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Mangerial economics

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Francis Làżár
Francis Làżár

Managerial economics involves applying economic theories and tools of analysis to business decision-making. It helps managers make optimal choices around issues like production, pricing, investment, and sales. The key economic concepts used include demand and cost analysis, production and pricing theories, and capital budgeting. Managerial economics draws from both microeconomics, analyzing internal business issues, and macroeconomics, examining the external economic environment. It provides a framework and analytical methods for managers to systematically evaluate alternatives and select decisions that best achieve organizational objectives under resource constraints.

Economy & Finance
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Managerial Economics
Meaning • Managerial economics is defined as the study of economic theories, logic and tools of economic analysis that are used in process of business decision-making. • In other words economic theories and techniques of economic analysis are applied to analyze business problems, evaluate business opportunities with a view to arrive at appropriate business decision. .
•Managerial Decision Areas Assessment of Investible funds Selecting Business areas Choice of Product Determining optimum Output Determining input-Combination of the product Sales promotion Application of Economic Concepts and Theories in Decision Making Use of Quantitative Methods •Mathematical tools •Statistical Tools •Econometrics Application of Economic Concepts, Theories and analytical Tools to find Optimum Solution to Business Problems
Why Economics? • Biology contributes to medical profession. • Physics to Engineering. • Economics to Managerial profession. Achieve objective of the firm Constraints is limited resources
Application of Economics to Decision Making I. Determining and defining the objective to be achieved. II. Collection and analysis of business related data and other information(Economic, social, Political and technological environment.). III. Inventing the possible courses of action IV. Select the possible action from the given alternatives. • II and III are crucial in decision making
Example Launching a product • Production Related issues and • Sales related issues.
Production Related issues • Available techniques of Production. • Cost of Production • Supply position of inputs • Price structure of inputs • Cost structure of competitive products • Availability of foreign exchange if inputs are available.
Sales related issues • Market size, general market trends and demand prospectus for the product • Trends in Industry • Competitors • Pricing of product • Pricing strategy of competitors • Degree of competition • Supply position of complementary goods
Scope of Managerial Economics • Economics applied to the analysis of business problems and decision making. • Area of business issues to which economic theories can be directly applied are broadly divided into 1.Micro Economics (Operational and internal issues) 2.Macro Economics (Environmental and external issues)
Operational or Internal issues • What to produce Nature of product or Business • How much to produce Size of firm • How to produce Choice of technology • How to price the commodity • How to promote sales • How to face price competition • How to manage profit and capital • How to manage an inventory
Environmental or External issues • The type of economic system in the country • Trends in GDP, Prices, Saving and Investment Employment, etc. • Trends in Financial System Banks, Financial and Insurance companies • Trends in Foreign Trade • Government Economic policies • Social Factors like value system, property rights, customs and habits. • Socio-economic organization like trade unions, consumer’s associations, Consumer co-operatives and producers unions. • Political environment • Degree of Globalization and Influence of MNC’s
Micro Economic Issues • What to produce • How much to produce • How to produce • How to price the commodity • How to promote sales • How to face competition • How to decide on new investment • How to manage profit and capital • How to manage an inventory
Examples of Economic Theories • Theory of Demand It deals with the consumer behaviour How do the consumer decides to buy the commodity How do they decide on Quantity When do they stop consuming How consumer behave on Price It helps in making choice in commodity, optimum level of production and price
Theory of Production and Decision Making • It explains the relationship between inputs and output. • Under what conditions the cost increases or decreases • Helps to decide the optimum size of the firm • Size of total output and amt of capital and labour to be employed given the objective
Market structure and Pricing theory • How price is determined. • When price discrimination is desirable, feasible and profitable. • How advertising will be helpful to increase sales. • Thus pricing and production decision will help to determine the optimum size of the firm.
Profit analysis and Management • Elements of risk is always there even if most efficient techniques are used. • It guide the firm to measure and manage profit, to make the allowance of risk premium, to calculate the pure return on capital and also future profit.
Theory of Capital and investment decision • It contribute to deciding choice of project, maintaining capital, capital budgeting, etc
Macro economic Issues • Trends in Economics: Level of GDP Investment climate Trends in National Output and employment Price trends
• Issues related to Foreign Trade Trends in International Trade Trends in International Prices Exchange rates Prospectus in International Market
• Issues related to Government Policies: Monetary Policy Fiscal Policy Foreign Trade Policy Environmental Policy etc
Other Topics related to Managerial Economics • Mathematical Tools
Economic theories for Decision Making • Economic concepts (Cost, Price, Demand etc.) • Ascertaining the variables which is relevant. • Relationship between the two or more variables.
What is Demand ? “ When the desire for a commodity is backed by the willingness and the ability to spent adequate sums of money, it becomes demand or effective demand in the economic sense of the curve. Only desire for commodity or having money for the same cannot give rise to its demand” Marshall “ Demand for a product refers the amount of it which will be bought per unit of time at a particular price”. 03/13/15 group 2 sec c 23
RELATIVE CONCEPT • Demand is the relative concept i.e. it is related to price and time: 1.The demand for rice is 100Kg 2.The demand for rice at Rs 5/- per Kg is 100Kg per day. • Second statement is complete because it mentions the price and time period, becoz demand varies from time and price. • The demand refers to the quantity of it purchased at a given price, during a specific time period.
Determinants of Demand 1.Price of the product. 2.Income and wealth distribution. 3.Tastes, habits and preferences. 4.Relative prices of other goods  Substitute products.  Complementary products. 5.Consumers satisfaction. 6.Quantity of money in circulation. 7.Utility of the commodity. 8.Quality. 9.Expectation regarding future price. 10.Number consumers, time and place: Transport, communication and market facilities will increase the consumers
11. Advertisements effects. 12. Growth of population. 13. Level of taxation. 14. Climatic or weather conditions. 15. Special occasions. 16. Technology. 17. Psychology of the consumers: Bandwagon effect: Demand arises becoz others have it others, Snob effect: Demand arises becoz when it is not commonly demanded, Demonstration effect: Copying the others.
INDIVIDUAL DEMAND Price per unit Demand for commodity X 50 10 40 20 30 30 20 40 10 50 05 60 It is the tabular representation of the various quantities of a commodity demanded by an Individual at a different prices during a given period of time
Individual Demand
MARKET DEMAND Price per Unit Qty Demanded A B C Total market Demand(A + B + C) 50 10 12 15 37 40 20 22 25 67 30 30 32 35 97 20 40 42 45 127 10 50 52 55 157
Demand and Demand Curves (d) – The market demand curve is the horizontal sum of the demand curves of all individuals. – Market dd curve is also negatively sloped because 1. Individual dd curves are downward sloping 2. At high prices some buyers will exit the market
MARKET DEMAND
Generalized demand function • The generalized demand function just set forth is expressed in the most mathematical form. • Economist and market researchers often expressed generalized demand function in a linear functional form. • The following equation is an example of a linear form of the generalized demand function: Qd = a + bP + cM + dPR + eT + fPe + gN • Where the Variables are (P,M,PR,T,Pe,N). • And a,b,c,d,e,f and g are parameters.
Generalized demand function • The intercept “a” shows the value of Qd when the variables P,M,PR,T,Pe,N are all simultaneously equal to zero. • The other parameter a,b,c,d,e,f and g are called slope parameters. • They measure the effect on quantity demanded of changing one of the variables while holding rest of it as constant. • E.g. b measures the change in Qty dd per unit change in price • i.e b = Qd/ P.
Summary of Generalized demand function Variable Relation to quantity demanded Sign of Slope parameter P INVERSE Negative M Direct for normal goods Inverse for inferior goods Positive Negative PR Direct for substitute goods Inverse for the complementary goods Positive Negative T Direct Positive Pe Direct Positive N Direct Positive
Demand functions • The relation between price and quantity demanded per period of time, when all other factors that affect demand held constant is called as demand function or simply demand. • It can be expressed as Qd = f (P)
illustration • Generalized demand function is Qd = 1800 – 20P + 0.6M – 50PR • To derive a demand functions Qd = (P) • The variables M and PR must be assigned fixed value. • Suppose M = 20000, PR = 250 • Substitute the value in generalized demand function.
• Qd = 1800 – 20P- 0.6(20000) – 50(250) = 1800 – 20P + 12000 – 12500 = 1300 – 20P • The intercept parameter 1300 is the amount of the good consumers would demand if price is zero. • The slope of the demand function is -20 and indicates that a Rs 1 increase in price causes qty dd to decrease by 20 units. Qd = 1300 – 20 (1) = 1300 -20 = 1280
Determinants of Demand Determinants of Demand Demand Increase s Demand decreases Sign of Slope parameter Income (M) Normal Goods Inferior goods M rises M Falls M Falls M rises C > 0 C < 0 Price of related goods (PR) Substitute goods Complement good PR rises PR falls PR falls PR rises d > 0 d < 0 Consumer Tastes (T) T rises T falls e > 0 Expected price (Pe) Pe rises Pe Falls f > 0 Number of consumers (N) N rises N Falls g > 0
Demand Schedule
The Law of Demand “Other factors remaining same (habits, tastes etc.) as price decreases demand increases and vice versa” Marshall “Ceteris paribus, higher the price of a commodity, smaller is the quantity demanded and lower the price, larger the quantity demanded.”
Demand Schedule (Hypothetical) Price of commodity (in Rs) Quantity demanded (unit per week) 5 4 3 2 1 100 200 300 400 500
Quantity demanded (Q) Q1 Q2 P1 P2 E1 E2 0 D D Price(P) P1 - old price P2 - new price Q1 – old quantity demanded Q2 – new quantity demanded DD – demand curve A Linear Demand Curve Demand Curve
Characteristics of A Typical Demand Curve  Drawn by joining different loci.  Downward sloping.  Reciprocal relationship between price and quantity demanded ( P α 1/Qd )  Linear Non - linear
Assumptions (Other things) a) No change in consumer’s income. b) No change in consumer’s preferences. c) No change in the fashion. d) No change in the price of related goods :  Substitute goods.  Complementary goods. a) No expectation of future price changes or shortages. b) No change in size, age, composition and sex ratio of the population. c) No change in the range of goods available to the consumers.
Contd… h) No change in the distribution of income and wealth. i) No change in the government policy. j) No change in weather conditions.
EXCEPTION TO LAW OF DEMAND • Giffen’s Paradox: Giffen gods are inferior goods. When the price rises the real income of the consumer rises and he will move to a superior goods. This is also called as Giffen’s paradox. • Qualitative changes: It may increase qty with the increase in the price. • Price illusion: Higher the price better is the quality. • Prestige goods: Purchased by the rich people.
• Demonstration effect: Imitating others or Snob appeal • Fashion: • Necessaries:
Movement along the curve OR Change in quantity demanded  Extension of demand ‘ With a decrease in price, there is increase in the quantity demand of the product’. P1 P2 Q1 Q2 E E` D D Quantity demanded Price
Contraction of demand ‘ With a increase in price, there is a decrease in quantity demanded’.’ Quantity demanded P2 Q2 P1 Q1 E E` Price
SOURCES OF SHIFTS IN THE DEMAND CURVES • Tastes • Prices of related goods • Income • Demographics • Information • Availability of credit • Changes in expectations
Movement of Demand Curve OR Change in demand  Increase in demand: a) More quantity demanded ------ at a given price. b) Same quantity demanded ------ at a higher price. P1 Q1 Q2 a b D D D` D` Q1 P1 P2 D D D` D`a b Quantity demanded Quantity demanded Pric e Price
 Decrease in demand : a) Less quantity demanded ---- at same price. b) Same quantity demanded ---- lower price. Q2 Q1 P1 a b Q1 Quantity demanded P1 D` b D` D D D` D D a D` Price Price Quantity demanded P2
Factors And Effects of Change (increase or decrease) in demand a) Change in income : Quantity demanded Price Increase Quantity demanded Price Decrease D` D` D D D D D` D`
b) Change in taste, habit and preference : D D D` D` D D D` D` Quantity demanded Price Quantity demanded Price Positive Negative
c) Change in fashion and customs : D D D` D` D D D` D` Quantity demanded Quantity demanded Price Price Favorable Unfavorable
g) Change in population : 03/13/15 group 2 sec c 57 Quantity demanded Quantity demanded Price Price D` D` D` D` D D D D Increase Decrease
h) Advertisement and publicity persuasion : 03/13/15 group 2 sec c 58 Quantity demanded Quantity demanded Price PriceD D D D D` D` D` D` Aggressive Docile
i) Change in value of money : Quantity demanded Quantity demanded Price Price D` D` D` D` D D D D Deflationary Inflationary ( Value of money) ( Value of money)
j) Change in level of taxation : Quantity demanded Quantity demanded D D` D` D` D D` D D Low High Price Price
k) Expectation of future changes in prices : Quantity demanded Quantity demanded D` D` D` D` D D D D Rise Fall Price Price
Shift in Demand Price Qd = 1300 – 20P (M = 20000) D0 Qd = 1600 – 20P (M = 20500) D1 Qd = 1000 – 20P (M = 19500) D2 65 0 300 0 60 100 400 0 50 300 600 0 40 500 800 200 30 700 1000 400 20 900 1200 600 10 1100 1400 800
Shift in Demand
Determinants of Demand Determinants of Demand Demand Increase s Demand decreases Sign of Slope parameter Income (M) Normal Goods Inferior goods M rises M Falls M Falls M rises C > 0 C < 0 Price of related goods (PR) Substitute goods Complement good PR rises PR falls PR falls PR rises d > 0 d < 0 Consumer Tastes (T) T rises T falls e > 0 Expected price (Pe) Pe rises Pe Falls f > 0 Number of consumers (N) N rises N Falls g > 0
Supply • The amount of a good or service offered for sale in a market during a given period of time (e.g a week, a month) is called quantity supplied.
Concept of Supply • Supply is defined as the various amounts of goods and services which the sellers are willing and able to sell at any given price during a specific period of time • It is related to time, place and person • The supply of sugar is 50 kg is not a complete sentence • The supply of a sugar at price Rs 5/- is 50kg. Per day is the complete sentence
Factors affecting Supply • Price • Price of other commodities • Goals of the producer • State of technology • Cost of production • Climate and forces of Nature • Transport facilities • Taxation: Heavy taxes supply will reduce • Expectation regarding future prices
• Self-consumption • Time element: Short period the supply is fixed and vice
Individual Supply Schedule Price Per Unit of X Qty. supplied of X U 5 10 V 10 20 W 15 30 X 20 40 Y 25 50 Z 30 60 Individual supply schedule is a tabular representation of the various quantities of commodity offered for sale by an individual seller at different prices during given period of time
Individual Supply Curve
Market supply schedule • It is the tabular representation of the various qty. of a commodity offered for sale by all the sellers at different prices during a given period of time. It is the total supply of a commodity by all the sellers at different prices
Market supply schedule Price( Rs ) Qty. supplied of X Market supply (I + II+ III) Seller I Seller II Seller III U 5 10 20 30 60 V 10 20 25 40 85 W 15 30 30 50 110 X 20 40 35 60 135 Y 25 50 40 70 160 Z 30 60 45 80 185
Market supply Curve
Law of Supply • Others things remaining the same , qty. supplied of a commodity directly varies with its price. i.e. S= f (p) SUPPLY SCHEDULE Price Per Unit of X Qty. supplied of X U 5 10 V 10 20 W 15 30 X 20 40 Y 25 50 Z 30 60
Supply Curve
Assumption • Price of other commodities remains the same • The cost of production remains the same • The method of production remains the same • No change in the availability of goods • No change in transport facilities • No change in weather condition • No change in tax structure and govt. policies • Goals of producer remains the same • No change in expectation about the price • No natural calamities and no self consumption
Exceptions to the law of supply • Backward bending supply curve Wage rate ( Rs.) Hours of work Daily Income (Rs.) 5 8 40 7 10 70 10 12 120 12 10 120
• Fixed income groups: If person expects the income of Rs.20 he will save 500 Rs at 4% rate of interest and at 5% rate he will save Rs. 400 Rs. • Expectation regarding future prices • Need for cash by the seller • Rare collection the supply is permanently fixed whatever the price. • Self consumption
Movements or variation in Supply • When there is change in supply exclusively due to change in Price
Shift in supply When there is a change in supply due to change in factors other than the Price
Generalized supply function • It shows how the different variables jointly determine the quantity supplied. • The generalized supply function is expressed mathematically as Qs = g(P, Pi, Pr, T, Pe, F)  Qs = Qty of goods and service offered for sale  P = Price of goods or service.  Pi = Price of inputs  Pr = Price of goods that are related to production.  T = Level of available technology.  Pr = Expected price of the producer  F = No. of firms in the industry
Generalized supply function • As in case of demand, economists often find itself to express the generalised supply function in linear functional form: Qs = h + kP + lPi+ mPr + nT + rPe + sF • Where P, Pi, Pr, T, Pe, F is a variables affecting the supply, h is the intercept parameter, and k, l, m, n, r, and s are the slope parameters.
Relation to Generalised demand function Variable Relation to Quantity supplied Sign of slope parameter P Direct K = is Positive Pi Inverse L = is Negative Pr Inverse for substitute in production (Wheat and Corn) Direct for complement in production(Oil and Gas) m = is Negative m = is Positive T Direct n = is Positive Pe Inverse r = is Negative F Direct S = is Positive
Supply function • Supply function is derived from generalised supply function. • A supply function shows the relation between supply and price. Qs = g(P, Pi, Pr, T, Pe, F) = g (P)  Illustration Qs = 50 + 10P – 8pi + 5F • Suppose the price of the input is Rs. 50 and there are 90 firms then the supply function will be Qs = 50 + 10P -8(50) + 5(90) = 100 + 10P • The supply schedule with equation can be drawn and is given in next slide
Qs = 100 +10P Price Quantity Supplied schedule 65 750 60 700 50 600 40 500 30 400 20 300 10 200
Shift in Supply Price Qs = 100 + 10P Pi = 50, F = 90 Qs = 250 + 10P Pi = 31.25, F = 90 Qs = -200 + 10P Pi = 50, F = 30 65 750 900 450 60 700 850 400 50 600 750 300 40 500 650 200 30 400 550 100 20 300 450 0 10 200 350 0
Shift in Supply Determinants of supply Supply Increases Supply Decreases Sign of Slope parameter Price of inputs (Pi) Pi falls Pi rises I < 0 Price of goods related in Production (Pr) Substitute good Complement good Pr falls Pr rises Pr rises Pr falls M < 0 M > 0 State of technology (T) T rises T falls n > 0 Expected Price (Pe) Pe falls Pe rises r < 0 Number of firms or productive capacity in Industry (F) F rises F falls S > 0
Market Equilibrium • Demand and supply provide an analytical framework for the analysis of the behaviour of buyers and sellers in markets. • Demand shows how buyers respond to changes in price and other variables that determine quantities, buyers are willing to purchase. • Supply shows how sellers respond to changes in price and other variables that determine quantities offered for sale. • The interaction of buyers and sellers in the market place leads to market equilibrium.
Market Equilibrium • Market equilibrium is a situation which at the prevailing price, consumers can buy all of a good they wish and producers can sell all of good they wish.
Market Equilibrium Price Qs = 100 + 10P S0 Qd = 1300 – 20P D0 Excess supply ( +) Excess Demand ( -) 65 750 0 +750 60 700 100 +600 50 600 300 +300 40 500 500 0 30 400 700 -300 20 300 900 -600 10 200 1100 -900 Qd = Qs 1300 – 20 P = 100 + 10P Solving this equation for the equilibrium price, 1200 = 30P P = 40
Market Equilibrium
Market Equilibrium • At Market clearing price of 40 Qd = 1300 – (20 * 40) = 500 Qs = 100 + (10 * 40) = 500 • If the price is Rs 50 there is a surplus of 300 units. Using the demand and supply. equations, when P = 50, • Therefore, When price is Rs 50. Qd = 1300 – (20 * 50) = 300 Qs = 100 + (10 * 50) = 600 There fore when the price is Rs 50 Qs – Qd = 600 – 300 = 300
Changes in Market Equilibrium Demand Shifts (Supply remains constant)
Supply Shifts (Demand Remains constant)
Simultaneous Shift in Demand and Supply
Simultaneous Shift in Demand and Supply
Predicting the Direction of change in Airfares (Qualitative analysis) • Suppose you manage a travel department for a U.S. corporation and your sales force makes heavy use of air travel to call on customers. • The president of the corporation to reduce travel expenditures for 2004. • You need to predict what will happen in future price of airfares in 2004. • The wall street journal recently came with the news.  A number of new, small airlines have recently entered the industry and others are expected to enter in 2004.  Video-conferencing is becoming a popular, cost effective alternative to business travel for many U.S. corporation. The trend will cut the price on teleconferencing rates.
Direction of change in Airfares: Qualitative Analysis
ELASTICITY OF DEMAND • The degree of responsiveness of Qty. demanded of a commodity to a change in its price is known as elasticity of demand. • Ed = % change in qty. dd /% change in determinant • Elastic: Small change in price brings big change in demand • Inelastic: Big change in price brings small change in demand
Kinds of Elasticity • Price Elasticity • Income Elasticity • Cross Elasticity • Arc Elasticity
PRICE EASTICITY OF DEMAND • IT is the degree of responsiveness of qty. demanded of a commodity to a change in its price. • Ed = % change in qty. dd /% change in P • Ed = proportionate change in qty. dd /Proportionate change in P • Ed = Q / Q = Q / Q * P / P P / P
Definition: Elasticity of Demand Price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price. Equation: Elasticity of Demand = % change in Qd % change in Price
Example Suppose Mongini’s cake is originally priced at Rs. 10 and the amount sold is 50 cakes per week. If the price is increased to Rs. 11, then 40 cakes are sold per week. What is the price elasticity of demand? % Change in Price = [(11-10)/10]*100 = 10% % Change in Quantity Demanded = [(40-50)/50]*100 = 20 % (ignoring the negative sign) Elasticity = 20/10 = 2 Even a very small change in price has lead a high-proportional fall in quantity demanded.
TYPES OF PRICE ELASTICITY OF DEMAND
TYPES OF PRICE ELASTICITY OF DEMAND
The Farmer’s Dilemma • For many crops, a strange situation arises a bad crop year results in a good year for farm incomes, and a good crop year results in a bad year for farm incomes. How can this be? • Price elasticity gives us the answer: – Bad crop year: supply decreases, prices for farm products rise, but quantity demanded doesn’t fall very much. The quantity demanded of farm products is not very responsive to changes in prices – Good crop year: supply increases, prices for farm products fall, but quantity demanded doesn’t increase very much. The quantity demanded of farm products is not very responsive to changes in prices • It is easy to show this with a graph. But first we need yet another concept: Total Revenue = Price x Quantity
Measurement of price elasticity of demand • Percentage Method • Total outlay Method • Geometric Method
Percentage Method or Ratio Method • It is the ratio of % change in Demand to a % change in Price. • Ed = % Q OR Q * P = P * Q • % P Q P Q P • Unit elastic Ed =1 • Relatively Elastic Ed >1 • Relatively Inelastic Ed <1
Total Outlay Method or Revenue Or Expenditure Method Price (Rs) QTY. DD (units) Total Outlay (Rs) Elasticity 50 5 250 Relatively elastic Ed > 140 10 400 30 20 600 Unit Elastic Ed = 1 20 30 600 10 40 400 Relatively inelastic Ed < 15 50 250
Geometric Method Or Exact Method • Ed = Lower segment of demand curve Upper segment of demand curve Ed at pt A = D’A/DA = 1 Ed at pt B = D’B/DB = 1/3 < 1 Ed at pt C = D’C/DC =9/3 > 1
Other concepts of Elasticity of Demand • Income Elasticity of Demand = Q * Y Y Q Ed = % change in qty. dd /% change in Y • Cross Elasticity of Demand = Q x * P y P y Q x Arc elasticity of Demand = Q x P Q1+ Q2 P1+ P2
Factors Influencing Elasticity • Nature of commodity: Necessary or luxurious goods • Availability of substitutes: • Number of Uses of a commodity:  Multipurpose elastic and vice-versa. • Income: • Proportion of Expenditure:  A small prop. Of exp demand is elastic. • Time period:
• Height of Price and Range of Price change:  Very low or very High price demand is inelastic; Diamonds or salt but moderately priced goods have elastic demand. • Urgent or postponement: • Durability of commodity:  Short run Inelastic , but long run elastic Perishable goods is elastic. • Habits and customs: • Complementary goods: Inelastic
• Recurring Demand: Relatively elastic • Demonstration effect:
Significance of elasticity of Demand • Useful to Producer and monopolist: • Useful to the govt. • Factor pricing: • Importance to trade unionist: • International Trade: • Useful to policy Makers: Prices of agricultural goods , Fiscal and monetary policies etc.
THEORY OF PRODUCTION • The fundamental questions that managers are faced with are  How can production optimized or cost minimize?  How does output respond to change in quantity of inputs?  How does technology matter in reducing the cost of production?  How can the least- cost combination of inputs be achieved?  Given the technology, what happens to the rate of return
Input and output • An input is simply anything which the firm buys for in its production or other processes. • Inputs are classified as 1) Fixed inputs: A fixed input is one whose supply is inelastic in the short-run. In technical sense, a fixed factor is one that remains fixed (or constant) for a certain level of output. 2) Variable inputs: A variable input is defined as one whose supply in the short-run is elastic, e.g., labour and raw material, etc. all the users of such factors can employ a larger quantity in the short-run as well as in the long-run.
Short-run and Long-run Production  The short-run refers to a period of time in which the supply of certain inputs (e.g. plant, building, machinery etc.) is fixed or inelastic.  In the short-run therefore, production of a commodity can be increased by increasing the use of only variable inputs like labour and raw materials.  Variable Input: labor force, Fixed Input: machinery, plant size, raw materials.  Long-run refers to a period of time in which the supply of all the inputs is elastic, but not enough to permit a change in technology.  That is, in the long-run, all the inputs are variable.  Corresponds to the planning stage
Production Function • The total amount of output produced by a firm is a function of the levels of input usage by the firm. • Relation Between Input and Output – the maximum amount of output that can be obtained per period of time given the factor inputs is captured by the production function. • Describes purely Technological Relationship. • Flow Concept.
Production Function • A real-life production function is generally very complex. Q = f(LB, L, K, M, T, t) • Where LB = land and building L= labour, K= capital, M= raw materials, T= technology and t= time. • The economists have however reduced the number of input variables used in a production function to only two, viz., capital(K) and labour(L), for the sake of convenience and simplicity in the analysis of input- output relations.
Production Function • Also, technology (T) of production remains constant over a period of time. • That is why, in most production functions, only labour and capital are include • As such, the general form of its production function for coal mining firm may be expressed as Qc = f (K, L) • Where Qc = the quantity of coal produced per time unit, K = capital, and L = labour.
Production Function • The short-run production function or what may also be termed as ‘single variable input production function’, can be expressed as • Q = f (K, L) where K is a constant …(1a) • For example, suppose a production function is expressed as Q = bL • Where b = gives constant returns to labour.
Total, Average and Marginal Product • Total Product: Total Output Produced during some period of time by all factors of Production employed during that Period. • Total Product (TP) function – In the Short Run captures relationship between the amount of labor and the level of output, ceteris paribus
Total Product Quantity of Labour Total Product 0 0 5 50 10 120 15 180 20 220 25 250 30 270 35 275 40 275 45 270 Variation of Output (One fixed, one variable factor), with Capital fixedat say 5 Units
Average Product • AP is merely the Total product per Unit of the Variable Factor AP = TP / L
Average Product Quantity of Labour Total Product Average Product 0 0 … 5 50 10.00 10 120 12.00 15 180 12.00 20 220 11.00 25 250 10.00 30 270 9.00 35 275 7.86 40 275 6.88 45 270 6.00
Marginal Product (MP) • The additional output that results from the use of an additional unit of a variable input, holding other inputs constant. • Measured as the ratio of the change in output (TP) to the change in the quantity of labor (or other variable input) used • MP = ∆ in Output / ∆ in Labour
Marginal Product Quantity of Labour Total Product Change in TP Marginal Product 0 0 … … 5 50 50 10 10 120 70 14 15 180 60 12 20 220 40 8 25 250 30 6 30 270 20 4 35 275 5 1 40 275 0 0 45 270 -5 -1
Marginal Product (Continued) • Note that the MP is positive when an increase in labor results in an increase in output; • A negative MP occurs when output falls when additional labor is used.
Production Function • In the long -term production function, both K and L are included and the function takes the following form. Q = f (K, L) …(1b) • Consider, for example, the Cobb-Douglas production function-the most famous and widely used production function – given in the form of an equation as Q = …(1.2) • (where K= capital, L= Labour, and A , a and b, are parameters and b =1 – a).
• α and β are the output elasticities of capital and labor, respectively. • These values are constants determined by available technology. • Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. • For example if α = 0.45, a 1% increase in capital usage would lead to approximately a 0.45% increase in output.
Production Function • Production function (1.2) gives the general form of Cobb- Douglas production function. • The numerical values of parameters A, a and b, can be estimated by using actual factory data on production, capital and labour. • Suppose numerical values of parameters are estimated as A=50, a=0.5 and b=0.5. • Once numerical values are known, the Cobb-Douglas production function can be expressed in its specific form as follows.
Production Function • This production function can be used to obtain the maximum quantity (Q) that can be produced with different combinations of capital (K) and Labour (L). • The maximum quantity of output that can be produced from different combinations of K and L can be worked out by using the following formula.
Production Function • For example, suppose K = 2 and L = 5. Then • And if K = 5 and L = 5, then • Similarly, by assigning different numerical values to K and L, the resulting output can be worked out for different combinations of K and L and a tabular form of production function can be prepared.
Similarly, by assigning different numerical values to K and L, the resulting output can be worked out for different combinations of K and L and a tabular form of production function can be prepared. • It is important to note that the four combinations of K and L • 10K + 1L • 5K + 5L • 2K + 5L and • 1K + 10L produces the same output
Production with one variable input • The law of diminishing returns states that when more and more units of a variable input are used with a given quantity of fixed inputs, • The total output may initially increase or increasing rate, but it will eventually increase at increasing rate. • That is, marginal increase in total output decreases eventually when additional units of a variable factor are used, given quantity of fixed factors.
Assumptions: • The law of diminishing returns is based on the following assumptions: Labor is the only variable input, capital remaining constant; Labour is homogeneous; Input prices are given.
• To illustrate the law of diminishing returns, we assume i) That a firm (say, the coal mining firm in our earlier example) as a set of mining machinery as its capital (K) fixed in the short-run and ii) It can employ only more mine workers to increase its coal production.
• Thus, the short run production function for the firm will take the following form. constant),Qc Kf(L= Let us assume also that the labour output relationship in coal production is given by a hypothetical production function of the following form. constantL,Q 3 c K1015LL 2 ++−=
• Given the production function, we may substitute different numerical values of L in the function and work out a series of Qci.e. • The quantity of coal that is produced with different number of workers. • For example, if L = 5, then by substitution, we get • Qc= -53 + 15 x 52 + 10 x 5 = -125 + 375 + 50 = 300
• What we need now is to work out marginal productivity of labour (MPL) to find the trend in the contribution of the marginal labour and average productivity of labour (APL) to find the average contribution of labour. • Marginal Productivity of Labour (MPL) can be obtained by differentiating the production function. • Thus, • can be written as 10303 2 ++−= ∂ ∂ = LL L Q MPL constantL),(Q 3 c K1015LL 2 ++−=
• Alternatively, where labour can be increased at least by one unit (MPL) can be obtained as MPL = TPL - TPL-1 • Average Productivity of Labour (APL) can be obtained by dividing the production function by L. Thus, 1015 1015 2 23 ++−= ++− = LL L LLL APL
No of Workers (N) Total Product (TPL) (tones) Marginal Product* (MPL) Average product (APL) Stages of production(based on MPL) 1 2 3 4 5 1 2 3 4 5 6 24 72 138 216 300 384 24 48 66 78 84 84 24 36 46 54 60 64 I Increasing returns 7 8 9 10 462 528 576 600 78 66 48 24 66 66 64 60 II Diminishing Returns 11 12 594 552 -6 -42 54 46 III Negative returns
SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION • Long-run and short-run production: – fixed and variable factors • The law of diminishing returns • The short-run production function: – total physical product (TPP) – average physical product (APP) – marginal physical product (MPP) – the graphical relationship between TPP, APP and MPP
Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)
0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Number of farm workers Tonnesofwheatproducedperyear Number of workers 0 1 2 3 4 5 6 7 8 TPP 0 3 10 24 36 40 42 42 40
Wheat production per year from a particular farm 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Number of farm workers Tonnesofwheatproducedperyear TPP
Wheat production per year from a particular farm 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Number of farm workers Tonnesofwheatproducedperyear TPP a b Diminishing returns set in here
Wheat production per year from a particular farm 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Number of farm workers Tonnesofwheatproducedperyear TPP a b d Maximum output
0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Number of farm workers (L) Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear Number of farm workers (L) ∆TPP = 7 ∆L = 1 MPP = ∆TPP / ∆L = 7
0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear MPP Number of farm workers (L) Number of farm workers (L)
0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP APP = TPP / L Number of farm workers (L) Number of farm workers (L)
0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP b Diminishing returns set in here Number of farm workers (L) Number of farm workers (L) b
0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP b d d Number of farm workers (L) Number of farm workers (L) Maximum outputb
0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP b b d d Number of farm workers (L) Number of farm workers (L) Slope = TPP / L = APP c c
Iso-quants An iso-quant is a curve or line that has various combinations of inputs that yield the same amount of output.
Production function •Here we will assume output is made with the inputs capital and labor. K = amount of capital used and L = amount of labor. •The production function is written in general as Q = F(K, L) – sometimes we put a y instead of Q, where Q = output, and F and the parentheses are general symbols that mean output is a function of capital and labor. •The output, Q, from the production function is the maximum output that can be obtained form the inputs. •On the next screen we will see some isoquants. Note: on a given curve L and K change while Q is fixed.
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS • Iso-quants – their shape – diminishing marginal rate of substitution – isoquants and returns to scale – isoquants and marginal returns • Iso-costs – slope and position of the isocost – shifts in the isocost
Units of K 40 20 10 6 4 Units of L 5 12 20 30 50 Point on diagram a b c d e a Units of labour (L) Unitsofcapital(K) An isoquant 0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45 50
Units of K 40 20 10 6 4 Units of L 5 12 20 30 50 Point on diagram a b c d e a b Units of labour (L) Unitsofcapital(K) An isoquant 0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45 50
An isoquant Units of K 40 20 10 6 4 Units of L 5 12 20 30 50 Point on diagram a b c d e a b c d e Units of labour (L) Unitsofcapital(K) 0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45 50
MRTS • The slope of the isoquant defines the substitutability between two factors of inputs (capital and labor). • This is known as the marginal rate of technical substitution (MRTS) and is presented mathematically as:
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 16 18 20 22 Unitsofcapital(K) Units of labour (L) g h ∆K = 2 ∆L = 1 isoquant MRS = 2 MRS = ∆K / ∆L Diminishing marginal rate of factor substitution
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 16 18 20 Unitsofcapital(K) Units of labour (L) g h j k ∆K = 2 ∆L = 1 ∆K = 1 ∆L = 1 Diminishing marginal rate of factor substitution isoquant MRS = 2 MRS = 1 MRS = ∆K / ∆L
0 10 20 30 0 10 20 An isoquant mapUnitsofcapital(K) Units of labour (L) I1
0 10 20 30 0 10 20 I2 Unitsofcapital(K) Units of labour (L) An isoquant map I1
0 10 20 30 0 10 20 I2 I3 Unitsofcapital(K) Units of labour (L) An isoquant map I1
0 10 20 30 0 10 20 I2 I3 I4 Unitsofcapital(K) Units of labour (L) An isoquant map I1
0 10 20 30 0 10 20 I1 I2 I3 I4 I5 Unitsofcapital(K) Units of labour (L) An isoquant map
• Assume that there are two resources, Labor (L) and Capital (K). • The money payments to these resources are Wages (W) and Rent (R). • An isocost line is similar to the budget line. It’s a set of points with the same cost, C. Let’s plot K on the y axis and L on the x axis. WL + RK = C; solve for K by first subtracting WL from both sides. RK = C - WL; next divide both sides by R. K = C/R – (W/R)L; note that C/R is the y intercept and W/R is the slope. A Cost Function: Two Resources
C/R C/W Absolute value of slope equals The relative price of Labor, W/R. K (machines rented) Labor hours used in production An isocost line
Bundles of: Labor Machine rental with C = Rs30 (Rs6 per labor hour) (Rs3 per machine hour) a 0 10 b 1 8 c 2 6 d 3 4 e 4 2 f 5 0 A Numerical Example Points a through f lie on the isocost line for C = Rs30/hour.
The Isocost Line 0 1 2 3 4 5 6 7 8 9 10 2 4 6 8 10 Labor, L (worker-hours employed) Capital,K(machinesrented) a b c d e f
The Isocost Line • Wage-rental ratio – With K on the y axis and L on the x axis, the slope of any isocost line equals W/R, the wage-rental ratio. It is also the relative price of labor. • The y-intercept shows the number of units of K that could be rented for Rs.C. • The x-intercept shows the number of units of L that could be hired for Rs.C.
Changes in One Resource Price 0 1 2 3 4 5 6 7 8 9 10 Capital,K(machinesrented) 2 4 6 8 10 Labor, L (worker-hours employed) a f Cost = Rs30; R = Rs3/machine The money wage, W = ... …Rs6 …Rs10 A Change in W h
Changes in Cost 0 1 2 3 4 5 6 7 8 9 10 Capital,K(machinesrented) 2 4 6 8 10 Labor, L (worker-hours employed) g h A Change in Cost; every point between g and h costs Rs18. W = Rs6; R = Rs3;C = Rs30
Cost Minimization 0 1 2 3 4 5 6 7 8 9 10 Capital,K(machinesrented) 2 4 6 8 10 Labor, L (worker-hours employed) a equ. W = Rs6; R = Rs3;C = Rs30 Choose the recipe where the desired isoquant is tangent to the lowest isocost. C = Rs18 12 C = Rs36
Conclusion: Buy resources such that the last dollar spent on K adds the same amount to output as the last dollar spent on L. • The |slope| of the isocost line = W/R. • The |slope| of the isoquant = MPL/MPK – This will be demonstrated on the board.
0 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 An isocost Units of labour (L) Unitsofcapital(K) Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs300 000 TC = Rs300 000 a
0 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 Units of labour (L) Unitsofcapital(K) TC = Rs300 000 a b Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs300 000 An isocost
0 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 Units of labour (L) Unitsofcapital(K) TC = Rs300 000 a b c Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs300 000 An isocost
0 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 Units of labour (L) Unitsofcapital(K) TC = Rs300 000 a b c d Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs300 000 An isocost
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS • Least-cost combination of factors for a given output – point of tangency – comparison with marginal productivity approach • Highest output for a given cost of production
0 5 10 15 20 25 30 35 0 10 20 30 40 50 Finding the least-cost method of production Units of labour (L) Unitsofcapital(K) Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs200 000 TC = Rs300 000 TC = Rs400 000 TC = Rs500 000
0 5 10 15 20 25 30 35 0 10 20 30 40 50 Units of labour (L) Unitsofcapital(K) Finding the least-cost method of production TPP1
0 5 10 15 20 25 30 35 0 10 20 30 40 50 Units of labour (L) Unitsofcapital(K) Finding the least-cost method of production TC = Rs400 000 r TPP1
0 5 10 15 20 25 30 35 0 10 20 30 40 50 Units of labour (L) Unitsofcapital(K) Finding the least-cost method of production TC = Rs400 000 TC = Rs500 000 s r t TPP1
Finding the maximum output for a given total cost TPP1 TPP2 TPP3 TPP4 TPP5 Unitsofcapital(K) Units of labour (L) O
O Isocost Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 Finding the maximum output for a given total cost
O r v Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 Finding the maximum output for a given total cost
O s u Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 r v Finding the maximum output for a given total cost
O t Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 r v s u Finding the maximum output for a given total cost
O K1 L1 Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 r v s u t Finding the maximum output for a given total cost
Properties of Iso-Quant • An isoquant has a negative slope in the economic region and in the economic range of isoquant. • Economic region is also known as the product maximizing region. • The negative slope of the isoquant implies substitutability between the inputs. • It means that if one of the inputs is reduced, the other input has to be so increased that the total output remains unaffected.
• Isoquants are convex to the origin  Convexity of isoquants implies two things. I) substitution between the two inputs, and II) diminishing marginal rate of technical substitution (MRTS) between the inputs in the economic region. III)The MRTS is defined as, = slope of the isoquant. IV)MRTS is the rate at which a marginal unit of labour can substitute a marginal unit of capital (moving downward on the isoquant) without affecting the total output. ΔL ΔK MRTSLK − =
• This rate is indicated by the slope of the isoquant. • The MRTS decreases for two reason: i) no factor is a perfect substitute for another, and ii)inputs are subject to diminishing marginal returns. Therefore, more and more units of an input are needed to replace each successive unit of the other input.
• the corresponding units of L substituting K go (in fig.) on increasing i.e. • As a result, MRTS = goes on decreasing i.e., • 321 ΔΔΔ LLL << 321 ΔKΔKΔK == L K ∆ ∆
• Isoquants are non-intersecting and non- tangential. This implies that in terms of output. L1 Q2 = 200 Q1 = 200 L2 O K M Capital (K) Labour (L) Fig. Intersecting Isoquants J (K)KL(L)OL(K)JL(L)OL 2222 +=+
• Since OL2 is common to both the sides, it means, J L2(K) = K L2 (K) But it can be seen in fig that J L2 < K L2(K)but the intersection of the two isoquants means that JL2 and KL2 are equal in terms of isoquants will not intersect or be tangent to each other.
Upper isoquants represent higher level of output. b a IQ2 = 200 IQ1 = 200 XO Quality of K Quality of L Fig. Comparison of Output at Two Isoquaqnts c
Economic region Q1 Upper ridge line Lower ridge line f g h a b c d Q3 Q2 Q4 Capital (K) Labour (L) o Economic region is that area of production plane in which substitution between two inputs is technically feasible without affecting the output. This area is marked by locating the points on the isoquants at which MRTS = 0. A zero MRTS implies that further substitution between inputs is technically not feasible. It also determines the minimum quantity of an input that must be used to production a given output. Beyond this point, an additional employment of one input will necessitates employing additional units of the other input.
• By joining the resulting points a, b, c and d we get a line called the upper ridge line, Od, similarly by joining the points e, f, f and h we get the lower ridge line, Oh. • The ridge lines are locus of points on the isoquants where the marginal products (MP) of the inputs are equal to zero. • The upper ridge line implies that MP of capital is zero along the line, Od. The lower ridge line implies that MP of labour is zero along the line, Oh. • The area between the two ridge lines, Od, and Oh, is called ‘Economic Region’ or technically efficient region of production. Upper ridge line Lower ridge line f g h a b c d Q3 Q2 Q4 Capital (K) Labour (L) o
The laws of returns to scale • The laws of returns to scale explain the behavior of output in response to a proportional and simultaneous change in inputs, increasing inputs proportionately and simultaneously is, in fact, an expansion of the scale of production.
Three technical possibilities • Total output may increase more than proportionately. • Total output may increase proportionately and • Total output may increase less than proportionately
kinds of returns to scale • Increasing returns to scale; • Constant returns to scale, and • Diminishing returns to scale.
Increasing returns to scale • When inputs, K and L are increased at a certain proportion and output increase more than proportionately, it exhibits increasing returns to scale. • The increasing returns to scale is illustrated in fig.
Increasing returns to scale Product lines Q = 50 Q = 25 Q = 10 B C c b a 4K 3K 2K 1K 1L 2L 3L 4L Labour (L) Fig. Increasing Returns to Scale The movement from point a to b on the line OB means doubling the inputs. It can be seen in fig that input combination increases from 1K + 1L to 2K + 2L. As a result of doubling the inputs, output is more than doubled; it increases from 10 to 25 units e.g. an increase of 150%. Similarly, the movement from point b to point c indicates 50% increase in inputs as a result of which the output increases from 25 units to 50 units i.e. by 100%. O Capital (K)
Economies of scale • The scale of production has an very important bearing on the cost of production. • It is the manufacturer’s common experience that larger the scale of production, the lower generally is the average cost of production. • That is why the entrepreneur is tempted to enlarge the scale of production so that he benefit from the resulting economies of scale. • There are two types of Internal and External Economies.
Internal Economies of Scale • These are those economies in production, those in production costs, which accrue to the firm itself when it expands its output or enlarges its scale of production. • The internal economies arise within a firm as a result of its own expansion of the industry. • The internal economies are simply due to the increase in the scale of production. • They arise from the use of the methods which small firms do not find it worthwhile to employ.
Three reasons for increasing returns to scale • Technical and managerial indivisibilities:  Certain inputs, particularly mechanical equipments and managers, used in the process of production are available in a given size.  Such inputs cannot be divided into parts to suit small scale of production.  Because of indivisibility of machinery and managers, given the state of technology, they have to be employed in a minimum quantity even if scale of production is much less than the capacity output.  Therefore, when scale of production is expanded by increasing all the inputs, the productivity of indivisible factors increases exponentially because of technological advantage. This results in increasing returns to scale.
Internal Economies • Labour Economies: Division of Labour, this will increase the efficiency, saves time and promote skill information. • Technical economies: Modern machinery. • Marketing Economies: Buying inputs at large qty when it expands the output. Small firms are deprived of these benefits.  The cost of marketing the product is also reduced providing thereby the economies of large scale transportation.  Per unit advertisement cost is reduced.
• Higher degree of specialization (Managerial economies)  The use of specialized labour suitable to a particular job and of a composite machinery increases productivity of both labour and capital per unit of inputs. • Financial economies: The finance will be available at competitive rate and at easy terms. Can also raise money from the market, because of its goodwill. • Risk Bearing Economies: Can diversify the risk by selling products in different parts of the world.
• Dimensional relations For example, when the length and breadth of a room (15’ x 10’ =- 150 Sq. ft.) are doubled then the size of the room is more than doubled; it increases to 30’ x 20’ = 600 sq. ft. In accordance with this dimensional relationship, when the labour and capital are doubled, the output is more than doubled and so on.
External Economies • These are those economies which accrue to each member firm as a result of the expansion of the industry as a whole.
External Economies • Availability of raw-material and machineries at lower price: Expansion of the industry may results in the availability of inputs like raw-material and other equipments at lower prices. • Technical external economies: Since the growth of industry enables the firm to use the new technical know-how employing thereby improved machinery and other inputs. • Development of Skill labour: By training and development of the industry. • The growth of subsidiary industry: Will supply the raw-material. • Transport and marketing facilities: • Information Service: Will disseminate information, technical knowledge and R and D
Constant returns to scale • When the increase in output is proportionate to the increase in inputs it exhibits constant returns to scale. Fig. Constant Return to Scale Capital (K) 1011 ⇒+ LK 2022 ⇒+ LK 3033 ⇒+ LK Product lines Q = 30 Q = 20 Q = 10 B c b a 4K 3K 2K 1K 1L 2L 3L 4L Labour (L)
Decreasing Return to Scale • When economies of scale reach their limits and diseconomies are yet to begin, returns to scale become constant. • For example, doubling of coal mining plant may not double the coal deposits. • Similarly doubling the fishing fleet may not double the fish output because availability of fish may decrease in the ocean when fishing is carried out on an increased scale.
Product lines Labour (L) Fig. Decreasing Return to Scale Scale Q = 24 Q = 18 Q = 10 B C 4K 3K 2K 1K 1L 2L 3L 4L Capital (K) Decreasing Return to Scale c b a
INTERNAL DISECONOMIES • Large scale production firms faces a problem of management and control over the production unit. • Lack of proper coordination and supervision of different departments. • So growth of the firm beyond the limit will bring more problems. • The increase in the scale of output beyond its optimum size creates the managerial structure inflexible and cumbersome which ultimately reduces efficiency of the management
External Diseconomies • Constraints in the Supply of raw-material. • Demand for labour will increase due to growth of industry. • Instabilities of demand for the product
Economies of Scope • When the cost efficiencies in production allow the firm to produce a variety of products rather than a single product in large volume, it can be referred to the Economies of Scope. • This allows product diversification in the same scale of plant and with the same technology.
Returns to Scale (Summary) • Increasing returns to scale – When the % change in output > % change in inputs • E.g. a 30% rise in factor inputs leads to a 50% rise in output – Long run average total cost will be falling • Decreasing returns to scale – When the % change in output < % change in inputs • E.g when a 60% rise in factor inputs raises output by only 20% – Long run average total cost will be rising • Constant returns to scale – When the % change in output = % change in inputs – E.g when a 10% increase in all factor inputs leads to a 10% rise in total output – Long run average total cost will be constant
Consumer Surplus • The concept was formulated by Dupuit in 1844 to measure the social benefits of Public goods such as canals, bridges, national highways etc, • Marshall further popularized the concept • The concept was based on cardinal measurability and interpersonal comparison of utility
Concept or Defination • It is simply the difference between ‘the price that one is willing to pay’ and the ‘price one actually pays pays’ for a particular product. • It is also used in policy formulation by government and price policy purchased by the monopolistic seller of a product.
• People generally get more utility from the consumption of goods than the price they actually pay for them. • This extra satisfaction which the consumer obtains from buying a good is called as consumer surplus.
• The amount of money which a person is willing to pay for a good indicates the amount of utility he derives from that good. • Marginal utility of a unit of a good determines the price a consumer will be prepared to pay for that unit. • The total utility which a person gets from a good is given by the sum of marginal utilities ( ∑ MU) of the units of a good purchased.
• The total price the consumer actually pays is equal to the price per unit of the good multiplied by the number of units of it purchased. • Consumer’s surplus = ∑ MU – (Price * No. of units of a commodity purchased.)
Consumer Surplus and DMU • The concept of consumer surplus is derived from the law of diminishing marginal utility. • As the consumer purchase more units of a good its MU diminishes and the consumer’s willingness to pay for additional units of commodity declines. • The consumer is in equilibrium when MU from a commodity becomes equal too its price. • That is consumer purchases the number of units of commodity at which MU equals price.
• This means willingness to pay and actually pays are equal but rest previous units there is a consumer surplus. • But for the previous units customer’s willingness to is greater than the price he actually pays for them. • Because the price of all units are same.
Consumer Surplus • It measures extra utility or satisfaction which a consumer obtains from the consumption of a certain amount of a commodity over and above the utility of its market value. • The total utility obtained from consuming water is immense while its market value is negligible. • It is due to the occurrence of DMU that a consumer gets total utility from the consumption of a commodity greater than its market value
• Marshall tried to obtain the monetary measure of this surplus, i.e. how many rupees this surplus of utility is worth to consumer. • It is the monetary value of this surplus that Marshall called Consumer surplus.
Determine Monetary value of Surplus • Total utility of money in terms of money that consumer expects to get from consumption of a certain amount of commodity. • The total market value of the amount of commodity consumed by him. • It is easy to find out market value i.e. P*Q
Marginal Utility and Consumer Surplus No. of Units Marginal Utility Price Net Marginal Benefit 1 20 12 8 2 18 12 6 3 16 12 4 4 14 12 2 5 12 12 0 6 10 12 -2 Consumer Surplus (from 5 Units) = 20
The consumer surplus of purchasing 5 units is the sum of the surplus derived from each one individually. Consumer Surplus 8 + 6 + 4 + 2 + 0 + -2 = 20 Consumer Surplus - Example Price of X Price (Rs) 2 3 4 5 6 13 0 1 14 10 12 14 16 18 20 Market Price Will not buy more than 5 because surplus from additional units is negative
Consumer Surplus The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller. Consumer surplus measures the total net benefit to consumers = total benefits from consumption (-)the total expenses. Thus, consumer surplus is area under the demand curve and above the price. Note that the area under the demand curve up to the level of consumption measures the total benefits.
Demand Curve Consumer Surplus Consumer Surplus Price of X Price (Rs.) 2 3 4 5 60 1 Actual Expenditure 12 20 Market Price
Consumer Surplus and Market Price A lower market price will usually increase consumer surplus.  A higher market price will usually reduce consumer surplus. Consumer surplus will be smaller when the demand curve is more elastic and larger when the demand curve is inelastic.
How the Price Affects Consumer Surplus? Initial consumer surplus Quantity Consumer Surplus at Price P2 vs. at Price P1 Price 0 Demand A B C D E F P1 Q1 P2 Q2 Consumer surplus to new consumers Additional consumer surplus to initial consumers
Consumer Surplus Price Quantity D Po Qo Maximum Willingness to Pay for Qo What is paid Consumer Surplus
Original Consumer Surplus Change in Consumer Surplus: Price Increase Quantity New Consumer Surplus Loss in Surplus: Consumers paying more Loss in Surplus: Consumers buying less Price D Po Qo P1 Q1
PRODUCER SURPLUS • The revenue that producers obtain from a good over and above the price paid. • This is the difference between the minimum supply price that sellers are willing to accept and the price that they actually receive. • A related notion from the demand side of the market is consumer surplus.
• Producers' surplus is the extra revenue received when selling a good. • The supply price is less than the price actually received. • Most producers under most circumstances receive some surplus of revenue. • Even competitive markets overflowing with efficiency generate an ample amount of producer surplus.
Producer Surplus • The amount a seller is paid , minus the seller’s cost. • It is the area above the supply curve, and below the equilibrium price.
Minimum Amount Needed to Supply Qo Producer Surplus Price Quantity Po Qo What is paid Producer Surplus S
Consumer and Producer Surplus Price Quantity Po Qo S Producer Surplus Consumer Surplus D
The magic of perfectly competitive markets • At equilibrium, both consumer and producer surplus are at their maximum • Any interference with the equilibrium price in perfectly competitive markets will reduce total consumer and producer surplus
Cost • By "Cost of Production" is meant the total sum of money required for the production of a specific quantity of output. In the word of Gulhrie and Wallace: • "In Economics, cost of production has a special meaning. • It is all of the payments or expenditures necessary to obtain the factors of production of land, labor, capital and management required to produce a commodity. • It represents money costs which we want to incur in order to acquire the factors of production".
Cost of Production • The following elements are included in the cost of production: (a) Purchase of raw machinery, (b) Installation of plant and machinery, (c) Wages of labor, (d) Rent of Building, (e) Interest on capital, (f) Wear and tear of the machinery and building, (g) Advertisement expenses, (h) Insurance charges, (i) Payment of taxes, (j) In the cost of production, the imputed value of the factor of production owned by the firm itself is also added, (k) The normal profit of the entrepreneur is also included In the cost of
FIXED, VARIABLE, AND INCREMENTAL COSTS • Fixed costs: unaffected by changes in activity level over a feasible range of operations for the capacity or capability available. • Typical fixed costs include: insurance and taxes on facilities general management and administrative salaries license fees interest costs on borrowed capital. • Fixed costs will be affected When: large changes in usage of resources occur plant expansion or shutdown is involved
FIXED, VARIABLE AND INCREMENTAL COSTS • Variable costs: associated with an operation that vary in total with the quantity of output or other measures of activity level. • Example of variable costs include : Costs of material and labor used in a product or service.
FIXED,VARIABLE AND INCREMENTAL COSTS • Incremental cost: additional cost that results from increasing output of a system by one (or more) units. • Incremental cost is often associated with “go / no go” decisions that involve a limited change in output or activity level. • A very simple example of incremental cost would be a factory producing widgets where it takes one employee an hour to produce one widget. • the incremental cost of a widget would include the wages for an hour in addition to the cost of materials used in production of a widget. • A more exact figure could comprise added costs, like electricity consumed if the factory had to stay open for a longer duration, or the cost for shipping the additional widget to a consumer.
SUNK COST AND OPPORTUNITY COST • A sunk cost is one that has occurred in the past and has no relevance to estimates of future costs and revenues related to an alternative course of action; • Example : Product Research • Companies spend money each year for research and development as they work to come up with new products and services. • While the nature of research varies from business to business, • It's recognized as a sunk cost, since once the money is spent on conducting a focus group or administering a survey, it's gone.
Opportunity cost • An opportunity cost is the cost of the best rejected ( i.e., foregone ) opportunity and is hidden or implied;
What is opportunity cost? • Andy had $65.00 to spend at the toy store. The basketball net cost $50.00, so he had to buy that instead of the skateboard, which cost $75.00. • Sara had enough money for either the rabbit or the bike. She decided to buy the bike because then she could ride bikes with her friends after school.
• Opportunity cost is the process of choosing one good or service over another. The item that you don’t pick is the opportunity cost. The rabbit is Sara’s opportunity cost and the skateboard is Andy’s opportunity cost. Opportunity Costs Purchases
Social Cost • Building a new railway $100 million • Creating pollution nearby (e.g. cutting trees, noises) $5 million • Social cost of building highway • = private cost + external cost • = $105 million
Historical Costs and Replacement Costs. • Historical cost or original costs of an asset refers to the original price paid by the management to purchase it in the past. • Whereas replacement costs refers to the cost that a firm incurs to replace or acquire the same asset now. • The distinction between the historical cost and the replacement cost result from the changes of prices over time. • In conventional financial accounts, the value of an asset is shown at their historical costs but in decision-making the firm needs to adjust them to reflect price level changes. • Example: If a firm acquires a machine for $20,000 in the year 1990 and the same machine costs $40,000 now. The amount $20,000 is the
Money Cost • Money Cost of production is the actual monetary expenditure made by company in the production process. • Money cost thus includes all the business expenses which involve outlay of money to support business operations. • For example the monetary expenditure on purchase of raw material, payment of wages and salaries, payment of rent and other charges of business etc can be termed as Money Cost.
Real Cost • Real Cost of production or business operation on the other hand includes all such expenses/costs of business which may or may not involve actual monetary expenditure. • For example if owner of a business venture uses his personal land and building for running the business venture and • He/she does not charge any rent for the same then such head will not be considered/included while computing the Money Cost but this head will be part of Real Cost computation.
Accounting Cost • Accounting Cost includes all such business expenses that are recorded in the book of accounts of a business firm as acceptable business expenses. • Such expenses include expenses like Cost of Raw Material, Wages and Salaries, Various Direct and Indirect business Overheads, Depreciation, Taxes etc. • When such business expenses or accounting expenses are deducted from the Sales income of any firm the accounting profit is obtained. • Such Accounting/Business expenses or costs are also termed as Explicit Costs.
• Accounting Cost: Various allowed business expenses. • Such as Cost of Raw Material, Salaries and Wages, Electricity Bill, Telephone Charges, Various Administrative Expenses, Selling and Distribution Expenses, Production Overhead Expenses, Other Indirect Overhead Expenses etc. • Accounting Profit = Sales Income - Accounting Cost
Economic Cost • Economic Cost on the other hand includes all the accounting expenses as well as the Opportunity cost of a business firm. • Economic Cost and Economic Profit is thus calculated as follows: • Economic Cost = Accounting Cost (Explicit Costs) + Opportunity Cost. • Economic Profit = Total Revenues - (Accounting Cost + Opportunity Cost)
Private Cost and Social Cost • The actual expenses of individuals/ firms which are borne or paid out by the individual or a firm can be termed as Private Cost. • Thus for a business firm this may include expenses like Cost of Raw Material, Salaries and Wages, Rent, Various Overhead Expenses etc. • On the other hand Private Cost for an individual will be his or her private expenses such as expense on food, rent of house, expenses on clothing, expenses on travel, expenses on entertainment etc.
Social Cost • Social Cost on the other hand includes Private Cost and also such costs which are not borne by the firm but by the society at large. • Such Cost (that is cost not borne or paid out by the firm) is also known as External Cost. • Another example of external cost can be the cost of providing the basic infrastructure facilities like good roads, sewage system or network, street lights etc.
Cost Concepts I. Total Costs (TC)I. Total Costs (TC) — whatever total cost is for any level of output — sum of all costs Two Sub-Components:Two Sub-Components: (A)Total Fixed Costs — TFC (Overhead Costs) — do not vary with output — come from fixed inputs (B) Total Variable Costs — TVC — vary with output — come from variable inputs Note: TC = TFC + TVC
Understanding Fixed, Variable, Total cost Number of Units Produced Fixed Cost Variable Cost Total Cost 1 10 5 15 2 10 10 20 3 10 17 27 4 10 30 40 5 10 45 55
Cost Concepts Cost(Rs)Cost(Rs) Output (or TP orOutput (or TP or Q)Q) Graph of Total Cost Concepts TC TVC TFC (TFC)
0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP b b d d Number of farm workers (L) Number of farm workers (L) Slope = TPP / L = APP c c
Cost Concepts II. Average Total Costs (ATC)II. Average Total Costs (ATC) – Total Cost Per Unit of Output Two Sub-Components:Two Sub-Components: Q TC ATC = (A) Average Fixed Cost: Q TFC AFC = (B) Average Variable Cost: Q TVC AVC = Two Average Costs!! Note: ATC = AFC + AVC
Cost Concepts III. Marginal Costs (MC) :III. Marginal Costs (MC) : Increase in Total Cost that results from an increase in output Q TC MC ∆ ∆ =
The Short Run Cost Function • Add ATC = AFC + AVC to the table
The Short Run Cost Function • ATC = AFC + AVC
Cost Concepts Cost(Rs)Cost(Rs) OutputOutput Graph of Average & Marginal Cost Concepts AVC AFC ATC MC Q2 Q1
Cost Concepts (1) When marginal is below average(1) When marginal is below average →→ average is falling.average is falling. (2) When marginal is above average(2) When marginal is above average →→ average is rising.average is rising. (3) When marginal is equal average(3) When marginal is equal average →→ average is at its lowestaverage is at its lowest point.point. Note : There is a certain correspondence between productNote : There is a certain correspondence between product concepts and cost concepts.concepts and cost concepts. Summary of Relationship Between Marginal Cost & Average Cost When AVC is at its minimum, AP will be at its maximum.When AVC is at its minimum, AP will be at its maximum. When MC is at a minimum, MP will be at its maximum.When MC is at a minimum, MP will be at its maximum. (See diagram in book.)(See diagram in book.)
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The Short Run Cost Function • Production cost graph or map is
The Short Run Cost Function • Important Map Observations – AFC declines steadily over the range of production. Why? – In general, ATC is u-shaped. Why? – MC intersects the minimum point (q*) on ATC. Why?
The Short Run Cost Function • A change in input prices will shift the cost curves. – If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected. Computer Chip Case
The Short Run Cost Function • A change in input prices will shift the cost curves. – If variable input costs are reduced then MC, AVC, and AC will all shift downward. Airline Industry Case
Long-Run Average Cost Curve (No distinction between fixed and variable in Long-Run) Total Costs perTotal Costs per Unit(Rs)Unit(Rs) (LRAC)(LRAC) Q (Output)Q (Output) Plots the relationship between the lowest attainable Average Cost and output when both capital (or plant size) and labor can be varied. LRAC 0 C1 Q1 C2 Q2 AttainableAttainable CostsCosts UnattainableUnattainable CostsCosts
Relationship Between SATC & LRAC Short-Run & Long-Run Costs AverageAverage Costs perCosts per Unit (Rs)Unit (Rs) Q (Output)Q (Output) 0 SATC1 SATC2 SATC3 LRAC LMC SMC1
Relationship Between SATC & LRAC Short-Run & Long-Run Costs AverageAverage Costs perCosts per Unit (Rs)Unit (Rs) Q (Output)Q (Output) 0 LRAC X Xmin X X = minimum pointX = minimum point
Long-Run Average Cost Curve Slope of LRAC Costs perCosts per UnitUnit QQ (Output)(Output) LRAC 0 Qm 0 to Qm: Economies of Scale Qm Rightward: Diseconomies of Scale * Q* Qmm is the most efficient point – doubly efficient:is the most efficient point – doubly efficient: (1) It represents the lowest possible costs for its production level (like all points on LRAC curve). (2) It is the output level that has absolutely lowest costs of all output levels.
Other Possible Shapes for LRAC Constant Returns to Scale : LRAC curve is horizontal AverageAverage Cost perCost per Unit (Rs)Unit (Rs) QQ (Output)(Output) LRAC 0 AverageAverage Cost perCost per Unit (Rs)Unit (Rs) QQ (Output)(Output) LRAC 0 OROR Doubling Input spending always leads to a doubling of output.
Other Possible Shapes for LRAC Continually Decreasing Costs AverageAverage Cost perCost per Unit (Rs)Unit (Rs) QQ (Output)(Output) LRAC 0 Decreasing Cost!!!
Minimum Efficient Scale Definition : The smallest quantity of output at which long- run average cost reaches its lowest level.
A Perfectly Competitive Market • For a market to be perfectly competitive, six conditions must be met: 1. Both buyers and sellers are price takers – a price taker is a firm or individual who takes the price determined by market supply and demand as given 2. The number of firms is large – any one firm’s output compared to the market output is imperceptible and what one firm does has no influence on other firms • A perfectly competitive market is a market in which economic forces operate unimpeded
A Perfectly Competitive Market 3. There are no barriers to entry – barriers to entry are social, political, or economic impediments that prevent firms from entering a market. 3. Firms’ products are identical – this requirement means that each firm’s output is indistinguishable from any other firm’s output 4. There is complete information – all consumers know all about the market such as prices, products, and available technology 5. Selling firms are profit-maximizing entrepreneurial firms – firms must seek maximum profit and only profit
Total Revenue of a Competitive Firm • Total revenue for a firm is the selling price times the quantity sold. TR = PTR = P ×× QQ
Average Revenue of a Competitive Firm • Average revenue is the revenue per unit sold – P = AR. – This is simply because all units sold are sold at the A v e r a g e R e v e n u e = T o t a l r e v e n u e Q u a n t i t y P r i c e Q u a n t i t y Q u a n t i t y P r i c e = × =
Marginal Revenue of a Competitive Firm • Marginal Revenue is the increase (Δ) in total revenue when an additional unit is sold. MRMR == ∆∆TRTR // ∆∆QQ
Revenue of a Perfectly Competitive Firm • Total Revenue: The amount of money received when the firm sells the product, i.e., – Total Revenue = Price of the product × Quantity of the product sold – TR = P × Q • Since the firm is a price taker under perfect competition, it sells each additional unit of the product for the same price. • Average Revenue = Total Revenue/Quantity sold – AR = TR/Q = P • Marginal Revenue = Additional revenue earned from selling an additional unit of the product. – MR = ∂TR/∂Q = P • Thus, for a competitive firm AR = P = MR
Total Revenue: P×Q TP = Q P TR AR MR 0 3 0 0 0 10 3 30 3 3 25 3 75 3 3 50 3 150 3 3 70 3 210 3 3 85 3 255 3 3 95 3 285 3 3 100 3 300 3 3 101 3 303 3 3 95 3 285 3 3 85 3 255 3 3
The Revenue of a Competitive Firm • In perfect competition, marginal revenue equals price: P = MR. • We saw earlier that P = AR • Therefore, for all firms in perfect competition, P = AR = MR
9.4 Profit Maximization (SR): TR and TC approach
What Is Perfect Competition? – Figure illustrates a firm’s revenue concepts. – Part (a) shows that market demand and market supply determine the market price that the firm must take.
What Is Perfect Competition? – A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces. – So the firm must decide: – 1. How to produce at minimum cost – 2. What quantity to produce – 3. Whether to enter or exit a market – We start by looking at the firm’s output decision.
Profit Maximization by the Competitive Firm: Approach I: Total Profit = TR – TC 0.00 50.00 100.00 150.00 200.00 250.00 300.00 350.00 0.00 20.00 40.00 60.00 80.00 100.00 120.00 Output TC,TR,&Profit TC TR L TP = Q TR TC Profit 0 0 0 80 -80 1 10 30 105 -75 2 25 75 130 -55 3 50 150 155 -5 4 70 210 180 30 5 85 255 205 50 6 95 285 235 50 7 100 300 255 45 8 101 303 280 23 9 95 285 305 -20 10 85 255 330 -75  On the Diagram, the profit maximizing level of output is the level where the vertical difference between the TR and TC is the largest.  With P = Rs 3/unit, profits are maximized by producing 95 units of output.
The Firm’s Output Decision • Profit-Maximizing Output – A perfectly competitive firm chooses the output that maximizes its economic profit. – One way to find the profit-maximizing output is to look at the firm’s the total revenue and total cost curves. – Figure on the next slide looks at these curves along with the firm’s total profit curve.
The Firm’s Output Decision – Part (a) shows the total revenue, TR, curve. Part (a) also shows the total cost curve, TC, which is like the one in previous Slides. Total revenue minus total cost is economic profit (or loss), shown by the curve EP in part (b).
The Firm’s Output Decision – At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs. At intermediate output levels, the firm makes an economic profit.
The Firm’s Output Decision – At high output levels, the firm again incurs an economic loss— now the firm faces steeply rising costs because of diminishing returns. The firm maximizes its economic profit when it produces 9 sweaters a day.
Max Profit Max Output Profit Maximization by the Competitive Firm: Approach I: Total Profit = TR – TC Input (L) TP (Q) AP (Q/L) MP TC TR Profit 0 0 0.00 80 0 -80 1 10 10.00 10 105 30 -75 2 25 12.50 15 130 75 -55 3 50 16.67 25 155 150 -5 4 70 17.50 20 180 210 30 5 85 17.00 15 205 255 50 6 95 15.83 10 235 285 50 7 100 14.29 5 255 300 45 8 101 12.63 1 280 303 23 9 95 10.55 -6 305 285 -20 10 85 8.50 -10 330 255 -75 StageIStageIIStageIII
Profit Maximization by the Competitive Firm: Approach II: MR = MC • Most managers do not make decisions looking at TR and TC. Most decisions are made at the “margin.” • The output level that will maximize profit is determined by comparing the amount that each additional unit of output adds to TR and TC. • Recall, Marginal Cost (MC) represents additional cost from producing an additional unit of output; and Marginal Revenue (MR) represents addition to TR from selling (producing) an additional (one more) unit of output, which is equal to the price of that output. • Thus, MC and MR can be used to determine profit maximizing level of output.
Profit Maximization by the Competitive Firm: Approach II: MR = MC • The firm will continue to expand production until MR is equal to MC, i.e., profit is maximized when MR = MC. • With P being Rs 3/unit, profits are maximized by producing 95 units of output. 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 0.00 20.00 40.00 60.00 80.00 100.00 120.00 Output MR, MC, & Profit MR MC L Q TR MR TC MC Profit 0 0 0 80 -80 1 10 30 3 105 2.50 -75 2 25 75 3 130 1.67 -55 3 50 150 3 155 1.00 -5 4 70 210 3 180 1.25 30 5 85 255 3 205 1.67 50 6 95 285 3 235 3.00 55 7 100 300 3 255 5.00 45 8 101 303 3 280 25.0 23 9 95 285 3 305 -4.17 -20 10 85 255 3 330 -2.50 -75
The Firm’s Output Decision • Marginal Analysis and Supply Decision – The firm can use marginal analysis to determine the profit-maximizing output. – Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC. – Figure on the next slide shows the marginal analysis that determines the profit-maximizing output.
The Firm’s Output Decision – At high output levels, the firm again incurs an economic loss— now the firm faces steeply rising costs because of diminishing returns. The firm maximizes its economic profit when it produces 9 sweaters a day.
The Firm’s Output Decision – If MR > MC, economic profit increases if output increases. If MR < MC, economic profit decreases if output increases. If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.
Determining Profits Graphically: A Firm with Profit AVC MC Q P ATC Find output where MC = MR, this is the profit maximizing Q P = D = MR MC = MR Qprofit max Find profit per unit where the profit max Q intersects ATC ATC at Qprofit max P ATC Profits Since P>ATC at the profit maximizing quantity, this firm is earning profits
Determining Profits Graphically: A Firm with Zero Profit or Losses AVC MC Q P ATC MC = MR Qprofit max ATC at Qprofit max P =ATC P = D = MR Since P=ATC at the profit maximizing quantity, this firm is earning zero profit or loss Find output where MC = MR, this is the profit maximizing Q Find profit per unit where the profit max Q intersects ATC
Determining Profits Graphically: A Firm with Losses AVC MC Q P ATC MC = MR Qprofit max ATC at Qprofit max P ATC P = D = MR Since P<ATC at the profit maximizing quantity, this firm is earning losses Find output where MC = MR, this is the profit maximizing Q Find profit per unit where the profit max Q intersects ATC Losses
Determining Profits Graphically: The Shutdown Decision AVC MC Q P ATC Qprofit max PShutdo wn P = D = MR • The shutdown point is the point below which the firm will be better off if it shuts down than it will if it stays in business • If P>min of AVC, then the firm will still produce, but earn a loss • If P<min of AVC, the firm will shut down • If a firm shuts down, it still has to pay its fixed costs
Short-Run Market Supply and Demand • The market (industry) supply curve is the horizontal sum of all the firms’ marginal cost curves • While the firm’s demand curve is perfectly elastic, the industry’s demand curve is downward sloping • The market supply curve takes into account any changes in input prices that might occur
ATC Profits Short-Run Market Supply and Demand Graph P Q Market Supply P Market Demand P Q P P = D = MR MC ATC Qprofit max Market Firm
Long-Run Competitive Equilibrium • Profits create incentives for new firms to enter, market supply will increase, and the price will fall until zero profits are made • At long run equilibrium, economic profits are zero • The existence of losses will cause firms to leave the industry, market supply will decrease, and the price will increase until losses are zero
Long-Run Competitive Equilibrium • Normal profit is the amount the owners would have received in their next best alternative • Zero profit does not mean that the entrepreneur does not get anything for his efforts • Economic profits are profits above normal profits
Long-Run Competitive Equilibrium Graph P Q P = D = MR MC SRATC LRATC At long-run equilibrium, economic profits are zero
SR Profits Market Response to an Increase in Demand Graph P Q S0(SR) P0 D0 P Q P0 MC ATC Q0,2 Market Firm S1(SR) D1 P1 1 P1 1 1 Q1 2 2 2 Q0 Q1 Q2 1 1 2 2 S(LR)
Long-Run Market Supply • If the long-run industry supply curve is upward sloping, the market is an increasing-cost industry • If the long-run industry supply curve is perfectly elastic, the market is a constant-cost industry • If the long-run industry supply curve is downward sloping, the market is a decreasing-cost industry • In the short run, the price does more of the adjusting, and in the long run, more of the adjustment is done by quantity
Monopoly • Only one seller of a particular product
Characteristics of Monopoly • Single Producer • No close substitute • Inelastic demand curve • Price Maker • Barriers to entry  Legal restrictions or barriers to entry of other firms  Control over key raw material • Examples: Public utilities – telephones and electricity etc.
Total Revenue Price Quantity Total Revenue 6 0 0 5 1 5 4 2 8 3 3 9 2 4 8 1 5 5 0 6 0 Can you work out the demand, total revenue and marginal revenue functions from this information?
TR Price Q Q TR Demand and Total Revenue AR = D 0 0 63 3 6 9 6 3 Graph B Graph A D
TR P,MR Q Q Marginal Revenue Q2 MR AR = D A B C 0 0 Q1 A C Graph B Graph A X TR
Profit Maximizing Output Decision under Monopoly in the Short-run The Total Curves Approach Profit maximization output decision rule for a monopolist depends on two considerations. • One, whether there is any output level at which TR exceeds the TVC. If not, the profit maximizing strategy is to shut down. • If there are output levels at which TR > TVC, the monopolist will produce where the vertical distance between TR and TC is at its maximum. $ TR TC TVC Q
Profit Maximizing Output Decision under Monopoly in the Short-run The Total Curves Approach • In this case, the vertical distance between TR and TC is at maximum at the Q* level of output. – Note that at Q* units of output, TR and TC curves have the same slope, i.e., MR = MC. (This is called the Necessary Condition of profit maximization) – Further, the slope of MC exceeds that of the MR (MC has a positive slope and MR has a negative slope). (This is called the Sufficient Condition of profit maximization) $ TR TC TVC QQ*
Output and Price Determination LO2 Steps for Graphically Determining the Profit-Maximizing Output, Profit-Maximizing Price, and Economic Profits (if Any) in Pure Monopoly Step 1 Determine the profit-maximizing output by finding where MR=MC. Step 2 Determine the profit-maximizing price by extending a vertical line upward from the output determined in step 1 to the pure monopolist’s demand curve. Step 3 Determine the pure monopolist’s economic profit by using one of two methods: Method 1. Find profit per unit by subtracting the average total cost of the profit-maximizing output from the profit-maximizing price. Then multiply the difference by the profit-maximizing output to determine economic profit (if any). Method 2. Find total cost by multiplying the average total cost of the profit- maximizing output by that output. Find total revenue by multiplying the profit-maximizing output by the profit-maximizing price. Then subtract total cost from total revenue to determine the economic profit (if any). 10-337
Finding Pm and Qm Price Quantity of output Market Demand MR MC Pm Qm MC = MR Cost data will determine a monopolist’s profit.
$200 175 150 125 25 100 75 50 Price,Costs,andRevenue 1 2 3 4 5 6 7 8 9 10 Quantity Output and Price Determination LO2 0 D MR ATC MC MR=MC A=$94 Economic Profit Pm=$122 10-339
Misconceptions of Monopoly Pricing • Not highest price • Total profit • Possibility of losses LO2 10-340
Misconceptions of Monopoly Pricing LO2 0 D MR ATC MC MR=MC Loss AVC Pm Qm V A 10-341
Price Discrimination It refers to discrimination of price for different consumers on the basis of their income or purchasing power, geographical location, age, sex, colour, marital status, quantity purchased, time of purchase etc. for eg:- • Physicians and hospitals • Merchandise sellers • Railways and Airlines • Cinema shows or musical concerts • Domestic and foreign markets
Necessary conditions • Different Markets must be separable for a seller • The Elasticity of demand must be different in different markets • There must be imperfect competition in the market • Profit maximizing output should be larger than the quantity demanded in a single market or section of consumers
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Mangerial economics

  • 2. Meaning • Managerial economics is defined as the study of economic theories, logic and tools of economic analysis that are used in process of business decision-making. • In other words economic theories and techniques of economic analysis are applied to analyze business problems, evaluate business opportunities with a view to arrive at appropriate business decision. .
  • 3. •Managerial Decision Areas Assessment of Investible funds Selecting Business areas Choice of Product Determining optimum Output Determining input-Combination of the product Sales promotion Application of Economic Concepts and Theories in Decision Making Use of Quantitative Methods •Mathematical tools •Statistical Tools •Econometrics Application of Economic Concepts, Theories and analytical Tools to find Optimum Solution to Business Problems
  • 4. Why Economics? • Biology contributes to medical profession. • Physics to Engineering. • Economics to Managerial profession. Achieve objective of the firm Constraints is limited resources
  • 5. Application of Economics to Decision Making I. Determining and defining the objective to be achieved. II. Collection and analysis of business related data and other information(Economic, social, Political and technological environment.). III. Inventing the possible courses of action IV. Select the possible action from the given alternatives. • II and III are crucial in decision making
  • 6. Example Launching a product • Production Related issues and • Sales related issues.
  • 7. Production Related issues • Available techniques of Production. • Cost of Production • Supply position of inputs • Price structure of inputs • Cost structure of competitive products • Availability of foreign exchange if inputs are available.
  • 8. Sales related issues • Market size, general market trends and demand prospectus for the product • Trends in Industry • Competitors • Pricing of product • Pricing strategy of competitors • Degree of competition • Supply position of complementary goods
  • 9. Scope of Managerial Economics • Economics applied to the analysis of business problems and decision making. • Area of business issues to which economic theories can be directly applied are broadly divided into 1.Micro Economics (Operational and internal issues) 2.Macro Economics (Environmental and external issues)
  • 10. Operational or Internal issues • What to produce Nature of product or Business • How much to produce Size of firm • How to produce Choice of technology • How to price the commodity • How to promote sales • How to face price competition • How to manage profit and capital • How to manage an inventory
  • 11. Environmental or External issues • The type of economic system in the country • Trends in GDP, Prices, Saving and Investment Employment, etc. • Trends in Financial System Banks, Financial and Insurance companies • Trends in Foreign Trade • Government Economic policies • Social Factors like value system, property rights, customs and habits. • Socio-economic organization like trade unions, consumer’s associations, Consumer co-operatives and producers unions. • Political environment • Degree of Globalization and Influence of MNC’s
  • 12. Micro Economic Issues • What to produce • How much to produce • How to produce • How to price the commodity • How to promote sales • How to face competition • How to decide on new investment • How to manage profit and capital • How to manage an inventory
  • 13. Examples of Economic Theories • Theory of Demand It deals with the consumer behaviour How do the consumer decides to buy the commodity How do they decide on Quantity When do they stop consuming How consumer behave on Price It helps in making choice in commodity, optimum level of production and price
  • 14. Theory of Production and Decision Making • It explains the relationship between inputs and output. • Under what conditions the cost increases or decreases • Helps to decide the optimum size of the firm • Size of total output and amt of capital and labour to be employed given the objective
  • 15. Market structure and Pricing theory • How price is determined. • When price discrimination is desirable, feasible and profitable. • How advertising will be helpful to increase sales. • Thus pricing and production decision will help to determine the optimum size of the firm.
  • 16. Profit analysis and Management • Elements of risk is always there even if most efficient techniques are used. • It guide the firm to measure and manage profit, to make the allowance of risk premium, to calculate the pure return on capital and also future profit.
  • 17. Theory of Capital and investment decision • It contribute to deciding choice of project, maintaining capital, capital budgeting, etc
  • 18. Macro economic Issues • Trends in Economics: Level of GDP Investment climate Trends in National Output and employment Price trends
  • 19. • Issues related to Foreign Trade Trends in International Trade Trends in International Prices Exchange rates Prospectus in International Market
  • 20. • Issues related to Government Policies: Monetary Policy Fiscal Policy Foreign Trade Policy Environmental Policy etc
  • 21. Other Topics related to Managerial Economics • Mathematical Tools
  • 22. Economic theories for Decision Making • Economic concepts (Cost, Price, Demand etc.) • Ascertaining the variables which is relevant. • Relationship between the two or more variables.
  • 23. What is Demand ? “ When the desire for a commodity is backed by the willingness and the ability to spent adequate sums of money, it becomes demand or effective demand in the economic sense of the curve. Only desire for commodity or having money for the same cannot give rise to its demand” Marshall “ Demand for a product refers the amount of it which will be bought per unit of time at a particular price”. 03/13/15 group 2 sec c 23
  • 24. RELATIVE CONCEPT • Demand is the relative concept i.e. it is related to price and time: 1.The demand for rice is 100Kg 2.The demand for rice at Rs 5/- per Kg is 100Kg per day. • Second statement is complete because it mentions the price and time period, becoz demand varies from time and price. • The demand refers to the quantity of it purchased at a given price, during a specific time period.
  • 25. Determinants of Demand 1.Price of the product. 2.Income and wealth distribution. 3.Tastes, habits and preferences. 4.Relative prices of other goods  Substitute products.  Complementary products. 5.Consumers satisfaction. 6.Quantity of money in circulation. 7.Utility of the commodity. 8.Quality. 9.Expectation regarding future price. 10.Number consumers, time and place: Transport, communication and market facilities will increase the consumers
  • 26. 11. Advertisements effects. 12. Growth of population. 13. Level of taxation. 14. Climatic or weather conditions. 15. Special occasions. 16. Technology. 17. Psychology of the consumers: Bandwagon effect: Demand arises becoz others have it others, Snob effect: Demand arises becoz when it is not commonly demanded, Demonstration effect: Copying the others.
  • 27. INDIVIDUAL DEMAND Price per unit Demand for commodity X 50 10 40 20 30 30 20 40 10 50 05 60 It is the tabular representation of the various quantities of a commodity demanded by an Individual at a different prices during a given period of time
  • 29. MARKET DEMAND Price per Unit Qty Demanded A B C Total market Demand(A + B + C) 50 10 12 15 37 40 20 22 25 67 30 30 32 35 97 20 40 42 45 127 10 50 52 55 157
  • 30. Demand and Demand Curves (d) – The market demand curve is the horizontal sum of the demand curves of all individuals. – Market dd curve is also negatively sloped because 1. Individual dd curves are downward sloping 2. At high prices some buyers will exit the market
  • 32.
  • 33. Generalized demand function • The generalized demand function just set forth is expressed in the most mathematical form. • Economist and market researchers often expressed generalized demand function in a linear functional form. • The following equation is an example of a linear form of the generalized demand function: Qd = a + bP + cM + dPR + eT + fPe + gN • Where the Variables are (P,M,PR,T,Pe,N). • And a,b,c,d,e,f and g are parameters.
  • 34. Generalized demand function • The intercept “a” shows the value of Qd when the variables P,M,PR,T,Pe,N are all simultaneously equal to zero. • The other parameter a,b,c,d,e,f and g are called slope parameters. • They measure the effect on quantity demanded of changing one of the variables while holding rest of it as constant. • E.g. b measures the change in Qty dd per unit change in price • i.e b = Qd/ P.
  • 35. Summary of Generalized demand function Variable Relation to quantity demanded Sign of Slope parameter P INVERSE Negative M Direct for normal goods Inverse for inferior goods Positive Negative PR Direct for substitute goods Inverse for the complementary goods Positive Negative T Direct Positive Pe Direct Positive N Direct Positive
  • 36. Demand functions • The relation between price and quantity demanded per period of time, when all other factors that affect demand held constant is called as demand function or simply demand. • It can be expressed as Qd = f (P)
  • 37. illustration • Generalized demand function is Qd = 1800 – 20P + 0.6M – 50PR • To derive a demand functions Qd = (P) • The variables M and PR must be assigned fixed value. • Suppose M = 20000, PR = 250 • Substitute the value in generalized demand function.
  • 38. • Qd = 1800 – 20P- 0.6(20000) – 50(250) = 1800 – 20P + 12000 – 12500 = 1300 – 20P • The intercept parameter 1300 is the amount of the good consumers would demand if price is zero. • The slope of the demand function is -20 and indicates that a Rs 1 increase in price causes qty dd to decrease by 20 units. Qd = 1300 – 20 (1) = 1300 -20 = 1280
  • 39. Determinants of Demand Determinants of Demand Demand Increase s Demand decreases Sign of Slope parameter Income (M) Normal Goods Inferior goods M rises M Falls M Falls M rises C > 0 C < 0 Price of related goods (PR) Substitute goods Complement good PR rises PR falls PR falls PR rises d > 0 d < 0 Consumer Tastes (T) T rises T falls e > 0 Expected price (Pe) Pe rises Pe Falls f > 0 Number of consumers (N) N rises N Falls g > 0
  • 41. The Law of Demand “Other factors remaining same (habits, tastes etc.) as price decreases demand increases and vice versa” Marshall “Ceteris paribus, higher the price of a commodity, smaller is the quantity demanded and lower the price, larger the quantity demanded.”
  • 42. Demand Schedule (Hypothetical) Price of commodity (in Rs) Quantity demanded (unit per week) 5 4 3 2 1 100 200 300 400 500
  • 43. Quantity demanded (Q) Q1 Q2 P1 P2 E1 E2 0 D D Price(P) P1 - old price P2 - new price Q1 – old quantity demanded Q2 – new quantity demanded DD – demand curve A Linear Demand Curve Demand Curve
  • 44. Characteristics of A Typical Demand Curve  Drawn by joining different loci.  Downward sloping.  Reciprocal relationship between price and quantity demanded ( P α 1/Qd )  Linear Non - linear
  • 45. Assumptions (Other things) a) No change in consumer’s income. b) No change in consumer’s preferences. c) No change in the fashion. d) No change in the price of related goods :  Substitute goods.  Complementary goods. a) No expectation of future price changes or shortages. b) No change in size, age, composition and sex ratio of the population. c) No change in the range of goods available to the consumers.
  • 46. Contd… h) No change in the distribution of income and wealth. i) No change in the government policy. j) No change in weather conditions.
  • 47. EXCEPTION TO LAW OF DEMAND • Giffen’s Paradox: Giffen gods are inferior goods. When the price rises the real income of the consumer rises and he will move to a superior goods. This is also called as Giffen’s paradox. • Qualitative changes: It may increase qty with the increase in the price. • Price illusion: Higher the price better is the quality. • Prestige goods: Purchased by the rich people.
  • 48. • Demonstration effect: Imitating others or Snob appeal • Fashion: • Necessaries:
  • 49. Movement along the curve OR Change in quantity demanded  Extension of demand ‘ With a decrease in price, there is increase in the quantity demand of the product’. P1 P2 Q1 Q2 E E` D D Quantity demanded Price
  • 50. Contraction of demand ‘ With a increase in price, there is a decrease in quantity demanded’.’ Quantity demanded P2 Q2 P1 Q1 E E` Price
  • 51. SOURCES OF SHIFTS IN THE DEMAND CURVES • Tastes • Prices of related goods • Income • Demographics • Information • Availability of credit • Changes in expectations
  • 52. Movement of Demand Curve OR Change in demand  Increase in demand: a) More quantity demanded ------ at a given price. b) Same quantity demanded ------ at a higher price. P1 Q1 Q2 a b D D D` D` Q1 P1 P2 D D D` D`a b Quantity demanded Quantity demanded Pric e Price
  • 53.  Decrease in demand : a) Less quantity demanded ---- at same price. b) Same quantity demanded ---- lower price. Q2 Q1 P1 a b Q1 Quantity demanded P1 D` b D` D D D` D D a D` Price Price Quantity demanded P2
  • 54. Factors And Effects of Change (increase or decrease) in demand a) Change in income : Quantity demanded Price Increase Quantity demanded Price Decrease D` D` D D D D D` D`
  • 55. b) Change in taste, habit and preference : D D D` D` D D D` D` Quantity demanded Price Quantity demanded Price Positive Negative
  • 56. c) Change in fashion and customs : D D D` D` D D D` D` Quantity demanded Quantity demanded Price Price Favorable Unfavorable
  • 57. g) Change in population : 03/13/15 group 2 sec c 57 Quantity demanded Quantity demanded Price Price D` D` D` D` D D D D Increase Decrease
  • 58. h) Advertisement and publicity persuasion : 03/13/15 group 2 sec c 58 Quantity demanded Quantity demanded Price PriceD D D D D` D` D` D` Aggressive Docile
  • 59. i) Change in value of money : Quantity demanded Quantity demanded Price Price D` D` D` D` D D D D Deflationary Inflationary ( Value of money) ( Value of money)
  • 60. j) Change in level of taxation : Quantity demanded Quantity demanded D D` D` D` D D` D D Low High Price Price
  • 61. k) Expectation of future changes in prices : Quantity demanded Quantity demanded D` D` D` D` D D D D Rise Fall Price Price
  • 62. Shift in Demand Price Qd = 1300 – 20P (M = 20000) D0 Qd = 1600 – 20P (M = 20500) D1 Qd = 1000 – 20P (M = 19500) D2 65 0 300 0 60 100 400 0 50 300 600 0 40 500 800 200 30 700 1000 400 20 900 1200 600 10 1100 1400 800
  • 64. Determinants of Demand Determinants of Demand Demand Increase s Demand decreases Sign of Slope parameter Income (M) Normal Goods Inferior goods M rises M Falls M Falls M rises C > 0 C < 0 Price of related goods (PR) Substitute goods Complement good PR rises PR falls PR falls PR rises d > 0 d < 0 Consumer Tastes (T) T rises T falls e > 0 Expected price (Pe) Pe rises Pe Falls f > 0 Number of consumers (N) N rises N Falls g > 0
  • 65. Supply • The amount of a good or service offered for sale in a market during a given period of time (e.g a week, a month) is called quantity supplied.
  • 66. Concept of Supply • Supply is defined as the various amounts of goods and services which the sellers are willing and able to sell at any given price during a specific period of time • It is related to time, place and person • The supply of sugar is 50 kg is not a complete sentence • The supply of a sugar at price Rs 5/- is 50kg. Per day is the complete sentence
  • 67. Factors affecting Supply • Price • Price of other commodities • Goals of the producer • State of technology • Cost of production • Climate and forces of Nature • Transport facilities • Taxation: Heavy taxes supply will reduce • Expectation regarding future prices
  • 68. • Self-consumption • Time element: Short period the supply is fixed and vice
  • 69. Individual Supply Schedule Price Per Unit of X Qty. supplied of X U 5 10 V 10 20 W 15 30 X 20 40 Y 25 50 Z 30 60 Individual supply schedule is a tabular representation of the various quantities of commodity offered for sale by an individual seller at different prices during given period of time
  • 71. Market supply schedule • It is the tabular representation of the various qty. of a commodity offered for sale by all the sellers at different prices during a given period of time. It is the total supply of a commodity by all the sellers at different prices
  • 72. Market supply schedule Price( Rs ) Qty. supplied of X Market supply (I + II+ III) Seller I Seller II Seller III U 5 10 20 30 60 V 10 20 25 40 85 W 15 30 30 50 110 X 20 40 35 60 135 Y 25 50 40 70 160 Z 30 60 45 80 185
  • 74. Law of Supply • Others things remaining the same , qty. supplied of a commodity directly varies with its price. i.e. S= f (p) SUPPLY SCHEDULE Price Per Unit of X Qty. supplied of X U 5 10 V 10 20 W 15 30 X 20 40 Y 25 50 Z 30 60
  • 76. Assumption • Price of other commodities remains the same • The cost of production remains the same • The method of production remains the same • No change in the availability of goods • No change in transport facilities • No change in weather condition • No change in tax structure and govt. policies • Goals of producer remains the same • No change in expectation about the price • No natural calamities and no self consumption
  • 77. Exceptions to the law of supply • Backward bending supply curve Wage rate ( Rs.) Hours of work Daily Income (Rs.) 5 8 40 7 10 70 10 12 120 12 10 120
  • 78. • Fixed income groups: If person expects the income of Rs.20 he will save 500 Rs at 4% rate of interest and at 5% rate he will save Rs. 400 Rs. • Expectation regarding future prices • Need for cash by the seller • Rare collection the supply is permanently fixed whatever the price. • Self consumption
  • 79. Movements or variation in Supply • When there is change in supply exclusively due to change in Price
  • 80. Shift in supply When there is a change in supply due to change in factors other than the Price
  • 81. Generalized supply function • It shows how the different variables jointly determine the quantity supplied. • The generalized supply function is expressed mathematically as Qs = g(P, Pi, Pr, T, Pe, F)  Qs = Qty of goods and service offered for sale  P = Price of goods or service.  Pi = Price of inputs  Pr = Price of goods that are related to production.  T = Level of available technology.  Pr = Expected price of the producer  F = No. of firms in the industry
  • 82. Generalized supply function • As in case of demand, economists often find itself to express the generalised supply function in linear functional form: Qs = h + kP + lPi+ mPr + nT + rPe + sF • Where P, Pi, Pr, T, Pe, F is a variables affecting the supply, h is the intercept parameter, and k, l, m, n, r, and s are the slope parameters.
  • 83. Relation to Generalised demand function Variable Relation to Quantity supplied Sign of slope parameter P Direct K = is Positive Pi Inverse L = is Negative Pr Inverse for substitute in production (Wheat and Corn) Direct for complement in production(Oil and Gas) m = is Negative m = is Positive T Direct n = is Positive Pe Inverse r = is Negative F Direct S = is Positive
  • 84. Supply function • Supply function is derived from generalised supply function. • A supply function shows the relation between supply and price. Qs = g(P, Pi, Pr, T, Pe, F) = g (P)  Illustration Qs = 50 + 10P – 8pi + 5F • Suppose the price of the input is Rs. 50 and there are 90 firms then the supply function will be Qs = 50 + 10P -8(50) + 5(90) = 100 + 10P • The supply schedule with equation can be drawn and is given in next slide
  • 85. Qs = 100 +10P Price Quantity Supplied schedule 65 750 60 700 50 600 40 500 30 400 20 300 10 200
  • 86. Shift in Supply Price Qs = 100 + 10P Pi = 50, F = 90 Qs = 250 + 10P Pi = 31.25, F = 90 Qs = -200 + 10P Pi = 50, F = 30 65 750 900 450 60 700 850 400 50 600 750 300 40 500 650 200 30 400 550 100 20 300 450 0 10 200 350 0
  • 87. Shift in Supply Determinants of supply Supply Increases Supply Decreases Sign of Slope parameter Price of inputs (Pi) Pi falls Pi rises I < 0 Price of goods related in Production (Pr) Substitute good Complement good Pr falls Pr rises Pr rises Pr falls M < 0 M > 0 State of technology (T) T rises T falls n > 0 Expected Price (Pe) Pe falls Pe rises r < 0 Number of firms or productive capacity in Industry (F) F rises F falls S > 0
  • 88. Market Equilibrium • Demand and supply provide an analytical framework for the analysis of the behaviour of buyers and sellers in markets. • Demand shows how buyers respond to changes in price and other variables that determine quantities, buyers are willing to purchase. • Supply shows how sellers respond to changes in price and other variables that determine quantities offered for sale. • The interaction of buyers and sellers in the market place leads to market equilibrium.
  • 89. Market Equilibrium • Market equilibrium is a situation which at the prevailing price, consumers can buy all of a good they wish and producers can sell all of good they wish.
  • 90. Market Equilibrium Price Qs = 100 + 10P S0 Qd = 1300 – 20P D0 Excess supply ( +) Excess Demand ( -) 65 750 0 +750 60 700 100 +600 50 600 300 +300 40 500 500 0 30 400 700 -300 20 300 900 -600 10 200 1100 -900 Qd = Qs 1300 – 20 P = 100 + 10P Solving this equation for the equilibrium price, 1200 = 30P P = 40
  • 92. Market Equilibrium • At Market clearing price of 40 Qd = 1300 – (20 * 40) = 500 Qs = 100 + (10 * 40) = 500 • If the price is Rs 50 there is a surplus of 300 units. Using the demand and supply. equations, when P = 50, • Therefore, When price is Rs 50. Qd = 1300 – (20 * 50) = 300 Qs = 100 + (10 * 50) = 600 There fore when the price is Rs 50 Qs – Qd = 600 – 300 = 300
  • 93. Changes in Market Equilibrium Demand Shifts (Supply remains constant)
  • 94. Supply Shifts (Demand Remains constant)
  • 95. Simultaneous Shift in Demand and Supply
  • 96. Simultaneous Shift in Demand and Supply
  • 97. Predicting the Direction of change in Airfares (Qualitative analysis) • Suppose you manage a travel department for a U.S. corporation and your sales force makes heavy use of air travel to call on customers. • The president of the corporation to reduce travel expenditures for 2004. • You need to predict what will happen in future price of airfares in 2004. • The wall street journal recently came with the news.  A number of new, small airlines have recently entered the industry and others are expected to enter in 2004.  Video-conferencing is becoming a popular, cost effective alternative to business travel for many U.S. corporation. The trend will cut the price on teleconferencing rates.
  • 98. Direction of change in Airfares: Qualitative Analysis
  • 99. ELASTICITY OF DEMAND • The degree of responsiveness of Qty. demanded of a commodity to a change in its price is known as elasticity of demand. • Ed = % change in qty. dd /% change in determinant • Elastic: Small change in price brings big change in demand • Inelastic: Big change in price brings small change in demand
  • 100. Kinds of Elasticity • Price Elasticity • Income Elasticity • Cross Elasticity • Arc Elasticity
  • 101. PRICE EASTICITY OF DEMAND • IT is the degree of responsiveness of qty. demanded of a commodity to a change in its price. • Ed = % change in qty. dd /% change in P • Ed = proportionate change in qty. dd /Proportionate change in P • Ed = Q / Q = Q / Q * P / P P / P
  • 102. Definition: Elasticity of Demand Price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price. Equation: Elasticity of Demand = % change in Qd % change in Price
  • 103. Example Suppose Mongini’s cake is originally priced at Rs. 10 and the amount sold is 50 cakes per week. If the price is increased to Rs. 11, then 40 cakes are sold per week. What is the price elasticity of demand? % Change in Price = [(11-10)/10]*100 = 10% % Change in Quantity Demanded = [(40-50)/50]*100 = 20 % (ignoring the negative sign) Elasticity = 20/10 = 2 Even a very small change in price has lead a high-proportional fall in quantity demanded.
  • 104. TYPES OF PRICE ELASTICITY OF DEMAND
  • 105. TYPES OF PRICE ELASTICITY OF DEMAND
  • 106.
  • 107. The Farmer’s Dilemma • For many crops, a strange situation arises a bad crop year results in a good year for farm incomes, and a good crop year results in a bad year for farm incomes. How can this be? • Price elasticity gives us the answer: – Bad crop year: supply decreases, prices for farm products rise, but quantity demanded doesn’t fall very much. The quantity demanded of farm products is not very responsive to changes in prices – Good crop year: supply increases, prices for farm products fall, but quantity demanded doesn’t increase very much. The quantity demanded of farm products is not very responsive to changes in prices • It is easy to show this with a graph. But first we need yet another concept: Total Revenue = Price x Quantity
  • 108. Measurement of price elasticity of demand • Percentage Method • Total outlay Method • Geometric Method
  • 109. Percentage Method or Ratio Method • It is the ratio of % change in Demand to a % change in Price. • Ed = % Q OR Q * P = P * Q • % P Q P Q P • Unit elastic Ed =1 • Relatively Elastic Ed >1 • Relatively Inelastic Ed <1
  • 110.
  • 111.
  • 112. Total Outlay Method or Revenue Or Expenditure Method Price (Rs) QTY. DD (units) Total Outlay (Rs) Elasticity 50 5 250 Relatively elastic Ed > 140 10 400 30 20 600 Unit Elastic Ed = 1 20 30 600 10 40 400 Relatively inelastic Ed < 15 50 250
  • 113. Geometric Method Or Exact Method • Ed = Lower segment of demand curve Upper segment of demand curve Ed at pt A = D’A/DA = 1 Ed at pt B = D’B/DB = 1/3 < 1 Ed at pt C = D’C/DC =9/3 > 1
  • 114. Other concepts of Elasticity of Demand • Income Elasticity of Demand = Q * Y Y Q Ed = % change in qty. dd /% change in Y • Cross Elasticity of Demand = Q x * P y P y Q x Arc elasticity of Demand = Q x P Q1+ Q2 P1+ P2
  • 115. Factors Influencing Elasticity • Nature of commodity: Necessary or luxurious goods • Availability of substitutes: • Number of Uses of a commodity:  Multipurpose elastic and vice-versa. • Income: • Proportion of Expenditure:  A small prop. Of exp demand is elastic. • Time period:
  • 116. • Height of Price and Range of Price change:  Very low or very High price demand is inelastic; Diamonds or salt but moderately priced goods have elastic demand. • Urgent or postponement: • Durability of commodity:  Short run Inelastic , but long run elastic Perishable goods is elastic. • Habits and customs: • Complementary goods: Inelastic
  • 117. • Recurring Demand: Relatively elastic • Demonstration effect:
  • 118. Significance of elasticity of Demand • Useful to Producer and monopolist: • Useful to the govt. • Factor pricing: • Importance to trade unionist: • International Trade: • Useful to policy Makers: Prices of agricultural goods , Fiscal and monetary policies etc.
  • 119. THEORY OF PRODUCTION • The fundamental questions that managers are faced with are  How can production optimized or cost minimize?  How does output respond to change in quantity of inputs?  How does technology matter in reducing the cost of production?  How can the least- cost combination of inputs be achieved?  Given the technology, what happens to the rate of return
  • 120. Input and output • An input is simply anything which the firm buys for in its production or other processes. • Inputs are classified as 1) Fixed inputs: A fixed input is one whose supply is inelastic in the short-run. In technical sense, a fixed factor is one that remains fixed (or constant) for a certain level of output. 2) Variable inputs: A variable input is defined as one whose supply in the short-run is elastic, e.g., labour and raw material, etc. all the users of such factors can employ a larger quantity in the short-run as well as in the long-run.
  • 121. Short-run and Long-run Production  The short-run refers to a period of time in which the supply of certain inputs (e.g. plant, building, machinery etc.) is fixed or inelastic.  In the short-run therefore, production of a commodity can be increased by increasing the use of only variable inputs like labour and raw materials.  Variable Input: labor force, Fixed Input: machinery, plant size, raw materials.  Long-run refers to a period of time in which the supply of all the inputs is elastic, but not enough to permit a change in technology.  That is, in the long-run, all the inputs are variable.  Corresponds to the planning stage
  • 122. Production Function • The total amount of output produced by a firm is a function of the levels of input usage by the firm. • Relation Between Input and Output – the maximum amount of output that can be obtained per period of time given the factor inputs is captured by the production function. • Describes purely Technological Relationship. • Flow Concept.
  • 123. Production Function • A real-life production function is generally very complex. Q = f(LB, L, K, M, T, t) • Where LB = land and building L= labour, K= capital, M= raw materials, T= technology and t= time. • The economists have however reduced the number of input variables used in a production function to only two, viz., capital(K) and labour(L), for the sake of convenience and simplicity in the analysis of input- output relations.
  • 124. Production Function • Also, technology (T) of production remains constant over a period of time. • That is why, in most production functions, only labour and capital are include • As such, the general form of its production function for coal mining firm may be expressed as Qc = f (K, L) • Where Qc = the quantity of coal produced per time unit, K = capital, and L = labour.
  • 125. Production Function • The short-run production function or what may also be termed as ‘single variable input production function’, can be expressed as • Q = f (K, L) where K is a constant …(1a) • For example, suppose a production function is expressed as Q = bL • Where b = gives constant returns to labour.
  • 126. Total, Average and Marginal Product • Total Product: Total Output Produced during some period of time by all factors of Production employed during that Period. • Total Product (TP) function – In the Short Run captures relationship between the amount of labor and the level of output, ceteris paribus
  • 127. Total Product Quantity of Labour Total Product 0 0 5 50 10 120 15 180 20 220 25 250 30 270 35 275 40 275 45 270 Variation of Output (One fixed, one variable factor), with Capital fixedat say 5 Units
  • 128. Average Product • AP is merely the Total product per Unit of the Variable Factor AP = TP / L
  • 129. Average Product Quantity of Labour Total Product Average Product 0 0 … 5 50 10.00 10 120 12.00 15 180 12.00 20 220 11.00 25 250 10.00 30 270 9.00 35 275 7.86 40 275 6.88 45 270 6.00
  • 130. Marginal Product (MP) • The additional output that results from the use of an additional unit of a variable input, holding other inputs constant. • Measured as the ratio of the change in output (TP) to the change in the quantity of labor (or other variable input) used • MP = ∆ in Output / ∆ in Labour
  • 131. Marginal Product Quantity of Labour Total Product Change in TP Marginal Product 0 0 … … 5 50 50 10 10 120 70 14 15 180 60 12 20 220 40 8 25 250 30 6 30 270 20 4 35 275 5 1 40 275 0 0 45 270 -5 -1
  • 132. Marginal Product (Continued) • Note that the MP is positive when an increase in labor results in an increase in output; • A negative MP occurs when output falls when additional labor is used.
  • 133. Production Function • In the long -term production function, both K and L are included and the function takes the following form. Q = f (K, L) …(1b) • Consider, for example, the Cobb-Douglas production function-the most famous and widely used production function – given in the form of an equation as Q = …(1.2) • (where K= capital, L= Labour, and A , a and b, are parameters and b =1 – a).
  • 134. • α and β are the output elasticities of capital and labor, respectively. • These values are constants determined by available technology. • Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. • For example if α = 0.45, a 1% increase in capital usage would lead to approximately a 0.45% increase in output.
  • 135. Production Function • Production function (1.2) gives the general form of Cobb- Douglas production function. • The numerical values of parameters A, a and b, can be estimated by using actual factory data on production, capital and labour. • Suppose numerical values of parameters are estimated as A=50, a=0.5 and b=0.5. • Once numerical values are known, the Cobb-Douglas production function can be expressed in its specific form as follows.
  • 136. Production Function • This production function can be used to obtain the maximum quantity (Q) that can be produced with different combinations of capital (K) and Labour (L). • The maximum quantity of output that can be produced from different combinations of K and L can be worked out by using the following formula.
  • 137. Production Function • For example, suppose K = 2 and L = 5. Then • And if K = 5 and L = 5, then • Similarly, by assigning different numerical values to K and L, the resulting output can be worked out for different combinations of K and L and a tabular form of production function can be prepared.
  • 138. Similarly, by assigning different numerical values to K and L, the resulting output can be worked out for different combinations of K and L and a tabular form of production function can be prepared. • It is important to note that the four combinations of K and L • 10K + 1L • 5K + 5L • 2K + 5L and • 1K + 10L produces the same output
  • 139. Production with one variable input • The law of diminishing returns states that when more and more units of a variable input are used with a given quantity of fixed inputs, • The total output may initially increase or increasing rate, but it will eventually increase at increasing rate. • That is, marginal increase in total output decreases eventually when additional units of a variable factor are used, given quantity of fixed factors.
  • 140. Assumptions: • The law of diminishing returns is based on the following assumptions: Labor is the only variable input, capital remaining constant; Labour is homogeneous; Input prices are given.
  • 141. • To illustrate the law of diminishing returns, we assume i) That a firm (say, the coal mining firm in our earlier example) as a set of mining machinery as its capital (K) fixed in the short-run and ii) It can employ only more mine workers to increase its coal production.
  • 142. • Thus, the short run production function for the firm will take the following form. constant),Qc Kf(L= Let us assume also that the labour output relationship in coal production is given by a hypothetical production function of the following form. constantL,Q 3 c K1015LL 2 ++−=
  • 143. • Given the production function, we may substitute different numerical values of L in the function and work out a series of Qci.e. • The quantity of coal that is produced with different number of workers. • For example, if L = 5, then by substitution, we get • Qc= -53 + 15 x 52 + 10 x 5 = -125 + 375 + 50 = 300
  • 144. • What we need now is to work out marginal productivity of labour (MPL) to find the trend in the contribution of the marginal labour and average productivity of labour (APL) to find the average contribution of labour. • Marginal Productivity of Labour (MPL) can be obtained by differentiating the production function. • Thus, • can be written as 10303 2 ++−= ∂ ∂ = LL L Q MPL constantL),(Q 3 c K1015LL 2 ++−=
  • 145. • Alternatively, where labour can be increased at least by one unit (MPL) can be obtained as MPL = TPL - TPL-1 • Average Productivity of Labour (APL) can be obtained by dividing the production function by L. Thus, 1015 1015 2 23 ++−= ++− = LL L LLL APL
  • 146. No of Workers (N) Total Product (TPL) (tones) Marginal Product* (MPL) Average product (APL) Stages of production(based on MPL) 1 2 3 4 5 1 2 3 4 5 6 24 72 138 216 300 384 24 48 66 78 84 84 24 36 46 54 60 64 I Increasing returns 7 8 9 10 462 528 576 600 78 66 48 24 66 66 64 60 II Diminishing Returns 11 12 594 552 -6 -42 54 46 III Negative returns
  • 147.
  • 148. SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION • Long-run and short-run production: – fixed and variable factors • The law of diminishing returns • The short-run production function: – total physical product (TPP) – average physical product (APP) – marginal physical product (MPP) – the graphical relationship between TPP, APP and MPP
  • 149. Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)
  • 150. 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Number of farm workers Tonnesofwheatproducedperyear Number of workers 0 1 2 3 4 5 6 7 8 TPP 0 3 10 24 36 40 42 42 40
  • 151. Wheat production per year from a particular farm 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Number of farm workers Tonnesofwheatproducedperyear TPP
  • 152. Wheat production per year from a particular farm 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Number of farm workers Tonnesofwheatproducedperyear TPP a b Diminishing returns set in here
  • 153. Wheat production per year from a particular farm 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Number of farm workers Tonnesofwheatproducedperyear TPP a b d Maximum output
  • 154. 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Number of farm workers (L) Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear Number of farm workers (L) ∆TPP = 7 ∆L = 1 MPP = ∆TPP / ∆L = 7
  • 155. 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear MPP Number of farm workers (L) Number of farm workers (L)
  • 156. 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP APP = TPP / L Number of farm workers (L) Number of farm workers (L)
  • 157. 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP b Diminishing returns set in here Number of farm workers (L) Number of farm workers (L) b
  • 158. 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP b d d Number of farm workers (L) Number of farm workers (L) Maximum outputb
  • 159. 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP b b d d Number of farm workers (L) Number of farm workers (L) Slope = TPP / L = APP c c
  • 160. Iso-quants An iso-quant is a curve or line that has various combinations of inputs that yield the same amount of output.
  • 161. Production function •Here we will assume output is made with the inputs capital and labor. K = amount of capital used and L = amount of labor. •The production function is written in general as Q = F(K, L) – sometimes we put a y instead of Q, where Q = output, and F and the parentheses are general symbols that mean output is a function of capital and labor. •The output, Q, from the production function is the maximum output that can be obtained form the inputs. •On the next screen we will see some isoquants. Note: on a given curve L and K change while Q is fixed.
  • 162. ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS • Iso-quants – their shape – diminishing marginal rate of substitution – isoquants and returns to scale – isoquants and marginal returns • Iso-costs – slope and position of the isocost – shifts in the isocost
  • 163. Units of K 40 20 10 6 4 Units of L 5 12 20 30 50 Point on diagram a b c d e a Units of labour (L) Unitsofcapital(K) An isoquant 0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45 50
  • 164. Units of K 40 20 10 6 4 Units of L 5 12 20 30 50 Point on diagram a b c d e a b Units of labour (L) Unitsofcapital(K) An isoquant 0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45 50
  • 165. An isoquant Units of K 40 20 10 6 4 Units of L 5 12 20 30 50 Point on diagram a b c d e a b c d e Units of labour (L) Unitsofcapital(K) 0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45 50
  • 166. MRTS • The slope of the isoquant defines the substitutability between two factors of inputs (capital and labor). • This is known as the marginal rate of technical substitution (MRTS) and is presented mathematically as:
  • 167. 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 16 18 20 22 Unitsofcapital(K) Units of labour (L) g h ∆K = 2 ∆L = 1 isoquant MRS = 2 MRS = ∆K / ∆L Diminishing marginal rate of factor substitution
  • 168. 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 16 18 20 Unitsofcapital(K) Units of labour (L) g h j k ∆K = 2 ∆L = 1 ∆K = 1 ∆L = 1 Diminishing marginal rate of factor substitution isoquant MRS = 2 MRS = 1 MRS = ∆K / ∆L
  • 169. 0 10 20 30 0 10 20 An isoquant mapUnitsofcapital(K) Units of labour (L) I1
  • 170. 0 10 20 30 0 10 20 I2 Unitsofcapital(K) Units of labour (L) An isoquant map I1
  • 171. 0 10 20 30 0 10 20 I2 I3 Unitsofcapital(K) Units of labour (L) An isoquant map I1
  • 172. 0 10 20 30 0 10 20 I2 I3 I4 Unitsofcapital(K) Units of labour (L) An isoquant map I1
  • 174. • Assume that there are two resources, Labor (L) and Capital (K). • The money payments to these resources are Wages (W) and Rent (R). • An isocost line is similar to the budget line. It’s a set of points with the same cost, C. Let’s plot K on the y axis and L on the x axis. WL + RK = C; solve for K by first subtracting WL from both sides. RK = C - WL; next divide both sides by R. K = C/R – (W/R)L; note that C/R is the y intercept and W/R is the slope. A Cost Function: Two Resources
  • 175. C/R C/W Absolute value of slope equals The relative price of Labor, W/R. K (machines rented) Labor hours used in production An isocost line
  • 176. Bundles of: Labor Machine rental with C = Rs30 (Rs6 per labor hour) (Rs3 per machine hour) a 0 10 b 1 8 c 2 6 d 3 4 e 4 2 f 5 0 A Numerical Example Points a through f lie on the isocost line for C = Rs30/hour.
  • 177. The Isocost Line 0 1 2 3 4 5 6 7 8 9 10 2 4 6 8 10 Labor, L (worker-hours employed) Capital,K(machinesrented) a b c d e f
  • 178. The Isocost Line • Wage-rental ratio – With K on the y axis and L on the x axis, the slope of any isocost line equals W/R, the wage-rental ratio. It is also the relative price of labor. • The y-intercept shows the number of units of K that could be rented for Rs.C. • The x-intercept shows the number of units of L that could be hired for Rs.C.
  • 179. Changes in One Resource Price 0 1 2 3 4 5 6 7 8 9 10 Capital,K(machinesrented) 2 4 6 8 10 Labor, L (worker-hours employed) a f Cost = Rs30; R = Rs3/machine The money wage, W = ... …Rs6 …Rs10 A Change in W h
  • 180. Changes in Cost 0 1 2 3 4 5 6 7 8 9 10 Capital,K(machinesrented) 2 4 6 8 10 Labor, L (worker-hours employed) g h A Change in Cost; every point between g and h costs Rs18. W = Rs6; R = Rs3;C = Rs30
  • 181. Cost Minimization 0 1 2 3 4 5 6 7 8 9 10 Capital,K(machinesrented) 2 4 6 8 10 Labor, L (worker-hours employed) a equ. W = Rs6; R = Rs3;C = Rs30 Choose the recipe where the desired isoquant is tangent to the lowest isocost. C = Rs18 12 C = Rs36
  • 182. Conclusion: Buy resources such that the last dollar spent on K adds the same amount to output as the last dollar spent on L. • The |slope| of the isocost line = W/R. • The |slope| of the isoquant = MPL/MPK – This will be demonstrated on the board.
  • 183. 0 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 An isocost Units of labour (L) Unitsofcapital(K) Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs300 000 TC = Rs300 000 a
  • 184. 0 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 Units of labour (L) Unitsofcapital(K) TC = Rs300 000 a b Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs300 000 An isocost
  • 185. 0 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 Units of labour (L) Unitsofcapital(K) TC = Rs300 000 a b c Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs300 000 An isocost
  • 186. 0 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 Units of labour (L) Unitsofcapital(K) TC = Rs300 000 a b c d Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs300 000 An isocost
  • 187. ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS • Least-cost combination of factors for a given output – point of tangency – comparison with marginal productivity approach • Highest output for a given cost of production
  • 188. 0 5 10 15 20 25 30 35 0 10 20 30 40 50 Finding the least-cost method of production Units of labour (L) Unitsofcapital(K) Assumptions PK = Rs20 000 W = Rs10 000 TC = Rs200 000 TC = Rs300 000 TC = Rs400 000 TC = Rs500 000
  • 189. 0 5 10 15 20 25 30 35 0 10 20 30 40 50 Units of labour (L) Unitsofcapital(K) Finding the least-cost method of production TPP1
  • 190. 0 5 10 15 20 25 30 35 0 10 20 30 40 50 Units of labour (L) Unitsofcapital(K) Finding the least-cost method of production TC = Rs400 000 r TPP1
  • 191. 0 5 10 15 20 25 30 35 0 10 20 30 40 50 Units of labour (L) Unitsofcapital(K) Finding the least-cost method of production TC = Rs400 000 TC = Rs500 000 s r t TPP1
  • 192. Finding the maximum output for a given total cost TPP1 TPP2 TPP3 TPP4 TPP5 Unitsofcapital(K) Units of labour (L) O
  • 193. O Isocost Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 Finding the maximum output for a given total cost
  • 194. O r v Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 Finding the maximum output for a given total cost
  • 195. O s u Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 r v Finding the maximum output for a given total cost
  • 196. O t Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 r v s u Finding the maximum output for a given total cost
  • 197. O K1 L1 Unitsofcapital(K) Units of labour (L) TPP1 TPP2 TPP3 TPP4 TPP5 r v s u t Finding the maximum output for a given total cost
  • 198. Properties of Iso-Quant • An isoquant has a negative slope in the economic region and in the economic range of isoquant. • Economic region is also known as the product maximizing region. • The negative slope of the isoquant implies substitutability between the inputs. • It means that if one of the inputs is reduced, the other input has to be so increased that the total output remains unaffected.
  • 199. • Isoquants are convex to the origin  Convexity of isoquants implies two things. I) substitution between the two inputs, and II) diminishing marginal rate of technical substitution (MRTS) between the inputs in the economic region. III)The MRTS is defined as, = slope of the isoquant. IV)MRTS is the rate at which a marginal unit of labour can substitute a marginal unit of capital (moving downward on the isoquant) without affecting the total output. ΔL ΔK MRTSLK − =
  • 200. • This rate is indicated by the slope of the isoquant. • The MRTS decreases for two reason: i) no factor is a perfect substitute for another, and ii)inputs are subject to diminishing marginal returns. Therefore, more and more units of an input are needed to replace each successive unit of the other input.
  • 201. • the corresponding units of L substituting K go (in fig.) on increasing i.e. • As a result, MRTS = goes on decreasing i.e., • 321 ΔΔΔ LLL << 321 ΔKΔKΔK == L K ∆ ∆
  • 202.
  • 203. • Isoquants are non-intersecting and non- tangential. This implies that in terms of output. L1 Q2 = 200 Q1 = 200 L2 O K M Capital (K) Labour (L) Fig. Intersecting Isoquants J (K)KL(L)OL(K)JL(L)OL 2222 +=+
  • 204. • Since OL2 is common to both the sides, it means, J L2(K) = K L2 (K) But it can be seen in fig that J L2 < K L2(K)but the intersection of the two isoquants means that JL2 and KL2 are equal in terms of isoquants will not intersect or be tangent to each other.
  • 205. Upper isoquants represent higher level of output. b a IQ2 = 200 IQ1 = 200 XO Quality of K Quality of L Fig. Comparison of Output at Two Isoquaqnts c
  • 206. Economic region Q1 Upper ridge line Lower ridge line f g h a b c d Q3 Q2 Q4 Capital (K) Labour (L) o Economic region is that area of production plane in which substitution between two inputs is technically feasible without affecting the output. This area is marked by locating the points on the isoquants at which MRTS = 0. A zero MRTS implies that further substitution between inputs is technically not feasible. It also determines the minimum quantity of an input that must be used to production a given output. Beyond this point, an additional employment of one input will necessitates employing additional units of the other input.
  • 207. • By joining the resulting points a, b, c and d we get a line called the upper ridge line, Od, similarly by joining the points e, f, f and h we get the lower ridge line, Oh. • The ridge lines are locus of points on the isoquants where the marginal products (MP) of the inputs are equal to zero. • The upper ridge line implies that MP of capital is zero along the line, Od. The lower ridge line implies that MP of labour is zero along the line, Oh. • The area between the two ridge lines, Od, and Oh, is called ‘Economic Region’ or technically efficient region of production. Upper ridge line Lower ridge line f g h a b c d Q3 Q2 Q4 Capital (K) Labour (L) o
  • 208. The laws of returns to scale • The laws of returns to scale explain the behavior of output in response to a proportional and simultaneous change in inputs, increasing inputs proportionately and simultaneously is, in fact, an expansion of the scale of production.
  • 209. Three technical possibilities • Total output may increase more than proportionately. • Total output may increase proportionately and • Total output may increase less than proportionately
  • 210. kinds of returns to scale • Increasing returns to scale; • Constant returns to scale, and • Diminishing returns to scale.
  • 211. Increasing returns to scale • When inputs, K and L are increased at a certain proportion and output increase more than proportionately, it exhibits increasing returns to scale. • The increasing returns to scale is illustrated in fig.
  • 212. Increasing returns to scale Product lines Q = 50 Q = 25 Q = 10 B C c b a 4K 3K 2K 1K 1L 2L 3L 4L Labour (L) Fig. Increasing Returns to Scale The movement from point a to b on the line OB means doubling the inputs. It can be seen in fig that input combination increases from 1K + 1L to 2K + 2L. As a result of doubling the inputs, output is more than doubled; it increases from 10 to 25 units e.g. an increase of 150%. Similarly, the movement from point b to point c indicates 50% increase in inputs as a result of which the output increases from 25 units to 50 units i.e. by 100%. O Capital (K)
  • 213. Economies of scale • The scale of production has an very important bearing on the cost of production. • It is the manufacturer’s common experience that larger the scale of production, the lower generally is the average cost of production. • That is why the entrepreneur is tempted to enlarge the scale of production so that he benefit from the resulting economies of scale. • There are two types of Internal and External Economies.
  • 214. Internal Economies of Scale • These are those economies in production, those in production costs, which accrue to the firm itself when it expands its output or enlarges its scale of production. • The internal economies arise within a firm as a result of its own expansion of the industry. • The internal economies are simply due to the increase in the scale of production. • They arise from the use of the methods which small firms do not find it worthwhile to employ.
  • 215. Three reasons for increasing returns to scale • Technical and managerial indivisibilities:  Certain inputs, particularly mechanical equipments and managers, used in the process of production are available in a given size.  Such inputs cannot be divided into parts to suit small scale of production.  Because of indivisibility of machinery and managers, given the state of technology, they have to be employed in a minimum quantity even if scale of production is much less than the capacity output.  Therefore, when scale of production is expanded by increasing all the inputs, the productivity of indivisible factors increases exponentially because of technological advantage. This results in increasing returns to scale.
  • 216. Internal Economies • Labour Economies: Division of Labour, this will increase the efficiency, saves time and promote skill information. • Technical economies: Modern machinery. • Marketing Economies: Buying inputs at large qty when it expands the output. Small firms are deprived of these benefits.  The cost of marketing the product is also reduced providing thereby the economies of large scale transportation.  Per unit advertisement cost is reduced.
  • 217. • Higher degree of specialization (Managerial economies)  The use of specialized labour suitable to a particular job and of a composite machinery increases productivity of both labour and capital per unit of inputs. • Financial economies: The finance will be available at competitive rate and at easy terms. Can also raise money from the market, because of its goodwill. • Risk Bearing Economies: Can diversify the risk by selling products in different parts of the world.
  • 218. • Dimensional relations For example, when the length and breadth of a room (15’ x 10’ =- 150 Sq. ft.) are doubled then the size of the room is more than doubled; it increases to 30’ x 20’ = 600 sq. ft. In accordance with this dimensional relationship, when the labour and capital are doubled, the output is more than doubled and so on.
  • 219. External Economies • These are those economies which accrue to each member firm as a result of the expansion of the industry as a whole.
  • 220. External Economies • Availability of raw-material and machineries at lower price: Expansion of the industry may results in the availability of inputs like raw-material and other equipments at lower prices. • Technical external economies: Since the growth of industry enables the firm to use the new technical know-how employing thereby improved machinery and other inputs. • Development of Skill labour: By training and development of the industry. • The growth of subsidiary industry: Will supply the raw-material. • Transport and marketing facilities: • Information Service: Will disseminate information, technical knowledge and R and D
  • 221. Constant returns to scale • When the increase in output is proportionate to the increase in inputs it exhibits constant returns to scale. Fig. Constant Return to Scale Capital (K) 1011 ⇒+ LK 2022 ⇒+ LK 3033 ⇒+ LK Product lines Q = 30 Q = 20 Q = 10 B c b a 4K 3K 2K 1K 1L 2L 3L 4L Labour (L)
  • 222. Decreasing Return to Scale • When economies of scale reach their limits and diseconomies are yet to begin, returns to scale become constant. • For example, doubling of coal mining plant may not double the coal deposits. • Similarly doubling the fishing fleet may not double the fish output because availability of fish may decrease in the ocean when fishing is carried out on an increased scale.
  • 223. Product lines Labour (L) Fig. Decreasing Return to Scale Scale Q = 24 Q = 18 Q = 10 B C 4K 3K 2K 1K 1L 2L 3L 4L Capital (K) Decreasing Return to Scale c b a
  • 224. INTERNAL DISECONOMIES • Large scale production firms faces a problem of management and control over the production unit. • Lack of proper coordination and supervision of different departments. • So growth of the firm beyond the limit will bring more problems. • The increase in the scale of output beyond its optimum size creates the managerial structure inflexible and cumbersome which ultimately reduces efficiency of the management
  • 225. External Diseconomies • Constraints in the Supply of raw-material. • Demand for labour will increase due to growth of industry. • Instabilities of demand for the product
  • 226. Economies of Scope • When the cost efficiencies in production allow the firm to produce a variety of products rather than a single product in large volume, it can be referred to the Economies of Scope. • This allows product diversification in the same scale of plant and with the same technology.
  • 227. Returns to Scale (Summary) • Increasing returns to scale – When the % change in output > % change in inputs • E.g. a 30% rise in factor inputs leads to a 50% rise in output – Long run average total cost will be falling • Decreasing returns to scale – When the % change in output < % change in inputs • E.g when a 60% rise in factor inputs raises output by only 20% – Long run average total cost will be rising • Constant returns to scale – When the % change in output = % change in inputs – E.g when a 10% increase in all factor inputs leads to a 10% rise in total output – Long run average total cost will be constant
  • 228. Consumer Surplus • The concept was formulated by Dupuit in 1844 to measure the social benefits of Public goods such as canals, bridges, national highways etc, • Marshall further popularized the concept • The concept was based on cardinal measurability and interpersonal comparison of utility
  • 229. Concept or Defination • It is simply the difference between ‘the price that one is willing to pay’ and the ‘price one actually pays pays’ for a particular product. • It is also used in policy formulation by government and price policy purchased by the monopolistic seller of a product.
  • 230. • People generally get more utility from the consumption of goods than the price they actually pay for them. • This extra satisfaction which the consumer obtains from buying a good is called as consumer surplus.
  • 231. • The amount of money which a person is willing to pay for a good indicates the amount of utility he derives from that good. • Marginal utility of a unit of a good determines the price a consumer will be prepared to pay for that unit. • The total utility which a person gets from a good is given by the sum of marginal utilities ( ∑ MU) of the units of a good purchased.
  • 232. • The total price the consumer actually pays is equal to the price per unit of the good multiplied by the number of units of it purchased. • Consumer’s surplus = ∑ MU – (Price * No. of units of a commodity purchased.)
  • 233. Consumer Surplus and DMU • The concept of consumer surplus is derived from the law of diminishing marginal utility. • As the consumer purchase more units of a good its MU diminishes and the consumer’s willingness to pay for additional units of commodity declines. • The consumer is in equilibrium when MU from a commodity becomes equal too its price. • That is consumer purchases the number of units of commodity at which MU equals price.
  • 234. • This means willingness to pay and actually pays are equal but rest previous units there is a consumer surplus. • But for the previous units customer’s willingness to is greater than the price he actually pays for them. • Because the price of all units are same.
  • 235. Consumer Surplus • It measures extra utility or satisfaction which a consumer obtains from the consumption of a certain amount of a commodity over and above the utility of its market value. • The total utility obtained from consuming water is immense while its market value is negligible. • It is due to the occurrence of DMU that a consumer gets total utility from the consumption of a commodity greater than its market value
  • 236. • Marshall tried to obtain the monetary measure of this surplus, i.e. how many rupees this surplus of utility is worth to consumer. • It is the monetary value of this surplus that Marshall called Consumer surplus.
  • 237. Determine Monetary value of Surplus • Total utility of money in terms of money that consumer expects to get from consumption of a certain amount of commodity. • The total market value of the amount of commodity consumed by him. • It is easy to find out market value i.e. P*Q
  • 238. Marginal Utility and Consumer Surplus No. of Units Marginal Utility Price Net Marginal Benefit 1 20 12 8 2 18 12 6 3 16 12 4 4 14 12 2 5 12 12 0 6 10 12 -2 Consumer Surplus (from 5 Units) = 20
  • 239. The consumer surplus of purchasing 5 units is the sum of the surplus derived from each one individually. Consumer Surplus 8 + 6 + 4 + 2 + 0 + -2 = 20 Consumer Surplus - Example Price of X Price (Rs) 2 3 4 5 6 13 0 1 14 10 12 14 16 18 20 Market Price Will not buy more than 5 because surplus from additional units is negative
  • 240. Consumer Surplus The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller. Consumer surplus measures the total net benefit to consumers = total benefits from consumption (-)the total expenses. Thus, consumer surplus is area under the demand curve and above the price. Note that the area under the demand curve up to the level of consumption measures the total benefits.
  • 241. Demand Curve Consumer Surplus Consumer Surplus Price of X Price (Rs.) 2 3 4 5 60 1 Actual Expenditure 12 20 Market Price
  • 242. Consumer Surplus and Market Price A lower market price will usually increase consumer surplus.  A higher market price will usually reduce consumer surplus. Consumer surplus will be smaller when the demand curve is more elastic and larger when the demand curve is inelastic.
  • 243. How the Price Affects Consumer Surplus? Initial consumer surplus Quantity Consumer Surplus at Price P2 vs. at Price P1 Price 0 Demand A B C D E F P1 Q1 P2 Q2 Consumer surplus to new consumers Additional consumer surplus to initial consumers
  • 244. Consumer Surplus Price Quantity D Po Qo Maximum Willingness to Pay for Qo What is paid Consumer Surplus
  • 245. Original Consumer Surplus Change in Consumer Surplus: Price Increase Quantity New Consumer Surplus Loss in Surplus: Consumers paying more Loss in Surplus: Consumers buying less Price D Po Qo P1 Q1
  • 246. PRODUCER SURPLUS • The revenue that producers obtain from a good over and above the price paid. • This is the difference between the minimum supply price that sellers are willing to accept and the price that they actually receive. • A related notion from the demand side of the market is consumer surplus.
  • 247. • Producers' surplus is the extra revenue received when selling a good. • The supply price is less than the price actually received. • Most producers under most circumstances receive some surplus of revenue. • Even competitive markets overflowing with efficiency generate an ample amount of producer surplus.
  • 248. Producer Surplus • The amount a seller is paid , minus the seller’s cost. • It is the area above the supply curve, and below the equilibrium price.
  • 249. Minimum Amount Needed to Supply Qo Producer Surplus Price Quantity Po Qo What is paid Producer Surplus S
  • 250. Consumer and Producer Surplus Price Quantity Po Qo S Producer Surplus Consumer Surplus D
  • 251. The magic of perfectly competitive markets • At equilibrium, both consumer and producer surplus are at their maximum • Any interference with the equilibrium price in perfectly competitive markets will reduce total consumer and producer surplus
  • 252. Cost • By "Cost of Production" is meant the total sum of money required for the production of a specific quantity of output. In the word of Gulhrie and Wallace: • "In Economics, cost of production has a special meaning. • It is all of the payments or expenditures necessary to obtain the factors of production of land, labor, capital and management required to produce a commodity. • It represents money costs which we want to incur in order to acquire the factors of production".
  • 253. Cost of Production • The following elements are included in the cost of production: (a) Purchase of raw machinery, (b) Installation of plant and machinery, (c) Wages of labor, (d) Rent of Building, (e) Interest on capital, (f) Wear and tear of the machinery and building, (g) Advertisement expenses, (h) Insurance charges, (i) Payment of taxes, (j) In the cost of production, the imputed value of the factor of production owned by the firm itself is also added, (k) The normal profit of the entrepreneur is also included In the cost of
  • 254. FIXED, VARIABLE, AND INCREMENTAL COSTS • Fixed costs: unaffected by changes in activity level over a feasible range of operations for the capacity or capability available. • Typical fixed costs include: insurance and taxes on facilities general management and administrative salaries license fees interest costs on borrowed capital. • Fixed costs will be affected When: large changes in usage of resources occur plant expansion or shutdown is involved
  • 255. FIXED, VARIABLE AND INCREMENTAL COSTS • Variable costs: associated with an operation that vary in total with the quantity of output or other measures of activity level. • Example of variable costs include : Costs of material and labor used in a product or service.
  • 256. FIXED,VARIABLE AND INCREMENTAL COSTS • Incremental cost: additional cost that results from increasing output of a system by one (or more) units. • Incremental cost is often associated with “go / no go” decisions that involve a limited change in output or activity level. • A very simple example of incremental cost would be a factory producing widgets where it takes one employee an hour to produce one widget. • the incremental cost of a widget would include the wages for an hour in addition to the cost of materials used in production of a widget. • A more exact figure could comprise added costs, like electricity consumed if the factory had to stay open for a longer duration, or the cost for shipping the additional widget to a consumer.
  • 257. SUNK COST AND OPPORTUNITY COST • A sunk cost is one that has occurred in the past and has no relevance to estimates of future costs and revenues related to an alternative course of action; • Example : Product Research • Companies spend money each year for research and development as they work to come up with new products and services. • While the nature of research varies from business to business, • It's recognized as a sunk cost, since once the money is spent on conducting a focus group or administering a survey, it's gone.
  • 258. Opportunity cost • An opportunity cost is the cost of the best rejected ( i.e., foregone ) opportunity and is hidden or implied;
  • 259. What is opportunity cost? • Andy had $65.00 to spend at the toy store. The basketball net cost $50.00, so he had to buy that instead of the skateboard, which cost $75.00. • Sara had enough money for either the rabbit or the bike. She decided to buy the bike because then she could ride bikes with her friends after school.
  • 260. • Opportunity cost is the process of choosing one good or service over another. The item that you don’t pick is the opportunity cost. The rabbit is Sara’s opportunity cost and the skateboard is Andy’s opportunity cost. Opportunity Costs Purchases
  • 261. Social Cost • Building a new railway $100 million • Creating pollution nearby (e.g. cutting trees, noises) $5 million • Social cost of building highway • = private cost + external cost • = $105 million
  • 262. Historical Costs and Replacement Costs. • Historical cost or original costs of an asset refers to the original price paid by the management to purchase it in the past. • Whereas replacement costs refers to the cost that a firm incurs to replace or acquire the same asset now. • The distinction between the historical cost and the replacement cost result from the changes of prices over time. • In conventional financial accounts, the value of an asset is shown at their historical costs but in decision-making the firm needs to adjust them to reflect price level changes. • Example: If a firm acquires a machine for $20,000 in the year 1990 and the same machine costs $40,000 now. The amount $20,000 is the
  • 263. Money Cost • Money Cost of production is the actual monetary expenditure made by company in the production process. • Money cost thus includes all the business expenses which involve outlay of money to support business operations. • For example the monetary expenditure on purchase of raw material, payment of wages and salaries, payment of rent and other charges of business etc can be termed as Money Cost.
  • 264. Real Cost • Real Cost of production or business operation on the other hand includes all such expenses/costs of business which may or may not involve actual monetary expenditure. • For example if owner of a business venture uses his personal land and building for running the business venture and • He/she does not charge any rent for the same then such head will not be considered/included while computing the Money Cost but this head will be part of Real Cost computation.
  • 265. Accounting Cost • Accounting Cost includes all such business expenses that are recorded in the book of accounts of a business firm as acceptable business expenses. • Such expenses include expenses like Cost of Raw Material, Wages and Salaries, Various Direct and Indirect business Overheads, Depreciation, Taxes etc. • When such business expenses or accounting expenses are deducted from the Sales income of any firm the accounting profit is obtained. • Such Accounting/Business expenses or costs are also termed as Explicit Costs.
  • 266. • Accounting Cost: Various allowed business expenses. • Such as Cost of Raw Material, Salaries and Wages, Electricity Bill, Telephone Charges, Various Administrative Expenses, Selling and Distribution Expenses, Production Overhead Expenses, Other Indirect Overhead Expenses etc. • Accounting Profit = Sales Income - Accounting Cost
  • 267. Economic Cost • Economic Cost on the other hand includes all the accounting expenses as well as the Opportunity cost of a business firm. • Economic Cost and Economic Profit is thus calculated as follows: • Economic Cost = Accounting Cost (Explicit Costs) + Opportunity Cost. • Economic Profit = Total Revenues - (Accounting Cost + Opportunity Cost)
  • 268. Private Cost and Social Cost • The actual expenses of individuals/ firms which are borne or paid out by the individual or a firm can be termed as Private Cost. • Thus for a business firm this may include expenses like Cost of Raw Material, Salaries and Wages, Rent, Various Overhead Expenses etc. • On the other hand Private Cost for an individual will be his or her private expenses such as expense on food, rent of house, expenses on clothing, expenses on travel, expenses on entertainment etc.
  • 269. Social Cost • Social Cost on the other hand includes Private Cost and also such costs which are not borne by the firm but by the society at large. • Such Cost (that is cost not borne or paid out by the firm) is also known as External Cost. • Another example of external cost can be the cost of providing the basic infrastructure facilities like good roads, sewage system or network, street lights etc.
  • 270. Cost Concepts I. Total Costs (TC)I. Total Costs (TC) — whatever total cost is for any level of output — sum of all costs Two Sub-Components:Two Sub-Components: (A)Total Fixed Costs — TFC (Overhead Costs) — do not vary with output — come from fixed inputs (B) Total Variable Costs — TVC — vary with output — come from variable inputs Note: TC = TFC + TVC
  • 271. Understanding Fixed, Variable, Total cost Number of Units Produced Fixed Cost Variable Cost Total Cost 1 10 5 15 2 10 10 20 3 10 17 27 4 10 30 40 5 10 45 55
  • 272. Cost Concepts Cost(Rs)Cost(Rs) Output (or TP orOutput (or TP or Q)Q) Graph of Total Cost Concepts TC TVC TFC (TFC)
  • 273. 0 10 20 30 40 0 1 2 3 4 5 6 7 8 Wheat production per year from a particular farm Tonnesofwheatperyear TPP -2 0 2 4 6 8 10 12 14 0 1 2 3 4 5 6 7 8 Tonnesofwheatperyear APP MPP b b d d Number of farm workers (L) Number of farm workers (L) Slope = TPP / L = APP c c
  • 274. Cost Concepts II. Average Total Costs (ATC)II. Average Total Costs (ATC) – Total Cost Per Unit of Output Two Sub-Components:Two Sub-Components: Q TC ATC = (A) Average Fixed Cost: Q TFC AFC = (B) Average Variable Cost: Q TVC AVC = Two Average Costs!! Note: ATC = AFC + AVC
  • 275. Cost Concepts III. Marginal Costs (MC) :III. Marginal Costs (MC) : Increase in Total Cost that results from an increase in output Q TC MC ∆ ∆ =
  • 276. The Short Run Cost Function • Add ATC = AFC + AVC to the table
  • 277.
  • 278. The Short Run Cost Function • ATC = AFC + AVC
  • 279. Cost Concepts Cost(Rs)Cost(Rs) OutputOutput Graph of Average & Marginal Cost Concepts AVC AFC ATC MC Q2 Q1
  • 280. Cost Concepts (1) When marginal is below average(1) When marginal is below average →→ average is falling.average is falling. (2) When marginal is above average(2) When marginal is above average →→ average is rising.average is rising. (3) When marginal is equal average(3) When marginal is equal average →→ average is at its lowestaverage is at its lowest point.point. Note : There is a certain correspondence between productNote : There is a certain correspondence between product concepts and cost concepts.concepts and cost concepts. Summary of Relationship Between Marginal Cost & Average Cost When AVC is at its minimum, AP will be at its maximum.When AVC is at its minimum, AP will be at its maximum. When MC is at a minimum, MP will be at its maximum.When MC is at a minimum, MP will be at its maximum. (See diagram in book.)(See diagram in book.)
  • 281. 285
  • 282. The Short Run Cost Function • Production cost graph or map is
  • 283. The Short Run Cost Function • Important Map Observations – AFC declines steadily over the range of production. Why? – In general, ATC is u-shaped. Why? – MC intersects the minimum point (q*) on ATC. Why?
  • 284. The Short Run Cost Function • A change in input prices will shift the cost curves. – If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected. Computer Chip Case
  • 285. The Short Run Cost Function • A change in input prices will shift the cost curves. – If variable input costs are reduced then MC, AVC, and AC will all shift downward. Airline Industry Case
  • 286. Long-Run Average Cost Curve (No distinction between fixed and variable in Long-Run) Total Costs perTotal Costs per Unit(Rs)Unit(Rs) (LRAC)(LRAC) Q (Output)Q (Output) Plots the relationship between the lowest attainable Average Cost and output when both capital (or plant size) and labor can be varied. LRAC 0 C1 Q1 C2 Q2 AttainableAttainable CostsCosts UnattainableUnattainable CostsCosts
  • 287. Relationship Between SATC & LRAC Short-Run & Long-Run Costs AverageAverage Costs perCosts per Unit (Rs)Unit (Rs) Q (Output)Q (Output) 0 SATC1 SATC2 SATC3 LRAC LMC SMC1
  • 288. Relationship Between SATC & LRAC Short-Run & Long-Run Costs AverageAverage Costs perCosts per Unit (Rs)Unit (Rs) Q (Output)Q (Output) 0 LRAC X Xmin X X = minimum pointX = minimum point
  • 289. Long-Run Average Cost Curve Slope of LRAC Costs perCosts per UnitUnit QQ (Output)(Output) LRAC 0 Qm 0 to Qm: Economies of Scale Qm Rightward: Diseconomies of Scale * Q* Qmm is the most efficient point – doubly efficient:is the most efficient point – doubly efficient: (1) It represents the lowest possible costs for its production level (like all points on LRAC curve). (2) It is the output level that has absolutely lowest costs of all output levels.
  • 290. Other Possible Shapes for LRAC Constant Returns to Scale : LRAC curve is horizontal AverageAverage Cost perCost per Unit (Rs)Unit (Rs) QQ (Output)(Output) LRAC 0 AverageAverage Cost perCost per Unit (Rs)Unit (Rs) QQ (Output)(Output) LRAC 0 OROR Doubling Input spending always leads to a doubling of output.
  • 291. Other Possible Shapes for LRAC Continually Decreasing Costs AverageAverage Cost perCost per Unit (Rs)Unit (Rs) QQ (Output)(Output) LRAC 0 Decreasing Cost!!!
  • 292. Minimum Efficient Scale Definition : The smallest quantity of output at which long- run average cost reaches its lowest level.
  • 293. A Perfectly Competitive Market • For a market to be perfectly competitive, six conditions must be met: 1. Both buyers and sellers are price takers – a price taker is a firm or individual who takes the price determined by market supply and demand as given 2. The number of firms is large – any one firm’s output compared to the market output is imperceptible and what one firm does has no influence on other firms • A perfectly competitive market is a market in which economic forces operate unimpeded
  • 294. A Perfectly Competitive Market 3. There are no barriers to entry – barriers to entry are social, political, or economic impediments that prevent firms from entering a market. 3. Firms’ products are identical – this requirement means that each firm’s output is indistinguishable from any other firm’s output 4. There is complete information – all consumers know all about the market such as prices, products, and available technology 5. Selling firms are profit-maximizing entrepreneurial firms – firms must seek maximum profit and only profit
  • 295. Total Revenue of a Competitive Firm • Total revenue for a firm is the selling price times the quantity sold. TR = PTR = P ×× QQ
  • 296. Average Revenue of a Competitive Firm • Average revenue is the revenue per unit sold – P = AR. – This is simply because all units sold are sold at the A v e r a g e R e v e n u e = T o t a l r e v e n u e Q u a n t i t y P r i c e Q u a n t i t y Q u a n t i t y P r i c e = × =
  • 297. Marginal Revenue of a Competitive Firm • Marginal Revenue is the increase (Δ) in total revenue when an additional unit is sold. MRMR == ∆∆TRTR // ∆∆QQ
  • 298. Revenue of a Perfectly Competitive Firm • Total Revenue: The amount of money received when the firm sells the product, i.e., – Total Revenue = Price of the product × Quantity of the product sold – TR = P × Q • Since the firm is a price taker under perfect competition, it sells each additional unit of the product for the same price. • Average Revenue = Total Revenue/Quantity sold – AR = TR/Q = P • Marginal Revenue = Additional revenue earned from selling an additional unit of the product. – MR = ∂TR/∂Q = P • Thus, for a competitive firm AR = P = MR
  • 299. Total Revenue: P×Q TP = Q P TR AR MR 0 3 0 0 0 10 3 30 3 3 25 3 75 3 3 50 3 150 3 3 70 3 210 3 3 85 3 255 3 3 95 3 285 3 3 100 3 300 3 3 101 3 303 3 3 95 3 285 3 3 85 3 255 3 3
  • 300. The Revenue of a Competitive Firm • In perfect competition, marginal revenue equals price: P = MR. • We saw earlier that P = AR • Therefore, for all firms in perfect competition, P = AR = MR
  • 301. 9.4 Profit Maximization (SR): TR and TC approach
  • 302. What Is Perfect Competition? – Figure illustrates a firm’s revenue concepts. – Part (a) shows that market demand and market supply determine the market price that the firm must take.
  • 303. What Is Perfect Competition? – A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces. – So the firm must decide: – 1. How to produce at minimum cost – 2. What quantity to produce – 3. Whether to enter or exit a market – We start by looking at the firm’s output decision.
  • 304. Profit Maximization by the Competitive Firm: Approach I: Total Profit = TR – TC 0.00 50.00 100.00 150.00 200.00 250.00 300.00 350.00 0.00 20.00 40.00 60.00 80.00 100.00 120.00 Output TC,TR,&Profit TC TR L TP = Q TR TC Profit 0 0 0 80 -80 1 10 30 105 -75 2 25 75 130 -55 3 50 150 155 -5 4 70 210 180 30 5 85 255 205 50 6 95 285 235 50 7 100 300 255 45 8 101 303 280 23 9 95 285 305 -20 10 85 255 330 -75  On the Diagram, the profit maximizing level of output is the level where the vertical difference between the TR and TC is the largest.  With P = Rs 3/unit, profits are maximized by producing 95 units of output.
  • 305. The Firm’s Output Decision • Profit-Maximizing Output – A perfectly competitive firm chooses the output that maximizes its economic profit. – One way to find the profit-maximizing output is to look at the firm’s the total revenue and total cost curves. – Figure on the next slide looks at these curves along with the firm’s total profit curve.
  • 306. The Firm’s Output Decision – Part (a) shows the total revenue, TR, curve. Part (a) also shows the total cost curve, TC, which is like the one in previous Slides. Total revenue minus total cost is economic profit (or loss), shown by the curve EP in part (b).
  • 307. The Firm’s Output Decision – At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs. At intermediate output levels, the firm makes an economic profit.
  • 308. The Firm’s Output Decision – At high output levels, the firm again incurs an economic loss— now the firm faces steeply rising costs because of diminishing returns. The firm maximizes its economic profit when it produces 9 sweaters a day.
  • 309. Max Profit Max Output Profit Maximization by the Competitive Firm: Approach I: Total Profit = TR – TC Input (L) TP (Q) AP (Q/L) MP TC TR Profit 0 0 0.00 80 0 -80 1 10 10.00 10 105 30 -75 2 25 12.50 15 130 75 -55 3 50 16.67 25 155 150 -5 4 70 17.50 20 180 210 30 5 85 17.00 15 205 255 50 6 95 15.83 10 235 285 50 7 100 14.29 5 255 300 45 8 101 12.63 1 280 303 23 9 95 10.55 -6 305 285 -20 10 85 8.50 -10 330 255 -75 StageIStageIIStageIII
  • 310. Profit Maximization by the Competitive Firm: Approach II: MR = MC • Most managers do not make decisions looking at TR and TC. Most decisions are made at the “margin.” • The output level that will maximize profit is determined by comparing the amount that each additional unit of output adds to TR and TC. • Recall, Marginal Cost (MC) represents additional cost from producing an additional unit of output; and Marginal Revenue (MR) represents addition to TR from selling (producing) an additional (one more) unit of output, which is equal to the price of that output. • Thus, MC and MR can be used to determine profit maximizing level of output.
  • 311. Profit Maximization by the Competitive Firm: Approach II: MR = MC • The firm will continue to expand production until MR is equal to MC, i.e., profit is maximized when MR = MC. • With P being Rs 3/unit, profits are maximized by producing 95 units of output. 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 0.00 20.00 40.00 60.00 80.00 100.00 120.00 Output MR, MC, & Profit MR MC L Q TR MR TC MC Profit 0 0 0 80 -80 1 10 30 3 105 2.50 -75 2 25 75 3 130 1.67 -55 3 50 150 3 155 1.00 -5 4 70 210 3 180 1.25 30 5 85 255 3 205 1.67 50 6 95 285 3 235 3.00 55 7 100 300 3 255 5.00 45 8 101 303 3 280 25.0 23 9 95 285 3 305 -4.17 -20 10 85 255 3 330 -2.50 -75
  • 312. The Firm’s Output Decision • Marginal Analysis and Supply Decision – The firm can use marginal analysis to determine the profit-maximizing output. – Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC. – Figure on the next slide shows the marginal analysis that determines the profit-maximizing output.
  • 313. The Firm’s Output Decision – At high output levels, the firm again incurs an economic loss— now the firm faces steeply rising costs because of diminishing returns. The firm maximizes its economic profit when it produces 9 sweaters a day.
  • 314. The Firm’s Output Decision – If MR > MC, economic profit increases if output increases. If MR < MC, economic profit decreases if output increases. If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.
  • 315. Determining Profits Graphically: A Firm with Profit AVC MC Q P ATC Find output where MC = MR, this is the profit maximizing Q P = D = MR MC = MR Qprofit max Find profit per unit where the profit max Q intersects ATC ATC at Qprofit max P ATC Profits Since P>ATC at the profit maximizing quantity, this firm is earning profits
  • 316. Determining Profits Graphically: A Firm with Zero Profit or Losses AVC MC Q P ATC MC = MR Qprofit max ATC at Qprofit max P =ATC P = D = MR Since P=ATC at the profit maximizing quantity, this firm is earning zero profit or loss Find output where MC = MR, this is the profit maximizing Q Find profit per unit where the profit max Q intersects ATC
  • 317. Determining Profits Graphically: A Firm with Losses AVC MC Q P ATC MC = MR Qprofit max ATC at Qprofit max P ATC P = D = MR Since P<ATC at the profit maximizing quantity, this firm is earning losses Find output where MC = MR, this is the profit maximizing Q Find profit per unit where the profit max Q intersects ATC Losses
  • 318. Determining Profits Graphically: The Shutdown Decision AVC MC Q P ATC Qprofit max PShutdo wn P = D = MR • The shutdown point is the point below which the firm will be better off if it shuts down than it will if it stays in business • If P>min of AVC, then the firm will still produce, but earn a loss • If P<min of AVC, the firm will shut down • If a firm shuts down, it still has to pay its fixed costs
  • 319. Short-Run Market Supply and Demand • The market (industry) supply curve is the horizontal sum of all the firms’ marginal cost curves • While the firm’s demand curve is perfectly elastic, the industry’s demand curve is downward sloping • The market supply curve takes into account any changes in input prices that might occur
  • 320. ATC Profits Short-Run Market Supply and Demand Graph P Q Market Supply P Market Demand P Q P P = D = MR MC ATC Qprofit max Market Firm
  • 321. Long-Run Competitive Equilibrium • Profits create incentives for new firms to enter, market supply will increase, and the price will fall until zero profits are made • At long run equilibrium, economic profits are zero • The existence of losses will cause firms to leave the industry, market supply will decrease, and the price will increase until losses are zero
  • 322. Long-Run Competitive Equilibrium • Normal profit is the amount the owners would have received in their next best alternative • Zero profit does not mean that the entrepreneur does not get anything for his efforts • Economic profits are profits above normal profits
  • 323. Long-Run Competitive Equilibrium Graph P Q P = D = MR MC SRATC LRATC At long-run equilibrium, economic profits are zero
  • 324. SR Profits Market Response to an Increase in Demand Graph P Q S0(SR) P0 D0 P Q P0 MC ATC Q0,2 Market Firm S1(SR) D1 P1 1 P1 1 1 Q1 2 2 2 Q0 Q1 Q2 1 1 2 2 S(LR)
  • 325. Long-Run Market Supply • If the long-run industry supply curve is upward sloping, the market is an increasing-cost industry • If the long-run industry supply curve is perfectly elastic, the market is a constant-cost industry • If the long-run industry supply curve is downward sloping, the market is a decreasing-cost industry • In the short run, the price does more of the adjusting, and in the long run, more of the adjustment is done by quantity
  • 326. Monopoly • Only one seller of a particular product
  • 327. Characteristics of Monopoly • Single Producer • No close substitute • Inelastic demand curve • Price Maker • Barriers to entry  Legal restrictions or barriers to entry of other firms  Control over key raw material • Examples: Public utilities – telephones and electricity etc.
  • 328. Total Revenue Price Quantity Total Revenue 6 0 0 5 1 5 4 2 8 3 3 9 2 4 8 1 5 5 0 6 0 Can you work out the demand, total revenue and marginal revenue functions from this information?
  • 329. TR Price Q Q TR Demand and Total Revenue AR = D 0 0 63 3 6 9 6 3 Graph B Graph A D
  • 330. TR P,MR Q Q Marginal Revenue Q2 MR AR = D A B C 0 0 Q1 A C Graph B Graph A X TR
  • 331. Profit Maximizing Output Decision under Monopoly in the Short-run The Total Curves Approach Profit maximization output decision rule for a monopolist depends on two considerations. • One, whether there is any output level at which TR exceeds the TVC. If not, the profit maximizing strategy is to shut down. • If there are output levels at which TR > TVC, the monopolist will produce where the vertical distance between TR and TC is at its maximum. $ TR TC TVC Q
  • 332. Profit Maximizing Output Decision under Monopoly in the Short-run The Total Curves Approach • In this case, the vertical distance between TR and TC is at maximum at the Q* level of output. – Note that at Q* units of output, TR and TC curves have the same slope, i.e., MR = MC. (This is called the Necessary Condition of profit maximization) – Further, the slope of MC exceeds that of the MR (MC has a positive slope and MR has a negative slope). (This is called the Sufficient Condition of profit maximization) $ TR TC TVC QQ*
  • 333. Output and Price Determination LO2 Steps for Graphically Determining the Profit-Maximizing Output, Profit-Maximizing Price, and Economic Profits (if Any) in Pure Monopoly Step 1 Determine the profit-maximizing output by finding where MR=MC. Step 2 Determine the profit-maximizing price by extending a vertical line upward from the output determined in step 1 to the pure monopolist’s demand curve. Step 3 Determine the pure monopolist’s economic profit by using one of two methods: Method 1. Find profit per unit by subtracting the average total cost of the profit-maximizing output from the profit-maximizing price. Then multiply the difference by the profit-maximizing output to determine economic profit (if any). Method 2. Find total cost by multiplying the average total cost of the profit- maximizing output by that output. Find total revenue by multiplying the profit-maximizing output by the profit-maximizing price. Then subtract total cost from total revenue to determine the economic profit (if any). 10-337
  • 334. Finding Pm and Qm Price Quantity of output Market Demand MR MC Pm Qm MC = MR Cost data will determine a monopolist’s profit.
  • 335. $200 175 150 125 25 100 75 50 Price,Costs,andRevenue 1 2 3 4 5 6 7 8 9 10 Quantity Output and Price Determination LO2 0 D MR ATC MC MR=MC A=$94 Economic Profit Pm=$122 10-339
  • 336. Misconceptions of Monopoly Pricing • Not highest price • Total profit • Possibility of losses LO2 10-340
  • 337. Misconceptions of Monopoly Pricing LO2 0 D MR ATC MC MR=MC Loss AVC Pm Qm V A 10-341
  • 338. Price Discrimination It refers to discrimination of price for different consumers on the basis of their income or purchasing power, geographical location, age, sex, colour, marital status, quantity purchased, time of purchase etc. for eg:- • Physicians and hospitals • Merchandise sellers • Railways and Airlines • Cinema shows or musical concerts • Domestic and foreign markets
  • 339. Necessary conditions • Different Markets must be separable for a seller • The Elasticity of demand must be different in different markets • There must be imperfect competition in the market • Profit maximizing output should be larger than the quantity demanded in a single market or section of consumers

Editor's Notes

  1. Instructor Notes: 1) The rows of the table list combinations of labor and capital costing $30, rent is $3 per machine hour, and the wage is $6 per hour. 2) For example, row shows us that how much K could be hired for $30: 10 machine hours but no labor.
  2. Instructor Points: 1) The isocost line is the continuous line af. 2) To calculate the equation, start with expenditure equal to C: $3K + $6L = $30 Divide by $3 to obtain K + 2L= 10 Subtract 2L from both sides to obtain K = 10 – 2L
  3. Instructor Notes: 1) Lisa’s income falls from $30 to $15 while the prices of movies and soda remain constant. 2) The budget line shifts leftward, but its slope does not change.
  4. Instructor Notes: 1) Cost, C, falls from $30 to $15 while the prices of labor and capital remain constant. 2) The isocost line shifts leftward, but its slope does not change.
  5. If there is price discrimination, P is not necessarily equal to AR. In fact, if there is price discrimination there is no such thing as a market price. So, AR cannot be equal to the market price, because the latter does not exist.
  6. In the table before you we have the elements of a demand curve, price and quantity, and total revenue which is derived from multiplying price by quantity. The price and quantity columns reflect the basic law of demand. At a price of £6 zero quantity is demanded per period of time. As price falls to £5 the quantity demanded increases to 1 unit. At a price of £4 quantity demanded is 2 units and so on until at a price of zero (that is, giving it away) the maximum quantity demanded is 6 units. You can see at this point I’ve set a simple series of questions for those of you with some modest mathematical ability. Can you work out the demand, total revenue and marginal revenue functions from the information in the table. Stop the show now using the pause button and try and work it out.
  7. The slide you see before you depicts the values in the previous table. Graph B (the bottom graph) shows the demand curve, displaying the relationship between price and quantity. Thus, when price was 6 the quantity demanded was zero (we are by the red D in the top left portion of graph B). When price was zero the maximum quantity demanded was 6 (we are by the AR=D in the bottom right portion of graph B). There were other points on the demand curve too. We have shown the point where price equals 3 quantity equals 3. This and other points on the demand curve translate directly on to the total revenue function shown in graph A – graph in the top part of the slide. When price equals 3 and quantity equals 3 total revenue equals 9. You should also note how the quantities of zero and six on the total revenue graph translate on to the demand graph. The total revenue curve has a dome shape reflecting the fact that as price falls and quantity rises total revenue increases at first (in our case until we reach 3 units) and then falls. We have drawn a perfect dome shape here on the assumption that we could divide the price and quantity categories into infinitely small numbers, e.g., when price equals £5.99 quantity equals 0.01 units and so on. This, of course, does not match our table exactly but you should see the logic of the argument used. It also helps to make the diagrammatic explanation simpler as we go!
  8. It is possible to derive marginal revenue from the total revenue function and place that on the traditional demand diagram. Marginal revenue is the change in total revenue resulting from a very small change in the quantity demanded. We can illustrate marginal revenue by examining the slope of the total revenue function. In Graph A of the diagram before you we have drawn tangents to the total revenue function in three places and you should see that the slope of the total revenue function changes as we increase the quantity demanded. Tangent A, for example, has a steep slope. Thus the absolute value of the slope at the point of tangency with the total revenue function is high. This high value can be translated on to Graph B. At a quantity demanded of Q1 the value of the slope of the total revenue function, I.e. the marginal revenue, is given by A in Graph B. Clearly, as we increase the quantity demanded the slopes of the tangents become shallower until they reach the top of the dome. The slope of the tangent at B, for example, is zero. So the marginal revenue is likewise zero. This is shown in Graph B at point X where marginal revenue crosses the horizontal axis. The tangent to total revenue at C is one intermediate point. It’s value is greater than zero but not as high as that associated with the tangent at A. You should note that marginal revenue becomes negative as total revenue falls. Thus, as quantity increases by one unit past the apex of the dome in graph A the change in total revenue falls. One final point that you should note from graph B is that with a straight line linear demand function marginal revenue will cut the horizontal axis in graph B exactly half way between zero and the point where the demand curve cuts the horizontal axis. This arises because the slope of the marginal revenue falls at twice the rate of the demand curve (at least when we have a linear demand curve). This sometimes known as the ‘twice as steep rule’.