EMBA 1ST SEMESTER

BUSINESS ECONOMICS - ECO400

SESSIONAL#01

SUBMITTED TO: Ms. SAIRA HABIB

SUBMITTED BY: MUHAMMAD USMAN
REG. NO: SP15-EMBA-290
EMAIL : sp15emba290@vcomsats.edu.pk
DATED: 19 APRIL, 2014

Q.1
A consumers demand curve can be viewed as a summary of the optimal decisions that arise
from his or her budget constraint and indifference curves.
The consumer optimizes by choosing the point on his budget constraint that lies on the highest
indifference curve. Lets take an example of quantity demanded for both the Pizza and the Pepsi
at given budget constraint. As shown in the figure below optimal choice occurs at the highest
indifference curve at point where it intersects the budget constraint line. Point A on the overall
highest indifferent curve is outside our budget which means it is not possible to achieve under
the circumstances. Whereas Point B would result in a bit more quantity of Pepsi while
forsaking a larger quantity of Pizza so its not optimum. The optimum quantity of both the Pepsi
and Pizza is obtained at the intersecting point where curve I2 meets with the budget constraint
line.

However, with an increase in the income, budget line will shift outwards and upside. Thus, as a
result, consumer will be able to choose a better combination of goods on a higher indifference
curve. See the illustration on the next page for the demonstration of that effect. New budget line
due to the increased income intersects a higher indifference curve I2 thus generating a better
combination and optimal quantity of both goods.

The derivation of demand is a useful tool, often combined with a supply curve in order to
determine equilibrium prices and understand the relationship between consumer needs and what
is

readily

available

in

the

market.

The law of demand in economics pertains to the derivation and recognition of a consumer's
relative desire for a product or service coupled with a willingness and ability to pay for or
purchase that good. Consumer purchasing behavior is a complicated process weighing varying
products/services against a constantly evolving economic backdrop.
Although there are a wide array of prospective goods and services in a simultaneously changing
economic environment, the law of demand pursues the derivation of a demand curve for a given
product that benchmarks the relative prices and quantities desired by consumers in a given
marketplace. The defining relation between the price of a good and the relative amount of that
good consumers will demand provides a basis for recognizing demand curves in the broader
context of consumer choice and purchasing behavior.
Under the normal circumstances, normal goods will demonstrate a higher demand as a result of
lower prices and vice versa. The derivation of demand curves for normal goods is therefore
relatively predictable with respect to the direction of the slope on a graph. The downward slope

represented in this figure states a critical principle that a given price point will reflect a given
quantity demanded by a given marketplace, allowing suppliers and economists to measure the
value of a product/service based on a price/quantity analysis of consumer purchasing behaviors.

(Deriving the demand curve for normal goods)

(The above figure demonstrates the way in which economists can identify a series of prices and quantities for goods
demanded,

which

ultimately

represents

the

overall

demand

curve

for

given

product/service. )

One important consideration in demand curve derivation is the differentiation between demand
curve shifts and movement along the curve itself. Movement along the curve identifies that what
quantity will be purchased at different price points. This means that the factors that underlie
consumer desire for the product remains constant, though the quantity or price changes to a new
point along the curve. On the other hand, sometimes external factors can shift the actual demand

for a given good, pushing the demand curve outwards to the right and up, or inwards down and
left. This represents a significant change in the actual demand for that product rather than a
quantity or price shift at a fixed demand level.

Exceptional scenarios; Giffen Goods and Neutral Goods

It is vital to keep in mind that some goods do not follow the traditional assumption that higher
prices will always result in lower demand. Giffen goods and neutral goods act in contradiction to
this rule. Giffen goods demonstrate an increase in demand as a result of a price rise and the
neutral goods react indifferently to price in regards to the quantity demanded (illustrated as a
completely vertical demand curve).

(Deriving the demand curve for Giffen goods)

(Giffen goods are essentially goods that demonstrate an increase in demand as a result of an increase in
price, generally considered counter-intuitive in traditional economic models. This graph illustrates the
derivation
of
a
demand
curve
for
these
goods.)

Giffen Goods
In a situation where the income effect supersedes the substitution effect, creating an increase in
demand despite a rise in price. Goods such as high-end luxury items like expensive fashion often
demonstrate this type of counter-intuitive trend, where the high price of an item is attractive to
the consumer for the sake of displaying wealth.

Neutral Goods
Neutral goods, unlike Giffen goods, demonstrate complete inconsistency to price. Consumers
will pay any price to get a fixed quantity. These goods are often necessities, defying the standard
law of demand due to the fact that they must be purchased regardless of price/situation. A good
example of this is water or healthcare, where not getting what is required will have dramatic
consequences.

Q. 2
Various measures of cost
Different costs of production can be viewed as follows;

Total Cost
The total cost is simply all the costs incurred in producing a certain number of goods. So the total
cost of producing three goods is 600 and the total cost of producing five goods is 1200.
Total cost (TC) = Total fixed costs (TFC) + Total variable costs (TVC)

Fixed Cost
Costs that do not vary with the quantity of output produced. Fixed costs are business expenses
that are not dependent on the level of goods or services produced by the business. They tend to
be time-related, such as salaries or rents being paid per month.

Variable Cost
Costs that do vary with the quantity of output produced. Variable costs are expenses that change
in proportion to the activity of a business. Variable cost is the sum of marginal costs over all units
produced. It can also be considered normal costs.

For example, a firm pays for raw materials. When activity is decreased, less raw material is used,
and so the spending for raw materials falls. When activity is increased, more raw materials are
used and spending therefore rises. Note that the changes in expenses happen with little or no
need for managerial intervention. These costs are variable costs.
The table below describes the various measures of cost and their inter-relationship using the
quantity consumed of Pepsi cans at a given cost.

Average
Total
fixed
cost=F.C+V.C
cost=FC/Q

Average
variable
cost=VC/Q

Average
total cost=
AFC+AV
C

Marginal
cost
Change in
total
cost/change
in quantity
$0.3

Quantity

Fixed
cost

Varia
ble
cost

$3

$0.0

$3

---

---

---

0.3

3.3

$3.0

$0.30

$3.3

0.8

3.8

1.5

0.40

1.9

1.5

4.5

1.0

0.50

1.5

2.4

5.4

0.75

0.6

1.35

3.5

6.5

0.6

0.7

1.30

4.8

7.8

0.5

0.8

1.30

6.3

9.3

0.43

0.9

1.33

8.0

11.0

0.38

1.0

1.38

9.9

12.9

0.33

1.10

1.43

10

12

15.0

0.30

1.20

1.50

0.5
0.7
0.9
1.1
1.3
1.5
1.7
1.9
2.1

(Above table accurately illustrates the various measures of cost and their inter-relationship)

Average Total Cost

Total cost divided by the quantity of output. Average cost or unit cost is equal to total cost
divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of
average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed
costs divided by Q).

Average total cost = Total Cost / Quantity

Average Fixed Cost

Fixed cost divided by the quantity of output.
Average fixed cost = Fixed cost / Quantity

Average Variable Cost

Variable cost divided by the quantity of output.
Average variable cost = Variable cost / Quantity

Marginal Cost
The increase in total cost that arises from an extra unit of production. The increase or decrease in
the total cost of a production run for making one additional unit of an item. It is computed in
situations where the breakeven point has been reached: the fixed costs have already been
absorbed by the already produced items and only the direct (variable) costs have to be accounted
for.
Marginal cost = Change in total cost / Change in quantity
Marginal costs are variable costs consisting of labor and material costs, plus an estimated portion
of fixed costs (such as administration overheads and selling expenses). In companies where
average costs are fairly constant, marginal cost is usually equal to average cost. However, in
industries that require heavy capital investment (automobile plants, airlines, mines) and have
high average costs, it is comparatively very low. The concept of marginal cost is critically
important in resource allocation because, for optimum results, management must concentrate its
resources where the excess of marginal revenue over the marginal cost is maximum. It is also
called as choice cost, differential cost, or incremental cost.

Shapes of Cost Curves

Cost Curves
The short-run marginal cost (MC) curve will at first decline and then will go up at some point,
and will intersect the average total cost and average variable cost curves at their minimum points.

The average variable cost (AVC)

The average variable cost (AVC) curve will go down (but will not be as steep as the marginal
cost), and then go up. This will not go up as fast as the marginal cost curve.

The average fixed cost (AFC)

The average fixed cost (AFC) curve will decline as additional units are produced, and continue to
decline.

The average total cost (ATC)

The average total cost (ATC) curve initially will decline as fixed costs are spread over a larger
number of units, but will go up as marginal costs increase due to the law of diminishing returns.
The graph below illustrates the shapes of these curves.

Relationship between ATC and MC

When MC is below ATC, ATC must be declining. When MC is above ATC, ATC must be
rising. Therefore, MC crosses ATC at the minimum of ATC.

Relationship between ATC, AFC, and AVC

AFC + AVC = ATC