2. What do We Study in Economics?
The study of economics deals with ordinary, everyday
things (e.g. Food, shelter, clothing, designer jeans,
prostitution, bass boats, etc.)
2
3. Introduction to Agricultural Economics
Introduction to Economics – You can’t have your
cake and eat it too!
What is Economics?
3
4. Introduction to Agricultural Economics
Introduction to Economics – You can’t have your
cake and eat it too!
What is Economics?
Economics is a social science that deals with how
consumers, producers and societies choose among
Alternative uses of scarce resources in the process
of producing, exchanging, and consuming goods
and services.
4
5. Basic Definition of Economics
The demand for goods and services is unlimited.
Yet the resources needed to make goods and services
all resources are limited.
Economics is the field of study that deals with the
allocation of these scarce resources among
competing needs, over time.
5
6. Types of Resources
Natural and Biological -- example (Land)
Human – example (Labor)
Manufactured – example (Capital)
Management – a special kind of labor
Scarcity – finite quantity of resources available, it’s
a relative concept.
6
7. The Study of Economics
Although economics deals with ordinary, everyday
things, it does so scientifically.
So economists look at these things in a
methodical and scientific way which allows
economists to draw conclusions and make
predictions;
Words
Data
Graphs
Equations
7
8. Economic Concepts
In order for any profession to function it must
develop a working set of relevant concepts
and an agreed upon definition for such
concepts.
In Economics this means that certain
attributes of goods and services and human
behavior are important enough to receive
special treatment and in some cases a
unique name.
8
9. What Is It That Gives Something Value?
For something to be of value it must
be useful; provide UTILITY.
Utility = usefulness = ability to
satisfy = value
9
10. What Is the Relationship Between Utility and
Price?
Water is a necessity of life yet it is free for the
gulping at the nearest tap.
Diamonds are hardly a necessity yet, they are
very expensive.
10
11. Utility, Scarcity, & Price
The key to understanding price is
the relationship between the amount
of a thing that is available and the
amount which is desired.
Water is abundant and diamonds are
scarce.
11
12. Utility, Scarcity, & Price
Two-headed dogs are scarce, yet they do
not command a high price in the market
place. This is because they have little utility.
For a good or service to command a high
price, it must be both useful and relatively
scarce.
12
13. Opportunity Cost
Opportunity cost is what one is willing to give up
to consume a particular good or service.
Opportunity cost is measured as being the cost or
value of the "next best" thing you could have been
doing, if you were doing something else; you could
have eaten an apple but you chose a peach.
13
15. Law of
Diminishing
Marginal Utility
When an individual
consumes additional
units of a commodity
(X), consumption of
other commodities
unchanged, the
amount of
satisfaction derived
from each additional
unit of commodity
(X) decreases.
15
16. Law of Diminishing Marginal Utility
A very hungry lad purchases a
dozen donuts.
The consumption of the first donut
will give him a great deal of
satisfaction. Consumption of the
second donut will also give him
much satisfaction but not quite as
much as the first. Consumption of
the third donut will likewise be
enjoyed by the lad but, again, not
quite as much as the second donut
and so on. This is the law of
diminishing marginal utility.
16
17. Macroeconomics
Deals with the economic system as a whole.
Scope; national & world economy.
GDP
Money supply
Unemployment rate
Interest rates
International currency exchange rates
Income Tax
Government Programs
17
18. Microeconomics
Scope; from a single individual to a
specific industry.
Market supply and demand
Commodity prices
Cost of production
18
19. Positive vs. Normative Economics
Facts vs. opinions
What is and what would happen
if
What should be or what ought to
be
19
20. Agricultural Economics
The agricultural industry is unique because;
◦ It produces products from living entities,
◦ Cyclical production which results in volatile
prices
An applied science dealing with the food &
fiber system.
Includes the economic issues related to
resources, production, processing, and
distribution.
20
21. Agribusiness
The sum total of all businesses involved in the
production, manufacture, and sale of
agricultural products.
Deals with any agricultural product from the
beginning of production to its final
consumption.
21
22. Graphs and Economics
Economic analysis is used to explain people’s
responses to changes in their economic environment.
Economists do this to try and predict future behavior
with some accuracy.
Relationships can be complicated and sometimes
better explained using graphs.
22
23. Graphs
Economic data is often displayed in graphic form.
Graphs make it easier to see relationships.
23
24. Graphs
Dependent variable.
Variable whose value changes as the result of a
change in another (independent) variable.
Independent variable.
Variable whose changes cause the value of another
(dependent) variable to change.
24
25. Graphs
The value of the dependent variable is
shown on one axis and the value of the
independent variable on the other axis.
Four basic relationships may exist
between two variables.
25
28. Graphs and Economics
What kind of values do X and Y take on in Quadrant 1?
2? .. 3? .. 4?
-2 -1 1 2
3
2
1
-1
-2
-3
Quadrant III
III IV
X
Y
28
29. Y
X
Quadrant I
values of X are positive
values of Y are positive
Quadrant II
values of X are negative
values of Y are positive
Quadrant III
values of X are negative
values of Y are negative
Quadrant IV
values of X are positive
values of Y are negative
0 1 2 3 4 5-4 -3 -2 -1
-1
3
-2
1
2
-3
Cartesian Coordinate System
29
30. Graphs and Economics
1 2 3 4
4
3
2
1
In Economics we use Quadrant I almost exclusively, Why is
that the case?
30
31. Graphs and Economics
1 2 3 4
4
3
2
1
Price is a variable that is denoted in TZS,
prices aren’t negative. Right?
Price TZS
31
32. Graphs and Economics
1 2 3 4
4
3
2
1
What about quantities? Can they be negative? What
are the Units?
Price TZS
Quantity
32
33. Graphs and Economics
1 2 3 4
4
3
2
1
What kind of relationship is denoted between price
and quantity In this graph?
Price TZS
Quantity
Demand
33
34. 1 2 3 4
4
3
2
1
What kind of relationship is denoted between price and
In this graph?
Price TZS
Quantity
Supply
34
35. 1 2 3 4
4
3
2
1
How would you describe this relationship?
What is true about Its slope throughout?
Price TZS
Quantity
Supply
35
36. 1 2 3 4
4
3
2
1
How would you describe this relationship?
What is true about Its slope?
Price TZS
Quantity
36
37. 1 2 3 4
4
3
2
1
How would you describe this relationship?
What is true about Its slope?
Costs TZS
Quantity
Average Total Costs
37
38. 1 2 3 4
4
3
2
1
Costs TZS
Quantity
Average Total Costs
This relationship is Convex, It has a minimum.
We want to minimize costs.
38
39. 1 2 3 4
4
3
2
1
How would you describe this relationship?
What is true about Its slope?
Output
Quantity Input
Total Physical Product
39
40. 1 2 3 4
4
3
2
1
This relationship is Concave, it has a maximum.
We want to maximize production or profit.
Output
Quantity Input
Total Physical Product
40
41. 1 2 3 4
4
3
2
1
This relationship is Concave, it looks like a cave!
Output
Quantity Input
What does this look
Like?
41
42. 1 2 3 4
4
3
2
1
This relationship is Concave and Convex, it does
have a global maximum though.
Output
Quantity Input
Total Physical Product
One more curvy line
42
48. Implicit Assumptions About Graphs
Economists tend to make a lot of assumptions
in order to simplify complex problems.
Ceteris paribus = all other things remaining
constant. When making a graph, this means
that all things not measured along the two
axes, are held constant.
48
49. Implicit Assumptions About Graphs
Homogeneous units = the physical units
measured along the axes are all alike.
Divisibility = in order to draw smooth
continuous lines, we assume that the units can
be divided into small fractions.
49
50. C H A P T E R 2
AEA 101: INTRODUCTION TO
AGRICULTURAL ECONOMICS
AND DEVELOPMENT
50
51. 1 . F A R M I N G A S P A R T O F T H E R U R A L S Y S T E M
2 . F A R M I N G A N D A G R I C U L T U R A L P O L I C Y
3 . T H E R O L E O F A G R I C U L T U R E I N E C O N O M I C
D E V E L O P M E N T
What will covered
51
52. 2.1 FARMING AS
PART OF THE
RURAL SYSTEM
Agricultural industry is
an activity which is
influenced by its
surroundings and at
the same time it is also
a means for changing
these surroundings
Farming as part of rural
system – only a part of
ecological system
Ecological
system
Rural system
Farming
52
53. What is system?
53
An assembly of related parts more loosely related
to each other than non-related parts
Can exist by itself or be part of other systems
It has a boundary – can be open or closed
A system influences the behaviour of its individual
elements
54. What is
system?
The Economic
system – producing,
distributing and
consuming goods
Political system:
within organization
conflicts
Social –cultural
system: values, norms
and goals networks of
social relationships
The technological
system: its individual
elements
Socio-cultural
systems
• Rural communities
• Farm families
Political system
• Farmer organization
Technological
system
• Extension
• Education
• Research
Economic system
• Firms & HH
• Utilizes land,
labour, capital to
make products
Agriculture
54
55. 2.2 Role of Agric in Econ Dev
55
Look at this in two ways
Closed economy – assume no foreign trade
Assuming all agricultural and industrial goods are
internationally traded
56. Role Of Agriculture in Econ Dev
56
Main contribution of agric to overall economic
growth
1. Growth of agricultural and food production
2. Transfer of resources (labour and capital) – only works if
productivity of transferred factor is higher in non-agric
sectors
3. Earnings of foreign exchange and stable balance of payments
– agriculture and food exports exceed imports
4. Industrialization – through raw material or purchase of
industrial goods
58. 1 . D E S C R I P T I O N O F E A S T A F R I C A
2 . F A C T O R T H A T I N F L U E N C E L A N D U S E P A T T E R N
3 . M A J O R L A N D U S E P A T T E R N S
4 . T H E L I V E S T O C K H U S B A N D R Y P R A C T I C E S
5 . P R I N C I P L E O F M A R G I N S O F C U L T I V A T I O N
TOPICS
58
59. 3.1 Description of EA
Almost every variation of physical features is to be
found
59
64. Physical Features of EA
• 16km – 64 km from Somalia to
Mozambique
• High rainfall, depend on monsoons
The coastal belt
• Northern – north province Kenya, South
– Mtwara region and parts of Coastal
region
The coastal
hinterland plains
• Lies btwn Alt 1200m – 2800m
• Follows the rift valley
• 14 lakes
Main EA plateau
• Lie btn rift valley and lake Victoria
• Parts of Uganda, Nyanza district in
Kenya, Mara and lake Kagera
The lake Victoria
depression
64
65. 3.2 Factor that influence land use patterns
ClimaticRainfall
Temperature
Humidity Soil fertility
Topography
Altitude
65
66. 3.2 Factor that influence land use patterns
Social
Population
Transport Land tenure
Administrative
set up
66
67. 3.3 Major Land Use Patterns
Farmers devise specific systems of farming according
to economic laws and principles
The law of relative advantage
“A farmer, in order to use his
available recourse to the best
advantage, will produce those crops
and / or classes of livestock for
which his farm is relatively best
suited”
67
68. 3.3 Major land use patterns
Comparison is made between enterprises on the
same farm
Effective use of recourses in producing “A” than “B”
and not necessarily more cheaply
There are 8 land use pattern discussed by Prof
Mlambiti (pg 41 – 55)
68
69. 3.4 The Livestock Husbandry Practice
Livestock production less efficient and thus more
expansive compared to crops production
Double convention of solar energy
Animal protein not absolute essential in human diets
Livestock can have 3 types of relationships with crops
grown
Complementary – Based on crop-by products or grass meant
for soil fertility
Supplementary – animals kept for draught
Competitive - when markets are available or most economic
means or the only means
69
70. Contribution of livestock to Agric GDP
Livestock production is one of the major agricultural
activities in Tanzania.
The sub sector contributes to
National food supply,
Converts rangelands resources into products suitable for human
consumption and
Is a source of cash incomes and an inflation – free store of value.
It provides about 30% of the Agricultural GDP.
40%, 30%, and 30% originates from beef, Milk and poultry and small
stock production.
70
71. Major livestock husbandry systems
PastoralismPastoralism
RanchingRanching
Liv.
Integrated
with crops
Liv.
Integrated
with crops
Landless
Liv. Prod
Landless
Liv. Prod
71
72. Nomadic pastoralism
Objectives
Provide livelihood in arid and semi arid regions
To meet small requirements for cash
To fulfil various other economic and social functions
Strength
Reduce risk and allows efficient utilization spatially and
seasonally variable fodder resources
72
73. Weaknesses of the system
Turn land into desertification
Pastoralist is not contributing to land as is land to him
Social conflicts are very frequent
Do not adapt well to rapid technological and political change
Suggested solution
Organized rotation of grazing
Distribution of reliable water supplies
Formulation of grazing associations
Alternative employments for the pastoralists
Nomadic pastoralism
73
74. Pastoral systems in arable areas
PastoralistsPastoralists
• Crop residues
• Extra milk-cultivators
cattle
• Calves and or money
CultivatorsCultivators
• Meat/cattle
• Manure
• Reduces risk from dry season
74
75. Ranching
Is a commercial range livestock production system
where all grazing and water are normally supplied
within a ring fence.
Main objective is to generate profit
Advantages
More efficient use of suitable rangelands than pastoralism
75
76. The Principle of margins of cultivation
“As long as it remains profitable to use more
of an input, farmers will continue applying
that input till additional profit resulting
from the use of the input equals additional
cost so incurred”
76
77. The concept of intensive margin
Intensive margin of cultivation reflects the
intensity with which land is used.
E.g. Use of fertilizer
Marginal Factor Cost = Marginal Value Product
If prices change what happens?
If costs changes what happens?
77
78. Concept of the Extensive Margin
Not all lands are of equal quality in terms of its
capacity to grow crops
A given quality of seed, fertilizer and others
resources will decline as the land is higher in altitude
or drier
E.g. use of fertilizer in varied land
78
79. 1 . SYSTEM, TYPE OF FARMING AND
FARMING STRUCTURE
2. TYPES OF FARMING IN EAST AFRICA
CHAPTER FOUR
79
80. SYSTEM OF FARMING
Farming system is a decision making unit comprising the farm
household, cropping and livestock system that transform land, capital and
labour into useful products that can be consumed or sold( fresco and
westphal,1988) or
Farming system is a resource management strategy to achieve
economic and sustained production to meet diverse requirement
to farm household while presenting resources base and maintaining a high
level environmental quality (lal and Millar 1990).
Farming system is a complex inter related matrix of soil plants, animals,
implements, power labour, capital and other inputs controlled in parts by
farming families and influenced to varying degree by political,
economic, institutional and socials forces that operate at many levels.
80
83. SYSTEM OF FARMING
Income through arable farming alone is insufficient
for bulk of the marginal farmers.
The other activities such as dairying, poultry,
sericulture, apiculture, fisheries etc. assume
critical importance in supplementing their farm
income.
Farming system research has the objective of
increasing productivity of various enterprises in
the farm while enterprises the crop production.
83
84. 84
Major Farming Systems of Sub-Saharan Africa
Farming
Systems
Land
Area
(% of
region)
Agric.
Popn.
(% of
region)
Principal
Livelihoods
Prevalence
of Poverty
Irrigated 1 2
Rice, cotton, vegetables,
rain fed crops, cattle,
poultry
Limited
Tree Crop 3 6
Cocoa, coffee, oil
palm, rubber, yams,
maize, off-farm work
Limited-
moderate
Forest Based 11 7
Cassava, maize,
beans, cocoyam's
Extensive
Rice-Tree Crop 1 2
Rice, banana,
coffee, maize, cassava,
legumes, livestock, off-
farm work
Moderate
85. 85
Major Farming Systems of Sub-Saharan Africa
Farming
Systems
Land
Area
(% of
region)
Agric.
Popn.
(% of
region)
Principal
Livelihoods
Prevalence
of Poverty
Highland
Perennial
1 8
Banana, plantain,
enset, coffee, cassava, sweet
potato,
beans, cereals,
livestock, poultry, off-farm
work
Extensive
Highland
Temperate
Mixed
2 7
Wheat barley, tef,
peas, lentils, broadbeans,
rape,
potatoes, sheep,
goats, livestock, poultry,
off-farm work
Moderate-
extensive
Root Crop 11 11
Yams, cassava, legumes,
off-farm work
Limited-
moderate
86. 86
Farming
Systems
Land
Area
(% of
region)
Agric.
Popn.
(% of
region)
Principal
Livelihoods
Prevalence
of Poverty
Cereal-Root
Crop
Mixed
13 15
Maize, sorghum,
millet, cassava, yams,
legumes, cattle
Limited
Maize Mixed 10 15
Maize, tobacco,
cotton, cattle, goats,
poultry, off-farm work
Moderate
Large
Commercial
and
Smallholder
5 4
Maize, pulses, sunflower,
cattle,
sheep, goats, remittances
Moderate
Agro-Pastoral
Millet/Sorghum
8 8
Sorghum, pearl millet,
pulses.
sesame, cattle, sheep,
goats, poultry, off-farm
work
Extensive
87. 87
Farming
Systems
Land
Area
(% of
region)
Agric.
Popn.
(% of
region)
Principal
Livelihoods
Prevalence
of Poverty
Pastoral 14 7
Cattle, camels,
sheep, goats, remittances
Extensive
Sparse (Arid) 17 1
Irrigated maize,
vegetables,
date palms, cattle, off-
farm work
Extensive
Coastal
Artisanal
Fishing
2 3
Marine fish, coconuts,
cashew,
banana, yams, fruit,
goats,
poultry, off-farm work
Moderate
Urban Based little 3
Fruit, vegetables, dairy,
cattle,
goats, poultry, off-farm
work
Moderate
88. TYPE OF FARMING
Refers to a practice or features common to a large
number of farms in a given geographical area
88
92. FARMING STRUCTURE
The composition of a system that is to be analysed.
Can be described in term of farms
Number
Size in area
Capital
Farming type
Tenure
Economic status
92
94. SUBSISTENCE AGRICULTURE
form of farming in which nearly all of the crops or
livestock raised are used to maintain the farmer and
the farmer’s family, leaving little, if any, surplus for
sale or trade.
Preindustrial agricultural peoples throughout the
world have traditionally practiced subsistence
farming.
Some of these peoples moved from site to site as
they exhausted the soil at each location.
94
95. SUBSISTENCE AGRICULTURE
As urban centres grew, agricultural production became
more specialized and commercial farming developed, with
farmers producing a sizable surplus of certain crops, which
they traded for manufactured goods or sold for cash.
Subsistence farming persists today on a relatively wide scale
in various areas of the world, including large parts of sub-
Saharan Africa.
Subsistence farms usually consist of no more than a few
acres, and farm technology tends to be primitive and of
low yield.
95
97. SMALL SCALE FARMING
Small scale farming is the most common level of
farm operations
Why do small scale farming exists?
1. Lack of capital
2. Lack of labour
3. Lack of technical know how
1. Emphasis weigh heavily on food crops
97
98. SMALL SCALE FARMING
"Small-scale" is often equated with a backward, non-
productive, non-commercial, subsistence agriculture
that we find in parts of the former homeland areas.
This not necessarily correct.
the fallacy that small relates to land size only.
98
100. LARGE SCALE FARMING
The debate
http://www.future-agricultures.org/EN/e-
debates/Big_Farms/farm_debate.html
http://land-
affairs.typepad.com/tanzania/2011/11/small-vs-
large-scale-farming-in-sub-saharan-africa-a-
verdict.html
Is farm size the key determinant of productivity?
100
105. INTRODUCTION
• The willingness of consumers to purchase a
product or service is the fundamental source of
profit for many business
• Understanding consumer behaviour, then is the
first step in making profitable pricing, advertising,
product design and production decisions
• Firms spends a great deal of time and money trying
to estimate and forecast the demand of their
products
105
106. INTRODUCTION
• A manager’s need for practical analysis of demand
– both estimation of demand and demand
forecasting – requires an economic model of
consumer behaviour to guide the analysis
• In this chapter only the most important aspects of
theory of consumer behaviour are presented
106
107. INTRODUCTION
• Each consumer has to face the problem of
multiplicity of wants and limited income.
• In such state of affairs it is the desire of each
consumer to maximize his/her satisfaction in the
presence of income constraint.
• Whenever a consumer maximizes his satisfaction,
he is satisfied with his spending pattern, does not
have any tendency to change his style of
expenditure, he is said to be in equilibrium in
economics.
107
108. OBJECTIVE OF THE CHAPTER
1. Understanding Why does a consumer buy a
particular bundle of goods and services rather than
others?
2. The importance of examining these issues will help
us understand consumer behavior and the law of
demand.
108
109. 6.1 CONSUMER PREFERENCE AND UTILITY
• As an economic model, the theory of
consumer behaviour employs some
simplifying assumptions
• These assumptions permit us to go directly
to the fundamental determinants of
consumer behaviour
109
110. 6.1 CONSUMER PREFERENCE AND UTILITY
a) Complete Information
a) Have complete information pertaining
their consumption decisions
b) They know the range of goods and
services available and the capacity of
each to provide utility
c) The price of each good is known exactly
110
111. 6.1 CONSUMER PREFERENCE AND UTILITY
b) Preference ordering
a) Consumer are able to rank all conceivable
bundles of commodities – prefer bundle A to B
– prefer bundle B to A – equally satisfied with
A and B (indifferent)
b) Price has nothing to do with preference
c) Preference is a theoretical concept about how
people rank bundles of goods and or services
111
112. 6.1 CONSUMER PREFERENCE AND UTILITY
c) Consumer is rational
a) If three bundles A, B, and C
b) A preferred to B and B preferred to C, then
A must be preferred to C
d) Preference for more than less
a) Consumers always prefer to have more of a
good rather than less
112
113. UTILITY
• Economists name the benefits consumers obtain from the
good and services they consume UTILITY
• The satisfaction or utility can be measured into numbers.
• E.g. If a consumer drinks a glass of milk, the satisfaction
he derives from that glass of milk can be represented
into number like 1,2,4,5 etc.
• It is the view of the economist that the satisfaction or utility is
a cardinally measureable quantity as length, weight and
volume.
• Therefore they accepted the existence of unit of measurement
of utility called “util”.
113
114. UTILITY
• Consumer preference can be presented in a UTILITY
FUNCTION: -
• UTILITY FUNCTION: an equation the shows an
individual’s perception of the level of utility that would be
attained from consuming each conceivable bundle or
combination of goods and services U=f(X, Y).
• Utility depends upon the quantities of goods and services
consumed
• The actual numbers assigned to the level of utility are
arbitrary.
• E.g. consumer prefer 20X and 30Y to 15X and 32Y
• U = f(20,30) > U = f(15,32)
114
115. 6.2 INDIFFERENCE CURVE
• Consumers are willing to trade-off or substitute
among different goods
• This willingness to substitute is determined by the
form of that persons utility function
• A fundamental tool for analysing consumer
behaviour is an INDIFFERENCE CURVE
115
116. 6.2 INDIFFERENCE CURVE
• “An indifference curve is a locus of points
representing different combinations of goods and
services like x and y which give a consumer an equal
satisfaction”.
• “An IC shows different bundles of two goods like x
and y amongst which consumer remains indifferent
because of all such bundles yield a specific level of
utility”.
• That is the consumer is indifferent between any two
commodity bundles (points) that lie on the same IC
curve. U = f(x,y) = k
116
117. PROPERTIES
1. An indifference curve is downward sloping –
more of X added Y must be reduced
2. Indifference curves are convex – Diminishing
marginal rate of substitution
117
119. MARGINAL RATE OF
SUBSTITUTION (MRS)
• It is an important concept in indifference curve
analysis
• Marginal rate of substitution MRSxy = dY/dX
• Simply the rate of exchange between two
commodities x and y is called MRS.
• In proper words by “MRSxy we mean how many
units of commodity Y the consumer has to forego
to get an additional unit of commodity X while the
new combination of commodity X and Y yields the
same level of satisfaction”.
119
120. MARGINAL RATE OF
SUBSTITUTION (MRS)
• MRS diminishes along an indifference curve
• MRS is also known as slope of an IC.
• If we observe the indifference schedule and indifference
curve, we find that MRS goes on to fall. Such tendency
of falling MRS is known as “Principle of DMRS”
between X and Y.
• It is well evident fact that as a consumer has more and
more of any commodity his desire to get any more of it
decreases because of an application of law of
diminishing marginal utility.
• When consumers has a small amount of X relative to Y,
they are willing to give up a lot of Y to gain another unit
of X
120
121. • An indifference
map is made up
of two or more
indifference
curves
• IC3 is preferred
to IC1
121
INDIFFERENCE MAPS
122. LAW OF DIMINISHING
MARGINAL UTILITY (DMU)
• By utility we mean, the power of a good to satisfy
human want. i.e. The water has a power to quench
one’s thirst. For our discussion, by utility we mean
“The satisfaction”.
• As we discussed above that utility or satisfaction
depends upon the units of a particular good. It is as:
U= f(Q) or TU=f(Q). This is called utility or total
utility function.
• By “Marginal utility” we mean the net change in total
utility by having consumed an additional unit of a
commodity.
122
123. LAW OF DIMINISHING
MARGINAL UTILITY (DMU)
• E.g. A consumer is using the units of apple, if the
total utility of 1st apple is 10 units while the total
utility goes to 18 units if he uses the two apples, then
the net change in total utility or marginal utility is 8.
• MU is the derivative of total utility function or it is
the slope of TU curve, it is as: U = f(Q).
• Then its derivative will be MU = dU/dQ.
123
124. TOTAL AND MARGINAL UTILITY
Apples
consumed
per meal
Total
Utility,
Utils
Marginal
Utility,
Utils
0
1
0
10
Units consumed per meal
Units consumed per meal
30
20
10
TotalUtility(utils)MarginalUtility(utils)
10
8
6
4
2
0
-2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
124
125. TOTALAND MARGINAL UTILITY
Apples
consumed
per meal
Total
Utility,
Utils
Marginal
Utility,
Utils
0
1
0
10
10
Units consumed per meal
Units consumed per meal
30
20
10
TotalUtility(utils)MarginalUtility(utils)
10
8
6
4
2
0
-2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
125
126. TOTALAND MARGINAL UTILITY
Apples
consumed
per meal
Total
Utility,
Utils
Marginal
Utility,
Utils
0
1
2
0
10
18
10
8
Units consumed per meal
Units consumed per meal
30
20
10
TotalUtility(utils)MarginalUtility(utils)
10
8
6
4
2
0
-2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
126
127. TOTALAND MARGINAL UTILITY
Apples
consumed
per meal
Total
Utility,
Utils
Marginal
Utility,
Utils
0
1
2
3
0
10
18
24
10
8
6 0 1 2 3 4 5 6 7
Units consumed per meal
Units consumed per meal
30
20
10
TotalUtility(utils)MarginalUtility(utils)
10
8
6
4
2
0
-2
1 2 3 4 5 6 7
127
128. TOTALAND MARGINAL UTILITY
Apples
consumed
per meal
Total
Utility,
Utils
Marginal
Utility,
Utils
0
1
2
3
4
0
10
18
24
28
10
8
6
4 Units consumed per meal
Units consumed per meal
30
20
10
TotalUtility(utils)MarginalUtility(utils)
10
8
6
4
2
0
-2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
128
129. TOTALAND MARGINAL UTILITY
Apples
consumed
per meal
Total
Utility,
Utils
Marginal
Utility,
Utils
0
1
2
3
4
5
0
10
18
24
28
30
10
8
6
4
2
Units consumed per meal
Units consumed per meal
30
20
10
TotalUtility(utils)MarginalUtility(utils)
10
8
6
4
2
0
-2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
129
130. TOTALAND MARGINAL UTILITY
Apples
consumed
per meal
Total
Utility,
Utils
Marginal
Utility,
Utils
0
1
2
3
4
5
6
0
10
18
24
28
30
30
10
8
6
4
2
0
Units consumed per meal
Units consumed per meal
30
20
10
TotalUtility(utils)MarginalUtility(utils)
10
8
6
4
2
0
-2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
130
131. TOTALAND MARGINAL UTILITY
Apples
consumed
per meal
Total
Utility,
Utils
Marginal
Utility,
Utils
0
1
2
3
4
5
6
7
0
10
18
24
28
30
30
28
10
8
6
4
2
0
-2
Units consumed per meal
Units consumed per meal
30
20
10
TotalUtility(utils)MarginalUtility(utils)
10
8
6
4
2
0
-2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
131
132. TOTALAND MARGINAL UTILITY
Apples
consumed
per meal
Total
Utility,
Utils
Marginal
Utility,
Utils
0
1
2
3
4
5
6
7
0
10
18
24
28
30
30
28
10
8
6
4
2
0
-2
Units consumed per meal
Units consumed per meal
30
20
10
TotalUtility(utils)MarginalUtility(utils)
10
8
6
4
2
0
-2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
Observe
Diminishing
Marginal
Utility
132
133. LAW OF DIMINISHING
MARGINAL UTILITY (DMU)
• TU increases as each additional apple is purchased
through the first 5, but utility rises at a diminishing rate
since each apple adds less and less to the consumer’s
satisfaction.
• At some point, MU becomes 0 and then even negative at
the 7th unit and beyond. If more than 6 Apples were
purchased, TU would begin to fall. This illustrates the law
of DMU.
• Now we introduce “Law of DMU”. This law is based
upon a common reality of life, “The more we have of any
commodity, the desire to get any more of it decreases”.
133
134. LAW OF DIMINISHING
MARGINAL UTILITY (DMU)
• Marginal Utility (MU) is the addition to Total utility that is
attributed to consiming one more unit of a good, holding
constant the amounts of all other goods – MU = ∆U/ ∆Q
• From the definition we deduce the following:
• Along with increase in use of any commodity, TU
increases at a decreasing rate, hence MU decreases
• When the total utility reaches maximum , MU becomes
zero. This situation is called point of saturation.
• When TU itself falls, MU becomes negative.
134
135. LAW OF DIMINISHING
MARGINAL UTILITY (DMU)
• In this context, we get the assistance of a specific
quadratic utility function which encompasses all of
above relationships.
• On such lines a specific utility function is as:
• U = 11Q – Q2.
• By assuming different values of “Q” we can find the
values of “U” and then values of MU will be
attained.
135
136. LAW OF DIMINISHING
MARGINAL UTILITY (DMU)
• The change in TU that results when both X and Y
change by a small amount is related to MU’s of X
and Y
• ∆U = (MUx * ∆X) + (MUy * ∆Y)
• Suppose ∆X = 2 and ∆Y = -1
• If MUx = 25 and MUy = 10
• ∆U = (25 * 2) + (10 * -1)
• ∆U = 40
• Therefore, two more X and 1 less Y increases TU by
40units of utility
136
137. LAW OF DIMINISHING
MARGINAL UTILITY (DMU)
• At a given indifference curve ∆ U = 0
• ∆ U = 0 = (MUx * ∆X) + (MUy * ∆Y)
• -∆Y/ ∆X = MUx/MUy
• MRS = -∆Y/ ∆X = MUx/MUy
137
138. 6.3 THE CONSUMER BUDGET
CONSTRAINT
• An IC shows different combinations of two
goods x and y which yield and equal level of
satisfaction.
• Now the question is this which combinations of
two goods a consumer can afford to purchase.
• This is concerned with the budget constraint
line, price line or budget line of the consumer.
138
139. 6.3 THE CONSUMER BUDGET
CONSTRAINT
• “Budget line is a locus of all bundles of
goods that can be purchased at a given price
if the entire money income is spent
• It is as: M = X * Px + Y * Py
• Where X represents X commodity, Px is price
of X, Y represents Y commodity and Py is the
price of Y while M is the income of the
consumer.
139
140. 6.3 THE CONSUMER BUDGET
CONSTRAINT
• “Budget line is a locus of all bundles of
goods that can be purchased at a given price
if the entire money income is spent
• It is as: M = X * Px + Y * Py
• Where X represents X commodity, Px is price
of X, Y represents Y commodity and Py is the
price of Y while M is the income of the
consumer.
140
141. BUDGET LINE
• Y = M/Py – Px/Py (x).
• Now by assuming different values of X, we can find the
values of Y and then putting such values of X and Y in
the budget constraint equation, the expenditure of the
consumer will become equal to the fixed given income of
the consumer.
• We suppose M = 10, Px = 2 and Py = 1.
• If X = 0,1,2,3,4,5. plotting values.
141
142. 142
Pairs X Y X * Px + Y * Py = M
A 0 10 0(2) + 10(1) = 10
B 1 8 1(2) + 8(1) = 10
C 2 6 2(2) + 6(1) = 10
D 3 4 3(2) + 4(1) = 10
E 4 2 4(2) + 2(1) = 10
F 5 0 5(2) + 0(1) = 10
144. BUDGET LINE
• The OF is X intercept of BL which has been attained as
M/Px=10/2 = 5.
• While OA is y intercept of BL which has been found as M/Py
= 10/1 = 10.
• Thus BL shows different pairs of X and Y where a consumer
is fully spent as the pairs A, B, C, D, E and F. Now we
explain certain properties of BL.
• The BL divides the entire commodity space into attainable
and unattainable pairs. As BL divides the commodity space
into the triangular area OAF and rest of space (unattainable
pairs). Given his fixed income and commodity
144
145. BUDGET LINE
• prices, the consumer can choose only among those
bundles that lie in the triangular area OAF,
including its boundaries.
• The existence of the unattainable set reflects the
influence of the law of scarcity.
• The BL depends upon only two elements: the
consumer’s money income (M) and commodity
prices (Px and Py).
145
146. BUDGET LINE
• When either of these two elements changes, the BL
shifts to a new position.
• However the BL remains totally unaffacted by a
particular change: a proportional increase or
decrease in money income and all commodity
prices.
• Such a change leaves horizontal and vertical axis
intercepts of the BL same.
146
147. ASSUMPTION OF LAW
OF DMU
1. There should be a continuous use of the
commodity which a consumer is consuming.
2. All the units of the commodity in use must be
similar.
3. The units of good must be a of a suitable
amount.
4. The taste of consumer should remain the same.
5. The income of the consumer should not
change.
147
148. CONSUMER EQUILIBRIUM
• According to law of equilibrium Marginal utility;
• “ A consumer is in equilibrium when he spends
his money income on different goods in such a
way that MU of the last units of money spent on
each good is equal”.
148
149. CONSUMER EQUILIBRIUM:
ONE COMMODITY
• As a general rule, a utility maximizing consumer
consuming several commodities reaches his/her
equilibrium when he/she maximizes his/her total utility
• Suppose that a consumer with certain money income
consumes only good X
• Since both his money income and product X have utility
for him, he can either spend money on product X or
retain it
• If he has total money and no commodity X, MU of
money will be lower than that of commodity X
149
150. CONSUMER EQUILIBRIUM:
ONE COMMODITY
• Since MUx is > than MUm, TU can be increased by exchanging
money for commodity X
• A utility maximizing consumer will continue to exchange his
money income for commodity X as long as MUx > MUm
• The utility maximizing consumer will reach his equilibrium with
the level of his maximum satisfaction where
MUx = Px (MUm ) : (where MUm = 1)
Or MUx/Px(MUm) = 1
• Note: assumption for cardinal utility: Marginal utility of money is
constant where as marginal utility of other commodities is subject
to diminishing returns.
150
151. CONSUMER EQUILIBRIUM:
THE GENERAL CASE
• Let us assume a simple two-commodity case.
• Suppose that a consumer consumes only two commodities X and
Y, their prices being Px and Py respectively.
• Following equilibrium single commodity case, the consumer
distribute his income between commodities X and Y so that:
MUx = Px (MUm ) and MUy = Py (MUm)
or
MUx/Px(MUm) = 1 and MUy/Py(MUm) = 1
Therefore, utility maximization is reached when
MUx/Px = MUy/Py
151
152. CONSUMER EQUILIBRIUM
• This is explained with the help of a schedule and
diagram.
• We assume that a consumer has 5 rupees which he
has to spend on two goods like “X” and “Y”.
• The MU of different units of money are assumed as:
152
154. CONSUMER EQUILIBRIUM
• When a consumer decided to spend his 1st unit of money
whether this will go for good X or for good Y. Obviously
it will go for good x because here he gets 16 utils.
• While he get 14 utils if he spends it on good Y. Then 2nd
rupee will be spend on good Y because spending it on Y
yields 14 utils while spending it on X yields 12 utils.
• The 3rd rupee will be spent on X, because 12>10. The 4th
rupee will be spent on Y and 5th will be spent on X
yielding the 10 utils each.
154
155. CONSUMER EQUILIBRIUM
• In this way out of 5 rupee, 3 rupee will be spend on
good X and the remaining 2 rupee will be spend on
good Y. By such arrangements the MU of the last
rupee spent on each good has equalized as 10=10.
• Now we prove here that how this situation leads to
maximization of satisfaction.
• Total satisfaction or total marginal utility when 3
rupee are spent on good X: 16+12+10 = 38.
155
156. CONSUMER EQUILIBRIUM
• Total satisfaction or total marginal utility when the
remaining 2 rupees are spent on good Y: 14+10 = 24.
• Total satisfaction or total marginal utility of 5
rupees: 38+24=62.
• We assume that if the consumer plans to spend 4
rupee on X and remaining 1 rupee on Y. This
situation will not equate MU of the last unit of
money spent on each good.
156
157. CONSUMER EQUILIBRIUM
• Moreover the total satisfaction will be less than
earlier,
• it is as: if 4th rupee is last on X, its MU = 8. if
remaining one rupee is spent on Y, its MU = 14. thus
8 not equal to 14.
• Total satisfaction of 4 rupee on X: 16+12+10+8 = 46.
Total satisfaction of 1 rupee on Y = 14. Total
satisfaction of 5 rupees: 46+14 = 60.
157
158. CONSUMER EQUILIBRIUM
• Finding the optimal bundle of hotdogs and cokes. $ 20 budget
constraint
• It is a hot day hence MU of coke is higher
158
Ph 2.5Pc 2
Units per Game MUh MUh/Ph MUc MUc/Pc
1 20 8 60 30
2 15 6 40 20
3 12.5 5 20 10
4 10 4 16 8
5 7.5 3 8 4
6 5 2 4 2
159. DERIVATION OF DEMAND CURVE
• The basic purpose of the analysis of consumer behaviour is to
derive consumer demand curve.
• We define demand as: the quantity of a good the consumer is
willing and able to purchase at each price in a list of prices
holding other things constant
• The consumer maximizes utility when the rate at which they
are willing to substitute one good for another just equals the
rate at which they are able to substitute
• Let us start with $1,000 income and Px = 10 and Py = 10
• Following the law of demand we hold income and Py constant
• We lower Px from 10 – 8 – 5
159
162. DEFINITION OF PRICE
ELASTICITY OF DEMAND
The change in the quantity demanded of
a product due to a change in its price is
known as Price elasticity of demand.
Thus, the sensitiveness or
responsiveness of demand to change
in price is as called elasticity of
demand
162
163. KINDS OF PRICE ELASTICITY OF
DEMAND
1) Perfectly elastic demand
2) Relatively elastic demand
3) Elasticity of demand equal to utility
4) Relatively inelastic demand
5) Perfectly inelastic demand
Let Us See Some Views On Them
163
164. PERFECTLY ELASTIC DEMAND
P
R
I
C
E
y
0 x
Perfectly elastic
demand curve
D D
When the
demand for a
product
changes –
increases or
decreases
even when
there is no
change in
price, it is
known as
164
165. RELATIVELY ELASTIC DEMAND
Relatively elastic
demand curve
P
R
I
C
E
demand0 x
y
D
D
When the
proportionate
change in
demand is
more than the
proportionate
changes in
price, it is
known as
relatively
elastic
demand.
165
166. ELASTICITY OF
DEMAND EQUAL TO
UTILITY
Elasticity of
demand equal
to utility curve
y
x0 demand
P
R
I
C
E
D
D
When the
proportionate
change in
demand is
equal to
proportionate
changes in
price, it is
known as
unitary elastic
demand
166
167. RELATIVELY
INELASTIC DEMAND
Relatively inelastic
demand curve
XO
Y
demand
D
D
P
R
I
C
E
When the
proportionate
change in
demand is less
than the
proportionate
changes in price,
it is known as
relatively inelastic
demand
167
169. ALL KINDS OF DEMAND CAN BE
SHOWN IN ONE DIAGRAM AS
FOLLOW
D
D1
D2
D3
D4
D5
Y
X0
DEMAND
P
R
I
C
E
WHERE
D1) Perfectly elastic
demand
D2)Relatively elastic
demand
D3)Elasticity of demand
equal to utility
D4)Relatively inelastic
demand
D5)Perfectly inelastic
demand
169
170. MEASUREMENT OF
PRICE ELASTICITY
OF DEMAND
There are main methods like
1. Percentage method or proportionate method
2. Total outlay method or total revenue method
3. Geometric method or point method
4. Arc elasticity of demand
170
173. FACTORS AFFECTING PRICE
ELASTICITY OF DEMAND
Nature of the Commodity
Availability of Substitutes
Variety of uses of commodity
Postponement
Influence of habits
Proportion of Income spent on a
commodity
173
176. OF THE CONCEPT OF
PRICE ELASTICITY OF
DEMAND
The concept is helpful in taking Business Decisions
Importance of the concept in formatting Tax Policy of the
government
For determining the rewards of the Factors of Production
To determine the Terms of Trades Between the Two Countries
176
177. OF THE CONCEPT OF
PRICE ELASTICITY OF
DEMAND
Determination of Rates of Foreign Exchange
For Nationalization of Certain Industries
In economic Analysis ,the concept of price elasticity of
demand helps in explaining the irony of poverty in the
midst of plenty.
177
179. TYPES OF INCOME ELASTICITY OF
DEMAND
Positive Income elasticity of demand
Negative Income elasticity of demand
Zero Income elasticity of demand
179
181. POSITIVE INCOME ELASTICITY
OF DEMAND
Income Elasticity Equal to Unity
or One
Income Elasticity Greater Than
Unity Or One
Income Elasticity Less Than Unity
or One
181
185. MEASUREMENT OF INCOME
ELASTICITY OF DEMAND
Income Elasticity Of
Demand =
Proportionate change in
Demand
Proportionate change in
Incomei.e.
Income Elasticity Of
Demand =
∆q
Q Y
∆
y+
185
186. MEASUREMENT OF INCOME
ELASTICITY OF DEMAND
Here , ∆q = Change in the quantity
demanded.
Q = Original quantity demanded.
∆y = Change in income.
Y = Original income.
For e.g. ,when Income of the consumer =
2,500/- , he purchases 20 units of X, when
income = 3,000/- he purchases 25 units of
X
186
187. MEASUREMENT OF INCOME
ELASTICITY OF DEMAND
Thus
Income Elasticity of Demand
=
= (5/20) + (500/2500)
= 1.5
therefore here the IED is 1.5 which is
more than one.
∆q
Q Y
∆
y+
187
189. IMPORTANCE OF THE CONCEPT OF
INCOME ELASTICITY OF DEMAND
In production planning and management
In forecasting demand when change in
consumers income is expected
In classifying goods as normal and inferior
In expansion and contraction of the firm by
the figure of income elasticity of demand
Markets situations could be studied with the
help of IED
189
190. (8) ELASTICITY OF SUBSTITUTION
The selection between two product or
thing is called substitution
So Elasticity of Substitution measures
the rate at which the particular product
is substituted .
Thus EOS is the degree to which one
product could be substituted in context
of price and proportion
190
191. ELASTICITY OF SUBSTITUTION
Elasticity of Substitution
= Proportionate change in the quantity
ratios of goods x & y DIVIDED BY
Proportionate change in the price
ratios of goods x & y.
191
192. TYPES OF ELASTICITY OF
SUBSTITUTION
Zero Elasticity of Substitution.
Infinite Elasticity Of Substitution
Elasticity of Substitution greater than
unityor1
Elasticity of Substitution is equal to one
Elasticity of Substitution is less than one
192
193. TYPES OF ELASTICITY OF
SUBSTITUTION ON GRAPH
ChangeinQUANTITIYratioofgood
x&y
Change in PRICE ratio of good x & y
O
X
Y
E4
E1
E2
E3
E5
193
194. RELATIONSHIP BETWEEN PRICE
ELASTICITY, INCOME ELASTICITY AND
SUBSTITUTION ELASTICITY
As Price is depended on income and
substitution effect similarly Price
Elasticity is depended on Income
Elasticity an Substitution Elasticity .
These relationship can be represented
by
Ep = Kx E1 + ( 1 – Kx ) es
194
195. PRICE ELASTICITY OF DEMAND
DEPENDS ON:
Proportion of income spent on particular
good say X.
Income elasticity of demand.
Elasticity of substitution.
Proportion of income spent on product
other than X.
195
196. CROSS ELASTICITY OF DEMAND
Cross elasticity of demand express a
relationship between the change in the
demand for a given product in
response to a change in the price of
some other product
E.g. if the X tea demand reduces
tremendously than it effect could be
seen in demand of sugar and milk.
196
197. TYPES OF CROSS ELASTICITY OF
DEMAND
Cross Elasticity of Demand Equal to
Unity or One
Cross Elasticity of Demand Greater than
Unity or one
Cross Elasticity of demand less than
unity or one
197
198. MEASUREMENT CROSS ELASTICITY
OF DEMAND
Proportionate change in
Demand for product X
Proportionate change in Price
of product Yi.e.
∆qx
Qx Py
∆p y
+
Cross Elasticity of
Demand =
Cross Elasticity of
Demand =
198
199. CROSS ELASTICITY OF DEMAND
FOR SUBSTITUTES
Priceof
Y
Demand for
O
Y
X
D
D
199
200. CROSS ELASTICITY OF DEMAND
FOR COMPLEMENTARY PRODUCTS
Priceof
Y
O
Y
X
D
D
Demand for
200
201. CROSS ELASTICITY OF DEMAND
FOR NEUTRAL PRODUCTS
Priceof
Y
O
Y
X
D
Demand for
201
202. IMPORTANCE OF CROSS
ELASTICITY OF DEMAND
The concept is of very great importance
in changing the price of the products
having substitutes and complementary
goods .
In demand forecasting
Helps in measuring interdependence of
price of commodity .
Multiproduct firms use these concept to
202
203. ADVERTISING ELASTICITY OF
DEMAND
Advertising elasticity of demand is the
measure of the rate of change in
demand due to change in advertising
expenditure
The amount of change in demand of
goods due to advertisement is known
as Advertisement Elasticity of Demand
.
203
204. ADVERTISING ELASTICITY OF
DEMAND
Proportionate change in
Demand for product
Proportionate change in
Advertising expenditurei.e.
∆qx
Q A
∆a
÷
Advertising Elasticity of
Demand =
Advertising Elasticity of
Demand =
204
206. FACTORS AFFECTING ADVERTISING
ELASTICITY OF DEMAND
The stage of the Product’s Market
Development .
Reaction of market Rival Firms.
Cumulative Effect of Past Advertisement.
Influence of Other Factors.
206
207. IMPORTANCE OF THE ADVERTISING
ELASTICITY OF DEMAND IN
BUSINESS DECISIONS
It is useful in competitive industries.
Though advertisement shifts the demand
curve to right path but it also increases
the fixed cost of the firm.
207
208. LIMITATION OF ADVERTISING
ELASTICITY OF THE DEMAND
The impact of advertising on sales is
different under different conditions,
even if other demand determinants are
constant.
Like wise, it is difficult to establish any
co-relationship between advertising
expenditure and volume of sales when
there counter advertisements by rival
firm in the market . The effect on sales
208
212. THE PRODUCTION FUNCTION
• Theory of production function establishes a relationship between
inputs and output.
• In other words production function shows a physical
relationship between inputs and output.
• “Production function (P.F) is a schedule or mathematical
equation that gives a maximum quantity of output (Q) that can
be produced from specified sets of inputs while techniques of
production are given”.
• Mathematically, we represent a firm’s production function as:
Q = ƒ(L, K)
• Assuming that the firm produces only one type of output with
two inputs, labor (L) and capital (K)
212
213. PRODUCTION FUNCTION
• The quality of output is a function of, or depend on, the
quantity of labour and capital used in production
• Output refers to the number of units of the commodity
produced
• Labour refers to the number of workers employed
• Capital refers to the amount of the equipment used in
production
• We assume that all units of L and K are homogenous or
identical
• Technology is assumed to remain constant during the
period of the analysis
213
214. Production Function In The
Short Run
• The short run is a time period in which the quantity of
some inputs, called fixed factors, cannot be increased.
• So it does not correspond to a specific number of
months or years
• A fixed factor is usually an element of capital (such as
plant and equipment).
• Therefore, in our production function capital is taken to
be the fixed factor and labour the variable one
• E.g. If any firm keeps the plant or machinery fixed
(which is not possible to change in short run) and go on
employing the units of labour such situation will
represent short run.
214
215. Production Function In The
Short Run
• Accordingly the classical or short run production
function is stated as:
Q = f(L)K
where Q represents total output, L represents units of
labour and K represents capital which is constant here.
• Keeping the other factor constant if we go on employing
the units of labour, the total production will increase at
different rates.
• In other words the rate of change in total product which
is called marginal product may increase, may remain
constant and may decrease.
215
216. TOTAL, AVERAGE AND
MARGINAL PRODUCTS
• Total product (TP) is the amount that is produced
during a given period of time
• Total product will change as more or less of the variable
factor is used in conjunction with the given amount of
the fixed factor
• Average product (AP) is the total product divided by the
number of units of the variable factor used to produce it
• Marginal product (MP) is the change in TP resulting
from the use of one additional unit of the variable factor
216
217. • By employing more labour if marginal product
(MP) increases such will demonstrate the
operation of “law of increasing returns”.
• If MP remains constant such depicts the situation
of “law of constant returns”.
• And if MP falls the it means “law of decreasing
returns”.
217
TOTAL, AVERAGE AND
MARGINAL PRODUCTS
226. 242
THEORY OF PRODUCTION AND
COST IN THE LONG RUN(LR)
• The theory of production in the LR provides the
theoretical basis for firm decision-making and LR
costs and supply.
• In essence, we will assume that the firm’s goal is to
maximize output subject to a cost constraint.
• We will see that this is the same as minimizing the
cost of producing a given level of output.
• Keep in mind that all inputs are variable in the LR
• plant size can be changed,
• new locations can be chosen
227. 243
PRODUCTION ISOQUANTS
• An isoquant is a locus of points indicating different
combinations of 2 inputs each of which yields the
same level of output.
• Note 2 inputs are assumed since we desire to
present model graphically.
),( KLfQ
228. 244
CHARACTERISTICS OF ISOQUANTS
1. Negative slope – tradeoffs, if more of L then less of
K if output is held constant
2. Convex to the origin – diminishing MRTS, the
more of L you have relative to K the more able you
are to trade L for K and hold output constant.
3. Isoquants cannot intersect
230. 246
MARGINAL RATE OF TECHNICAL
SUBSTITUTION
• The MRTS is the (negative of the) slope of the
isoquant. Therefore it reflects
• It is a measure of the number of units of K that must
be given up if L is increased by a single unit,
holding output constant. Note it will diminish as
we move down an isoquant.
L
K
MRTS
233. 10.249
CONCEPT OF AN ISOQUANT MAP
• Graph of several isoquants each representing different
levels of output.
• The higher (further from the origin) an isoquant, the
greater the level of output.
235. 10.251
MARGINAL PRODUCT AND
MRTS
Marginal product of an input is the change in total product in
response to increasing the variable input by a single unit.
The change in total product is given by the following
equation
)()( KMPLMPQ KL
236. 10.252
MARGINAL PRODUCT
AND MRTS
Along an isoquant the change in output is equal to zero and
MRTS
MP
MP
L
K
LMPKMP
KMPLMP
K
L
LK
KL
)()(
)()(0
)()( KMPLMPQ KL
237. 10.253
THE COST CONSTRAINT
– ISOCOST LINES
Suppose you have $100, C, to spend on two
inputs , L & K, and the prices of each are $10,
PL, and $20, PK, respectively. Determine the
equation relating K to L reflecting your
budget constraint.
100 = 10L+20K or
K=5-0.5L
In general, the cost constraint is
K = C/PK-(PL/PK)L
Note linear and slope is ratio of prices
238. 10.254
CHANGES IN ISOCOST
What happens to the isocost if cost, C, changes?
What happens to budget line if one of the prices change?
K = C/PK-(PL/PK)L, w=PL, r=PK,C-bar = cost level then isocost
is
L
r
w
r
C
K
241. 10.257
DETERMINING THE OPTIMAL
COMBINATION OF INPUTS
Producer’s goal is to maximize profits:
• Minimize cost of producing a constant level of
output
• Maximize output subject to a cost constraint
The isocost line shows what combinations of L and
K that the producer is able to purchase with a
fixed cost level.
The isoquant map shows the producer’s
preferences for X and Y.
242. 10.258
MINIMIZING COST OF PRODUCING A
GIVEN LEVEL OF OUTPUT
• The Optimal Solution, where the producer minimizes
cost subject to an output constraint, is found where
the isocost line is tangent to an isoquant.
• Since isoquants cannot intersect this will be the
highest possible level of utility given the constraint.
243. 10.259
COST MINIMIZATION
• At any tangency point the slopes of the two
relationships must be equal.
• Slope of isoquant is the MRTS – the rate the
producer is willing to substitute K for L,
holding output constant.
• Slope of isocost line is the ratio of prices,
PL/PK, which reflects the rate the producer is
able to substitute K for L and maintain
constant cost.
245. 10.261
COST MINIMIZATION
• Recall the Marginal Product interpretation of the
MRTS or slope of the isoquant. Note PL = w and PK
= r in text.
K
K
L
L
K
L
K
L
P
MP
P
MP
P
P
MP
MP
MRTS
246. 10.262
EQUILIBRIUM FOR THE FIRM
• A producer is hiring 20 units of labor and 6 units of capital
(bundle A). The price of labor is $10, the price of capital is
$2, and at A, the marginal products of labor and capital are
both equal to 20.
• Is the firm in equilibrium?
• No, MP to price ratios are not equal, should use more
capital and less labor.
• Beginning at A, what happens to output and cost if the
producer increases labor by one unit and decreases
capital by 1 unit?
• Output remains constant and cost increases by $8.
247. 10.263
EQUILIBRIUM FOR THE FIRM
A producer is hiring 20 units of labor and 6
units of capital (bundle A). The price of
labor is $10, the price of capital is $2, and
at A, the marginal products of labor and
capital are both equal to 20.
In equilibrium, which of the following will be
true?
• MPL will be less than 20.
• MPK will be more than 20.
• MPL will be 5 times MPK.
248. 10.264
EXPANSION PATH
An expansion path is a curve that shows the least
costly combination of two inputs required to
produce each level of output, holding the input
price ratio constant.
Along an expansion path,
K
K
L
L
K
L
K
L
P
MP
P
MP
P
P
MP
MP
MRTS
251. 267
COST CURVE DERIVED
FROM EXPANSION PATH
Since the Expansion Path plots points the
optimal combination of inputs required to
produce each level of output, total cost
for each level of output can be
determined since it is assumed that the
prices of inputs are fixed.
Thus, if the optimal quantity of labor and
capital to produce 100 units of output are
10 and 5 respectively, and the wage rate
is $20 and price of capital, $50 then the
total cost is
$20(10) + $50(5) = $450
252. 268
RETURNS TO SCALE
Returns to Scale deals with the impact on
output of a change in the
scale(proportional changes in all inputs)
of a firm’s operations.
Returns to scale can be classified as
• Constant: output changes proportionately to the
change in the inputs
• Increasing: output changes more than
proportionate to the change in the inputs
• Decreasing: output changes less than
proportionate to the change in the inputs
253. 269
RETURNS TO SCALE
Recall the general form of our production function
is Q = f(L,K). Now, suppose we increase all
inputs by the factor c as represented in the
following production function,
F(cL, cK) = zQ
What are the returns to scale if
• z = c ?
• z > c ?
• z < c ?
254. 270
LONG RUN COSTS
The long run average, LAC, and marginal, LMC,
cost curves have the same basic shape that the
equivalent short run cost curves.
However, the reason why each is U-shaped is for
different reasons, which are
• Short run – the Law of Diminishing Marginal returns
• Long run – economies/diseconomies of scale
255. 271
ECONOMIES OF SCALE
Economies of Scale exist when LAC decreases as output
increases.
Diseconomies of Scale exist when LAC increases as output
increases.
Q
LAC
economies diseconomies
256. 272
ECONOMIES OF SCALE
Reasons for economies of scale are
• Specialization and division of labor
• Better meshing of equipment
• Economies on capital purchases – machines that
are 10 times as productive may not cost 10 times
as much
• More capital intensive
Reason for diseconomies of scale
• Inefficiency in management
257. 273
ECONOMIES OF SCOPE
Scope economies exist if the joint costs of producing two or
more products is less than the separate costs of producing
each individually.
An example might be an auto air conditioning repair shop that
adds radiator/cooling system repairs
