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Managerial Economics
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  • Managerial Economics

  • MeaningManagerial 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..

  • Why Economics?Biology contributes to medical profession.Physics to Engineering. Economics to Managerial profession.Achieve objective of the firmConstraints is limited resources

  • Application of Economics to Decision MakingDetermining and defining the objective to be achieved.

    Collection and analysis of business related data and other information(Economic, social, Political and technological environment.).

    Inventing the possible courses of action

    Select the possible action from the given alternatives.

    II and III are crucial in decision making

  • Example Launching a productProduction Related issues andSales related issues.

  • Production Related issuesAvailable techniques of Production.Cost of Production Supply position of inputsPrice structure of inputsCost structure of competitive productsAvailability of foreign exchange if inputs are available.

  • Sales related issuesMarket size, general market trends and demand prospectus for the productTrends in IndustryCompetitorsPricing of productPricing strategy of competitorsDegree of competitionSupply position of complementary goods

  • Scope of Managerial EconomicsEconomics 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 intoMicro Economics (Operational and internal issues)Macro Economics (Environmental and external issues)

  • Operational or Internal issues What to produce Nature of product or BusinessHow much to produce Size of firmHow to produce Choice of technologyHow to price the commodityHow to promote salesHow to face price competition How to manage profit and capitalHow to manage an inventory

  • Environmental or External issuesThe type of economic system in the countryTrends in GDP, Prices, Saving and Investment Employment, etc.Trends in Financial System Banks, Financial and Insurance companiesTrends in Foreign TradeGovernment Economic policiesSocial Factors like value system, property rights, customs and habits.Socio-economic organization like trade unions, consumers associations, Consumer co-operatives and producers unions.Political environmentDegree of Globalization and Influence of MNCs

  • Micro Economic IssuesWhat to produceHow much to produceHow to produceHow to price the commodityHow to promote salesHow to face competitionHow to decide on new investmentHow to manage profit and capitalHow to manage an inventory

  • Examples of Economic TheoriesTheory of DemandIt deals with the consumer behaviourHow do the consumer decides to buy the commodityHow do they decide on QuantityWhen do they stop consumingHow consumer behave on PriceIt 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 decreasesHelps to decide the optimum size of the firmSize of total output and amt of capital and labour to be employed given the objective

  • Market structure and Pricing theoryHow 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 ManagementElements 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 decisionIt contribute to deciding choice of project, maintaining capital, capital budgeting, etc

  • Macro economic IssuesTrends in Economics: Level of GDPInvestment climateTrends in National Output and employmentPrice trends

  • Issues related to Foreign TradeTrends in International TradeTrends in International PricesExchange ratesProspectus in International Market

  • Issues related to Government Policies:Monetary PolicyFiscal PolicyForeign Trade PolicyEnvironmental Policy etc

  • Other Topics related to Managerial EconomicsMathematical Tools

  • Economic theories for Decision MakingEconomic 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. *group 2 sec c*

    group 2 sec c

  • RELATIVE CONCEPTDemand is the relative concept i.e. it is related to price and time:The demand for rice is 100KgThe 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 DemandPrice of the product.Income and wealth distribution.Tastes, habits and preferences.Relative prices of other goodsSubstitute products.Complementary products. Consumers satisfaction.Quantity of money in circulation.Utility of the commodity.Quality.Expectation regarding future price.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 DEMANDIt 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

    Price per unitDemand for commodity X501040203030204010500560

  • Individual Demand

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  • MARKET DEMAND

    Price per UnitQty DemandedABCTotal market Demand(A + B + C)5010121537402022256730303235972040424512710505255157

  • 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

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    Market Demand for Commodity (A + B + C)

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    Total market DemandA + B + CPrice per Unit

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  • Generalized demand functionThe 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 functionThe 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 parameterPINVERSENegative MDirect for normal goodsInverse for inferior goodsPositive NegativePRDirect for substitute goodsInverse for the complementary goodsPositive Negative

    TDirectPositivePeDirectPositiveNDirectPositive

  • Demand functionsThe 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)

  • illustrationGeneralized demand function isQd = 1800 20P + 0.6M 50PRTo derive a demand functionsQd = (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 20PThe 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 DemandDemand IncreasesDemand decreasesSign of Slope parameterIncome (M)Normal GoodsInferior goodsM risesM FallsM FallsM risesC > 0C < 0Price of related goods (PR)

    Substitute goodsComplement good

    PR risesPR falls

    PR fallsPR rises

    d > 0d < 0Consumer Tastes (T)T risesT fallse > 0Expected price (Pe)Pe risesPe Fallsf > 0Number of consumers (N)N risesN Fallsg > 0

  • Demand Schedule

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    Demand functionQd = 1300 20P

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  • 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)Q1Q2P1P2E1E20DDPrice(P)P1 - old priceP2 - new priceQ1 old quantity demandedQ2 new quantity demandedDD demand curve

    A Linear Demand CurveDemand Curve

  • Characteristics of A Typical Demand CurveDrawn by joining different loci.

    Downward sloping.

    Reciprocal relationship between price and quantity demanded ( P 1/Qd )

    Linear Non - linear

  • Assumptions (Other things)No change in consumers income.No change in consumers preferences.No change in the fashion.No change in the price of related goods :Substitute goods.Complementary goods.No expectation of future price changes or shortages.No change in size, age, composition and sex ratio of the population.No change in the range of goods available to the consumers.

  • ContdNo change in the distribution of income and wealth.No change in the government policy.No change in weather conditions.

  • EXCEPTION TO LAW OF DEMANDGiffens 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 Giffens 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 curveORChange in quantity demanded Extension of demand With a decrease in price, there is increase in the quantity demand of the product.

    P1P2Q1Q2EE`DDQuantity demandedPrice

  • Contraction of demand With a increase in price, there is a decrease in quantity demanded.Quantity demandedP2Q2P1Q1EE`Price

  • SOURCES OF SHIFTS IN THE DEMAND CURVES TastesPrices of related goodsIncomeDemographicsInformationAvailability of creditChanges in expectations

  • Movement of Demand CurveORChange in demand Increase in demand:More quantity demanded ------ at a given price.Same quantity demanded ------ at a higher price. P1Q1Q2abDDD`D`Q1P1P2DDD`D`abQuantity demandedQuantity demandedPricePrice

  • Decrease in demand :Less quantity demanded ---- at same price.Same quantity demanded ---- lower price. Q2Q1P1abQ1Quantity demanded

    P1D`bD`DDD`DDaD`PricePriceQuantity demandedP2

  • Factors And Effects of Change (increase or decrease) in demandChange in income :Quantity demandedPriceIncreaseQuantity demandedPriceDecreaseD`D`DDDDD`D`

  • Change in taste, habit and preference :DDD`D`DDD`D`Quantity demandedPriceQuantity demandedPricePositiveNegative

  • Change in fashion and customs :DDD`D`DDD`D`Quantity demandedQuantity demandedPricePriceFavorableUnfavorable

  • Change in population :*group 2 sec c*Quantity demandedQuantity demandedPricePriceD`D`D`D`DDDDIncreaseDecrease

    group 2 sec c

  • Advertisement and publicity persuasion :*group 2 sec c*Quantity demandedQuantity demandedPricePriceDDDDD`D`D`D`AggressiveDocile

    group 2 sec c

  • Change in value of money :Quantity demandedQuantity demandedPricePriceD`D`D`D`DDDDDeflationaryInflationary( Value of money)( Value of money)

  • Change in level of taxation :Quantity demandedQuantity demandedDD`D`D`DD`DDLowHighPricePrice

  • Expectation of future changes in prices :Quantity demandedQuantity demandedD`D`D`D`DDDDRiseFallPricePrice

  • Shift in Demand

    Price Qd = 1300 20P (M = 20000) D0Qd = 1600 20P (M = 20500) D1Qd = 1000 20P(M = 19500) D26503000601004000503006000405008002003070010004002090012006001011001400800

  • Shift in Demand

  • Determinants of Demand

    Determinants of DemandDemand IncreasesDemand decreasesSign of Slope parameterIncome (M)Normal GoodsInferior goodsM risesM FallsM FallsM risesC > 0C < 0Price of related goods (PR)

    Substitute goodsComplement good

    PR risesPR falls

    PR fallsPR rises

    d > 0d < 0Consumer Tastes (T)T risesT fallse > 0Expected price (Pe)Pe risesPe Fallsf > 0Number of consumers (N)N risesN Fallsg > 0

  • SupplyThe 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 SupplySupply 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 timeIt is related to time, place and personThe supply of sugar is 50 kg is not a complete sentenceThe supply of a sugar at price Rs 5/- is 50kg. Per day is the complete sentence

  • Factors affecting SupplyPricePrice of other commoditiesGoals of the producerState of technologyCost of productionClimate and forces of NatureTransport facilitiesTaxation: Heavy taxes supply will reduceExpectation regarding future prices

  • Self-consumptionTime element: Short period the supply is fixed and vice

  • Individual Supply ScheduleIndividual 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

    Price Per Unit of XQty. supplied of XU510V1020W1530X2040Y2550Z3060

  • Individual Supply Curve

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  • Market supply scheduleIt 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 XMarket supply (I + II+ III)Seller ISeller IISeller IIIU510203060V1020254085W15303050110X20403560135Y25504070160Z30604580185

  • Market supply Curve

  • Law of SupplyOthers things remaining the same , qty. supplied of a commodity directly varies with its price. i.e. S= f (p)

    SUPPLY SCHEDULEPrice Per Unit of XQty. supplied of XU510V1020W1530X2040Y2550Z3060

  • Supply Curve

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  • Assumption Price of other commodities remains the sameThe cost of production remains the sameThe method of production remains the sameNo change in the availability of goodsNo change in transport facilitiesNo change in weather conditionNo change in tax structure and govt. policiesGoals of producer remains the sameNo change in expectation about the priceNo natural calamities and no self consumption

  • Exceptions to the law of supply Backward bending supply curve

    Wage rate ( Rs.)Hours of workDaily Income (Rs.)58407107010121201210120

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  • 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 pricesNeed for cash by the seller Rare collection the supply is permanently fixed whatever the price.Self consumption

  • Movements or variation in SupplyWhen there is change in supply exclusively due to change in Price

  • Shift in supplyWhen there is a change in supply due to change in factors other than the Price

  • Generalized supply functionIt 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 saleP = Price of goods or service.Pi = Price of inputsPr = Price of goods that are related to production.T = Level of available technology.Pr = Expected price of the producerF = No. of firms in the industry

  • Generalized supply functionAs 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 + sFWhere 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

    VariableRelation to Quantity suppliedSign of slope parameterPDirect K = is PositivePiInverseL = is Negative

    PrInverse for substitute in production (Wheat and Corn)Direct for complement in production(Oil and Gas)m = is Negative

    m = is Positive

    TDirect n = is PositivePeInverser = is NegativeFDirectS = is Positive

  • Supply functionSupply 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) IllustrationQs = 50 + 10P 8pi + 5FSuppose 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 schedule65750607005060040500304002030010200

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  • Shift in Supply

    Price Qs = 100 + 10PPi = 50, F = 90Qs = 250 + 10PPi = 31.25, F = 90Qs = -200 + 10PPi = 50, F = 30

    6575090045060700850400506007503004050065020030400550100203004500102003500

  • Shift in Supply

    Determinants of supplySupply Increases Supply DecreasesSign of Slope parameterPrice of inputs (Pi)Pi fallsPi risesI < 0Price of goods related in Production (Pr)Substitute goodComplement good

    Pr fallsPr rises

    Pr risesPr falls

    M < 0M > 0State of technology (T)T risesT fallsn > 0Expected Price (Pe)Pe fallsPe risesr < 0Number of firms or productive capacity in Industry (F)F risesF fallsS > 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 Qd = Qs1300 20 P = 100 + 10PSolving this equation for the equilibrium price,1200 = 30PP = 40

    Price Qs = 100 + 10PS0Qd = 1300 20P D0Excess supply ( +) Excess Demand ( -)657500+75060700100+60050600300+3004050050003040070030020300900-600102001100-900

  • Market Equilibrium

  • Market EquilibriumAt Market clearing price of 40

    Qd = 1300 (20 * 40) = 500Qs = 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) = 300Qs = 100 + (10 * 50) = 600

    There fore when the price is Rs 50Qs Qd = 600 300 = 300

  • Changes in Market EquilibriumDemand 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 DEMANDThe 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 determinantElastic: Small change in price brings big change in demandInelastic: Big change in price brings small change in demand

  • Kinds of ElasticityPrice ElasticityIncome ElasticityCross ElasticityArc Elasticity

  • PRICE EASTICITY OF DEMANDIT is the degree of responsiveness of qty. demanded of a commodity to a change in its price.Ed = % change in qty. dd /% change in PEd = proportionate change in qty. dd /Proportionate change in PEd = Q / Q = Q / Q * P / P P / P

  • Definition: Elasticity of DemandPrice 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

  • ExampleSuppose Monginis 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 Farmers DilemmaFor 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 doesnt fall very much. The quantity demanded of farm products is not very responsive to changes in pricesGood crop year: supply increases, prices for farm products fall, but quantity demanded doesnt increase very much. The quantity demanded of farm products is not very responsive to changes in pricesIt 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 demandPercentage 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 =1Relatively Elastic Ed >1 Relatively Inelastic Ed

  • Total Outlay Method or Revenue Or Expenditure Method

    Price (Rs)QTY. DD (units)Total Outlay (Rs)Elasticity505250Relatively elastic Ed > 140104003020600Unit Elastic Ed = 120306001040400Relatively inelastic Ed < 1550250

  • Geometric Method Or Exact MethodEd = Lower segment of demand curve Upper segment of demand curve Ed at pt A = DA/DA = 1Ed at pt B = DB/DB = 1/3 < 1Ed at pt C = DC/DC =9/3 > 1

  • Other concepts of Elasticity of DemandIncome Elasticity of Demand = Q * Y Y QEd = % change in qty. dd /% change in YCross Elasticity of Demand = Q x * P y P y Q x Arc elasticity of Demand = Q x P Q1+ Q2 P1+ P2

  • Factors Influencing ElasticityNature 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 DemandUseful 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 when more plants are added to the firm?

  • Input and outputAn 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 ProductionThe 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 FunctionThe 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 FunctionA 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 FunctionAlso, 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 FunctionThe 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 = bLWhere b = gives constant returns to labour.

  • Total, Average and Marginal ProductTotal 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

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    Quantity of LabourTotal Product

    00

    550

    10120

    15180

    20220

    25250

    30270

    35275

    40275

    45270

    Sheet2

    Sheet3

  • Average ProductAP is merely the Total product per Unit of the Variable Factor

    AP = TP / L

  • Average Product

    Sheet1

    Quantity of LabourTotal ProductAverage Product

    00

    55010.00

    1012012.00

    1518012.00

    2022011.00

    2525010.00

    302709.00

    352757.86

    402756.88

    452706.00

    Sheet2

    Sheet3

  • 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) usedMP = in Output / in Labour

  • Marginal Product

    Sheet1

    Variation of Output (One fixed, one variable factor), with Capital fixed at say 5 Units

    Quantity of LabourTotal ProductChange in TPMarginal Product

    00

    5505010

    101207014

    151806012

    20220408

    25250306

    30270204

    3527551

    4027500

    45270-5-1

    Sheet2

    Sheet3

  • 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 FunctionIn 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).

  • and 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 = 0.45, a 1% increase in capital usage would lead to approximately a 0.45% increase in output.

  • Production FunctionProduction 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 FunctionThis 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 FunctionFor 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 + 1L5K + 5L2K + 5L and1K + 10L produces the same output

  • Production with one variable inputThe 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

    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.

    Let us assume also that the labour output relationship in coal production is given by a hypothetical production function of the following form.

  • Given the production function, we may substitute different numerical values of L in the function and work out a series of Qc i.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

  • 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,

  • No of Workers (N)Total Product (TPL) (tones)Marginal Product* (MPL)Average product (APL)Stages of production(based on MPL)123451234562472138216300384244866788484243646546064IIncreasingreturns789104625285766007866482466666460IIDiminishingReturns1112594552-6-425446IIINegative returns

  • SHORT-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)

    Number of

    Workers (Lb)

    TPP

    APP

    (=TPP/Lb)

    MPP

    (=TPP/Lb)

    (a)

    0

    0

    -

    3

    1

    3

    3

    7

    2

    10

    5

    (b)

    14

    3

    24

    8

    12

    (c)

    4

    36

    9

    4

    5

    40

    8

    2

    6

    42

    7

    (d)

    0

    7

    42

    6

    -2

    8

    40

    5

  • Wheat production per year from a particular farmNumber of farm workersTonnes of wheat produced per yearNumber of workers 012345678 TPP 0 310243640424240

  • Wheat production per year from a particular farmNumber of farm workersTonnes of wheat produced per yearTPP

  • Wheat production per year from a particular farmNumber of farm workersTonnes of wheat produced per yearTPPabDiminishing returnsset in here

  • Wheat production per year from a particular farmNumber of farm workersTonnes of wheat produced per yearTPPabdMaximum output

  • Wheat production per year from a particular farmNumber offarm workers (L)Tonnes of wheat per yearTPPTonnes of wheat per yearNumber offarm workers (L)DTPP = 7DL = 1MPP = DTPP / DL = 7

    Sheet:

  • Wheat production per year from a particular farmTonnes of wheat per yearTPPTonnes of wheat per yearMPPNumber offarm workers (L)Number offarm workers (L)

  • Wheat production per year from a particular farmTonnes of wheat per yearTPPTonnes of wheat per yearAPPMPPAPP = TPP / LNumber offarm workers (L)Number offarm workers (L)

  • Wheat production per year from a particular farmTonnes of wheat per yearTPPTonnes of wheat per yearAPPMPPbDiminishing returnsset in hereNumber offarm workers (L)Number offarm workers (L)b

  • Wheat production per year from a particular farmTonnes of wheat per yearTPPTonnes of wheat per yearAPPMPPbddNumber offarm workers (L)Number offarm workers (L)Maximumoutputb

  • Wheat production per year from a particular farmTonnes of wheat per yearTPPTonnes of wheat per yearAPPMPPbbddNumber offarm workers (L)Number offarm workers (L)Slope = TPP / L= APPcc

  • Iso-quantsAn iso-quant is a curve or line that has various combinations of inputs that yield the same amount of output.

  • Production functionHere 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 ANALYSISIso-quantstheir shapediminishing marginal rate of substitutionisoquants and returns to scaleisoquants and marginal returnsIso-costsslope and position of the isocostshifts in the isocost

  • Unitsof K402010 6 4Unitsof L 512203050Point ondiagramabcdeaUnits of labour (L)Units of capital (K)An isoquant

  • Unitsof K402010 6 4Unitsof L 512203050Point ondiagramabcdeabUnits of labour (L)Units of capital (K)An isoquant

  • An isoquantUnitsof K402010 6 4Unitsof L 512203050Point ondiagramabcdeabcdeUnits of labour (L)Units of capital (K)

  • MRTSThe 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:

  • Units of capital (K)Units of labour (L)ghDK = 2DL = 1isoquantMRS = 2MRS = DK / DLDiminishing marginal rate of factor substitution

    Sheet:

  • Units of capital (K)Units of labour (L)ghjkDK = 2DL = 1DK = 1DL = 1Diminishing marginal rate of factor substitutionisoquantMRS = 2MRS = 1MRS = DK / DL

    Sheet:

  • An isoquant mapUnits of capital (K)Units of labour (L)I1

    Sheet:

  • I2Units of capital (K)Units of labour (L)An isoquant mapI1

    Sheet:

  • I2I3Units of capital (K)Units of labour (L)An isoquant mapI1

    Sheet:

  • I2I3I4Units of capital (K)Units of labour (L)An isoquant mapI1

    Sheet:

  • I1I2I3I4I5Units of capital (K)Units of labour (L)An isoquant map

    Sheet:

  • 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. Its a set of points with the same cost, C. Lets 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/RC/WAn isocost line

  • Bundles of: Labor Machine rental with C = Rs30 (Rs6 per labor hour) (Rs3 per machine hour)a0 10b1 8c2 6d3 4e4 2f5 0A Numerical ExamplePoints a through f lie on the isocost line for C = Rs30/hour.

  • The Isocost Line0 1 2 3 4 5 6 7 8 9 10246810Labor, L (worker-hours employed)Capital, K (machines rented)abcdef

  • The Isocost Line0 1 2 3 4 5 6 7 8 9 10Labor, L (worker-hours employed)Capital, K (machines rented)Cost = Rs30R = Rs3/machineW = Rs6/hour246810abcdef

  • Learning ObjectivesCalculate and graph a firms isocost lineWork out how the isocost line changes when resource prices or total cost changeMake a map of production recipes (technology) using isoquantsExplain the choices that firms make

  • The Isocost LineWage-rental ratioWith 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 Price0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)246810Labor, L (worker-hours employed)afCost = Rs30; R = Rs3/machineThe money wage, W = ...Rs6Rs10A Change in Wh

  • Changes in One Resource Price0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)246810Labor, L (worker-hours employed)aCost = Rs30; R = Rs3/machineThe money wage, W = ...A Change in W

  • Changes in Cost0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)

    246810Labor, L (worker-hours employed)ghA Change in Cost; every point between g and h costs Rs18.W = Rs6; R = Rs3;C = Rs30

  • Changes in Cost0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)

    246810Labor, L (worker-hours employed)ghA Change in Cost; every point between g and h costs Rs18.W = Rs6; R = Rs3;C = Rs30

  • Cost Minimization0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)

    246810Labor, L (worker-hours employed)aequ.W = Rs6; R = Rs3;C = Rs30Choose the recipe where the desired isoquant is tangent to the lowest isocost.C = Rs1812C = 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/MPKThis will be demonstrated on the board.

  • An isocostUnits of labour (L)Units of capital (K)Assumptions

    PK = Rs20 000 W = Rs10 000TC = Rs300 000TC = Rs300 000a

  • Units of labour (L)Units of capital (K)TC = Rs300 000abAssumptions

    PK = Rs20 000 W = Rs10 000TC = Rs300 000An isocost

  • Units of labour (L)Units of capital (K)TC = Rs300 000abcAssumptions

    PK = Rs20 000 W = Rs10 000TC = Rs300 000An isocost

  • Units of labour (L)Units of capital (K)TC = Rs300 000abcdAssumptions

    PK = Rs20 000 W = Rs10 000TC = Rs300 000An isocost

  • ISOQUANT- ISOCOST ANALYSISLeast-cost combination of factors for a given outputpoint of tangencycomparison with marginal productivity approachHighest output for a given cost of production

  • Finding the least-cost method of productionUnits of labour (L)Units of capital (K)AssumptionsPK = Rs20 000W = Rs10 000TC = Rs200 000TC = Rs300 000TC = Rs400 000TC = Rs500 000

    Sheet:

  • Units of labour (L)Units of capital (K)Finding the least-cost method of productionTPP1

    Sheet:

  • Units of labour (L)Units of capital (K)Finding the least-cost method of productionTC = Rs400 000rTPP1

  • Units of labour (L)Units of capital (K)Finding the least-cost method of productionTC = Rs400 000TC = Rs500 000srtTPP1

    Sheet:

  • Finding the maximum output for a given total costTPP1TPP2TPP3TPP4TPP5Units of capital (K)Units of labour (L)O

  • OIsocostUnits of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5Finding the maximum output for a given total cost

  • OrvUnits of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5Finding the maximum output for a given total cost

  • OsuUnits of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5rvFinding the maximum output for a given total cost

  • OtUnits of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5rvsuFinding the maximum output for a given total cost

  • OK1L1Units of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5rvsutFinding the maximum output for a given total cost

  • Properties of Iso-QuantAn 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 originConvexity of isoquants implies two things.

    substitution between the two inputs, and

    diminishing marginal rate of technical substitution (MRTS) between the inputs in the economic region.

    The MRTS is defined as, = slope of the isoquant.

    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.

  • This rate is indicated by the slope of the isoquant.

    The MRTS decreases for two reason:

    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.,

  • Isoquants are non-intersecting and non-tangential. This implies that in terms of output.

  • 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.

  • Economic regionQ1Economic 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.

  • The laws of returns to scaleThe 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 possibilitiesTotal output may increase more than proportionately.

    Total output may increase proportionately and

    Total output may increase less than proportionately

  • kinds of returns to scaleIncreasing returns to scale;

    Constant returns to scale, and

    Diminishing returns to scale.

  • Increasing returns to scaleWhen 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 scaleThe 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%.OCapital (K)

  • Economies of scaleThe scale of production has an very important bearing on the cost of production.

    It is the manufacturers 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 ScaleThese 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 scaleTechnical 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 EconomiesLabour 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 relationsFor 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 EconomiesAvailability 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 scaleWhen the increase in output is proportionate to the increase in inputs it exhibits constant returns to scale. Fig. Constant Return to Scale Capital (K)

  • 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.

  • Capital (K)Decreasing Return to Scalea

  • INTERNAL DISECONOMIESLarge 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 DiseconomiesConstraints in the Supply of raw-material.

    Demand for labour will increase due to growth of industry.

    Instabilities of demand for the product

  • Economies of ScopeWhen 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 scaleWhen the % change in output > % change in inputsE.g. a 30% rise in factor inputs leads to a 50% rise in outputLong run average total cost will be falling

    Decreasing returns to scale When the % change in output < % change in inputsE.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 inputsE.g when a 10% increase in all factor inputs leads to a 10% rise in total outputLong run average total cost will be constant

  • Consumer SurplusThe 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 DefinationIt 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.

    Consumers surplus = MU (Price * No. of units of a commodity purchased.)

  • Consumer Surplus and DMUThe 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 consumers 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 customers willingness to is greater than the price he actually pays for them.

    Because the price of all units are same.

  • Consumer SurplusIt 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 SurplusTotal 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 12012821812631612441412251212061012-2Consumer Surplus (from 5 Units) =20

  • The consumer surplusof purchasing 5 units is the sum of thesurplus derived from each one individually. Consumer Surplus 8 + 6 + 4 + 2 + 0 + -2 = 20 Consumer Surplus - ExamplePrice of XPrice (Rs)23456130114101214161820Will not buy more than 5 because surplus from additional units is negative

  • Consumer SurplusThe 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.

  • ConsumerSurplusConsumer SurplusPrice of XPrice (Rs.)23456011220

  • Consumer Surplus and Market PriceA 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?QuantityConsumer Surplus at Price P2 vs. at Price P1 Price0

  • Consumer SurplusPoQo

  • Change in Consumer Surplus: Price IncreaseQuantity

  • 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 sellers cost.

    It is the area above the supply curve, and below the equilibrium price.

  • Producer SurplusPoQoS

  • Consumer and Producer SurplusPoQoSProducer SurplusConsumer SurplusD

  • The magic of perfectly competitive marketsAt 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 production.

  • FIXED, VARIABLE, AND INCREMENTAL COSTSFixed 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 facilitiesgeneral management and administrative salarieslicense feesinterest costs on borrowed capital.

    Fixed costs will be affected When:large changes in usage of resources occurplant expansion or shutdown is involved

  • FIXED, VARIABLE AND INCREMENTAL COSTSVariable 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 COSTSIncremental 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 COSTA 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 ResearchCompanies 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 costAn 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 dont pick is the opportunity cost. The rabbit is Saras opportunity cost and the skateboard is Andys opportunity cost.

  • Social CostBuilding a new railway $100 millionCreating pollution nearby (e.g. cutting trees, noises) $5 millionSocial 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 historical cost and the amount $40,000 is the replacement cost.

  • Money CostMoney 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 CostReal 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 CostAccounting 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 CostEconomic 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 CostThe 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 CostSocial 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 ConceptsI. Total Costs (TC) whatever total cost is for any level of output sum of all costsTwo 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 inputsNote: TC = TFC + TVC

  • Understanding Fixed, Variable, Total costNumber 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 ConceptsCost(Rs)Output (or TP or Q)Graph of Total Cost ConceptsTCTVCTFC(TFC)

  • Wheat production per year from a particular farmTonnes of wheat per yearTPPTonnes of wheat per yearAPPMPPbbddNumber offarm workers (L)Number offarm workers (L)Slope = TPP / L= APPcc

  • Cost ConceptsII. Average Total Costs (ATC) Total Cost Per Unit of OutputTwo Sub-Components: (A) Average Fixed Cost: (B) Average Variable Cost: TwoAverageCosts!!Note: ATC = AFC + AVC

  • Cost ConceptsIII. Marginal Costs (MC) : Increase in Total Cost that results from an increase in output

  • The Short Run Cost FunctionAdd ATC = AFC + AVC to the table

  • The Short Run Cost FunctionATC = AFC + AVC

  • Cost ConceptsCost(Rs)OutputGraph of Average & Marginal Cost ConceptsAVCAFCATCMCQ2Q1

  • Cost Concepts(1) When marginal is below average average is falling.(2) When marginal is above average average is rising.(3) When marginal is equal average average is at its lowest point.Note : There is a certain correspondence between productconcepts and cost concepts.Summary of Relationship Between Marginal Cost & Average CostWhen AVC is at its minimum, AP will be at its maximum.When MC is at a minimum, MP will be at its maximum.(See diagram in book.)

  • *

  • The Short Run Cost FunctionProduction cost graph or map is

  • The Short Run Cost FunctionImportant Map ObservationsAFC 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 FunctionA 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 FunctionA 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 per Unit(Rs)(LRAC)Q (Output)Plots the relationship between the lowest attainable Average Cost and output when both capital (or plant size) and labor can be varied.LRAC0C1Q1C2Q2Attainable CostsUnattainable Costs

  • Relationship Between SATC & LRACShort-Run & Long-Run CostsAverage Costs per Unit (Rs) Q (Output)0SATC1SATC2SATC3LRACLMCSMC1

  • Relationship Between SATC & LRACShort-Run & Long-Run CostsAverage Costs per Unit (Rs)Q (Output)0LRACXXminXX = minimum point

  • Long-Run Average Cost CurveSlope of LRAC0 to Qm: Economies of ScaleQm Rightward: Diseconomies of Scale* Qm 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 LRACConstant Returns to Scale : LRAC curve is horizontalAverage Cost per Unit (Rs)Q (Output)LRAC0Average Cost per Unit (Rs)Q (Output)LRAC0ORDoubling Input spending always leads to a doubling of output.

  • Other Possible Shapes for LRACContinually Decreasing CostsAverage Cost per Unit (Rs)Q (Output)LRAC0Decreasing Cost!!!

  • Minimum Efficient ScaleDefinition : The smallest quantity of output at which long-run average cost reaches its lowest level.

  • A Perfectly Competitive MarketFor a market to be perfectly competitive, six conditions must be met: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 givenThe number of firms is large any one firms 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 MarketThere are no barriers to entry barriers to entry are social, political, or economic impediments that prevent firms from entering a market. Firms products are identical this requirement means that each firms output is indistinguishable from any other firms output There is complete information all consumers know all about the market such as prices, products, and available technology Selling firms are profit-maximizing entrepreneurial firms firms must seek maximum profit and only profit

  • Total Revenue of a Competitive FirmTotal revenue for a firm is the selling price times the quantity sold.TR = P Q

  • Average Revenue of a Competitive FirmAverage revenue is the revenue per unit sold P = AR.This is simply because all units sold are sold at the same price.

  • Marginal Revenue of a Competitive FirmMarginal Revenue is the increase () in total revenue when an additional unit is sold.MR = TR / Q

  • Revenue of a Perfectly Competitive FirmTotal Revenue: The amount of money received when the firm sells the product, i.e.,Total Revenue = Price of the product Quantity of the product soldTR = P QSince 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 soldAR = TR/Q = PMarginal Revenue = Additional revenue earned from selling an additional unit of the product.MR = TR/Q = PThus, for a competitive firm AR = P = MR

  • Total Revenue: PQ

    TP = QPTR ARMR0300010330332537533503150337032103385325533953285331003300331013303339532853385325533

  • The Revenue of a Competitive FirmIn 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 firms 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 firms goal is to make maximum economic profit, given the constraints it faces.So the firm must decide:1. How to produce at minimum cost2. What quantity to produce3. Whether to enter or exit a marketWe start by looking at the firms output decision.

  • Profit Maximization by the Competitive Firm: Approach I: Total Profit = TR TCOn 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.

    LTP = QTR TCProfit000808011030105-7522575130-55350150155-5470210180305852552055069528523550710030025545810130328023995285305-201085255330-75

    Chart6

    80.000.00

    105.0030.00

    130.0075.00

    155.00150.00

    180.00210.00

    205.00255.00

    230.00285.00

    255.00300.00

    280.00303.00

    305.00285.00

    330.00255.00

    TC

    TR

    Output

    TC, TR, & Profit

    Sheet1

    XTPPTFCTVCTCTPPAFCAVCATCMCPYTPPTRTPPARTPPMRProfit

    0.000.0080.000.0080.000.003.000.000.000.000.00-80.00

    1.0010.0080.0025.00105.0010.008.002.5010.502.503.0010.0030.0010.003.0010.003.00-75.00

    2.0025.0080.0050.00130.0025.003.203.005.201.673.0025.0075.0025.003.0025.003.00-55.00

    3.0050.0080.0075.00155.0050.001.601.503.101.003.0050.00150.0050.003.0050.003.00-5.00

    4.0070.0080.00100.00180.0070.001.141.432.571.253.0070.00210.0070.003.0070.003.0030.00

    5.0085.0080.00125.00205.0085.000.941.472.411.673.0085.00255.0085.003.0085.003.0050.00

    6.0095.0080.00150.00230.0095.000.841.582.422.503.0095.00285.0095.003.0095.003.0055.00

    7.00100.0080.00175.00255.00100.000.801.752.555.003.00100.00300.00100.003.00100.003.0045.00

    8.00101.0080.00200.00280.00101.000.791.982.7725.003.00101.00303.00101.003.00101.003.0023.00

    9.0095.0080.00225.00305.0095.000.842.373.21-4.173.0095.00285.0095.003.0095.003.00-20.00

    10.0085.0080.00250.00330.0085.000.942.943.88-2.503.0085.00255.0085.003.0085.003.00-75.00

    Sheet1

    TFC

    TVC

    TC

    Output

    Costs

    TFC, TVC, and TC Curves

    Sheet2

    AFC

    AVC

    ATC

    MC

    Output

    Costs/Unit

    AFC, AVC, ATC, and MC Curves

    Sheet3

    TR

    Output

    Dollars

    Total Revenue

    AR

    Output

    $/Unit

    MR

    Output

    $/Unit

    MR

    TC

    TR

    Output

    Dollars

    TC, TR, & Profit

  • The Firms Output DecisionProfit-Maximizing OutputA perfectly competitive firm chooses the output that maximizes its economic profit.One way to find the profit-maximizing output is to look at the firms the total revenue and total cost curves.Figure on the next slide looks at these curves along with the firms total profit curve.

  • The Firms Output DecisionPart (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 Firms Output DecisionAt low output levels, the firm incurs an economic lossit cant cover its fixed costs.At intermediate output levels, the firm makes an economic profit.

  • The Firms Output DecisionAt high output levels, the firm again incurs an economic lossnow the firm faces steeply rising costs because of diminishing returns.The firm maximizes its economic profit when it produces 9 sweaters a day.

  • Max ProfitMax OutputProfit Maximization by the Competitive Firm: Approach I: Total Profit = TR TC

  • Profit Maximization by the Competitive Firm: Approach II: MR = MCMost 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 = MCThe 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.

    LQTR MRTCMCProfit00080801103031052.50-752257531301.67-5535015031551.00-547021031801.253058525532051.675069528532353.0055710030032555.00458101303328025.0239952853305-4.17-2010852553330-2.50-75

    Chart9

    0.000.00

    3.002.50

    3.001.67

    3.001.00

    3.001.25

    3.001.67

    3.002.50

    3.005.00

    3.0025.00

    3.0095.00

    3.0085.00

    MR

    MC

    Output

    MR, MC, & Profit

    Sheet1

    XTPPTFCTVCTCTPPAFCAVCATCMCPYTPPTRTPPARTPPMRProfit

    0.000.0080.000.0080.000.003.000.000.000.000.00-80.00

    1.0010.0080.0025.00105.0010.008.002.5010.502.503.0010.0030.0010.003.0010.003.00-75.00

    2.0025.0080.0050.00130.0025.003.203.005.201.673.0025.0075.0025.003.0025.003.00-55.00

    3.0050.0080.0075.00155.0050.001.601.503.101.003.0050.00150.0050.003.0050.003.00-5.00

    4.0070.0080.00100.00180.0070.001.141.432.571.253.0070.00210.0070.003.0070.003.0030.00

    5.0085.0080.00125.00205.0085.000.941.472.411.673.0085.00255.0085.003.0085.003.0050.00

    6.0095.0080.00150.00230.0095.000.841.582.422.503.0095.00285.0095.003.0095.003.0055.00

    7.00100.0080.00175.00255.00100.000.801.752.555.003.00100.00300.00100.003.00100.003.0045.00

    8.00101.0080.00200.00280.00101.000.791.982.7725.003.00101.00303.00101.003.00101.003.0023.00

    9.0095.0080.00225.00305.0095.000.842.373.21-4.173.0095.00285.0095.003.0095.003.00-20.00

    10.0085.0080.00250.00330.0085.000.942.943.88-2.503.0085.00255.0085.003.0085.003.00-75.00

    Sheet1

    TFC

    TVC

    TC

    Output

    Costs

    TFC, TVC, and TC Curves

    Sheet2

    AFC

    AVC

    ATC

    MC

    Output

    Costs/Unit

    AFC, AVC, ATC, and MC Curves

    Sheet3

    TR

    Output

    Dollars

    Total Revenue

    AR

    Output

    $/Unit

    MR

    Output

    $/Unit

    MR

    TC

    TR

    Output

    Dollars

    TC, TR, & Profit

    MR

    MC

    Output

    $/Unit

    MR, MC, & Profit

  • The Firms Output DecisionMarginal Analysis and Supply DecisionThe 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 Firms Output DecisionAt high output levels, the firm again incurs an economic lossnow the firm faces steeply rising costs because of diminishing returns.The firm maximizes its economic profit when it produces 9 sweaters a day.

  • The Firms Output DecisionIf 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 ProfitAVCMCQPATCFind output where MC = MR, this is the profit maximizing QP = D = MRMC = MRQprofit maxFind profit per unit where the profit max Q intersects ATC ATC at Qprofit maxPATCProfitsSince P>ATC at the profit maximizing quantity, this firm is earning profits

  • Determining Profits Graphically: A Firm with Zero Profit or LossesAVCMCQPATCMC = MRQprofit maxATC at Qprofit maxP


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