BAQ108_Micro Economics(English)

Price and Output Determination of the Firm and Industry 245 represented by SAC2. P2Q2 is the price determined. Since the price or the average revenue P2Q2 exceeds A2Q2 long-run average cost, pure monopoly profit is earned, which is represented by the shaded rectangle P2A2B2C2. Long run monopoly equilibrium is determined at a point E at which LMC curve intersects LMR curve. With the long run adjustment of output, both optional short run and long run marginal costs are equal to the marginal revenue. The optional plant-size here refers to that short run phase wherein the short run average total cost curve (SAC2 in our illustration) is tangent to the long run average curve (LAG) at the point A2 that corresponds to the long run equilibrium output (OQ2). Obviously, then the profit obtained amounting to P2A2B2C2 is definitely greater than the profit P1A1B1C1, obtained from the previous plant size (SAC1). Figure 9.4 portrays shifting equilibrium of the monopolist from the short run to the long run. It follows that in the long run also, the monopolist can earn a high excess profit. This is because of absence of rivals. In fact, a monopolist reaps a high monopoly profit by reason of his power to restrict output and to equate MC with MR and with AR or price. If he were to produce more, he will have to lower the price so that his excess profit would dwindle. He can restrict output because of absence of rivals. Thus, it has been said that the monopolist makes a monopoly profit for not producing. The above analysis of Figure 9.4 also implies that a monopolist does not produce goods but produces profits. Indeed, a monopolist’s power to make profit is limited by the demand conditions, cost situation and the nature of entry barriers. 9.9 Perfect Competition and Monopoly: A Comparison Following Koutsoyiannis, we may adopt the following methodological scheme for the comparison of two market models, such as perfect competition and monopoly.  Objectives of the firm.  Assumptions regarding the market conditions.  Behavioural Rules of the firm. CU IDOL SELF LEARNING MATERIAL (SLM)

246 Micro Economics - I  Basic magnitude of the long run market equilibrium, viz.,  (i) price, (ii) output, (iii) profit, and (iv) capacity utilisation. Comparison of Objectives of the Firm Theoretically, both types of firms, whether competitive or monopolistic, are seeking profit maximisation. However, a monopolist is in a somewhat better position to maximise his profits than a competitive producer. He may also strive to acquire more market power, in practice. Comparison of Assumptions Regarding Market Conditions Assumptions of the competitive and monopoly market models sharply differ from each other as follows:  Number of Sellers: In a perfectly competitive market, there is a large number of sellers. In a monopolistic market, there is only a single seller.  Control over Market Supply: A competitive firm has no control over the market supply. Its action is insignificant in the market because its individual supply is just a fraction of the total market supply. A monopolist, on the other hand, has full control over the market supply.  Industry: In a competitive model, many firms producing homogeneous products constitute an industry. In a monopolistic market, the monopolistic firm is itself the industry.  Entry Conditions: Perfect competition is characterised by the free entry and exit of the firms. There are no entry-barriers. In a monopolistic market, entry of rivals is blocked.  Degree of Knowledge: Perfect knowledge about market conditions is assumed on the part of participants in both market structures — perfect competition and monopoly. Comparison of Behavioural Rules of the Firm  A competitive firm is a price-taker. A monopolistic firm is a price-maker. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 247  The demand curve confronted by a competitive firm for its product is perfectly elastic. It is a horizontal straight-line. It implies that the firm can sell any amount of output at the ruling market price. While the demand curve confronted by a monopolist is relatively inelastic. It is a downward sloping curve. It suggests that the monopolist can sell more only by lowering price.  To a competitive firm, price is given in the market. So at that price, the average and marginal revenue will be the same. Hence, AR and MR curves coincide and are represented through the demand curve which is horizontal straight-line. In the case of monopoly, the downward-sloping demand curve represents the AR curve. The MR curve also slopes downwards, but it lies below the AR curve. If it is linear, then it lies at half the distance between the price-axis and the demand curve.  It follows that a major difference between a competitive equilibrium and a monopoly equilibrium is that whilst in the case of the former, the MC curve of the firm must be rising at or near the equilibrium level of output, in the case of the latter this is not essential. A monopoly firm can attain equilibrium under any state of returns to scale or cost conditions, whether constant, rising or falling. The fundamental condition of monopoly equilibrium that must be satisfied is MC = MR, and the MC curve must intersect the MR curve from below (yet it need not necessarily be rising). 9.10 Meaning of Price Discrimination A monopoly firm which adopts the policy of price discrimination is referred to as a discriminating monopoly. Price discrimination implies the act of selling the output of the same product at different prices in different markets or to different buyers. In a broad sense, price discrimination occurs in two ways: (i) by charging different prices for the same product, and (ii) by not setting prices of different varieties of products or different products in relation to their cost differences. In the theory of discriminating monopolies, however, for the sake of simplicity and convenience, the meaning of price discrimination is basically confined to the former notion, i.e., charging of different prices for the same product to different buyers or in different markets. Indeed, the conclusion arrived at from this simple variation of price discrimination can be extended to a more complicated version. CU IDOL SELF LEARNING MATERIAL (SLM)

248 Micro Economics - I 9.11 Forms of Price Discrimination Price discrimination may take many forms and guises. The common forms of price discrimination may be stated as under:  Personal discrimination: Generally, depending upon the economic status of buyers, different prices may be charged to different buyers in providing similar services. For example, a surgeon may charge a high operation fee to a rich patient and a lower fee to a poor one. Similarly, lawyers may charge different fees to different types of clients depending on their income status. A teacher also discriminates between rich and poor students as regards his private tuition fees.  Age discrimination: Price discrimination may be based on the basis of age of the buyers. Usually, buyers are grouped into children and adults. Thus, for instance, a barber may charge lower rates for children’s haircuts than those for adults. In railways and bus transport services, it is a commonly adopted form of price discrimination that persons below 12 years of age are charged at half the rates.  Sex discrimination: In selling certain goods, producers may discriminate between male and female buyers by charging low prices to females. For instance, a tour organising firm may provide seats to ladies at concessional rates. In certain cinema houses in small towns, a Zenana show may be arranged at concessional rates for ladies only.  Locational or territorial discrimination: When a monopolist charges different prices in different markets located at different places, it is called locational or geographical discrimination. For instance, a film producer may sell distribution rights to different film distributors in different territories at different prices. Similarly, a firm may discriminate between domestic markets and export markets for its products.  Size discrimination: On the basis of size or quantity of the product, different prices may be charged. For instance, an economy size toothpaste tube is relatively cheaper than a small size tube. Similarly, a product is sold in the retail market at a higher price than in the wholesale market by the producer. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 249  Quality variation discrimination: On the basis of some qualitative differences, different prices may be charged for the same product. For instance, a publisher may sell a deluxe edition of the same book at a higher price than its paperback edition. Quality variation may be in the form of material used, the nature of packing, colour, style, etc. Thus, jellies packed in tins are sold at a lower price than in bottles. A tailor charges higher stitching charges for a safari bush shirt than for an ordinary shirt. A particular print or colour saree may be priced higher than other sarees of the same cloth.  Special service or comforts: Price discrimination may also be resorted to on the basis of special facilities or comforts. Railways, for instance, charge different fares for the first class and second class travel. Similarly, cinema houses keep different admission rates for stalls, upper stalls, dress circle and balcony. Likewise, restaurants charge different rates for special rooms and general tables. In a hospital also, charges for special wards and general wards are different.  Use discrimination: Sometimes, depending on the kind of use of the product, different rates may be charged. For instance, an electricity distribution company may charge low rates for domestic consumption of electricity while still lower rates for industrial use as compared to the higher rates for light and fan.  Time discrimination: On the basis of the time of service, different rates may be charged. For instance, cinema houses charge lower rates of admission for morning and matinee shows than for regular shows. Similarly, the telephone company charges half-rates for trunk-calls at night.  Nature of commodity discrimination: Sometimes, because of the nature of a commodity, price discrimination may be made, for instance, freight charges by the railways are different for coal and iron for the same distance. 9.12 Degrees of Price Discrimination The extent and mode of price discrimination depend on circumstances. Professor Pigou, however, distinguishes between three degrees of price discrimination, viz.: (i) first degree price discrimination, (ii) second-degree price discrimination, and (iii) third-degree price discrimination. CU IDOL SELF LEARNING MATERIAL (SLM)

250 Micro Economics - I First Degree Price Discrimination It is the extreme case of price discrimination. Under this, the monopolist charges different prices to different buyers for each different unit of the same product. The price charged for each unit, in each buyer’s case, is set in accordance with the marginal utility the buyer estimates and thus at what maximum price he is willing to pay for it. Under first degree price discrimination, the entire consumer’s surplus of the buyer is converted into monopolist revenue and profits. Here, the demand curve itself becomes the MR curve of the monopolist (See Fig. 9.5). Mrs. Joan Robinson describes this as ‘perfect discrimination’. It is possible only when buyers are few so that each one can be dealt with individually and the monopolist fully knows what maximum they would pay for each unit of his product. This being a rare phenomenon, the discrimination of first degree is almost a rarity. (P) the highest price charged to a buyer P P1 the lower price S(MC) P2 still lower price Producer E Surplus Buyer’s price for the Qth unit of the products S D(AR) OQ (Q) Fig. 9.5: Perfect Price Discrimination: (First Degree) Perfect Price Discrimination First degree price discrimination may better be called perfect price discrimination. When a monopolist can charge each buyer the highest price that he/she is willing to pay, the price discrimination is perfect. Figure 9.5 illustrates perfect price discrimination theoretically through a diagrammatic model. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 251 The monopoly firm equates its supply curve with demand curve and produces OQ equilibrium level of output. The firm charges each buyer a price which he is willing to pay the most highest say, he may be charging 19 to a buyer which he is willing to pay utmost. He charges 9 to a buyer who is willing to pay only up to 9 for the unit and so on. When the price is charged to each buyer in accordance with what he is willing to pay utmost, there is no consumer surplus left with any buyer. In other words, the entire consumer surplus is converted into producer surplus. The producer surplus is shown as PSE in this diagram. Under perfect price discrimination, thus the monopolist maximises its profit to this extent. There are two major problems encountered in resorting to perfect price discrimination. First, the monopolist should know perfectly well as to how much maximum price a buyer is willing to pay. This the buyer may not intend to reveal correctly. Second, there should be no possibility of reselling. In practice, these conditions cannot be met perfectly well. Often, therefore, price discrimination tends to be imperfect. It may be of a second degree or third degree price discrimination. Second-Degree Price Discrimination Under this category of price discrimination, the monopolist sells blocks of output at different prices. Here, the possible maximum price is charged for some given minimum block of output purchased by the buyer and then the additional blocks are sold at successively lower prices. However, the units in a particular block will be uniformly priced. Thus, when first degree price discrimination is a case of unit wise differing prices, the second degree price discrimination is a case of block wise differing prices. In the second degree price discrimination, the monopolist captures a part of the consumer’s surplus and not the whole of it. In each group or market, the marginal buyers, of course, do not get any consumer’s surplus, as the price is equal to what they are prepared to pay, while intramarginal buyers receive some consumer’s surplus for what they have been asked to pay is actually less than what they are willing to pay for the commodity. This sort of price discrimination is feasible when the total market for the product is very wide, with a large number of buyers having different tastes, different incomes, and different conditions, so that subdivisions of the market or groups of buyers can be easily made. CU IDOL SELF LEARNING MATERIAL (SLM)

252 Micro Economics - I Thus, in the case of public utilities, like supply of electricity, telephone services, gas services, rail and bus transport services, etc., the services are given in blocks of small units, such as kilowatt hours of electricity, minutes of telephoning, cubic feet of gas, kilometres of distance, etc., that can be easily measured, recorded and billed. A graphical illustration of second-degree price discrimination is given in Figure 9.7. Thus, in the case of public utilities, like supply of electricity, telephone services, gas services, rail and bus transport services, etc., the services are given in blocks of small units, such as kilowatt hours of electricity, minutes of telephoning, cubic feet of gas, kilometres of distance, etc., that can be easily measured, recorded and billed. A graphical illustration of second-degree price discrimination is given in Figure 9.7. Y Y D MARGINAL DI CS PRICEP4 UTKILITY P1 A PRICEP3 II P2 P1 P2 E B I I I P FC P3 D X D X OQ O Q1 Q2 Q3 QUANTITY QUANTITY Fig. 9.6: Price Discrimination Fig. 9.7: Price Discrimination (Second Degree) (First Degree) In Figure 9.7, DD is the market demand curve for electricity in a region. Say, the monopolist produces output OQ3, which can be sold at OP3 uniform price. Then, the total revenue of the monopolist would be: OP3 GQ3. Instead, if price discrimination is adopted, total revenue can be enhanced. The market demand may be divided into say three groups. Their limits are represented by points A, B, and C. Thus, OQ1 amount may be sold in the first group (I) at OP1, Q1 Q2 amount is sold in group II at OP2 price, and Q2Q3 is sold to group III at OP3 price. Thus, under price discrimination the total revenue of the monopolist becomes the sum of the three rectangles: OP1AQ1 + Q1 EBQ2 +Q2FCQ3 area OP1 AEBFCQ3, which is obviously greater than OP3GQ3. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 253 Third Degree Price Discrimination Third degree price discrimination is the most common type of monopolist price discrimination in which the firm divides its total output into many submarkets and sets different prices for its product in each market in relation to the demand elasticities. The third degree price discrimination, thus, crucially differs from the second degree one in one respect that in the latter case, the price tends to be minimum as per the marginal utility of the marginal buyers, while in the case of the former, price depends on the allocation of output and the related demand elasticities in each market. For allocations of output, the monopolist would follow the principle of equi-marginal revenue, i.e., total output in each market will be distributed for sale in such a way that from each market, the resulting marginal revenue should be equal, so that the revenue is the maximum. Different prices are charged in different market, but in each market, buyers are treated equally. Figure 9.8 represents the case of third degree price discrimination. Two markets are taken into account. Demand curves for Market I and Market II are D1 and D2, respectively. D1 is less elastic and D2 is more elastic demand curve. When the monopoly firm produces Q1Q2 total output, it distributes OQ1 amount in Market I and OQ2 in Market II. OP1 price is set in Market I and OP2 price in Market II. MARKET - I MARKET - II P1 A P2 M1 M2 D2 DD1 1 MR2 X MR1 Q2 Q1 O Fig. 9.8: Third Degree Price Discrimination CU IDOL SELF LEARNING MATERIAL (SLM)

254 Micro Economics - I OP1 is a higher price charged in Market I having less elastic demand for the product than OP2 price charged in Market II (having more elastic demand). In this way, however, marginal revenues from both markets are equated (M1Q1 = M2Q2). 9.13 The Ingredients for Discriminating Monopoly: Conditions Essential for Price Discrimination The following are the essential conditions enabling the firm to resort to price discrimination:  Monopoly: Monopoly is a prerequisite of price discrimination. Undoubtedly, price discrimination is incompatible with perfect competition, because, as there are many sellers selling a homogeneous product, if one seller quotes a higher price to a group of buyers, who know the ruling market price, it is quite likely that they will go to other sellers. Under a monopoly price discrimination is possible because even though different buyers would know that they are differently charged, they have no alternative source of buying the product. Monopoly is a necessary but a sufficient condition to engage in price discrimination. Other ingredients for price discrimination are as follows:  Segmentation of the market: The monopolist should be in a position to segment the market by classifying the buyers into separate groups. When total market is divided into submarkets, each submarket acquires a separate identity so that one submarket has no connection with the others. Again, consumers have no inclination to move from a high priced market to a low priced one, either due to ignorance or absence of inertia.  Apparent product differentiation: Through artificial differences in the same product, such as differences in packing, brand name, etc., an apparent product differentiation may be created, so that it can be sold to the poor and the rich consumers at different prices. Price discrimination, with product differentiation, is tolerated by buyers.  Buyers’ illusion: When consumers have an irrational attitude that high priced goods are always highly qualitative, a monopolist can resort to price discrimination. Obviously, there is hardly any difference in viewing a film from the last row of the stalls and from the front row in the upper stall seats, yet a purchaser of an upper stall seat derives greater pleasure or place utility of occupying a high priced seat. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 255  Prevention of resale or re-exchange of goods: Goods of discriminating monopoly, sold in different markets, should not be re-exchangeable between buyers of a low priced market and a high-priced market. Wide geographical distance, high cost of transport, national frontiers (in case of internationally traded goods) and tariffs, effectively prevent re-exchange.  Non-transferability characteristics of goods: There are some goods which, by their very nature, are non-transferable between one buyer and another. In direct personal services, therefore, price discrimination is easily resorted to because of this non-transferability characteristic. Obviously, a poor person cannot go on behalf of the rich to get medical treatment from a doctor. Similarly, haircuts, private tuitions, etc., are non-transferable services by their very nature.  Let-go attitude of buyers: When price differences between two markets are very small, the consumers do not think it worthwhile to consider such discrimination. For instance, in the distribution of Dalda Vanaspati (cooking medium), there is a zonal price differential which is a marginal one, so that we hardly pay any attention to such differences of 5 to 10 paise per kilogram in different zones.  Legal sanction: When, in some cases, price discrimination is legally sanctioned, the transfer of use of the produce is legally prohibited in order to make it effective. For instance, if electricity, for domestic purposes is used for commercial purposes, the customer is liable to penalties. 9.14 The Concept of Monopolistic Competition Monopolistic competition refers to the market organisation in which there is keen competition, but neither perfect nor pure, among a group of a large number of small producers or suppliers having some degree of monopoly power because of their differential products. Thus, monopolistic competition is a mixture of competition and a certain degree of monopoly power. In other words, a market with a blending of monopoly and competition is described as monopolistic competition. It is a hybrid of monopoly and competition — thus, monopolistic competition. CU IDOL SELF LEARNING MATERIAL (SLM)

256 Micro Economics - I 9.15 Characterisitcs of Monopolistic Competition Monopolistic competition, as the term suggests, entails the attributes of both monopoly and competition: The following are the main features of monopolistic competition:  Large Number of Sellers: A market organisation characterised by monopolistic competition must have a sufficiently large number of sellers or firms selling closely related, but not identical products. The large number of firms, in the same line of production, leads to competition. Since there is no homogeneity of goods supplied, competition tends to be impure but keen. The number of firms being relatively large, there are less chances of collusion of business combines to eliminate competition and to rig prices.  Product Differentiation: Monopolistic competition is essentially competition with differentiated products. It is the most distinguishing feature of monopolistic competition that the product of each seller is branded and identified. Unlike perfect competition, thus; there is no homogeneity of product. Through product differentiation each seller acquires a limited degree of monopoly power.  Large Number of Buyers: There are a large number of buyers in this type of market. However, each buyer has a preference for a specific brand of the product. He, thus, becomes a patron of a particular seller. Unlike perfect competition, here buying is by choice and not by chance.  Free Entry: Under monopolistic competition, there are no entry barriers. Firms can enter or quit freely. This makes competition stiff because of the close substitutes produced by the new entrants with their own brand names.  Selling Costs: Selling costs are a unique feature of monopolistic competition. Since products are differentiated and may be varied from time-to-time, advertising and other forms of sales promotion become an integral part in marketing the goods. Outlays incurred on this account are termed as selling costs. Selling costs are, thus, costs which are meant for sales promotion. This distinguishes it sharply from pure competition. In pure or perfect competition, there is no need to advertise products and undertake sales promotion efforts because the CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 257 goods are homogeneous and each firm experiences a perfectly elastic demand curve so that it can sell as much as it likes at the ruling price. Under monopolistic competition, products are differentiated and these differences are made known to buyers through advertisement and other means of sales promotion. Again, selling efforts are needed to cause a shift in demand for the product and to capture a wider market.  Two-Dimensional Competition: Monopolistic competition has two facets: (a) price competition, and (b) non-price competition. In this kind of market, the firms compete with each other on the price issue. They also compete on non-price issues to expand their sale. Non-price competition is in terms of product variation and selling costs incurred by each seller to capture his share in the market.  The Group: Chamberlin introduced the concept of group to replace the traditional concept of industry in the theory of value. Industry refers to a collection of firms producing a homogeneous commodity. The term ‘industry’ is in perfect tune with pure or perfect competition. It is also conducive to a monopoly market, as a monopoly firm itself is the industry. But the term is not in harmony with monopolistic competition. Monopolistic competition is characterised by product differentiation. Firms, under monopolistic competition produce similar but not identical goods. Therefore, we cannot conceive of an industry in the monopolistically competitive market. It is ridiculous to talk of the furniture industry, bicycle industry, automobile industry, etc., in an analytical sense. This is because, on account of product differentiation, the product of each firm is identifiable and, in a sense, therefore, each firm is an industry in itself, just like a monopoly firm. In short, since there is no homogeneity of products sold by all the sellers in the monopolistically competitive market, we cannot think of industry as conceived by Marshall. Chamberlin, therefore, introduced the concept of group. A group is a cluster of firms producing very related but differentiated products. Thus, when product differentiation is a prominent feature of the market, the collection of firms that produce similar varieties of product having a high negative cross elasticity of demand is referred to as ‘group’ or ‘product group.’ Chamberlin assumed the ‘group’ to be open that is, there is unrestricted entry of new firms into the groups till it reaches complete equilibrium. CU IDOL SELF LEARNING MATERIAL (SLM)

258 Micro Economics - I 9.16 Equilibrium Output and Price Determination of a Firm under Monopolistic Competition A firm under monopolistic competition is a price-maker. Thus, unlike perfect competition, there is a pricing problem. The firm has to determine a suitable price for its product which yields a maximum total profit. Assuming a given variety of product and constant selling outlays, when price is considered as the only variable factor, the short run analysis of price adjustment by an individual firm under monopolistic competition, more or less, entails the same features like that of price output determination under pure monopoly. In the long run, however, a major difference is noticeable in the equilibrium process and position due to a change in demand conditions and other factors associated with the process of group equilibrium. The Short Run Equilibrium To explain the process of individual equilibrium, we assume that all other producers are in equilibrium with respect to their prices, varieties of products, and sales outlays. We further assume that the firm which we have taken in our consideration has also a given variety of product and constant sales expenditure. Hence, there is only the problem of price and output determination. In the short run, the firm can adopt an independent price policy, with least consideration for the varieties produced and prices charged by other producers. The firm being rational in determining the price for a given product will seek to maximise total profits. Knowing the demand curve, which is the sales curve of the firm for a given product, we can easily derive its marginal revenue curve. The demand curve itself is the average revenue curve, which is downward-sloping curve for a firm in a monopolistically competitive market. The marginal revenue curve also slopes downward and lies below the average revenue curve. In order to maximise its total profits or minimise its losses in the short run, the firm produces that level of output at which marginal cost is equal to marginal revenue (i.e., MC = MR). Thus, equilibrium output is determined at the point of intersection of the MC curve and the MR curve as shown in Figure 9.9. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 259 Y PRICE, COST, REVENUE SMC A SAC P B C SAR SMR OQ X OUTPUT Fig. 9.9: Short Run Equilibrium of a Monopolistically Competitive Firm In Figure 9.9, we have assumed the case of a representative firm with hypothetical cost and revenue data in a monopolistically competitive market. For the sake of simplicity, it is thus assumed that (i) demand conditions, and (ii) cost conditions are identical for all the firms in the group. These assumptions, in fact, are the bold assumptions made by Chamberlin in his theory of monopolistic competition and its characteristic, i.e., diversity of group under product differentiation. No doubt, these assumptions very much simplify our model, but they are not altogether unrealistic. In the case of retail shops such as provision stores or chemist shops, etc., standardised products will tend to have more or less identical demand and cost conditions, as their product differentiation is confined to only locational differences. Equilibrium point E is determined where, SMC = SMR. OP price. OQ output. PABC is profit. In Figure 9.9, we see that the firm attains equilibrium when OQ output is produced at which SMR = SMC. In relation to the given demand curve (SAR curve), the firm will set OP price to sell OQ output. The firm as such earns supernormal profits to the tune of PABC. Such profits in the short run are possible when there are not enough rivals who sell closely competitive substitutes to compete these profits away. CU IDOL SELF LEARNING MATERIAL (SLM)

260 Micro Economics - I The Long Run Equilibrium When firms in the short run earn supernormal profits in a monopolistically competitive market, some new firms will be attracted to enter the business, as the group pertaining to the industry is open. On account of rivals’ entry, the demand curve faced by the typical firm will shift to the origin and it will also tend to be more elastic, as its share in the total market is reduced due to competition from an increasing number of close substitutes. Gradually, in the long run, when the firm’s demand curve (AR curve) becomes tangent to its average curve, the firm earns only normal profits. The situation is depicted in Figure 9.10. Y PRICE, COST, REVENUE LMC PRICE = AC LAC AP LAR E LMR O Q OUTPUT X Fig. 9.10: Long Run Equilibrium of a Monopolistically Competitive Firm As shown in Figure 9.10 in the long run the firm produces OQ level of output, at which LMC = LMR, (EQ). At this equilibrium output, the LMR curve is tangent to the LAG curve at point P. Thus, PQ, is the price which is equal to the average cost. Apparently, OQPA is the total revenue as well as total cost, so the firm earns only normal profit in the long run. Existing competitors in the market in the long run will be producing similar products, and their economic profits will be competed away. Thus, in the absence of long run profits, there is an incentive to the entry of new firms. Furthermore, it can also be noticed that when a typical firm attains equilibrium and determines the price (= AC), by producing OQ level of output as shown in Figure 9.10, it is just breaking even. Since the LAR curve is tangent to the LAC curve at point P, which is attainable only by producing OQ level of output, any output less than that implies that AR < AC, indicating a loss. So also, any output more than OQ means P < AC and a loss. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 261 At E, LMC = LMR. Further, PQ Price = LAR. Only normal profit. It should be noted that monopolistic competition implies severe competition between a large number of firms producing close substitute products. Hence, this market situation is more similar to perfect competition than monopoly. In a monopolistic group, owing to the unrestricted entry of new firms, abnormal profits are usually competed away in the long run, and firms will always seek to realise pure economic profits once again by advertising and innovation in products or processes. Consequently, firms will resort to non-price competition, i.e., competition in product variation as well as by increasing their advertising expenditure (selling costs). 9.17 Product Differentiation: Basis and objectives Product differentiation is a unique feature of monopolistic competition. Basis of Product Differentiation There are many ways of making products different from one another. Branding is the most common and essenial aspect of unique identification of product. Analytically, differentiation may be classified into two types: (i) quality and characteristics of the product itself, and (ii) conditions relating to the sale of the product. Product differentiation relating to quality and characteristics of the product can have a wide dimension, implying real as well as spurious or imaginary differences. Products of different firms may have real or physical differences in their functional features — the mode of use and operations, etc.; size, design and style, strength and durability, differences in the quality of materials, chemical composition, workmanship, cost of inputs, etc. There may be imaginary or spurious differences relating to trade marks and brand names (e.g., aspirin products like Aspro, Anacin, Avedan, etc.), colour and packing, etc. Advertising claims and sales propaganda are also some of the spurious differences which may influence the minds of buyers of products of different sellers. Product differentiation may be due to the conditions of sale and marketing. In this regard, the proximity and prestige of the location of business, the attitude and courteous approach of the personnel attending to customers, the firm’s own business reputation, buyer’s confidence, the terms of trade, such as discount and credit, acceptance of returned goods, and guarantee of service and repairs, etc., are the important aspects of product differentiation. CU IDOL SELF LEARNING MATERIAL (SLM)

262 Micro Economics - I Product differentiation, thus, may range from strong to weak, which influences the consumer’s psychology and preference or choice. In any event, product differentiation, whether real or spurious, identifies the seller and confers on him a degree of monopoly power which he can exploit well to capture a segment of the market. Red Bull, for instance, became a big brand by creating a new market and labeling this new market “Enough Drinks”. Objectives of Product Differentiation Product differentiation has two dimensions: (i) product differentiation as a point of time, and (ii) product development or quality variation over a period of time. Product differentiation at a point of time aims at identifying the product of the seller from the product of rivals. But over a long period of time, when the sellers resort to product competition, each one adopts quality variation of improvement in the product. The purpose of product development is in quality variation. The product is adjusted more sensitively to the tastes and preferences of consumers, which would ensure their strong patronage. Instances of product development undertaken by Indian producers, from time-to- time, are not uncommon. For instance, for better results, TV manufacturers are making technical improvements in their sets. In electrical appliances, furniture, garments, etc., also, material, design, styles, etc., are varied for betterment of the products. Even in textbooks and other books, when new editions are brought out, there is some improvement in the quality. By resorting to product improvement and giving a new brand name to it, the producer hopes to have a more inelastic demand for his product as well as a demand curve further up and to the right of origin. So, he can charge a higher price than what was charged for the old variety, without losing patronage. This is possible because he then enjoys greater attachment of the consumers to this product. If he charges the same price and improves his product, his sales are bound to multiply. That is how when producers resort to quality variation and product differentiation in a monopolistically competitive market, the phenomenon of product competition takes place. 9.18 Product Differentiation: a Facet of Non-Price Competition In a monopolistic group, when a firm resorts to non-price competition, it undertakes quality variations. Qualitative changes in the product imply adapting the product to the latent demand of CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 263 prospective buyers. It means moulding a variant of the product item that makes a greater and wider appeal to the consumers. Indeed one variant of the product may command the loyalty of more buyers than another one. When a quality improvement of product is brought about in relation to the materials used, the workmanship or to the service, etc., the firm benefits from altogether a new demand for its product than what it had for its previous product. This is because the quality variation conforms to the tastes and preferences of buyers. With improved product and enhanced utility, the producer hopes to face a more inelastic demand for the product. The demand curve as a result shifts up and to the right with respect to the origin. Apparently, when the producer finds demand for his product or sales curve less elastic due to quality variation, other things being unchanged, he charges a higher price than before, without experiencing any market contraction in the sale of his product, or, if he continues to charge the same price, he finds an increase in the demand for his product. The line of argument is further exposed in Figure 9.11. PRICE A B CC P Db Dc Da O Q1 Q2 Q3 X QUANTUM OF SALES/DEMAND Fig. 9.11: Sales Curves with Product Improvement Demand Curve Da corresponds to variety A, Db to B and Dc to C. Still improved variety C. PC is a demand line. In Figure 9.11 with different improved varieties A, B, C, etc., of the product, the illustrative firm faces more and more inelastic demands as well as a demand curve further up to the right, such as Da, Db, Dc, etc. Remember, here each variant of the product has its typical demand or sales curve. Hence, the shift from Da to Db is not a shift of the demand curve but Da and Db are the two different demand (or sales) curves for the two varieties of the product, namely, A and B. At a given CU IDOL SELF LEARNING MATERIAL (SLM)

264 Micro Economics - I price OP, we find points A, B, C, etc., on each demand curve Da, Db, Dc, etc., showing their respective price-quantity relations. Besides, product variation involves changes in the cost of production curve. Qualitative improvement in the product implies an increase in the cost of production; so the cost curve shifts. In short, when product variation is undertaken, cost of production changes and simultaneously, there is an alteration in the demand for it. A peculiar feature of product variation is that as the product is varied qualitatively rather than quantitatively, a series of product variations, as such cannot be measured along an axis and displayed in a single diagram. Hence, for each variety of product, a diagram is to be imagined with regard to its cost curve and the relative demand position. In the product adjustment, the problem of the entrepreneur is to select the “product” whose cost and whose demand are such as will yield the largest total profit at a given price (Chamberlin, 1962: 78). In other words, a rational producer seeks to choose that variety of product at a given price which yields the maximum total profits. To illustrate the point, let us assume two varieties of product, A and B. In Figure 18.4, the curve AA represents the cost curve for product A and the curve BB represents the cost curve for product B. Assuming a fixed price OP for any variety of the product, we have OQ demand for the product A and OQ2 demand for the product B. It should be noted that PL is a fixed price line, but it is not a demand line. Y B A REVENUE COST PF RL HG S T B A O Q1 Q2 X OUTPUT Fig. 9.12: Product Adjustment: Individual Equilibrium CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 265 It does not imply, in this case, that at a given price there is indefinitely a large demand. Though price is the same, each variety of the product has its typical demand. At point F, thus, there stands a demand curve and at point R, there is a different demand curve implied. These demand curves are not drawn in the diagram just to avoid complexities. Thus, in the process of attaining product equilibrium, the firm cannot move back and forth along the cost curve, say along AA, in order to determine the most profitable output. Rather, the firm has to move from one cost curve to another in accordance with the product variation. In order to select a variety, the firm makes comparisons between costs and demands and the resulting profits for all possible varieties and chooses the most profitable one. In our illustration, for product A, the firm’s total revenue at OP price is from OPR (FQ1) while its total cost is OHGQ1. Therefore, the total profit is PFGH. For product B, however, total revenue at OP price is OPRQ2 > and total cost is for OQ2 output OTSQ2. Therefore, the total profit is PRST. Comparing the two it is easy to see that PRST > PFGH. Evidently, the rational firm will choose B and sell its OQ2 amount at OP price. It may be observed that for the selected variety of the product is not relating to the most C production, i.e., OQ2 is not produced at the minimum point of average cost curve. Again, the product chosen may not have the lowest cost of product to the cost conditions or its other varieties. For instance, the curve BB, the curve AA, but its product B which yields a larger profit than that. Moreover, the product chosen may not necessarily be the one which is in demand. Suppose we may take product C into account whose demand is high the cost is also relatively high, the relative profitability of C may be less than that of B. In that case, the rational firm will choose product B rather than C. Price and Cost Product Variation So far we have analysed the equilibrium process of an individual monopolistic competition, assuming price as constant and product as a variant. Let us now consider both the factors, price and product, as variable. A rational producer will choose that variety of product and price which yields maximum total profits. To illustrate the point, let us assume three varieties A, B, and C of a product, demand curves, Da, Db and Dc, as shown in Fig. 9.13. CU IDOL SELF LEARNING MATERIAL (SLM)

266 Micro Economics - I Y Y Y PRODUCT A PRODUCT B PRODUCT C N P3 MCc ACb PRICE, COST, REVENUE T P2 MCb H P1 MCa ACb M R GF ACa S Db MRc Dc XO MRa Da MRb Q2 O Q1 XO OOUUTTPPUUTT Q3 X Fig. 9.13: Price-cum-Product Variation: Individual Equilibrium For product A, equilibrium price and output conditions are P1Q1 and OQ1. Its yields profits (P1FGH. Product B has equilibrium condition of P2Q2 price and OQ2 output which yields profit for P2RST. Similarly, for product C, equilibrium price is P3Q3 and output is OQ3, which yield profits P3LMN. On comparison, P2 RST > P3LMN > P1FGH. It, thus, follows that product B is the largest profit-yielding variety. So, the producer will select product B and produce OQ2quantity and determine the price P2Q2 for it. 9.19 Selling Costs Expenditure incurred by a firm on advertising and sales promotion of its product is known as selling costs. Thus, selling costs include the following items of expenses: 1. Advertising and publicity expenditure of all sorts. 2. Expenses of sales departments, such as commissions and salaries of sales manager, sales executives and other staff. 3. Margins granted to dealers in order to increase their efforts in favour of particular goods. 4. Expenses for window displays, demonstration of goods, free distribution of samples, etc. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 267 Economists, however, define selling costs as costs incurred in order to alter the location or shape of the demand curve or sales curve of a product. The effect of advertising expenses is to shift the demand curve for a given product to the right by making known to the prospective buyers its availability, by describing it, and by suggesting the uses it can be put to. Briefly, the aim of any producer, who incurs advertising expenses, is to sell a larger output at a given price than what he can sell in absence of these costs. Under monopolistic competition, often extensive advertising expenditure becomes essential to highlight the features of product differentiation of the firm’s product from that of rivals. Through a successful advertising campaign the firm may establish the buyers’ preference, patronage and brand loyal for its product. Thus, render the demand inelastic — so that, it can raise price for augmenting sales revenue and profits. Sales promotion is based on two important factors: (i) imperfect knowledge on the part of the consumers; and (ii) the possibility of changing their wants through advertising or selling appeal. Thus, the impact of selling costs on consumer demand depends on these two factors. To Chamberlin, ignorance of products on the part of the consumer is an important reason for advertising. Buyers usually are ignorant of the different sellers in a given line of product and the differences in the quality of their products. They are also dimly aware of relative prices for similar goods. In this regard, a seller may resort to “informative advertising”, i.e., describing the quality and price of his product and thereby try to influence the shape and location of the demand curve. By spreading information about the product through appropriate advertisement, seller’s market may increase, which leads to a shift to the right in the demand curve for the product. Without advertising, new products or varieties cannot reach the market under monopolistic competition. Indeed, the demand curve will be higher when more people are informed about the product through advertising. There can also be ‘manipulative advertising’, which affects consumer demand by altering the wants or preferences of the people. CU IDOL SELF LEARNING MATERIAL (SLM)

268 Micro Economics - I 9.20 Distinction between Selling Costs and Production Costs The selling costs must be clearly distinguished from the pure cost of production of a given commodity. Following Chamberlin, we may lay down the significant points of distinction as under:  Cost of production includes all expenses which must be incurred in order to provide the goods or service, transport it to the buyer, and place it into his hands ready for consumption. Cost of selling, on the other hand, includes all expenses incurred to obtain a demand, or market, for the product.  Production costs are meant for the creation of utilities which would satisfy the latent demand of the buyers. Selling costs, on other hand, are meant for the creation and shifting of demand for the product.  Production costs are meant to adapt the product to demand, while selling costs are undertaken to adapt demand to the product. In other words, production costs manipulate the product, selling costs manipulate demand.  Increase in the costs of production increases the supply of the product. Increase in the selling costs increases the demand for the product.  Production costs and selling costs exert their effect on prices in different directions. When production costs increase (assuming factor prices as given), the volume of output supplied increases. Hence, in the context of a given demand for a product, its market price tends to fall. While if additional selling costs are incurred, additional demand for the product is created which, in turn, causes the market price to rise. Thus, the distinction between production and selling costs has immense theoretical significance. In classical theory, in the analysis of costs, the element of selling costs was neglected because selling costs appeared to be inconsistent with perfect competition on account of a standardised product and a large number of rivals. In practice, production costs and selling costs are intermixed throughout the price system. Thus, at no single point can we say that production costs have ended and selling costs have begun. Say for instance, the transport cost cannot always be described as selling cost. Since transport cost CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 269 enhances the place utility of product, logically, it can be treated as production cost along with the cost of manufacturing. Hence, it is difficult in practice to separate production costs from selling costs. However, in determining the price, it is obvious that production costs-cum-selling costs must be covered by the firm if it is to remain in business. Average Selling Cost Curve (ASC) Advertising (synonymous with selling costs) increases the demand for the product. Hence, increasing selling costs imply increasing sales. Like production costs, selling costs are also subject to the three sequential stages of returns, viz., increasing sales returns, constant and diminishing sales returns. According to Chamberlin, in the course of analysis, selling costs, like production costs, can be split up into various factors of production, like land, labour and capital that are hired for selling purpose in different proportions. “The most efficient Marginal Selling Cost MSC intersects from below the Average Selling Cost ASC as its minimum point combination of factors will always be sought for any given total expenditure, and the general laws governing its determination will be the same for the sales organisation as for the production organisation.” It follows from this that, like the average production cost curve, the average selling cost curve is also U-shaped, as depicted in Figure 9.14. Y SELLING COST MSC ASC O X OUTPUT (SALES) Fig. 9.14: Average and Marginal Selling Costs CU IDOL SELF LEARNING MATERIAL (SLM)

270 Micro Economics - I In Figure 9.14 the curve ASC, representing average selling cost, is U-shaped. This implies that the selling cost per unit of output initially falls as returns are increasing, reaches the minimum and then, rises again under diminishing returns. This suggests that, initially, increase in selling costs, leads to a more than proportionate increase in demand for the product. Thereafter, demand tends to increase in proportion to increase in total sales outlay. Beyond a certain point, the demand tends to rise less proportionately to the rise in sales outlay. The addition made to total selling outlay, for expanding the sale of one extra unit of a given product, is referred to as the marginal selling cost. The marginal selling cost curve (MSC) also behaves in a U-shaped manner as shown in Fig. 9.14. It, thus, suggests that initially the marginal selling cost declines with the expansion of output and sales. It reaches the minimum, may remain constant for a while and, thereafter, starts rising. The reasons for this sort of behaviour of MSC are the same as has been discussed in the case of ASC. Concept of the Combined Cost In determining the optimum level of selling outlays, Chamberlin opines that we cannot draw any conclusion unless the cost of production is also taken into account. Here, he introduces the concept of combined cost. The aggregate of production costs and selling costs is referred to as combined costs. Thus, Combined Cost = Production Cost + Selling Cost. It follows that when as average production cost curve and the average selling cost curve are added together, a combined average cost curve is obtained (See Fig. 9.15). CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 271 Y C SELLING COST A BB CAC X D C SELLING COSTS APC OM OUT PUT Fig. 9.15: Combined Costs In Figure 9.15, the average production cost curve is represented by the curve APC. The average combined cost curve is denoted by ACC. Both the curves are U-shaped, however, the relationship between these two curves is as follows: The vertical distance between the two curves measures the average selling cost at each level of output. For instance, for OM level of output, CM is the average production cost and BM the average combined cost. Thus, BC is the average selling cost. Again, the area underlying the APC curve measures total production cost for a given level of output, while the area between the range of ACC and APC curves represents the total selling outlays. The area corresponding to the distance between ACC and APC curves also measures the total selling costs. In the figure, at OM level of output, total production cost is OMCD and the total combined cost is OMBA. Therefore, ABCD measures the total selling costs. 9.21 Individual Equilibrium: Selling Costs No doubt, sales expenditure results in an increase in the demand for the firm’s product. But the question is how much sales expenditure should the firm incur? The optimum sales expenditure is the one which yields maximum profits. Its determination, however, is an intricate problem because, to a monopolistically competitive firm, selling cost is one of the three interrelated variables — price, CU IDOL SELF LEARNING MATERIAL (SLM)

272 Micro Economics - I output and selling cost. Thus, in attaining equilibrium, the firm has to actually determine the most profitable output and incorporate relevant sales expenditure in order to create demand for that output. The firm has, therefore, to determine maximum profits or net returns, measured as follows: Net Returns (Profits) = (Price × Output) – (Production Cost + Selling Cost) Let us assume that product and price are given. The firm has to determine equilibrium output with a suitable sales expenditure. It will follow the same marginal rule of profit maximisation, but because of selling cost, it has to consider the combined cost rather than production cost alone. Thus, by equating marginal combined cost (MMC) with the marginal revenue (MR), it will determine the most profitable output as well as required selling cost. Since price and product are given, the MR curve tends to be a horizontal line at a fixed price. The process of equilibrium is depicted in Fig. 18.8. Y CMC CAC PRICE, COST, REVENUE P E DMR=AR PROFIT APC RS T V OM X OUTPUT Fig. 9.16: Selling Costs Equilibrium At E : CMC = MR. OM equilibrium output. RSTV measures selling costs. PESR represents profit. In Figure 9.16, APC is the average production cost curve, ACC is the combined average cost (production cost + selling cost) curve. MCC is the marginal combined cost curve. At OP price, the line PD represents MR = AR. Equilibrium point E is determined by the intersection of the CMC curve with the MR curve (PD). Thus, OM, the equilibrium level of output is determined. To create sufficient demand for OM output, the total selling cost required is measured by the area RSTV. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 273 Similarly, the maximum profit obtainable is shown by the area. Be First  Market Mantra for Evergreen Success : ‘Create a new category . You be the first to do so in the market.’ A few examples:  Amazon.com : the first online bookstore  Carrier: the first air-condition  Dell : the first direct seller of personal compute.  Domino’s “the first home- delivery pizza chain.  Heineken : the first imported beer  KFC : the first fast food chicken chain.  Nike :the first athletic shoe.  Swatch : the first fashion watch .  Xerox :the first plain paper copies. 9.22 Summary  Monopoly refers to a market structure characterised by a single seller, selling a unique product in the market.  Monopolistic enjoy the power of setting the price for this product.  The key cost of monopoly is restriction of industry production thus, unutilisation/wastage of productive resources of the country.  When a monopoly is formed by the firm, it stops competition fro, the outside.  Monopolies, in the economy as a whole,reduce productivity and kill substitutes.  Monopoly.increase income inequality by concentrating wealth in major cities.Whether it is CU IDOL SELF LEARNING MATERIAL (SLM)

274 Micro Economics - I America or India.  Monopolistic competition characteristic an industry in which many firms offer products/ services that are similar, but not perfect substitutes. No Barbers, for example, are equally alike in their hair-cut or hair-style giving services. Saved habit may home same shop model in different area of Mumbai, but the efficiencies of the hair dressers may not be the exactly same in every shops despite being trained.  Heavy advertising and marketing is common among firms under monopolistic competition, which may be regarded as wasteful.  Term monopolistic competition has been coined by Prof. Edwane Chamberlain.  In shoes markets, brands like Nike, Bata, Adidas, Pump, etc. All have share in sports shoes, apparels, etc.They all have separate market, Share and have in the market, which bestows a degree of monopoly power, but they all are competing extensively & intensively to capture their share in the market.  Selling costs refer to advertising expenses and promotional activity costs. 9.23 Key Words/Abbreviations  Monopoly: A single seller in the market.  Monopolistic Competition: Many sellers with a degree of monopoly power competing through product differentiation.  Non- Price Competition: Product variation and branding.  Selling costs: Advertising and sales promotion costs.  Grasp: Comprising firms setting differential products. Items, the concept of industry is replaced by group in the new theory offered by Chamberlain. CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 275 9.24 Learning Activity 1. Visit bata shop in your area and collect data on price and product and prepare your report. -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- 2. Compare the AR, MR of new market product with old product with reference to advertisement. -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- 9.25 Unit End Questions (MCQs and Descriptive) A. Descriptive Types Questions 1. State the main features of Perfect Competition. 2. Expose the condition of short-run equilibrium of a competition firm. 3. Drawing the diagram explain less normal profit and excess profit making output positions of a competitive firm. 4. Define Monopoly. What are its characteristic features? 5. State the measures of monopoly power. 6. State the sources of Monopoly power. 7. Explain briefly, short-run monopoly equilibrium. 8. Write a note on long-run Monopoly Equilibrium. 9. Make a competition between competition and monopoly market models. 10. What is price discrimination? What are its forms? 11. Define monopolistic competition. State the main features of such a market situation. CU IDOL SELF LEARNING MATERIAL (SLM)

276 Micro Economics - I 12. Diagrammatically expose the short-run equilibrium condition of a monopolistic competitive firm. 13. Discuss the basis and objectives of Product Differentiation. 14. Distinguish between Selling Costs and Production Costs. 15. Trace the equilibrium of a firm involving selling costs. B. Multiple Choice/Objective Type Questions 1. The Behavioural Rule of Profit Maximisation is to equal __________. (a) MR with MC (b) TR with TC (c) MR with TC (d) TC with Output Quantity 2. A monopoly Firm is __________. (a) Price-taker (b) Price-maker (c) Price-destroyer (d) All these 3. Monopoly power is expressed in changing __________. (a) a high price much above cost (b) A high price equal to high cost (c) A dumping price (d) A normal profit making price 4. Monopoly power can be required through __________. (a) Technical progress (b) Trade Marks (c) Wage control (d) Patronising Politicians 5. Price Discrimination implies __________. (a) Charging different prices to different buyer (b) Charging different prices to for different products CU IDOL SELF LEARNING MATERIAL (SLM)

Price and Output Determination of the Firm and Industry 277 (c) Charging different prices to the same customer (d) All of These 6. Under Monopolistic Competition __________. (a) There is no government rule (b) There is no free entry (c) There is no license fees (d) these are no entry barriers 7. A firm under monopolistic competition is __________. (a) price-seizer (b) Price-taker (c) Price-maker (d) None of these 8. Branding is __________. (b) Rewarding (a) Bursting (d) Time-saving (c) Integrating 9. Selling costs is __________. (a) Managerial costs (b) Banner costs (c) Painting costs (d) Advertising costs 10. Production cost + Selling cost is termed as __________. (a) Combined cost (b) Monopolistic costs (c) New cost (d) None of these Answers 1. (a), 2. (b), 3. (a), 4. (b), 5. (a), 6. (d), 7. (c), 8. (b), 9. (d), 10. (a) CU IDOL SELF LEARNING MATERIAL (SLM)

278 Micro Economics - I 9.26 References 1. Chamberlain, E.H.L., 1962, “The theory of Monopolistic Competition”, Cambridge, Harvard University, Press. 2. Hierarchy M. And Pappns, J.L., 1998, “Fundamental of managerial economics”, Singapore, Thomson Asia. 3. Samuelson W.F. & S.K.Marks, 2003, “Managerial Economic”, John Wiley N.J. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 279 UNIT 10 CONCEPTS AND THEORIES OF RENT, INTEREST, PROFIT Structure: 10.0 Learning Objectives 10.1 Introduction 10.2 Concept of rent 10.3 Quasi-Rent 10.4 The Ricardian Theory of Rent 10.5 Modern Theory of Rent 10.6 The Meaning of Interest 10.7 Gross and Net Interest 10.8 The Classical Theory of Interest 10.9 The Loanable Funds Theory of Interest 10.10 The Concept of Profit 10.11 Gross Profit and Net Profit 10.12 Dynamic Theoryof Profit 10.13 Risk and Uncertainty-Bearing Theory of Profit 10.14 Summary 10.15 Key Words/Abbreviations 10.16 LearningActivity 10.17 Unit End Questions (MCQs and Descriptive) 10.18 References CU IDOL SELF LEARNING MATERIAL (SLM)

280 Micro Economics - I 10.0 Learning Objectives After studying this unit, you will be able to:  Elaborate the basic concept of Rent, Interest, and Profits  Explain Ricardian Theory of Rent  Discuss Modern Theory of rent  Analyse Loanrble Funds Theory of Interest  Describe Rich and Uncertainty Theories of Profit. 10.1 Introduction Rent is the reward for land. The term ‘rent’, in the economic sense, has a more precise and scientific connotation than its ordinary usage or meaning. Ordinarily, rent refers to the compensation for the use of somebody’s belongings for a period of time such as a car, an airconditioner, a computer, a house, or a farm. In economics, however, the term ‘rent’ originally meant the payment for the productive use of land. But modern economists have given it a broader connotation by defining it as the surplus earned by a factor over and above the minimum earnings necessary to induce it to continue its work. 10.2 Concept of Rent Analytically speaking, distinction between contract rent and economic rent will be useful in order to have a better understanding of the term ‘rent’. Contract Rent Contract rent is a commercial rent referring to a periodical payment for the use of something. It is a rental income. It is the price paid per unit of time (say, monthly or yearly, for instance) for the services of a durable good, such as land, house, machine, car, furniture, computer, etc., when hired rather than purchased outright. Thus, the rent of a house, the rent of car, the rent of a piece of land, the rent of a television set, the rent of a VCR, etc., are contract rents. These are referred to as ‘rents’ or ‘rentals’. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 281 Contract rent is a contractual payment for a stated period. Contract rent is a gross rent. Contract rent, being a gross rent, includes economic rent, or pure rent, plus other elements such as interest on capital, service charges, profit, etc. For example, the rent of a hotel room is gross rent as it includes compensation for the use of land or ground, interest for capital invested, wages of management and other services, and profit for the risk involved. Economic Rent Rent in economics means ‘economic rent’. Economic rent is a differential surplus. According to Ricardo, economic rent is the surplus of the yields of super-marginal or more fertile land over the yields of the marginal or the least fertile land. To him, economic rent is a true surplus which is paid to the landlord for the use of natural utility — the productive powers of the soil. The classical economists, thus, held that economic rent was applicable to land alone. To modern economists, however, economic rent means income or yield derived from any factor whose supply is inelastic. In modern terminology, economic rent is the surplus over supply price of the factor measured in terms of its opportunity cost. More precisely, economic rent is defined as any excess of payment made to a factor of production over and above what is necessary to keep it in its current activity. Alternatively, economic rent is the excess of a factor of production’s actual earnings over its transfer earnings. Transfer earning is the supply price of the factor measured in terms of its opportunity costs. Thus, transfer earnings are what the particular factor could earn from its next nest alternative use. Thus, transfer earnings are the minimum which must be paid to a unit of a factor to retain it in its present activity or use. Anything which is earned as a surplus over its transfer earning by a factor is described as economic rent. 10.3 Quasi-Rent Alfred Marshall originated the concept of quasi-rent, which refers to the short-run earnings of some factors of production, especially capital, such as machines and other man-made instruments of production that are in fixed supply during a short period. Unlike land, these factors of production, like machines, capital equipment, factory buildings, ships and even human ability are in fixed supply but only for a short period. Their supply is elastic in the long-run. In the short-run, as their supply is inelastic, when the demand for them increases, their income rises, and they earn a surplus. The surplus earned by these factors is temporary, as their supply becomes elastic in the long-run. When CU IDOL SELF LEARNING MATERIAL (SLM)

282 Micro Economics - I in the long-run, their supply increases and is adjusted with their demand, their surplus earnings get wiped out during the short period. Hence, the short-run surplus earnings from the use of these factors cannot be regarded strictly as rent, though the earnings look like rent due to its inelastic supply. Marshall, therefore, coined the term ‘quasi-rent’ (meaning just like rent) to describe this phenomenon. Briefly quasi-rent may be defined as the surplus income over the normal earnings derived from the use of certain factors, especially capital and special categories of labour, in the short period during which their supply is inelastic. Quasi-rent is, thus, a short-term temporary surplus earning of some factors. Regarding man-made factors like capital, from the above definition, it appears that the additional returns on capital in the short-run are similar to rent because of inelasticity. But that is not so in the long-run when its supply becomes elastic. That is why such returns are called ‘quasi-rent’. Regarding capital’s reward, Marshall states that the quasi-rent in the short-run becomes interest in the long- run, as the rate of return on capital investment tends to be equal to the long-term rate of interest under competitive market conditions. Quasi-rent refers not to the whole of income but to the short-term extra income earned by a factor in excess of its normal return. A popular example of quasi-rent is the earnings made by ships during the Second World War, when there was a sudden increase in the demand for shipping. Since ships could not be built overnight, the supply of ships during the short period was inelastic. An acute shortage of shipping was felt during the war. Consequently, freight charges of cargo ships went up abnormally high. Hence, the earnings from ships to shipping companies during the war period were far more in excess of their normal incomes. This surplus income was similar to rent, i.e., ‘quasi- rent’. In the post-war period, when the high demand for shipping persisted, new ships were built. Hence, shipping charges came down to their normal level, so the surplus earnings disappeared. In this way quasi-rent remains a short-run phenomenon. Marshall does not present a formal and explicit definition of quasi-rent. Stonier and Hague have, however, tried to give a formal definition of the concept as follows: “The quasi-rent of a machine is its total short period receipts less the total costs of hiring the variable factors used in association with it to produce output, and of keeping the machine in running order in the short-run.” Thus, in the short-run, any returns earned by the use of a machine in excess of the prime costs (or variable cost of running it) can be regarded as rent — the quasi-rent. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 283 In short, to a firm or entrepreneur, the surplus of revenue received over the variable costs incurred in producing output in the short-run is quasi-rent. Indeed, quasi-rent is derived as the income from the use of fixed factors like machines, etc., and is price-determined in the short period. To express it symbollically: Q.R. = STR – STVC, where Q.R. = Quasi-Rent, STR = Total revenue in the short-run, and STVC = Total variable costs in the short period. Thus, any part of fixed costs covered by the price in the short-run is broadly treated as quasi- rent. In this way, quasi-rent is price-determined. This means, as the price of output rises in the short- run, more and more amount is received in excess of total price cost, which is considered as quasi- rent. To elucidate the point further, let us graphically illustrate the case of a firm which has only one fixed factor, say, a machine, and one variable factor, labour. Thus, the wage bill is the total variable cost in the short-run. The investment cost of the machine is obviously fixed cost. The firm’s decision to produce is independent of this fixed cost. The firm will continue to remain in business so long as it recovers its prime costs in the short-run. Thus, the minimum supply price of the firm’s output is the short-run total variable cost (STVC). Any return, in excess, is a surplus. It is the return for the use of the machine — a fixed factor. This surplus is regarded as quasi-rent (see Fig. 10.1 in this regard). Y PRICE AND COST ATC MC P3 E3 D3 (AR 3 = MR 3) P2 E2 D2 (AR 2 = MR 2) AVC P1 E1 D1 (AR 1 = MR 1) B3 A3 B2 A1 A2 B1 E P D (AR = MR) O Q Q1 Q2 Q3 X OUTPUT Fig. 10.1: Quasi-Rent CU IDOL SELF LEARNING MATERIAL (SLM)

284 Micro Economics - I In Fig. 10.1, the AVC curve represents prime cost of employing labour, i.e., wage bill. Distance between the ATC and AVC curves measures the supplementary cost of installing a machine. The MC curve represents the marginal cost of output. The price of the product is determined by the interaction of total demand and total supply. However, D, D1, D2 and D3 are the firm’s demand at alternative prices P, P1, P2 and P3. These demand curves represent the firm’s average and marginal revenues at respective levels of prices. E1, E1, E3 and E are the respective equilibrium points for the firm’s output determination in the short-run. At OP price, the firm prdouces OQ units and obtains total revenue OPEQ which is equal to the total variable cost. Hence, quasi-rent is nil. With the increase in demand, when price rises to OP1 the firm produces OQ1 and obtains OP1E1Q1 total revenue, which exceeds total variable cost OB1A1Q1 by the area P1E1B1A1. So, it is quasi-rent. Similarly, at OP2 price, OQ2 output is produced, with the intensive use of the given machine. Hence — Total Revenue: OP2E2Q2 — Total variable cost: OB2A2Q2.  Quasi-rent = P2E2A2B2. Similarly, at OP3 price of the output, OQ3 output is produced, P3E3A3B3 amount of quasi-rent is earned. In this case, there is an abnormally high quasi-rent as it is in excess of the fixed investments. It follows, thus, that like rent, quasi-rent is also demand-determined. Because, when demand increases, price goes up, and extra income is earned. Indeed, quasi-rent can also be looked upon as the difference between equilibrium price and the average cost of production (AVC). Thus: Quasi-rent = Price – AVC. Quasi-rent, is however, different from super-normal or normal profits, Super-normal profit = Price – ATC. Normal profit is obtianed when price = ATC. Further, profits can be negaitve. But quasi-rent cannot be negative because, if price is less than AVC, the firm will no longer remain in business. Again, quasi-rent is a short-term phenomenon only, because in the long run, all costs become variable costs and the equilibrium price = AVC. As Marshall puts it, in the long-run, any quasi-rent “is expected to, and generally does, yield a normal rate of interest... on the free capital, represented by a sum of money that was invested in producing it.” CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 285 10.4 The Ricardian Theory of Rent In the early years of the nineteenth century, David Ricardo, a noted classical economist, presented a theory of rent in his Principles of Political Economy and Taxation. The Ricardian Theory of Rent enquires into and explores: (i) the nature of rent, and (ii) the laws governing the rise and fall of rent. Ricardo, however, did not explain determinants of rent. He was chiefly concerned with the distribution of wealth, in which rent occupied a central position. He developed the theory of rent as a corollary to his labour theory of value. It is also said that Ricardo developed this theory of rent as a differential surplus, as an attack on the landed aristocracy. Main Postulates of the Ricardian Theory Ricardo’s theory of rent contains several interrelated propositions, as follows: 1. Rent is the Return for the Use of Land Rent is the return made to the landlord for the use of land. Ricardo David Ricardo defined rent as “that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible power of the soil”. Hence, to him, rent is paid by the tenant to the landlord for the use of natural productive properties of the soil. He, thus, distinguished the payment made for the power of the soil from the payment made for improvements on land. Rent is often, in fact, compounded with interest on capital. It is gross rent. Economic rent, however, is a true surplus which is paid for the use of the natural utility of land. 2. Rent is an Indication of the Niggardliness of Nature Ricardo viewed that high rents are not due to the bounty of nature but caused by the niggardliness of nature. What he implied is that it is the scarcity of land and the high prices of its produce that cause high rents. CU IDOL SELF LEARNING MATERIAL (SLM)

286 Micro Economics - I In the Ricardian systems, land signifies the original and indestructible powers of the soil which makes it supply perfectly inelastic. Land, in this sense, being a naturally fixed factor, its supply does not vary when the rent varies. Thus, with the rising demand, land appears to be more and more scarce. This scarcity of land leads to higher and higher rents. To Ricardo, the comparative scarcity of fertile land is the basic cause of the emergence of rent. He thus enunciated the principle of scarcity underlying the rent of land. He attributed rent to two basic factors, thus: (i) Scarcity of fertile land, and (ii) Ununiform quality of land. 3. Rent is a Residual Product Rent is a surplus left over after other factors such as labour and capital have been paid as per the value of their marginal product. 4. Rent is a Differential Surplus Ricardo viewed that rent is a ‘differential surplus’ earned by more fertile plots of land in comparison with the less fertile plots of land. When the demand for land produce rises, and prices increase, surplus over costs rises and rent tends to rise. Ricardo, however, denied absolute rent and went on explaining the differential rent. His theory of rent is, therefore, also regarded as the theory of differential rent or differential surplus. Under the tacit assumptions of heterogeneity of land (i.e., lands differing in fertility), the law of diminishing returns, inelastic or fixed supply of land, rising demand for land produce due to population growth, Ricardo advanced the theory that rent emerges on account of the differences in the quality of land. Qualitatively, some lands are more fertile, while others are less fertile. Superior and more fertile lands yield a surplus due to their differential advantages in production over inferior or less fertiles ones. This producer’s surplus of superior land Ricardo describes as rent. Hence, the more the fertility of the land, the higher is the rent yielded. The Ricardian theory may thus be called the “theory of differential advantage or differential theory of rent”. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 287 An Illustration: To clarify the Ricardian differential theory of rent, let us take a case study of a self-sufficient small village community. Let us assume that there are only four plots of land A, B, C and D labelled in order of their fertility, i.e., A is the most fertile land, B is inferior to A,C is inferior to B and D is the least fertile land. We may also assume that wheat is being cultivated on these plots. Again, these plots are of the same size; only their soil fertility varies. Moreover, the same doses of labour and capital are being applied on these plots. An extensive method of cultivations is used. Thus, to begin with, first A grade land is cultivated. To view the situation in a historical perspective, when a community first settles on land, people will use only the best land, i.e., grade A land. To the extent grade A land is abundant in supply, there will be no rent, as nobody would pay for the use of land when its supply is abundant. Say, if the demand for wheat is only up to 100 quintals, cultivation of land A is sufficient, and there is no rent. But, with the growth of population, as the demand for food increases, say up to 170 quintals, the scarcity of land A is felt, and inferior land B will be brought under cultivation. Now, when the cost of cultivation of land A and B is the same, because the same amount of labour and capital is applied, yet land A will yield 100 quintals or wheat, while land B yields only 70 quintals. This means that land A realises a surplus of 30 quintals over the yield of land B. It is a producer’s surplus or it is a rent which can be claimed by the owner of the land, i.e., it is a surplus of superior land over inferior land. If, however, the demand for food increases still further to say, 220 quintals, land C will have to be brought under cultivation. It yields, with the same amount of capital and labour, say, 50 quintals of wheat (70-50), which will be claimed by their respective owners. When population continues to grow and demand for wheat increases, it becomes necessary in due course to cultivate land of still poorer quality, i.e., D grade land. When land D is brought under cultivation with the same amount of labour and capital, it may yield 30 quintals of wheat. Now land A yields a surplus of 70 quintals of wheat, B yields 40 quintals and land C also now yields 20 quintals. Thus, land C, which did not get any rent previously, also earns rent when an inferior quality of land is brought under cultivation. We may also express the same thing in terms of money by calculating the price of labour and capital and the price of wheat. Here, we consider rent as the surplus over cost of production. Suppose the price of a given amount of labour and capital is 6,000. Now the price of wheat in a perfectly competitive market is such that total revenue equals total cost of marginal land. Thus, marginal land must fetch a total revenue of 6,000 and, for this, the market price has to be 200 per quintal of wheat. Thus, rent yields of different land would be as shown in Table 10.1. CU IDOL SELF LEARNING MATERIAL (SLM)

288 Micro Economics - I Table 10.1: Differential Rent Land Price × Quantity Surplus = Total Revenue – Total Cost = Total Revenue = Rent A B 200 × 100 = 20,000 20,000 – 6,000 = 14,000 C 200 × 70 = 14,000 14,000 – 6,000 = 8,000 D 200 × 50 = 10,000 10,000 – 6,000 = 4,000 200 × 30 = 6,000 6,000 – 6,000 = Nil Ricardo describes superior or more fertile land as intra-marginal or super-marginal land, while the last category of less fertile land as marginal land. Marginal land is so-called because it provides just the revenue to cover its cost of cultivation. Eventually, when even more inferior land is brought into cultivation, it is regarded as marginal land and the previous marginal land now becomes super- marginal land. Marginal land is no-rent land.Super-marginal land earns rent equal to the difference of its surplus yield over the yield of marginal land. Thus: Y INTRA-MARGINAL LAND (R( s.. 0000) 20 RENT OUTPUT RETURN 14 RENT RENT MARGINAL SURPLUS SURPLUS SURPLUS (NO-RENT) (Rs8. ,80,0000)0) ((Rs.44,0,0000) ) 10 LAND ((Rs.1144,0,000) ) 6 INPUT COST OA B C D X Fig. 10.2 Differential Rent Differential Rent: Surplus = Yields of super-marginal land – Yield of marginal land. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 289 Diagrammatical Presentation: Considering the arithmetical illustration of Table 10.1, the differential rent of different lands may diagrammatically be represented as in Fig. 10.2. Another way of graphical presentation of differential rent is through a competitive market model of the equilibrium of the different froms, with different qualities of land, as shown in Fig. 10.3. YY Y Y P4 MC MC MC AC MC AC B AC C XO P4 A P4 RENTE2 P4 D P3 G T RENT L RENT E1 AC F AR = MR P2 E2 E1 NO-RENT N M LAND P1 O A1A2A3A4 XO B1B2 B3 XO C1 C2 D1 X (c) (d) (a) (b) OUTPUT Fig. 10.3: Differential Rent: Ricardian Theory In Fig. 10.3, Panel (A) represents the average and marginal cost curves of the most fetile land A, Panel (B) represents those of land grade B, Panel (C) represents those of land grade C, and the average and marginal cost curves of grade D land are plotted in Panel (D). To begin with, when only land A is cultivated, initially OP1 is the market price and E1 is the equilibrium point at which MC = MR. (At each price, the connected horizontal line represents the average and marginal revenue curve.) OA1 is the equilibrium output produced. Land A at this stage does not earn any rent, as there is no surplus. Rent, in Ricardian theory, is defined as differential rent, which is a surplus revenue over cost. With the increase in demand for land produce, its price rises, say to OP2 Now, land A will be intensively cultivated. Moreover, the less fertile grade B land will also be brought into cultivation to meet the increased demand. Land B will not be cultivated unitl the price is at least OP2 so that price = average cost and E1 is the equilibrium point. Hence, OB1 is the amount produced by land B, whereas, for land A the equilibrium point shifts to E2 so it produces OA2 quantity of output. Since AR > AC for this output level, land A realises a surplus. This surplus, according to Ricardo, is claimed as rent by the landlord. Again, when the demand for food or any such land produce (wheat in our illustration) increases further, the price tends to rise. Let price be OP3 now. Land A will be more intensively cultivated so that OA3 equilibrium output is produced. The price or average revenue being much above the average cost, a large surplus is realised in the case of land A, so it yields more CU IDOL SELF LEARNING MATERIAL (SLM)

290 Micro Economics - I rent than before. With a rise in the price, land B is also intensively cultivated. Consequently OB2 is the equilibrium output, at which AR > AC; so there is a surplus which yields OP3 price, sufficient for the economic operation of the relatively inferior land C. Hence, there is also extensive cultivation to meet the increased demand for the land produce. Land C is, therefore, brought under cultivation, but it does not yield any rent at this stage. It is regarded as no rent or marginal rent land, while land A and B are intra-marginal. It must be noted that land A became intra-marginal when land B was brought into cultivation. Land B becomes intra-marginal when a comparatively low grade land C is brought into extensive cultivation. Indeed, it is intensive cultivation of the superior land which causes surplus to maximise and yield maximum rent under the given cost or price conditions. Now, in the process, if we assume a further increase in demand for the land produce, the price will tend to rise. If price goes up, say to OP4, it is economically viable to bring still inferior grade land D into extensive cultivation. Lands A, B, and C will then be more intensively used to increase the supply, but on account of diminishing returns, their output cannot be sufficiently increased; so the use of land D and extensive cultivation becomes inevitable. Land D produces OD1 output at which the average revenue (or price) is equal to its average cost. It has no surplus, so it yields no rent. It is also regarded as marginal land, for which AR = AC, so surplus is zero and it is no-rent land. Apparently, other superior grade lands — intra-marginal lands — A, B and C in this illustration now earn a rent. Land A will now earn highest rent, land B will earn less rent than that of A but more than that of C and land D will earn the least rent. Land C, which was marginal, would become intra-marginal land when land D is brought under cultivation. Land A produces OA4, land B produces OB3 and land C produces OC2 at price OP4, in accordance with their respective equilibrium points A, B and C are which their marginal cost curves intersect the MR curve which is common to all. The shaded rectangles show the surplus of revenue over cost, i.e., rent in the case of intra-marginal lands. For land A, the rent area is P4 AMN, for land B, the rent area is P4 BFG and for land C, the rent area is P4 CLT. Land D is no rent land. 5. Rent is a Pure Economic Surplus Rent is a pure economic surplus, since land has no cost of production from society’s point of view. Rent, according to Ricardo, is a unique factor which is not determined by the cost of production, because land is a free gift of nature — it has no cost of production. Hece, rent is a true surplus. It CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 291 is paid as the surplus over the cost of cultivation involved. Thus, when the price of land produce tends to rise, assuming — cost of cultivation — payments made to labour and capital inputs — to be constant, a higher surplus is left, so rent also becomes high. Because, this very surplus is payable as rent for the use of land. Obviously, if land output fails to earn surplus revenue over costs it bears no rent. 6. Rent is Price-Determined Rent is a non-cost income. Ricardo held that since rent is determined by the price of the land output, it does not enter into price. According to his theory, rent arises when the price of land output rises and not that price is high because rent is high. He asserted that rent of land is high because the price of corn is high. To quote him, “Corn is not high because a rent is paid, but a rent is paid because corn is high, and it has justly been observed that no reduction would take place in the price of corn although landlords should forgo the whole of their rent”. Indeed, if we accept Ricardo’s thesis that rent is a differential surplus between the super- marginal and the marginal lands and cost of production of the marginal land sets the price of corn, more fertile super-marginal land earns surplus returns as rent: the marginal land fetches no rent. As such, rent does not enter price. 10.5 Modern Theory of Rent The modern theory of rent is a mixture of new ideas and views, as well as modifications, amplifications, and refinements in the Ricardian theory of rent presented by a host of modern economists like Marshall, Joan Robinson and Boulding. The gist of modern economists’ views on the theory of rent lies in the following propositions. 1. Rent arises due to scarcity of land. 2. Rent is a generalised surplus earned by all factors. 3. Rent as a surplus, earned by a factor, is measured with reference to transfer earnings of the factor in its prevailing employment. CU IDOL SELF LEARNING MATERIAL (SLM)

292 Micro Economics - I 1. Scarcity Rent In essence, the modern concept of rent is scarcity rent. Modern economists pint out that the main shortcoming of the Ricardian theory of rent is that it concentrates only on the differential aspects and neglects the scarcity aspect of land, in its true sense. Hence, it fails to give a clear exposition of the ‘scarcity rent’ emerging from the scarcity of land in relation to its demand. The Ricardian theory only exposes ‘differential rent’, i.e., differential surplus, accruing to superior lands over inferior ones. Again, Ricardo assumes that marginal land is no rent land. However, when demand increases due to population growth, extensive cultivation has to be adopted so that marginal land, in turn, becomes intra-marginal land, with the adoption of a lower quality of land for cultivation. Hence, former marginal land now becomes super-marginal and starts yielding rent. This is not a very convincing argument if we notice that once all land is used, there will be no availability of surplus inferior land. Then, the so-called marginal land, in the Ricardian system, will always remain no-rent land. But, in reality, there is no such no-rent land in existence. All lands, whether superior or inferior, do fetch rent. Again, the differential theory loses ground if we assume lack of heterogeniety in lands in an area. Hence, modern economists advocate the scarcity rent theory as more refined and realistic, which adopts the framework of demand and supply analysis in the determination of rent. Another criticism is that Ricardo too closely relates the notion of rent with the motion of land as a free gift of nature — so it is land having no social cost as such. Ricardo thus treats rent as the peculiarity of land alone, and presents a special theory of rent separated from the general theory of value. To modern economists, there is no need for such a separate theory. Like the reward for other factors, the determination of rent can also be explained in terms of the interaction of demand and supply forces. Rent is based on the scarcity of the availability of land — it is immaterial whether it is of superior or inferior or any other quality. Rent emerges even if all lands are homogeneous, if they are scarce in relation to demand. To elucidate the point, let us assume that all land is homogeneous and specific in use, but is scarce on account of its rigid supply. In any period, whether long or short, the supply of land in existence is perfectly inelastic. Thus, the rise in the demand for land, with the growth of population, will intensify its relative scarcity, so the price of land, i.e., rent, tends to rise further and further with the rise in demand. This phenomenon has been graphically illustrated in Fig. 10.4. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 293 Y S RENT R3 E3 R2 E2 X R1 E1 D3 D2 D1 OQ QUANTITY OF LAND Fig. 10.4: Scarcity Rent In Fig. 10.4, SQ is the supply curve of land, showing that the availability of land is fixed at OQ. As the demand curve (D1) for land intersects the supply curve (SQ) at point E1, like the equilibrium price, the equilibrium rent, OR1 is determined. If, however, demand inreases to D2, rent increases to OR2. Similarly, with a further shift in the demand curve (D3), rent rises to OR3. Thus, rent rises because of demand pressure and scarcity of land. In short, scarcity is demand-determined. Indeed, Ricardo too recognises that rent is demand- determined. In his general view on economic development, he envisages that as the demand for land shifts to the light, rent tends to increase. Again, like differential rent, scarcity rent is the producer’s surplus. Similarly, the concept of differential rent also contains the element of scarcity. It implies that because superior lands are scarce in relation to demand, they fetch rent. Indeed, differences in rent earned by different grades of land and the differences in their surplus are ultimately due to scarcity of better quality lands. The concept of scarcity rent, on the other hand, implies that rent emerges because of scarcity of land. The concept of scarcity rent, on the other hand, implies tht rent emerges because of scarcity of land in general as against its demand. Evidently, the similarities between the two concepts of scarcity rent and differential rent are more significant than their differences. Marshall, therefore, states that “in a sense, all rents are scarcity rents, and all rents are differential rents.” CU IDOL SELF LEARNING MATERIAL (SLM)

294 Micro Economics - I 2. Rent: Generalised Surplus Like Ricardo, modern economists regard rent as a surplus. But, to them, rent is a generalised surplus, that is, rent is not a peculiar earning of land alone. It can be earned by any factor of production of which is scarce in relation to its demand. Scarcity implies inelasticity of supply. Inelasticity of supply is not a peculiarity of land alone. Other factors of production (labour, capital and enterprise), too, are inelastic in supply, at least in the short period. Marshall thus states, “If the supply of any factor of production is limited and incapable of such increase by man’s effort in any given period of time, then the income to be derived from it is to be regarded as of the nature of rent.” In short, any factor of production which is scarce, or inelastic in supply at any time, can earn rent. On account of different degrees of inelasticities of supply of various productive resources in different industries, their agents (workers, capitalists, entrepreneurs) also may earn different incomes similar to the differential incomes earned by the landlord from the use of land. Here, differential income is defined as under: Differential income = Reward earned by a factor – The minimum supply price of the factor. The differential income so measured is regarded as economic rent. In a more precise manner. Mrs. Joan Robinson states: “The essence of the conception of rent is the conception of a surplus earned by a particular part of a factor of production over and above and minimum earnings necessary to induce it to do its work.” In short, economic rent, when defined as a surplus earning of a factor in excess of its supply price or the minimum necessary payment to attract it into a particular use, becomes a generalised surplus. That is, every factor of production, whether it belongs to the category of land or not, earns rent. The amount of rent earned, however, depends on the relative degree of inelasticity of supply of the factor concerned to its demand. The greater the degree of inelasticity of supply, the larger the relative surplus accrues to the factor’s earning in the form of economic rent. Evidently, a factor eanrs rent till its supply remains less than perfectly elastic. When its supply becomes perfectly elastic, it earns no surplus, no rent. Marshall, thus, remarks: Rent of land is seen, not as a thing by itself, but as the leading species of a large genus.” CU IDOL SELF LEARNING MATERIAL (SLM)