Economics-I

Chanderprabhu Jain College of Higher Studies & School of Law
Plot No. OCF, Sector A-8, Narela, New Delhi – 110040
(Affiliated to Guru Gobind Singh Indraprastha University and Approved by Govt of NCT of Delhi & Bar Council of India)
Semester: Third Semester
Name of the Subject:
Economics-I
Semester: Third Semester
Name of the Subject:
Economics-I
Definition of Economics

Introduction
Economics is the science of analyzing the production, distribution, and
consumption of goods and services. In other words, what choices people make
and how and why they make them when making purchases.
The study of economics can be subcategorized into microeconomics and
macroeconomics. Microeconomics is the study of economics at the individual or
business level; how individual people or businesses behave given scarcity and
government intervention. Microeconomics includes concepts such as supply and
demand, price elasticity, quantity demanded, and quantity
supplied. Macroeconomics is the study of the performance and structure of the
whole economy rather than individual markets. Macroeconomics includes
concepts such as inflation, international trade, unemployment, and national
consumption and production.

• Economics is a study of ‘Choices’ or ‘Choice Making’
• Choice-making is relevant for every individuals, families, societies,
institutions, areas, state and nations and for the whole world.
• Hence, Economics has wide applications and relevance to all individuals and
institutions.
Meaning of the word ‘Economics’
• The word ‘Economics’ originates from a Greek word ‘Oikonomikos’
• This Greek word has two parts: – ‘Oikos’ meaning ‘Home’ – ‘Nomos’
meaning ‘Management’ Hence, Economics means ‘Home Management’
• Economics emerged as a subject with high level of applications in all other
disciplines due to its basic principle of ‘Choice making for optimization with the
given resources of scarcity and surplus’. • To arrive at this phenomenon in the
definition of economics, it has taken almost 235 years.

Evolution in the Definitions of Economics
               • A. Wealth Definition (1776) Adam Smith
               • B. Welfare Definition (1890) Alfred Marshall

                • C. Scarcity Definition (1932) Lionel Robbins

                • D. Growth Definition (1948) P.A. Samuelson
                • E. Modern Definition (2011) A.C. Dhas

Wealth Definition (1776)
• Adam Smith, who is regarded as Father of Economics, published a
book titled ‘An Inquiry into the Nature and Causes of the Wealth of
Nations’ in 1776.
• He defined economics as “a science which inquires into the nature and
cause of wealth of nations”.
• He emphasized the production and growth of wealth as the subject
matter of economics.

Features of Wealth Definition
• Characteristics: It takes into account only material goods Exaggerated
the emphasis on wealth It inquires the caused behind creation of wealth
• Criticisms: It considered economics as a dismal or selfish science. It
defined wealth in a very narrow and restricted sense. It considered only
material and tangible goods. It gave emphasis only to wealth and reduced
man to secondary place. Welfare Definition (1890):

WELFARE DEFINITION (1890)
In 1890, Alfred Marshall stated that “Economics is a study of mankind in
the ordinary business of life; it examines that part of individual and social
action which is most closely connected with the attainment and with the
use of material requisites of wellbeing”.
• It is on one side a study of wealth; and on the other side, a study of
human welfare based on wealth.

Features of Welfare Definition
• Characteristics: It is primarily the study of mankind. It is on one side a
study of wealth; and on other side the study of man. It takes into account
ordinary business of life – It is not concerned with social, religious and
political aspects of man’s life. It emphasises on material welfare i.e.,
human welfare which is related to wealth. It limits the scope to activities
amenable to measurement in terms of money
• Criticisms: It considers economics as a social science rather than a
human science. It restricts the scope of economics to the study of persons
living in organized communities only. Welfare in itself has a wide
meaning which is not made clear in definition.

Scarcity Definition (1932)
• According to Lionel Robbins: “Economics is the science which studies
human behavior as a relationship between ends and scarce means which
have alternative uses.”
• He emphasized on ‘choice under scarcity’. In his own words,
“Economics is concerned with that aspect of behaviour which arises from
the scarcity of means to achieve given ends.”

Features of Scarcity Definition
• Characteristics: Economics is a positive science. New concepts:
Unlimited ends, scarce means, and alternate uses of means. It emphases on
Choice – A study of human behavior It tried to bring the economic
problem which forms the foundation of economics as a social science. It
takes into account all human activities.
• Criticisms: It does not focus on many important economic issues of
cyclical instability, unemployment, income determination and economic
growth and development. It did not take into account the possibility of
increase in resources over time. It has treated economics as a science of
scarcity only.

Growth Definition (1948)
• According to Prof. Paul A Samuelson “Economics is the study of how
men and society choose with or without the use of money, to employ the
scarce productive resources which have alternative uses, to produce
various commodities over time and distribute them for consumption now
and in future among various people and groups of society. It analyses the
costs and benefits of improving pattern of resource allocation”.
• This definition introduced the dimension of growth under scarce
situation.

Main criticisms of the classical definition:
i. This definition is too narrow as it does not consider the major problems
faced by a society or an individual. Smith’s definition is based primarily
on the assumption of an ‘economic man’ who is concerned with wealth-
hunting. That is why critics condemned economics as ‘the bread-and-
butter science’.
ii. The central focus of economics should be on scarcity and choice. Since
scarcity is the fundamental economic problem of any society, choice is
unavoidable. Adam Smith ignored this simple but essential aspect of any
economic system.

Marshall’s Welfare Definition
Alfred Marshall in his book ‘Principles of Economics published in
1890 placed emphasis on human activities or human welfare rather
than on wealth. Emphasis on human welfare is evident in Marshall’s
own words:
“Political Economy or Economics is a study of mankind in the
ordinary business of life; it examines that part of individual and
social action which is most closely connected with the attainment
and with the use of the material requisites of well-being.”

Features of Scarcity Definition
• Characteristics: It is not merely concerned with the allocation of
resources but also with the expansion of resources. It analysed how the
expansion and growth of resources to be used to cope with increasing
human wants. It is a more dynamic approach. It considers the problem of
resource allocation as a universal problem. It focused on both production
and consumption activities. It is comprehensive in nature as it is both
growth-oriented as well as future-oriented. It incorporated the features of
all the earlier definitions
• Criticisms: It assumes that economics is relevant for scarcity situations
and it ignored surplus resource conditions.

Modern Definition of Economics (2011)
• According to Prof.A.C.Dhas, “Economics is the study of choice making
by individuals, institutions, societies, nations and globe under conditions
of scarcity and surplus towards maximizing benefits and satisfying their
unlimited needs at present and future”.
• In short, the subject Economics is defined as the “Study of choices by all
in maximizing production and consumption benefits with the given
resources of scarce and surplus, for present and future needs.

Features of Modern Definition
• Characteristics: • It takes into account all the earlier definitions –
wealth, welfare, scarcity and growth.
• It covers both micro and macro aspects of economics. • It considers both
production and consumption activities.
• It emphasises Choice Making dimension as crucial in economics.
• It aims at obtaining maximum benefits with given resources • It is
suitable in conditions of both scarcity and surplus.
• It takes in to account the present and future –Time dimension – Growth
dimension. • It is relevant in the context of globalisation and sustainable
development.

UNIT - IIUNIT - II
Theory of Production

Production
Function is the
relation between a
firms physical
production(output) and
the material factors
of production(input).
Q=𝒇 𝑳, 𝑪, �
Where,
Q is quantity of output
L is labour
C is capital N is land
In simple form
Q=𝒇(𝑳, 𝑪)

According to Prof. L. R. Klein:
The production
function is a
technical or
engineering
relation between
input and output.
As long as the
natural laws of
technology

TYPES OF PRODUCTION
FUNCTIONSHORT RUN
PRODUCTIO
N
LONG RUN
PRODUCTIO
N
One variable
factor
All factors
are variable
Works in
tandem with
Laws of
variable
Proportions
Works in
tandem with
Laws of return
to scale
3 Stages-
• Increasing
returns
• Increasing
returns to

PRODUCTION
FUNCTION
Short Run
Production Function
Long Run
Production Function
Return to a
Factor
Law of Return
to Scale
All factors are
Variable
Laws of Variable
Proportion
One Variable
Factor
Return to
Scale

Features of Production Function
Substitutability of factors
Complementarity of factors
Specificity of factors

SUBSTITUTABILIT
Y OF FACTOR
• The factors of
production or inputs
are substitutes of
one another which
make it possible to
vary the total
output by changing
the quantity of one
or a few inputs,
while the quantities

COMPLEMENTARITY
OF FACTORS
• The factor of production are also
complementary to one another, i.e. the two
or more inputs are to be used together as
nothing will be produced if the quantity of
either of the inputs used in the production
process is zero.

SPECIFICITY OF
FACTORS
• It reveals that the
inputs are specific
to the production of
a particular
product. Machines
and equipment's
specialized works
and raw materials
are a few examples
of the specificity

RETURN TO SCALE
 It is type of Long Run Production Function
 The term return to scale refers to the changes in output
as all factors change by the same proportion.
-
Koutsoyiannis
 Returns to scale relates to the behavior of total output
as all inputs are varied and
is a long run concept
-Leibhfsky
 Explanation:-
In the long run, output can be increased by increasing all
factors in the same proportion. Generally, laws of
returns to scale refer to an increase in output due to

RETURN TO SCALE
 Production
Function
P=𝒇(𝑳, 𝑪)
 If both factors of production labour and
capital are Increased in same proportion
i.e., x, production function will be
rewritten as
P1=𝒇(𝒙𝑳, 𝒙𝑪)

RETURN TO
SCALE
 If � 𝟏 increases in the same proportion as
the increase infactors of
production
i.e.
�𝟏
�
=x, it will be constant
return tosca
le
 If � 𝟏 incteases less then the
proportionate increase in thefactors of
production i.e.
�𝟏
�
<x, it will be
diminishing return toscal
e. If � 𝟏 increases more than proportionate
increase in the
factors of
production i.e.,
�𝟏
�
<x, it will be
increasing return toscal
e.

RETURN TO
SCALES.No.
Scale
Total Product
Marginal
Product Phases
1
.
2
.
3
.
4
.
1 machine + 1
labour
2 machine + 2
labour
3 machine + 3
labour
4 machine + 4
labour
4
1
0
1
8
2
8
4
6
8
1
0
I
Increas
ing
Return
s5
.
6
.
5 machine + 5
labour
6 machine + 6
labour
3
8
4
8
1
0
1
0
II
Consta
nt
Return
7
8
.
7 machine + 7
labour
8 machine + 8
labour
5
6
6
2
8
6
III
Decreasing
Returns

EXAMPLE OF RETURN TO
SCALE
Barry’s barbershop was experiencing what it thought was
overwhelming customer purchases. In one week the shop
served 250 clients. To capitalize on this market, Barry
hired 2 additional barbers,  which gave him a total of 10
barbers. In this case the barbers were the input of
resource, increased by 25%. As a result, the barbershop
experienced average weekly sales of 320 for the next five
weeks, an  increase in output of 28%, increasing returns
to scale. If instead the barbershop had made 225 sales
after the increase in input, it would have experienced
decreasing returns to scale.

INCREASING RETURN TO
SCALE
 If all inputs are
doubled, output will
also increase at the
faster rate than
double.
Reasons
→ Division of labour
→ Specialisation
→ External economies of
scale

CAUSES OF INCREASING
RETURNS TO SCALE
Technical and
managerial
indivisibilities
Higher degree
of
specialization
Dimensional

CONSTANT RETURN TO
SCALE
If all inputs are
doubled, output
will also doubled.
Reason
Economies of Scale
is balanced by
diseconomies of
Scasle

CAUSES OF CONSTANT
RETURNS TO SCALE
Indivisibility of
fixed factors.
When the factors
of production are
perfectly divisible,
the production

DIMINISHING
RETURN TO SCALE
Ifall inputs are
doubled, output
will be less
than doubled.
• Reasons
Internal
diseconomies
External
diseconomies

CAUSES OF INCREASING
RETURNS TO SCALE
Size ofthe
firms expands,
managerial
efficiency
decreases.
Limited resources.

DISECONOMIES OF SCALE OF
PRODUCTION INTERNAL
DISECONOMIES
 Inefficient
Management
 Technical
Difficulties
 Production
Diseconomies
 Marketing
Diseconomies
 Fnancial
Diseconomies
 EXTERNAL
DISECONOMIES

Facto
rs
Natur
e of
Input
s
Laws of
Return
Some
Inputs
are
Fixed
Return
to
Scale
All
Inputs
are
Variabl
e
Time
Elem
ent
Short Run
Production
Function
Long Run
Production
Function
Homo
genei
ty
Non
Homogeneou
s
Production
Function
Homogeneous
Production
Function
Law of
Increasi
ng
Return
Non Linear,
Non
Homogeneou
s
Production
Function
Non
Linear,
Homogene
ous
FunctionLaw of
Constan
t Return
Linear,
Non
Homogene
ous
Function
Linear,
Homogeneou
s Production
FunctionLaw of
Diminishin
g Return
Non Linear,
Non
Homogeneou
s
Production
Non
Linear,
Homogene
ous
Function

Opportunity cost and Actual cost
• Opportunity cost
¬ Refers to the loss of earnings due to opportunities foregone because of
the scarcity of resources.
¬ If resources are unlimited – there would be no opportunity cost
¬ The opportunity cost may be defined as the expected returns from the
second best use of the resources foregone due to the scarcity of
resources.
¬ Economic rent or economic profit – excess of the earning from current
business over the income from other alternative foregone
¬ Implication – investing in the current business is preferable so long as
its economic rent is greater than zero.

Opportunity cost and actual cost
• Actual cost
¬ Those costs which are actually incurred by the firm in
payment for labour, material, plant, building, machinery,
equipment, travelling and transport, advertisement, etc.
¬ The total money expenses, recorded in the books of
accounts are, for all practical purposes, the actual costs.
Actual cost comes under the accounting concept.

Business Costs and Full Costs:
• Business cost
¬ Business costs include all the expenses which are incurred
to carry out business.
¬ The concept of business costs is similar to the actual or real
costs.
¬ Business costs “include all the payments and contractual
obligations made by the firm together with the book cost of
depreciation on plant and equipment”.
¬ These cost concepts are used for calculating business
profits and losses and for filling returns for income-tax and
also for other legal purposes.

Explicit and Implicit or Imputed Costs:
• Explicit costs
¬ Explicit costs refer to those which fall under actual
or business costs entered in the books of accounts.
¬ The payments for wages and salaries, materials,
license fee, insurance premium, depreciation
charges are the examples of explicit costs.
¬ These costs involve cash payments and are
recorded in normal accounting practices.

Explicit and Implicit or Imputed Costs:
• Implicit costs
¬ costs which do not take the form of cash outlays, nor do
they appear in the accounting system.
¬ Implicit costs may be defined as the earning expected from
the second best alternative use of resources.
¬ Implicit costs are not taken into account while calculating
the loss or gains of the business, but they form an important
consideration in whether or not a factor would remain in its
present occupation.
¬ The explicit and implicit costs together make the economic
cost.

Short-Run and Long-Run Costs:
• Short-run costs are the costs which vary with the variation
in output, the size of the firm remaining the same. In other
words, short-run costs are the same as variable costs.
•
Long-run costs, on the other hand, are the costs which are
incurred on the fixed assets like plant, building, machinery,
etc. Such costs have long-run implication in the sense that
these are not used up in the single batch of production.
•
‘the short-run costs are those associated with variables in
the utilization of fixed plant or other facilities whereas long-
run costs are associated with the changes in the size and
kind of plant.’

Incremental Costs and Sunk Costs
• Incremental Costs
¬ Incremental costs are closely related to the concept of marginal cost but
with a relatively wider connotation. While marginal cost refers to the cost
of the marginal unit of output, incremental cost refers to the total
additional cost associated with the marginal batch of output.
¬ The concept of incremental cost is based on the fact that in the real
world, it is not practicable for lack of perfect divisibility of inputs to
employ factors for each unit of output separately.
¬ Besides, in the long run, firms expand their production; hire more men,
materials, machinery and equipment.
¬ The expenditures of this nature are incremental costs and not the
marginal cost

Incremental Costs and Sunk Costs
• Sunk Costs
¬ The Sunk costs are those which cannot be altered,
increased or decreased, by varying the rate of
output.
¬ For example, once it is decided to make
incremental investment expenditure and the funds
are allocated and spent, all the preceding costs are
considered to be the sunk costs since they accord
to the prior commitment and cannot be revised or
reversed or recovered when there is change in
market conditions or change in business decisions.

Historical and Replacement Costs:
• Historical costs are those costs of an asset acquired in the
past whereas replacement cost refers to the outlay which has
to be made for replacing an old asset.
• Stable prices over time, other things given, keep historical
and replacement costs on par with each other. Instability in
asset prices makes the two costs differ from each other.
• Historical cost of assets is used for accounting purposes, in
the assessment of net worth of the firm. The replacement
cost figures in the business decision regarding the renovation
of the firm.

Private and Social Costs:
• Private costs are those which are actually incurred or
provided for by an individual or a firm on the purchase of
goods and services from the market.
• For a firm, all the actual costs both explicit and implicit are
private costs. Private costs are internalized costs that are
incorporated in the firm’s total cost of production.
• Social costs on the other hand, refer to the total cost to the
society on account of production of a commodity.

Theory of Cost
Traditional Theory of Cost
Modern Theory of Cost

Traditional Theory of Cost
Short run
¬Short run is the period during
which some factor(s) is fixed;
¬usually capital equipment and entrepreneurship
are considered as fixed in the short run.
Long run
¬ The long run is the period over which all factors
become variable.

• Costs of a firm is incurred to establish the
production unit and to purchase different
factors of production.
• Cost of a firm (TC) is classified into two
broad categories - Fixed cost (TFC) and
Variable cost (TVC).
i.e. TC = TFC + TVC
• However, nothing is fixed in the long run.

Fixed costs
Fixed costs are expenses that does not
change in proportion to the activity of a
business.
Fixed costs include overheads (rent,
insurance-premium, interests), and also
direct costs such as payroll (particularly
salaries).

Fixed cost does not change with the
volume of production.
TFC
Q
costs
100
O

Variable costs
Variable costs change in direct
proportion to the activity of a business
such as sales or production volume. In
retail, the cost of goods is almost entirely
variable. In manufacturing, direct
material costs, wages, fuel costs are
examples of variable costs.

For example, a manufacturing firm pays for
raw materials. When activity is decreased,
less raw material is used, and so the
spending for raw materials falls. When
activity is increased, more raw material is
used and spending therefore rises.
Although tax usually varies with profit,
which in turn varies with sales volume, it
is not normally considered a variable
cost.

0
2
0
4
0
6
0
8
0
10
0
0 1 2 3
f4i
g
5 6 7 8
TFC
0
1
2
3
4
5
6
7
Output TFC
(Q) (£)
12
12
12
12
12
12
12
12
Total costs for
firm X

0
2
0
4
0
6
0
8
0
10
0
0 1 2 3
f4i
g
5 6 7 8
TFC
0
1
2
3
4
5
6
7
Output TFC TVC
(Q) (£)
(£)
12 0
12
10
12
16
12
21
12
28
12
40
12
60
12
91
Total costs for
firm X

0
2
0
4
0
6
0
8
0
10
0
0 1 2 3
f4i
g
5 6 7 8
TVC0
1
2
3
4
5
6
7
Output TFC TVC
(Q) (£)
(£)
12 0
12
10
12
16
12
21
12
28
12
40
12
60
12
91
TFC
Total costs for
firm X

0
2
0
4
0
6
0
8
0
10
0
0 1 2 3
f4i
g
5 6 7 8
TVC
TFC
Diminishing marginal
returns set in here
Total costs for
firm X

0
2
0
4
0
6
0
8
0
10
0
0 1 2 3
f4i
g
5 6 7 8
TVC
TFC
0
1
2
3
4
5
6
7
Output TFC
(Q) (£)
TVC TC
(£) (£)
12 0 12
12 10 22
12 16 28
12 21 33
12 28 40
12 40 52
12 60 72
12 91
103
Total costs for
firm X

0
4
0
2
0
6
0
8
0
10
0
0 1 2 3
f4i
g
5 6 7 8
0
1
2
3
4
5
6
7
Output TFC
(Q) (£)
TVC TC
(£) (£)
12 0 12
12 10 22
12 16 28
12 21 33
12 28 40
12 40 52
12 60 72
12 91
103
TC
TVC
TFC
Total costs for
firm X

0
4
0
2
0
6
0
8
0
10
0
0 1 2 3
f4i
g
5 6 7 8
TC
TVC
TFC
returns set in here
Total costs for
firm X

Average fixed cost
Average fixed cost (AFC) = TFC/Q
where TFC = fixed cost, Q = total number of
units produced.
Unit fixed costs decline along with volume,
following a rectangular hyperbola. As a
result, the total unit cost of a product will
decline as volume increases.

Average Fixed costs
Q
Costs
AFC
O

Average variable cost
Average variable cost (AVC) is the TVC of a firm
divided by the total units of output (Q).
AVC = TVC/Q
Q
costs
Y
AVC
O

Average cost
Average cost (AC) is the TC of a firm divided by
the total units of output (Q).
AC = TC/Q = AFC + AVC
Q
costs
Z
AC
O

Marginal Cost
The additional cost incurred to produce
one additional unit of output is called the
Marginal Cost (MC).
MC = dC/dQ

Marginal Cost
The marginal cost
curve is U-shaped.
Marginal cost is
relatively high at small
quantities of output -
then as production
increases, it declines -
then reaches a
minimum value - then
rises.
This shape of the

Outputfi
(g
Q
)
MC
x
returns set in here
Marginal
costs

Numerical Example
Q TFC TVC TC AFC
0 100 0 100
1 100 20 120 100
2 100 37 137 50
3 100 52 152 33.33
4 100 80 180 25
5 100 120 220 20
6 100 165 265 16.67
AVC AC MC
20 120 20
18.5 68.5 17
17.33 50.67 15
20 45 28
24 44 40
27.5 44.17 45

Outputfi
(g
Q
)
AFC
MC
AC
AVC
z
y
x
Average and marginal costs

Relationship between MC and AC

Production Rules for the Short-Run
1. If expected selling price < minimum AVC (which implies
TR<TVC)
¬ A loss cannot be avoided
¬ Minimize loss by not producing
¬ The loss will be equal to TFC
2. If expected selling price < minimum ATC but
> minimum AVC (TR > TVC but < TC)
¬ A loss can not be avoided
¬ Minimize loss by producing where MR = MC
¬ The loss will be between 0 and TFC

Production Rules for the Short-Run
3. If expected selling price > minimum
ATC (which implies TR>TC)
¬ A profit can be made
¬ Maximize profit by producing where MR=MC

LONG RUN COSTS
The Envelope Curve

Long run cost curves
The Long run average cost (LRAC or LAC)
curve illustrates - for a given quantity of
production - the average cost per unit
which a firm faces in the long run (i.e.
when no factors of production is fixed).

LRAC
LRAC curve is derived from a
series of short run average
cost curves.
It is also called the ‘Envelope
curve' since it envelops all the
short run average cost curve.
The curve is created as an
envelope of an infinite number
of short-run average total cost
curves.
The LAC is derived from short-
run cost curves.
Each point of on the LAC

LAC
The LRAC curve is U-
shaped, reflecting
economies of scale
when it is negatively-
sloped and
diseconomies of scale
when it is positively
sloped.
In perfect competition,
the LRAC curve is flat
at the point of

LAC
In some industries, the
LRAC is L-shaped,
and economies of scale
increase indefinitely.
This means that the
largest firm tends to
have a cost advantage,
and the industry tends
naturally to become a
monopoly, and hence is
called a natural
monopoly. Natural

fig
Long-run average cost curves
OutputO
LRAC
Economies of Scale

fig
OutputO
LRAC
Diseconomies of Scale
long-run average cost curves

fig
OutputO
LRAC
Constant costs
long-run average cost curves

Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are given
• state of technology and factor quality are given
• firms choose least-cost combination of factors

fig
A typical long-run average cost curve
OutputO
LRAC

fig
OutputO
LRACEconomies
of scale
Constant
costs
Diseconomies
of scale
A typical long-run average cost curve

fig
Long-run average and marginal costs
OutputO
LRAC
LRMC
Economies of Scale

fig
OutputO
LRAC
LRMC
Diseconomies of Scale
Due to managerial
inefficiencies

fig
OutputO
LRAC = LRMC
Constant costs

fig
OutputO
LRMC
LRAC
Initial economies of scale,
then diseconomies of
scale
Long-run average and marginal
costs

Envelope Curve
The envelope curve is based on the point of each short-run
ATC curve that provides the lowest possible average cost for
each quantity of output.
It is a planning curve because on the basis of this curve the firm
decides what plant to set up in order to produce optimally the
expected level of output.
The LAC envelops the SAC curves because of the assumption
that each plant size is designed to produce optimally a single
level of output

Deriving long-run average cost curves: plants of fixed size
SRAC3
Output
O
SRAC4
SRAC5
SRAC1 SRAC 2

SRAC3
SRAC1 SRAC 2
SRAC4
SRAC5
LRAC
Outpfig
O
Deriving long-run average cost curves: factories of fixed size

Deriving a long-run average cost curve: choice of factory size
Outpfig
O
Examples of short-run
average cost curves

LRAC
Outpfig
O
Deriving a long-run average cost curve: choice of factory size

Envelope Curve
Each point on the LAC represents the least unit
cost for producing the corresponding level of
output. Any point above the LAC is inefficient
in that it shows a higher cost for producing
the corresponding level of output.
Any point below the LAC is economically
desirable because it implies a lower unit cost,
but it is not attainable in the current state of
technology and with the prevailing market
prices of factors of production.

LMC
The LMC is derived is derived from the SMC
curves but does not envelope them.
The LMC is formed from points of intersection
of the SRMC curves with vertical lines drawn
from the points of tangency of the
corresponding SAC curves and the LRA cost
curves.
The LMC must be equal to the SMC for the
output at which the corresponding SAC is
tangent to the LAC.

Overall
The TC curve is roughly S-shaped ATC, AVC
and MC are all U shaped
MC curve intersects the other two curves at
their minimum points

• The short-run average variable cost has a flat
stretch over a range of output which reflects the fact that
firms build plants with some flexibility in their productive
capacity
Because
•The businessman will want to be able to seasonal and
cyclical fluctuations in his demand
•It gives the businessman greater flexibility for repairs of
broken down machinery without disrupting the smooth flow
of the production process
•The entrepreneur will want to have more freedom to
increase his output if demand increases because he/she
does not like to let all new demand go to his rivals

•
•
•
It also gives him/her some flexibility for minor alterations of
his product, in view of changing tastes of customers.
Technology usually makes it necessary to build into the plant
some reserve capacity
It is always allowed in case of land and building because
operations may be seriously limited if new land or new
buildings have to be acquired
•There will be some reserve capacity on
the organizational and administrative level.
In summary,
The businessman will not necessarily choose the plant which
will give him today the lowest cost, but rather that equipment
which will allow him the greatest possible flexibility, for minor
alterations of his product or his technique.

• Average Variable Costs
• Average Fixed Costs
Short Run Costs

• The salaries and other expenses of administrative
staffs
• The salaries of staff involved directly in the
production, but paid on a fixed-term basis
• The wear and tear of machinery
• The expenses for maintenance of buildings
• The expenses for the maintenance of land on which the plant is installed
and operates.
Short Run Average Fixed Costs

SAFC
C
O
A B
XA XB
a
b
X
Largest capacity units of
machinery as absolute limit in
the short run
Small unit machinery – sets
a limit to expansion
By paying
overtime to
direct
labor
By buying
additional
small unit
types of
machinery

• Direct labor which varies with output
• Raw materials
• Running expenses of machinery
Short Run Average Variable Costs

SAVC
C
O
X
Better utilization of the fixed
factor and the consequent
increase in skills and
productivity of variable factor,
reduced wastage of raw
materials
SAVC = MC
MC SAV
C
MC
SAV
C
• Reduction
productivity
in labor
due
to
•
longer hours of work;
increase cost of labor
•
•
due to overtime
payment;
wastage of materials;
frequent breakdown of
machinery

• Due to the reserve capacity, which is further
planned in order to give maximum flexibility in the
operation of the firm
• Reserve capacity is completely different from
excess capacity
Why SAVC flat shaped over a range

Excess capacity vs reserve capacity
C
0 X
SAVC
X XM
Excess
capacity
C
0 XX1 X2
SAVC
Reserve
capacity

SATC
C
O
X
SAVC = MC
MC
SAV
C
MC
SAV
C
XA

• Production Costs
• Managerial Costs
Long-Run Costs

•
•
•
•
•
Production costs falls steeply to begin with and then
gradually as the scale of production increases
The L-shape of production cost curve is due to the technical
economies of large scale production
Initially these economies are substantial
But after a certain level of output is reached all or most of
these economies are attained and the firm is said to have
reached the minimum optimal scale, given the technology of
the industry.
If new techniques are invented for larger scales of output,
they must be cheaper to operate.
Production costs

• Each management technique is applicable to
a range of output.
• Organizational techniques may be small
scale as well as large scale
• The cost of different techniques of
management first fall up to a certain plant
size.
• At very large scales of output managerial
costs may rise, but very slowly
Managerial Costs

• Production costs fall smoothly at very large
scales, while managerial costs may rise only
slowly at very large scales.
• The fall in production costs more than offsets
the probable rise of managerial costs, so that
the LRAC curve falls smoothly or remains
constant at very large scales of output.
LRC curves

Derivation of LRAC Curve
Load factor: Ratio of average actual rate of use to the capacity
In business practice it is customary to consider that a plant is used
‘normally’ when it operates at a level between two-thirds and three-
quarters of capacity.
Here the typical load factor of each plant is taken as 2/3
SAC1
X
2/3
C
2/3
2/3
2/3
LAC
0
SAC2
SAC3
SAC4
LMC
•
• LAC does not turn up at very
large scales of output
It is not the envelope
of theSATC curves, but rather
intersects them

LAC
C
O
X
LAC = LMC
LMC
LAC
XA
Minimum
optimal scale

UNIT - IIIUNIT - III
Theory of Demand

INTRODUCTION
• How much to produce and what price to
charge?
• Factors determining demand for a product.
• Explores the relationship between price and
demand for a product.
• Examines likely impact of the potential factors
that influence its demand.

WHAT IS DEMAND?
The quantity of a product consumers are
willing and able to buy at different prices in a
specified time period.
Types of Demand
-Direct and derived demands
-Individual and market demand
-Recurring and replacement
-Complementary and competing
-New and replacement demands

DETERMINANTS OF DEMAND
• Price of Product
• Income of Consumer
• Price of Related Good
• Tastes and Preferences
• Advertising
• Consumer’s expectation of future Income and Price
• Growth of Economy
• Seasonal conditions
• Population

DEMAND SCHEDULE
• It shows the price and output relationship.
• Tabular representation of price and
demand.

DEMAND CURVE
• The geometrical representation of
demand schedule is called the demand
curve.

LAW OF DEMAND
• As the price of a good rises, quantity demanded
of that good falls.
• As the price of a good falls, quantity demanded
of that good rises.
• Ceteris paribus.

DEMAND FUNCTION
• When we express the relationship between demand
and its determinant mathematically, the relationship
is known as demand function.
• The demand for product X can be written in
functional form as-
Dx= f (Px, Y, Po, T, A, Ef, N )

EXCEPTIONS TO THE LAW OF
DEMAND
• Inferior Goods
• Snob Appeal
• Demonstration Effect
• Future Expectation of Prices
• Insignificant proportion of income
spent
• Goods with no Substitutes

CHANGE IN DEMAND VS.
CHANGE IN QUANTITY
DEMANDED• A shift of the entire demand curve to a new position
is called change in demand.
• Changes in non-price determinants of demand.

QUANTITY DEMANDED
• Fluctuations in price, another determinant of
demand, cause movement along the demand curve.

Why the demand curve slope
downwards?
• Law of diminishing marginal utility.
• Income effect.
• Substitution effect.
• New consumers.
• Multiple use of commodity.

ELASTICITY OF DEMAND
• Elasticity of demand is defined as the responsiveness of the
quantity of a good to changes in one of the variables on
which demand depends-
 Price of the commodity
 Income of the Consumer
 Various other factor
DEFINATION-’’The elasticity of demand measures the response
of the demand for the commodity to change in price”.

PRICE ELASTICITY OF DEMAND
• The price elasticity of demand is the percentage change in
quantity demanded divided by the percentage change in
price.
Price elasticity of demand =
Percentage change in quantity
demanded
Percentage change in price

PRICE ELASTICITY OF
DEMAND
PEPoint Definition
Arc
Definition
P
Q / Q Q P
P / P P
Q
Q2 Q1
P2 P1
E
P2 P1 Q2 Q1

Perfectly Inelastic Demand:
Elasticity Equals 0
city of Demand
Copyright©2003 Southwestern/Thomson Learning
$5
4
Demand
0 100 Quantity
1. An
increase
in price . . .
2. . . . leaves the quantity demanded unchanged.
Price

Inelastic Demand: Elasticity Is
Less Than 1
Demand1. A 22%
increase
in price . . .
Price
2. . . . leads to an 11% decrease in quantity demanded.
$5
4
0 90 100 Quantity

Unit Elastic Demand: Elasticity
Equals 1
Copyright©2003 Southwestern/Thomson Learning
2. . . . leads to a 22% decrease in quantity demanded.
Price
$5
4
0 80 100 Quantity
1. A 22%
increase
in price . . .
Demand

Elastic Demand: Elasticity Is
Greater Than 1
Demand
Price
$5
4
0 50 100 Quantity
1. A 22%
increase
in price . . .
2. . . . leads to a 67% decrease in quantity demanded.

Perfectly Elastic Demand:
Elasticity Equals
Infinity
Quantity0
Price
$4 Demand
2. At exactly $4,
consumers will buy
any quantity.
1. At any price above
$4, quantity
demanded is zero.
3. At a price below $4,
quantity demanded is infinite.

INCOME
ELASTICITY• The degree of responsiveness of the demand for the
commodity to a change in the income of the consumer.
• It is defined as Ratio of percentage change in the quantity
demanded of a commodity to the percentage change in the
income of consumer

• Negative ( inferior commodities )
• Zero ( neutral commodities )
• Greater than zero but less than 1( normal
commodities )
• Greater than unity ( Luxurious commodity )
INCOME
ELASTICITY

• Point Definition
I
Q / Q Q I
E
• Arc Definition
2 1
I
I / I I Q
Q2 Q1 I2
I1
E
I I1 Q2 Q
INCOME
ELASTICITY

Cross Elasticity of
Demand (CED)
• Cross price elasticity (CED) measures the responsiveness of
demand for good X following a change in the price of good
Y (a related good)
• CED = % change in quantity demanded of product A
% change in price of product B
• With cross price elasticity we make an important
distinction between substitute products and
complementary goods and services.

Substitute
s
Quantity demanded of
Good T
Demand
Price of
Two Weak Substitutes
Good S
P1
P2
+
Goods S and
T are weak
substitutes
A rise in the
price of
Good S leads
to a small
rise in the
demand for
good T

Complement
s
Price of
Good X
Good Y
Two Close Complements
Demand
P1
P2
Goods X and Y are
close complements
A fall in the price
of good X leads to
a large rise in the
demand for good Y
Petrol and
petrol
-

Goods with zero cross-price elasticity of
demand . INDEPENDENT
Price of
Good
A
Good B
Demand
P1
P2
P3
Goods A and B have no
relationship.
A fall in the price of good
A leads to no change in
the demand for good B
Therefore the cross-price
elasticity of demand is zero
salt!

THANK YOU

Economics-I

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