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EABDM Slides for Indifference curve.pptx
- 1. 1 Economic Analysis and BusinessDecision Making EABDM PGP Batch 16
- 2. 2 Component Weightage Quiz 10 ClassPreparedness 10 Project 20 Mid term exam 30 End term exam 30 Text Book: Principles of Microeconomics by n. Gregory Mankiw, 7th edition. Cengage. Name of Faculty Office e-mail Dr. Ujjawal Sawarn 07 ujjawal.sawarn@iimrohtak.ac.in
- 3. 3 Economics Economics is thesocial science that studies how individuals, businesses, governments, and societies allocate scarce resources to satisfy unlimited wants and needs. Decisions: • Scarcity: Resources are limited • Choice: Decisions must be made • Allocation: Who gets what and how
- 4. 4 Microeconomics and Macroeconomics Microeconomicsis the branch of economics that studies the behavior and decision-making of individual units such as consumers, firms, and industries, and how they interact in specific markets to determine prices and resource allocation. Macroeconomics is the branch of economics that studies the behavior and performance of the entire economy, focusing on aggregate indicators such as national income, employment, inflation, and economic growth.
- 5. 5 Three basic questionof Consumer choice • What to produce • How to produce • Whom to produce
- 6. 6 Consumer Preference Consumer Preferencesdescribe the way in which a consumer ranks different consumption bundles (combinations of goods and services) according to the level of utility (satisfaction) they provide, without necessarily assigning numerical values.
- 7. 7 Assumptions of ConsumerPreference theory 1) Completeness (or Complete Preferences): • Consumers can compare and rank all possible bundles. • For any two bundles A and B, the consumer can say: • A is preferred to B, or • B is preferred to A, or • A and B are equally preferred (indifferent). 2) Transitivity: • If a consumer prefers A over B, and B over C, then they must prefer A over C.
- 8. 8 Assumptions of ConsumerPreference theory 3) Non-Satiation (or More is Better) 4) Convexity of Preferences: • Consumers prefer diversified bundles over extreme ones. • This means indifference curves are convex to the origin. 5) Continuity: • Preferences are continuous; small changes in bundles don't cause abrupt jumps in preference. • This allows for smooth, well-behaved indifference curves. They are normative assumptions – not always true in reality but necessary for building consistent economic models.
- 9. 9 Utility • Utility isthe satisfaction or pleasure a consumer derives from consuming a good or service. • It is a way of measuring consumer preferences. • Ordinal (ranked) – ranks preferences without measuring them numerically (e.g., A preferred to B). • Cardinal utility?
- 10. 10 Marginal Utility • MarginalUtility is the additional utility gained from consuming one more unit of a good or service. • MU=ΔTU / ΔQ Cup of Tea Total Utility (TU) Marginal Utility (MU) 1 10 10 2 18 8 3 24 6 4 28 4 5 30 2
- 11. 11 Indifference curve An IndifferenceCurve is a graph that shows all combinations of two goods which provide the same level of satisfaction (utility) to the consumer. Key Properties of Indifference Curves: • Downward Sloping To maintain the same utility, if the quantity of one good increases, the quantity of the other must decrease. • Higher Curves Represent Higher Utility A curve farther from the origin gives a higher level of satisfaction. • Indifference Curves Never Intersect This would violate the transitivity of preferences. • Convex to the Origin Shows diminishing Marginal Rate of Substitution (MRS), meaning the consumer prefers a balanced bundle.
- 12. 12 Which of thefollowings are not the indifference curve?
- 13. 13 Are Indifference curveparallel to each other?
- 14. 14 Complimentary Goods versusSubstitutes
- 15. 15 Marginal Rate ofSubstitution (MRS) • The Marginal Rate of Substitution is the rate at which a consumer is willing to give up one good in exchange for an additional unit of another good, while keeping the same level of satisfaction. MRSXY = −dy /dx= MUX /MUY • Diminishing MRS: • As a consumer consumes more of good X and less of good Y, they are less willing to substitute Y for X. • This gives the indifference curve its convex shape.
- 16. 16 Budget line • ABudget Line (or Budget Constraint) shows all the combinations of two goods that a consumer can afford to buy given their income and the prices of the goods. PXX+PYY=M ⋅ ⋅ • This is the budget line equation – it shows how much of good X and good Y can be bought within income M. • The budget line is downward sloping.
- 17. 17 Budget line Slope ofthe Budget Line: Slope= − PX /PY • This is the opportunity cost of good X in terms of good Y. Shifts in the Budget Line (increase in Income and Increase in Price). Q: Can the Budget Line be a curve instead of a straight line?
- 18. 18 Consumer equilibrium • Theconsumer equilibrium is where the budget line is tangent to the highest indifference curve. MRSXY = PX /PY • Prove: MUX/PX = MUY/PY • Interpretation: At the optimum, the marginal utility per dollar spent on good X equals the marginal utility per dollar spent on good Y.
- 19. 19 Deriving the demandcurve Optimal Solution: Slope of IC curve = Slope of Budget line When the slope of the IC curve is steeper than the slope of the budget line, it means that the consumer is willing to give up more units of Y for one additional unit of X.
- 20. 20 Change in Incomeand consumer choices The Income Effect refers to the change in a consumer's optimal consumption bundle when their income changes, holding prices constant. Type of Good Income Increases → Income Effect Normal Good Quantity demanded increases Positive income effect Inferior Good Quantity demanded decreases Negative income effect
- 21. 21 Change in Priceand consumer choices The Substitution Effect refers to the change in a consumer’s quantity demanded of a good when its price changes, making it relatively cheaper or more expensive than other goods — holding real income (utility) constant. The Substitution Effect is: Movement from original consumption point to a new point on a higher budget line but the same indifference curve (adjusted for same utility). Q: Why does a consumer always substitute toward a cheaper good, even if it's an inferior good?
- 22. 22 Giffen good Characteristics: • Mustbe an inferior good. • Must form a large part of the consumer’s budget. • No close substitutes available. • Negative income effect dominates the substitution effect. • Might be cultural preference.
- 23. 23 Corner Solution Three cases: •Preferences are not convex, e.g., perfect substitutes • One good provides very little utility compared to its price. • Indifference curves are flatter or steeper than the budget line at all points Example: Good X: public bus rides (cheap but disliked) Good Y: cab rides (expensive but preferred) If you strongly prefer cab rides, you may spend your entire transport budget on cabs, even if that means taking fewer rides — this is a corner solution (0 bus rides, all cab rides).
- 24. 24 Type of goods- Summary Type of Good Substitution Effect Income Effect Net Effect When Price Falls Example Normal Good Positive Positive Buy more Milk, shoes Inferior Good Positive Negative Depends on strength Bus rides, coarse grains Giffen Good Positive Strong Negative Buy less (overall) Coarse rice (rare cases) Veblen Good Not applicable (status-based) Not about income Buy less if price falls Luxury watches
- 25. 25 Consumer Preference andChoices Aspect Consumer Preference Consumer Choice Meaning What the consumer likes or ranks higher What the consumer actually buys Based On Taste or utility Taste plus income and prices Tool Used Indifference curves Indifference curves + budget line Outcome Ranking of bundles Optimal bundle within budget
- 26. 26 Application Refer to textbookfor the following topics: • Giffen good • Consumption-leisure problem with wage rate changes • Consumption today versus consumption tomorrow with interest rate changes
- 27. 27 Deriving indifference curvefrom utility function
- 28. 28 Example 1 -Cobb-Douglas Utility function Utility function: U(X, Y) = X^0.5 * Y^0.5 Set utility constant: X^0.5 * Y^0.5 = U-bar Solve for Y: Y^0.5 = U-bar / X^0.5 Y = (U-bar^2) / X Final equation: Y = K / X (where K = U-bar squared) Shape: Convex, downward-sloping hyperbola.
- 29. 29 Example 2 -Perfect Substitutes Utility function: U(X, Y) = aX + bY Set utility constant: aX + bY = U-bar Solve for Y: Y = (U-bar - aX) / b Final equation: Straight line, constant slope.
- 30. 30 Example 3 -Perfect Complements Utility function: U(X, Y) = min {aX, bY} Set both components equal to utility level: aX = bY = U-bar Solve for Y: Y = (a / b) * X Final equation: Y = constant * X Shape: Right-angle ("L-shaped") indifference curves.
- 31. 31 Example 3 –Quasilinear Utility function A) ln X + Y B) X + Y C) sqrt(X) + Y
- 32. 32 Practice problem -I Consider the two goods, food and clothing with the utility function U(F,C) = 20 F2 C2 . The price of food is Rs. 100 and price of clothing is Rs. 250. Your income is Rs. 1000. A) Draw the indifference curve B) Draw the budget line C) Find the optimum allocation point and show it on the graph.
- 33. 33 Practice problem -II Consider that Tom has a monthly income of Rs. 2000 and he can allocate it to Cold coffee and Pizza. A) Suppose Pizza cost Rs. 200 and the cold coffee Rs. 80. Draw the budget constraint. B) Consider that the utility function is U(C, P) = 2C + P. What combination of the cold coffee and Pizza should Tom try. C) What is the MRS of Coffee to Pizza for Tom? D) Consider that Rohan offers Tom to trade 2 pizza for 3 coffee. Will Tom trade? C) Jessica too have a monthly income of Rs. 2000, but her preference is U(C, P) = C0.75 P0.75 . What combination would Jessica choose.
- 34. 34 Deriving demand curveequation from utility function and budget line equation - Refer class notes
- 35. 35 Theory of demandand Supply: Equilibrium
- 36. Theory of Demand Lawof demand: The claim that, other things equal, the quantity demanded of a good falls when the price of the good rises. Demand schedule: A table that shows the relationship between the price of a good and the quantity demanded. Demand curve: A graph of the relationship between the price of a good and the quantity demanded.
- 37. Individual and marketdemand curve Plot Individual demand curve Plot market demand curve Shift in the demand curve vs Movement along the demand curve
- 38. Factors that influencemarket demand • Price of goods • Income • Prices of related goods • Tastes • Expectations • Numbers of buyers
- 39. Type of Goodsand demand curve Normal good: A good for which, other things equal, an increase in income leads to an increase in demand. Inferior good: A good for which, other things equal, an increase in income leads to a decrease in demand. Substitutes: Two goods for which an increase in the price of one leads to an increase in the demand for the other. Complements: Two goods for which an increase in the price of one leads to a decrease in the demand for the other.
- 40. Theory of Supply Lawof supply: The claim that, other things equal, the quantity supplied of a good rises when the price of the good rises. Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied. Supply curve: A graph of the relationship between the price of a good and the quantity supplied
- 41. Individual and marketsupply curve • Plot Individual supply curve • Plot market supply curve
- 42. Factors that influencemarket supply • Input price • Technology • Expectations • Number of sellers
- 43. Equilibrium Plot the Supplycurve, demand curve, equilibrium price and equilibrium quantity
- 44. Equilibrium Equilibrium: A situationin which the market price has reached the level at which quantity supplied equals quantity demanded. Equilibrium price: The price that balances quantity supplied, and quantity demanded. Equilibrium quantity: The quantity supplied, and the quantity demanded at the equilibrium price. Surplus: A situation in which quantity supplied is greater than quantity demanded. Shortage: a situation in which quantity demanded is greater than quantity supplied.
- 45. Class Exercise A) Shyamwent to the market and found that the demand of the product varies with the price in relation Qd = 600 – 2P. Plot the graph for the same. B) Shyam went to the market and found that the supply of the product varies with the price in relation Qs = 300 + P. Plot the graph for the same. C) Find out the equilibrium price and equilibrium quantity
- 46. 46 Consumer Surplus • ConsumerSurplus is the difference between what a consumer is willing to pay for a good or service (maximum willingness to pay) and what they actually pay (market price). Consumer Surplus = Willingness to Pay – Actual Price Paid • Different consumers value a good differently. • In a market, all consumers pay the same price, but some were willing to pay more. • This difference creates surplus satisfaction (extra benefit) for them.
- 47. 47 Producer Surplus • ProducerSurplus is the difference between the price a producer actually receives (market price) and the minimum price the producer is willing to accept (marginal cost or reservation price) for selling a good. Producer Surplus = Market Price – Minimum Acceptable Price • Different producers have different costs of producing the same good. • But all producers sell at the same market price. • Producers whose costs are lower than the market price enjoy extra profit (surplus).
- 48. 48 Deadweight loss • DeadweightLoss (DWL) refers to the total loss of economic welfare (total surplus) that occurs when a market is not operating efficiently. • It's the loss of potential gains from trade due to market distortions like taxes, price controls, or monopolies. Cause Effect Taxes Buyers pay more, sellers get less, quantity falls Price Ceiling (e.g., rent control) Creates shortages, reduces quantity supplied Price Floor (e.g., minimum wage) Creates surpluses, reduces quantity demanded Monopoly Pricing Limits quantity to keep prices high Subsidies (in some cases) Distorts market allocation
- 49. 49 Efficiency versus equity AspectEfficiency Equity Meaning Maximizing total economic output and welfare Ensuring fairness in distribution of income and opportunities Focus Grow the economic “pie” Divide the economic “pie” fairly Key Principle Pareto Efficiency: No one can be made better off without making someone else worse off Fairness, social justice, and equal access Approach Minimize government intervention; let markets allocate resources Redistribute wealth via taxes, welfare, and social policies Typical Supporters Free-market economists, business groups Social welfare advocates, social democrats Policy Examples Deregulation, tax cuts, trade liberalization Progressive taxation, subsidies, social security Benefits Drives growth, innovation, and productivity Reduces poverty, social unrest, and inequality Drawbacks Can increase inequality and social exclusion May reduce incentives to work and innovate (if overdone) Government Role Minimal — only correct market failures Strong — ensure redistribution and protection of vulnerable groups Measurement Methods Pareto efficiency, Dead weight loss (DWL) Gini Coefficient Poverty headcount ratio Human Development Index (HDI) Access to healthcare, education Vertical and horizontal equity
- 50. 50 When should Governmentinterfere in the market • Market failure (Externality, Information Asymmetry) • Equity and welfare concern (education and health) • Macroeconomic instability • Correcting irrational behaviour (Poor health decisions, Under-saving for retirement) • Strategic national interests
- 51. 51 Market failures Type ofMarket Failure Meaning Example Information Asymmetry One party has better info than the other Schools hiding costs, unsafe food, health care Public Goods Goods where no one can be excluded and consumption is non- rival National defense, street lighting Externalities Costs/benefits not reflected in market prices Pollution (negative), vaccination (positive) Monopoly/Market Power Single firms controlling prices and restricting output Telecoms, Railways in early stages Incomplete Markets Some markets simply don't exist Market for disaster insurance Coordination Failures Private actors can’t coordinate to achieve better outcomes Urban planning, network standards
- 52. 52 Government in market Typeof Interference Purpose Examples (India-focused) Price Controls (Price ceiling and Price floor), Price support and Production Quotas Protect consumers/producers from unfair prices Price cap on school fees (Gujarat) MSP for wheat Essential medicine price controls Taxes and Subsidies Discourage harmful goods or support essential sectors Tobacco & alcohol tax Fertilizer subsidy EV subsidies (FAME scheme) Market Regulations Ensure safety, quality, and fair practices Pollution control by CPCB FSSAI food safety rules School recognition/licensing Provision of Public Goods Supply goods/services markets won’t provide National defense Public roads Free vaccination programs Competition & Monopoly Control Prevent abuse of market power CCI action against cartels Telecom deregulation to end monopoly
- 53. Elasticity and itsapplication Elasticity: A measure of responsiveness of quantity demanded or quantity supplied to a change in one of its determinants.
- 54. Price elasticity Price elasticityof demand: A measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in the price.
- 55. Price elasticity ofdemand • Availability of close substitutes • Necessities versus luxuries • Definition of the market • Time horizon
- 56. Computing the priceof elasticity of demand / / P Q Q Q P E P P P Q Linear Function Point Definition 1 P P E a Q 2 1 2 1 2 1 2 1 P Q Q P P E P P Q Q Arc Definition
- 57. Elasticity calculation –end point vs mid- point method Consider on the demand curve the equilibrium moves from Point A to Point B. Point A: Price Rs. 20 and quantity demanded 100 units. Point B: Price Rs. 40 and quantity demanded 60 units. a. Find the price elasticity of the demand with end-point and mid-point method. b. What is the price elasticity of the demand if the equilibrium moves from Point B to Point A.
- 58. 58 Is elasticity sameeverywhere on the demand curve
- 59. Class Exercise A) Asthe price rises from Rs 200 to Rs 250, what is the price elasticity of demand for business travelers and vacation travelers B) Why might the vacationers have a different elasticity from business travelers. Price QD (business travellers) QD (vacaation travellers) 150 2100 1000 200 2000 800 250 1900 600 300 1800 400
- 60. Variety of demandcurve • Perfectly inelastic demand • Inelastic demand • Unit elastic demand • Elastic demand • Perfectly elastic demand
- 61. Total revenue changeand price elasticity of demand (mid-point method) Price Quantity Total revenue Percentage change in Price Percentage change in Quantity Elasticity Description 7 0 6 2 5 4 4 6 3 8 2 10 1 12 0 14
- 62. Income Elasticity ofDemand Linear Function Point Definition / / I Q Q Q I E I I I Q 3 I I E a Q
- 63. Income Elasticity ofDemand Arc Definition 2 1 2 1 2 1 2 1 I Q Q I I E I I Q Q Normal Good Inferior Good 0 I E 0 I E
- 64. Cross-price elasticity ofdemand Cross-Price elasticity of demand = (Percent change in quantity demand of good X/ percent change in price of good Y)
- 65. The Elasticity ofsupply Price Elasticity of Supply: A measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in the quantity supplied divided by the percentage change in the percentage change in the price. • Computing price elasticity of supply • Variety of supply curve
- 66. Class Exercise Price Quantity demanded (income= Rs. 20000) Quantity demanded (income = Rs. 30000) 6 40 50 10 32 45 14 24 30 18 16 20 22 8 12 For the given demand schedule: a) Using mid-point method, compute the price elasticity of demand as the price of DVDs increase from Rs 6 to Rs 10, if your income is i) Rs 20000 ii) Rs 30000 b) Calculate the income elasticity of the demand as your income increases from Rs 20000 to Rs 30000 if your price is i) Rs. 14 ii) Rs. 18
- 67. Applications from thebook: A. Can good news for farming be bad news for farmers? B. Why did OPEC fail to keep the price of oil high? C. Does drug interdiction increase or decrease the drug related crime?
- 68. 68 Class Assignment -Case: Sugar Tax and Beverage Consumption in the UK In response to growing concerns about rising obesity, type 2 diabetes, and tooth decay, the UK Government introduced the Soft Drinks Industry Levy (SDIL) in 2018. This policy, commonly referred to as the "sugar tax," was aimed at discouraging the consumption of high-sugar beverages and encouraging companies to reformulate products. Under the levy, drinks containing: • More than 8g of sugar per 100ml are taxed at a higher rate. • Between 5–8g of sugar per 100ml are taxed at a lower rate. • Below 5g per 100ml are exempt from the tax. Despite reformulation by manufacturers, sugary beverages still make up a substantial part of the diet, especially among younger consumers and low-income households. Health economists and policymakers continue to explore whether increasing the tax rate further could lead to a more significant drop in consumption. Recent studies in the UK show that the price elasticity of demand for sugary drinks is -0.6, meaning that for every 10% increase in price, quantity demanded falls by about 6%. Currently, the average price for a 500ml bottle of sugary soft drink is £1.00.
- 69. 69 Questions for Discussion QuestionA: The UK government wants to reduce consumption of sugary soft drinks by 15% to improve public health outcomes. By what percentage must the price be increased to achieve this target reduction, assuming the price elasticity of demand remains constant? Question B: If the proposed price increase is implemented permanently: Will the impact on consumption be greater in 1 year or in 3 years? Explain using the concept of short-run vs long-run elasticity. Question C: Empirical research finds that the price elasticity of demand is higher for school-age teenagers compared to working adults. Explain why younger consumers might be more sensitive to price changes in sugary beverages. Question D: Find the expected revenue from the tax after the price increase. Question E: Find the possible deadweight loss or consumer welfare implications.
- 70. 70 Theory of Production:Short-run and long-run Consumer Preferences Production Technology Budget Constraints Cost Constraints Consumer choices Input Choices
- 71. 71 Why do weneed firms?
- 72. 72 Chapters answer thefollowing questions: How much assemble line machinery to have? How much labour should we hire? If we want to increase production, should we hire more labour or construct new plant or both. Does one plant should make different models of product or should each model be prepared in different plant. What is the likely cost of productions and how it affects the decision of level of production.
- 73. 73 Production function A productionfunction shows the relationship between inputs and outputs in the production process. It tells us how much output (goods/services) can be produced with given quantities of inputs (like labor, capital, land). General Form: Q = f(L, K) Where: Q = Quantity of output L = Labor input K = Capital input Example: Q = 5L + 2K
- 74. 74 Factors of Productions Traditional Factors Modern/EmergingEquivalents Explanation / Relevance 1. Land Infrastructure (Physical & Digital) Includes physical land, office space, logistics, data centers, cloud infrastructure, etc. 2. Labor Human Capital & Global Talent Emphasis on skilled labor, remote teams, creativity, and knowledge- based work. 3. Capital Financial, Technological & Intellectual Capital Beyond money—includes software, AI models, patents, brand equity, and VC funding. 4. Entrepreneurship Strategic Leadership & Innovation Visionary leadership, agility, and ability to innovate and align with market changes.
- 75. 75 Average and MarginalProduct Average Product: Output per unit of a particular input Marginal product: Additional output produced as input in increased by one unit. Marginal Product reflects the slope of the product curve. When MP > AP AP is increasing When MP < AP AP is decreasing
- 76. 76 Production with onevariable input Amount of labour (L) Amount of Capital (K) Total Output (q) Average Product (q/L) Marginal Product 0 10 0 1 10 10 2 10 30 3 10 60 4 10 80 5 10 95 6 10 108 7 10 112 Draw the total product curve for the above table.
- 77. 77 Production with twovariable inputs Isoquants: An isoquant is a curve that shows all combinations of two inputs (typically labor and capital) that produce the same level of output. Key properties: • Downward sloping • Convex to the origin • Do not intersect • Higher isoquant = more output
- 78. 78 Diminishing Marginal Returns Lawof diminishing marginal returns: The principle states that as the use of an input increases with the other inputs fixed, the resulting additions of output will eventually decreases. • Effect of technological improvement
- 79. 79 Marginal rate oftechnical substitution The Marginal Rate of Technical Substitution (MRTS) is the rate at which a firm can substitute one input for another while keeping the level of output constant. MRTS = MPL/MPK MPL is marginal product of labour MPK is marginal product of capital Diminishing MRTS: As more labor is substituted for capital, each additional unit of labor replaces less and less capital.
- 80. 80 Special Cases When inputsare perfect substitutes When inputs are in fixed proportions
- 81. 81 Question 1) The marginalproduct of labour in the production of bicycle is 10 cycles per hour. The marginal rate of technical substitution of hours for labour for hours of machine is 1/5. What is the marginal product of capital? 2) If the production function is given by: Q=f(L,K)=10 * L^0.5 * K^0.5 The cost of labour is Rs 200 and cost of capital is Rs 800. The firm is producing 100 units of output. The cost minimizing number of labour and capital are 20 and 5. i) Graphically show isoquant and isocost curves. ii) Find MRTS, MPL, MPK iii) If firm want to increase output to 140 and capital is fixed in short-run, what is the number of labour required. iv) If MRTS is K/L, what is optimal unit of K and L required to produce 140 units of output.
- 82. 82 Class Assignment -Case: The Cookie Crunch Dilemma at ChocoDelight ChocoDelight is a boutique cookie company in Pune, known for its handcrafted chocolate-chip cookies. Until recently, the owner, Meera, baked everything herself using one oven and a small preparation space. As demand grew, she decided to hire temporary workers to help with daily production — mixing dough, baking, and packing. The capital input (oven, space, equipment) remains fixed in the short run (Fixed Capital: 1 oven, 200 sq ft kitchen), but she can hire more workers each day to increase production. In the first week, Meera tracked cookie output as she added more workers. Here are her observations:
- 83. 83 Case: The CookieCrunch Dilemma at ChocoDelight No. of Workers Total Output (Dozens) 0 0 1 8 2 20 3 36 4 48 5 55 6 59 7 60 1.Compute Marginal Product (MP) and Average Product (AP) for each level of labor. 2.Identify the stage at which: 1. Marginal returns begin to diminish. 2. Negative returns might occur if workers keep increasing. 3.Draw the TP, MP, and AP curves to visualize the Law of Variable Proportions. 4.Why does marginal product initially increase? What factors might cause it? 5.If Meera hires an 8th worker and TP falls to 58 dozens, what does it indicate? 6.Suppose Meera is paying 500 per worker per day. Calculate ₹ the marginal cost per dozen cookies at each level. 7.How can she decide the optimal number of workers for daily production?
- 84. 84 Production possibility frontieror Product transformation curve
- 85.
- 86. 86 Accounting Profit Accounting profitis the total revenue a firm earns minus its explicit costs (actual monetary payments made for inputs like wages, rent, materials, etc.). Accounting Profit = Total Revenue – Explicit Costs Example: If a bakery earns 500,000 in revenue and spends 350,000 on wages, ₹ ₹ flour, and rent, the accounting profit is: ₹500,000 – 350,000 = 150,000 ₹ ₹
- 87. 87 Economic Profit • Economicprofit considers both explicit and implicit costs. It subtracts opportunity costs from total revenue. This gives a deeper measure of profitability, reflecting what the firm could have earned using its resources elsewhere. • Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs) • Economic Profit = Accounting Profit – Opportunity Costs Example: • Consider a bakery with the following details: • Revenue = 500,000 ₹ • Explicit Costs = 350,000 ₹ • Implicit Costs (e.g. owner’s forgone salary or rent from using own building) = 80,000 ₹ • Economic Profit = 500,000 – 430,000 = 70,000 ₹ ₹ ₹
- 88. 88 Opportunity cost Opportunity costis the value of the next best alternative foregone when a decision is made. It reflects the true cost of a choice. Examples: • If you choose to attend college, the opportunity cost includes the income you could have earned by working instead. • A farmer using land to grow wheat gives up the opportunity to grow barley. Why It Matters: Opportunity cost helps in rational decision-making and is key to calculating economic profit.
- 89. 89 Fixed cost, Variablecost, Marginal cost • Fixed Cost: Costs that does not vary with the level of the output and can be eliminated by shutting down the business. • Variable Cost: Costs that vary with the level of the output produced.
- 90. 90 Sunk Cost • Expensesthat has been made and cannot be recovered. Fixed cost versus Sunk cost • Fixed cost can be avoided if the firm shuts down. Sunk cost are the costs that have been incurred and cannot be recovered. • Most firms don’t distinguish between fixed cost and sunk cost. Amortization: Policy of treating a one-time expenditure as an annual cost spread overs some number of years.
- 91. 91 Marginal Cost Marginal Costis the additional cost incurred by a firm when it produces one more unit of output. MC = change in variable cost/ change in output = wage rate * change in no. of labour/ change in output = wage rate/ marginal product of labour Where MPL = change in output/ change in number of labours
- 92. 92 Firm cost structure OutputFC VC TC MC AFC AVC ATC 0 50 0 1 50 50 2 50 78 3 50 98 4 50 112 5 50 130 6 50 150 7 50 175 8 50 204 9 50 242
- 93. 93 Plotting AVC, AFC,ATC, MC cost curve
- 94. 94 Example Suppose that thecompany want to buy a building in a city and the firm has bought an option last year worth Rs. 50000 to buy the building at Rs 50,00,000 in the following year. Now, this year a similar building is available with price Rs 50,25,000. Which building the company should consider to buy?
- 95. 95 Shape of costcurve • Total Cost (TC) • Fixed Cost (FC) • Variable Cost (VC) • Average total cost (ATC) • Average fixed cost (AFC) • Average variable cost (AVC) • Marginal cost (MC) ATC is minimum when MC = ATC.
- 96. 96 Isocost line An isocostline shows all combinations of two inputs (typically labor (L) and capital (K)) that a firm can purchase for a given total cost. It is the producer’s budget constraint, just like the budget line in consumer theory.
- 97.
- 98. 98 Relationship between long-runand short-run cost curve Short-run: When one or more of the input choices are constrained to change. Long run: when all the input choices are variable.
- 99. 99 Economies of scale Economiesof scale refer to the cost advantages that a firm experiences as it increases its scale of production, leading to a decrease in average cost per unit. Why it happens: • Better utilization of fixed inputs • Specialization of labor • Bulk purchasing of inputs • Improved technology or management Result: • Long-Run Average Cost (LRAC) curve slopes downward.
- 100. 100 Constant Returns toScale Constant returns to scale occur when a proportional increase in all inputs leads to an equal proportional increase in output, causing the average cost to remain constant as production expands. Example: Doubling inputs → Output doubles → LRAC stays flat Result: LRAC curve is horizontal (flat segment).
- 101. 101 Diseconomies of Scale Diseconomiesof scale arise when increasing the scale of production leads to a higher average cost per unit. Why it happens: • Coordination and communication problems • Bureaucratic inefficiencies • Loss of managerial control Result: LRAC curve slopes upward.
- 102. 102 Case: Riya's GreenPlateExpansion Decision Riya, a young entrepreneur in Mumbai, successfully runs a food truck business named GreenPlate Foods. Her truck, stationed near a bustling college campus, offers healthy organic meals and has earned a loyal customer base. Encouraged by the popularity of her food and consistent profits, Riya begins considering an expansion. Recently, she noticed a growing demand for quick lunch options at a newly developed IT park across the city. To tap into this opportunity, Riya contemplates investing in a second food truck that would operate at the IT park location. However, the success of the new outlet would depend on her personal supervision and active management, especially in the first several months. Hiring someone to manage it independently would be risky and increase costs. Therefore, Riya would need to dedicate full-time effort to managing this second truck herself. To proceed, Riya would need to buy a new food truck for 4,00,000—a non-refundable investment that would ₹ not generate any returns if the plan fails. Beyond this initial sunk cost, she estimates that running the new truck would require monthly fixed expenses of 40,000. These would include staff wages, fuel, parking permits, and ₹ local food licenses. In addition, for every meal she sells, she incurs a variable cost of 50, accounting for raw ₹ materials, packaging, and utilities. Riya plans to sell each meal for 100 and expects to serve about 2,000 ₹ meals per month at the new location. Just as Riya begins planning for this expansion, she receives a tempting offer from a well-known restaurant chain. They offer her a managerial role with a fixed salary of 80,000 per month. The role would be full-time ₹ and mutually exclusive with her involvement in the second truck. She must now choose: either invest in the second truck and manage it herself, or accept the salaried job and give up the expansion plan.
- 103. 103 Class Practice -Case: Cost Optimization at Viraj Motors Viraj Motors is a young electric scooter manufacturer planning to optimize its production costs. Before launching full operations, the company invested 6,00,000 ₹ in setting up its plant and purchasing equipment. This investment was made upfront and cannot be recovered. In addition, the company incurs 50,000 every month for ₹ salaries of administrative staff and factory lease payments, which remain constant regardless of production levels. As the production line starts operating, the finance team collects the following cost data based on recent monthly output: OUTPUT (UNITS PER MONTH) TOTAL COST INCURRED ( ) ₹ 10 1,70,000 20 2,50,000 30 3,20,000 40 3,90,000 50 4,80,000 60 5,90,000 70 7,30,000
- 104. 104 Class Practice -Case: Cost Optimization at Viraj Motors Management has noticed that producing more units initially seems to reduce per-unit costs, but after a certain point, the average cost starts rising. With pressure to increase output due to rising demand, the operations team is unsure whether expanding production beyond 50 units is cost-effective. They also realize they need a clearer understanding of how their costs are behaving at different levels of production. The finance head has tasked the analyst team with breaking down the cost structure, identifying the nature of different costs, and providing insights into where cost efficiency peaks — and whether further expansion is advisable based on cost dynamics.