of responsiveness between two
variables. It measures percentage rate of change in the dependent variable due to change in the
independent variable
Elasticity of demand shows what happens to demand for a commodity when the variables which
affect demand undergo some change, that are the price of the good in question, price of related
goods and income
Engels curve represents all points of consumer equilibrium at all positive income levels, but in
income-commodity space as opposed to ICP which is drawn in commodity-space
Entrepreneur is a person who takes risks for finding new channels of profitable investments for
the sake of further accumulation of capital
Equilibrium is the position where there is no further tendency for change. In the context of
market, it refers to the situation when demand is equal to supply
Equilibrium price is the price where demand is equal to supply
Equi-marginal principle states that at consumer equilibrium, the ratio of marginal utilities to
prices is equal for all goods consumed. Verbally, it says that marginal utility of the last rupee
spent on one good should be equal to the marginal utility of the last rupee spent on another good
Euler’s Theorem says that when the production function displays constant returns to scale, it
satisfies the adding up property: output equals sum of the marginal products of inputs times their
level of use
Excess-demand refers to the situation when demand is greater than supply at some positive price
level
Excess-supply refers to the situation when supply is greater than demand at some positive price
level
668
Glossary
Expansion path is the set of all cost-minimizing input combinations at all output levels, given
the prices of inputs and knowledge about technology
Explicit cost refers to expenses which the entrepreneur has to pay from his own pocket for the
purchase of inputs
External growth is a companies’ expansion in sales or output achieved through the purchase of
necessary resources externally (i.e. via mergers and acquisitions)
Factor-price ratio is the ratio of input prices—ratio of wage rate to rental rate—and measures the
relative prices of factors
Factors of production are inputs that are not embodied in output and are retained after the end of
production process. They include labor, land, capital and entrepreneur
Firm equilibrium means firm doing its best to maximize profit. This is characterized by the
condition when marginal revenue equals marginal revenue
Firm is an entity that undertakes the activity of production for maximizing profit
Fixed cost is the part of cost that does not change as output changes and that can’t be avoided in
the short run
Fixed factor is the input that cannot be changed in short run (also called fixed input)
Fixed-proportion production function refers to the situation when there is only one technically
efficient way of producing a given amount of output and, hence, shows no possibility of trade-off
between inputs; i.e. there is no way to substitute labor for capital or vice versa
Franchise monopoly is a monopoly business created out of state granted legal rights or
protection
Full income is a consumer’s maximum possible labor income (including non-labor income)
assuming all of his time is sold at the market wage rate
Giffen good is a commodity which has positive segment of demand curve due to the positive
income effect larger than the negative substitution effect
Herfindahl-Hirschman Index is a measure of market concentration that is calculated by
summing the squared market shares for competing firms in an industry
Homogeneity of degree zero is the property of a function which says that if each of the
arguments of a function is multiplied by a positive number, the value of the function remains
unchanged. Demand functions are also homogenous of degree zero in prices and income meaning
doubling all prices and income changes only the units by which we count, not the physical
quantities demanded
Hypothesis is a proposition which affirms or denies some fact
Imperfect competition means market structure where any of the single conditions of perfectly
competitive markets are missing or lacking
Implicit cost stresses the cost of foregone alternative actions though no physical payment is made
against them out of pocket
Income effect is the change in demand due to change in income holding the final price fixed. It
has a negative sign for normal goods and positive for inferior goods with regard to price change
Income elastic demand is greater than 1. The demand changes by more than the change in
income in percentage terms
Income elasticity of demand shows percentage change in demand due to percentage change in
income
669
Glossary
Income inelastic demand is less than 1. The demand changes by less than the change in income
in percentage terms
Income-consumption curve (or path) is a curve showing all points of consumer equilibrium at
positive income levels, drawn in the commodity-plane
Increasing returns to scale means returns to scale is greater than 1, reflecting the fact that output
increases at a greater percentage rate than all inputs
Indifference curve represents all combinations between two goods that give equal satisfaction or
utility to a consumer
Indifference map shows a family of indifference curves representing the utility an individual can
obtain from all possible consumption options
Industry is the collection of all firms concerned with a particular line of production
Inertia shopping rule says that consumers tend to buy from the firm that charges the lowest
price, but if he is already buying from a firm and another firm enters the market with a lower
price, he gives his current firm a chance to meet the entrant’s price before shifting his demand
Inferior good has a negative relationship between income and its demand. It displays negative
income elasticity
Inferior goods are goods for which there is negative relationship between income and demand
Interior solution occurs when consumer opts to consume positive amounts of both the
commodities.
Interpersonal comparison of utility refers to the idea that in order to obtain social welfare
function by adding up the utilities of more than one individual, one must be able to compare and
rank the utility scales of all individuals (which is impossible because utility is a subjective
phenomenon, known as impossibility of interpersonal comparison of utility)
Intertemporal budget constraint is the budget constraint applicable to income and expenditures
involving more than single time period
Intertemporal choice is the choice involving different periods of time
Inverse demand curves shows quantity demanded of a commodity as a function of its price
Iso-cost line represents different input combinations that cost the same amount
Iso-quant curve shows different combinations of inputs that yield same level of output
Labor demand curve shows the number of workers firms are willing to hire at different wage
levels
Labor refers to the amount of time an individual chooses to offer in the market at a specific wage
rate
Labor supply curve reflects the working hours which the workers are ready to sell at different
wage levels in the market
Law of demand says that other things held constant, there is inverse relationship between
demand and price of a commodity
Law of one-price means a commodity can be sold at one and only one price in a competitive
market. This happens due to arbitrage
Law of supply says that other things held constant, there is positive relationship between supply
and price of a commodity
Leisure is all the time spent off the market job
Limit pricing is a pricing strategy used by existing firm by setting a price such that an entrant
can’t make profits at that price
670
Glossary
Limited liability ownership means that an investor’s liability to debt is limited to the extent of
their shareholdings or initial investment
Limited partner in partnership is one who, like shareholders, risks only his initial investment in
a firm
Linear demand curve is one for which the slope is constant at all points while elasticity varies
from zero to infinity
Lock out is a firm’s refusal to operate its plant and employ its workers
Long run average total cost curve is the envelop of short-run average total cost curves
Long run equilibrium of a competitive firm and market is achieved when marginal cost, average
total cost and price are all equal; i.e. P = MC = ATC. In the long run equilibrium, no firm has
incentive to exit or enter the market
Long-run is the time duration when all inputs can be changed
Luxuries are the goods which have income elasticity greater than 1
Marginal condition for profit maximization implies that maximum profit output is one where
marginal revenue equals marginal cost and marginal cost curve cuts marginal revenue from below
Marginal cost is the change in total (or variable) cost due to change in output
Marginal expenditures represent the amount needed to purchase an extra unit of labor.
Technically speaking, marginal expenditure on labor is the change in total wage bill due to hiring
of one extra unit of labor
Marginal product of a factor is the change in output due to change in an input
Marginal productivity theory of income distribution asserts that the income share of a factor of
production is determined by its contribution in output produced
Marginal rate of substitution (MRS) measures the rate at which the extra unit of x is substituted
with y to keep utility constant
Marginal rate of technical substitution (MRTS) measures the rate at which labor can be
substituted for capital still producing the same level of output
Marginal revenue is the change in total revenue due to one unit change in out
Marginal revenue product also indicates the change in revenue of a firm due to the sale of output
produced by one additional input, but it is less than the VMP of a competitive firm (if we do make a
distinction between the two)
Marginal utility is the rate of change in utility due to change in the consumption of a
commodity. Marginal utility is usually assumed to decline as more of a commodity is consumed,
other things held constant
Marginal-cost-pricing means setting price equal to marginal cost of production
Market demand curve relates the price of a commodity to the total demand for that commodity
by all individuals in the market. Economists wrongly claim that such a negatively sloped curve
can be obtained by horizontal summation of all individuals’ demand curves
Market demand is the sum of all individuals’ demand at a particular price. Graphically, it is the
horizontal summation of individuals’ demand curves at all price levels
Market or price mechanism is the tendency for price to change until market clears
Market period refers to the time duration when the supply quantity available for immediate sale
cannot be increased
Market supply is the sum of supply by all individual firms at different price levels
Merger represents the decision of a number of independent firms to form a single corporation
671
Glossary
Microeconomics a branch of economics concerned with the description of competitive process:

its functioning, consequences and legitimacy. It also provides a theoretical foundation for
legitimizing the motive of self-interest as the corner stone of society
Monopolistic competition refers to a market structure characterized by many sellers competing
with each other on differentiated products and facing easy market entry conditions
Monopolistic exploitation is the difference between the wage offered by a monopolistic firm and
that offered by a competitive market
Monopoly is a business dominated by single firm which ignores pricing reaction of any other
firms to its pricing decision
Monopoly power refers to the extent to which a firm can control market price
Monopsonistic exploitation is the difference between the wage offered by a monopsonistic firm
and the one offered by a competitive market
Monopsony is a business structure where only a single buyer faces the entire market supply
Nash equilibrium is a set of actions where each player does the best it can, given the best of its
competitor
Natural monopoly is a business with increasing returns to scale at the level of the whole market.
The result of such a business structure is that the average total cost (ATC) curve keeps declining
as firm expands its operation
Necessities are the goods which have income elasticity less than 1
Neutral goods are those which have zero marginal utility to a consumer
Non price rationing is the use of mechanism other than price to ration or equate the demand for
something with its available supply
Non-collusive oligopoly means that the firms are competing with each other in the oligopoly
market instead of joining hands together and therefore have to be attentive of the reactions of
other firms when making price decisions
Non-Giffen inferior good is an inferior good but has a negatively sloped demand curve.
Non-satiation is a claim about consumer psyche which says that a consumer is always greedy;
i.e. he prefers more goods to less
Normal factor is one whose use increases with the increase in output produced
Normal good is one for which an increase in income leads to an increase in demand. It has
positive income elasticity
Normal goods are goods for which there is positive relationship between income and demand
Normal profit means all firms are earning zero economic profit in the market
Oligopoly is a market structure in which few firms compete with each other while entry barriers
are significant
One-shot game is one in which players take actions and receive pay-offs only once
Opportunity cost is the value of second best alternative
Opportunity cost of a particular choice is the satisfaction that would have been derived from the
next best alternative foregone; in other words, it is the value of forgone activities in making a
certain choice or decision
Optimum bundle is that combination of (x,y) which lies on the highest indifference curve. It is
that bundle for which the utility of the consumer is maximum
Ordinal utility function represents a consumer’s taste showing only the order of the preferences,
not the utility differences
672
Glossary
Organic growth is the growth in companies’ sales or output achieved by making investment
internally (i.e. excludes growth through M&A)
Own price is the price of a commodity in some monetary terms
Paradigm refers to some metaphysical beliefs regarding the behaviour of subject which form the
conceptual framework (hard core) of any scientific discipline through which the world is viewed.
It also involves some standard experimental and theoretical techniques to apply the fundamental
laws to a variety of situations in order to match paradigm with nature
Partnership is a firm owned and operated by two or more people
Pay-off matrix refers to a tabular representation of profit (or payoff) to each player given its
decision and the decision of its competitor
Perfect complements are the goods that are used in specific combination with each other.
Perfect substitutes are those commodities that have equal value to a consumer and he ranks them
same in order in terms of taste
Plant comprises the physical capital of a firm at a particular location used for producing
commodities—i.e. it is the unit of production in a firm
Point elasticity measures elasticity at a specific point on a demand curve
Price cap regulation is a regulatory method designed to encourage efficient production by
allowing firms to share in any cost savings that they have achieved in production process
Price ceiling is the maximum price of a commodity that can be legally charged for that
commodity. Such a price is set below its equilibrium price.
Price elastic demand is greater than 1 in absolute value. The quantity demanded changes more
than the change in price in percentage terms
Price elasticity of demand shows the percentage change in quantity demanded due to percentage
change in price
Price elasticity of supply is the percentage change in quantity supplied due to percentage change
in price
Price inelastic demand is less than 1 in absolute value. The quantity demanded changes less than
the change in price in percentage terms
Price setting behavior means firm is facing downward sloping demand curve and hence can set
price
Price-consumption curve (or path) is a curve showing all points of consumer equilibrium at all
relative prices
Price-floor is the minimum price that must legally be offered for a commodity. This minimum
price is set above the equilibrium or market price of a commodity
Price-rigidity is a characteristic of oligopolistic markets which explains why firms can be
reluctant to change prices even if costs or demand change
Price-taker is a consumer who does not have any control to determine market prices and accepts
them as given information by the market for making his choice decision
Price-taking behavior is a competitive behavior when all agents in the market lack any control
to determine market prices and take them as given information by the market for making their
choice decisions
Prisoner’s dilemma attempts to demonstrate why two agents might not cooperate even if it is in
their best interests to do so
Privatization is the sale of state owned enterprise to private individuals
673
Glossary
Producer equilibrium is the cost-minimizing input combination point where iso-quant and iso
cost line are tangent to each other
Product innovation is the practice of continuously bringing new and more expansive goods and
services in the market in order to sustain continuous economic growth
Production function is a relation between the amount of output a firm can produce with given
inputs
Production is the activity of combining and processing goods, called inputs, in technological
process to convert them into some other goods, called output.
Proprietorship is a firm which is owned and headed by a single person
Rate of return regulation means setting a maximum rate of return on invested capital that a
utility is allowed to earn
Rate of time preference measures the rate at which the consumer is willing to substitute second
period consumption for first period consumption
Rationality is a hypothesis about consumers by which they can make logical and consistent
choices based on universal greed
Reaction function is the relationship between a firm’s profit-maximizing output and the amount
of output it believes its competitor will produce
Relative barriers are the ones which place a new entrant at a disadvantage, but they are not
insurmountable ones
Relative price is the price of one good in terms of another. It is the rate at which one must give
up another commodity to obtain one good in terms of specific good.
Repeated game is one where actions are taken and pay-offs are received by players over and
again
Representative commodity always shows a proportional change in its demand as income of
consumer increases. This holds only if taste of consumer always remains unchanged for a
commodity as income increases
Representative consumer is a mystical consumer in economic theory whose taste is supposed to
be followed by all individuals living in capitalist society; i.e. his taste represents the taste of all
consumers
Reserve capacity is the fact of designing plants with some flexibility in productive capacity so
that average variable cost curve has a flat stretch over a range of output
Resource is anything that can satisfy a human want
Return to factor / inputs refers to the behavior of change in output in response to change in a
single input: what happens to output as we change single input
Returns to scale measures the percentage change in output due to percentage change in all
inputs: what happens to output as we change all inputs
Saving is the residual amount of income left out of consumption expenditures
Scarcity is a subjective phenomenon which refers to the degree by which people’s desire for
something exceeds its availability
Self-interest is an economic hypothesis about human behavior which says that while doing
something, an individual must always look for his own objectives or desires; i.e. each activity
should be motivated by the expectation of fulfilling one’s own desire
Self-interest is the essence of rationality of an economic man. It is the ability of an economic man to
rank his preferences as per his personal desires
674
Glossary
Short run equilibrium of a competitive firm is achieved when it produces where its price is
equal to marginal cost of production, i.e. P = MC
Short run total cost is the total cost of production, given some level of fixed factor. It is the sum
of fixed and variable cost components
Short-run Expansion path is the set of all cost-minimizing input combinations at all output
levels, given the prices of inputs, knowledge about technology and the level of fixed factor usage
Short-run is the time duration when at least one input is fixed
Shut down rule says that under circumstances of loss, firm should try to minimize its loss. Firm
should shut down its business only when operating loss is greater than its fixed cost.
Alternatively, it should shut down when revenue is less than variable cost of operation
Slope measures the rate of change in the dependent variable due to change in the independent
variable
Social indifference map ranks the sum of all consumers’ preferences in a consistent manner and
is expected to have same properties as individual indifference map
Social sciences work out the laws governing the behavior of individuals and social institutions of
a society that prioritizes maximization of freedom as its ultimate objective
Social utility or welfare is the sum of all individuals’ utilities or welfare living in a capitalist
society
Speculation occurs when something is purchased in the expectation of selling it at a higher price
in future without increasing its value by processing it in some way. It is an unproductive and
freeloading activity that is wholly separable from the real economy where production of goods
and services takes place.
Stackelberg model of oligopoly in which one firm sets its output before other firms do
Static efficiency is getting the most in terms of human satisfaction from given resources (also
called Pareto efficiency)
Strategy is the rule or plan of action defined for playing a game
Strike refers to the refusal of a group to work under the prevailing working conditions
Substitutes are goods that can be used in place of each other because they serve more or less the
same purpose in the eyes of a consumer
Substitutes are the goods which posses positive cross price elasticity
Substitutions effect shows change in demand for a good due to change in its own price keeping
real income constant. It always moves opposite to the price change and, hence, has a negative
sign
Super normal profit refers to positive economic profit earned by firms in the market
Supply function simply says that sellers’ decision to sell a particular amount of output depends
upon the own price of commodity that they are selling, prices of inputs and technology
Supply is the amount of output that individuals are willing to sell at positive price
Supply of saving reflects the amount of savings supplied by an economic agent at different rates of
interest
Sustainable monopoly is natural monopoly that can prevent entry and keep others out of market
Tastes are all the hypothetical exchanges that an individual is willing to make at various terms of
trade
Tatonnement process refers to a hypothetical perfect market setting where an impartial and
costless auctioneer coordinates market exchange
675
Glossary
Time allocation problem suggests that the fundamental scare resource in the economy is the
availability of human time and a rational economic agent tries to allocate his time between work
and leisure activities such that it results in maximum utility
Total condition for profit maximization says that profit is maximum where slopes of total
revenue and cost curves are equal and revenue curve is above cost curve
Total effect is the observed effect of a price change on the quantity demanded of a commodity. It
is the sum of substitution and income effects.
Transaction cost is the cost of executing exchange; e.g. transportation and brokerage costs
Transitivity is an assumption about consumer taste which says that given any triple of
commodity bundles, A, B and C if A P B and B P C then A P C
Unique solution is that which has only one solution value. Consumer utility maximization
problem has a unique solution if indifference curves are strictly convex. The tangency
condition shows the only one point at which utility is maximized
Unitary price elastic demand is equal to 1 in absolute value. Change in quantity demanded and
price are equal in percentage terms
Utility function is a way of assigning a number to every possible consumption bundle such that
more preferred bundles get larger numbers than the less preferred ones
Utility-maximization is a hypothesis about consumer behavior which says that the objective of a
consumer is to maximize utility subject to his income constraint
Value of marginal product indicates the change in revenue of a firm resulting from the sale of
output produced by one additional input
Variable cost is the part of cost that changes with output
Variable factor is the input that can be easily varied in the short run (also called variable input)
Zero economic profit means amount of profit which is necessary to keep an input in its existing
use. It is attained when all inputs are receiving their market reward; i.e. their opportunity costs
676

Micro Economics Theory Practice and Evaluation DR Javed Akbar Ansari

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MICROECONOMICS

Theory, Practice and Evaluation

University of Karachi Press

so as to help them seek guidance

from the intellectual foot-steps of

Imam Al-Ghazali (RA)

Zahid Siddique is Assistant Professor of Economics in the Management Science Department at

CHAPTER 1: INTRODUCTION TO ECONOMICS

1.1: WHAT IS ECONOMICS? ................................................................................................ 1

FYI BOX 1.1........................................................................................................9

FYI BOX 1.3......................................................................................................13

CHAPTER 2: INTRODUCTION TO CAPITALISM AND THEORY OF VALUE

2.1: THE CAPITALIST SYSTEM ........................................................................................... 27

PART 2: MARKETS: LIBERAL FRAMEWORK OF ANALYSIS

CHAPTER 3: DEMAND AND SUPPLY: Basic Competitive Model

3.1: DEMAND .................................................................................................................... 57

FYI: B O X 3.1 ................................................................................................60

FYI: B O X 3.2 ................................................................................................67

APPLICATION BOX 3.1.......................................................................75

APPLICATION BOX 3.3.......................................................................84

APPLICATION BOX 3.5.......................................................................88

APPLICATION BOX 3.6.......................................................................89

CHAPTER 4: MARKETS and PRICE CONTROLS

4.1: PRICE-CEILING ........................................................................................................ 101

APPLICATION BOX 4.2..................................................................... 104

APPLICATION BOX 4.6..................................................................... 116

5.1: SLOPE AND ELASTICITY ........................................................................................... 125

APPLICATION BOX 5.1..................................................................... 132

APPLICATION BOX 5.3..................................................................... 144

APPLICATION BOX 5.4..................................................................... 154

PART 3: BEHIND MARKETS: CONSUMER AND PRODUCER BEHAVIOR

CHAPTER 6: PREFERENCES AND UTILITY

6.1: WHO IS CONSUMER? ............................................................................................... 167

FYI: B O X 6.2 .............................................................................................. 196

7.1: THE BUDGET SET ..................................................................................................... 207

APPLICATION BOX 7.1..................................................................... 225

CHAPTER 8: CHANGES IN DEMAND: Comparative Static Analysis

8.1: INCOME CHANGES AND DEMAND ........................................................................... 247

Application BOX 8.1 ............................................................................................. 254

FYI: B O X 8.1 .............................................................................................. 263

APPLICATION BOX 8.2..................................................................... 274

APPLICATION BOX 8.3..................................................................... 275

FYI: B O X 8.2 .......................................................................................................... 278

CHAPTER 9: FIRM AND PRODUCTION IN CAPITALIST SOCIETY

9.1: FIRM: THE AGENT OF PRODUCTION IN CAPITALIST ORDER ................................. 291

Application BOX 9.2 .......................................................................... 301

CHAPTER 10: NEOCLASSICAL THEORY OF PRODUCTION

10.1: THE PRODUCTION FUNCTION ............................................................................... 313

APPLICATION BOX 10.1 .................................................................. 317

APPLICATION BOX 10.4 .................................................................. 347

CHAPTER 11: NEOCLASSICAL THEORY OF COST

11.1: THE ECONOMIC CONCEPT OF COST ..................................................................... 359

PART 4: FIRM IN THE OUTPUT MARKET

CHAPTER 12: PERFECT COMPETITION

12.1: STRUCTURE OF PERFECT COMPETITION ............................................................... 395

APPLICATION BOX 12.1 .................................................................. 396

FYI BOX 12.1 ................................................................................................. 398

APPLICATION BOX 12.2 .................................................................. 408

APPLICATION BOX 12.3 .................................................................. 411